AC3091_vle Financial reporting

Financial reporting J. Haslam and D. Chow AC3091, 2790091

2012

Undergraduate study in Economics, Management, Finance and the Social Sciences This subject guide is for a 300 course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ). For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

The 2012 edition of this guide was prepared for the University of London International Programmes by: Professor J. Haslam, Heriot-Watt University and Dr D.Chow, Durham University It draws on previous editions of the guide prepared by J. Horton and S. Miles Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter Business School. It was revised and updated in 2007 by: S. Miles, PhD. Department of Accounting, The Business School, Oxford Brookes University. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2012 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents

Introduction ............................................................................................................ 1 Aims and objectives of this course ................................................................................. 1 Learning outcomes ........................................................................................................ 1 Syllabus......................................................................................................................... 1 How to use this guide .................................................................................................... 2 Essential reading ........................................................................................................... 3 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 Aims of the chapter ..................................................................................................... 11 Learning outcomes ...................................................................................................... 11 Essential reading ......................................................................................................... 11 Further reading............................................................................................................ 11 Financial accounting theory ......................................................................................... 12 Financial accounting and its role .................................................................................. 13 Financial accounting regulation ................................................................................... 15 Accounting standards: what form should they take? ..................................................... 17 Descriptions of accounting and its regulation ............................................................... 19 UK accounting regulation and the influence of international accounting standards ....... 20 Institutional setting for accounting regulation: the UK .................................................. 20 Statutory regulation: IASs/IFRSs gained force of law ..................................................... 22 Mandatory regulation: standard-setting and the case of the UK .................................... 23 Stock Exchange ........................................................................................................... 25 Reminder of learning outcomes.................................................................................... 26 Sample examination questions ..................................................................................... 27 Chapter 2: Conceptual framework ....................................................................... 29 Aims of the chapter ..................................................................................................... 29 Learning outcomes ...................................................................................................... 29 Essential reading ......................................................................................................... 29 Further reading............................................................................................................ 29 Definition of a conceptual framework........................................................................... 30 Rationale for a conceptual framework .......................................................................... 31 Advantages claimed for a conceptual framework .......................................................... 31 The US, IASC and UK initiatives compared .................................................................... 32 Objectives of financial reporting ................................................................................... 33 Qualitative characteristics of accounting information .................................................... 35 Elements of financial statements .................................................................................. 38 Recognition and measurement in financial statements SFAC 5, SOP .............................. 41 Presentation of financial information............................................................................ 44 Review of the conceptual framework .......................................................................... 45 Conclusions ................................................................................................................. 46 i

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Reminder of learning outcomes.................................................................................... 47 Sample examination questions ..................................................................................... 47 Chapter 3: Income measurement and capital maintenance ................................. 49 Aims of the chapter ..................................................................................................... 49 Learning outcomes ...................................................................................................... 49 Essential reading ......................................................................................................... 49 Further reading............................................................................................................ 49 A view of income and capital often characterised as the accountant’s view ................... 50 A view of income and capital often characterised as the economist’s view .................... 50 Hicks’s version of the economist’s concept of income.................................................... 51 Hicks’s income number 1 ............................................................................................. 51 Income ex ante and income ex post ............................................................................. 55 What if interest rates are expected to change? ............................................................. 58 Hicks’s income number 2 ............................................................................................. 60 Hicks’s income number 3 ............................................................................................. 64 Implications of Hicks’s measures of income .................................................................. 64 Implications for accountants ........................................................................................ 64 Reminder of learning outcomes.................................................................................... 66 Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values ......................................................................................................... 67 Aims of the chapter ..................................................................................................... 67 Learning outcomes ...................................................................................................... 67 Essential reading ......................................................................................................... 68 Further reading............................................................................................................ 68 Introduction ................................................................................................................ 68 Revising HCA .............................................................................................................. 69 Characteristics of HCA ................................................................................................. 70 Advantages of HCA ..................................................................................................... 70 Disadvantages of HCA ................................................................................................. 71 Alternatives to HCA ..................................................................................................... 73 Introducing CPP accounting ......................................................................................... 73 General and specific changes in price ........................................................................... 74 Profit recognition and capital maintenance .................................................................. 74 Assessing CPP accounting?.......................................................................................... 75 Converting from HCA to CPP: a step-by-step guide ...................................................... 76 Worked example and explanation of CPP ..................................................................... 78 Advantages of CPP ...................................................................................................... 82 Disadvantages of CPP .................................................................................................. 82 Introduction to current value accounting (CVA) ............................................................ 83 Replacement cost accounting (RCA) ............................................................................. 83 Net realisable value (NRV) ........................................................................................... 83 Present value (PV) ....................................................................................................... 84 Deprival value (DV) ...................................................................................................... 84 Holding gains and current operating profit ................................................................... 87 Capital maintenance concepts .................................................................................... 88 Current value accounting using replacement cost ........................................................ 91 Worked example and explanation of CVA..................................................................... 91 More on deprival value ................................................................................................ 96 Advantages and disadvantages of replacement cost ................................................... 100 Advantages and disadvantages of deprival value ........................................................ 101 ii

Contents

Combined CPP/CVA system ....................................................................................... 101 Reminder of learning outcomes.................................................................................. 107 Sample examination questions ................................................................................... 108 Chapter 5: Accounting for groups ...................................................................... 111 Aims of the chapter ................................................................................................... 111 Learning outcomes .................................................................................................... 111 Essential reading ....................................................................................................... 111 Further reading.......................................................................................................... 111 Introduction .............................................................................................................. 112 Key principles and rationales ...................................................................................... 113 Requirement for consolidated accounts ...................................................................... 116 Different models of group accounting ....................................................................... 117 Different types of relationships within a group ......................................................... 118 Accounting for subsidiaries ........................................................................................ 119 Merger accounting .................................................................................................... 138 Accounting for associates .......................................................................................... 138 Accounting for joint ventures ................................................................................... 142 Discussion ................................................................................................................. 145 Reminder of learning outcomes.................................................................................. 147 Sample examination questions ................................................................................... 148 Chapter 6: Accounting for foreign currencies .................................................... 151 Learning outcomes .................................................................................................... 151 Essential reading ....................................................................................................... 151 Further reading.......................................................................................................... 151 Introduction .............................................................................................................. 151 Foreign currency conversion: business transactions ..................................................... 152 Foreign currency translation: business transactions ..................................................... 153 Which exchange rate should be used to record foreign currency translations? ............ 155 Accounting for the closing rate method and the temporal method .............................. 157 Final thoughts ........................................................................................................... 162 Reminder of learning outcomes.................................................................................. 162 Sample examination question .................................................................................... 163 Chapter 7: Accounting for tangible non-current assets ..................................... 165 Aims of the chapter ................................................................................................... 165 Learning outcomes .................................................................................................... 165 Essential reading ....................................................................................................... 165 Further reading.......................................................................................................... 165 Tangible non-current assets (owned) .......................................................................... 166 Measurement of tangible non-current assets .............................................................. 166 Borrowing costs......................................................................................................... 167 Measurement after recognition: revaluation ............................................................... 168 Depreciation .............................................................................................................. 170 Tangible non-current assets (not owned): leases ......................................................... 179 Reminder of learning outcomes.................................................................................. 184 Sample examination questions ................................................................................... 185 Chapter 8: Intangible assets: goodwill and R&D ................................................ 187 Aims of the chapter ................................................................................................... 187 Learning outcomes .................................................................................................... 187 Essential reading ....................................................................................................... 187 Further reading.......................................................................................................... 187 iii

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Introduction .............................................................................................................. 188 Goodwill: the debate ................................................................................................. 188 Intangible assets (other than goodwill) ...................................................................... 194 Impairment: IAS 36.................................................................................................... 197 Research and development ........................................................................................ 198 International differences ............................................................................................ 200 Reminder of learning outcomes.................................................................................. 201 Sample examination question .................................................................................... 201 Chapter 9: Accounting for inventories and construction contracts ................... 203 Aims of the chapter ................................................................................................... 203 Learning outcomes .................................................................................................... 203 Essential reading ....................................................................................................... 203 Further reading.......................................................................................................... 203 Components of inventory ........................................................................................... 203 Implications of inventory for the accounts .................................................................. 204 Inventory valuation: definitions ................................................................................. 206 Implications of fair value accounting .......................................................................... 208 Construction contracts ............................................................................................... 208 Profit recognition methods......................................................................................... 208 Reminder of learning outcomes.................................................................................. 213 Sample examination question ................................................................................... 213 Chapter 10: Accounting for equity and liabilities .............................................. 215 Aims of the chapter ................................................................................................... 215 Learning outcomes .................................................................................................... 215 Essential reading ....................................................................................................... 215 Further reading.......................................................................................................... 215 Share capital and reserves ......................................................................................... 216 Ordinary shares ......................................................................................................... 216 Preference shares ...................................................................................................... 216 Accounting issues: equity or liability? ......................................................................... 217 Off-balance sheet financing ....................................................................................... 225 Reminder of learning outcomes.................................................................................. 226 Sample examination questions ................................................................................... 227 Chapter 11: Accounting for taxation .................................................................. 229 Aims of the chapter ................................................................................................... 229 Learning outcomes .................................................................................................... 229 Essential reading ....................................................................................................... 229 Further reading.......................................................................................................... 229 An introduction to corporation tax systems ................................................................ 230 UK: corporation tax.................................................................................................... 230 Deferred taxation: taxable profit versus accounting profit ........................................... 233 Three approaches to the accounting treatment of deferred tax.................................... 235 Value-added tax (VAT) ............................................................................................... 238 Reminder of learning outcomes.................................................................................. 238 Sample examination questions ................................................................................... 239 Chapter 12: Analysis and interpretation of financial reports............................. 241 Learning outcomes .................................................................................................... 241 Essential reading ....................................................................................................... 241 Further reading.......................................................................................................... 241 Introduction to the interpretation of financial statements ........................................... 241 iv

Contents

Ratio analysis – introduction ...................................................................................... 242 Cash flow statement.................................................................................................. 246 Trend analysis ............................................................................................................ 246 International differences ............................................................................................ 247 Reminder of learning outcomes.................................................................................. 249 Sample examination questions ................................................................................... 250 Appendix 1: Sample examination paper ............................................................ 251 Appendix 2: Solutions to activities and sample examination questions............ 259 Chapter 3 .................................................................................................................. 259 Chapter 4 .................................................................................................................. 259 Chapter 5 .................................................................................................................. 265 Chapter 6 .................................................................................................................. 269 Chapter 7 .................................................................................................................. 272 Chapter 8 .................................................................................................................. 278 Chapter 9 .................................................................................................................. 279 Chapter 10 ................................................................................................................ 285 Chapter 12 ................................................................................................................ 286 Appendix 3: Example of eight-column accounting paper ................................. 287

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Notes

vi

Introduction

Introduction What is or should be the role of accounting in society? How important is or might be accounting in this respect? In what sense is and should accounting be regulated? You may have encountered the financial accounting statements of companies, a major focus here, as part of your work or as a shareholder or other user. These statements will probably have been prepared by accountants and audited by an independent firm of auditors. The statements would still require some analysis by the user, for instance: Which figures are subject to management discretion? Which figures depend on accounting choice? How can you distinguish between two companies with identical earnings? How should accounting be regulated? Who should regulate or organise the production of accounting? This subject guide is concerned with helping you to develop an understanding of financial accounting consistent with the aims and objectives of the course specified below.

Aims and objectives of this course The Financial reporting syllabus is concerned with the theory and practice of financial accounting. This involves a sound understanding of the concepts and choices that underlie measurement and disclosure in financial statements. The aims and objectives of the course are to: • stimulate theoretical enquiry into financial accounting issues • develop your knowledge and understanding of financial accounting • prepare you for further academic study in accounting and related areas • enable you to pursue a professional accountancy qualification • equip you for employment in areas where an understanding of accounting issues and tools is helpful.

Learning outcomes At the end of this course and having completed the Essential readings and activities, you should be able to: • explain and apply a number of theoretical 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. The learning outcomes that you are expected to achieve for the various topics are listed at the end of each chapter.

Syllabus The rationale for financial reporting. Arguments for and against regulation of financial reporting. Methods or regulation, including standarisation of accounting practices. The nature and purposes of a conceptual framework for financial reporting: the objectives of financial reporting; the qualitative 1

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characteristics of accounting information; the definitions of an asset and a liability; recognition and measurement in financial statements; international framework. Narrative reporting and issues of corporate social responsibility. Economic and accounting concepts of income, capital and value with particular reference to Hicks’ income concepts. Strengths and weaknesses of historical cost accounting. Bases of asset valuation. Capital maintenance concepts and various associated techniques: current value accounting systems, current purchasing power accounting, replacement cost accounting; in addition to entry (historical cost) and exit value accounting. Accounting for investments and groups of companies. The merger and acquisition methods. Associated companies and joint ventures. Accounting for foreign currency transactions, foreign subsidiaries and branches: the temporal and closing rate/net investment methods of foreign currency translation. Accounting for tangible and intangible assets: fixed assets and depreciation; stocks and long-term contracts; research and development; goodwill. Accounting for leases. Accounting for liabilities. Accounting for taxation, including deferred taxation. Analysis and interpretation of corporate financial reports; introduction to international differences in financial reporting.

Accounting standards in this subject guide This subject guide is written for International Programmes students, who will be studying in many different countries subject to different accounting rules and regulations. The International Accounting Standards Board (IASB) is quickly becoming the generally accepted accounting regulator at the international level. In the EU and Australia, for example, all listed companies are required to produce group financial statements in accordance with current International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) – the latter are gradually replacing the former as the IASs come to be updated and revised. Many other countries such as the USA and China are working towards closing the convergence gap between IASs/IFRSs and national regulations. This subject guide has been written with this in mind. The subject guide has an international focus but within that we give some particular consideration to the UK (e.g. in the context of accounting for changing prices) because it serves to illustrate some key developments. All worked examples use £ sterling as the currency. A list of abbreviations reflecting the emphases of the guide is given at the end of the Introduction.

How to use this guide This subject guide is intended to supplement the Essential reading, not to replace it. It should be read in conjunction with the Essential reading and supported by Further reading. The list of Further reading is a selection from many possible sources. Please seek additional reading on any topics that you find difficult to grasp. Please note that, given the rapid pace of change in financial accounting, you should use the latest editions of texts, particularly the Essential reading text for the course. In addition to the Essential reading listed at the beginning of each chapter, you should read the appropriate available accounting practitioner journal 2

Introduction

(e.g. Accountancy and Certified Accountant in the UK). Journals of other professional accountancy bodies in other countries are just as relevant. It may also be useful for you to obtain a copy of the Annual Reports and Accounts of a large company in your country. This will provide you with a good reference aid for some of the main issues addressed in this guide. You can generally obtain these reports on the company’s website. Alternatively you could write to the company asking for a copy of their report.

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.iasb.org.uk for the International Accounting Standards Board (IASB). Unless otherwise stated, all websites in this subject guide were accessed in April 2012. 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 12 chapters, the majority of which are self-contained. Most 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 of them require you to do additional reading. Solutions to some of the activities and sample examination questions are available in Appendix 2 at the back of the guide.

Sample examination questions There are sample examination questions at the end of each chapter, aimed to test your knowledge and prepare you for the examination. However, the Sample examination paper in Appendix 1 is a more accurate reflection of the type of questions that are likely to come up in the examination.

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 financial accounting textbooks. References for specific Further reading will also be given where appropriate. You are advised to check if new editions of these textbooks are available.

Essential reading Alexander, D., A. Britton and A. Jorissen International Financial Reporting and Analysis. (Andover: Cengange Learning EMEA, 2011) fifth edition [ISBN 9781408032282]. Hereafter, we will refer to this book simply as International Financial Reporting.

Detailed reading references in this subject guide refer to the editions of the set textbooks listed below. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check 3

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the virtual learning environment (VLE) regularly for updated guidance on readings.

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 free 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].

You might find it helpful to refer to a dictionary of accounting when you encounter a new term. Two such dictionaries are: Nobes, C. The Penguin Dictionary of Accounting. (London: Penguin Books Ltd, 2006) second edition [ISBN 9780141025254]. Owen, G. Dictionary of Accounting. (Oxford: Oxford University Press, 2005) third edition [ISBN 9780192806277].

It is also recommended that you purchase or have access to the following reference texts: Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGrawHill, 2011) second European edition [ISBN 9780077126735]. Glautier, M.W.E., B. Underdown and D. Morris Accounting Theory and Practice. (Harlow: Financial Times Prentice Hall, 2011) eighth edition [ISBN 9780273693857]. Please note that this is the Essential reading for 25 Principles of accounting so you may already own a copy. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Palepu, K.G., and P.M. Healy Business Analysis and Valuation: Using Financial Statements. (Mason, OH: Thomson South-Western, 2008) fourth edition [ISBN 9780324302929].

Suitable international texts for reference include: Nobes, C. and R. Parker Comparative International Accounting. (Harlow: Financial Times Prentice Hall, 2012) twelfth edition [ISBN 9780273763796]. Choi, F.D. and G.K. Meek International Accounting. (Harlow: Pearson, 2012) seventh edition [ISBN 9780132311496].

Those of you who have studied 25 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, 1971) [ISBN 042114470X]. Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984) [ISBN 9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201). Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting Review 54(1) 1979. 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: PrenticeHall, 1981) [ISBN 9780133161335]. Chapter 7. 4

Introduction Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing, 1992) [ISBN 9780273034643] Chapters 3, 4, 10–12. (Although this focuses specifically on FASBs Conceptual Framework, it also discusses a number of issues about the conceptual framework approach that can be considered in relation to the IASB’s Framework for the Preparation and Presentation of Financial Statements and the ASBs Statement of Principles.) Cadbury report (1992). Available at www.iia.org.uk – search for ‘Cadbury report’. Company Law Review Steering Group, Company Law Reform. Modern Company Law for a Competitive Economy: Developing the Framework. Available at www.berr.gov.uk/files/file23245.pdf Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An Assessment of the Effective Annual Rate Method as a Basis for Making Accounting Allocations’, Journal of Business Finance & Accounting 20(1) 1993, pp.56–63. Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic dimensions of accounting in the global context: the IASB and accounting disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64. Hicks, J.R. ‘Income’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]. Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition [ISBN 9780198282693] Chapter 14. Holmes, G., A. Sugden and P. Gee Interpreting Company Reports and Accounts. (Harlow: Prentice-Hall, 2008) tenth edition [ISBN 9780273711414] Chapters 4, 10 and 11. Ijiri, Y. ‘A Defence for Historical Cost Accounting’ in R. Sterling (ed.) Asset Valuation and Income Determination. (Lawrance, KA: Scholars Book Co., 1971) [ISBN 9780914348115]. Macve, R. ‘Accounting for Long-Term Loans’, in B. Carsberg and S. Dev (eds) External Financial Reporting. (Harlow: Prentice Hall, 1984). Macve, R. A Conceptual Framework For Financial Accounting and Reporting: the Possibilities for an Agreed Structure. (London: Institute of Chartered Accountants in England and Wales, 1981) [ISBN 9780852913116]. Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940. Peerless, S. ‘Accounting for Business Marriages’, Accountancy Magazine, October 1994, p.100. Prakesh, P. and S. Sunder ‘The Case Against Separation of Current Operating Profit and Holding Gains’, American Accounting Review, January 1979 (pp.1–22). Sandilands Report, Inflation Accounting: Report of the Inflation Accounting Committee, Cmnd. 6225 (London: HMSO, 1975). Chapters 10 and 12 (pp.159–65). Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011) [ISBN 9780135119150]. Smith, T. Accounting for Growth. (London: Century, 1996) second edition [ISBN 9780712675949]. Chapter 16. Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]. Weetman, P. (ed.) SSAP 15 Accounting for Deferred Taxation. (Edinburgh: The Institute of Chartered Accountants in Scotland, 1992) [ISBN 9781871250237]. Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge: Cambridge University Press, 1983) [ISBN 9780521270557].

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Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you forget your login details at any point, please email uolia.support@ london.ac.uk quoting your student number.

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: • Self-testing activities: Doing these allows you to test your own understanding of subject material. • Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered. • A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. • Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions. • Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available. • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. • Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you 6

Introduction

will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

Changes to the syllabus The material contained in this subject guide reflects the syllabus for the year 2012–2013. The field of accounting changes regularly, and there may be updates to the syllabus for this course that are not included in this subject guide. Any such updates will be posted on the VLE. It is essential that you check the VLE at the beginning of each academic year (September) for new material and changes to the syllabus. Any additional material posted on the VLE will be examinable.

Preparation for the examination Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. Remember, it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered. With regard to this subject guide, you should: • refer to the Essential reading and any Further reading you might require to fully understand the topics in the syllabus • attempt all the activities in each chapter • complete all the sample examination questions. We also recommend that you read through the section on examinations in Strategies for success. It contains some useful guidelines on preparing for examinations.

Format of the examination The examination could cover any of the subjects that are addressed in this syllabus. The examination is three hours long, and you are normally required to answer four questions from a choice of seven. These will be a mixture of essay-style questions and computation with discussion questions. You therefore need to concentrate on both the qualitative and quantitative characteristics of the topics. You cannot rely purely upon, for 7

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example, the computation aspects to pass the examination. The entire syllabus is examinable. Appendix 1 contains a Sample examination paper and Appendix 2 contains solutions to activities and to Sample examination questions. Note that solutions are available only for selected activities and questions. The examination also has an additional 15 minutes which is given as reading time. You may begin writing at any point after the start of the examination (which remains three hours in length). The total time available to you in the examination hall will therefore be 3 hours and 15 minutes.

Overview of the guide As emphasised throughout this subject guide, accounting is a communication tool. The business entity communicates financial information to interested parties (e.g. potential and existing shareholders, creditors, managers, employees, NGOs, suppliers, the government, etc.) in the form of financial statements. These financial statements will in themselves impart information about the economic resources of the entity which are under the control of management. Policy-makers (e.g. standard-setters) and others helping to shape accounting (including practising accountants) have to ask themselves a number of basic questions before they can even begin to construct the financial statements. For example: • Which disclosures and figures should be included in these Financial accounting statements? How much detail should be given? • How should these figures be calculated? • Who are the users of this information? • Will they find the figures useful for their decisions and purposes? What is accounting’s role? T. Smith quotes an old joke which summarises some criticisms of accounting: An old man was lost in a hot air balloon. Fortunately he saw someone walking in a field below him so he lost height and when he was within range shouted ‘Can you tell me where I am?’ The walker stopped paused for thought and shouted back ‘You’re in a hot air balloon.’ ‘You must be an accountant’ retorted the balloonist. ‘Amazing’, said the walker. ‘How did you know that?’ ‘Because the information you just gave me was both totally accurate and completely useless!’ (Smith, T. Accounting for Growth, 1996, p.73)

Chapter 2 of this subject guide addresses some key accounting issues: • What is and should be accounting’s role in society? • Who are the users? • What information would they benefit from? • What should the underlying criteria be: relevant information, reliable information, or both (if possible)? • In what sense is or should accounting be regulated? The remaining chapters consider a number of basic questions and issues that have been debated over the years when deciding upon which disclosures and figures should be reported in the accounts, for instance: 8

Introduction

• What alternative measurement methods are available? • Will they capture the underlying economic reality of the business? • Will they be useful and understandable to users? • Will the figures enable users to make optimal decisions concerning the allocation of their own scarce economic resources? • What do the standard-setters believe firms should be measuring and reporting, and why? • Are the standards theoretically and conceptually correct in requiring companies to report and measure certain figures? • Are the methods appropriate given the environment in which companies now operate? • What issues still need to be addressed and why? Chapters 3–4 deal with income measurement and capital maintenance (and also consider economic approaches, such as those proposed by Hicks), historical cost accounting, current purchasing power accounting and current value accounting. Chapters 5–12 are firmly based upon the modified historical cost/mixed measurement systems relating possibilities to the Hicks income concepts. We discuss implications if Hicksian theory and would also recommend Biekpe, N., M. Tippett and R. Willett ‘Accounting Earnings, Permanent Cash Flow And The Distribution Of The Earnings To Price Ratio’, The British Accounting Review 30(2) 1998, pp.105–40. We are concerned to point to the relevance of context and seek to broaden horizons on financial accounting. We consider possible futures for accounting.

Index of abbreviations used in this guide AEC

Annual equivalent costs

ASB

Accounting Standards Board

CBS

Consolidated Balance Sheet

CIS

Consolidated Income Statement

CPP

current purchasing power

CVA

current value accounting

DV

deprival value, also known as ‘value to the business’ or ‘value to the owner’.

EPS

earnings per share

EC

European Community

EU

European Union

FASB

Financial Accounting Standards Board

FIFO

first-in, first-out

FPPFS

Framework for the Preparation and Presentation of Financial Statements

FRS

Financial Reporting Standard

GPP

General Purchasing Power

HCA

Historical Cost Accounting

IAS

International Accounting Standard

IASB

International Accounting Standards Board

IASC

International Accounting Standards Committee 9

91 Financial reporting

IFRS

International Financial Reporting Standard

IOSCO International Organization of Securities Commissions

10

LIFO

last-in, first-out

NBV

net book value

NPV

net present value

NRV

net realisable value, also known as ‘current exit value’

P/E

price/earnings ratio

PV

present value, also known as ‘economic value’

RC

replacement cost, also known as ‘current entry cost’

ROCE

return on capital employed

RPI

Retail Price Index

SEC

Securities Exchange Commission

SOP

Statement of Principles

SSAP

Statement of Standard Accounting Practice

Chapter 1: Rationale for financial reporting and its regulation

Chapter 1: Rationale for financial reporting and its regulation 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 consideration of accounting regulation, including voluntary disclosure

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • delineate the basic character of financial accounting theory • discuss the role of accounting in society • explain the different levels of authority in the UK regulatory framework • explain and discuss the implications of the International Accounting Standards Board (IASB) • discuss the arguments for and against accounting standards • discuss the theory of regulation.

Essential reading International Financial Reporting, Chapter 1.

Further reading 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: PrenticeHall, 1981) [ISBN 9780133161335]. Chapter 7. Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 10 and 11. Cadbury report (1992); this can be viewed on the internet. See the website for the Institute of Internal Auditors: www.iia.org.uk followed by a search for ‘Cadbury report’. Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGrawHill, 2011) second European edition [ISBN 9780077126735] Chapters 1–4. Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic dimensions of accounting in the global context: the IASB and accounting disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498] Chapters 1–3. Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011) [ISBN 9780135119150].

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Financial accounting theory What is financial accounting? There are different understandings of it. Some would equate it to ‘external accounting’, which indicates an accounting that, in the case of the business firm, goes outside the organisation to owners not closely involved in internal business management or into the broader public realm. This is potentially a quite broad understanding of financial accounting. Interestingly, it could actually go beyond the financial, if including it, and may reflect very old notions of rendering an account more generally. A common, narrower usage understands financial accounting to be external and financial. In most university courses on financial accounting there is a further narrowing with the typical focus being on the commercial business organisation that is owned by shareholders who are understood to be other than the company’s management. Financial accounting, where it is seen as external, which is usually the case, is often distinguished from internal ‘management accounting’. In broad terms, all accounting can be understood in terms of decision making and control roles (where these encompass dimensions of accountability and stewardship). The relation between financial accounting and financial reporting is also not a settled one. In some usages they are taken to be the same or at least substantively so. In others, the accounting implies a broader activity (e.g. recording) and reporting is understood as a branch of it. In yet other usages, financial reporting equates to a broader external reporting that need not be restricted to the financial whereas financial accounting (or simply accounting) is understood to be so restricted. In trying to introduce the subject matter, it is appropriate to give insight into these nuances that are found in what is a quite diverse literature on accounting. Both financial reporting and financial accounting may be distinguished from financial statements in perhaps including narrative reports. In this subject guide, we shall typically equate financial accounting and financial reporting and where we intend a different connotation we shall make that explicit. Often, reflecting much of the literature and practice, we shall use the term financial accounting where we mean the external and financial accounting of organisations (typically commercial business organisations) but we shall give some recognition to broader definitions (e.g. in referring to some notions of corporate social responsibility accounting) and in those cases make clear that we are departing from the narrower view. We shall adopt the broad understanding of accounting’s role. But here we need to introduce a further framework for understanding. Controversies do not end with issues of definition or delineation. The study of financial accounting (whether understood broadly or narrowly) is the study of a social phenomenon. Accounting is constructed by people in a context and impacts upon them and the context. Presumably its justification is in terms of social well-being. The study of accounting may clearly be seen, and is typically understood, as a social science. One common way of classifying theories in the social sciences (e.g. in economics) is to distinguish between normative and positive approaches, or (as is preferred here) between prescriptive and descriptive approaches. Prescriptive approaches are concerned with developing a theory of accounting ‘as it should be’ and descriptive approaches with developing a theory of accounting ‘as it is’. 12

Chapter 1: Rationale for financial reporting and its regulation

In this subject guide we give insights into the more prescriptive and the more descriptive approaches. Again, there are different approaches within this broad categorisation. For instance, there are those who draw primarily from economics in formulating either prescriptive or descriptive theories of accounting. And one should note here that there are different views within economics! Others draw from sociology or adopt a more interdisciplinary perspective. The latter approach overlaps with concerns to understand financial accounting more broadly and especially in terms of its scope, the variety of influences upon it and its diverse consequences. Many academics and policy-makers consider mainstream economic theory to be a good basis for theorising financial accounting prescriptively and descriptively while for others it is a narrow approach that does not take into account the actual and potential repercussions of financial accounting. We shall try to give insights into major instances of the more economistic approaches and other approaches and also here try to draw bridges between them. We shall thus begin to explore how accounting’s role has been variously theorised prescriptively, e.g. as improving economic decisions so as to enhance social welfare or as contributing to a better democracy and shall consider descriptive studies of accounting so as to also reflect the diverse approaches of the literature. In this chapter we consider prescriptive views that have emerged in relation to issues of accounting’s regulation. We shall see that many views here reflect mainstream economistic thinking. We offer descriptions of financial accounting practice and its context in the UK and internationally, with again an emphasis on how financial accounting is regulated. It becomes clear here that a mainstream economistic thinking has been influential in the construction of a regulatory framework with linked institutions in this area. We also give some attention to ways of seeing beyond the economistic.

Financial accounting and its role Mainstream economistic views see financial accounting as information that guides economic decisions. Actually, in many abstract models that are not uncommon in economic reasoning, perfect information is simply taken to exist. To the extent that information in general and financial accounting in particular are considered more realistically, the approaching of perfect information is often taken as desired. As the information increases in quality (a notion encompassing increased transparency) economic decisions are understood to improve. Perhaps more detailed, disaggregated information could be given. Perhaps companies could be valued better or report better their value. The view is that scarce resources are better allocated in the economy and social welfare increased. A modification of this position again in the direction of greater realism appreciates that information is costly. Its benefits should exceed its costs. Substantively, the latter are ostensibly the dominant views of the influential accounting policy-makers. The IASB, for instance, emphasises the role of financial accounting information in guiding economic decisions and thus enhancing social welfare. Less frequently in official pronouncements but often used to justify actual policy decisions, explicit reference is made to the costliness of this or that possible provision (although the UK’s ASB does make reference to it in its stated aims – as well as pointing out that it is not in favour of revolutionary changes to financial reporting!). 13

91 Financial reporting

Those giving thought to 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 market contexts, improving information 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). Such considerations may help us with descriptive theory. Factors such as the above, together with information’s costliness, as well as lack of shareholder control over corporate management, may explain why many commentators believe that financial accounting information falls short of the information that one might assume, from a more mainstream position, capital providers would want (Tinker, 1985, even refers to shareholder alienation). 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 imperfect markets (towards an appreciation of the imperfect character of the socioeconomic 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 be used for 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 necessary in an imperfect context. 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 socioeconomic 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 their perspectives) all things of relevance to social well-being (in relation to corporate operations). More generally, the concern for a more holistic external accounting involves going beyond mainstream perceptions and includes prescriptions of non-financial information (see Gallhofer and Haslam, 2007).

14

These prescriptive suggestions have had little influence on accounting policy-makers, although The Corporate Report (1975), a draft policy statement of the UK Accounting Standards Steering Committee (a forerunner of today’s UK ASB), did put forward a stakeholder-orientated form of external accounting that included non-financial as well as financial information. It never became a standard (Gallhofer and Haslam, 2007).

Chapter 1: Rationale for financial reporting and its regulation

Financial accounting regulation Mainstream economistic reasoning has also been influential in respect of the issue of how best to regulate financial accounting. Some of the above perspectives have implications for how accounting should be regulated. Perspectives that assume the existence of perfect information clearly would not see the need for further regulation. Under the scenario of perfect and complete markets, a company that accepted all projects with non-negative present values would simply have to announce these present values or cash flows to the market, if we take a slightly less abstract view (although strictly in such reasoning this would automatically happen for markets to be perfect and complete). The value of the company would then equal the present value of these cash flows, which in turn would equal the market price. Under these circumstances one may even question whether annual reports are necessary. Within mainstream economic thinking (that assumes ‘perfect and complete markets’ to maximise well-being and the role of ‘accounting information’ to be confined to serving markets), the answer to this question would be in the negative as it would be to the question ‘is the regulation of accounting necessary in this context?’ The market here provides what is deemed an unambiguous and value free measure of wealth. Even in a broader, more holistic view, the argument might weigh against state and/or quasi-state regulation in this economic sphere where markets were more perfect and complete. In any case, the scenario of perfect and complete markets does not reflect the real world. Markets are not complete and perfect and thus the market does not provide an unambiguous measure. So we can consider the case for state and/or quasi-state regulation within a mainstream economics perspective. Other perspectives hold that the functioning of markets (within an institutional, regulatory framework) is enough to regulate financial accounting adequately. Businesses have an incentive to provide accounting information to the market to raise capital and an interest in being honest and providing good quality information due to the negative impacts of loss of reputation (organisations failing to inform or misleading the capital market will be regarded as ‘lemons’ – and punished). Another way of seeing this is that there are strong incentives for managers to disclose information, e.g. they may need to raise finance in the competitive market and will thus provide relevant information to aid them in this (and reputation has a value here so honesty may pay). In addition there is a market for managers, in so far as the managers themselves would want to inform the market as to how well they are doing and hence enable them to seek other jobs elsewhere. The ‘free market’ camp would thus argue that, even in the real world, we should leave it to the market or what some call ‘market regulation’ (noting that markets themselves always appear to require some form of state regulation in practice). Some argue the market for information is good enough to produce an optimal supply. There are also contracting arguments that have been put forward. Companies could simply have a contract with their suppliers of capital to disclose certain information to them, including having the information audited. Any undisclosed information could then be obtained by private searches and/or payment for additional information that may be required. One point that may be made here too is that regulation beyond the market may displace some of the positives of market functioning. It may problematically, for instance, restrict the accounting methods that may be used (although that may also reflect a poor form of interventionist 15

91 Financial reporting

regulation). Further, users will tend to overstate their desire for disclosure if they do not have to pay for it (although indirectly they may bear costs). The costs will be borne by those supplying the information. History does indicate that companies will voluntarily disclose at least some information (at least they will disclose some information under other pressures). While those observing practice historically admit to some evidence of this type of market-induced effect, substantively they point to weak financial accounting here and the case for regulating financial accounting in terms of state and/or state-backed or quasi-state professional regulation, beyond the more liberal approach. The view here is that the market for information is such that without interventionist regulation a sub-optimal amount of information will be produced. And the comparability it facilitates may be less than desirable. The case for likewise regulating notions of broader corporate social responsibility accounting is similar. This said, contexts vary and a great deal of pressure may be placed on business (e.g. by competitive forces, a strong civil society) without legislation or quasi-law. Under the contracting arguments, the actual cost of enforcing the individual contracts or ‘group contracts’ would be higher than those costs associated with state and/or state-like regulation. Even with these contracts there would be a need for comparability of accounting practices. A number of related arguments for regulation have been suggested, reflecting the assumption of an imperfect markets context, including the following: • Left unregulated as envisaged, market forces would ‘lead to an uneven possession of information among investors’. Consequently the regulation would provide an equitable solution. ‘It is only fair that the less informed be protected from the more informed.’ Some have more power than others (over others) in terms of accessing information. • Accounting information shares the characteristics of a public good, and therefore suffers the same problems of externalities and free riders. Under these conditions the absence of the regulation envisaged could result in the under provision of information. • Managers have incentives not to disclose unfavourable information. Consequently investors would be unable to distinguish good companies from bad ones, resulting in ‘adverse selection’. Further, investors need protection from the fraudulent, which would actually produce misleading information. Due to information asymmetries, the disclosures may not obviously be seen as fraudulent. Others argue markets are not so speedy in re-adjusting to changes. If they may keep returning to reasonable positions or an equilibrium (a contestable view for some), people may get hurt in the process, given its slow speed. Indeed this may be in ways they can scarcely be compensated for. The ‘balanced’ view on financial accounting discussed above may be taken as implying that regulation to improve transparency should not be universally overly strict, or it might imply the need for a regulation that has limits and that might be set so as to prevent firms competing in the market place in terms of information disclosure, which may drive disclosure towards too much transparency. In an imperfect markets context, a particular level of disclosure or transparency would be optimal for social welfare. A degree of secrecy or confidentiality is required

16

Chapter 1: Rationale for financial reporting and its regulation

to allow the system to function for the best (e.g. create incentives for research and development, discourage monopolistic practice that might be encouraged through information sharing). A degree of transparency is required to facilitate financing and the better allocation of resources. The regulation envisaged may bring this balanced disclosure about better. Markets functioning without that may lead to ‘beggar-my-neighbour’ disruptive forms of competition in respect of disclosure. Some analysts of the issues have used game theory as a framework and tried to model (appreciating the possibility of audit) external financial accounting disclosures in relation to the incentives of regulators and corporate managers (e.g. incentives to disclose or hide, to be honest or dishonest). From this quasi-descriptive modelling (to which dimensions of uncertainty and the costliness of information can be built in) an attempt is made to see if answers can be found to questions such as: Is rigid regulation better than flexible regulation? Is mandatory disclosure better than a looser more voluntary approach? This framework can enhance appreciation of the character and feasibility of actual and potential regulatory forms, although it is not straightforward to translate this into social welfare implications in an imperfect markets and imperfect societal context. 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 (2007) see accounting regulation?

Accounting standards: what form should they take? One way of regulating accounting, suggesting intervention beyond the more liberal approach, is through accounting standards. These could be prescribed by law or by ostensibly independent professional bodies (and the latter’s prescriptions may then in some way be backed by law). If we believe in regulating accounting through the use of accounting standards, what form should the standards take? We could consider Edey (1977)’s discussion. Edey (1977) discussed and illustrated four possible types of accounting standards, all with different levels of detailed rules, with the lowest level (Type 1) being less prescriptive than the highest level (Type 4). Type 1: ‘Tell people what you have done.’ This type of standard in the first place restricts accounting to information about what has happened but Edey emphasises that the restriction is to basic disclosure rules. Type 2: Uniformity of presentation. This type of standard would only concern rules on how you should present your financial results and hence create some form of uniformity and consistency. Type 3: Disclosure of specific matters. This type of standard would require disclosure of specific matters in certain cases. Type 4: How to value assets/liabilities, what is regarded as income, how income is allocated to periods, and so on. Edey here characterises this type of standard as specifying considerable detail. In terms of the earlier argumentation, the more detailed and the less flexible the requirements then the stronger the regulation. 17

91 Financial reporting

Comparing arguments for and against standards is clearly related, then, to arguments for and against forms of regulation. We extend or refine the earlier argumentation by considering Baxter. These reflect an understanding of the nature of company law in the UK context, whereby that law is assumed not to prescribe very detailed inflexible accounting standards.

Arguments for accounting standards Baxter outlines the arguments for the imposition of accounting standards, suggesting that: • standards provide handy rules for the daily work of accountants. Types 1–3 in Edey’s typology would: • help improve published reports • supplement company law with fuller, clearer and more consistent figures • foster comparability which in turn would help analysts and potential investors compare and evaluate firms • force weaker accountants to improve their work • provide a defence for accountants in court, and strengthen resistance ‘if a tycoon tries to bully his accountants into producing biased figures’. Other arguments put forward include the following: • They would provide credibility to the accounting profession which might otherwise be undermined if there are continued scandals over the extreme subjectivity of some companies’ financial statements. • They provide discipline – although some believe that if companies were left to their own devices they would ultimately be disciplined by the financial markets. • In the short term, the use of standards attempts to alleviate the risk to investors.

Arguments against accounting standards The following arguments have been made: • Accounting standards are costly and bureaucratic. • Accounting figures (due to their very nature) do not lend themselves to standardisation; industries differ, so do firms; the needs of users vary. Thus standards may be suitable for the average but may not suit the fringes. • Standards can lead to a kind of rule following, where two similar situations might be treated differently becuase they fall either side of a rule. • Standard-setters may bow to political pressures and thus the development of accounting standards may be merely consensus-seeking (e.g. accounting standards could be over-influenced by those parties with easiest access to the standard-setters or the most vocal lobbyist). • Standards in themselves could actually reduce professional judgement and be bad for the academic education of accountants (e.g. they might be more interested in what is required to comply with the standard than in investigating the ideal accounting system). • Standards may lull users into a false sense of security (i.e. investors may believe that the accounts are all based on the same specific rules, 18

Chapter 1: Rationale for financial reporting and its regulation

when in fact a standard principle may still leave room for different estimates). Consequently investors and other users need to be educated about this. • If they do not take account of possible economic consequences, standards may result in adverse allocation effects. Accounting standards might result in sub-optimal behaviour purely to ensure that accounting earnings are not reduced. • Standards could result in overload, e.g. if there are too many standards; if standards are too detailed; if standards are not specific enough; if there are too many standard-setters. Activity 1.2 What criteria are relevant in deciding upon accounting standards? Should standards specify the detail or be more in the nature of general guidelines?

Descriptions of accounting and its regulation There are various types of descriptive theory. They may be more or less subjective or subjectivist in their orientation. They may be developed from a quite precise theoretical proposition or hypothesis or from a much looser, open stance. All theories may be considered mixtures of the deductive and inductive (i.e. they are developed through a process of logical deduction from underlying premises and from reflection on observed reality) but they may have a deductive or an inductive emphasis. They can draw upon different understandings of context and have different themes. They may be more or less critical (i.e. their prescriptive dimension may imply a more or less radical position). Deegan and Unerman (2011) provided an overview of different descriptive theories of financial accounting. Financial accounting may be understood in practice to equate to what it should be in a prescriptive theory or it could be understood as failing against its prescriptive benchmark. Deegan and Unerman (2011) point to theorists who suggest it is biased to serve the relatively rich and powerful in society. Others suggest that financial accounting may promote a materialist or narrow culture. For instance, they suggest that accounting portrays that a materialist profit making is the only thing important about a business organisation, which accounting constructs as a financial machine, and it encourages a simplistic dichotomous debit-credit kind of thinking in areas beyond technical accounting. In terms of accounting regulation, again this may be seen in a descriptive theory to equate with a prescriptive theory of accounting regulation as it should be. Other theories include capture theory – where those who are meant to be regulated control the regulations – and theories that, for example, suggest that accounting regulation is largely controlled by the relatively rich and powerful. Many descriptive theories begin with an attempt to understand what accounting and accounting regulation are like in terms of basic content and form, e.g. what are the requirements of a law or standard? This is an emphasis in what follows. Many theories see actual regulatory developments as appropriately responding to regulatory failures (although these developments may be found wanting as things change – giving rise to new regulations also deemed appropriate). Such theories are very similar to those that equate actual practice to some variant of prescriptive theory. They may also be considered official theories as they are theories that official regulatory bodies would use to describe themselves. 19

91 Financial reporting

We focus here initially on accounting regulation in ways that substantively reflect such basic description and mainstream interpretation. We focus on accounting regulation in the UK but in the global context, reflecting the significant influence of international accounting standards in the UK (and beyond).

UK accounting regulation and the influence of international accounting standards The regulatory framework relating to financial reporting varies from country to country. For Cooke and Parker (1994), the nature of the regulatory framework will depend upon (among other things): • the influence of tax rules • the type of legal system • the history and influence of the accounting profession. In the UK, the regulatory framework has developed over many years and consists of a mass of rules and regulations – some statutory, some mandatory, others customary. We shall consider the variety of rules and regulations that exist in the UK. Note that the UK regulatory framework has been influential in many other countries. For instance, Cooke and Parker (1994) state that: Malaysia’s colonial past is reflected in many ways in the current reporting environment, which is very similar, though not identical to the UK environment.

Impetus for regulation Often, regulations are implemented after well-publicised scandals. This was the case with the establishment of the UK’s Accounting Standards Steering Committee (ASSC) in 1970. Two scandals in the late 1960s were understood to highlight the extent of subjectivity in financial reporting: the General Electric Corporation (GEC) takeover of AEI Ltd and Pergamon Press’s profit figure both led to questions about the correctness of published financial statements of UK companies. Even today, with the existence of standards that have over time tended to become more extensive and detailed, similar questions are asked, e.g. in the US following the scandal of Enron.

Institutional setting for accounting regulation: the UK The rules applicable to large UK companies (rather than small or mediumsized ones) come in three main forms: • Statutory legislation: primarily the Companies Act 1985 and the Companies Act 1989 (revised). The European Union (EU) instigated a harmonisation programme that involved the issuing of a number of directives in order to harmonise the accounting practices of companies within the EU. In November 1995 the EU announced: ‘Rather than amend existing Directives, the proposal is to improve the present situation by associating the EU with the efforts undertaken by IASC and IOSCO towards a broader international harmonisation of accounting standards.’ The EU adopted regulations with effect from 1 January 2005 that required listed companies in Europe to use generally accepted international accounting principles (IASs/IFRSs) when preparing their group accounts.

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Chapter 1: Rationale for financial reporting and its regulation

• Mandatory regulation: the Statements of Standard Accounting Practice (SSAP) developed originally by the Accounting Standards Committee (ASC) and adopted by the Accounting Standards Board (ASB), and Financial Reporting Standards (FRSs) issued by the ASB since 1990. • The Stock Exchange Listing Rules: these impose rules on companies listed on the London Stock Exchange, including compliance with the Combined Code of Corporate Governance (2003). Statutory legislation: Companies Act The Companies Acts prior to the early 1980s contained only general requirements for companies and groups relating to the need to prepare, distribute and file financial statements. There was very little detail in the Acts – this was left to the practices adopted by accountants. In 1981 requirements about the form and content of published accounts underwent a radical change when the UK implemented the EC (now EU) Fourth Directive in the Companies Act 1981. The Fourth Directive imposed standardised formats for the income statement and balance sheet, and required a ‘true and fair view’1 (see below). This was achieved by making rules about: • the format of accounts • certain accounting principles • valuation rules • disclosure of information.

1

The ‘true and fair view’ was required in the UK prior to the Fourth Directive. Indeed, it was as a result of the UK’s pressure upon the EU that the true and fair requirement was included in the Directive.

The Companies Act 1985 (CA 1985) consolidated the previous Acts (1947, 1948, 1967, 1980 and 1981) and set out general rules and formats governing the content and form of published company accounts. CA 1985 was then amended and supplemented by the Companies Act 1989, which enacted the Seventh EU Directive. This Directive had a similar role to the Fourth, but in connection with consolidated accounts. Its objective again was to harmonise practice within the EU, but its effect in the UK was less dramatic than had been the case with the Fourth Directive, because the basis of the Seventh Directive was to a large extent the AngloSaxon model of consolidation, whereas the Fourth Directive had been based more on continental practices.

The ‘true and fair’ requirement In addition to preparing accounts, s.226 of the 1985 requires that: (2) The balance sheet shall give a true and fair view of the state of affairs of the company as at the end of the financial year; and the [income statement] shall give a true and fair view of the profit and loss of the company for the financial year. (3) A company’s individual accounts shall comply with the provisions of Schedule 4 as to the form and content of the balance sheet and [income statement] and additional information to be provided by way of notes to the accounts.

In the above respect, 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 21

91 Financial reporting such departure, the reasons for it and its effect shall be given in the note to the accounts. (Section 226(5))

What is the definition of ‘true and fair’? The Companies Act does not define ‘true and fair’. However, 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.

Statutory regulation: IASs/IFRSs gained force of law The International Accounting Standards Board (IASB) was preceded by the Board of the International Accounting Standards Committee (IASC), which operated from 1973 until 2001. The IASC gained the acceptance of the International Federation of Accountants, a worldwide association of accountancy bodies with the aim of harmonising accounting standards at an international level. The IASC was (as the IASB is) a private sector body ostensibly independent of government influence. The level of harmonisation achieved was understood to be reduced by (a) weak standards that permitted too many accounting choices in order to satisfy diverse member requirements and (b) a lack of enforcement power. Enforcement was eventually achieved via the International Organization of Securities Commissions (IOSCO) (see stock exchange regulation below) and the EU. In 1995 the EU agreed to require all listed European companies to conform to IASs/IFRSs, following a review of the standards. The following year the EU Contact Committee reported that IASs/IFRSs were compatible with EU directives, with minor exceptions, leading to legislation in 2001 that required all EU listed companies to follow IASs/ IFRSs from 2005. Hence, IASs/IFRSs constituted statutory regulation for the listed companies. The IASB superseded the IASC in 2001, inheriting 34 standards, 14 of which were criticised by the IOSCO as unacceptable by regulators worldwide. The IASB was set up initially recognising the IASs but gradually replacing them and adding to them with IFRSs. The IASB decided to improve the standards before the EU adoption in 2005, and thereby embarked on the improvements project. This project was completed by 2003, resulting in 15 revised IASs (IFRSs). From 2005 Australian-listed groups and from 2007 New Zealand-listed groups had to comply with IASs/IFRSs. More recently South Korea, China, Brazil, Israel, Malaysia and Mexico have made similar moves or committed to the same. Several countries have domestic GAAP identical to the IASs/IFRSs and some have abandoned developing their own standards. FASB and IASB are committed to a convergence process and progress on this has been made.

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Chapter 1: Rationale for financial reporting and its regulation

Mandatory regulation: standard-setting and the case of the UK In the UK, prior to the establishment of the Accounting Standards Committee (ASC), legislated accounting regulation was limited to a few statutory rules governing the presentation of financial statements within the Companies Act. These were very basic and accounting practices were varied and inconsistent. Consequently the ASC was set up in 1976. Its objectives were to: define accounting concepts, to narrow differences of financial accounting and reporting treatment, and to codify generally accepted best practice in the public interest.

The ASCs membership consisted of representatives from the various UK accounting bodies. They were part-time and unpaid. Following major criticism of the ASC that it was unable to respond quickly to changing needs or to deal with fundamental issues, a Review Committee was established in 1987 under the chairmanship of Sir Ronald Dearing. Following the Dearing Report on the creation of accounting standards, the following bodies were established: FRC Ltd Board

Accounting Standards Board

Auditing Practices Board

Board for Actuarial Standards

Professional Oversight Board

Council

Accountancy Financial Investigation Reporting and Discipline Review Panel Board

Committee on Corporate Governance

Urgent Issues 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 Accounting Standards Board (ASB) on work programmes, priorities and issues of concern, and is responsible for financing arrangements. The chairman 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 against the two-thirds from the accountancy profession and financial institutions respectively). The FRC aims ‘to promote confidence in corporate reporting and governance’. • 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 23

91 Financial reporting requirement that annual accounts shall show a true and fair view, might have been breached.

It has been authorised under the Companies Act to make application to the court for a declaration that a company’s annual accounts of a company do not comply with the requirements of the Companies Act and for an order that the directors prepare revised accounts. (See below.) • Accounting Standards Board (ASB) Established in August 1990, this replaced the ASC. It is an expert body to develop, issue and withdraw accounting standards, with a full-time chairman and technical director and 10 members in total (originally nine). It also has a large full-time secretariat. It issues Financial Reporting Standards (FRS) on its own authority, on a two-thirds majority. A committee of the FRC appoints its members. The ASB has stated its aims as follows: to establish and improve standards of financial accounting and reporting, for the benefit of users, preparers and auditors of financial information.

One of the ways in which it intends to achieve its aims is by ‘developing principles to guide it in establishing standards and to provide a framework within which others can exercise judgement in resolving accounting issues.’ It has listed a number of ‘fundamental guidelines’ which include ‘to be objective and to ensure that the information resulting from the application of accounting standards faithfully represents the underlying commercial activity’; such information should be ‘neutral in the sense that it is free from any form of bias intended to influence users in a particular direction and should not be designed to favour any group of users or preparers.’ Other fundamental guidelines include issuing standards only when the expected benefits exceed the perceived costs, and ‘taking account of the desire of the financial community for evolutionary rather than revolutionary change in the reporting process where this is consistent with the objectives.’ • Urgent Issue Task Force (UITF) This is concerned with serious differences in current practice. Its main role is to assist the ASB in areas where an accounting standard or Companies Act provision exists but where unsatisfactory or conflicting interpretations have arisen or seem likely to develop. It reaches a consensus about issues and its pronouncements are published in Abstracts, available on the FRC website.

Accounting standards and company law Following the Dearing Committee’s review of standard-setting, changes were also made to company law: • Section 19 of the Companies Act 1989 inserted a new section (s.256) into CA 1985. This includes a definition of accounting standards and, among other things, gives the Secretary of State power to make grants to bodies (or for the purpose of): • issuing accounting standards overseeing and directing their issue • investigating departures from standards or from the accounting requirements of the Act and taking steps to secure compliance with them. 24

Chapter 1: Rationale for financial reporting and its regulation

• The Companies Act 1989 inserted a new paragraph 36A into Schedule 4 of CA 1985. This requires it to be stated whether the accounts have been prepared in accordance with applicable accounting standards, with particulars of any material departure from those standards and reasons for these to be given. • Section 12 of the Companies Act 1989 inserted a new section (s.254B) into CA 1985 giving the Secretary of State power to apply to the court for a declaration that a company’s annual accounts do not comply with the requirements of the Act and for an order that the directors prepare revised accounts. The Secretary of State may also authorise a person for this purpose and, as noted above, has authorised the Financial Reporting Review Panel (FRRP) to make such applications. If the court finds against the company, it may order that application costs and reasonable expenses of the company in connection with (or in consequence of) preparing revised accounts shall be borne by the directors who were party to approving the defective accounts. Note that the power to apply to the courts relates to non-compliance with the Act’s requirements rather than specifically with standards. This then raises the question of the relationship between accounting standards and the requirement for accounts to show a true and fair view. Below is the professional opinion of Mary Arden QC: Compliance with accounting standards will normally be necessary for Financial Statements to give a true and fair view… The requirement to give a true and fair view may in special circumstances require a departure from accounting standards… If in exceptional circumstances compliance with an accounting standard is inconsistent with the requirement to give a true and fair view, the requirement of the accounting standard should be departed from to the extent necessary to give a true and fair view. (Appendix to Foreword to Accounting Standards, ASB, 1993)

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’.)

The Companies Act 2006 implemented some of the proposals of the Company Law Review (see Activity 1.4).

Stock Exchange The London Stock Exchange also lays down regulations concerning listed companies’ published accounts. The regulations require the provision of more information, and more frequently, than either the law or the UK ASB or the IASB requires. For example, companies are required to publish interim accounts and provide more detail regarding certain liabilities (e.g. bank loans). In 1995 the International Organization of Securities Commissions (IOSCO) agreed to a review of IASs, with a view to endorsing IASs for cross-border 25

91 Financial reporting

offerings. Fourteen standards were rejected by IOSCO but later revised by the IASB. The IOSCO’s technical committee now ‘recommends that its members allow multinational issuers to use IFRSs in cross-border offerings and listings, as supplemented by reconciliation, disclosure and interpretation where necessary to address outstanding substantive issues at a national or regional level’ (Technical Committee of IOSCO, Statement on the development and use of International Financial Reporting Standards in 2005, February 2005, p.4). UK listed companies must also comply with the Combined Code of Corporate governance (Higgs, 2003). The Combined Code 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 a number of accelerated reviews of governance frameworks and resulted in an increased number of practical pronouncements. In the USA the Sarbanes-Oxley Act on corporate governance is the most comprehensive law to affect accounting and the audit profession since the Securities and Exchange Act 1934. By changing guidelines into formal law, this represents a divergence from the UK model on corporate governance (Friedman and Miles, 2006, p.258) 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? Activity 1.4 The Company Law Review was set up to examine the whole framework of company law. Study its recommendations: Company Law Reform. Modern Company Law for a Competitive Economy: Developing the Framework, which can be found at: www.berr.gov.uk/files/file23245.pdf. A companies Act was introduced in 2006. To what extent did it implement the recommendations?

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • delineate the basic character of financial accounting theory • discuss the role of accounting in society • explain the different levels of authority in the UK regulatory framework • explain and discuss the implications of the International Accounting Standards Board on the role of the Accounting Standards Board • discuss the arguments for and against accounting standards • discuss the theory of regulation

26

Chapter 1: Rationale for financial reporting and its regulation

Sample examination questions Question 1.1 To what extent should accounting standards take economic consequences into account? Discuss.

Question 1.2 What factors should be considered in deciding upon the form of accounting regulation?

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Notes

28

Chapter 2: Conceptual framework

Chapter 2: Conceptual framework Aims of the chapter The aim of this chapter is to consider what a conceptual framework is and then to address some of the key principles related to setting up a conceptual framework. These principles have been examined by many different groups of standard-setters around the world (including in Australia, Canada, the UK and the USA). We will look at the UK’s 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. It is strongly recommended that you review the FPPFS.1

Learning outcomes

1

To find this, consult the IASB website: www.iasb.org.uk/

By the end of this chapter, and having completed the Essential readings and activities, you should be able to: • define a conceptual framework • identify the main efforts by the US, the IASC and the UK to introduce a conceptual framework • describe the objectives of financial reporting as per the conceptual frameworks produced • explain the ‘ideal’ qualitative characteristics of accounting information as suggested by these frameworks • define assets and liabilities as suggested by these frameworks • explain and describe recognition and measurement • apply the conceptual frameworks to particular transactions; for instance, would they help in deciding how to account for research and development?

Essential reading International Financial Reporting, Chapter 8. Accounting Standards Board, 1999, Statement of Principles for Financial Reporting. (Reproduced in Accountancy, March 2000, pp.109–38). See below for the ASB website.

Websites See also the following websites: www.frc.org.uk/asb/technical/principles.cfm www.iasb.org.uk/ then follow links to summaries of international financial reporting standards

Further reading Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. Chapter 2. Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing, 1992) [ISBN 9780273034643]. Chapter 12 (Although this focuses specifically on the FASB’s conceptual framework, it also 29

91 Financial reporting discusses a number of issues about the conceptual framework approach that can be considered in relation to the IASB’s FPPFS and the ASB’s Statement of Principles.) Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 1. Macve, R. A Conceptual Framework For Financial Accounting and Reporting: the Possibilities for an Agreed Structure. (London: Institute of Chartered Accountants in England and Wales, 1981) [ISBN 9780852913116].

Relevant IASB publication Framework for the Preparation and Presentation of Financial Statements.

Relevant UK standards The Statement of Principles. FRS 18 Accounting Policies (replaced SSAP 2 Disclosure of Accounting Policies).

Definition of a conceptual framework The quest for a conceptual framework for financial reporting has been undertaken (with varying degrees of success in terms of securing agreement) in many different countries. But what is a conceptual framework? In the USA, one definition by the Financial Accounting Standards Board (FASB) is: A Conceptual framework is a constitution, a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function and limits of financial accounting and financial statements.

The ASB in the UK states that their Statement of Principles (SOP) (equivalent to the US conceptual framework): sets out the principles that the Accounting Standards Board 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.

However, he also recognised that it would be difficult to implement such a conceptual 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 financial statements themselves. For instance: • What are the objectives of financial statements? • For whom and by whom are these financial statements required? • What information do the users of these financial statements require? • What types of financial statement would best satisfy these users’ needs? • Do current financial statements meet these requirements? • How could current financial statements be improved? 30

Chapter 2: Conceptual framework

Although these questions are fundamental, the extent to which they have been addressed varies among countries. However, in general: 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, 2001)

In other words, too often standard-setting is reactive (to particular problems) rather than proactive.

Rationale for a conceptual framework The FASB states that the rationale for a conceptual framework is: 1. To facilitate decisions on controversial accounting issues – providing a clear basis for reaching conclusions that those with vested interests would find it hard to resist. 2. To provide a common framework of reference on theoretical issues, so as to avoid both waste of effort in addressing such issues from first principles for each specific standard and the dangers of inconsistency. 3. To reduce the need for many detailed standards on specific issues – by enabling accountants to resolve issues by reference to general principles rather than detailed rules.

Advantages claimed for a conceptual framework According to the UK Statement of Principles, a conceptual framework should: • clarify the conceptual underpinnings of proposed accounting standards • enable standards to be developed on a consistent basis • reduce the need to debate fundamental issues each time a standard is developed or revised • enable preparers and users of financial statements to understand the Board’s approach to setting standards and the nature and function of information in general purpose financial statements • help preparers and auditors with new issues to carry out an initial analysis of the issues in the absence of applicable accounting standards. Other advantages claimed for a conceptual framework are that it: • facilitates decisions on controversial items, by reducing the scope for personal bias and political pressure • may reduce the need for many detailed standards if accountants can resolve issues by general principles • limits the bounds of judgement and hence increases comparability • may protect accounting from intervention by governments • helps justify accounting practices when they are under attack in the courts, if they can be shown to be derived from, and consistent with, a conceptual framework.

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The US, IASC and UK initiatives compared In this section we consider briefly some of the important milestones in the quest for a conceptual framework in the US, IASB and the UK. You need not know the exact detail as such, but you should be aware of the main considerations of each initiative and the main similarities and differences between each approach.

US initiative: FASB conceptual framework The FASB issued six concept statements in the late 1970s/early 1980s, of which five are listed here: • Statement of Financial Accounting Concept (SFAC) No. 1 Objectives of Financial Reporting by Business Enterprises. • SFAC No. 2 Qualitative Characteristics of Accounting Information. • SFAC No. 4 Objectives of Financial Reporting by Non Business Organisations. • SFAC No. 5 Recognition and Measurement in Financial Statements of Business Enterprises. • SFAC No. 6 Elements of Financial Statements (replacing SFAC No. 3). • SFAC No. 7 Using Cash Flow Information and Present Value in Accounting Measurements. This chapter will discuss four of these concept statements – 1, 2, 5 and 6 – which address some of the key conceptual issues.

IASC Framework for the presentation and preparation of financial statements The IASC conceptual framework was introduced as an exposure draft in May 1988, and a final statement in September 1989, in an attempt to ‘explain the conceptual framework that underlies the preparation and presentation of financial statements.’ Apparently modelled on the FASB framework, it exhibits many of the strengths and weaknesses of that earlier framework (see discussions below).

UK: ASB’s Statement of Principles (SOP) In the UK the ASB issued a Draft Statement of Principles, initially chapter by chapter but then as a whole, for general comment. In 1996, some aspects of the Draft Statement of Principles attracted adverse comment and as a result this framework was modified. The final version of the SOP was agreed in October 1999. Appendix II notes that the SOP was based on the IASC’s Framework. Appendix III points out that the Board does not regard the SOP as the final word on the principles underlying financial reporting and that, as accounting thought is continually evolving, it may need to be revised from time to time. Currently the SOP consists of eight chapters: Chapter 1: The Objective of Financial Statements Chapter 2: The Reporting Entity Chapter 3: The Qualitative Characteristics of Financial Information Chapter 4: The Elements of Financial Statements Chapter 5: Recognition in Financial Statements Chapter 6: Measurement in Financial Statements Chapter 7: Presentation of Financial Information 32

Chapter 2: Conceptual framework

Chapter 8: Accounting for Interests in Other Entities. Although the main purpose of the SOP is to help set accounting standards, the Introduction to it notes that, due to other factors to be considered when setting standards (including legal requirements and cost/benefit considerations), a standard may still adopt an approach different from that suggested by the principles. The SOP has not been developed within the constraints imposed by company law so it may contribute to the future development of law.

Objectives of financial reporting The underlying objective of all the conceptual frameworks discussed above in relation to financial reporting is to provide useful information so users can make business and economic decisions. This is sometimes contrasted with an alternative objective – to provide information on how the business has carried out its stewardship responsibilities. There is an overlap, however, between these objectives. One may argue that information about historical stewardship, or accountability for past actions, is relevant for decision making and control and indeed the rationale for it may be expressed in these terms. Nevertheless the objective promoted in the conceptual frameworks is not as restricted. In principle, it goes beyond history, stewardship and accountability without limit. This freedom results in threats as well as opportunities for and through accounting. Decision usefulness appears to be a reasonable objective, although we have seen that it should be subject to our discussion in the last chapter of context and the imperfect nature thereof. To satisfy it two questions should be considered: 1. Who are the users? 2. What type of information do they need? In the case of the FASB, the statement identifies many potential users of accounts 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 generalpurpose 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 essentially 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.

The SOP requires that financial reports provide information about: • the economic resources of an enterprise, its obligations and owners’ equity • enterprise performance and earnings • liquidity, solvency and funds flow • management stewardship and performance. 33

91 Financial reporting

It notes in relation to its requirement for information about enterprise performance that: …interest in an enterprise’s cash flows and its ability to generate favourable cash flows leads primarily to an interest in information about its earnings rather than information directly about its cash flows… Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than information about current cash receipts and payments.

The FASB then asserts that what investors want are balance sheets and income statements: inductively from the fact that this is what they currently actually get and politically because the FASB has no intention of undermining the very basis of present practice and thus has rationalised accrual accounting. However, the FASB has actually steered away from trying to identify the kind of information that may assist users (e.g. current value information, management forecasts, etc.) In the UK, the ASB’s SOP states that the objective is to provide information about the financial performance and financial position of an entity which would be useful to a wide range of users in assessing the stewardship of managers. The ASB has selected the investor’s perspective as the one most likely to help in the preparation of general-purpose financial statements. It states that, whilst recognising a large number of potential users of financial statements, who usually require different information for the different decisions they must make, a statement based on such a perspective focuses on the common interest of all users – the entity’s cash-generating ability and financial adaptability. It therefore focuses on present and potential investors as the defining class of user, arguing that in meeting their needs financial statements will meet the common needs of other users. It notes that information that is not needed by investors need not be given in the financial statements. The SOP details the information required by investors, which is very similar to the FASB, and is said to comprise the following: • In relation to financial performance: the return obtained on its resources, the components of that return and the characteristics of those components. • In relation to financial position: the economic resources controlled by the entity, its financial structure, liquidity and solvency, risk profile and risk management approach, and capacity to adapt to changes in the environment. • Information about the generation and use of cash, which provides a further perspective on financial performance.

Outside commentators on the objectives of reporting delineated in conceptual frameworks: Many practitioners and academics have commented on the above approaches. For example, Bromwich (1992) pointed out that in the FASB’s Conceptual Framework the emphasis was strongly on information for decision-making. The same is true of the ASB Statement of Principles. Depending on how information for decision making is understood and how stewardship is understood, it is possible that information useful for decision-making purposes may not be useful for assessing stewardship? 34

Chapter 2: Conceptual framework

The ASB defines stewardship broadly so as to include accountability not only for the safekeeping of the resources, but also for their proper, efficient and profitable use. It therefore involves an economic decision on whether (for example) to hold or sell shares and to reappoint or dismiss the management. Some would take a narrower view of stewardship and the information deemed useful by the ASB may not stretch to this specific. Similarly, by focusing on the assumed common need, does the FASB ignore the possibility of differing (and possibly conflicting) needs of different users? In focusing in particular on investors and creditors, many other groups could be harmed by standards promulgated to meet the needs of these particular groups. This is the ‘social choice’ problem. As Macve (1981) stated: [R]ecognition of the variety of users’ needs and of conflicts between different rights leads to the view that reaching agreement on the form and content of financial statements is as much a ‘political’ process, a search for compromise between different parties, as it is a search for the methods which are ‘technically’ best.

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 financial reporting.

Qualitative characteristics of accounting information Although most conceptual frameworks identify many of the same qualitative characteristics of accounting information, the hierarchy of these characteristics might vary. The overriding concern is that the information that is provided to users should be useful in relation to their decisionmaking process. To ensure that it is useful, this information should have certain characteristics. The characteristics considered here are: • relevance • reliability • comparability • understandability. The FASB, in SFAC 2 Qualitative Characteristics of Accounting Infornation, examines the characteristics that make accounting information useful. It establishes a ‘hierarchy of accounting qualities’ (see Figure 2.1).

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Decision makers and their characteristics

Users of accounting information Pervasive constraint

Benefit > Cost

User-specific qualities

Understandability Decision usefulness

Primary decision-specific qualities Ingredients of primary qualities

Relevance

Predictive value

Feedback value

Reliability

Timeliness

Verifiability

Secondary and interactive qualities

Comparability (including consistency)

Threshold for recognition

Materiality

Representational faithfulness

Neutrality

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 but based on the same characteristics discussed above (see Figure 2.2). What makes financial information useful? Giving information that is not material may impair the usefulness of the other information given

Threshold quality MATERIALITY

RELEVANCE Information that has the ability to influence decisions

RELIABILITY Information that is a complete and faithful representation

COMPARABILITY

UNDERSTANDABILITY

Similarities and differences can be discerned and evaluated

The significance of the information can be perceived

Predictive Confirmatory Faithful Neutral Free Complete Prudence Consistency Disclosure value value representation from material error

Figure 2.2 ASB’s qualitative characteristics of useful financial information The various terms used in the two figures are discussed below.

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? 36

User’s Aggregation abilities and classification

Chapter 2: Conceptual framework

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.’

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.

Comparability The ASB states that comparability enables users to discern similarities in and differences between 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.

Understandability To be useful, information must be understandable. This depends on the way in which 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).

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 that there is a place for conservatism in financial reporting, but that if it is not applied with care it may conflict with qualitative characteristics such as neutrality and representational faithfulness by introducing bias. Conservatism should not imply deliberate, consistent understatement of profit and net assets; rather it requires that adequate consideration be given to the risks and uncertainty attached to business situations. Similarly the ASB states that prudence is only necessary in conditions of uncertainty and should not be used for deliberate overstatement of liabilities/losses or deliberate understatement of assets/gains, nor to create excessive provisions of hidden reserves.

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Trade-off between relevance and reliability Both statements highlight the trade-offs that have to be made between relevance and reliability. The ASB states that where there is conflict ‘it will usually be appropriate to use the information that is the most relevant of whichever information is reliable’. However, financial information should not be provided until it is reliable. But how is one to assess which is ‘most relevant’? What if, for example, one method has greater predictive value but another greater confirmatory value? Neither statement helps the reader to determine how to make these trade-offs. What if different users have different preferences? Bromwich (1992) points to the problem of identifying characteristics for accounting information which are utility- or value-free.

Further comments Does spelling out what is meant by ‘useful’ get us very far? For Macve (1981): ‘many other studies have identified desirable attributes but have not led to greater agreement in practice about particular problems and it shifts the area of disagreement from ‘is this information useful?’ to ‘is this reliable?’ or ‘is this relevant?’ and may merely lead to ‘wordshuffling’. But the analysis may help us identify some reasons for disagreement (e.g. ‘this proposed treatment does not have predictive value/confirmatory value/ faithful representation’). It has been suggested that the definition of ‘reliable’ is circular: information is reliable if it can be depended upon to represent what it purports to represent (i.e. it is reliable if it is reliable). Bromwich (1992) points to two problems with the use of predictive value in the FASB conceptual framework projects: It has not made explicit the decision model it sees investors using. It has not shown how accounting information can obtain predictive value. Activity 2.2 1. Often an accounting standard will have to make a trade-off between reliability and relevance: a. b. c.

What is the difference between reliability and relevance? How should accounting standards rank these two qualitative characteristics? Which user groups need to be considered when determining the relative importance of reliability and relevance? 2. Other qualitative characteristics might be important. Discuss how timeliness, objectivity, verifiability and neutrality might fit in with characteristics we have described already. 3. The benefits from reporting accounting information should exceed the costs. How easy (or difficult) do you think it is to quantify the costs and benefits of an accounting item?

Elements of financial statements Both the ASB and the FASB identify and define elements of financial statements which comprise the building blocks with which financial statements are constructed. The FASB defines 10 interrelated elements whereas the ASB defines only seven.

38

Chapter 2: Conceptual framework

Definition

FASB

ASB

Assets





Liabilities





Ownership interest (equity)





Gains





Losses





Contributions (investment) from owners





Distributions from owners





Comprehensive income



Expenses



Revenues



Central to these definitions are the definitions of assets and liabilities. The ASB defines: • assets as ‘rights or other access to future economic benefits controlled by an entity as a result of past transactions or events’, and • liabilities as ‘obligations of an entity to transfer economic benefits as a result of past transactions or events.’ Although the definition of an asset covers most non-monetary assets found in the balance sheet, it does not necessarily cover all assets, such as certain intangible assets such as client lists. The use of the word ‘rights’ does not restrict the definition to an ownership criterion (consider finance leases).2 In particular, the statements point out that just because a transaction or event affects an element (e.g. results in the creation of a new asset), this does not mean that the effect will be recognised in the financial statements; that depends on the recognition and measurement criteria (discussed below).

2

See Chapter 7.

In addition, ownership interest is defined as ‘the residual amount found by deducting all the entity’s liabilities from all of the entity’s assets.’ The ASB definitions are practically identical to the FASB’s definitions. The FASB statement points out the essential characteristics of assets and liabilities: An asset has three essential characteristics: a. it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash flows, b. a particular entity can obtain the benefit and control others’ access to it, and c. the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. A liability has three essential characteristics: a. it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand b. the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and c. the transaction or other event obligating the entity has already happened.

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91 Financial reporting

The ASB makes further points in relation to assets and liabilities: In relation to assets it notes that: • An asset is not the item of property itself but the rights or other access to some or all of the future economic benefits derived from it. • There need not be legal ownership of the property from which the future benefits are derived. • There need not be legal rights to future benefits. • The future economic benefits need not be certain (though uncertainty may affect recognition). • Entity control involves power to obtain for itself any economic benefits that arise and to prevent or limit others’ access to those benefits; the SOP notes that ‘it is generally not possible for an entity to choose if and when to realise the economic benefits derivable from factors such as its market share, superior management or good labour relations because the rights or other access to such benefits cannot be controlled independently of the business as a whole.’ • Control need not be legally enforceable. • In relation to liabilities the ASB notes that: • ‘Obligations’ implies that the entity cannot avoid the outflow of resources. • Legal obligation is not necessary (for example an obligation may be created by a pattern of past practice). • It need not be certain that there will be a transfer of future economic benefits, only that there might be such a transfer; obligations that may not result in such a transfer will still be obligations, but may not be recognised in the financial statements. • The obligation need not be to transfer known amounts of cash, it could involve, for example, the provision of services.

Further comments Are the definitions useful, given that they are sufficient but not necessary conditions for the inclusion of an item in the financial statements? Macve (1981) points out that the definitions are so general that they are unlikely to exclude anything that one might reasonably want to include. Indeed, the FASB statement itself points out that it expects most assets and liabilities in the present practice to continue to qualify as assets or liabilities under the definitions, and that the definitions neither require nor presage upheavals in present practice. Note that these definitions do not depend on legal enforceability. But how far removed from a legal one might a right or claim be? Is it a question of the probability of future benefits or sacrifice of future benefits? But how probable is probable? (The FASB statement notes that probable is used with its ‘usual general meaning’, referring to ‘that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved.’) What is a past transaction? What gives rise to the existence of an asset or liability? These are some of the recognition problems that the statements do not help with, but which are particularly important for executory contracts3 – that is, a promise for a promise, for example an agreement to sell goods at a future date in return for payment at a future date. The ‘Elements’ chapter in the ASB statement says that rights and obligations under such unperformed contracts represent a single asset or liability 40

3

See below for further discussion.

Chapter 2: Conceptual framework

(‘a net position comprising a combined right and obligation either to participate in the exchange or alternatively to be compensated (or to compensate) for the consequences of the exchange not taking place’), and initially the rights and obligations are likely to be exactly offsetting, though often that will not remain the case. In the chapter on ‘Recognition’, the ASB notes that changing circumstances may cause an imbalance to arise, in which case the net position will either be an asset or a liability and will be recognised if the recognition criteria are met. It states, however, that where such an asset or liability exists, if the historical cost basis of measurement is being used, the carrying value will be the cost of entering into the agreement, which is usually nil. In effect the contract is recognised at nil. Macve concludes that it is difficult to understand why the FASB should think these definitions helpful in analysing and resolving new accounting issues as they arise. Activity 2.3 What do the definitions of assets and liabilities above actually mean? Explain in your own words.

Recognition and measurement in financial statements SFAC 5, SOP4

4

Chapter 4.

Recognition Recognition deals with those items that should appear in the financial statements. The ASB states: The objective of financial statements is achieved to a large extent through depicting in the primary financial statements, in words and by a monetary amount, the effects that transactions and other events have on the elements. This process is known as recognition.

The criteria for initial recognition of an element5 in the SOP are that: 1. There is sufficient evidence that the change in assets or liabilities inherent in the element has occurred (including, as appropriate, evidence that a future beneficial inflow or outflow of will occur). 2. The element can be measured as a monetary amount with sufficient reliability.

5

The elements of financial statements are those discussed above such as assets, liabilities, ownership interest, gain and so on.

Similarly the FASB sets out four fundamental recognition criteria: 1. meeting the definition of an element 2. measurability – having a relevant attribute which is measurable with sufficient reliability 3. relevance 4. reliability. The ASB’s SOP points out that although the starting point for the recognition process may be the effect on assets and liabilities, the notions of ‘matching’ and the ‘critical event’ may help in identifying the effects. However, the SOP emphasises that ‘matching’ is not used to drive the recognition process. It seeks to prevent unrestricted use of the matching concept, otherwise it would be possible to delay recognition in the performance statement of most items of expenditure whose hoped-for benefits lay in the future. It restricts this by allowing only items that meet the definition of assets, liabilities and ownership interest to appear in the 41

91 Financial reporting

balance sheet. Thus expenditure or losses not associated with control of rights or other access to future economic benefits will be recognised as a loss in the period in which they are incurred; and expenditure incurred with a view to future economic benefits where the relationship is too uncertain will be recognised as a loss immediately. However, it recognises that, for example, if future economic benefits are eliminated over several accounting periods, the cost of the asset that comprises those benefits will be recognised as a loss over the same accounting periods. The SOP suggests that focusing on the critical event in the operating cycle may make it easier to identify gains arising from the provision of goods and services; this will be the point at which there is sufficient evidence that the gain exists and it can be measured reliably. This need not be at the time of full performance. The statement suggests that a contract to, for example, build large buildings might involve performing a series of stages for each of which there is a critical event. It suggests that ‘in such circumstances the gain that is expected to be earned on the contract as a whole will need to be allocated among the critical events.’6 The concept of realisation does not appear amongst 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?

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 US, SFAC No. 5 dealt more with current practices than actual recommendations (and 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: 42

6

See Chapter 9.

Chapter 2: Conceptual framework

• 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 suggests 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 changes is acute ‘it will be necessary to adopt a system of accounting that informs the user of the significance of specific price changes for the entity’s financial performance and financial position.’ Little in the FASB statement is likely to lead to a change from existing US practice. Indeed, it largely reaffirms it. Paragraph 2 notes that ‘the recognition criteria and guidance in the Statement are generally consistent with current practice and do not imply radical change’ (though it notes the possibility of future change is not foreclosed – see also paragraph 91). However, the ASB states, in Chapter 6 of the SOP, that the measurement is based on the assumption that a ‘mixed measurement’ approach (often referred to as ‘modified historical cost’)7 will be adopted, whereby some items will be measured at historical cost and others at current value. It suggests that ‘the basis selected will be the one that best meets the objective of financial statement and the demands of the qualitative characteristics of financial information bearing in mind the nature of the assets or liabilities concerned and the circumstances involved.’ Following initial recognition, items will be remeasured, as necessary, to ensure that items measured at historical cost are carried at the lower of cost and recoverable amount, and items shown at current value are kept up-to-date.

7

The ASB (1999) states that although the measurement basis noted above is often referred to as the ‘modified historical cost basis’, it is more accurately referred to as the ‘mixed measurement system’.

The statement asserts that ‘current value is at its most relevant when it reflects the loss that the entity would suffer if it were deprived of the asset involved’ and therefore advocates a measurement basis known as ‘value to the business’ or ‘deprival value’, depicted diagrammatically in Figure 2.3. (The concept of deprival value will be discussed in more detail later in the subject guide.)

Value to the business = lower of:

Replacement cost

and

Recoverable amount = higher of:

Value in use

and

Net realisable value

Figure 2.3 ‘Value to the business’ or ‘deprival value’ 43

91 Financial reporting

The SOP notes that the ‘relief value’ of a liability may be selected in a similar manner. It stops short of advocating a move towards current value accounting: [I]t says nothing about the desirability or otherwise of adopting an approach that involves all balance sheet items being measured at current value, just as it says nothing about the desirability or otherwise of adopting an approach that involves all balance sheet items being measured at historical cost. All it does say is that both these approaches would involve a radical change to existing practice. (ASB, 1999)

However, in discussing the choice of a measurement basis it makes the following points: • As markets develop, measurement bases once thought unreliable may become more reliable. • 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 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. The statement 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’.8

Presentation of financial information Chapter 7 of the SOP discusses the financial statements and the presentation of financial information. It identifies what constitutes good presentation in: 1. the statement of financial performance (the components of performance and their characteristics – ‘their nature, cause, function, relative continuity or re-occurrence, stability, risk, predictability and reliability’) 44

Accountancy, October 1999.

8

Chapter 2: Conceptual framework

2. the statement of financial position (the types and functions of assets and liabilities and the relationships between them) 3. the cash flow statement (distinguishing in particular cash flows from operating activities, and those from other activities). The statement notes the importance of aggregation, interpretation and simplification in portraying items in financial statements, to avoid excessive detail obscuring the message; the notes to the accounts should be used to amplify and explain the statements.

Accounting for interests and other entities Chapter 8 of the SOP discusses how different investments in other entities should be reflected in a single entity’s accounts and in consolidated accounts. This involves issues, such as accounting for business combinations and entities over which there is significant influence, which are considered later, in Chapter 5 of this guide.

Review of the conceptual framework The IASB produced a Discussion Paper in 2006 – Preliminary views on an improved conceptual framework for financial reporting. Subsequently an Exposure Draft (with the same name) was issued in 2008. It was part of series of initiatives developed jointly by the FASB and the IASB to provide a foundation for principles-based and converged standards. The focus is on information for providers of capital and substantively it is wedded to the conventions of previous influential frameworks. Let us review its qualitative characteristics. Relevance and faithful representation are classified as fundamental qualitative characteristics. Faithful representation is meant to replace reliability – and hence is controversial, depending upon how it is interpreted. Comparability, verifiability, timeliness and understandability are classified as enhancing qualitative characteristics. Specific attention is directed to ‘constraints of financial reporting’: • Materiality: the report should not be cluttered with immaterial information: information is understood as material if its omission or misstatement would influence user decisions. • Costs: Benefits of financial reporting should be greater than costs. The emphasis on decision-usefulness is controversial for those who recognise the need to constrain disclosure in an imperfect markets context or who fear that the stewardship dimension might be overlooked. Some believe stewardship should be specifically referred to, perhaps even as a separate objective. A further exposure draft in relation to this project was issued in 2010. This focused on the development of a reporting entity concept. This is again from the perspective of providers of capital seeking information they do not have about a ‘circumscribed area of business activity’. We shall consider the reporting entity concept further later in relation to group accounts. Discussion on other areas, including elements and recognition, and, measurement, continue.

45

91 Financial reporting

Conclusions The ASB’s Statement of Principles in many respects resembles much of the existing practice. However, the SOP has played a significant role in the development of new Financial Reporting Standards (FRSs). As the ASB states ‘…all the standards that have been issued since then [i.e. after the SOP] are therefore based on those principles. Indeed, some of the principles play very significant roles in those standards [i.e. new standards]. For example: • FRS 2 Accounting for Subsidiary Undertakings uses the reporting entity concept described in Chapter 2 of the statement • FRS 4 Capital Instruments, FRS 5 Reporting the Substance of Transactions, FRS 7 Fair Values in Acquisition Accounting, FRS 12 Provisions, Contingent Liabilities and Contingent Assets, FRS 19 Deferred Tax, FRS 26 Financial Instruments: Recognition and Measurement all use the definition of assets and liabilities (where applicable) set out in Chapter 4; • FRS 11 Impairment of Non-Current Assets and Goodwill uses the recoverable amount notion described in Chapter 6; and • FRS 3 Reporting Financial Performance draws on the principles of good presentation described in Chapter 7. • FRS 18 Accounting Policies and FRS 28 Corresponding Amounts draws on the qualitative characteristics of accounting information set out in Chapter 3.’ However the one major difference with existing practice revolves around the notion of ‘matching’. An earlier draft was also criticised for appearing to downgrade the importance of ‘matching’ in the accounting process. Many commentators saw the SOP’s focus on assets and liabilities as emphasising the balance sheet at the expense of the matching concept. They saw this as meaning that certain items which presently appear in the balance sheet as a result of the matching process (certain deferred debits/credits) would be excluded. They agreed that accounting should continue to be based on the recognition of transactions. The SOP retains the emphasis on assets and liabilities, but points out that transactions will continue to be the most common form of event affecting the elements and therefore the most common reason for recognising and de-recognising items in financial statements. However it does not accord primacy to matching; the matching process will be restricted in that expenditure and losses will be carried forward only if there are economic benefits still to be derived from them. Baxter, in supporting this approach, points out that ‘matching’ is a misnomer: [O]ften income rises or falls without a linked match. Thus overheads have no cause-and-effect links with particular revenues; neither have storm damage nor stores’ obsolescence; interest is earned without a cost and so on… If matching is unnecessary for such ‘unlinked’ assets changes, it cannot be essential to the income concept. What matters are the changes in the assets… (Accountancy, October 1999)

46

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).

Reminder of learning outcomes Having completed this chapter, and the Essential readings and activities, you should be able to: • define a conceptual framework • identify the main efforts by the US, the IASC and the UK to introduce a conceptual framework • describe the objectives of financial reporting • explain the ‘ideal’ qualitative characteristics of accounting information • define assets and liabilities • explain and describe recognition and measurement • apply the conceptual frameworks to particular transactions; for instance, would they help in deciding how to account for research and development?

Sample examination questions Question 2.1 Select a ‘conceptual framework’ that is most relevant to your country or the country in which you are studying (e.g. FASB, IASC, ASB). Discuss the main arguments in favour of and against a conceptual framework in general and the strengths and weaknesses of the particular framework that you have selected.

Question 2.2 The FASB’s conceptual framework was expected to: a. guide the body responsible for establishing standards b. provide a frame of reference for resolving accounting questions in the absence of a specific promulgated standard c. determine bounds of judgement in preparing financial statements d. increase users’ understanding of, and confidence in, financial statements e. 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 Evaluate efforts to date to re-orientate the conceptual framework for financial reporting that are part of the IASB and FASB convergence project.

47

091 Financial reporting

Notes

48

Chapter 3: Income measurement and capital maintenance

Chapter 3: Income measurement and capital maintenance Aims of the chapter This chapter introduces different views of income and capital. One is often characterised as the view of accountants, the other is often characterised as the view of economists. The economist view is then considered further in terms of its possible implications for accounting.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • contrast the accountant’s and the economist’s approach to income and asset value measurement • explain Hicks’s definition of ‘well-offness’ and measures of income numbers 1 and 2 • discuss ex ante income and both ex post incomes for Hicks’s income 1 and 2 • calculate income ex ante and ex post for both Hicks’s income measures • discuss the implications of Hicks’s income measures for both economists and accountants.

Essential reading International Financial Reporting, Chapter 4.

Further reading Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting Review 54(1) 1979. Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 3 and 4. Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition. Chapter 14. Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 4. Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940. Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]). Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge: Cambridge University Press, 1983) [ISBN 9780521270557]. Chapter 2.

49

91 Financial reporting

A view of income and capital often characterised as the accountant’s view The accountant is here understood as computing the income for a period by one or both of two approaches that logically give the same financial number: 1. Take revenues less the cost of sales and other expenses for a period to compute profit Y01 directly 2. Compute profit for a period by comparing opening and closing net assets, adjusting for new capital injections or withdrawals, thus (assuming no capital injections) calculating the value of NA1 – NA0 + D0–1 Y01 = NA1 – NA0 + D0–1 Where: Y01

= profit for the period

NA1

= net assets at the end of the period

NA0

= net assets at the beginning of the period

D0–1

= distribution for the period.

Net profit here is the difference between opening and closing net assets before distributions: consistent here with seeing the balancing figure in the balance sheet as profit for the year. By this logic, beyond constraints of a particular view, income depends on valuation of net assets. The approach associated with the economist values net assets using net present values (NPVs).

A view of income and capital often characterised as the economist’s view The relationship between income and capital can be expressed as: Y01 = V1 – V0 + D1 Here V0 is the opening capital value, V1 is the closing capital value and D1 represents consumption (or expected cash flow to be received at the end of year 1). The value of the business is calculated using the present value of expected cash flows. Activity 3.1 Compare and contrast the views of income and capital discussed above. Activity 3.2 A business is set up by Zillah Corporations with an expected four-year life. At the start of 2010, the cash flows expected to occur at the end of the years to which they relate are: £ 2010

10,000

2011

8,000

2012

6,000

2013

4,000

Assume the interest rate is 10% and is expected to remain constant. What would be the economic value of the business at the start of 2010 (i.e. V2010)? The solution to this activity is given in Appendix 2. 50

Chapter 3: Income measurement and capital maintenance

Hicks’s version of the economist’s concept of income Many accounting theorists have appealed to the notions of Economic Income developed by Sir John Hicks in his book Value and Capital.1 This is perhaps strange, as Hicks notes that income is a ‘rough approximation’, a ‘guide for prudent conduct’, whose purpose in practical affairs is ‘to give people an indication of the amount which they can consume without impoverishing themselves’. This leads to Hicks’s central concept of income:

1

See Further reading above.

the maximum value a person can consume during a week and still expect to be as well off at the end of the week as at the beginning.

(Note that Hicks uses ‘week’ to denote a period during which variations in price might be neglected in analysis; extreme inflatory conditions, for example, may problematise this.) Although Hicks’s analysis relates to the individual, it has also been applied to measuring corporate income. The Sandilands Committee on inflation accounting based its proposals on Hicks’s central concept, defined for a company as: the maximum value the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning.

The corporate equivalent of ability to consume is thus related to the dividend the company could pay. What, then, does it mean ‘to be as well off’? Hicks spells out a number of practical ‘approximations’ to his central concept (see below).

Hicks’s income number 1 Hicks’s first approximation (income number 1) is: the maximum amount that can be spent during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts (in money terms).

Actually, all Hicks’s constructs refer to the individual’s spending in a period, if in principle the key to each construct is the individuals consumption during the period. Hicks notes that the measure of durable goods consumption could be difficult without satisfactory secondhand markets for the goods (if such markets exist, consumption can be measured by change in the goods’ value over the specified period). Under Hicks’s number 1, ‘well-offness’ to be maintained is thus the NPV of future cash flows. Hicks sees this as the definition most people implicitly use in their private affairs, but as leading to ambiguities when interest rates change (see Hicks’s number 2 below). Let us assume all future cash flows occur at the end of each relevant period with certainty, and that there is one constant interest rate for borrowing and lending. Taking time 0 as the present time and time 1 as the end of the first period (say a year), we initially use the following notation: D1 = the cash flow arising at time 1 V1 = the capital value at time 1 (= PV of future cash flows from time 1 onwards) V0 = the capital value at time 0 (= PV of future cash flows from time 0 onwards). 51

91 Financial reporting

The capital values are measured excluding dividends, i.e. V1 does not include the cash flow receivable at time 1 (D1). Income number 1 for the period from time 0 to time 1 (Y01) is thus measured as: Y01 = D1 + V1 – V0 If the individual actually consumes this amount of income assuming consumption in the period from t0 to t1 is all paid for at the time t1), then remaining wealth at t1 is V0, so the individual is as well-off at the end of the period as at the beginning. The above expression can be interpreted in two ways. First, we can write the expression as: Y01 = (D1 + V1) – V0 The term in parentheses represents the total expected wealth, made up of net cash received plus the present value of expected future net receipts, at the end of the first period. So Y01 is the amount by which total wealth is expected to increase during the period. The second way of splitting the expression above is: Y01 = D1 + (V1 – V0) This can be interpreted as dividing economic income into two components: the expected cash flow for the period and the expected change in the value of the individual’s wealth (excluding end-of-period cash D1). We might refer to the component in parentheses as an expected holding gain or loss. This should be distinguished from a windfall gain or loss (discussed below), which is unexpected.

Example 1: perpetuity A government bond pays £150 a year for ever. If the interest rate is 10%, then the capital value of the bond at time 0 (ex interest) is: £150 = £1,500 = V0 0.1 At t1 the value of the bond (cum, or with, interest) is: £150 + £150 = £1,650 = V1 0.1 Therefore the income from the bond is: Y01 = £1,500 – £1,650 = £150 This is the same each year, and the capital value remains at £1,500 (ex interest).

Example 2: an annuity An annuity pays £150 p.a. at the end of each of the three years and costs £373.00. The interest rate is 10%. Analyse each year’s receipts into ‘income’ and repayment of ‘capital’. Assume that all the ‘income’ is spent and the ‘capital’ receipts are reinvested in a bank account which pays interest at 10%:

52

Chapter 3: Income measurement and capital maintenance

£

1

2

3

4

5

6

7

Opening value

Income from annuity

‘Capital’ receipt from annuity

Total receipts from annuity

Interest on bank deposit @ 10%

Total income (2+5)

Capital Bank value of balance annuity after payment

Total capital (7+8)

(10% × 1)

(10% × 8)

8

9

Time t0

–

–

–

–

–

–

373.00

–

373.00

t1

373.00

37.30

112.70

150.00

–

37.30

260.30

112.70

373.00

t2

260.30

26.03

123.97

150.00

11.27

37.30

136.33

236.67

373.00

t3

136.33

13.63

136.37

150.00

23.67

37.30

–

373.00

373.00

Thereafter the bank pays £37.30 interest each year on the balance of £373.00. Applying the formulae above, we find: V0 = £373.00 V1 = £260.30 D1 = £150 Y01 = £150 + £260.30 – £373 = £37.30 Note: The actual financing and consumption policy adopted will not alter the calculation of the income from the annuity in column 1.

Example 3: a ‘capital budgeting project’ An investment project is expected to have the following cash outlays and receipts. Time

Cash Flows

Discount Factor @ 10%

t0

– 4,000

1.0000

t1

+2,000

0.9091

t2

+1,500

0.8264

t3

+2,000

0.7513

Activity 3.3 If the cost of capital is 10%, what is the NPV of the project to the nearest £1? The solution is in Appendix 2 at the back of this guide. Analyse the cash flows into ‘income’ and ‘capital’, on similar assumptions to the previous example above and assuming the initial outlay of £4,000 was borrowed via a bank overdraft.

53

91 Financial reporting

£

1

2

3

4

Opening value

Income from project

Capital receipt or shortfall (4-1)

Total project receipts

(10% × 1)

5

Interest received/ (paid) (payments) to bank

6

7

8

9

Total income (2+5)

Capital value of project

Bank balance

Total capital (7+8)

(overdraft)

(10% × 8)

Time t0

–

–

(4,000)

(4,000)

–

–

4,560

(4,000)

560

t1

4,560

456

1,544

2,000

(400)

56

3,016

(2,456)

560

t2

3016

302

1,198

1,500

(246)

56

1,818

(1,258)

560

t3

1,818

182

1,818

2,000

(126)

56

–

560

560

Therefore the bank account will pay £56 p.a. interest on the £560 balance. Applying the valuation and income formulae above: Project value at time 1 = £1,500 × (0.9091) + £2,000 × (0.8264) = £3,016 Project value at time 2 = £2,000 × (0.9091) = £1,818

Example 4: Cash flows Your friend expects to get cash of £1,000 at time 1 and £2,000 p.a. thereafter (all cash flows arise at year end) in perpetuity. The rate of interest is expected to remain at 10% p.a. He wishes to consume all income, but no more, and can borrow from and lend to the bank at 10% p.a. What is his income in year 1? Relevant variables are as follows: D1 = £1,000 (= cash flow at time 1) V1 = £2,000 = £20,000 0.1 (= PV of future cash flows from t1 onwards)

(

V0 = £1,000 + 1.1

)

£2,000 × 1 0.1 1.1

= £909.09 + £18,181.82 = £19,090.91

(= PV of future cash flows from t0 onwards) Therefore income number 1 equals £1909.09: £1,000 + £20,000 – £19,090.91 = £1,909.09 How can he consume £1,909.09 when the year’s cash flow is only £1,000? He only has cash of £1,000, but could borrow £909.09 from the bank at the prevailing rate of interest; this would reduce his capital at time 1 (V1) from £20,000 to £19,090.91 thus maintaining his original capital (V0). Interest of £90.91 p.a. on the loan would reduce net future cash flows to (£2,000 – £90.91) = £1909.09 p.a. (Rather than borrow, he could realise £909.90 of the capital value at time 1 by sale, leaving capital value at £19,090.1, on which future receipts at 10% p.a. would be £1,909.09.) Future income will remain at £1909.90 p.a. provided he exactly maintains his opening capital. In this example income equals the rate of interest (r) applied to the opening capital value (i.e. rV0). This is because V0 equals (D1 + V1) discounted back one period by r, which in turns means that (D1 + V1) equals (1 + r)V0 ; income may thus be expressed as (1 + r)V0 – V0, or rV0. 54

Chapter 3: Income measurement and capital maintenance

It should also be noted that, on the assumptions made so far, if the opening capital is exactly maintained and all the income (including the accretion to capital value) consumed, then in future years the income figure would be constant (and equal to rV0). Summary of formulae: Y01

= D1 + V1 + V0

V0

= D1 + V1 l+r

(l + r)V0

= D1 + V1

Y01

= (l + r) V0 _ V0

Y01

= rV0

Income ex ante and income ex post If we relax the assumption of certainty, problems arise. In addition to different people having different expectations about the future, in conditions of uncertainty actual cash flows will tend to differ from forecast cash flows. Moreover, new information or changing conditions will revise expectations about all future cash flows. Given these differences, we will have different amounts for the capital values at time 1 and time 0, and for the cash flow at time 1, depending on whether these were calculated at the beginning or end of the year. We may call our calculations made at the beginning of the year, at t0, ex ante or ‘forward-looking’ and add the symbol ‘t0’ to show they were computed at time 0 in the light of the knowledge and expectations we had at that time. We may call our calculations made at the end of the year, at time 1, ex post, or ‘backward-looking’ and add the symbol ‘t1’ to show they were computed at time 1 in the light of our revised knowledge and expectation. We use the following notation: Ex ante variables D1t0

=

the cash flow we expect to receive at time 1, given our knowledge and expectations at time 0

V1t0

=

the expected capital value at time 1, given our knowledge and expectations at time 0

V0t0

=

the opening capital value at time 0, given our knowledge and expectations at time 0 (This will equal (D1t0 + V1t0) discounted back one period at the rate of interest for that period.)

Ex post variables D1t1

=

the actual cash flow occurring at time 1

V1t0

=

the capital value at time 1, given our revised knowledge and expectations at time 1

V0t1

=

the revised calculation of our opening capital value given the actual cash flow for the year and our revised expectations at the end of the year. (This will equal (D1t1 + V1t1) discounted back one period at the rate of interest prevailing for that period.)

Given these differences between ex ante and ex post calculations, we now have different measures of income number 1 depending on the time the income number is calculated. 55

91 Financial reporting

Income number 1 ex ante First of all, we may calculate income ex ante, or ‘forecast’ income based entirely on our expectations at the beginning of the period, time 0. For Hicks, this is the figure relevant to decisions. This makes sense if income is regarded as a guide to consumption. Income number 1 ex ante may be expressed as: Number 1 Y01 ex ante = D1t0 + V1t0 – V0t0 As noted earlier, this equals rV0t0. For the reason given above, income number 1 ex ante will always equal interest on the capital value at the start of the period.

Income number 1 ex post version A and version B We may alternatively (or in addition) calculate income number 1 ex post, income for the period calculated at the end of the period. There are, however, two possible versions of income number 1 ex post, which we will call ‘version A’ and ‘version B’. They differ in their treatment of windfall (unexpected) gains and losses. Windfalls (unexpected) arise from differences between: • forecast and actual cash flows for the period • original expectations of future cash flows from the end of the period onwards and our revised expectations of future cash flows. (They may also arise from differences between expected and actual interest rates, or changes in expected interest rates, but we are as yet assuming constant interest rates.) Version A Version A may be expressed as: Income number 1 Y01 ex post version A = D1t1 + V1t1 – V0t0 This is actual cash flow for the period plus capital accumulated including windfalls. Hicks describes income ex post as income ex ante plus windfalls. Thus the definition of ex post income incorporates all windfalls measured as: (D1t1 + V1t1) – (D1t0 + V1t0) Here, income is no longer equal to rV0t0 (because windfalls are not reflected in the opening capital value). It could be argued that the definition of Hicks income 1 ex post version A set out above is meaningless as it compares two numbers calculated using information available at time t1 with a number calculated using only information available at time t0. If the individual had the information at t0 that the individual has at t1, the individual’s calculation of NPV would not have been the originally calculated V0t0 but rather: V0t1 =

1 (D1t1 + V1t1) l+r

This gives an alternative version of ex post income: version B. Version B Version B may be expressed as: Income number 1 Y01ex post version B = D1t1 + V1t1 – V0t1 This is actual cash flow for the period, plus capital accumulation excluding windfalls. 56

Chapter 3: Income measurement and capital maintenance

Windfalls are excluded because we have restated our opening capital with the benefit of hindsight to what it would have been had we had perfect foresight at t0. This measure would therefore have been our ex ante income number 1 if we had had perfect knowledge at t0; it follows that income under this version is equal to rV0t1. The treatment adopted for these ex post windfalls determines our ex ante income for future periods (assuming we consume all income). Including them in income under version A maintains our originally foreseen capital value as the basis for measuring future income ex ante and (assuming constant interest rates) our ex ante income for the next period would equal ex ante income for this period (rV0t0). Excluding them from income as per version B maintains revised opening capital value as the basis for future ex ante income and (assuming constant interest rates) ex ante income for the next period would equal ex post (version B) income for this period (= rV0t1). Thus this second version of ex post income is closer to Hicks’s own intentions than version A.

Example 5 A project is expected to generate cash flows of £10,000 p.a. in perpetuity. The interest rate is expected to remain at 10% p.a. Cash flows arise at year end. At the end of the first year the actual cash receipts are £5,000. At that time, expectations of future cash receipts are changed to £12,000 p.a. The interest rate for the first year is 10% and is expected to remain unchanged. 1. What is the income for the first period (i) ex ante and (ii) ex post? 2. Reconcile the ex ante income with both versions of ex post income. At time 0 and time 1 we have the following information: ex ante

Beginning of the year →

currently here

D1 0

t2 10,000 ………….…

t3 10,000

t4 → 10,000 8

t1 10,000

→

t0 Cash flows

V 1t0 →………

V 0t0 →……………………………………………………………………… ex post

→

End of the year →

currently here Cash flows

t2

t3

t4 →

5,000

12,000

12,000

12,000

D1t1

8

t1

…………. … V 1t1 →…………………… →

t0

V 0t1→ ………………………………………………………………………

Ex ante variables

Ex post variables

D1t0 = £10,000

D1t1 = £5,000

V1t0 = £10,000 = £100,000 0.1

V1t1 = £12,000 = £120,000 0.1

V0t0 = £10,000 = £100,000 0.1

V0t1 = £5,000 + £120,000 = £113,636 1.1 1.1

→

57

91 Financial reporting

Income 1 ex ante, Y 01

ex ante = D1t0 + V1t0 – V0t0 = £10,000 + £100,000 – £100,000 = £10,000 (= 10% × £100,000 = rV0t0)

Income 1 ex post Y01

ex post version A = D1t1 + V1t1 – V0t0 = £5,000 + £120,000 – £100,000 = £25,000 (no longer equal to interest on the opening capital value).

Y01

ex post version B = D1t1 + V1t1 – V0t1 = £5,000 + £120,000 – £113,636 = £11,364 (=10% × £113,636 = rV0t1)

Note that even if ex post income is based upon knowledge of the actual cash flow that we know at time 1, it is still based upon expectations of the future from time 1 onwards; V1t1 still measures expected future cash flows discounted at the expected rate of interest. Thus, income ex post is still a very subjective measure. Reconciliation

£

1. Budgeted income for year (ex ante)

10,000

Revision of current cash flow (D0t1–D1t0)



Revision of forecast cash flows (V0t1–V1t1) Income for the year (ex post) version A +2,000 0.1

20,000

2. Budgeted income for year (ex ante)

25,000

10,000

Revision to capital value at beginning of the year due to: Decrease in actual cash flow

– 5,000 = 1.1

Revision to forecasts after t1:

+ 2,000 × 1 = 0.1 1.1

Net change Add interest on net change 13,637 @ 10% Income for the year (ex post) version B

18,182 13,637 1,364 11,364

What if interest rates are expected to change? So far interest rates have been assumed to remain constant. What happens if interest rates are expected to change, or change unexpectedly? How does this affect our concept of income? We have already noted with income number 1 that unexpected changes in interest rates would give rise to windfalls through the effect on capital values (see also example 7 below). But Hicks goes further and suggests that once we allow for changes in the rate of interest we must change our ideas about what constitutes ‘well-offness’ and hence our ideas about income measurement. Now that interest rates are allowed to change, the following additional notation will be used: 58

Chapter 3: Income measurement and capital maintenance

Ex ante variables r0t0

= the interest rate from time 0 to time 1, given our knowledge and expectations at time 0

r1t0

= the interest rate from time 1 to time 2, given our knowledge and expectations at time 0

rnt0

= the interest rate from time n to time n + 1, given our knowledge and expectations at time 0

Ex post variables r0t1

= the interest rate that actually prevailed from time 0 to time 1

r1t1

= the interest rate from time 1 to time 2, given our knowledge and expectations at time 1

rnt1

= the interest rate from time n to time n + 1, given our knowledge and expectations at time 1

Example 6 A security pays £200 a year forever. At time 0 the interest rate is expected to be 10% p.a. for the first two years and 20% p.a. thereafter. All cash flows arise year end. At the end of each year the difference between income (calculated on a number 1 basis) and cash received is invested in a bank account at the prevailing interest rate so as to maintain the opening capital value. What is income number 1 ex ante for each of the first three years? Ex ante variables D1t0

= £200 (= Dnt0 for all n from 2 to infinity)

V2t0

= £200 = £1,000 (Vnt0 for all n from 3 to infinity) 0.2

V1t0

= £200 + £200 × 1 1.1 0.2 1.1

V0t0

= £200 + £200 + £200 × 1 = £1,173.50 1.1 (1.1)2 0.2 (1.1)2

r0t0 = r1to = 10%

(

(

)

= £1,090.90

)

r2t0 = 20% = rnt0 for all n from 3 to infinity Y01 = £200 + £1,090.90 – £1,173.50 = £117.40 (=10% × £1,173.50) £82.60 will be invested in the bank, so that total capital at time 1 is now £1,173.50 (i.e. the security valued at £1,090.90 plus the bank balance of £82.60). The expected capital value at time 2 is now the security valued at £1,000 plus £82.60 in the bank, a total of £1,082.60. The bank pays interest of £8.3 (rounded) at t2 so that cash receipts at time 2 total £208.30. Y12 = £208.30 + £1,082.60 – £1,173.50 = £117.40 £90.90 will be invested in the bank at t2, so that total capital (security plus bank balance) is once more maintained at £1,173.50; the total amount now in the bank is £173.50 (i.e. £82.60 plus £90.90), on which interest at 20% will be £34.70 p.a. Future cash receipts will therefore total £234.70. Capital value at time 3 will consist of the security valued at £1,000 and the bank deposit of £173.50 = £1,173.50. Y23 (and each year thereafter) = £234.7 + £1,173.50 – £1,173.50 = £234.70 59

91 Financial reporting

Since the capital value is henceforth expected to be constant, and the interest rate to remain constant at 20%, ex ante income for period 3 onwards will be £234.70 p.a. for ever. Thus, according to Hicks’s income number 1 ex ante, the income stream here will be £117.40, £117.40, £234.70, £234.70,…,£234.70. But in these circumstances Hicks suggests that someone who could consume that pattern of income appears to be getting better off over time as the prospect of spending £234.70 a year draws nearer; one may be thought better off if one can consume £234.70 a year rather than £117.40 a year. Yet in his central concept Hicks has defined income as the amount one can consume during the year while remaining as well-off at the end as at the start; thus, there would be no change in one’s well-offness. Hence Hicks suggests that maintenance of the capitalised value of prospective money receipts does not correspond with our ideas of welloffness when interest rates change.

Hicks’s income number 2 The possibility that individuals could exploit changes in interest rates to change their consumption pattern leads Hicks to develop his second approximation of income: the maximum amount the individual can spend this week and still expect to be able to spend the same amount in each ensuing week.

For a company we may define it as: the maximum dividend the company can pay in a period and still expect to be able to pay the same dividend in all future periods.

When interest rates are not expected to change (and do not change), this will be the same as income number 1; if interest rates are expected to change (or do unexpectedly), the two income measures differ and Hicks regards number 2 as a better measure of income and closer to his central concept. In example 6 above, income number 2 would be £200 every year – the amount the security pays every year regardless of the interest rate. Note also the effect of an unexpected change in the interest rate on income number 1, ex post, compared with income 2, even when cash flows are regular perpetuities.

Example 7 A bond pays £100 at the end of each year forever. The rate of interest is expected to be 20% p.a. forever (i.e. r0t0 = rnt0 for all n from 1 to infinity), so the bond’s value is £500 (i.e. 100/0.2). At time 1 the interest rate (r1t1) unexpectedly changes to 10% and is expected to remain at 10% forever thereafter (i.e. r1t1 for all n from 2 to infinity); the bond’s value therefore rises to £1,000 (i.e. 100/0.1). The revised opening capital value is: V0t1 = (D1t1 + V 1t1) = 100 + (100/0.1) = £916.66 1.2 1.2 Income ex ante, both number 1 and 2, is £100 (= 20% × £500, i.e. r0t0(V0t0)) since the interest rate is not expected to change. Income number 1 ex post version A is: 100 + 1,000 – 500 = 600 Income number 1 ex post version B is: 100 + 1,000 – 916.66 = 183.34. Although this is 20% on the revised opening capital value (i.e. r0t1(V0t1)) note that future income ex ante will no longer be this amount, but 60

Chapter 3: Income measurement and capital maintenance

(assuming that all of the income is consumed so that the capital is maintained at V0t1) will be 10% × £916.66 = £91.66 (i.e. r1t1(V0t1)). But here income number 2 still measures ex post income as £100. The constant annual cash flow is unaffected by the change in the interest rate; it is therefore the amount that can be spent this period with the expectations of being able to spend the same amount in all future periods. (As noted below, however, if cash flows are not regular perpetuities, an unexpected change in the rate of interest will affect income number 2 ex post.) Number 2 ex ante When the net cash flows are regular perpetuities, income number 2 ex ante will equal the amount of the net cash flows. If they are not regular perpetuities but interest rates are assumed constant, it will (as noted above) equal income number 1 ex ante. If the cash flows are not regular perpetuities and there are expected changes in the interest rate, calculation of income number 2 ex ante is more difficult. Assuming, however, that just one change is expected, at time 1, after which rates are expected to remain constant (i.e. r1t0 = rnt0 for all n from 2 to infinity) then income number 2 ex ante may be calculated by solving for Y in the following: V0t0 =

Y + 1 + r0 t0

(

Y × r1 t0

1 1 + r0 t0

)

where Y equals the amount of the annual income. This reflects the fact that the constant annual stream of consumption when discounted at the prevailing interest rates must have a present value equal to the opening ‘well-offness’ or capital value. In the case considered here, it may be solved also by finding income (Y) such that: Y =r1t0 (D1t0 + V1t0 – Y) So Y =

r1 t0 (D1t0 + V 1t0) 1 + r1 t0

Number 2 ex post Income number 2 will be affected if there are differences between expected and actual cash flows or differences between originally expected cash flows and our revised expectations of those cash flows. Once again we will have ex post measures. Moreover, there will again be two different measures of ex post income, depending upon how we treat windfalls. Income number 2 ex post version A may be defined as: the maximum amount an individual can consume in a period and still expect to be able to consume the originally foreseen number 2 ex ante income in all future periods.

This version treats as windfall gains or losses all end-of-year period wealth that is not needed to generate in future periods the initially determined Hicks’s number 2 income ex ante. The second version of ex post Hicks’s number 2 aims to calculate the amount that, if consumed in the first period, will leave enough wealth to permit the individual to consume the same amount in all subsequent periods. Income number 2 ex post version B may be defined as: the maximum amount an individual can consume in a period and still expect to be able to consume the same amount in all future periods. 61

91 Financial reporting

It therefore follows the basic definition of number 2, but calculates as income what would have been the ex ante income had one, at time 0, had the knowledge and expectations that one has at time 1. It therefore excludes windfalls from income. When the cash flows are not regular perpetuities, an unexpected change in the interest rate will also affect income number 2 ex post, because of the additional borrowing and lending necessary to achieve the equalised stream of consumption.

Example 8 A project is expected to generate cash flows of £2,000 per annum in perpetuity. The rate of interest is expected to remain constant at 10%. £2,000 is actually received at time 1, but at that time the rate of interest suddenly changes to 20% and is expected to remain at that level forever. Also at that time, expectations of future cash flows are changed to £4,000 per annum forever. All cash flows arise at the end of the year. What is the income for the first period?

Ex ante

Beginning of the year currently here ↓

V 0t0

t2

t3

t4 →

2,000

2,000

2,000

2,000

D1t0

……….…

8

t1

→

t0 Cash flows

V 1t0 →………

r0t0 = 10% (= rnt0 for all n from 1 to infinity) End of the year

Ex post

currently here↓ Cash flows V 0t1

t2

2,000

4,000

D1t1

t3

t4 →

8

t1

4,000 →

t0

……….…

r1t1 = 20% (=rn t1 for all n from 2 to infinity)

At time 0 and time 1 we have the following information: Ex ante variables

Ex post variables

D1t0 = £2,000

D1t1 = £2,000

V1t0 = £2,000 = £20,000 0.1

V1t1 = £4,000 = £20,000 0.2

V0t0 = £2,000 = £20,000 0.1

V0t1 = £2,000 + £20,000 = £20,000 1.1 1.1

Income number 1 ex ante and income number 2 ex ante These both equal £2,000 per annum since the interest rate was not expected to change. 62

4,000

V 1t1→………

Chapter 3: Income measurement and capital maintenance

Income number 1 ex post This would also equal £2,000 as capital values at time 1 and time 0 are unchanged at £20,000. Income number 2 ex post version A Given that there is only one change in the interest rate and it is expected to be constant from time 1 onwards, income number 2 ex post version A may be calculated as follows. The original number 2 ex ante income was £2,000. To maintain it in the future at 20% p.a. requires capital of only £10,000 (i.e. 2,000/0.2). Since the capital value at time 1 (v1t1) is £20,000, £10,000 of that may be consumed as income this year, which, added to the actual cash flow for the period, gives total income for the year of £12,000. This may be expressed as: Y = D1t1 + V 1t1 – Original number 2 ex ante income r1t1 To consume this income it would be necessary to sell £10,000 of the capital value at time 1, or to borrow £10,000 at 20%. Reconciliation

£

Budgeted income for the year ex ante

2,000

Change in forecasted cash flows + 2,000= 0.1

20,000

Change in interest rate

2,000 – 2,000 = 0.2 0.1

Income for the year ex post version A

12,000

Income number 2 ex post version B Income number 2 ex post version B may be calculated by making use of the fact that the revised standard stream of consumption from time 0 onwards must have a present value, when discounted at the prevailing interest rates, equal to the revised opening capital value (v0t1). Thus, V0t1 =

Y + 1 + r0 t1

(

Y × 1 r1 t1 1 + r0 t1

)

where Y equals the amount of the annual income. Thus: 20,000 =

Y + 1.1

(

Y × 1 0.2 1.1

)

which, when solved for Y, gives income of £3,666.67. In order to consume this, capital of £1,666.67 must be realised by sale (or borrowed at 20%), leaving £18,333.33, on which income at 20% p.a. will be £3,666.67. Here, this may alternatively be calculated by solving for: Y = r1t1 (D1t1 + V 1t1  Y) Reconciliation

£

Budgeted income for the year ex ante

2,000.00

Change in forecasted cash flows +2,000 × 1 = 8,333.33 0.2 1.2 Interest on revision to capital @ 20% (8,333.33 × 0.2) =

1,666.67

Income for the year ex post version B

3,666.67

63

91 Financial reporting

Note that this is the only ex post income measure that involves no looking backwards. The other figures are based on information at time t0 or use the interest rate that has just passed. Hicks income number 2 ex post version B uses only end-of-year period realisations of cash flows and capital values and prospective interest rates.

Hicks’s income number 3 Hicks recognises that even income number 2 is not the end of the story, because if prices are changing we want to be able to consume the same amount in real terms each week: we need a standard stream of real consumption. He therefore defines approximation number 3 as: the maximum amount of money which the individual can spend this week and still expect to be able to spend the same amount in real terms in each ensuing week.

Hicks sees that the problem with calculating this lies in finding an appropriate index number of prices – a problem we return to in our discussions of current purchasing power accounting in Chapter 4.

Implications of Hicks’s measures of income Hicks price-level income is not uniquely defined. Even ignoring contrasting changes, and calculation to income numbers 1 and 2, the result is six different measures of income. Does this matter? Hicks observes that all definitions are based on an individual’s expectations. Income has been defined as a forward-looking, ex ante concept. This makes sense if income is a guide to consumption. But what happens if expectations are not achieved? Hicks notes that the value of an individual’s prospective receipts at the end of the period can be more or less than the same value determined at the beginning of the period. In other words, the information available to the individual at the end of the period may lead to revision of the original calculation of the capital value of prospective receipts. Basing his discussion on Hicks income number 1, Hicks calls increases or decreases in the capital value of prospective receipts at the end of the period windfall gains or losses, and describes income ex post as income ex ante plus windfall gains less windfall losses. Although Hicks acknowledges that ex post measures of income might have usefulness as historical measures of activity, he sees no role for them in economic analysis, as ex post measures (by definition) come too late to affect individual decision making. This leads him to argue that windfall gains and losses will come into future income calculations. Thus Hicks concludes that income is a ‘very dangerous term’, that ‘the concept is one that a positive theoretical economist only employs in his argument at his peril’ and that income is ‘a bad tool which breaks in our hands’.

Implications for accountants Using income as a basis for sharing out rewards from past performance (‘ex post settling up’) depends in part on an updated view of likely future performance. One version of income ex post (A above) would be objective if the capital values at the beginning and end of the period were fully represented 64

Chapter 3: Income measurement and capital maintenance

by assets whose values were established in perfect markets. The assets of many manufacturing and trading businesses illustrate that this is not reality. Such assets are specific and not regularly traded, and the businesses’ prospects of future earnings depend largely on the skills of the company’s employees, established trading relationships, reputation for product quality, market power and so on; in other words the value of these businesses comprises a large element of ‘goodwill’ whose value is essentially subjective. The other version of income ex post (B above) is subjective, relying on estimates of what the opening capitalised value of the prospects would have been at the beginning of the period if information available now had been available then. For a decision-making perspective, calculation of income ex post has value primarily in terms of budgetary control (i.e. monitoring of outturn and revision of plans in order to learn from mistakes in the hope of improving future decisions). The ex post incomes have little significance on their own for future decisions – these must be based on the new calculation of income ex ante for future periods (which version B also provides). As calculation of the new income ex ante includes the capital value now, this does suggest that information on the present market values of assets (i.e. current wealth endowment) may be helpful, to both management and shareholders, in forming their estimates of a company’s likely future prospects. Although such estimates must be subjective, it could be helpful for shareholders to be given the management’s estimates, since these are the basis on which the management are reinvesting the shareholder’s money.

So what is the value in studying these theoretical concepts of income? The value lies not so much in deriving prescriptions for accounting, as in the appreciation of the following limitations of any practical income measurement: 1. There can be no objective income measurement (including historical cost); actual cash flows may be seen as objective financial results. Any attempt at income measurement requires valuations which in most cases are subjective and cannot be ‘correct’. 2. Income measurements based on changes in the value of the recorded ‘net assets’ of a business can give only a partial picture of the changes in the value of the business as a whole. 3. Income measurements ‘ex post’ are not in themselves useful for management or shareholders’ investment decisions. They may help to improve decision-making (through comparisons with previous plans), but are only helpful for current and future decisions in so far as they can assist the formation of expectations about the future. Some would argue that ex post measures are useful as ‘control’ information (i.e. providing feedback for assigning responsibility and for corrective action). But Solomons (1961) argues that two coupled factors also severely limit the potential of ex post income measurement for control: • the general impossibility of identifying how much of any variance from, or revision to, a plan is ‘controllable’ and therefore the responsibility of the relevant manager • the inherent subjectivity in making revised expectations about the future. 65

91 Financial reporting

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • contrast the accountant’s and the economist’s approach to income and asset value measurement • explain Hicks’s definition of ‘well-offness’ and measures of income numbers 1 and 2 • discuss ex ante income and both ex post incomes for Hicks’s income 1 and 2 • calculate income ex ante and ex post for both Hicks’s income measures • discuss the implications of Hicks’s income measures for both economists and accountants.

66

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values 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 to adjust for general price changes. 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 approach that tries to combine these two approaches.

Learning outcomes By the end of this chapter, and having completed the Essential readings and activities, you should be able to: • discuss the basis of HCA • describe the advantages and disadvantages of HCA • identify why other conventions have been proposed as alternatives/ supplements to HCA • discuss why CPP was proposed as an alternative to HCA • describe the difference between monetary and non-monetary items • convert HCA to CPP by following the step-by-step guide • understand conceptually the different treatments of monetary and nonmonetary items • compute real gains and losses on monetary items • delineate advantages and disadvantages of CPP • relate the CPP concepts here to Hicks’s versions of income • explain the concept of deprival value (DV) • discuss replacement cost (RC), net realisable value (NRV) and present value (PV) • explain the concepts of current operating income and holding gains • discuss different concepts of capital maintenance and their implications for corporate reporting • explain the implications of Hicksian income in relation to the capital maintenance concepts • prepare a balance sheet and income statement using specific price indices, including calculating holding gains and losses • calculate deprival values when replacement involves: • replacement with a brand new asset • replacement when prices have changed • replacement following technological changes 67

91 Financial reporting

• assess whether deprival values reflect the Hicksian income approach • delineate advantages and disadvantages of RC accounting and DV accounting • prepare a fully stabilised current value income statement and a fully stabilised balance sheet, including calculating real realised and real unrealised holding gains/losses • explain current operating profit and holding gains in fully stabilised current value accounting.

Essential reading International Financial Reporting, Chapters 5, 6 and 7.

Further reading Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984) [ISBN 9780860036234] Chapters 3, 8 (pp.103–115) and 12 (pp.182–201). Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing 1992) [ISBN 9780273034643]. Company Law Review Steering Group Final Report. Chapter 3, paragraphs 3.33–3.45. Ijiri, Y. ‘A Defence for Historical Cost Accounting’ in R. Sterling (ed.) Asset Valuation and Income Determination. (Lawrance, KA: Scholars Book Co., 1971) [ISBN 9780914348115]. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 4. Peerless, S. ‘Accounting for Business Marriages’, Accountancy Magazine, October 1994, p.100. Prakesh, P. and S. Sunder ‘The Case Against Separation of Current Operating Profit and Holding Gains’, American Accounting Review, January 1979 (pp.1–22). Sandilands Report, Inflation Accounting: Report of the Inflation Accounting Committee, Cmnd. 6225. (London: HMSO, 1975). Chapters 10 and 12 (pp.159–65). Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge: Cambridge University Press, 1983) [ISBN 9780521270557].

Relevant IASB standards IAS 1 Presentation of Financial Statements. IAS 29 Financial Reporting In Hyperinflationary Economies.

Introduction The historical cost convention has had a major influence on financial accounting. The basic principle is that transactions are recorded at their original money (or nominal) cost. Without adjustment, the application of this principle produces accounts that poorly reflect notions of economic value and profit in real world contexts, most evidently when things change. Even in the absence of inflation (a general rise in prices), prices change. This questions the relevance of reporting at £100 (the original purchase price) an asset that can now be sold for £1,000 and would cost as much to replace (because of changes in its value in the market place). In conditions of inflation, £100 at the start of a year would have less purchasing power than £100 at the end of a year, questioning the relevance again of historic cost accounts, for example for decision 68

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

making involving comparisons and for raising issues about the logic of adding together money figures equating to different purchasing power (as representing transactions occurring at different points in time). In principle, a current value accounting (concerned with reflecting specific price changes) may be combined with a current purchasing power accounting.

Revising HCA The historical cost convention records transactions at the £ value at the date of transaction: An asset or liability being measured using the historical cost basis is recognised initially at transaction cost. (Statement of Principles, 1999, Chapter 6, Principles).

This convention is used as a basis for financial statements. In the income statement, revenues and expenses are recorded at the £ value shown on the invoice. HCA might be useful for certain purposes. It has been deemed relatively reliable and objective and has been seen as a suitable convention for decision making regarding basic stewardship. But it may not be the most suitable for all decisions and at all times, e.g. regarding investment in a dynamic context. Such a view has been apparent in the UK, with attempts to introduce supplementary accounts based on the current purchasing power (CPP) convention (in 1974) and the current cost convention (CCA) (in 1980). Neither of these was adopted after their initial trial. However, in the UK, standard-setters have moved away from a modified historical cost system to a mixed system: [A]ssets will, depending on the circumstances, be carried in the financial statements at historical cost, replacement cost, net realisable value or value in use and that liabilities will, again depending on the circumstances, be carried at historical cost or the lowest amount at which the liability could be settled. (Statement of Principles, para. 6.32)

For example, in accordance with the prudence concept, inventory is valued at the lower of cost or net realisable value.1 The balance sheet does not always reflect historical cost; for instance, in the UK, land and buildings can be revalued and other assets with a finite economic life can be depreciated or amortised. In addition some assets may be carried at fair value:

1

See Chapter 9.

An asset or liability that is being measured using the historical cost basis will be recognised initially at transaction cost or, if an event other than a transaction is involved, at its fair value at the time it was acquired or assumed. (Statement of Principles, para. 6.11)

Or at current value:2 If an asset or liability arises from a transaction that was not carried out at fair value, it will often be more appropriate to measure the asset or liability at current value rather than historical cost. (Statement of Principles, para. 6.15)

2

See later in this chapter.

If you look in the notes to a company’s accounts, accounting policies will typically state that the financial statements have been prepared under the historical cost convention. However, most quoted companies in the UK will also have some revaluations and will take into account fair values. In many hyper-inflationary economies HCA might not be used. 69

91 Financial reporting

Activity 4.1 Why do you think that changing prices might create problems in interpreting both the balance sheet and the income statement?

Characteristics of HCA HCA became the traditional way in which accounting transactions are recorded, reported and interpreted. The main characteristics of HCA include the following: • Objectivity/factuality: in itself it is objective and factual in that the figures can be vouched to actual transactions. • Profit/income concept: profit as the difference between revenue and expenses resonates with common understandings to some extent. The accounting measurement of income represents historical income and is an ex post measure. Activity 4.2 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.

Advantages of HCA HCA has both advantages and disadvantages but it remains an influential convention in preparing accounts. The advantages are: • It is more objective/factual/verifiable and in this sense reliable (although it may involve subjective allocations). • Because of its relative objectivity, HCA may reduce conflicts over numbers – its ‘hardness’ reduces the ability to disagree with the accounting figures. For example, Iriji (1971) states that hard measurement systems are those which ‘generate verifiable facts by justifiable rules in a rigid system which allows only a unique set of rules for a given situation’. Consequently when dealing with performance related pay, for instance, debate about pay levels may revolve less around the firm’s actual profit figures as all in the dispute are likely to understand how historical cost profits are calculated: Hardness is argued to be a desirable characteristic for accounting figures which are likely to be used in conflict situations – performance measurement, for example. Such figures reduce any squabbles concerning the figures themselves and therefore allow the true items of debate to emerge. (Bromwich, 1992)

• It may be relevant to users’ legal needs, for example for legal/ contractual purposes (in particular stewardship), to show what funds have been raised and how they have been spent. • It is relatively inexpensive to operate.

70

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values The historical cost convention has the advantage of familiarity. This probably makes it cheaper to apply, because procedures for its implementation are well established, and easier to use, because users too have established routines for interpreting it. This advantage may extend to any existing departures from historical cost: familiarity on the part of both preparers and users may be reduced costs and increased acceptability. (Exposure Draft: Statement of Principles for Financial Reporting, ASB 1995)

• It enables comparability. • For Ijiri (1967) 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)

Disadvantages of HCA Many of the disadvantages of HCA relating to price changes have prompted calls for alternative accounting systems. The disadvantages include: • It is still subjective in practice (e.g. it depends on depreciation policy and inventory valuation): ...adjustments made to the historical cost carrying value of trade receivables to make allowance for bad and doubtful debts involve a degree of estimation that is not dissimilar to that involved in estimating current values not derived from an active market – and the results are often of broadly similar reliability. There is a similar level of estimation involved in determining the cost of self-generated assets and by-products, and generally in all circumstances involving allocations of substantial amounts of indirect costs. (Statement of Principles, para. 6.28)

• It is unlikely to be relevant to the economic needs of users since it is unlikely to reflect future cash flows to be earned by an asset/assets or the future cash flows likely to replace it/them, and therefore may lack predictive value in times of changing prices. Only in the case of completed ventures or a stationary state of perfect and complete markets, with accounting depreciation equalling changes in market values, would historical cost give economic income and value.3 • The balance sheet does not report a company’s value4 and hence lacks apparent relevance.

3

See Chapter 3.

4

See Chapter 3.

…this ‘pure historical cost basis’ is rarely used. Instead, to make historical cost more relevant to the needs of users, a variation is used that involves a limited amount of remeasurement. (Statement of Principles, para. 6.18)

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91 Financial reporting

• Holding gains and operating gains are not distinguished5 and unrealised gains are not reported which may result in fictitious profits from the perspective of economic theory.6 This is because a historical cost income statement reports gains on holding assets when they are realised, not when they occur. Consequently no distinction is made between past period gains realised in the current period and current gains realised in the current period.

5 See later in this chapter and refer back to the discussion of Hicksian income in Chapter 3.

6

See later in this chapter.

• Consequently HCA confuses gains from operating and gains from holding assets in a period of price change. • Some argue that HCA fails the ‘additivity’7 test, because £s of different values are being added together to give a meaningless total. But is this the fault of historical cost, in itself, or of the measuring unit? The question, however, still arises, however, as to whether it is actually useful: [T]he capital of the entity is defined as the monetary amount of ownership interest (the financial capital maintenance concept) and is measured in monetary amounts. With this approach, the capital of the entity will be maintained if the amount of gains during a period is at least equal to the amount of losses in that period…Whilst this approach is satisfactory under conditions of stable prices, it is open to criticism when general or specific price changes are significant. (Statement of Principles, paras. 6.40–2)

For example: If specific prices are rising e.g. if the prices of particular noncurrent assets and inventory are increasing and general prices 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 depreciation)

50,000

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. 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) Matched with inventories (hold three months inventory so assume average cost) Depreciation for various dates between Other expenses evenly throughout the year so on average Profit 72

£JUNE £MARCH £1953–2010 £JUNE ______?

7

The total number in a statement should not mean something different in kind from its constituent numbers.

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

• 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: in e.g. leases, financial instruments and executive share options.

Alternatives to HCA There have been many attempts to identify alternatives to HCA. Deprival value is one approach to asset valuation. For Bonbright (1937): the value of a property to its owner is identical in amount with the adverse value of the entire loss, direct or indirect, that the owner might expect to suffer if he were deprived of the property.

We shall consider the following methods: • Current purchasing power or general purchasing power: this method considers general price levels. • Replacement cost (RC) – also known as ‘current entry cost’. This is a form of current value accounting (CVA) which considers specific price levels. • Net Realisable value (NRV) – also known as ‘current exit value’. This is another form of CVA which considers the NRV of assets. • Present value (PV) – also known as ‘economic value’. This method is another form of CVA which considers the net present value (NPV) of future cash flows. • Deprival value – also known as ‘value to the business’ or ‘value to the owner’. This involves consideration of RC, NRV and PV (with the PV of asset use being calculated) valuation bases.

Introducing CPP accounting We have suggested that one major disadvantage of HCA is its inability to cope with changing prices. In particular, in times of rising prices HCA will overstate profits. Consequently, the accounting profession developed what may be considered two broad approaches in response to the problems raised by accounting for changing prices/inflation: 1. An approach concentrating on the effects of general price changes (i.e. inflation). This is known as current purchasing power accounting (CPP). 2. An approach concentrating on the effects of specific prices and the current values of the assets and other items in the financial statements – the replacement cost, realisable values and the variant combining cost/value as value to the business or deprival value. This is known as current value accounting (CVA). These two approaches, together with HCA, are predominantly distinguished by two elements: 1. how you value assets 2. how you treat capital maintenance. 73

91 Financial reporting

General and specific changes in price We suggested that, in times of rising prices, HCA should be adjusted to reflect price changes. However, what is the appropriate price adjustment? The nature of changing prices involves change in the relationship between money and goods and services. There are two broad ways in which the relationship between money and goods can change: 1. specific or relative price change 2. general price change. The latter may be measured through indices, and in the UK the Retail Price Index (RPI8) has been used. This tries to measure inflation (the general tendency of prices to rise) on an individual’s purchasing power. Thus if you bought a textbook last year for £10 and during the year the RPI was 5% then you would expect to pay £10.50 to replace your textbook. A specific or relative price change, however, is based purely on the goods or services in question (e.g. if the cost of your textbook in the shops is £10.60 then the specific price change is 6%). CPP (or general purchasing power (GPP)) uses a general price adjustment to convert HCA to CPP. Note: HCA uses monetary units (e.g. UK £) as the unit of measurement. CPP units measured on (say) 31 December 2008 are not the same as CPP units measured on (say) 31 December 2010. It is important that you understand this underlying feature of CPP.

Profit recognition and capital maintenance In times of rising prices HCA will overstate profits so CPP adjusts HCA figures to account for inflation. Subsequently, profit recognition depends on maintaining capital in real terms. Note that there are different ways in which capital maintenance can be assessed.9 The focus here is on capital maintenance of financial capital in real terms.

Relationship to Hicksian income This may be related to the Hicksian concept of income HCA is based essentially on the maintenance of financial capital in money terms. For example, Company A has an opening capital of £50,000 and a closing capital of £65,000. Thus profit is £15,000 (assuming no distributions or capital injections), which it could consume and still be as well-off as it was at the start of the period. Would this hold true if there had been high levels of inflation experienced during this period? No. Comparing opening and closing historical cost balance sheets when prices are changing gives dubious information. Similarly, due to the inextricable link between balance sheet values and figures in the income statement, this latter account will not produce profit/income to satisfy Hicks’s definition of income in a time of changing prices. If we take the RPI as the inflation measure and it has risen by 20%, withdrawing £15,000 will leave the business ‘worse-off’. Why? Because to maintain capital maintenance in real terms and be as well-off at the end of the period as at the beginning, you would need to set aside £10,000 to maintain the purchasing power (i.e. £60,000 at the end of the period has the equivalent purchasing power of £50,000 at the beginning of the period). Therefore income under capital maintenance of 74

8

The RPI is calculated each month by taking a sample of goods and services that the typical household might buy. Included are such items as food, heating, housing, household goods, bus fares and petrol. Every month, a civil servant will visit a number of shops and examine prices and record the details for the benefit of government statisticians. These figures for retail prices will reveal the trend for prices over the previous month, but an annual rate is also published and it is this number which attracts the attention of the media, wage bargainers and policy makers who have to decide whether it is appropriate to increase tax allowances and state benefits to compensate for inflation.

9

Glautier and Underdown cite five concepts of capital maintenance. This subject guide discusses only three of these, which are sufficient to illustrate the differences in concepts. However, you should consider the additional concepts.

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

financial capital in real terms is now only £5,000. CPP accounting attempts to deal with this problem by adjusting HCA for the effects of inflation, thereby maintaining its general purchasing power.

Application in the UK Throughout most of the 1970s and early 1980s, inflation was relatively high in the UK, with rates of inflation well above 10% and on occasions over 20%. Consequently it was recommended in the Provisional Statement of Standard Accounting Practice, (PSSAP 7), which was published in May 1974 but withdrawn in 1978, that companies were expected to supplement HCA with a statement illustrating the effects of changes in the purchasing power of money. PSSAP 7, para. 12, stated: Companies will continue to keep their records and present their basic annual accounts in historical pounds, i.e. in terms of the value of the pound at the time of each transaction or revaluation; in addition, all listed companies should present to their shareholders a supplementary statement in terms of the value of the pound at the end of the period to which the accounts relate; the conversion of the figures in the basic accounts into the figures in the supplementary statement should be by means of a general index of the purchasing power of the pound. [SSAP 7 recommended that the RPI should be used for this purpose.]

Assessing CPP accounting? From HCA to CPP: Monetary and Non-monetary items CPP accounting requires the separation in the accounts of monetary and non-monetary items. CPP attempts to identify and reflect the gain or loss on holding these monetary items. Duting inflation, one loses from holding monetary assets (such as cash) as opposed to non-monetary assets. For example, holding £1,000 of cash in your wallet for a year, when prices are increasing, will result in a loss of purchasing power (since what you could have bought for a £1,000 a year ago is not equivalent to what you could now purchase as goods and services are more expensive).

Monetary items These items are fixed by contract in terms of a currency (e.g. UK £) and the monetary amount is unaffected by price changes. Typically shortterm monetary assets and liabilities include cash and trade receivables, creditors and bank overdrafts, and long-term monetary liabilities include long-term loans (and interest thereon). In contrast to holding monetary assets, if you hold monetary liabilities you will gain when prices are increasing. For example, say Company A obtained a long-term loan of £10,000 payable in five years’ time, when the company actually comes to pay this loan off in cash, the cash used has less purchasing power than it had at the time the loan was incurred: £10,000 in period-end pounds is worth less than £10,000 was in start-of-period pounds.

Non-monetary items These items typically include non-current assets, inventory and shareholders’ equity (equity share capital, reserves, retained profit reserve). 75

91 Financial reporting

Converting from HCA to CPP: a step-by-step guide Step 1: Convert the income statement The HCA income statement must be converted to a CPP income statement. Each HCA item in the income statement needs to be indexed to do this. The process of converting HCA to CPP is relatively simple and easy to use. It is based on the same underlying principles as HCA but uses £s of a common date. CPP involves multiplying the HCA values by the change in the relevant general index (such as the RPI). The change in the relevant index is calculated as follows: The index on the date of stabilisation The index on the date of transaction What is the date of stabilisation? Let us assume the income statement is for the year ending 31 December 2002 and you wish to restate the income statement to £s of a common date (e.g. to 31 December 2002 purchasing power), then the index used is the RPI for the 31 December 2002. What is the date of transaction? In a similar way, the date of the transaction is based upon when the actual item in the income statement (e.g., a sale) took place; say on 30 June 2002. Thus the index on the date of transaction used is the RPI for 30 June 2002. When stabilising total sales, total purchases and so on, a simplifying assumption is that they all took place evenly throughout the year and hence you would use the average RPI.10 This is a convenient assumption; without it you would have to index every individual sale, purchase and so on taking place during the year. Activity 4.3 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 for the following months: Date

RPI

1 January 2010

100

30 June 2010

120

31 December 2010

150

10

Note that such a simplifying assumption would only be applied if it was valid. See the worked example and explanation of CPP below.

What would the stabilised value of the sales be in the CPP income statement? The solution to this activity is given in Appendix 2.

Step 2: Calculate the losses or gains on monetary items The calculation of gains or losses on monetary items may be calculated as separate gains/losses on holding each monetary item (e.g. trade receivables, cash, creditors) or as combined losses/gains on net short-term monetary items. The first method11 is best explained via an example. Let us assume that Company A wishes to stabilise its accounts to 31 December 2010. During the year it had a creditor (account payable) of £12,000 outstanding from 30 April 2010 to 31 July 2010. The RPI index for the relevant months was: 76

11

In the section ‘Worked example and explanation of CPP’, both methods of calculating loss or gain on monetary items will be shown.

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Date

RPI

30 April 2010

115

30 July 2010

132

31 December 2010

150

To calculate the holding gain for this three-month period you need to allow for the movement in the index from 30 April to 31 July. This gain is measured by the term in brackets below and amounts to £1,774. However, the gain at 31 July is measured in purchasing power as at 31 July 2010, and in accounts stabilised to 31 December 2010 the gain must be restated to purchasing power as at 31 December, by allowing for the movement in the index from 31 July to 31 December. Hence the gain on the monetary item as at 31 July is multiplied by 150/132, that is, from 31 July to 31 December. Therefore the gain on creditors (accounts payable) is £12,000 ×

(

132 – 115 × 150 115 132

)

= £2,016

Activity 4.4 Try to explain the nature of the holding gain of £2,016 on the monetary item above.

Step 3: Convert the balance sheet The HCA closing balance sheet is converted into CPP based on closing balance pounds of purchasing power. However, only the non-monetary items are converted by the change in purchasing power since they were initially recorded. The monetary items should not be converted; adjustments were already made in Step 2 to capture holding gains and losses on these items. Activity 4.5 Why do you think the monetary items are not converted? Activity 4.6 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 were: 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? The solution to this activity is given in Appendix 2.

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91 Financial reporting

Worked example and explanation of CPP 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

31 December 2010

121

117

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 4: Historical cost accounting (HCA) and accounting for changing prices/values

Solution to Anderson Ltd Step 1: Convert the income statement Transaction Date Item

HCA (£)

Evenly*

600,000

×

121/110

660,000

Sales

Index

CPP (£31DEC2007)

Less cost of sales 1 January

Opening inventory

70,000

×

121/100

84,700

Evenly*

Purchases

344,000

×

121/110

378,400

414,000 30 October

463,100

Less closing inventory (120,000) ×

121/117

(124,103)

294,000

338,997

Gross profit

306,000

321,003

Depreciation:

_______

________

Less expenses Buildings

(3,200)

×

121/100

(3,872)

P&E

(10,000)

×

121/102

(11,863)

31 December Interest

(12,000)

**

Evenly*

Wages

(150,000) ×

121/110

(165,000)

Evenly*

Sundry expenses

(80,000)

121/110

(88,000)

×

(12,000)

(255,200)

(280,735)

Gain and losses on 50,800 on monetary items:

40,268

Loss on cash

(11,451)

Loss on trade receivables

(1,913)

Gain on debentures

16,800 3,436

Income statement

50,800

43,704

Notes * The average index for the year is used for sales/purchases/expenses as they are assumed to have occurred evenly throughout the year. ** Denotes monetary items.

Explanation for converting the income statement The index used to convert HCA to CPP items has the same numerator of 121. This captures the date when one is stabilising the accounts – 31 December 2010. The denominator captures the date the transaction occurred (sales were assumed to take place evenly over the year and therefore the appropriate RPI is for the average of 110, the June RPI).

79

91 Financial reporting

Step 2: Calculate losses/gains on short-term and long-term monetary items Short-term monetary items here are cash and receivables. The long-term monetary item is debentures (due 2018). Loss on short-term monetary items may be calculated in two ways: 1. as separate losses on holding trade receivable and cash 2. as a combined loss on net short-term monetary items. Short-term monetary items calculated as separate losses • Calculating the loss on trade receivables The receivable was outstanding from 30 June to 30 September. At 30 September a loss on having a receivable for three months is calculated by allowing for movement in the index from 30 June to 30 September. This loss is measured by the term in brackets below and amounts to £1,818; however, the loss at 30 September is measured in £30Sept10, and in accounts stabilised in £31Dec10 the loss is restated to £31Dec10 by allowing for movement in the index from 30 September to 31 December. Hence the loss in £30Sept10 is multiplied by 121/115:

(

)

40,000 × 115 – 110 110

×

121 115

= £1,913

• Calculating the loss on cash The loss on holding cash is the difference between the HCA closing cash balance and the CPP closing cash balance. To convert the HCA cash balance to a CPP balance, each item in the cash account is stabilised to the year-end. Usage of the index is as before. Date

Item

HCA(£)

Index

1 Jan

Ordinary shares

260,000

121/100

1 Jan

Debenture

1 Jan

Factory premises

1 Jan

Inventory

1 Feb

Plant & equipment

30 June Cash sales* 30 June Purchases 30 June Sundry expenses 30 June Wages 30 Sept Received from Trade receivable 30 Sept Ordinary shares 31 Dec

Interest paid

31 Dec

Closing balance

CPP (£31Dec10) 314,600

80,000

121/100

96,800

(136,000)

121/100

(164,560)

(70,000)

121/100

(84,700)

(100,000)

121/102

(118,627)

560,000

121/110

616,000

(344,000)

121/110

(378,400)

(80,000)

121/110

(88,000)

(150,000)

121/110

(165,000)

40,000

121/115

42,087

24,000

121/115

25,252

(12,000)

121/121

(12,000)

72,000

83,452 (rounded) Loss = £11,452

Note

* The average index for the year is used for sales/purchases/expenses as they are assumed to have occurred evenly throughout the year.

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Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Short-term monetary items calculated as a combined loss on net shortterm monetary items Date Item HCA(£) Index CPP (£31Dec10) 1 Jan

Ordinary shares

1 Jan

Debenture

1 Jan

Factory premises

1 Jan

Inventory

1 Feb

Plant & equipment

260,000

121/100

314,600

80,000

121/100

96,800

(136,000)

121/100

(164,560)

(70,000)

121/100

(84,700)

(100,000)

121/102

(118,627)

600,000

121/110

660,000

(344,000)

121/110

(378,400)

(80,000)

121/110

(88,000)

(150,000)

121/110

(165,000)

30 June Total sales 30 June Purchases 30 June Sundry expenses 30 June Wages 30 Sept Ordinary shares 31 Dec

Interest paid

31 Dec

Closing balance

24,000

121/115

25,252

(12,000)

121/121

(12,000)

72,000

85,364 (rounded) Loss = £13,364

Activity 4.7 Reconcile the two methods of calculating short-term monetary losses calculated above. The solution to this activity is given in Appendix 2.

Step 3: Convert the HCA balance sheet Transaction date 1 January 1 January 1 February

Item Land Buildings (NBV) Plant (NBV)

HCA (£) 56,000 × 76,800 × 90,000 ×

Index CPP (£31Dec2010) 121/100 67,760 121/100 92,928 121/102 106,765

222,800 30 October

Inventory Cash

Debentures

120,000 × 72,000

267,453 121/117 **

124,103 72,000

192,000

196,103

414,800 80,000

463,556 80,000

**

334,800 Shareholders’ funds Ordinary shares 260,000 × Ordinary shares 20,000 × Share premium A/C 4,000 ×

1 January 30 September 30 September (From income statement above) Income statement 50,800 334,800

383,556 121/100 121/115 121/115

314,600 21,043 4,209 43,704 383,556

Note: ** denotes monetary items.

81

91 Financial reporting

Activity 4.8 Why has HCA profit (£50,800) become £43,704 (£CPP at 31 December 2010) profit. Activity 4.9 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? The solution to this activity is given in Appendix 2.

Advantages of CPP Several advantages have been put forward in support of CPP: • It is easy to convert HCA into CPP accounts. • The conversion is objective and verifiable as it is based on an inflation measure applied universally. • It expresses all items in common purchasing power. It corrects timelag errors (particularly on inventories and depreciation) in the income statement. • It facilitates comparison between companies and understanding of trends (e.g. of sales and profit) if all years are expressed in the same purchasing power. • It measures profit after maintaining shareholders’ capital in real terms. As it shows real gains and losses on monetary items, users of the accounts can assess the financial management policy.

Disadvantages of CPP A number of disadvantages have been suggested: • CPP accounts are still based on HCA rather than current values. Any subjectivity problems associated with HCA remain. • The balance sheet does not provide up-to-date asset values nor does the income statement have up-to-date charges for assets consumed. • There may be problems in interpreting/explaining the figures. The education problem when measuring units change is often overlooked (compare lbs v. kilos, inches v. centimetres, fahrenheit v. centigrade). Part of the education problem is getting users to appreciate that companies typically have monetary working capital for operations and therefore will report purchasing power losses on those items. • HCA accounts are converted into CPP units – but what exactly are CPP units? • The difficulty of finding the appropriate index: • Some argue that inflation is unquantifiable (but is it better to be partly right than completely wrong?) • Some say the RPI is inappropriate because companies buy, for example, things like plant and machinery not goods such as clothing, food and television sets (which determine the RPI). But are we trying to measure the income of the company as a separate entity, or the income of the shareholders? If the latter, the RPI is relevant, because shareholders are concerned with their ability to buy goods and services in general.

82

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

• Others say the RPI is not representative of the effect of inflation on the shareholder group. But empirical tests of the heterogeneity hypothesis12 suggest that the impact of inflation on different groups is very similar. • Does the focus on maintaining purchasing power of shareholders’ funds give the most meaningful concept of profit?

Introduction to current value accounting (CVA)

12

The heterogeneity hypothesis states that changes in different individuals’ purchasing power are not captured by changes in a general index.

In current value accounting, the balance sheet and income statement show current values in place of historical cost of assets. One problem is which current values should be used: • Replacement cost? (And how should that be defined?) • Net realisable values? • Present value (sometimes called ‘economic value’)? • Deprival value (sometimes referred to as ‘value to the business’ or ‘value to the owner’). Each valuation method will be investigated.13 We will also explore a combined CVA/CPP system of accounting and consider two capital maintenance concepts: • operating (or physical) capital maintenance

13 All of these bases of valuation are further discussed in Whittington (1983), pp.115–31.

• financial capital maintenance in money terms.

Replacement cost accounting (RCA) In RCA, all the assets are entered in the financial statements at the cashequivalent value of what it would cost the organisation to replace them (also known as entry costs). There may be a choice of three possible ‘replacement costs’: 1. Reproduction cost: the amount that would currently have to be paid to purchase an asset identical to the one currently owned (i.e. like-with-like). 2. Cost of replacing with best alternative asset (i.e. one best suited to perform the function of the existing asset, adjusted for depreciation). This has the advantage of allowing for the possibility that technological change has rendered the existing asset obsolete. 3. Replacement of service potential tries to measure the cost of replacing the services provided by the existing asset. It does this by adjusting the above(2) for operating advantages or disadvantages compared with the existing asset. An issue with the RCA is that if the company has no intention of replacing (because the capital budget shows replacement is not worthwhile), or cannot replace, is the figure of any relevance?. This will be discussed later.

Net realisable value (NRV) Using NRV, the value of an asset is the estimated amount that could be raised from its sale (net of selling expenses); this is also known as the exit value. For example, consider a vehicle bought for £24,000, with an expected life of four years, a nil residual value and a straight-line depreciation policy. At the end of the first year the HCA net book value is £18,000 (£24,000 – £6,000). If the vehicle’s NRV at the end of the first 83

91 Financial reporting

year was £19,500 then the balance sheet carrying value is £19,500 and the depreciation charge is £4,500 (£24,000 – £19,500). The arguments in favour of this basis are that it: • measures the economic sacrifice made by continuing to hold and use the asset • enables users to compare the return earned with the return available on investing those funds elsewhere • reflects the adaptability of the company. But against NRV is its lack of predictive value if the company has no intention of selling the asset. This would be greater if the company owned highly specific assets with a zero or negligible (or even negative) realisable value. Such NRVs would provide no indication of expected future cash flows and would produce some strange income numbers: The accounts show a loss if the firm buys useful but specific machines and a profit if it buys unsuitable machines with a high resale value.14

Activity 4.10 How do you think NRV accounting reconciles with the going concern concept? In general, do you consider RC accounting or NRV accounting to be the more prudent?

Present value (PV) This basis measures assets at the net present values of future cash flows to the asset. The main variant is the PV from using the asset: its value in use in the business. For example, let us assume you have an asset that has an expected useful life with the company of four years. Its net cash contribution (revenue less operating and maintenance costs) over the four years would be £15,000 per annum. The company expects to earn 10% per annum on all capital invested, and this would be the discount rate. The asset would be valued in the accounts at £47,549, that is, £15,000 multiplied by an annuity factor at 10% for four years (£15,000 × 3.1699). The PV from sale could also be calculated (of course, when an asset is being used this value is typically lower than the value in use and hence not the PV of the asset considered in terms of all possibilities). In its favour, it is argued that it would provide a Hicksian measure of income in the accounts and would also be useful as a predictor of future cash flows. But the figures may lack reliability. To compute present values requires estimation of all future cash flows together with an appropriate discount rate. Moreover, if we adopted an asset-by-asset approach to financial reporting, it would be difficult to allocate cash flows to individual assets when they work as part of a team. It may only be possible to measure the cash flows of the business as a whole.

Deprival value (DV) Deprival value was developed from the ideas of Bonbright who wrote (in The Valuation of Property, 1937): The valuation of a property to its owners is identical in amount with the adverse value of the entire loss, direct and indirect, that the owner might expect to suffer if he were to be deprived of the property. 84

14

Baxter (1984), p.124.

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

In other words, the DV of an asset is the amount of the loss which a business would suffer if that asset was lost or destroyed, assuming that the owner takes optimal action on deprival. According to the circumstances, deprival value will either be RC or NRV or PV (typically, in use). DV = min.[RC, max (NRV,PV)] Or diagrammatically: Deprival value = lower of: RC higher of: NRV

PV

If the asset is traded in a good market RC and NRV will be available. Alexander et al. (2005, p.95) discuss the six possible relationships that exist between these three values, which can be summarised as follows: Correct valuation NRV> PV > RC

RC

NRV>RC > PV

RC

PV > RC > NRV

RC

PV >NRV> RC

RC

RC > PV > NRV

PV

RC >NRV> PV

NRV.

The relationships can be described as follows: 1. If an asset is worth replacing then state it at RC. 2. If an asset is not worth replacing but is worth keeping then state it at PV in use. 3. If an asset is not worth replacing or keeping then state it at NRV (or, conceivably, PV from sale if that differs from NRV). DV reflects courses of action implied by mainstream economics and values assets on this basis. It asks how much compensation would be needed if the asset was lost. Problems in calculating the DV of depreciating assets, and pros and cons of DV are considered later. Activity 4.11 Let us assume you were going to attend an interview for a job paying £20,000 p.a. and an hour before the interview someone spilt coffee down your business suit. The cost of replacing your suit would be £800 and you don’t have time to get it cleaned before the interview. What would be the best action to take and hence what would be the deprival value of your suit? The solution to this activity is given in Appendix 2.

Example: DV CheapAir Ltd., a small airline company, has decided to account for assets on a current value basis, using DV as current value. However, the accountant does not understand DV and has asked you to help. The table and notes below give management estimates relating to two of the company’s aircraft, the 001Y and the 890T. 85

91 Financial reporting

001Y £

890T £

Net book value

50,000

1,400,000

Net realisable value in market

60,000

1,440,000

Current purchase price of an aircraft in similar condition

90,000

1,500,000

Notes: a. 001Y is rarely used, but is kept as a stand-by machine. If it were not available it is estimated that average annual cash outlay on rental of £17,000 would have to be spent on hire of a machine from another company. The annual expenditure on keeping 001Y airworthy is £10,000. Stand-by facilities will continue to be required as long as can be foreseen. b. 890T if retained would have in its best use an expected flying life of 10 years with the company, at the end of which its NRV would be £600,000. Its annual net contribution to the cash flow over the ten years would be £240,000. The company expects to earn 10% p.a. on capital invested. This discount rate should be used in your calculation. To ascertain the DVs you will need the PV, the NRV and the RC for each aircraft. You currently, in the table above, have the RC and NRV; therefore you need to calculate their PVs (in use). Calculating the PV for 001Y and 890T 001Y:

The net annual saving of cash expenditure on stand-by: £ Rent saved Less maintenance required on present machine

17,000 (10,000) 7,000

Present value of perpetuity at 10% p.a. therefore equals £70,000 890T: Cash flow Annual contribution in service (i) Present value of 10-year annuity at 10% Terminal realisation value

1,473,600 600,000

(ii) Present value of terminal realisation value Present value of future contribution in use ((i)+(ii)) Calculating deprival value for 001Y and 890T 001Y

86

PV

240,000

For aircraft 001Y, RC= £90,000, NRV = £60,000 and PV (in use) = £70,000. Under these conditions it is worthwhile for the company to retain the asset since it is worth more in use than selling now, that is, PV (in use) >NRV. Given that PV (in use)NRV. However, unlike aircraft 001Y, RC RC of total business. – The sum of RC of individual assets > PV (in use) of total business. – The sum of PV of individual assets > PV (in use) of total business. • Does the concept of deprival have meaning for all assets (e.g. development expenditure)? • Is the idea of replacement always appropriate (e.g. development expenditure, goodwill)? Note: Many of these problems would apply equally to other systems; for example, one based purely on PV (in use) would be subjective, while those based purely on RC would have the same problems about the absence of good markets, and piecemeal versus wholesale replacement.

Combined CPP/CVA system Lewis and Pendrill (2004, Chapter 21) raise interesting points on: ‘whether current cost accounting can be further developed as a fully stabilised set of accounts based on a CPP unit of measurement’; and ask, ‘why not combine the best features of CVA and CPP?’ As we know, CPP and CVA offer opposing approaches when dealing with price rises: • CPP accounting deals with general price rises only. • CVA deals only with specific price rises. 101

91 Financial reporting

However, both types of price rise are in fact occurring at the same time. Consequently, for example, any holding gains on assets under CVA may be fictitious since, although it may be a money gain, it may not actually be a real gain. For example, let us assume you own an asset that had originally cost £15 when purchased a year ago; now the current replacement cost is £20. In the CVA accounts you would have shown a holding gain of £5. But what if the RPI had increased over that year by 20%? Thus £5 × 20% or £1 of that holding gain of £5 is not ‘real’ because it cannot be translated into an increase in purchasing power. CPP/CVA in combination – known as ‘fully stabilised current value accounts’ – would indicate whether the company’s financial capital (the shareholders’ funds) is maintained in real terms. The basic approach is to restate the CVA accounts into current purchasing power. Example and explanation Given the information from the Barrow Ltd example above, the following movements occurred during 2010 in the retail prices index: RPI 1 January 2010

100

30 June 2010

110

31 December 2010

121

Required An income statement for the year ended 31 December 2010 and a balance sheet at that date, on a financial capital maintenance basis, incorporating replacement costs for assets sold, consumed and held, stabilised in purchasing power units of 31 December 2010 (i.e. fully stabilised current value accounts).

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Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Income statement for CVA (financial)22 and fully stabilised CVA (FSCVA) (financial) CVA Financial £

Index

FSCVA Financial £

Sales

26,000

121/110

28,600

Cost of sales

15,840

121/110

17,424

10,160

11,176

Depreciation

3,750

121/121

3,750

Expenses

6,000

121/110

6,600

Current operating profit Debenture interest

410 1,000

22 Given in the solution for the example above – Barrow Ltd.

826 121/121

1,000

(590)

(174)

750

120

6,750

1,080

– Real realised

3,840

2,904

– Real unrealised

3,520

1,840

Holding gains: Non-current assets – Real realised – Real unrealised Inventories

Gains/losses on monetary items Gain on long-term monetary items

–

2,100

Loss on short-term monetary items

–

(4,100)

14,270

3,770

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91 Financial reporting

Balance sheet at 31 December CVA Financial £

Index

FSCVA Financial £

37,500

121/121

37,500

3,750

121/121

3,750

Non-current assets – cost/replacement – depreciation

33,750

33,750

Current assets Inventory – cost/ replacement cost23

11,520

121/121

11,520

Inventory – cost/ replacement cost24

14,000

121/121

14,000

Trade receivables

6,000

*

6,000

23,000

*

23,000

Cash

54,520

54,520

Creditors

14,000

14,000

Net current assets

40,520

40,520

74,270

74,270

10% debentures

10,000

*

64,270

10,000 64,270

Ordinary share capital

50,000

121/100

60,500

Income statement

14,270

3,770

64,270

64,270

Note * Denotes monetary items.

Definitions Real realised holding gain. This is the difference between: 1. the current value at the time of consumption 2. and its historical cost updated to the time of consumption by movement in the general index. When necessary, a real gain must then be updated to year-end pounds. Real unrealised holding gain. This is the difference between: 1. the current value of an asset at the balance sheet date 2. and its historical cost updated by the change in the general index (or, if the asset was owned at the start of the period, its value then updated by the change in the general index).

104

23 The remaining balance of the inventory purchased on 1 January 2010. 24 The inventory purchased on 31 December 2010.

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Explanations and notes for guidance The fully stabilised current value accounts approach is based on the same concepts and methodology as CPP accounting. However, there are two issues you need to be aware of: 1. In fully stabilised current value accounts, all transactions are updated by charges in the general index to express them all in terms of current purchasing power. However, for the income statement certain items (i.e. cost of sales and depreciation), have been indexed up to the time of consumption/ replacement. Therefore in order to stabilise these items you need to index from the date of consumption/replacement, to the date of stabilisation (in this case 31 December). All other items that are not at current values (e.g. expenses) need to be represented in current purchasing power and are based on the CPP methodology. 2. Fully stabilised current value accounting adjusts the holding gains (real and realised) by eliminating from profit any appreciation in asset values which is purely fictitious and measuring only real realised/ real unrealised holding gains and losses (see discussion above). This accords with its rationale of measuring changes in shareholders’ real capital.

Workings Inventory – real realised holding gain The real realised gain equals the amount by which the current value ‘cost of sales’ at the time of consumption/replacement (i.e. sale) exceeds the historical cost ‘cost of sales’ adjusted by the changes in the general index between the times of purchase and the time of consumption/replacement. Because the gain is here measured at 30 June it must be updated to yearend £s. The HC ‘cost of sales’ (i.e. £12,000) adjusted to time of sale (30 June) by changes in the general index equals: £12,000 × 110/100 = £13,200 (CPP @ June £s) The difference between this and the current value ‘cost of sales’ at 30 June equals: £15,840 (CVA @ 30 June £s) – £13,200 (CPP @ 30 June £s) = £2,640 This gain updated to year-end £s equals £2,640 × 121/110 = £2,904 (FSCVA @ Dec £s) Alternatively, you could measure the real realised holding gain on inventory by deducting: 1. the historical cost ‘cost of sales’ stabilised in year-end £s (as in CPP accounts) from 2. the fully stabilised current value ‘cost of sales’ (i.e. the current value ‘cost of sales’ stabilised in year-end £s appearing in the fully stabilised current value accounts). Using this method, the gain would already be measured in year-end £s. The historical cost ‘cost of sales’ stabilised in year-end £s equals: £12,000 × 121/110 = £14,520 (CPP @ Dec £s) The difference between this and the fully stabilised current value ‘Cost of Sales’ equals: £17,424 (FSCVA @ Dec £s) – £14,520 (CPP @ Dec £s) = £2,904 105

91 Financial reporting

Inventory – real unrealised holding gain The real unrealised holding gain equals the amount by which the current value of the balance sheet inventory (i.e. closing inventory) exceeds its historical cost adjusted by the increase in the general index from time of purchase to the balance sheet date. The historical cost ‘closing inventory’ stabilised in year-end £s equals: Transaction

HCA

CPP

1 January

£8,000 × 121/100

= £9,680

31 December

£14,000 × 121/121

= £14,000 £23,680

Hence the real unrealised holding gain on inventory equals: £25,520 (CVA @ Dec £s) – £23,680 (CPP @ Dec £s) = £1,840 Non-current assets – real realised holding loss The real realised holding loss may be calculated as the difference between: 1. the current value depreciation charge and 2. the historical cost depreciation charge adjusted by the change in the general index from the time of purchase to the time of consumption. As this is here taken as the year-end, no further stabilisation is required. Depreciation (£HCA) = £3,000 Therefore: Depreciation (£CPP) = £3,000 × 121/100 = £3,630 Thus the real realised holding gain is: £3,750 (FSCVA @ Dec) – £3,630 (CPP @ Dec) = £120 Non-current assets – real unrealised holding gain The real unrealised holding loss may be calculated as the difference between: 1. the current value net book value at the balance sheet date and 2. the historical cost net book value adjusted by the change in the general index from time of purchase to the balance sheet date. Thus: £HCA Non-current assets – net book value =

£CPP

27,000 × 121/100 = £32,670

Therefore the real unrealised holding gain on non-current assets equals: £33,750 (FSCVA @ Dec £s) – £32,670 (CPP @ Dec £s) = £1,080 An alternative: calculating total real holding gains Total real holding gains (i.e. realised and unrealised) can be calculated as they equal the amount by which the gross current value at the balance sheet date is less than the historical cost adjusted by the change in the general index from purchase date to balance sheet date. £HCA Non-current assets @ cost

106

£CPP

30,000 × 121/100 = 36,300

£CVA 37,500

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Therefore: £37,500 (FSCVA @ Dec £s) – £36,300 (CPP @ Dec £s) = £1,200 Of that, 1/10th has been realised by use (i.e. expected life = 10 years of which one had expired), resulting in a real realised holding gain of: 1/10 × 1,200 = £120 and a real unrealised holding gain (i.e. 9/10 is unrealised) of: 9/10 × 1,200 = £1,080. Activity 4.18 Show that: a. the gain on long-term monetary items in the income statement above equals £2,100 b. the loss on short-term monetary items in the income statement above equals £4,100. If you have problems with this activity, refer back to the discussion on CPP accounting.

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • discuss the basis of HCA • describe the advantages and disadvantages of HCA • identify why other conventions have been proposed as alternatives/ supplements to HCA • discuss why CPP was proposed as an alternative to HCA • describe the difference between monetary and non-monetary items • convert HCA to CPP by following the step-by-step guide • understand conceptually the different treatments of monetary and nonmonetary items • compute real gains and losses on monetary items • delineate advantages and disadvantages of CPP • relate the CPP concepts here to Hicks’s versions of income • explain the concept of deprival value (DV) • discuss replacement cost (RC), net realisable value (NRV) and present value (PV) • explain the concepts of current operating income and holding gains • discuss different concepts of capital maintenance and their implications for corporate reporting • explain the implications of Hicksian income in relation to the capital maintenance concepts • prepare a balance sheet and income statement using specific price indices, including calculating holding gains and losses • calculate deprival values when replacement involves: • replacement with a brand new asset • replacement when prices have changed • replacement following technological changes • assess whether deprival values reflect the Hicksian income approach

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91 Financial reporting

• describe the advantages and disadvantages of RC accounting and DV accounting • prepare a fully stabilised current value income statement and a fully stabilised balance sheet, including calculating real realised and real unrealised holding gains and losses • explain the concepts of current operating profit and holding gains in fully stabilised current value accounting.

Sample examination questions This chapter only provides a review of HCA. There are no sample examination questions for HCA, but you should ensure you understand HCA as other examination questions will likely assume knowledge of it.

Question 4.1 Highprice Plc began on 1 January 2010. On that date the following transactions occurred: • 200,000 ordinary shares of £1 each were issued at £1.20. Preliminary expenses of £5,000 were paid. • Non-current assets were bought for £240,000. Payment terms provided for immediate payment of £80,000 followed by payments of £80,000 on 30 June 2010 and 31 December 2010. • Inventory was purchased for £120,000. The HCA balance sheet at 31 December 2010 and HCA income statement for the year then ended, follows: Balance sheet as at 31 December 2010

£’000 Non-current assets – net book value (NBV)

£’000 216

Current assets Inventories

140

Trade receivables

185 325

Creditors due within one year Bank overdraft

10

Trade payables

174 184

Net current assets

141

Total assets less current assets

357

Shareholders’ funds Ordinary share of £1 Share premium account Income statement

200 35 122 357

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Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values

Income statement for the year ended 31 December 2010

£’000 Sales

£’000

1,100

Less cost of sales: Opening inventory

120

Further purchases

820 940

Less closing inventory

140

Gross profit

800 300

Less expenses Depreciation

24

Sundry expenses

145 169

Operating profit

131

Dividends Interim dividend paid

9

Retained profit

122

You have the following additional information: • Sales, purchases, and sundry trading expenses occurred evenly during the year ended 31 December 2010. The interim dividend was paid to shareholders on 31 October 2010. • Inventory at 31 December 2010 was purchased on average on 31 October 2010. • Depreciation was provided on non-current assets to write them off to zero residual value on a straight-line basis over 10 years. The general index of retail prices moved as follows: RPI 1 January 2010

120

30 June 2010 (=average for 2010)

130

31 October 2010

135

31 December 2010

142

Restate the HCA of Highprice Plc for 2010 in units of year-end purchasing power (i.e. CPP accounts stabilised in £ of 31 December 2010). Comment on the view that accounting for changing prices is unnecessary when inflation is low. Solutions to this question are given in Appendix 2.

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91 Financial reporting

Notes

110

Chapter 5: Accounting for groups

Chapter 5: Accounting for groups Aims of the chapter We need to consider how to account for two or more companies that are controlled by a single management and act as one economic entity. This chapter aims to investigate different approaches that have been discussed by the accounting profession and those which have been adopted by standard-setters. We will also investigate other forms of business 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.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • explain how different non-current asset investments are distinguished and accounted for • describe a ‘group’ • describe the rationales used to develop different models of consolidation (acquisition, merger, equity, proportional) • be aware of the main ideas underpinning the now disallowed merger method • explain why the definition of a subsidiary is important • describe associates and joint ventures and how to account for them in consolidation • prepare consolidated accounts (balance sheet and profit and loss or income statements) using the acquisition, equity and proportional consolidation methods • compute the value of goodwill and non-controlling (minority) interest • appreciate the importance of the transaction date and the difference between pre and post transaction profits/income in consolidated accounts.

Essential reading International Financial Reporting, Chapter 24.

Further reading Collins, B. and J. McKeith Financial Accounting and Reporting. (London: McGraw-Hill, 2010)[ISBN 9780077114527] Chapter 10. Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. This book covers the detailed legal and accounting standard requirements for company accounting, or provides examples of disclosure. The level of detail provided by this book is much greater than you will be expected to know at the end of this course, so it should be consulted for reference only. 111

91 Financial reporting Kothari, J. and E. Barone Advanced Financial Accounting: An International Approach. (Harlow: Financial Times Prentice Hall, 2011) [ISBN 9780273712749] Chapters 18–20.

Relevant IASB standards IFRS 10 Consolidated Financial Statements (from 2013 onwards). IFRS 3 Business Combinations (revised 2008). IAS 27 Consolidated and Separate Financial Statements. (Note that in May 2011, IAS 27 was split into IAS 27 Separate Financial Statements and IFRS 10 Consolidated Financial Statements.) IAS 28 Investments in Associates. IAS 31 Interests in Joint Ventures. IAS 36 Impairment of Assets. IAS 38 Intangible Assets.

Introduction 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.

Structure of a group The structure of a group can take many forms. The most basic form is where a holding company H owns one subsidiary S, for example:

H S A more complex group is where H either holds several subsidiaries or holds one subsidiary that then holds other subsidiaries:

H S

S

H S

S S

Why own other companies/entities? There are numerous motives for acquiring or merging with other companies, for example: 112

Chapter 5: Accounting for groups

• 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. • 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.

Key principles and rationales Let us assume you run a large public trading company, such as Microsoft, which owns and controls many other companies who trade separately from them. In order to see the full extent of Microsoft Plc activities, the accounts need to reflect this ownership and hence reflect the underlying trading activities of the Microsoft Group. Your shareholders need this information, since they own shares in Microsoft, which implicitly means that they also own a stake in the subsidiaries. For example: Company A (the holding company) owns Company B (the subsidiary company) and Company B does all the trading. If the only accounts that were required related purely to Company A’s accounts then in Company A’s accounts: • the income statement would reflect income as the dividends received and receivable from Company B and the expenses would relate to Company A’s management costs • the balance sheet would reflect the cost (or valuation) of the investment in Company B as an asset and the liabilities would relate to the equity and loans of Company A only. Consequently the accounts would not reflect the underlying economic activities of the group. How should we correct for this obvious defect in the accounts? There are a number of possible solutions, such as preparing: • holding company accounts plus additional information • holding company accounts plus accounts of subsidiaries • holding company accounts plus overall summary of subsidiaries’ accounts • consolidation accounts of the holding company and subsidiaries. Activity 5.1 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.

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Activity 5.2 Is there a difference if Company X acquires varying stakes in Company Y – say either 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? The need for a precise definition of what constitutes a member of a group for consolidation purposes is self-evident. Consolidation provides shareholders with information about aggregate profit/loss, and assets and liabilities under control of the holding company. This information is a basic requirement for a shareholder to determine how the holding company is performing. If accounting standards do not prescribe precise definitions as to which fixed asset investments should be consolidated, a holding company might opt to consolidate the results and net assets of well-performing companies and omit the results and net assets of poorlyperforming companies or those with high levels of debt financing. There are a number of treatments in accounting for groups amongst national versus international standards. Our approach here is to focus on the core ideas underpinning principles common across many of these standards. As such, we adopt current IFRS approaches, but also consider how the IFRS approach was derived from older standards. For group accounts, the main standards are IAS 27 (Consolidated and Separate Financial Statements) and IFRS 3 (Business Combinations), though from 2013, IFRS 10 (Consolidated Financial Statements) will replace IAS 27. For study purposes, it is sufficient to know that IAS 27 sets out the general principles for consolidation (which we will discuss) while IFRS 3 elaborates on how goodwill is to be treated in consolidation.

Definition of a subsidiary IAS 27, para. 4 defines a subsidiary as: ‘An entity, including an unincorporated entity such as a partnership, which is controlled by another entity (known as the parent)’. Consequently this definition is not purely based on the strict form of the shareholder relationship between two entities, but is nearer to one that reflects the substance of the commercial relationship. This relationship thus is defined by ‘control’.

Control There are two parts to defining control: (1) Control over the financial and operating policies of another entity; (2) Control over the (usually financial) benefits obtained from another entity. Revisit your answers to Activity 5.2 and compare it to the IAS 27, para. 13 definition of control – ‘Control is presumed when the parent acquires more than half of the voting rights of the enterprise.’ Note that even when more than one half of the voting rights is not acquired, control may be evidenced by other forms of power, such as from (1) above. The emphasis on control in IFRS 3 indicates that an acquirer must be identified for all business combinations. This replaces IAS 22, which had permitted the merger (pooling of interest) method if an acquirer could not be identified (see later in this chapter for details on the pooling of interest method). IFRS 3 provides comprehensive guidance for identifying the acquirer via the definition of control. Para. 19 states that control is: • power over more than half of the voting rights of the other enterprises by virtue of an agreement with other investors

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• power to govern the financial and operating policies of the other enterprises under a statute or an agreement • power to appoint or remove the majority of the members of the board of directors or equivalent governing body of the other enterprise • power to cast the majority votes at meetings of the board of directors or equivalent governing body of the enterprise. The question of the definition of a subsidiary is thus fundamental to any discussion of group accounts because otherwise it is impossible to say what constitutes the entity which is the subject of the report. 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 (SPE) 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. IFRS 10 defines control as: ‘An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee’ (paras. 5–6, 8). Note the three elements of control under IFRS 10: (1) power over an investee (2) exposure to rights or variable returns from investee and (3) ability to use power over investee. An investor has to have all three elements before it is deem to control the investee. The density of new criteria incorporated into IFRS 10 can be interpreted as reflective of increasingly complex business transactions. Activity 5.3 Identify (using general principles of IAS 27) whether Big (B) exercises control over Small (S). 1. B has 30% voting rights of S. B also has arranged with Outsider 1 (O1) who has 25% of voting rights over S that allows B to use all of O1’s rights. 2. B owns 30% of S and 100% of O1. O1 owns 25% of S. 3. B has 30% voting rights of S but can influence the appointment/removal of 3 out of 5 directors of S. 4. B has 40% ownership of S but can cast a ‘golden share’ which allows it to have a majority vote. 5. B has 45% voting rights of S but has special statutory rights to influence the development of S’s financial and operating policies. 6. B has 49% voting rights of S. 7. B owns 30% of S. 8. B owns 30% of S and 40% of O1. O1 owns 60% of O2. O2 owns 70% of S. Answers: (1), (3), (4) and (5) are subsidiary relationships. In (7), S is not a subsidiary. (2) 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 (8) 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.

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Requirement for consolidated accounts IFRS 3, para. 4 defines a business combination as ‘the bringing together of separate entities or businesses into one reporting entity’. In the UK this is also a legal requirement under the Companies Act 1989. The consolidated accounts show the group income statement, the group balance sheet, the group cash flow statement and the holding company’s balance sheet. Thus group accounts are designed to extend the reporting entity to embrace other entities which are subject to its control or influence; the overall aim, therefore, is to present the results and state of affairs of the group as if they were those of a single entity. Given the above example of Companies A and B, consolidating the accounts would involve the construction of: • a group income statement – which involves replacing the dividends received from Company B with the actual profit achieved by the subsidiary (e.g. sales and expenses) • a group balance sheet which would reflect all the assets and liabilities of the group (i.e. replace the cost of the investment with the underlying assets and liabilities of Company B). These consolidated accounts therefore prevent the distortion of a holding company’s profit by dividends from subsidiaries and prevent any concealment of effective liabilities of the subsidiaries. However, the forthcoming IFRS 10’s definition of control may further increase the complexity in judging whether a company has control or not. In the following (abridged) example, which builds on Activity 5.3, we see that control can also be defined when a company is the largest shareholder by far, even if they do not have majority voting/shareholding, if it is a scenario whereby other shareholders find it near impossible to coordinate their actions/votes to ensure majority rule. B owns 48% of S. The remaining investors consist of very small shareholders, none owning 1% or more of S, nor are these small shareholders able to coordinate their voting or actions. In this case, B can be deemed to have control, as the size of the 48% shareholding dwarfs the individual holdings of other small and fragmented shareholders, who cannot coordinate to achieve a counter-weight or majority to B.

Circumstances where consolidation is not required IAS 27, para. 9 states that the basic requirement is for subsidiary undertakings to be included in the consolidated accounts. However, there are some circumstances under which subsidiaries can be excluded from the consolidation. IAS 27, para. 10 states: A parent is not required to (but may) present consolidated financial statements if and only if all of the following four conditions are met: a. the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; b. the parent’s debt or equity instruments are not traded in a public market; c. the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and 116

Chapter 5: Accounting for groups

d. the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards. Following the publication of IFRS 5 (non-current assets held for sale and discontinued operations), IAS 27 has been amended to include an exemption for a subsidiary for which control is intended to be temporary because 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 under IAS 27.

Different models of group accounting There are a number of different ways (models) in which to account for business combinations. It is therefore important to at least understand the principles and assumptions used to develop these models. According to 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 (IFR usage; NCI is formerly known as minority interest).

Economic entity model The group includes: 100% of B (assets, liabilities and equity) and 100% of S (assets, liabilities and equity). NCI is treated as part of the group’s equity. Using the language of the accounting equation (assets – liabilities = equity) for illustration: B (100% net assets) + S (100% net assets) = B (100% equity) + S (60% equity owned by B) + S (40% equity owned by NCI)

Parent entity model The group includes: 100% of B (assets, liabilities and equity) and 100% of S (assets, liabilities and equity). NCI is treated as part of the group’s liability. B (100% net assets) + S (100% net assets) – S (40% NCI equity as group liability) = B (100% equity) + S (60% equity owned by B)

Proprietary model The group includes: 100% of B (assets, liabilities and equity) and 60% of S (assets, liabilities and equity). NCI (40% of S) is not shown in the group accounts. B (100% net assets) + S (60% net assets) = B (100% equity) + S (60% equity owned by B) The current standard, IFRS 3, is a mixed concept as it incorporates elements from both economic entity and parent entity model (Kothari and Barone, 2011, p.541). For example: NCI shown in the equity section of the balance sheet (economic entity) Goodwill on consolidation relates only to parent’s share of subsidiary (parent entity) Note that these terminologies can sometimes vary between different authors: For example, International Financial Reporting uses entity, parent/ 117

91 Financial reporting

proprietary and proportional instead of economic entity, parent entity and proprietary. As long as you are clear of the conceptual distinctions, variations in terminology, you will avoid such labelling minefields. Activity 5.4 What assumptions does each model make about its users? If you were a regulator in your country, which model appeals to you and why?

Different types of relationships within a group Based on the models above, we now proceed to understanding the different methods by which we can account for business combinations involving two or more companies.

Acquisition method • Used to account for holding company (or parent) to subsidiary relationships. • The acquirer purchases the interests of the acquired company’s shareholders (i.e. the absorption of the target into the clutches of the predator – continuity is only for the holding company). This is by far the most common method used to represent holding company – subsidiary relationships.

Merger or pooling of interest method • Formerly used in accounting for combinations of equal entities. • The two parties combine to create a new entity (i.e. the uniting of the interests of two formerly distinct shareholder groups). • Note that IFRS 3 has banned merger accounting since ‘the result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses, the acquiree’ (para. 4). This aligns International GAAP with American accounting standards. • Acquisition accounting is more common in the UK and this is described below with worked examples of this approach. Merger accounting can only be used when a strict set of conditions are met – for theoretical interest (to be used for discussion only, not calculation), we include a summary of differences between acquisition and merger accounting at the end of this chapter.

Equity method • Typically used in group accounting for associates. • Investment by the holding company into another company (that it has a ‘significant influence’, by no control, over), typically its ‘associate’, treated at cost and adjusted thereafter for share of profits. ‘Associate’ and ‘significant influence’ will be defined in subsequent sections.

Proportional method • Typically used in group accounting for joint ventures. • This is a method is derived from the proprietary model of accounting for groups, where ‘a venturer’s share of each of the assets, liabilities, income and expenses of a jointly controlled entity is combined line by line with similar items in the venturer’s financial statements or reported as separate line items in the venturer’s financial statements.’ (IAS 31, para. 3). 118

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• There are two methods: • line-by-line: assets, liabilities, income and expenses are combined with similar items on a line-by-line basis • separate line items: share of assets, liabilities, income and expenses of the jointly controlled entity are shown, i.e. each item is separated into the accounts of the parent and joint venture entity. Note that both methods will give you the same final totals in the income and expenditure (profit and loss) account and the balance sheet We will discuss the acquisition method in depth, as it is the main method used to account for subsidiaries, but later on in the chapter, we will also examine the equity method as used in accounting for associates, and the proportional method, which is used in accounting for joint ventures.

Accounting for subsidiaries Acquisition accounting involves the aggregation of the individual accounts of the holding company and its subsidiaries by adding together their income statements and the balance sheet figures on a line-by-line basis (see Example 1 below). These aggregated figures are then amended to deal with what is known as consolidation adjustments. Such adjustments are necessary in order to achieve the consolidation by: • recognising the date of acquisition (this has implications for how pre and post-acquisition profits are dealt with), and/or • dealing with goodwill (see Examples 4a and 4 below), and/or • dealing with fair value adjustments (if required), and/or • dealing with non-controlling interest or NCI (previously referred to as minority interest) (see Example 6a and 6b below), and/or • adjusting individual figures of subsidiaries to bring them on to common accounting policies (see discussion later in this chapter), and/or • eliminating intra-group transactions (see Examples 9 to 12b below). In order to account for the acquisition, the acquiring company must first measure the cost of what it is accounting for, which normally represents: • the cost of the investment1 in its own balance sheet • the amount to be allocated between the identifiable net assets of the subsidiary in the consolidated accounts. Secondly, in allocating the cost of acquisition, the acquiring company then needs to identify the assets and liabilities of the subsidiary and attribute fair values to them, rather then merely relying on the book values in the subsidiary’s accounts. Once fair values of both the consideration given and the net assets acquired have been measured, the difference between the two represents purchased goodwill (see also Chapter 10), which remains to be accounted for.

1

The cost of the investment (i.e. the consideration paid) may be any of (or a mixture of) (1) cash, (2) shares of the acquired at market value, (3) other financial instruments such as debentures, convertible bonds and deferred shares.

The best way to discuss acquisition accounting is to illustrate the main points using a series of worked examples. A group balance sheet will initially be considered, and later in the chapter we will look at the group income statement.

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Consolidated balance sheet with on subsidary In these examples, the balance sheets of two companies, the holding or parent company (H Ltd) and its subsidiary (S Ltd), are as follows, as at 1 January 2011, before any transactions described below are recorded: H Ltd

S Ltd

£

£

Non-current assets

6,000

2,400

Cash

4,000 10,000

2,400

£1 ordinary shares

9,000

2,000

Retained profits

1,000

400

10,000

2,400

10,000

2,400

Net asset

It is assumed at this stage, for reasons of simplicity, that the fair value of the net assets of S is equal to their book value.2

Example 1: Wholly owned subsidiary with no goodwill, acquired using share issue The first example involves the holding company purchasing 100% of the subsidiary. (But remember that, for an entity to be classified as a subsidiary, the acquiring company does not have to purchase all the shares.) On 1 January 2011, H acquires all of the ordinary shares in S in exchange for the issue of 600 new ordinary shares in H. The current value of each ordinary share in H is £4.00. One approach to preparing the consolidated balance sheet is to view the transaction as one where shares (in H) are issued to acquire assets (of S). The transactions using the accounting equation method (assets – liabilities = equity) is: • increase value of H’s assets by net asset value of S, and • increase value of H’s equity only by the corresponding amount. H is issuing new shares worth £2,400 in order to acquire all of a company whose net assets are worth £2,400. As the current value (£4.00) exceeds the par value (£1.00), therefore a share premium account is created – 600 shares  £1/share = £600 to the ordinary share account, and 600 shares  £(4 – 1 = 3) = £1800 to share premium. This fund of £2,400 is then used to acquire the net assets of S at £2400, which are then reflected in the group accounts. H Ltd

S Ltd

CBS

£

£

£

Non-current assets

6,000

2,400

8,400

Cash

4,000

£1 ordinary shares

4,000

10,000

2,400

12,400

9,000

2,000

9,600

1,000

400

1,000

10,000

2,400

12,400

Share premium Retained profits

120

1,800

2

The concept of fair values and its implications for the goodwill calculation is discussed later in this chapter.

Chapter 5: Accounting for groups

The consolidated balance sheet for the group (CBS) is one where all the net assets (non-current assets and cash) are added together line by line (non-current assets of H with S; cash of H with S), which is ‘paid for’ by a corresponding increase in equity of H. Ordinary shares have increased from £9,000 to £9,600 and share premium from £0 to £1,800. The equity side of the CBS reflects the adjusted (if any) equity of H (in this case ordinary shares and share premium were adjusted, but retained profits of H remained the same). Note that you do not include any equity (ordinary shares, share premium, retained profits etc.) of S.

Example 2: Wholly owned subsidiary with no goodwill, acquired using cash Contrast this with the previous example whereby H uses its cash resources instead of issuing new shares to acquire S (note: no adjustments to equity compared to Example 1). Here, the CBS reflects a deduction of cash of £2400 to pay for the acquired non-current assets of S.

Non-current assets Cash

£1 ordinary shares Retained profits

H Ltd £ 6,000 4,000 10,000

S Ltd £ 2,400 2,400

CBS £ 8,400 1,600 10,000

9,000 1,000 10,000 10,000

2,000 400 2,400 2,400

9,000 1,000 10,000 12,400

Example 3: Wholly owned subsidiary with no goodwill, acquired using cash and shares In this example, we consider the CBS whereby 50% of the acquisition is paid for by cash and the rest by share issue. As consideration is £2,400, therefore £1,200 cash is needed. In addition, 300 ordinary shares are issued at a market value of £4 each, giving £1,200 towards the acquisition. Share premium is £(4 – 1)  300 shares = £900.

Non-current assets Cash

£1 ordinary shares Share premium Retained profits

H Ltd £ 6,000 4,000 10,000

S Ltd £ 2,400 2,400

9,000

2,000

1,000 10,000

400 2,400

CBS £ 8,400 2,800 11,200 9,300 900 1,000 11,200

In all three examples, the equity of S is not included in the CBS because we view the consolation 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 £6.00 each rather than £4.00 each. H is now issuing shares worth £3,600 (600 ordinary shares  £6.00) 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. 121

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Definition of goodwill IFRS 3, para. 51 states that ‘goodwill is recognised by the acquirer as an asset from the acquisition date and is initially measured as the excess of the cost of the business combination over the acquirer’s share of the net fair values of the acquiree’s identifiable assets, liabilities and contingent liabilities.’ This raises a number of questions: • How can we determine fair values? • What do we mean by identifiable? and • How do we account for goodwill?

Fair values The acquirer measures the cost of a business combination as the sum of the fair values at the date of exchange rather than at their historical cost. The exercise of restating assets and liabilities at their fair value is an attempt to provide a realistic measurement of the assets and liabilities of the acquired company that should be consolidated – in other words, to account fairly for the acquisition transaction by asking what the acquiring group has spent and what it has got for its money. IFRS 3 states that market price is the best evidence of fair value. However, if a market price does not exist or is not considered reliable, other valuation techniques are used to measure fair value (IFRS 3, para. 27). IFRS 3 also requires that fair values of identifiable assets and liabilities acquired on acquisition should be determined by ‘reference to their intended use by the acquirer’. IAS 16, para. 6 defines fair value as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.’

Identifiable assets and liabilities IFRS3, para. 37 states: [T]he acquirer recognises separately, at the acquisition date, the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the following recognition criteria at that date, regardless of whether they had been previously recognised in the acquiree’s financial statements: a. an asset other than an intangible asset is recognised if it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably; b. a liability other than a contingent liability is recognised if it is probable that an outflow of resources will be required to settle the obligation, and its fair value can be measured reliably; and c. an intangible asset or a contingent liability is recognised if its fair value can be measured reliably.

In the past, huge provisions, such as reorganisation provisions, had been provided for at the time of acquisition. These provisions inflated the amount of goodwill and also inflated subsequent years’ profit. Now there are stricter limitations regarding those items which can be provided for at the time of acquisition. Crucially, provisions for future losses/ reorganisation/integration and changes resulting from the acquirer’s intentions or future actions cannot be accounted for as part of the fair value exercise: ‘in applying the purchase method, an acquirer must not 122

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recognise provisions for future losses or restructuring costs expected to be incurred as a result of the business combination. These must be treated as post-combination expenses’ (IFRS 3, para. 41).

Accounting for goodwill How we account for goodwill has been a subject on which widely differing opinions are held. These will be discussed in Chapter 10. IFRS 3 requires goodwill acquired in a business combination to be recognised as an asset from the acquisition date. Goodwill is calculated as the excess of the purchase price paid over the fair value of net assets acquired. Goodwill cannot be amortised; instead it should be tested annually for impairment (or more frequently, if circumstances indicate that this is necessary – see IAS 36 Impairment of Assets).

Example 4a: Wholly owned subsidiary with (positive) goodwill Following the increase in H’s share price from £4.00 per share to £6.00 per share, discussed above, the acquisition of S will be reported in H’s balance sheet as follows: Goodwill = Price paid (shares issued) less fair value = £3,600 – £2,400 = £1,200. Share premium = £(6 – 1: market value less par) = £5 per share, or £5  600 shares = £3,000.

Non-current assets Goodwill Cash

£1 ordinary shares Share premium Retained profits

H Ltd £ 6,000

S Ltd £ 2,400

4,000 10,000

2,400

9,000

2,000

1,000 10,000

400 2,400

CBS £ 8,400 1,200 4,000 13,600 9,600 3,000 1,000 13,600

Example 4b: Wholly owned subsidiary with (negative) goodwill In some situations, goodwill may not be positive, but negative. This arises when a discount is being given for the acquirer to take over the acquiree. This discount could reflect potential future losses as a result of the acquisition, or to reflect the possibility that assets at the time of acquisition may not be at fair value. Assume that the consideration for S was £2,000, paid for by issuing 500 shares at £4 each. Share premium = £(4 – 1)  500 shares = £1,500. Goodwill (negative) = £2,000 – £2,400 = (£400) or –£400.

Non-current assets Goodwill (negative) Cash

£1 ordinary shares Share premium Retained profits

H Ltd £ 6,000

S Ltd £ 2,400

4,000 10,000

2,400

9,000

2,000

1,000 10,000

400 2,400

CBS £ 8,400 (400) 4,000 12,000 9,500 1,500 1,000 12,000

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Example 5: Wholly owned subsidiary with goodwill and fair values It is often the case that the book values of the assets of a company being acquired are not equal to the current fair values of the assets. In such circumstances, it is necessary under IFRS 3 to revalue the assets being acquired before including them on the CBS. Based on the information in Examples 4a and 4b, assume that S’s net assets are £2,400 book value but £2,800 is fair value. Thus H is issuing shares worth £3,600 to acquire a company whose fair value net assets are worth £2,800. Consequently goodwill is now £800 (i.e. difference between consideration and fair value; £3,600 – £2,800). The acquisition of S will be reported in H’s balance sheet exactly as in Examples 4a and 4b, but the CBS would be prepared as follows:

Non-current assets Goodwill Cash

£1 ordinary shares Share premium Revaluation Retained profits

H Ltd £ 6,000

S Ltd £ 2,800

4,000 10,000

2,800

9,000

2,000

1,000 10,000

400 400 2,800

CBS £ 8,800 800 4,000 13,600 9,600 3000 1,000 13,600

Note: Any surpluses arising on revaluations of the subsidiary’s assets subsequent to the acquisition are post-acquisition3 in the analysis of the subsidiary’s equity, and the group share of the surplus will be shown on the CBS normally in consolidation revaluation surplus. In other words, if the revaluation took place following the acquisition (post-acquisition) then this increase would be treated like any other revaluation (i.e. increase the assets concerned and set up a revaluation surplus). Since in the above example the revaluation took place prior to acquisition, this is regarded as pre-acquisition and therefore needs to be eliminated on consolidation. (We will discuss this in more detail later in this chapter.)

Depreciation of non-current assets with fair value adjustment A problem arises when the assets being revalued on acquisition are depreciable, for example non-current assets with a limited useful life. In these circumstances, depreciation in the consolidated income statement must be based on the restated fair values, even though depreciation in the subsidiary’s own accounts is based on existing book values. For example, suppose that the subsidiary owns a five-year-old asset which had originally 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.

Non-controlling (minority interests (MI)) What happens if H acquired less than 100% of S? If a subsidiary is not wholly-owned there will be a group of non-controlling interests (minority shareholders) who are not a part of the group. Consolidation requires that the entire subsidiary’s assets and liabilities should be included in the group’s accounts because they are under the control of the directors of the holding company, whether or not the holding company actually owns 124

3

See below for further discussion of pre- and post- acquisition profits

Chapter 5: Accounting for groups

100% of the share capital of the subsidiary. IFRS 3 allows two methods for dealing with NCI in the CBS: • Method 1: NCI’s proportionate share of net assets of the acquiree (i.e. no goodwill in NCI) • Method 2: NCI at fair value (full goodwill method). Suppose that H buys only 75% of the ordinary shares in S in exchange for 500 ordinary shares in H, each worth £4.00. 75% interest in net assets of S is worth £1,800 (75% of £2,400). The other 25% of the shares in S are held by NCI, worth £600 (25% of £2,400). Since the CBS shows the total assets of H and S, it is necessary to show the NCI on the CBS so that the net interest of the shareholders of H may be identified.

Example 6a: Partially owned subsidiary – NCI (IFRS 3 Method 1) Analysis of equity for S Group Total 75% £1 ordinary shares 2,000 1,500

NCI 25% 500

Retained profits

400

300

100

2,400

1,800 2,000 200

600

Consideration paid by H Difference = goodwill

Non-current assets Goodwill Cash

£1 ordinary shares Share premium Retained profits NCI

H Ltd £ 6,000

S Ltd £ 2,400

4,000 10,000

2,400

9,000

2,000

1,000

400

10,000

2,400

CBS £ 8,400 200 4,000 12,600 9,500 1,500 1,000 600 12,600

Example 6b: Partially owned subsidiary – NCI (IFRS 3 Method 2) Suppose that H elects to measure the entire NCI stake at fair value = 650 (as opposed to the £600, which was calculated as a proportion of S), therefore goodwill is calculated: Goodwill = consideration + fair value NCI less fair value net assets of S Goodwill = 2000 + 650 – 2400 = 250

Non-current assets Goodwill Cash £1 ordinary shares Share premium Retained profits NCI

H Ltd £ 6,000

S Ltd £ 2,400

4,000 10,000

2,400

9,000

2,000

1,000

400

10,000

2,400

CBS £ 8,400 250 4,000 12,650 9,500 1,500 1,000 650 12,650

The fair value of the 25% NCI in S will not necessarily be proportionate to the consideration paid by H for its 75%, primarily due to control premium or discount (see IFRS 3, para. B45). 125

91 Financial reporting

Example 7: Fair value adjustment with NCI How are fair values adjusted when there is NCI? Any surplus or deficit on revaluation must be divided between the group and the NCI in the relevant proportions. Based on the information in Example 5, assume that S’s fair value is £2,500 compared with its book value of £2,400. The NCI would be calculated by preparing an analysis of equity for S exactly as under Example 5, but we would also need to make the fair value adjustment of £100 (£2,500 – £2,400).

£1 ordinary shares

Analysis of equity Group Total 75% 2,000 1,500

for S NCI 25% 500

Retained profits

400

300

100

Fair value adjustment Consideration paid by H

2,400 1,00 2,500

1,800 75 1,875 2,000 125

600 25 625

Difference = goodwill

Non-current assets

H Ltd

S Ltd

CBS

£ 6,000

£ 2,500

£ 8,500

Goodwill Cash

£1 ordinary shares

4,000

4,000

10,000

2,500

12,625

9,000

2,000

9,500

1,000

400

Share premium Retained profits

1,500 1,000

100

Revaluation NCI

625 10,000

2,500

12,625

Example 8: Distinction between pre versus post-acquisition profits A distinction is made between pre- and post-acquisition profits because the holding company is not entitled to the share of the subsidiary’s preacquisition profits. Instead, this profit is treated in the calculation of goodwill (i.e. capitalised) while post-acquisition profits are incorporated into the group’s profit. Given the information in Example 6a and assuming we are now at the end of the year (i.e. on 31 December 2011), we are told that during 2011 H makes profits of £800 cash and S makes £600 cash profits, both represented by increased net assets. No dividends were paid. Since we are one year on from the date of acquisition, the consolidated balance sheet as at 31 December 2011 must include the group’s total retained profits. The groups retained profit will therefore include the total holding company’s retained profits and a percentage of the post-acquisition retained profits of the subsidiary. The percentage will be determined by the percentage of ownership (i.e. in this case 75%). Similarly, minority shareholders are also entitled to their share of the subsidiaries’ retained profits (25%). On consolidation, since H’s share of the post-acquisition profits of S may be included in the group’s retained profits shown in the CBS, we may use an extended form of the analysis of equity for S to show this. 126

Chapter 5: Accounting for groups Analysis of equity for S

£1 ordinary shares

Group

75%

NCI

£

£

£

£

Total

Pre-acq

Post-acq

25%

2,000

1,500

500

300

100

Retained profits Pre-acq 400 Post-acq 600 3,000

1,800

Consideration paid by H

2,000

Difference = goodwill

200

Non-current assets

450

150

450

750

1/1/11 1/1/11 31/12/11 31/12/11

31/12/11

H Ltd

S Ltd

H Ltd

S Ltd

CBS

£

£

£

£

£

6,000

2,400

6,000

2,400

8,400

Goodwill

200

Investment in S Cash

£1 ordinary shares

2000 4,000

600

5,400

10,000

2,400

12,800

3,000

14,000

9,000

2,000

9,500

2,000

9,500

Share premium Retained profits

4,800

1,500 1,000

400

1,800

1500 1,000

NCI

2,250 750

10,000

2,400

12,800

3,000

14,000

The group’s retained profit is calculated as follows: H’s profit at the start of the year (1/1/11) + H’s profit for year ended 31/12/11 + H’s share of S’s profits for year ended 31/12/11 = £1,000 + £800 + (75%  £600 = £450) = £2,250

Inter-company transactions: consolidated balance sheet It frequently happens that one company in a group will be in a trading relationship with another, or may pay expenses on behalf of another company. As a result, one company in a group may be a trade or other receivable or a trade or other payable of another company. It is usual practice in a CBS to show those group account receivables or account payables arising in respect of third parties outside the group. Accounting standards require that such inter-company transactions be eliminated in full. Consequently these are set off against each other and eliminated on consolidation.

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91 Financial reporting

Example 9: Reconciliation of inter-company transactions Below is an extract of net assets from the balance sheets of H and S: H Ltd £

S Ltd £

Netting-off £

CBS £

Balance due from S

2,000

Other receivables Cash at bank

10,000 4,000

6,000 2,000

16,000 6,000

16,000

8,000

22,000

5,400 5,400 10,600

2,000 3,200 5,200 2,800

Balance due to H Other payables Net assets

(2,000)

(2,000) 8,600 8,600 13,400

On consolidation the balance due from S in H’s balance sheet is set off against the balance due to H in S’s balance sheet, leaving the above assets and liabilities to be included in the CBS. The same netting-off treatment is followed when one of the companies in a group has made a loan to another company in the group. For example, if S had issued £5,000 of debentures, of which H held £3,500, the CBS would show only the £1,500 of debentures held outside the group as a liability. Since presumably interest is being paid on the £3,500 debenture, this would also have to be cancelled, i.e. interest income and interest expense would offset one another (examples to follow later). What happens when the balances don’t net off?

Cash in transit Occasionally the inter-company accounts do not exactly cancel out, because items may have been included in one company’s books but not in those of the other company. Suppose that the net assets of H and S at 31 December 2011 are now as follows:

Example 10: Reconciliation of cash in transit S Ltd £

Balance due from S

H Ltd £ 2,000

Other receivables

10,000

6,000

Cash at bank

Balance due to H Other payables Net assets

4,000

2,000

16,000

8,000

5,400 5,400 10,600

1,000 3,200 4,200 3,800

The balance due to H shown in S’s account is lower than the balance due from S shown in H’s accounts because S had sent a cheque for £1,000 to H on the last day of the year, but H had not yet received the cheque and therefore could not reflect this receipt in its accounts until the cheque is received after the year-end. The £1,000 is called cash in transit and is a group asset, even though it does not appear in either of the companies’ balance sheets. By including the cash in transit, it is possible to eliminate the inter-company accounts on consolidation. The consolidated accounts of the group will include this cash in transit in the CBS: 128

Chapter 5: Accounting for groups

H Ltd

S Ltd

Cash in transit

Netting-off CBS

£

£

£

£

(1,000)

(1,000)

£

Balance due from S

2,000

Other trade receivables

10,000

6,000

16,000

Cash at bank

4,000

1,000

5,000

Cash in transit

1,000 16,000

Balance due to H

7,000

22,000

1,000

Other creditors

Net assets

1,000

(1,000)

5,400

3,200

8,600

5,400

4,200

8,600

10,600

2,800

13,400

Example 11: Intra-group sales at cost price One of the objectives of consolidation is to show the transaction of the group as a single economic entity. To achieve this, transactions entirely within the group have to be eliminated, so that only those transactions with third parties are shown. Usually, we simply have to cancel out an income item against an expense item, while the group profit is unaffected. We reuse Example 6a, but add the following. Assume H sold goods to S at cost for £300. H will keep a current account of S (debtor) and S will also have a corresponding account for H (creditor). H Ltd

S Ltd

CBS

£

£

£

Non-current assets

5,700

2,700

8,400

Current Account S

300

Current Account H

(300)

Goodwill Cash

£1 ordinary shares

200 4,000

4,000

10,000

2,400

12,600

9,000

2,000

9,500

Share premium Retained profits

1,500 1,000

400

NCI

1,000 600

10,000

2,400

12,600

Note that when H sold goods to S, non-current assets were credited by £300 and current account of S debited by £300 (see also corresponding transactions for S). However, in the CBS, current accounts are eliminated, and the CBS here is exactly the same as in Example 6a. The same principle applies for when S sells goods at cost to H. The following Examples 12a and b consider situations where there is an unrealised profit element to the transaction.

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91 Financial reporting

Unrealised profits The most difficult aspect of inter-company transactions occurs when there has been a profit (or loss) recorded on the transaction. For example, one company in a group might sell goods to another company within the group and record a profit on sale. In the group’s accounts, profits are recognised only on sales outside the group (i.e. only transactions with third parties). Profits made on transactions entirely within the group have to be eliminated. The reason for making such eliminations is straightforward: ‘no person can make a profit by trading with themselves’ and when a group is trying to present its results as if it were a single entity, it clearly must not regard internal transactions as giving rise to a realised profit.

Example 12a: Intra-group sales with unrealised profit – H sells to S Assume H owns 75% of S, and sold goods to S at £300, where £100 is (the unrealised) profit and £200 cost of goods sold. These goods remained in stock at S at the year-end. As the group’s profit and stock figures are overstated, they need to be adjusted: The group’s stock is reduced by the value of unrealised profit £(800 + 300 – 100 = 1000) and retained profits reduced correspondingly by the same amount £(1100 – 100 = 1000).

Other non-current assets

H Ltd £ 5,000

S Ltd £ 2,000

CBS £ 7,000

Stock

800

300

1,000

4,300 10,100

100 2,400

200 4,400 12,600

9,000

2,000

1,100

400

10,100

2,400

Goodwill Cash

£1 ordinary shares Share premium Retained profits NCI

9,500 1,500 1,000 600 12,600

In Example 12a, note that the subsidiary S is not wholly owned, but there were no issues with NCI so far as H sold to S, and the adjustments were to reduce group stock and group retained profits. However, an issue arises when S is the company which makes a profit by selling goods to H. Since S is owned not only by the holding company but also by NCI, any unrealised profit from this sale needs to be eliminated from both the group’s retained profits and also from the NCI element. The whole amount of unrealised profit must be eliminated and the adjustment be apportioned between the majority and minority interests in proportion to their holdings in the selling company.

Example 12b: Intra-group sales with unrealised profit – H sells to S Assume S owns 75% of H, and sold goods to S at £300, where £100 is (the unrealised) profit and £200 cost of goods sold. These goods remained in stock at H at the year-end. As the group’s profit and stock figures are overstated, they need to be adjusted:

130

Chapter 5: Accounting for groups H Ltd

S Ltd

CBS

£

£

£

Other non-current assets

5,000

2,000

7,000

Stock

800

300

1,000

Goodwill Cash

£1 ordinary shares

200 4,300

100

4,400

10,100

2,400

12,600

9,000

2,000

9,500

Share premium Retained profits

1,500 1,100

400

NCI

1,025 575

10,100

2,400

12,600

The adjustment consists of: The group’s stock is reduced by the value of unrealised profit £(800 + 300 – 100 = 1,000) but group retained profits reduced by its share of 75% S’s unrealised profit £(1,100 – (75%  100) = 1,025). NCI is also reduced correspondingly £(600 – (25%  100) = 575).

Dividends paid from pre-acquisition profits These might be more aptly described as dividends paid with preacquisition assets. When a subsidiary pays a dividend using assets (normally cash) that have been accumulated before the day of acquisition, it is in effect returning to the holding company some of the assets that the holding company in substance acquired when it bought the shares in the subsidiary. Accountants therefore regard such a dividend paid out of preacquisition profits as a partial return of the holding company’s investment in the subsidiary. In the holding company’s accounts, dividends paid out of pre-acquisition profits are credited to the investment in subsidiary accounts, thus reducing the amount at which the investment in the subsidiary is carried in the holding company’s accounts. In the analysis of equity for the subsidiary, the dividends are deducted from the pre-acquisition reserves of the subsidiary. The net effect on goodwill is zero because the same amount is deducted from the consideration paid and the fair value of assets acquired. When goodwill on consolidation is calculated by deducting the writtendown cost of the investment from the written-down pre-acquisition capital and reserves of the subsidiary, the figure for goodwill originally calculated at the time of the acquisition still remains. Dividends out of pre-acquisition profits are not common, but might arise when a newly acquired subsidiary has declared a final dividend out of profits of the year prior to that in which the acquisition takes place, or when a subsidiary is acquired part-way through the year.

Consistent accounting policies Group accounts should be prepared on consistent accounting policies. This is normally achieved by changing the accounting policies of the subsidiary so as to conform to those of the holding company (in the largest groups there will be a manual of group accounting policies and practices to which all subsidiaries must conform). Sometimes, however, subsidiaries must draw their accounts up using policies inconsistent with those of the holding company. This is particularly the case for overseas subsidiaries,

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91 Financial reporting

which must comply with the law and accounting practices of the countries in which they are based, and these might differ from those of the holding company’s country. Where the accounts of a subsidiary are drawn up on a basis inconsistent with those of the holding company, adjustments must be made on consolidation to bring the subsidiary’s accounts into line with those of the holding company.

Consolidated balance sheet with more than one subsidiary All of the above principles apply, but calculations have to be separately performed for each subsidiary before being combined together for the consolidation.

Example 13: Consolidation with two subsidiaries Assume the following balance sheets below and where H controls 75% of S1 and 80% of S2, and paid £2,000 for S1 and £3,000 for S2 from the issue of 1,250 ordinary (£1) shares at £4 per share (500 shares for S1 and 750 shares for S2). Share premium is £(3  500 = 1,500) for S1 and £(3  750 = 2,250) for S2. NCI is £(25%  2,400 = 600) for S1 and £(20%  3,600 = 720) for S2. Goodwill is £200 (S1) + £120 (S2) = £320. Analysis of equity for S S1

S2

Group NCI

Group NCI

Total

75%

25%

Total

80%

20%

£

£

£

£

£

£

£1 ordinary shares

2,000

1,500

500

3,000

2,400

600

Retained profits

400

300

100

600

480

120

2,400

1,800

600

3,600

2,880

720

Consideration paid by H Difference = goodwill Shares issued (number)

Non-current assets

2,000

3,000

200

120

500

750

H Ltd

S1

S2

CBS

£

£

£

£

6,000

2,400

3,600

Goodwill Cash

£1 ordinary shares

4,000

4,000

10,000

2,400

3,600

16,320

9,000

2,000

3.;000

10,250

1,000

400

600

1,000

Share premium Retained profits

12,000 320

3,750

NCI

1.320 10,000

2,400

3,600

16,320

Consolidated income statement Assume that the income statements for H and S for the year ended 31

132

Chapter 5: Accounting for groups

December 2011 are: H Ltd £ Sales Cost of Sales: Opening stock Purchases

200 2,200 2,400 400

Closing stock Gross profit Expenses Profit on ordinary activities before taxation Taxation Profit for the financial year Retained profit brought forward Retained profit carried forward

£ 3,600

2,000 1,600 600

S Ltd £

£ 2,400

300 1,300 1,600 200

1,400 1,000 300

1,000

700

400 600 1,000 1,600

300 400 400 800

Example 14: Wholly owned subsidiary: subsidiary owned throughout the year The consolidated income statement (CIS) is a line-by-line addition of the income statements of the holding company and subsidiaries. With the figures above (but assuming goodwill of £400), assuming S is a wholly owned subsidiary of H throughout the year, the CIS will be: H Ltd £ Sales Cost of sales: Opening inventories Purchases Closing inventories Gross profit Expenses4 Profit on ordinary activities before tax Taxation Profit for the financial year

£ 3,600

S Ltd £

CIS

£ 2,400

£

200

300

500

2,200 2,400 400

1,300 1,600 200

3,500 4,000 600

2,000 1,600 600 1,000 400 600

1,400 1,000 300 700 300 400

£ 6,000

3,400 2,600 900 1,700 700 1,000

Note that the line-by-line addition goes down only to the profit for the financial year. 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 preacquisition5, and the CIS would show retained profits carried forward at the end of the year of £2,000 being: Group profits for the year as above

£1,000

Retained profits brought forward (=H’s retained profits)

£1,000

Group retained profits carried forward

£2,000

4

If a policy to amortise goodwill over 20 years was followed (as permitted by FRS 7), an expense of £20 for goodwill amortisation would appear here in the CIS. The corresponding credit would be to reduce the value of the intangible asset in the balance sheet.

5

Remember that pre-acquisition reserves are included in the analysis of equity for S for the determination of goodwill.

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91 Financial reporting

Example 15: Wholly-owned subsidiary: subsidiary acquired during the year It is vitally important that we know the effective date of acquisition (‘date of exchange’), especially when we construct the CIS, since the CIS only includes the results of the new subsidiary from the date of exchange. This means that it is necessary to apportion the subsidiary’s income statement between pre- and post-acquisition periods. In practice, interim accounts up to the date of acquisition are often prepared, but, if this is not done, the apportionment will normally be done on a time basis. Suppose that H acquires S on 30 June 2011. The CIS for the year ended 31 December 2011 will include all of H’s results but only half of S’s results (assuming that the income and expenses occurred evenly throughout the year), on a line-by-line basis: H Ltd £

S Ltd £

£

2,400

4,800

1,400

2,700

1,600

1,000

2,100

600

300

750

1,000

700

1,350

Taxation

400

300

550

Profit for the financial year

600

400

800

Sales

£

£

CIS

3,600

Cost of sales: Opening inventories Purchases

200

300

2,200

1,300

2,400

1,600

Closing inventories

400

Gross profit

2,000

Expenses

200

Profit on ordinary activities before tax

Retained profits b/f (H only)

1,000

Retained profits c/f

1,800

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.

Example 16: Partially-owned subsidiary Where the holding company owns less than 100% of a subsidiary, we still consolidate the results of the subsidiary in full on a line-by-line basis (similar to the construction of the balance sheet following the control concept). But you then show the NCI in the CIS, equal to the noncontrolling share of the subsidiary’s result after taxation for the year. 134

Chapter 5: Accounting for groups

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 2011). H Ltd £ Sales

S Ltd

£

£

3,600

CIS £

£

2,400

£ 6,000

Cost of sales: Opening inventories

200

Purchases

500

2,200

1,300

3,500

2,400

1,600

4,000

400

Closing inventories

300

Gross profit

2,000

200

1,400

600

3,400

1,600

1,000

2,600 900

Expenses Profit on ordinary activities before tax Taxation

600

300

1,000 400

700 300

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

If a holding company acquires a majority interest in a subsidiary part-way through the year, it is necessary first of all to apportion the results of the subsidiary between the pre-acquisition and post-acquisition periods. The NCI is then calculated from the post-acquisition amounts.

Example 17: Intra-group transactions: Income and expenses Assume that the holding company makes a management charge of £200 to the subsidiary S. H will have an income item of £200 and will have an expense item of £200. On consolidation, these are simply eliminated against each other. 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. Extract from CIS Sales

H Ltd

S Ltd

ADD

ELIM

CIS

200

300

500

(200)

300

100

200

300

(200)

100

100

100

200

Cost of sales Purchases Gross profit

200

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 credited by the holding company, no problem arises, as there is an income item in the holding company against which the dividend in the subsidiary’s accounts may be eliminated. 135

91 Financial reporting

The situation of ‘proposed dividends’ has been simplified with the implementation of IAS 10. This removed the requirement to report dividends proposed after the balance sheet date in the income statement. Instead IAS 10 requires disclosure in the notes to the accounts. Consequently dividends declared after the balance sheet date should not be recorded as a liability in the balance sheet. Prior to IAS 10, the usual practice in the CIS was to assume that the dividend had not been proposed and to increase the subsidiary’s retained profits accordingly. This procedure ensured that any proposed dividend payable to minority shareholders was reflected in the minority interest on the CBS. (Special problems arise when a subsidiary pays a dividend out of pre-acquisition profits, and these are dealt with in ‘Dividends paid from pre-acquisition profits’ below.)

Example 18: Intra-group transactions: Unrealised profits In the following example, H sells stock to S for £200 which originally cost £100. S then sells them to a third party for £300. In this case there is no unrealised profit since all the stock sold to S by H has been sold on to a third party outside the group. The group has made a profit of £200, that is, H made a profit of £100 by selling to S and S made a profit of £100 by selling to a third party; or conversely the stock cost the group £100 and the group sold it to a third party for £300 – see extract of CIS below. However if any of the goods involved in inter-company trading remain as stock at the end of the year (i.e. are still within the group), it will be necessary to state them in the consolidated balance sheet at original cost to the group, excluding any element of inter-company unrealised profit. This involves writing down the value of the stock held by one company within the group at the year-end which has been purchased from another group company which has made a profit on the deal. The adjusting entry is simply to remove the profit element from the stock valuation and from the balance on the group income statement. This will result in the stock being stated at their cost to the group. H sells stock to S for £200 which originally cost £100. S still holds the stock at the year-end. In this case there is only a transaction within the group the stock has not been sold to a third party. Therefore we need to remove the unrealised profit of £100 (i.e. H’s profit on the sale to S). The corresponding entry is to remove this unrealised profit element from the stock so we show stock at the cost to the group (i.e. £100). We adjust the value of stock in the consolidated balance sheet and the consolidated income statement.

Sales Cost of sales Purchases Closing stock Gross profit

136

H Ltd £ 200

S Ltd £

Add £ 200

Deduct £ 200

CIS £ 0

100 200 100 100

200 200 0 0

300 100

200 100

100 0 0

Chapter 5: Accounting for groups

Example 19: Intra-group transactions: Unrealised profits We now see how the adjustments in Example 18 operate in a full example. Assume the income statements of H and S for the year ended 31 December 2011 are as follows: H Ltd £ Sales Cost of sales: Opening stock Purchases

200 2,200 2,400 400

Closing stock

£ 3,600

2,000 1,600

Gross profit

S Ltd £

£ 2,400

300 1,300 1,600 200

1,400 1,000

Let us assume that S has been a subsidiary of H for several years before 1 January 2011. S’s inventory at 1 January 2011 included goods bought from H for £100, which had originally cost H £60; similarly, S’s stock at 31 December 2011 included goods bought from H for £60, which had originally cost H £40. During the year 2011, H sold goods to S for a total price of £400. We then have the following calculation of group profit:

Sales Cost of sales: Opening stock Purchases Closing stock Gross profit

H Ltd

S Ltd

Add

Deduct

CIS

£

£

£

£

£

Notes

3,600

2,400

6,000

(400)

5,600

a

200

300

500

(40)

460

b

2,200

1,300

3,500

(400)

3,100

a

2,400

1,600

4,000

(440)

3,560

400

200

600

(20)

580

2,000

1,400

3,400

(420)

2,980

1,600

1,000

2,600

20

2,620

c

a: Elimination of £400 inter-company sales b: Elimination of £40 unrealised inter-company profit 1/1/2011 c: Elimination of £20 unrealised inter-company profit 31/12/2011 Note that it is not necessary to know the total inter-company profit on sales of £400 during the year, as that part of the inter-company profit relating to goods sold outside the group is realised and is legitimately included in the CIS. It is necessary to adjust only for the unrealised element of profit relating to goods still in inventory. We can reconcile the effect of the adjustments on gross profit as follows:

Gross profit of H Gross profit of S Less: unrealised profit at 31 December 2011 Add: unrealised profit at 1 January 2011 now realised Gross profit

£ 1,600 1,000 2,600 20 2,580 40 2,620

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91 Financial reporting

As well as adjusting the CIS for unrealised inter-company profits, it is also necessary to adjust the CBS, 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 CBS. In the above example, the inventory shown on the CBS at 31 December 2011 would be £580, eliminating the unrealised profits of £20, and the group retained profits on the CBS 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).

Merger accounting Despite the discontinued used of merger accounting, it is important to understand its conceptual differences from acquisition accounting (and problems generated from its use). Acquisition accounting

Merger accounting

Shares issued accounted for at fair value

Shares issued accounted for at nominal value (i.e. no share premium account)

Underlying net assets of acquired company consolidated at fair value – hence revaluations on consolidation and possibility of increased depreciation

Underlying net assets of acquired company consolidated at existing book value

Goodwill on consolidation may arise

Goodwill on consolidation does not arise – ‘difference on consolidation’ is not written off/amortised

Pre-acquisition reserves of acquired company not distributable by group and excluded from CBS

Pre-acquisition reserves of acquired company included in CBS and available to group

Acquired company consolidated from effective date of acquisition only

Acquired company consolidated as if it had always been part of group – comparative figures are restated

Accounting for associates Broadly speaking, associates are entities where the holding company has a significant influence (but not control). Conventionally, a figure of 20–50% voting/shareholding is taken as a measure of ‘significant influence’. IAS 28 (Investment in Associates) defines associates as: Entities that have the power to participate in the financial and operating policy decisions of the investee but is not in control or joint control over those policies.

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 per cent 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 138

Chapter 5: Accounting for groups

holds, directly or indirectly (e.g. through subsidiaries), less that 20 per cent 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.

Accounting treatment of associates: the equity method IAS 28 requires all associates to be accounted using the equity method. This entails the investment in an associated company being shown at cost (less any amounts written off as permanent diminutions in value) in the investing company balance sheet, and the income statement including only dividends received and receivable (i.e. declared but not yet received). The investing group’s consolidated balance sheet will include interests in associated companies at the total of: 1. the investing group’s share of net assets (other than any goodwill) of the associated companies, stated where possible after attributing fair values to the net assets at the time of acquisition of the interest in the associated companies and 2. any premium paid on acquisition of the interests in the associated companies (‘goodwill’). Where the cost of the investment equals the investing group’s share of the net assets of an associated company (reflecting, if appropriate, adjustments to fair value) at the date of acquisition, there will be no acquisition premium, and subsequent consolidated balance sheets will show the investment in that associated company at cost, plus the investing group’s share of all post-acquisition reserves of the associated company. The investing group’s consolidated income statement will also include, immediately below the reported group operating results, the share of operating profits or losses on ordinary activities (i.e. before interest and tax) of associated companies in arriving at the group profit before tax. Group interest and tax will include the share of the interest and taxation attributable to the profit and loss of the associated companies. (This will be disclosed separately, either on the face of the consolidated income statement or in notes to the accounts).

Example 20: Accounting for associates – preparing the CBS (equity method) and CIS On 1 January 2011, H acquires 40% of the shares of A for a total cash consideration of £1,400. On that date, the fair value of A’s tangible net assets corresponds with book value. H is presumed to exercise significant influence over A. The 40% represents H’s ownership of A and therefore H must report their share of A’s taxation (see ‘Extract from the consolidated income statement’ after step 3). Below are the summarised financial statements of H and its associated company A as at 31/12/11:

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91 Financial reporting

Balance sheet

H Ltd £

A Ltd £

Tangible non-current assets

12,600

4,000

1,400

–

14,000

4,000

4,000

2,000

18,000

6,000

6,000

3,000

12,000

3,000

Ordinary shares of £1

8,000

2,000

Income statement

4,000

1,000

12,000

3,000

H Ltd £

A Ltd £

Sales

5,000

1,800

Cost of sales

2,400

800

Gross profit

2,600

1,000

Expenses

1,280

500

Operating profit

1,320

500

80

–

1,400

500

400

100

1,000

400

Dividends paid

400

200

Retained profits for the year

600

200

Retained profits brought forward

3,400

800

Retained profits carried forward

4,000

1,000

Investment in A Ltd

Net current assets

Loan capital

Income statement for year 31/12/11

Dividend from A Ltd Profit on ordinary activities before tax Taxation Profit for the financial year

Step 1: Calculate the premium (‘goodwill’) Consideration = £1,400 Fair value at 1 January 2011 = [£3,000 (book value at 31 December 2011) – £200 (profits earned during year)]  40% = £1,120 Premium = difference between consideration paid and fair value at the date of acquisition = £1,400 – £1,120 = £280 140

Chapter 5: Accounting for groups

Step 2: Balance sheet – carrying value of the associate £ 1. Group share of the net assets @ balance sheet date (40% of £3,000)

1,200

2. Premium Paid

280

Investment in associated company

1,480

Therefore within the consolidated balance sheet the associate will be valued at £1,480 and will be placed beneath the tangible non-current assets. Extract of the consolidated balance sheet £ 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 consolidated income statement 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 consolidated income statement 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: Balance sheet as at 31/12/11 Tangible non-current assets Investment in associated company Net current assets Loan capital Net assets Ordinary shares of £1 Income statement

H £ 12,600 1,400 14,000 4,000 18,000 6,000 12,000

A £ 4,000 4,000 2,000 6,000 3,000 3,000

Group £ 12,600 1480 14,080 4,000 18,080 6,000 12,080

8,000 4,000 12,000

2,000 1,000 3,000

8,000 4,080 12,080

Notes

a

a

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91 Financial reporting Income statement for y/e 31/12/11 Sales Cost of sales Gross profit Expenses Operating profit Share of profits from associated company Dividend from A Ltd Profit on ordinary activities before tax Taxation Profit for the financial year Dividends paid Retained profits for the year Retained profits brought forward Retained profits carried forward

H £ 5,000 2,400 2,600 1,280 1,320 80 1,400 400 1,000 400 600 3,400 4,000

A £ 1,800 800 1,000 500 500

500 100 400 200 200 800 1,000

Group £ 5,000 2,400 2,600 1,280 1,320 200 1,520 440 1,080 400 680 3,400 4,080

Notes

b c d c

Notes

a: changes in investment represented by corresponding change income statement b: add share of profits to H to give group CIS c: 80 represents 40% x 200 dividends paid by A to H (rest to external party); this is cancelled in the CIS as it is an intra-group transaction d: group taxation also need to include share of tax paid by A

Note that some (usually smaller) enterprises do not have any subsidiaries and thus do not need to prepare consolidated accounts. If however such companies have significant holdings in associates (but no subsidiaries), they are allowed to use either equity accounting (i.e. the conventional treatment for associates) or to account for such investment at cost (or valuation).

Accounting for joint ventures IAS 31 (Interests in joint ventures) defined joint ventures as: A contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. Joint control is the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers). Control is the power to govern the financial and operating policies of an economic activity so as to obtain benefits from it.

IAS 31 recognises that joint ventures take many forms and explicitly identifies three: • jointly controlled operations • jointly controlled assets • jointly controlled entities. We are mainly concerned with jointly controlled entities. This is because a separate legal entity has to prepare its own set of accounts, and we have to understand how to consolidate this form of joint venture. IAS 31 states that:

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Chapter 5: Accounting for groups A venturer shall recognise its interest in a jointly controlled entity using proportionate consolidation or the equity method.

Proportional consolidation is rare in the UK and the USA, but common for joint ventures in France and the Netherlands (Nobes and Parker, 2012). Proportional consolidation is a method of accounting whereby each venturer’s share of each assets, liabilities, income and expenses of a jointly controlled entity is combined line by line with similar items in the venturer’s financial statements or reported as separate line items in the venturer’s financial statements (IAS 31). This differs from the equity method (as used for associates) in that under the equity method the joint venture is initially recorded at cost and adjusted thereafter for the post-acquisition change in the venturer’s share of net assets of the jointly controlled entity. In the income statement, under equity accounting, the venturer’s share of the profit or loss of the jointly controlled entity is included in the income statement. In other words it consolidates in the group accounts that proportion of an investment (i.e. proportion of the share capital) that is owned. Therefore, the proportion of all assets and liabilities owned in an associated company are shown in the balance sheet (plus any goodwill on acquisition) replacing the cost of the investment. In the case of associate companies, the income statement will show the proportion of all revenues and expenses of the associated company.

Example 21: Accounting for joint ventures using proportional consolidation H acquired 200 ordinary (£1) shares of JV at a price of £1.80, when JV’s retained profits were £600. The balance sheets of H and V and a CBS on a line-by-line basis is shown below. Balance sheet as at 31/12/11 Tangible non-current assets Investment in JV Goodwill in JV Net current assets Loan capital Net assets Ordinary shares of £1 Income statement

H £ 13,060

CBS JV 10% of JV line-by-line £ £ £ 4,000 400 13,460

360 4,580 18,000 6,000 12,000

2,000 6,000 3,000 3,000

8,000 4,000 12,000

2,000 1,000 3,000

200 600 300 300

100 4,780 18,340 6,300 12,040 8,000 4,040 12,040

Goodwill calculations are similar to those used in acquisition accounting, delineating between pre- and post-acquisition profit.

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91 Financial reporting Goodwill calculation

£

Consideration (Investment in JV)

£ 360

Net assets JV 1/1/11 (ord. shares + pre-JV Profit) 10% assets controlled in joint venture on 1/1/11

2,600 260

Goodwill

100

We also need to calculate the share of JV’s profits in the CBS. Calculating profit reserves H income statement

4,000

10% of JV post-acquisition profits

40 4,040

The CBS shown above is on a line by line basis, but IAS 31 prefers that separate line items are shown, as in the presentation below (note that the Net assets value for the proportional consolidation, whether on a line-byline or separate line items, is the same). CBS as at 31/12/11 Tangible non-current assets Tangible non-current assets JV Goodwill in JV Net current assets Net current assets JV

CBS £ 13,060 400

Loan capital Loan capital JV Net assets

4,580 200 6,000 300

Ordinary shares of £1 Income statement

£ 13,460 100 4,780 18,340 6,300 12,040 8,000 4,040 12,040

The general approach to calculating proportional consolidation is as follows: Let y equal the investor’s share, and (1–y) equal the ‘outside shareholders’ interest’. Income statement:

R–C=

Balance sheet:

A–L=E

Where R = revenues, C = costs,  = profit, A = assets, L = liabilities, E = equity. Basis of ‘equity accounting’ for investee: Income statement:

Bring in y()

Balance sheet:

Bring in y(E)

Whereas the basis of ‘proportional consolidation’ of investee is:

144

Income statement:

Bring in y(R–C) = y()

Balance sheet:

Bring in y(A–L) = y(E)

Chapter 5: Accounting for groups

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 CBS arise between these methods when H acquires less than 100% of S.

Example 22: Comparing different methods of consolidating a subsidiary H acquires 80% of S for £2,100, when net book value (NBV) of S’s net assets is £2,400 and fair value (FV) at £2,600. The balance sheets for H and S (along with CBS using the different models of consolidation we have come across – economic entity, parent entity and proprietary) are as follows. In this example, the parent entity approach can be sub-divided into two different methods, depending on whether NCI is valued at fair value or net book value. The later argues that from the perspective of the ‘parent’ company H, the parent is only concerned with reflecting the impact of fair value on the parent’s share of S, not the NCI’s share of S (as the NCI is not the responsibility of the parent). The fair value approach introduces consistency and avoids having mixed valuations on the CBS. Models of CBS

A Economic

H Ltd S Ltd £ £ 6,000 2,400 2,100 1,900 10,000 2,400

CBS £ 8,600 25 1,900 10,525

B Parent NCI at FV CBS £ 8,600 20 1,900 (520) 10,000

9,000 1,000 10,000

9,000 1,000 525 10,525

9,000 1,000 10,000

NBV

Non-current assets Investment in S Goodwill Cash (Liability): NCI

£1 ordinary shares Retained profits NCI

NBV

2,000 400 2,400

C D E Parent Proprietary IFRS 3 NCI at NBV CBS CBS CBS £ £ £ 8,560 8,080 8,600 20 20 20 1,900 1,900 1,900 (480) 10,000 10,000 10,520 9,000 1,000 10,000

9,000 9,000 1,000 1,000 520 10,000 10,520

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91 Financial reporting

Model A: economic entity approach The workings for goodwill and calculation of net assets are as follows: 1 Economic entity

£

Investment in S (80%) 100% implied value of S (100/80  2100) FV net assets of S Goodwill NCI’s share of goodwill (20%) NCI (20%  £2625)

£

2,100 2,625 2,600 25 5 525

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 from.

Model B: parent entity approach, NCI at FV 2 Parent entity, NCI at FV

£

Investment in S (80%) FV net assets of S 80% FV net assets of S Goodwill NCI calculation

£ 2,100

2,600 2,080

2,080 20 520

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 CBS, unlike in the economic entity approach.

Model C: parent entity approach, NCI at NBV 3 Parent entity, NCI at NBV

Calculation of non-current assets NCI at NBV (20%  2400)

£

£

£

£ CBS

NBV

FV

NBV

100% H

80% S

20% S

a

b

c

=a+b+c

6,000

2,080

480

8,560 480

The NCI at NBV approach takes the parent perspective more strictly, by removing all increases in FV attributed to the NCI in representing the consolidated non-current assets on the CBS. £ Investment in S (80%) FV net assets of S 80% FV net assets of S Goodwill

146

2,600 2,080

£ 2,100 2,080 20

Chapter 5: Accounting for groups

Model D: proprietary approach 4 Proprietary (proportional) entity

Calculation of non-current assets 80% Investment in S FV net assets of S 80% FV net assets of S Goodwill

£ NBV 100% H 6,000

£ FV 80% S 2,080

£ CBS 8,080

2,100 2,600 2,080

2,080 20

We see that the proprietary entity only shows the proportion of S’s net assets controlled, completely removing NCI. In this example, as S was acquired using 100% cash, therefore it is observed that the CBS net asset value of H equal to CBS (i.e. £10,000).

Model E: The current (hybrid/mixed) approach, IFRS 3 Finally, we reiterate a point made earlier that the current standard, IFRS 3, is a hybrid/mixed concept as it incorporates elements from both economic entity and parent entity model. The workings are as follows: NCI shown in the equity section of the balance sheet (economic entity) Goodwill on consolidation relates only to parent’s share of subsidiary (parent entity) 5 IFRS 3 approach (economic + parent)

£

£

Goodwill (parent approach) Investment in S (80%)

2,100

FV net assets of S

2,600

80% FV net assets of S

2,080

Goodwill NCI (20%  £2,600)

2,080 20 520

To conclude, we can see that the value of net assets vary across the different methods, depending on whether the method allocates the full value of goodwill to the CBS.

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • explain how different non-current asset investments are distinguished and accounted for • describe a ‘group’ • describe the rationales used to develop different models of consolidation (acquisition, merger, equity, proportional) • be aware of the main ideas underpinning the now disallowed merger method • explain why the definition of a subsidiary is important • describe associates and joint ventures and how to account for them in consolidation • prepare consolidated accounts (balance sheet and profit and loss or income statements) using the acquisition, equity and proportional consolidation methods 147

91 Financial reporting

• compute the value of goodwill and non-controlling (minority) interest • appreciate the importance of the transaction date and the difference between pre and post transaction profits/income in consolidated accounts.

Sample examination questions Question 5.1 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 2011 2010 £m £m Balance sheets Tangible non-current assets Investment in Gidget

840 80

780 –

460 –

420 –

Net current assets

920 160

780 140

460 120

420 80

1080 200

920 200

580 160

500 160

880

720

420

340

480 400

400 320

160 260

160 180

Loan capital

Ordinary shares of £1 Income statement

148

Gidget 2011 2010 £m £m

880

720

420

340

Income statements Sales Cost of sales

2,540 1,420

1,960 1,080

1,520 840

1,380 760

Gross profit Other expenses

1,120 820

880 600

680 520

620 584

Profit before taxation Taxation

300 100

280 120

160 80

36 12

Profit for the financial year Dividends

200 120

160 100

80 –

24 8

80

60

80

16

Chapter 5: Accounting for groups

The following information is relevant: 1. The fair value of the tangible non-current assets of Gidget at 1 July 2011 exceeded book value by £140 million. The book value of other assets and liabilities can be assumed to equal their fair value at that date. 2. The effect of basing depreciation on the fair value of the assets of 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. You are required to prepare summarised consolidated statements for Widget-Gidget Plc for 2011 using acquisition accounting Solutions to this question are given in Appendix 2.

Question 5.2 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. 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-Props and BestProp are as follows: Balance sheets as at 31 December 201

Investment properties at valuation

Top-of-Prop

BestProp

£m

£m

400

240

Investment in BestProp at cost

8

–

Net current assets/(liabilities)

80

20

488

220

120

180

368

40

Share capital

160

20

Revaluation surplus

140

40

68

(20)

368

40

Loan capital

Income statement

149

91 Financial reporting Income statements for the year ended 31 December 2011 Rents receivable less expenses

28

10

(10)

(30)

Profit/(loss) before taxation

18

(20)

Taxation charge

(4)

–

Profit/(loss) after taxation

14

(20)

Interest payable

You are required to: a. prepare consolidated financial statements for Top-of-Prop Plc as at 31 December 2011, treating the investment in BestProp Plc on the following bases: i. as an investment ii. as an associated company iii. using proportional consolidation iv. using full consolidation b. discuss briefly the different views of the financial position and profitability of Top-of-Prop Plc given by these accounting treatments, illustrating your answer where appropriate with significant ratios. Solutions to this question are given in Appendix 2.

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Chapter 6: Accounting for foreign currencies

Chapter 6: Accounting for foreign currencies Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • explain why foreign currency translation is necessary • explain the importance of the exchange rate and how to treat exchange differences • describe the four main methods of foreign currency translation • discuss the different treatment of foreign subsidiaries and branches • describe and use both the closing rate and the temporal method of foreign currency translation.

Essential reading International Financial Reporting, Chapter 29.

Further reading Relevant IASB standard IAS 21 The Effects of Changes in Foreign Exchange Rates.

Introduction Two main types of foreign currency operation can be identified: • Direct business transactions denominated in foreign currency (e.g. a contract to purchase a fixed asset from the US 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 at £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.

151

91 Financial reporting

Foreign currency conversion: business transactions In this section, we are only going to deal with accounting for an individual company’s transactions that are denominated in foreign currencies; translating the accounts of overseas subsidiaries (and related topics) is discussed later in this chapter.

Purchase of non-current assets According to IAS 21, if a UK company purchases non-current assets, inventory and so on from an overseas company, it will record the acquisition at the rate of exchange ruling at the date of the transaction (i.e. record these when they occur). The £ sterling value of the acquisition will then be fixed and there would be no subsequent retranslation of the asset or purchase if rates change when payment is made; a gain or loss on the exchange will arise on settlement which would be taken to the income statement. Note: If a contract had been agreed subject to an agreed exchange rate, that rate will be used to record the transaction. If the company had entered into a matching forward contract, the rate in the contract could be used. Consider the following examples in which Winterholder Plc (a UK company) enters into one foreign currency transaction. The balance sheet date of Winterholder Plc is 31 December 2011.

Example 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. • The real questions are: • How should the non-current assets be recorded in the accounts of Winterholder Plc? How should the difference on the exchange be treated? Solution to Example 1 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. Dr Trade payable

£7,500

Cr Cash

£6,000

Cr Gain on exchange

£1,500

Example 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 152

Chapter 6: Accounting for foreign currencies

the exchange rate was £1:$1.5. Again the real questions are: • How should the fixed asset be recorded in the accounts of Winterholder Plc? • How should the difference on exchange be treated? Solution to Example 2 Once again the fixed asset is recorded at its historical cost at the date of 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. Dr Trade payable

£7,500

Dr Loss on exchange

£2,500

Cr Cash

£10,000

Foreign currency translation: business transactions Examples 1 and 2 dealt with situations in which the transactions were completed by the year-end. Example 3 looks at how to deal with foreign currency transactions that are not complete by the year-end.

Example 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 balance sheet 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. The questions are: • 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? Solution to Example 3 The fixed asset is recorded at its historical cost at the date of 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 balance sheet 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 Winterholders 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 this chapter), that is, the rate of exchange ruling at the balance sheet date. Therefore, an exchange gain 153

91 Financial reporting

of £1,500 (£7,500–£6,000) is credited to the income statement for the year ending 31 December 2011. Dr Trade payable

£1,500

Cr Gain on exchange

£1,500

When the transaction is settled on 31 January 2012 the cash payment is £5,000 ($15,000/$3), representing a total realised gain on exchange of £2,500 (£7,500–£5,000). As £1,500 was credited to the previous year’s income statement, the balance of £1,000 is credited to the income statement for the year ending 31 December 2012. Dr Trade payable

£6,000

Cr Cash

£5,000

Cr Gain on exchange

£1,000

Activity 6.1 What is the rationale for crediting exchange gains on unsettled transactions at the yearend to the income statement? What would happen if the exchange rate at 31 January 2012 was £1:$1.5? Feedback to the activity is given in Appendix 2.

Example 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: Dr Trade receivables

£1,000

Cr Sales

£1,000

The US customer pays for the goods on 30 April when the rate of exchange is £1:$3.2. In Winterholder’s books the entries will be: Dr Cash

£923

Dr Loss on exchange

£77

Cr Trade receivables

£1,000

Under IAS 21 the difference on exchange will go to the income statement. If it is a gain on exchange, it is treated as a realised profit.

Example 5 Suppose that the sales Winterholder made to the US customer in Example 4 above were not settled at the balance sheet date. At the balance sheet date the exchange rate was £1:$2.5. How would these be shown in Winterholder’s accounts? Solution to Example 5 The trade receivable of $2,950 would still be outstanding at that date. IAS 21 requires that the trade receivable of $2,950 to be translated at the closing rate (i.e. the rate of exchange prevailing at the balance sheet date, unless there is an agreed rate or matching forward contract). The trade receivable would therefore appear in the balance sheet as £1,180 and there would be a gain on exchange of £180, which IAS 21 154

Chapter 6: Accounting for foreign currencies

takes to the income statement. (Any loss on short-term monetary items is also regarded as realised under IAS 21 and is taken to the income statement.)

Example 6: Long-term liabilities On 1 January 2011 a UK company raised a five-year loan of $20,000,000 in the USA when the exchange rate was £1:$2.90. At that date it would have been recorded as a liability of £6,896,522. At what amounts should the liability appear in the balance sheet at 31 December: 2011, 2012, 2013, etc? IAS 21 argues that the best predictor of the rate when the loan is finally repayable is the closing rate at each balance sheet date. So if the rate at 31 December 2011 were £1:$3.1 and at 31 December 2012 were £1:$2.95, the loan would appear at £6,451,613 and £6,779,661 respectively. The exchange gain on the translation of unsettled long-term monetary items at each balance sheet date is regarded by IAS 21 as unrealised and the gain should be taken to the income statement. A similar principle also applies to exchange losses: any loss on the translation of unsettled longterm monetary items would also be taken to the income statement. Note: In the UK when exchange gains and losses arise from trading transactions they should normally be included under ‘Other operating income and expenses’ in the income statement. When they arise from financing transactions they should be included with ‘other interest receivable/payable and similar income/expenses’.

Summary of accounting rules for individual transactions Completed transactions: translated on day of transaction. Incomplete transactions: short-term monetary items (trade receivables, inventories, etc) translate at year-end rate. Take unrealised loss or gain to the income statement. Incomplete transactions: long-term monetary items (loans, etc) translate at year- end rate. Take unrealised loss or gain to the income statement.

Which exchange rate should be used to record foreign currency translations? In the previous section we introduced foreign currency transactions. In the remainder of the chapter we will consider the case in which foreign operations are conducted abroad through a foreign enterprise (e.g. subsidiary, associate or branch). The questions are: • How should their accounts be translated into £UK? • How should any differences on exchange be treated? There are four distinct choices of exchange rate translation. The four methods are: 1. Closing rate method. All assets and liabilities are translated at the exchange rate applicable at the balance sheet date (i.e. the closing rate). This method is also known as the ‘net investment method’ or the ‘current rate method’ in the USA. 2. Temporal method. All assets and liabilities that are carried at current prices (e.g. cash, trade and other receivables, trade and other payables) are translated at the closing rate. All assets and liabilities are carried at past prices (e.g. property, plant and equipment) and are translated at the exchange rate applicable at the historical date. 155

91 Financial reporting

3. Current/non-current method. All current assets and current liabilities are translated at the closing rate. All non-current assets and non-current liabilities are translated at the historical rate. 4. Monetary/non-monetary method. All monetary assets and liabilities (relating to the right/obligation to receive/pay a fixed amount of money) are translated at the closing rate. All non-monetary assets and non-monetary liabilities are translated at the historical rate. The income statement can typically be translated at the average or closing rate for the closing rate method, and at the historical or average rate for the other three methods. In the remainder of the chapter we will concentrate on the temporal method and the closing rate method. Each method is discussed in more detail and evidenced with a worked example.

Distinguish between the use of closing rate and the temporal method The two most commonly used methods of translation are the closing rate method and the temporal method. Both of these methods are permitted under IAS 21, depending on the circumstances leading to translation. The closing rate method is most prevalent. The method which should be used depends on the financial and other operational relationships between the investing company and the foreign enterprise. In order to understand the circumstances in which each method is required, we need to familiarise ourselves with some terminology. IAS 21 was revised following the IASB’s improvement project. One change that was made was to replace the notion of ‘reporting currency’ as with two aspects of currency: Functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash (IAS 21, para. 9). Presentation currency is the currency in which the financial statements are presented. Here we are concerned with the translation of functional currency to presentation currency. For many companies the determination of functional currency will be a straightforward exercise. IAS 21, paras. 9–12 outline factors that companies should consider when making this decision: a. the currency that mainly influences sales prices for goods and services; and of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services; b. the currency that mainly influences labour, materials and other costs of providing goods or services. The following factors may also provide evidence of an entity’s functional currency: • The currency in which funds from financing activities are generated. • The currency in which receipts from operating activities are usually retained. The following additional factors are considered in determining the functional currency of a foreign operation and whether its functional currency is the same as that of the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture) (IAS 21, para. 11): 156

Chapter 6: Accounting for foreign currencies

Whether the activities of the foreign operations are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency. Whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities. 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 6.2 From an economic point of view, why might companies wish to set up a foreign subsidiary or branch?

Accounting for the closing rate method and the temporal method We have discussed the circumstances in which the closing rate and temporal methods are used. In this section we briefly review the accounting treatment required for each method.

Closing rate: balance sheet The closing rate at the balance sheet date is used to translate the balance sheet of the foreign enterprise into the investing company’s currency. However, the share capital is translated at the historic rate applicable. The exchange difference is taken to reserves (not to the income statement).

Closing rate: income statement IAS 21 requires that the foreign enterprise’s income statement should be translated using the average rate. 157

91 Financial reporting

Closing rate: exchange differences Exchange differences relating to retranslation of the opening net investment (i.e. where the opening and closing balance sheets are translated at different exchange rates) using average rate for the income statement are taken to the reserves. Activity 6.3 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.

Temporal method: balance sheet Monetary assets and liabilities should be translated at the closing rate. Non-monetary assets and liabilities should be translated at the applicable rate at which they were first recorded (if stated at historical cost) or at the applicable rate at the time at which any revaluation took place (if stated at a re-valued amount). The exchange difference is taken to the income statement (unlike the closing method which requires this to be taken to reserves).

Temporal method: income statement The general rule is that all transactions should be translated at the rate applicable on the transaction date. Alternatively, an average rate can be used if the rates do not fluctuate too much over the period. However, you need to approach this with caution. Depreciation will be based on the rate used for non-current assets; accrued revenues and expenses are translated at an average rate; other revenues and expenses are translated at a specific or appropriate average rate.

Temporal method: exchange differences All exchange differences are taken to the income statement and included within the ordinary activities of the group. Activity 6.4 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?

Example 7: The closing rate and the temporal methods • On 1 January 2011 Radmond Plc (UK investing company) set up Dunfor (foreign subsidiary) and carried out the following transactions: • share capital of 200,000 shares of $1 each • purchased $100,000 worth of non-current assets (five-year useful life; nil scrap value; straight-line depreciation) • cash purchase of 1,000 units of inventory for $20,000. • On 30 June 2011, Dunfor had the following: • cash sales of 400 units of inventory for $60 each • credit sales (eight months’ credit) for 400 units for $60 each cash expenses of $4,000.

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The exchange rates were: • £1:$5 on 1 January 2011 • £1:$10 on 30 June 2011 • £1:$12 on 31 December 2011. Given this information, we will translate Dunfor’s balance sheet and income statement into £UK using both the closing rate method and the temporal method. Closing rate method Income statement for Dunfor for year ended 31 December 2011 $ Sales

$

Exchange rate

48,000

£

10

4,800

Purchases

20,000

10

2,000

Less closing inventory

(4,000)

10

(400)

Cost of goods sold

£

(16,000)

(1,600)

Gross profit

32,000

10

3,200

Expenses

(4,000)

10

(400)

(20,000)

10

(2,000)

Depreciation Net profit

8,000

800

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 6.5 What would the net profit be if we used the closing rate (rather than the average rate) to translate the income statement. The solution to this activity is given in Appendix 2. Balance sheet for Dunfor as at 31 December 2011 $ Non-current assets (NBV)

Exchange Rate

£

80,000

12

6,667

4,000

12

333

24,000

12

2,000

100,000

12

8,333

Current assets: Inventory Trade receivables Cash

Share capital Retained profit

128,000

10,666

208,000

17,333

200,000 8,000 208,000

5

40,000

(= balancing figure)

22,667 17,333

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91 Financial reporting

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 Exchange difference

£– £800 (£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) Net profit at average rate £8,000 @ £1:$10

=

£800

Net profit at closing rate £8,000 @ £1:$12

=

£667

Exchange loss on net profit

=

(£133)

Total exchange difference

=

(£23,466)

(£23,467 with rounding) Activity 6.6 What would the exchange difference reconciliation be if the closing rate (rather than the average rate) was used to translate the income statement? The solution to this activity is given in Appendix 2. 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.

Temporal method The mechanics of the temporal method requires translating each transaction of the foreign enterprise at the rates ruling at the date of each transaction.

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Chapter 6: Accounting for foreign currencies

The restated accounts (under the temporal method) are as follows: Income statement for Dunfor for year ended 31 December 2011 $ Sales

$

Exchange rate

48,000

£

10

4,800

Purchases

20,000

5

4,000

Less closing inventory

(4,000)

5

(800)

Cost of goods sold

£

(16,000)

(3,200)

Gross profit

32,000

1,600

Expenses

(4,000)

10

(400)

(20,000)

5

(4,000)

Depreciation

(2,800) Translation loss Net profit

(10,067) 8,000

(12,867)

Activity 6.7 Why do we use an exchange rate of $5 to £1 to translate inventory figures? (See earlier in the chapter.) 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 balance sheet. The translation loss is the balancing figure that ensures a net loss of £12,867. Balance sheet for Dunfor as at 31 December 2011 $ Non-current assets (NBV)

Exchange Rate

£

80,000

5

16,000

4,000

5

800

24,000

1

22,000

100,000

12

8,333

Current assets: Inventory Trade receivables Cash

Share capital Retained profit

128,000

11,133

208,000

27,133

200,000 8,000

5

40,000

(= balancing figure)

12,867

208,000

27,133

Note that the retained profit is the balancing figure.

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91 Financial reporting

The translation loss of £10,067 can be calculated easily because it is the exchange loss on monetary items: Opening

Closing

monetary items

monetary items

$

$

–

24,000

80,000

100,000

80,000

124,000

Trade receivables Cash Opening monetary items @ opening rate: $80,000 @ £1:$5 =

£16,000

Opening monetary items @ closing rate: $80,000 @ £1:$12 =

£ 6,667 (£ 9,333)

Change in monetary items @ average rate: $44,000 @ £1:$10 =

£ 4,400

Change in monetary items @ closing rate: $44,000 @ £1:$12 =

£ 3,667 (£ 733)

Total exchange loss

(£10,066) (£10,067 rounded)

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.

Final thoughts You have now worked through foreign exchange translations using both the closing rate method and the temporal method. In the previous worked example Dunfor is translated using both methods. To conclude this chapter please consider the questions in Activity 6.8. Activity 6.8 • Why are the income statement retained profit figures different? • What is the reasoning for the different outcomes produced by each method?

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • explain why foreign currency translation is necessary • explain the importance of the exchange rate and how to treat exchange differences • describe the four main methods of foreign currency translation • discuss the different treatment of foreign subsidiaries and branches 162

Chapter 6: Accounting for foreign currencies

• describe and use both the closing rate and the temporal method of foreign currency translation.

Sample examination question Question 6.1 On 1 January 2011 Dunelm Plc (a UK investing company) set up its foreign subsidiary (Dunfor) in Zongaland, which uses Zonga dollars (Z$). The following transactions are relevant on that date: • start up share capital of 200,000 shares of $1 each with paid-in cash • purchased $100,000 worth of non-current assets (five-year useful life; nil scrap value; straight-line depreciation) • cash purchase of 1,000 units of inventory for $20,000. On 30 June 2011 Dunfor has its first sales transactions: • cash sales of 300 units of inventory for $70 each • credit sales (eight months’ credit) of 300 units for $70 each • cash expenses of $3,000. The exchange rates relevant for the current example are: • £1:$10 on 1 January 2011 • £1:$8 on 30 June 2011 • £1:$5 on 31 December 2011. What is the difference between a ‘functional currency’ versus a ‘presentation currency’? State a factor that determines a ‘functional currency’. Translate Dunfor’s balance sheet and income statement into £UK using the temporal method. Solutions to this question are given in Appendix 2.

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91 Financial reporting

Notes

164

Chapter 7: Accounting for tangible non–current assets

Chapter 7: Accounting for tangible non-current assets 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. The main issue of tangible assets is at what cost/value they should be recorded in the balance sheet 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 noncurrent assets should appear in the balance sheet at all.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • discuss tangible non-current assets, both owned and leased • explain and compute the annuity method of depreciation (including its relationship to Hicks and deprival values) • explain the implications of revaluation on interpretation of the financial statements • appreciate accounting for investment property as distinct from accounting for property more generally • describe both operating leases and finance leases • demonstrate accounting for both operating and finance leases, and explain possible implications for accounts’ users • discuss off-balance sheet financing in relation to operating leases.

Essential reading International Financial Reporting, Chapter 12.

Further reading Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1971) [ISBN 042114470X]. Ernst and Young International GAAP 2012: Generally Accepted Accounting Practices under International Financial Reporting Standards (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 5. 165

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Relevant IASB standards IAS 16 Property Plant and Equipment. IAS 17 Accounting for Leases. IAS 23 Borrowing Costs. IAS 36 Impairment of Assets. IAS 40 Investment Property. IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

Tangible non-current assets (owned) Definition The IASB Framework for the Preparation and Presentation of Financial Statements (FPPFS) defines assets as: a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. (FPPFS, para. 49)

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)

Examples of tangible non-current assets include: • land • property • plant and equipment • vehicles • fixtures and fittings.

Measurement of tangible non-current assets What cost/value should be recorded? How should tangible non-current assets be recorded in the balance sheet? Should non-current assets be recorded at historical cost or at current value (e.g. replacement cost)? According to IAS 16, non-current assets are recorded at historical cost. However, historical cost can either be the purchase price or the production 166

Chapter 7: Accounting for tangible non–current assets

costs, depending upon whether the asset was bought or made. Purchase cost is reasonably straightforward (if it can include ancillary expenses such as delivery charges or legal and architect’s fees),1 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 fixed asset in the balance sheet for subsequent charging to the income statement as depreciation).2

1

See ‘Initial cost’ below.

2

See ‘Depreciation’ below.

Initial cost According to IAS 16 (para. 15) tangible non-current assets should initially be recorded at cost. Cost includes purchase price plus ‘any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management’ (para. 16). This would include the following, which can all be capitalised as part of the asset’s initial cost: • original purchase price for a purchased asset • labour costs of its own employees arising directly from the construction for a constructed asset • site preparation costs • related professional fees (solicitors, architects and engineers) • delivery and handling • installation • the estimated cost of dismantling and removing the asset and restoring the site (see IAS 37 Provisions, Contingent Liabilities and Contingent Assets). If payment for an item of property, plant, and equipment is deferred, interest at a market rate must be recognised or imputed (para. 23). If an asset is acquired in exchange for another instead of being bought, the cost is measured at the fair value unless: a. the exchange transaction lacks commercial substance; or, b. the fair value of neither asset received nor asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up. (IAS 16, para. 24)

Borrowing costs As there is a separate international standard (IAS 23 Borrowing Costs), IAS 16 does not address this issue. IAS 23 defines borrowing costs in para. 4 as: Interests and other costs incurred by an entity in connection with the borrowing of funds [on a] qualifying asset [that] necessarily takes a substantial period of time to get ready for its intended use or sale. (IAS 23, para. 4)

For example, the construction of a new hotel development, labour, materials and interest charges on loans relating to the non-current assets of construction can all be capitalised, and consequently represent the initial cost of the fixed asset.

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91 Financial reporting

The benchmark treatment is that borrowing costs are recognised as an expense in the period in which they are incurred (para. 7). As an alternative treatment, ‘borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset’ (para. 10). These borrowing costs are those that would have been avoided if the expenditure on the qualifying asset had not been made (e.g. if funds are borrowed specifically to obtain the asset). Capitalisation begins with expenditure and when borrowing costs are incurred and the preparation of the asset for use or sale is in progress (para. 20). It is to cease on completion of the asset for use or for sale (para. 25)

Subsequent expenditure Subsequent expenditure such as repairs or upkeep to maintain assets is charged to the income statement. However, if this expenditure satisfies the recognition criteria for an asset, such as the replacement of parts of the item, the expenditure may be capitalised. Activity 7.1 Make sure that you can 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?

Measurement after recognition: revaluation IAS 16 permits two options: • The cost model: ‘after recognition as an asset, an item of property, plant and equipment shall be carried at cost less any accumulated depreciation and any accumulated impairment loss’ (IAS 16, para. 30). • The revaluation model: ‘after recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses’ (IAS 16, para. 31). Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction (IAS 16, para. 6). If the revaluation model is chosen it must be applied to all assets of the same class (IAS 16, para. 36), if not necessarily to all classes of tangible non-current assets. This avoids companies ‘cherry picking’ assets for revaluation. If companies choose revaluation they must continue to do so on a consistent basis and keep it up-to-date. The frequency of valuations: depends upon the changes in fair values of the items… being revalued. When the fair value of a revalued asset differs materially from its carrying amount, a further revaluation is required. Some items… experience significant and volatile changes in fair value, thus necessitating annual revaluation. Such frequent revaluations are unnecessary for items… with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years (IAS 16, para. 34).

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Chapter 7: Accounting for tangible non–current assets

Accounting for revaluations Accounting for revaluations is common for companies which otherwise use historical cost accounting to revalue some of their non-current assets, particularly land and buildings; the resultant system is usually referred to as modified historical cost. This section sets out the main accounting considerations involved; it is based on the assumption of an upward revaluation and does not deal with revaluation deficits. On revaluing a fixed asset for the first time, the difference between the revalued amount and the net book value of the asset at the date of revaluation goes to the revaluation surplus (part of equity) as an unrealised surplus. Revalued assets, with the exception of land and investment properties, with a finite useful life, are still subject to depreciation. This is because the ‘depreciable amount of an asset shall be allocated on a systematic basis over its useful life’ (IAS 16, para. 50). When revaluing assets the opportunity will usually be taken to review the expected useful life and the revalued amount should be written off over the remaining estimated useful life of the asset. When an asset is revalued at the start of the year, depreciation for the year will be based on the revalued amount. The whole of the depreciation on the revalued amount must be charged to the income statement; it is not permitted to charge ‘split depreciation’ (i.e. charge part to the income statement and part to the revaluation surplus). When a fixed asset is revalued at the end of the year it is still necessary to charge depreciation for the year: ideally this should be based on the average value for the year, but either the opening or closing value may be used; most companies are likely to base it on the opening value. In subsequent years the depreciation charge will be based on the revalued amount.

Summary of accounting for revaluations Revaluation gain. Difference between the revalued amount and the net book value of the asset at the date of revaluation is: • debited to property, plant and equipment • credited to equity in the balance sheet under the heading of revaluation surplus. Revaluation losses. Difference between the revalued amount and the net book value of the asset at the date of revaluation is: • debited to the income statement (unless previously revalued) • credited to property, plant and equipment.

Example Land and Buildings cost £250,000 on 1 January 2010; of this, £100,000 was attributed to the land. At that date the buildings were estimated to have a useful life of 50 years with no residual value. They are being depreciated on a straight-line basis.3 On 31 December 2010 the property was professionally revalued at £400,000, of which £160,000 was attributed to the land. No charge was made to the estimated useful life of the buildings.

4

See ‘Which depreciation method?’ below.

During the year ended 31 December 2010 depreciation of £3,000 on buildings will have been charged, based on the opening value at the start of the year. At 31 December the property, plant and equipment will therefore have a net book value of £247,000. In the accounts at 31 December 2011 the following entries will be made to reflect the revaluation (£400,000 – £247,000) in the balance sheet: 169

91 Financial reporting

Dr Property, plant and equipment

£150,000

Dr Depreciation of buildings

£3,000

Cr Revaluation surplus

£153,000

In subsequent years, depreciation will be based on the revalued amount for buildings, that is, £240,000 over 40 years or £6,000 p.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).

Depreciation Depreciation is a measure of the wearing out, consumption or other reduction in the useful life of a fixed 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 is charged to each accounting period. This allocation is in accordance with the ‘matching concept’.4 IAS 16 defines depreciation as:

4

See the subject guide for 25 Principles of accounting.

...the systematic allocation of the depreciable amount of an asset over its useful life.

Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. The residual value of an asset is: the estimated amount that an entity would currently obtain from the disposal of an asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

And useful life is a. the period of time over which an asset is expected to be used by an entity b. or the number of production or similar units expected to be obtained from the asset by an entity. The residual value and useful life of an asset should be reviewed at least at each financial year-end and, if expectations differ from previous estimates, any change should be accounted for prospectively as a change in estimate under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. (IAS 16, para.51) Several questions arise from the discussion of depreciation: 1. What methods can be used to allocate depreciation to different accounting periods? The different types of depreciation methods are discussed in the next section. 2. How is useful life determined? The determination depends on internal factors such as the durability and workload of an asset, and external factors such as technological or economic changes. As you will appreciate, these determinants may be very subjective. For example, what is the useful life of a Pentium-chip PC? Based on the IAS 16 definition, the useful life is the time over which the present owner will benefit and not the asset’s potential life (the two are not necessarily the same). Therefore, if the company has a policy of replacing all its PCs every three years then this will be their estimated useful life for depreciation purposes.5 170

5

Typically, the economic lives of assets are grouped together (e.g. office equipment, vehicles, etc).

Chapter 7: Accounting for tangible non–current assets

In general, companies have tended to use a ‘broad brush’ approach to estimating the useful life of assets. For example, AMEC Plc states in its notes to its 2006 Report and Accounts (p.73): Property, plant and equipment is measured at cost less accumulated depreciation and impairment losses. The cost of property, plant and equipment at 1 January 2004, the date of transition to IFRS, was determined by reference to its fair value at that date. Depreciation is provided on all property, plant and equipment, with the exception of freehold land, at rates calculated to write-off the cost, less estimated residual value, of each asset on a straight line basis over its estimated useful life. Reviews are made annually of the estimated remaining lives and residual values of individual assets. The estimated lives used are: Freehold buildings: Up to 50 years Leasehold land and buildings: The shorter of the lease term or 50 years Plant and equipment: Mainly three to five years

Whereas ICI appeared to have a more precise approach in their 2006 annual report: The Group’s policy is to write off the book value of property, plant and equipment, excluding land, and intangible assets other than goodwill to their residual value evenly over their estimated remaining life. Residual values are reviewed on an annual basis. Reviews are made annually of the estimated remaining lives of individual productive assets, taking account of commercial and technological obsolescence as well as normal wear and tear. Under this policy, the lives approximate to 30 years for buildings, 12 years for plant and equipment and 3 to 5 years for computer software. Depreciation of assets qualifying for grants is calculated on their full cost. No depreciation has been provided on land. Impairment reviews are performed where there is an indication of potential impairment. If the carrying value of an asset exceeds the higher of the discounted estimated future cash flows from the asset and net realisable value of the asset, the resulting impairment is charged to the income statement.

3. What happens if the tangible asset’s life is so long (over 50 years) or the residual value is so high (or both) that any depreciation calculated would be immaterial? IAS 16 states that once the company has shown that the depreciation charge would be immaterial then it should be subject to an ‘impairment review’ in accordance with IAS 36. 4. What happens in the case of land which has an infinite life rather than a useful life? Typically no depreciation is provided. 5. What happens in the case of intangible non-current assets, which do not necessarily have a finite useful life? How can one assess the certainty of future economic benefits? Amortisation (depreciation for intangibles) is discussed later. 6. What happens if property is held as an investment rather than for use in the normal activities of a business? Investment properties are discussed later. 171

91 Financial reporting

Which depreciation method? The depreciation method used should reflect the pattern of consumption of the asset’s benefits (IAS 16, para. 60). This should be reviewed at least annually and, if the pattern of consumption of benefits has changed, the depreciation method should be changed prospectively as a change in estimate under IAS 8 (IAS 16, para. 61). What is the fair way to allocate the cost/value of a fixed asset over its useful life? Should the depreciation charge be linear? Or should it be based on a more theoretically attractive method, for example a method which takes account of the cost of capital notionally invested in the asset (Baxter, 1971). A number of different depreciation methods may be used: 1. Straight-line. This is the most popular method in the UK. It charges equal instalments over the asset’s useful life. The depreciation charge: = (cost – residual value) / expected useful life. 2. Reducing balance (or declining method). The annual depreciation charge is calculated as a fixed percentage (depreciation rate) of the net book value of a fixed asset (cost – accumulated depreciation). The depreciation rate: = 1– (residual value/cost)1/n (where n = expected useful life). 3. Sum of digits. This is a compromise between straight-line and reducing balance (found in the USA for accelerated depreciation). For instance, the sum of the digits for a five-year useful life is 15(1+2+3+4+5). In year 1, 5/15 of the total depreciation will be charged; in year 2, 4/15 of the total depreciation will be charged and so on. 4. Machine hours. Depreciation is allocated according to the actual usage (machine hours) of the machine. 5. Annuity method. This tries to account for the cost of capital notionally tied up in the asset. The depreciation charge is shown net of the notional interest charge (based on the capital invested). The first three methods above are covered in 25 Principles of accounting. However, to aid revision, there is a worked example of these methods below.

Worked example: three depreciation methods Payman Plc buys a tangible fixed asset for £20,000, which has an estimated useful life of five years and an estimated residual value of £5,000. The following example shows the annual depreciation charge to the income statement and the net book value (the carrying amount in the balance sheet) for the: • straight-line method (SL) • reducing balance method (RB) • sum of digits method (SD). The depreciation rate for RB is:

= 1 – (5,000/20,000)1/5 = 1 – (0.758) = 24.2%

172

Chapter 7: Accounting for tangible non–current assets

Annual depreciation charge (£): SL

RB

SD

Year 1

3,000

4,840

5,000

Year 2

3,000

3,669

4,000

Year 3

3,000

2,781

3,000

Year 4

3,000

2,108

2,000

Year 5

3,000

1,602

1,000

SL

RB

SD

Year 1

17,000

15,160

15,000

Year 2

14,000

11,491

11,000

Year 3

11,000

8,710

8,000

Year 4

8,000

6,602

6,000

Year 5

5,000

5,000

5,000

End-of-year net book value (£):

Activity 7.2 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? Solutions to this activity are available in Appendix 2 at the back of this guide.

Annuity depreciation Interest methods of depreciation, such as the annuity method, are designed to take into account the time value of money when allocating depreciation to particular accounting periods during an asset’s useful life. This has the effect of back-end loading the depreciation charge; in other words, reducing the depreciation charge in the earlier years of an asset’s useful economic life and increasing the charge in later years. This is more theoretically appealing method, given that it takes account of the cost of capital notionally tied up in the asset; and is consistent with the Hicksian theory of income and deprival value. Let us consider the following scenario: If we assume the market is relatively efficient, the RC of an asset approaches the net present values of its future cash flows at a cost of capital of 10%. £

Discount factor

Present value

Cost of purchase

12,000

–

12,000

t1–t3 Annual net cash inflow

4,021

a30.1= 2.4869

+10,000

t3

2,662

v3 = 0.7513

+ 2,000

t0

Scrap receipts

0 173

91 Financial reporting

Thus, at t0 the deprival value of the asset (RC) obviously reflects the Hicks’ number 1 approach of capital value as the PV of future cash flows. The Hicksian analysis (number 1 ex ante) requires that in succeeding periods reported income be such that capital is maintained intact, the income figure equals the required rate of return on the opening capital value and the value of the assets in the balance sheet equals the present value of future cash flows. Since we are assuming a constant cost of capital, Hicks number 1 equals Hicks number 2 and assuming all net profits are paid out as dividends and the surplus cash reinvested at 10% p.a., total reported income (including earnings on cash reinvested) should be constant each year. Activity 7.3 If the company always pays a dividend equal to its income (calculated as Hicks’ number 1 income ex ante), what is the planned dividend in the scenario above? The solution to this activity is given in Appendix 2. This asset represents the company’s only project. If straight-line depreciation is used the accounts will appear as follows: Income statements Year 1

Year 2

Year 3

4,021

4,021

4,021

3,113

3,113

3,112

908

908

908

–

311

623

Net profit

908

1,219

1,532

Dividend

908

1,219

1,532

–

–

–

Net operating cash flows Less depreciation 12,000 – 2,662 3 Operating income Earnings from cash reinvested @ 10%

Balance sheets

Machine – cost Depreciation Written-down value Cash* Capital employed

t0

t1

t2

t3 (Before disposal)

t3 (After disposal)

12,000

12,000

12,000

12,000

–

–

3,113

6,226

9,338

–

12,000

8,887

5,774

2,662

–

–

3,113

6,226

9,338

12,000

12,000

12,000

12,000

12,000

12,000

* The workings needed to produce the figures for cash in the balance sheet are given below under ‘Cash movement: workings’.

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Chapter 7: Accounting for tangible non–current assets

Cash movement: workings Year 1

Year 2

Year 3

Balance brought forward

–

3,113

6,226

Interest thereon @ 10%

–

311

623

4,021

4,021

4,021

4,021

7,445

10,870

908

1,219

1,532

3,113

6,226

9,338

Operating flow Dividend Balance carried forward Proceeds of machine

2,662

Cash after disposal

12,000

Return on capital employed (ROCE) Year 1

Year 2

Year 3

On machine

908 = 7.56% 12,000

908 = 10.22% 8.887

908 = 15.74% 5.774

On total capital

908 = 7.56% 12,000

1,219 = 10.16% 12,000

1,532 = 12.77% 12,000

Thus, ROCE and annual profits are not constant and, although total capital is maintained, the intermediate values of the machine do not represent the present value of the cash flows associated with it. To reflect planning assumptions and accord with Hicks, we need to reflect the cost of capital in calculating depreciation. Since the net operating cash flow p.a. is constant, the annuity method is here appropriate. The annuity is the minimum annual net operating cash flow needed to justify the investment, calculated as: Annuity =

Cost – Present value of scrap ani

where n = the life of the asset. (‘Cost’ may include the present value of any major outlays such as overhauls which are capitalised as part of the cost of the asset when they occur.) Here: 12,000 – 2,662v3 = 4,021 a30.1 Annual depreciation is then calculated as the sum of the annuity less interest at the cost of capital rate on the asset’s opening value at the start of each year. The annuity method gives a charge that increases each year. On this basis the accounts will be as follows:

175

91 Financial reporting

Income statements Net operating cash flows Less depreciation: Annuity

Year 1

Year 2

Year 3

4,021

4,021

4,021

4,021

Interest on opening

(1,200)

4,021 2,821

4,021

(918)

3,103

(607)

3,414

written-down value Operating income

1,200

918

607

reinvested

–

282

593

Net profit

1,200

1,200

1,200

Dividend

1,200

1,200

1,200

Earnings from cash

Balance sheets

Machine – cost

t0

t1

t2

t3 (Before disposal)

t3 (After disposal)

12,000

12,000

12,000

12,000

–

–

2,821

5,924

9,338

–

12,000

9,179

6,076

2,662

–

–

2,821

5,924

9,338

12,000

12,000

12,000

12,000

12,000

12,000

Depreciation Written-down value Cash* Capital employed

* The workings needed to produce the figures for cash in the balance sheet are given below under ‘Cash movement: workings’. Cash movement: workings Year 1

Year 2

Year 3

Balance brought forward

–

2,821

5,924

Interest thereon @ 10%

–

282

593

4,021

4,021

4,021

4,021

7,124

10,538

Dividend

1,200

1,200

1,200

Balance carried forward

2,821

5,924

9,338

Operating flow

Proceeds of machine

2,662

Cash after disposal

12,000

Return on opening capital employed On machine

On total capital

Year 1

Year 2

Year 3

1,200 = 10% 12,000

918 = 10% 9,179

607 = 10% 6,076

1,200

1,200

12,000

= 10%

12,000

= 10%

1,200

= 10%

12,000

Note that here, as well as reporting a constant profit and a constant rate of return, the capital maintained is such that the machine’s written-down value at each balance sheet date is equal to the discounted present value of cash flows associated with the asset. 176

Chapter 7: Accounting for tangible non–current assets

For example, at t2

6,076 =

4,021 + 2,662 1.1

Annuity depreciation is merely a special case of the more general ‘discounted present value depreciation’ applicable where the annual net operating cash flows are constant. Where they are not constant, but the net present value is zero, depreciation may be measured as the difference between each year’s net operating cash flow and interest on the asset value at the beginning of the year. The depreciation may also be shown in an asset schedule, thus: Initial cost of asset

12,000

Interest in Year 1

1,200

Annuity

(4,021)

Written-down value at end of Year 1

9,179

Interest in Year 2

918

Annuity

(4,021)

Written-down value at end of Year 2

6,076

Interest in Year 3

607

Annuity

(4,021)

Scrap value at end of Year 3

2,662

The annual depreciation will be the difference between the amount of the annuity and interest on the opening asset value at the start of each year.

Annuity depreciation method and deprival value Decisions about optimal asset use and replacement, and therefore asset values, must reflect the time value of money (i.e. the cost of capital). With an even cash flow pattern, annuity depreciation reflects change in asset DV each year. The written-down values in the example above therefore equal the asset’s DVs, assuming we are replacing with an identical asset. Given the information above we can show that the written-down value equals the DV by constructing Have and Have Not budgets: End of year

2

3

4

Have Receive scrap

(2,662)

Pay annual equivalent cost (AEC)

4,021

Have Not Pay annual equivalent cost (AEC)

4,021

4,021

4,021

Difference in costs

4,021

6,683

–

Present value of difference: End of year 1 = 4,021v1 + 6,683v2 = £9,179 = deprival value at end of year 1 End of year 2 = 6,683v1 = £6,076 = deprival value at end of year 2

177

91 Financial reporting

Example We can carry out a similar process for the example discussed earlier when we looked at accounting for specific price changes and DV. An asset costs £100,000 and has a five-year life. Annual operating costs are at £20,000. It requires an overhaul costing £15,000 at the end of the third year of its life. Its scrap value at any time is £6,000. It produces constant annual revenues. The company’s cost of capital is 10% p.a. Apart from the cost of purchase, all cash flows may be assumed to occur at the end of the years concerned. We could also arrive at the DV by using the annuity method of depreciation, rather than Have and Have Not budgets. The annuity here is calculated as follows: Initial cost + present value of the cost of the overhaul – present value of scrap an0.1 = 1000,000 + 15,000v3 – 6000v5 a50.1 = £28,370

Annuity depreciation schedule Cost

100,000

Interest

10,000

Annuity

(28,370) 81,630

Interest

8,163

Annuity

(28,370)

DV at end of year 2

61,423

At the end of year 3 the overhaul would be treated as increasing the value of the asset, thus partially offsetting the depreciation. DV year 2 as above Interest Cost of overhaul Annuity DV at end of year 3

61,423 6,142 15,000 (28,370) 54,195

(£54,195 = 28,370v1 + 34,370v2 as in Have/Have Not budgets) Activity 7.4 A subsidiary company in a group depreciates its plant on the discounted present value basis; its cost of capital is 10% p.a. It bought some plant costing £25,000 at the beginning of 2010. It has an expected useful life of five years, at the end of which its estimated residual value is £3,000. The plant generates a constant annual cash flow just sufficient to show the required return on the capital remaining invested and recover the original investment. a. Calculate the annual cash flow. b. Show the company’s summarised income statement for each of the five years on the assumptions that: i. The plant is the only asset. ii. The whole net profit is paid out in dividend to the parent company. 178

Chapter 7: Accounting for tangible non–current assets

iii. All surplus cash (equal to the sum of the annual depreciation) is deposited with the parent company which credits the subsidiary company, with an annual net interest of 10% on the deposit. (Work to the nearest £.) Solutions to this activity are given in Appendix 2.

IAS 40: Investment properties IAS 40 defines investment property as: property (land or a building - or part of a building – or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: a. use in the production or supply of goods or services or for administrative purposes; or b. sale in the ordinary course of business.

This definition indicates that an investment property is capable of generating cash flows independently of the other assets of the business. IAS 40 requires entities to choose one of two accounting models to be applied consistently to all of its investment properies. The two models are: a. A fair value model. Investment property should be measured at fair value and changes in fair value should be recognised in the income statement. No depreciation is required; or b. A cost model, as defined in IAS 16. Investment property should be measured at depreciated cost (less any accumulated impairment losses). An enterprise that chooses the cost model should disclose the fair value of its investment property. A change from one model to the other should be made only if the change will result in a more appropriate presentation: this is highly unlikely to be the case for a change from the fair value model to the cost model. IAS 40 also considers interests under operating leases. Para. 6 states that a property interest held by a lessee under an operating lease may be classed as an investment property if, and only if, the property would otherwise meet the definition of investment property and the lessee uses the fair value model for the asset recognised.

Tangible non-current assets (not owned): leases Classification of finance and operating leases (IAS 17) A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. The lease entitles the lessee to use that asset for a certain period but the lessor retains the ownership of that asset. Part of the reason for the growth in leasing in the UK in recent times was the effective separation of tax allowances from the actual use of an asset. The lessor owns the asset and is entitled to the tax allowance on that asset; if the lessee was tax-exhausted (as was the case with many companies in the UK, who were unable to use tax allowances for the purchase of non-current assets), this benefit would not be as attractive to the lessee. We know that, for example, if an airline company owns an aircraft then we expect the aircraft to appear on the balance sheet as a fixed asset. However, what happens if an airline company leases an aircraft for (say) 179

91 Financial reporting

20 years? The lessee will use that aircraft for 20 years, but will there be any evidence of that leased asset on the lessee’s balance sheet? The short answer is ‘it depends’. There are two types of leases – finance and operating – and they are treated differently in the accounts.

Finance lease According to IAS 17, para. 4: ‘A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases.’ Whether a lease is a finance lease or not depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease are outlined in IAS 17, para. 10. These include the following: • The lease transfers ownership of the asset to the lessee by the end of the lease term. • The lessee has the option to buy the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised. • The lease term is for the major part of the economic life of the asset, even if title is not transferred. • At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially the fair value of the leased asset. • The leased assets are of a specialised nature such that only the lessee can use them without major modifications being made. Other situations that might also lead to classification as a finance lease are (IAS 17, para. 11): • If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee. • Gains or losses from fluctuations in residual fair value fall to the lessee (for example, by means of a rebate of lease payments). • The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent. If a company borrowed money to buy an asset, the loan would appear as a liability and the asset as a fixed asset in the balance sheet. The gearing of the company would be affected by it. As is shown below, IAS 17 requires a finance lease to be treated in a similar way, thus bringing on to the balance sheet what would otherwise be a form of ‘off-balance sheet finance’.

Operating lease An operating lease is ‘a lease other than a finance lease’. These tend to be more short-term commitments and do not normally cover the whole of the asset’s useful life. Different users will often hire assets in succession under an operating lease. Operating leases represent a form of off-balance sheet financing, which improves the lessee’s gearing, return on assets and return on investment. In the past, the difficulty in classifying leases has aided this arrangement. • In IAS 17 Leases, other definitions include: • Lease term: the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue leasing the asset, with or without 180

Chapter 7: Accounting for tangible non–current assets

further payment, when, at the inception of the lease, it is reasonably certain that the lessee will exercise the option. • Minimum lease payments: payments over the lease term that the lessee is, or can be, required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with: • in the case of the lessee, any amounts guaranteed by the lessee or by a party related to the lessee • or in the case of the lessor, any residual value guaranteed to the lessor by either (1) the lessee; (2) a party related to the lessee; (3) or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. Interest rate implicit in the lease: the discount rate that, at the inception of the lease, causes the aggregate PV of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of fair value of the leased asset and any initial direct cost of the lessor. Note: For simplicity, it will be assumed here that there will be no guaranteed or unguaranteed residual values and no amounts for which the lessor is accountable to the lessee; hence the interest rate implicit in the lease will be calculated purely by reference to the minimum payments over the remaining part of the lease.

Accounting treatment of leases (from the perspective of the lessee) Rentals paid on an operating lease are charged to the income statement. They should be charged on a straight-line basis over the lease term, even if the payments are not made on such a basis, unless a more systematic and rational basis is appropriate. In accounting for a finance lease it is necessary to record the lease in the balance sheet as both an asset and an obligation to pay future rentals. The sum at which the asset and liability are initially recorded should be the PV of the minimum lease payments discounted at the interest rate implicit in the lease, though in practice the fair value of the asset will usually be a sufficiently close approximation. Rentals paid under a finance lease are to be apportioned between a finance charge (in the income statement) and a reduction in the obligation to pay future rentals (in the balance sheet). The leased asset should be depreciated over the shorter of the lease term and its useful life. The total finance charge should be allocated to time periods to give a constant periodic rate of charge on the outstanding obligation for each accounting period. This is best achieved by the use of the actuarial method illustrated below. In the balance sheet, the amount outstanding on obligations under finance leases should be apportioned between amounts falling due within one year and amounts falling due after more than one year.

Example: Finance lease An asset, which could be purchased outright for £23,450, is instead leased by Lessee Co for three years (its useful life, at the end of which it will have no residual value). Lessee Co is responsible for all maintenance and insurance costs. The lease provides for half-yearly payments in advance of £4,500, the first payment being made on 1 January 2009. Show the sums that will appear in the income statement and balance sheet in respect of this leased asset. 181

91 Financial reporting

Since the lease covers the whole of the economic life of the asset and Lessee Co has to maintain and insure it, the lease may be deemed to transfer substantially all of the risks and rewards of ownership. It is therefore necessary to ascertain the interest implicit in the lease. This may be done as follows: 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). £23,450 = £4,500 + £4,500 a5? (NB: the annuity factor here is calculated for only five periods, since the first payment under the lease is made in advance.) £23,450 – £4,500 = £4,500 a5? £18,950 = a5? £4,500 Therefore a5? = 4.21. Reading from the five periods column of annuity tables it can be seen that this annuity factor is for an interest rate of 6% per period. Step 2 Analyse the rental payments under the lease as follows: Date

Rental payment

Finance Reduction in charge obligation

1/1/2009

Balance of obligation under finance lease

23,450 (initial balance)

1/1/2009

4,500

–

4,500

18,950

1/7/2009

4,500

1,137

3,363

15,587

1/1/2010

4,500

935

3,565

12,022

1/7/2010

4,500

721

3,779

8,243

1/1/2011

4,500

495

4,005

4,238

1/7/2011

4,500

254

4,246

– (Small difference due to rounding)

The finance charge here is calculated at 6% per period on the amount outstanding at the start of each period. Since in this example lease payments are made in advance, the first payment on 1 January 2009 is entirely a reduction in the obligation under the finance lease and no element of finance charge is attributable to that payment. Income statement In the income statement for 2009 a finance charge of £2,072 will be shown. This is made up of the amounts of £1,137 deemed paid on 1 July 2009 and an accrual for the finance charge of £935 payable on 1 January 2010 (but which relates to the six months from 1 July 2009 to 1 January 2010). There will also be a depreciation charge. Balance sheet – liability In the balance sheet at 31 December 2009 the figure of £935 will be included with the accruals, and obligations will be shown under the finance lease amounting to £15,587. This will be split between amounts falling due within one year (£3,565 + £3,779 = £7,344) and amounts falling due after more than one year (£8,243). 182

Chapter 7: Accounting for tangible non–current assets

Balance sheet – asset The asset will be included amongst non-current assets at an amount equal to the initial obligation under the finance lease (£23,450) and will be depreciated over its useful life, which coincides here with the lease term. It should be depreciated on the same basis as assets which are owned. Assuming use of straight-line basis, depreciation of £7,817 p.a. will be charged to the income statement. Activity 9.5 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. Solutions to this activity are given in Appendix 2.

Example: Operating lease Let us assume that in the above example the estimated useful life of the asset was 10 years and that Lessee Co is not responsible for the maintenance and insurance costs. This may be defined as an operating lease. Consequently the lease rental of £9,000 p.a. would be charged to the income statement (with no asset or obligation in the balance sheet) just like any other expense item. The level of future commitments (£18,000) will be disclosed in the notes. Activity 7.6 Helena Plc acquired an item on a lease with the following conditions: • Ten annual instalments of £30,000 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 there is no value. Calculate the charges to the income statement for 2010 and 2011 if this is treated as an operating lease. Solutions to this activity are given in Appendix 2.

Off-balance sheet financing The balance sheets of Lessee Co (with operating or finance lease) illustrate the debate concerning off-balance sheet financing. Under both methods the company is leasing an asset worth £23,450 for a period of three years. However, only under the finance lease is this and the associated liability shown in the balance sheet. Consequently operating leases are off-balance sheet financing. 183

91 Financial reporting

Activity 7.7 What difference does the operating/finance lease classification have on some key ratios such as gearing, return on capital employed and return on net assets?

Sale and leaseback transactions A company may enter into a sale and leaseback transaction: it agrees to sell an asset it owns and immediately agrees to lease it back. The lease may be an operating or a finance lease. The accounting issues here are complicated, depending on several factors; IAS 17 is key. Where the lease is a finance lease, excess of sales over the asset’s carrying amount is deferred and amortised over the lease term. Where it is an operating lease, profit/loss is recognised immediately if the transaction is carried out at fair value (otherwise a general principle of substance over form applies). Detailed knowledge of this area is not required on this course.

The way forward Some point to deficiencies in lease accounting because of the rigid (and arbitrary) distinction between the types of lease. In 1999 the policy-makers produced a discussion paper, Leases: Implementation of a New Approach, which (consistent with a previous 1996 Special Report of the G4+1 entitled ‘Accounting for Leases: A New Approach’) suggested that the comparability (and hence usefulness) of financial statements would be enhanced if the then (and on-going) treatment of operating leases and finance leases were replaced by an approach applying the same requirements to all leases. The approach favours lessees recognising material rights and obligations (re: leases) as assets and liabilities, i.e. non-cancellable operating leases should be treated as finance leases. The amounts recognised as asset and liability by a lessee would vary in amount depending on the lease’s character. The practice of structuring leases to avoid showing leased assets and the resulting liabilities on balance sheet may be a consequence of a standard that draws a bright line between similar transactions. In the UK, the ASB undertook research to inform the IASB’s development of a new leasing standard. The objective was to develop a single method of accounting (a conceptual model) for leases consistent with the IASB framework. This had regard to the prior work of the G4+1 project. IAS 17 is still in place as the international standard, with emphasis placed on substance over form in this area. The IASB has been busy on many matters. Nevertheless, a new IASB standard on this area is expected soon. It is expected to be shaped by the criticisms and to result in a single approach to lease accounting.

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • discuss tangible non-current assets, both owned and leased • explain and compute the annuity method of depreciation (including its relationship to Hicks and deprival values) • explain the implications of revaluation on interpretation of the financial statements • appreciate accounting for investment property as distinct from accounting for property more generally • describe both operating leases and finance leases 184

Chapter 7: Accounting for tangible non–current assets

• demonstrate accounting for both operating and finance leases, and explain possible implications for accounts’ users • discuss off-balance sheet financing in relation to operating leases.

Sample examination questions Question 7.1 A company has some equipment that has an expected life of 20 years. It expects the equipment to generate a constant annual output and has sought your advice as to the appropriate method of depreciating it. a. For equipment bought for £2,000,000 at the beginning of 2010, with an expected residual value of zero, show the difference between the charge for depreciation on a straight-line basis and the charge for depreciation on a discounted present value basis (i.e. annuity method), assuming the annual cash flow to be earned is constant, using 8% cost of capital rate, in: b. year 1 i.e. 2010 • year 10 • year 20. Work to the nearest £1,000. c. Comment briefly on your results in relation to the company’s stated aim in setting its prices at a level sufficient to earn a return of 8% on capital employed. (Ignore inflation.) Solutions to this question are available in Appendix 2.

Question 7.2 On 1 January 2010 Marl Plc established five wholly owned subsidiary companies, all in the same line of business: • Apple was financed entirely by issued share capital of £70,000. • Pear had issued share capital of £20,000 and in addition raised £50,000 from the issue of 12% debentures, interest on which was payable annually on 31 December. • Banana, Kiwi and Orange were each financed by £20,000 issued share capital. As well as initial working capital of £20,000, all of the companies required the use of a widget-making machine. The machines cost £50,000 each and have a 10-year useful life with no residual value. Apple and Pear bought a machine each. Banana, Kiwi and Orange each leased a machine for an annual rental payment of £8,850 over 10 years, payable in arrears on 31 December. The cost of capital for each of the five companies is 12% p.a. Each company earns annual gross revenues of £18,000 and incurs annual operating costs (before interest, rental charges and depreciation) of £6,650. Interest and rentals were all paid on the due dates. a. For each subsidiary prepare an income statement for the year ended 31 December 2010 and balance sheet at that date and show the reported return on Marl’s initial equity investment in each subsidiary, on the following assumptions: • that Apple and Pear each use straight-line depreciation over the asset’s useful life 185

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• that Banana treats the lease as an operating lease (in spite of IAS 17 – follow Banana’s method) • that Kiwi treats the lease as a finance lease and depreciates the asset on a straight-line basis • that Orange treats the lease as a finance lease and depreciates the asset using the annuity method. b. Comment on the results shown by your accounts. Solutions to this question are given in Appendix 2.

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Chapter 8: Intangible assets: goodwill and R&D

Chapter 8: Intangible assets: goodwill and R&D Aims of the chapter This chapter considers how intangible assets are treated in the consolidated accounts of a group of companies, with particular reference to research and development (R&D) and goodwill.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • define intangible assets, R&D and goodwill • describe and explain the accounting treatment of intangibles, R&D and goodwill • explain the process of impairment reviews and its relationship to deprival values • describe the effect of intangible assets, R&D and goodwill for both the consolidated accounts and ratio analysis • compare and contrast the capitalisation and amortisation of goodwill and immediate write-off against reserves previously permitted in the UK under SSAP 22, and discuss managers’ motives for choosing the immediate write-off option • describe the areas of subjectivity and difficulty in relation to the intangibles’ assets, development expenditure and goodwill • discuss the continued problems with FRS 10 in relation to goodwill and intangibles.

Essential reading International Financial Reporting, Chapter 13.

Further reading Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Financial Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. This book covers the detailed legal and accounting standard requirements for company accounting, and provides examples of disclosure. The level of detail provided by this book is much greater than you will be expected to know at the end of this course, so detailed IFRS should be consulted for reference only.

Relevant IASB standards IFRS3 Business Combinations. IAS 36 Impairment of Assets. IAS 38 Intangible Assets.

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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 resources 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: • 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, AMEC’s intangible assets are valued in their 2010 consolidated balance sheet at £621.3 million – nearly half of shareholders’ funds. CBS extract of AMEC (UK Plc) Intangible assets All other assets All liabilities Net assets Share capital Share premium account Hedging and translation reserves Capital redemption reserve Retained earnings NCI Total equity

2010 £ million 621.3 1,642.0 (988.3) 1,275.0 169 100.7 127.2 17.2 858.1 2.8 1,275.0

Goodwill: the debate As we know from Chapter 5, goodwill is the difference between the value of the business and the fair value of its identifiable net assets. Due to widely differing opinions held by companies, practitioners, users, regulators and so on, the accounting treatment for goodwill has been under consideration since the early 1970s.

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Chapter 8: Intangible assets: goodwill and R&D

What is goodwill? Conceptually, goodwill is the difference between the value of a business as a whole and the aggregate value of its separately identifiable net assets. It arises because of economic advantages attaching to an existing business (e.g. reputation, established market share, skilled workforce) which form a ‘barrier to entry’ to competitors who would be starting from scratch by buying an otherwise equivalent set of resources. Hence the attraction of ‘taking over’ an existing, established company. Traditionally there were two views on accounting for goodwill: • Goodwill is merely an accounting difference that should be either carried indefinitely in the balance sheet (but subject to regular reviews of its value; see IFRS 3) or written off as soon as possible (the preferred approach of SSAP 22, the old UK standard). • Goodwill is an asset rather than a difference, which should be capitalised and amortised like any other (FRS 10). Thus the discussions have focused on a number of interrelated questions: • Is it an asset? Or an accounting difference? • If it is an asset, how do we account for it? • If it is an asset, what is its economic life? • If the economic life is finite, how should it then be amortised? • Is the useful life infinite? • How should any reductions in value be measured and/or treated in the accounts? If it is an accounting difference, how do we account for it?

Is goodwill an asset? As mentioned above, assets are defined in the FPPFS as resources controlled by an enterprise as a result of past events from which future economic resources 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. So following this definition, is goodwill an asset? The IASB believes that it is. It defines goodwill as ‘future economic benefits arising from assets that are not individually identified and separately recognised’. The IASB considers goodwill to be an asset, similar to other assets, which has been acquired at a cost and which needs to be accounted for in the same way as any other. Others view it as a consolidation difference1 that emerges as part of the accounting process and has to be dealt with in the least damaging manner possible.

Issues with recognising goodwill an asset? If goodwill is an asset which has been acquired at cost, then it should be capitalised initially in the balance sheet and then possibly charged to revenue over its economic life (in order to be consistent with the accounting treatment of other non-current assets). But what is its economic life? Is it finite, or indefinite? If it has a finite life then what is the most appropriate amortisation period? Given that the asset may be regarded as unidentifiable in the first place, it may be impossible to determine when its life can be thought to have ended. Consequently any amortisation periods would be arbitrary and presumably nothing should be written off unless there is evidence that its value has been impaired. The UK’s ABS states in FRS 10, para.

1

You may note that goodwill is by definition an accounting difference. It may be useful in particular cases to consider whether the resulting goodwill can be rationalised in conventional terms – this may point, for example, to a failure to recognise all relevant assets or to some unreliability in fair values. But it will not always be possible to explain the balance of goodwill on a transaction.

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19: ‘There is a rebuttable presumption that the useful lives of purchased goodwill and intangible assets are limited to periods of 20 years or less.’ If we could suggest an amortisation period the next question is: what method of amortisation should we use (e.g. refer back to the discussion of depreciation methods in Chapter 9)? Or should we in fact conduct an annual review? If it has an indefinite life there will be no need for annual amortisation. To justify the carrying of goodwill without systematic amortisation would require an impairment review. IFRS 3 ‘prohibits the amortisation of goodwill acquired in a business combination and instead requires goodwill to be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired, in accordance with IAS 36 Impairment of Assets.’ Recognising goodwill as an asset is a contentious issue. Commentators have raised the following concerns: • Annual amortisation charged through the income statement results in ‘double-counting’, as goodwill creating or maintaining expenses such as training, advertising, promotion and technical support is already charged to the income statement. [Advocates of amortisation argue that any goodwill-related expenses that arise after acquisition result in the development of non-purchased (inherent) goodwill and therefore there is no case to answer with respect to double-counting]. • Goodwill cannot be realisable separately from the business as a whole. • It is unclear how goodwill is related to other business costs if it is defined as a difference (i.e. it is hard to envisage the application of the matching principle here). • Individual contributing factors cannot be valued separately (although some may be identified as specific ‘intangibles’). • The value of goodwill may fluctuate widely and unsystematically. • Valuation is highly subjective. • Goodwill will continue to increase if the company continues to acquire new companies. • The accounting treatment of purchased and internally generated goodwill is inconsistent – costs associated with internally generated goodwill (such as advertising) are generally expensed. • The accounting treatment of goodwill and other assets – tangibles and intangibles – is inconsistent. Note that only purchased goodwill is recognised in the accounts, not internally generated goodwill (whereas internally generated assets, such as self-constructed buildings (‘tangible’) or patents for inventions (‘intangible’) may be capitalised).

Issues with not recognising goodwill an asset? If we do not consider goodwill as an asset, then we may favour eliminating goodwill directly against reserves in the year of acquisition (given that the accounts should deal only with identifiable items which arise from acquisition). Indeed many believe it is a futile attempt to account for the unaccountable since it is only a product of the accounting process and hence should be eliminated by an accounting entry (not reported as a consumption of an identifiable resource). Let us assume, then, that goodwill is simply this by-product: which (profit) reserve should we write it off against? First, whichever reserve we use for the immediate write-off, this could result in negligible shareholders’ funds; indeed, if a company made 190

Chapter 8: Intangible assets: goodwill and R&D

numerous acquisitions and continually wrote off this acquired goodwill it could result in a negative value of shareholders’ funds. What would this mean given that, say, a company had made acquisitions of real value which were generating profits but yet the totals in shareholders’ funds were decreasing? Indeed, this could make the company vulnerable to take-overs and create problems with gearing ratios for debt covenants and distort some of the primary ratios. Secondly, what possible explanations are there for writing off goodwill against reserves apart from achieving consistency of treatment with nonpurchased goodwill? There are a number of problems with this approach: • Managers are not held fully accountable for investment in acquisitions. If goodwill is written off immediately, the company’s return on capital employed is boosted, since the profits are free from amortisation charges and the capital is reduced by the goodwill write-off. • Managers would have incentives to manipulate the reported goodwill by ‘accounting arbitrage’, i.e. exploiting inconsistencies in accounting policies (FRS 7 did attempt to reduce these). • Acquisition companies could ‘run out of reserves’. This could make a company vulnerable to take-over or cause problems with gearing ratios for debt covenants. Under the old (and now defunct) UK standard SSAP 22, goodwill was allowed to be written off immediately against reserves or capitalised and amortised through the income statement. This form of flexibility allowed companies to freely choose the accounting treatment that reflects best on their financial performance (in practice this was where goodwill was written off immediately – this meant that the pain of expensing goodwill was only felt in the year of acquisition, and subsequent years’ profits were boosted). Consequently, this treatment was prohibited following the publication of the UK’s FRS 10. FRS 10, however, still did not recognise goodwill as a (standalone) asset, despite advocating its disclosure alongside intangible assets in the balance sheet. This muddle in thinking is reflected in FRS 10: Goodwill arising on acquisition is neither an asset like other assets nor an immediate loss in value. Rather, it forms the bridge between the cost of the investment shown as an asset in the acquirer’s own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements. Although the purchased goodwill is not in itself an asset, its inclusion amongst the assets of the reporting entity, rather than a deduction from shareholders’ equity, recognises that goodwill is part of a larger asset, the investment for which management remains accountable.

Activity 8.1 Go to www2.accaglobal.com/archive/2888864/31100. Read this to understand the historical development on accounting for goodwill in the UK. (Although our aim is not to emphasise UK-specific standards/discussions, due to the UK’s significant influence over international standard setting, understanding its historical development has general implications as well for the international development of standards on goodwill and intangibles). What does this tell you about how accounting standards are developed? Who were 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 for why these key players were upset with the standard-setter’s reason to remove the option to expense goodwill immediately? 191

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Different models to account for purchased goodwill The historical development of goodwill has a varied past, with numerous models (i.e. accounting standards) used. The current standard for goodwill (in IFRS 3) should be your key reference. However, it is also important to understand other attempts (i.e. models) used to account for goodwill. A historical perspective on the development of goodwill allows you to contrast the benefits/limitations of various models used, and raises the awareness that current economic considerations have on determining the way in which goodwill is accounted. The possible accounting treatments for goodwill are: 1. capitalisation and predetermined life; amortisation expense to the income statement (SSAP 22, FRS 10) 2. capitalisation and predetermined life; amortisation expense to (profit) reserves 3. capitalisation and annual review for impairment (IFRS 3, FRS 10) 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 (see also International Financial Reporting, pp.304–5, Activity 13.2). 1. Straightforward application of matching principle. 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. 4. Assumes asset does not exist and overly conservative; could lead to over-stated profitability ratios in subsequent accounts when reserves are immediately reduced. 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 in the creation of a special profit reserve to indicate that diminution in reserves 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. 192

Chapter 8: Intangible assets: goodwill and R&D

The current treatment for goodwill is as follows: Goodwill is covered in IFRS 3 Business Combinations. As mentioned previously, IFRS 3 defines goodwill as ‘future economic benefits arising from assets that are not individually identified and separately recognised’. The amounts that are recognised in the financial statements are therefore a function of the recognition criteria and valuation rules applicable to the identifiable assets. These are covered in IAS 36 Impairment of Assets, IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IAS 38 Intangible Assets and IAS 39 Financial Instruments: Recognition and Measurement. Para. 36 of IFRS 3 states: [T]he acquirer shall, at the date of acquisition, allocate the cost of a business combination by recognizing the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria in paragraph 37 at their fair values at that date, except for non-current assets (or disposal groups) that are classified as held for sale in accordance with IFRS 5, NonCurrent Assets Held for Sales and Discontinued Operations... Any difference between the cost of the business combination and the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognized shall be accounted for as goodwill.

Para. 37 states: The acquirer shall recognize separately the acquiree’s identifiable assets, liabilities and contingent liabilities at the acquisition date only if they satisfy the following criteria to date: • In the case of an asset other than an intangible asset, it is probable that any associated future economic benefits will flow to the acquirer and its fair value can be measured reliably • In the case of a liability other than a contingent liability, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and its fair value cane be measured reliably • In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.

Paragraphs 51–52 state how goodwill should be accounted for: The acquirer shall, at the acquisition date: • Recognize goodwill acquired in a business combination as an asset; and • Initially measure the goodwill at its cost, being the excess of the cost of the business combination over the acquirer’s interest in the fair value of the identifiable assets, liabilities and contingent liabilities recognized in accordance with paragraph 36.

Goodwill acquired in a business combination represents a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised. Goodwill acquired in a business combination shall not be amortised. Instead, the acquirer shall test it for impairment annually, or more frequently if events or changes in circumstances indicate that it might be impaired, in accordance with IAS 36, Impairment of Assets. We will look at this later.

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Intangible assets (other than goodwill) IAS 38 prescribes the accounting treatment for intangible assets that are not dealt with specifically in other standards (e.g. IFRS 3 for goodwill, IAS 17 for leases, IAS 2 and IAS 11 for intangible assets held for resale and IAS 12 for deferred tax assets). A number of key principles underpin discussions on intangible assets under IAS 38, particularly those of identifiability and control.

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. Hence, separability is a sufficient but not a necessary condition for identifiability. Identifiability is necessary in order to distinguish an intangible asset from goodwill. The recognition of an item as an intangible asset requires an entity to demonstrate that the item meets: • the definition of an intangible asset; and • the recognition criteria. An intangible asset shall be recognised if, and only if: • it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and • the cost of the asset can be measured reliably. Control of the asset must also be demonstrated. Control is exercised by an enterprise over an asset if the enterprise: • has the power to obtain the future economic benefits flowing from the underlying resource • can also restrict the access of others to such benefits. The above requirements on identifiability and control apply to costs incurred initially to acquire or internally generate an intangible asset and those incurred subsequently to add to, replace part of or service it.

Examples of intangibles • leases (covered in IAS 17) patent rights • trade marks • copyright and titles • franchises and licences • research and development costs • secret technological know-how • computer software • business names • brand names 194

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• client lists • a skilled workforce. All of the above examples are regarded as assets in the sense of being expected to bring future benefits, and therefore worth buying or expending a lot of money to develop. But are they ‘identifiable’ and ‘controllable’? Richard Branson sold the Virgin record label to EMI while keeping Virgin airlines/trains/cola. One cannot force clients or skilled employees to stay. Some of the internally generated intangible assets will fail the recognition criteria and consequently will not be capitalised in the balance sheet.

Internally generated intangibles Unlike internally generated goodwill, internally generated intangibles may be capitalised as an asset, but only if they meet the recognition criteria stated above. The cost of an internally generated asset is the sum of expenditure incurred from the date when the intangible asset first meets the recognition criteria. Costs include all expenditure that is directly attributable to generating the asset or has been allocated (reasonably and consistently) to the activities of generating the asset. Expenditure that does not include part of the cost of the intangible asset includes selling, administration and training staff to operate the asset. Any subsequent expenditure on an intangible asset should be expensed in the income statement, except in the rare cases shown in IAS 38, paras. 18–20 where: • probable enhancement of the economic benefits that will flow from the assets can be demonstrated • the expenditure can be measured and attributed to the asset reliably.

Measurement of intangible assets An intangible asset shall be measured at cost initially, or, if acquired via an asset exchange, at the fair value of the assets given up. Two measurement treatments are advocated by IAS 38: • The cost model is that an intangible asset should be carried at cost less any accumulated depreciation and (if any) accumulated impairment losses (IAS 38, para. 63). • The revaluation model is to carry the intangible asset at a revalued amount. The revalued amount should be the fair value of the asset at the date of revaluation less any subsequent accumulated depreciation and (if any) subsequent impairment losses (IAS 38, para. 75). Note: IAS 38 uses the terms depreciation and amortisation interchangeably. If the intangible asset is revalued, all assets in its class should also be revalued. Fair values should be determined by reference to an active market. Revaluations should be conducted regularly to ensure that the carrying value in the balance sheet approximates the fair value of the asset.

Active market value IAS 38 (para. 8) defines an active market as one in which all of the following conditions exists: • the items traded within it are homogenous • willing buyers and sellers can normally be found at any time (within reason) • prices are public information. 195

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IAS 38 (para. 67) states that it is unlikely that such an active market exists for an intangible asset. This argument therefore explicitly rules out the possibility of recognising unique intangibles (such as brands, publishing titles, etc.) if they are home-grown rather than acquired. Thus the significance of this concept is that the cost of an internally generated intangible that fails the active market test must be written off to the income statement as it arises. There is also no restriction on capitalising an intangible purchased as part of a business where it has an active market value. The two key features of an active market value appear to be frequency of transactions in the relevant type of asset and the homogeneity of the class of asset. • Frequency of transactions: An active market should be evidenced by frequent transactions. The standard gives no further explanation of what is meant by ‘frequent’ or why it should be important. However, one could reasonably assume that a market with frequent trading would have the following characteristics – that buyers could normally be found at any time and that prices are available to the public. • Homogeneity: Homogenous means ‘of the same kind’. In a commercial context, a market might be homogenous if the purchaser were indifferent between suppliers or particular things to be bought. Thus brands, patents, formulas and other proprietary rights are clearly not homogeneous and cannot be said to have a readily ascertainable market value. On the other hand, licences to use scarce resources are more likely to be homogenous: the useful radio-wave spectrum is limited and is divided into segments for mobile telephone, radio and television bandwidths. In some places there may also exist, or be in development, a homogenous market for airport landing slots, or for taxi licenses. Activity 8.2 Taxem PLC has bought a taxi license for £10,000 two years ago. The license has three years to run, and can be freely traded amongst other operators. Accumulated amortisation is estimated to be £4,000. As a result of a government decision to allow taxi fares to increase by 5%, the current tradable value of the license is now £12,000. How would you account for the revised carrying amount (net book value)? Answer: 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 license: 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 License and Cr revaluation reserve by £6,000. The journal entries are as follows:

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Chapter 8: Intangible assets: goodwill and R&D Intangible asset: License Dr

Cr

Cost

10000 Accum amort.

4000

Accum amort.

4000 Bal c/f

16000

Revaluation Res.

6000 20000

20000

Accumulated amortisation Dr

Cr

License

4000 License

4000

4000

4000

Revaluation reserve Dr

Cr

License

6000 License

6000

Amortisation 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.

An intangible asset with an indefinite life shall not be amortised. Alternatively the entity should apply IAS 36 and test the asset for impairment, annually, and whenever there is an indication that the intangible asset may be impaired.

Impairment: IAS 36 An asset is impaired when its carrying amount exceeds its recoverable amount (IAS 36, para. 8). Indications that an asset may be impaired include: • decline in market value of an asset • adverse effects of technological, market, economic or legal environment • obsolescence or physical damage • changes in use or expected use of asset • economic performance of the asset is worse than expected.

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Definitions (IAS 36, para. 6): The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. The fair value less costs to sell of an asset is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal. Value in use is the present value of the future cash flows expected to be derived from an asset.

Accounting for impairment An entity shall assess at each reporting date whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset (IAS 36, para. 9). IAS 38 states that irrespective of whether there is any indication of impairment, an entity shall also: Test an intangible asset with an indefinite useful life for impairment annually by comparing its carrying amount with its recoverable amount. This impairment test may be performed at any time during an annual period, provided it is performed at the same time each year. Different intangible assets may be tested for impairment at different times. However, if such an intangible asset was initially recognised during the current annual period, that intangible asset shall be tested for impairment before the end of the current annual period

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).

Research and development 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.

How to account for R&D Your immediate view might be that R&D (as for any other intangible asset) is an investment with future benefits and therefore represents an asset. 198

Chapter 8: Intangible assets: goodwill and R&D

This view is difficult to substantiate if you consider the difficulties in being reasonably certain that the intended economic benefits of R&D activities will flow to the enterprise. A more prudent view might be to write off R&D as a cost in the year in which it was incurred rather than report it as an asset. In actual fact IAS 38 distinguishes between research costs and development costs, as follows: 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

Research cost should be written off through the income statement in the year of expenditure because this represents part of the continuing operations of a business. If development costs meet all of the stringent criteria specified below (that is, there is reasonable expectation of specific commercial success) then they may be capitalised as an asset and amortised on a systematic basis. IAS 38 states: An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following: • the technical feasibility of completing the intangible asset so that it will be available for use or sale • its intention to complete the intangible asset and use or sell it • its ability to use or sell the intangible asset • how the intangible asset will generate future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset • the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset • its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Capitalised development expenditure is subject to amortisation/ impairment as detailed in the section on ‘Amortisation’ above.

Research and development (R&D): some considerations • What activities are included within R&D? The definition of R&D in the standard appears to allow a broad scope about what can be included. The key determinant appears to be whether the activity involves innovation and departs from routine. • What costs are included within R&D? Although IAS 38 gives no guidance, typical costs within R&D relate to salaries and wages, cost of materials and services consumed, property depreciation, R&D plant and equipment, relevant overheads and related costs such as the amortisation of patents and licences. For example, if you build a research lab, this is a tangible asset and is capitalised and depreciated as normal, although the depreciation is charged to the Research and Development expense. 199

91 Financial reporting

• Selection of either immediate write-off or capitalisation of development expenditure In the UK, if a development project satisfies all conditions, companies can choose whether to write off or capitalise development costs. You should be aware that this will impact on the profit figure (e.g. if a large development project is written off in the year of expenditure) and care should be taken when comparing companies in the high R&D spend industry. The accounting policies of such companies should be examined. We illustrate current UK multinational practice of intangibles’ reporting, using notes to the 2010 annual accounts of GlaxoSmithKline, a pharmaceuticals and consumer products company (e.g. they make Ribena). Excerpts from the notes (p.112): • Goodwill is stated at cost less impairments. Goodwill is deemed to have an indefinite useful life and is tested for impairment annually. • Intangible assets are stated at cost less provisions for amortisation and impairments… Licences, patents, know-how and marketing rights separately acquired or acquired as part of a business combination are amortised over their estimated useful lives, generally not exceeding 20 years, using the straight-line basis, from the time they are available for use... Brands are amortised over their estimated useful lives of up to 20 years, except where it is considered that the useful economic life is indefinite.

International differences International Financial Reporting (p.303) has outlined major differences between International (IASB) versus US (FASB) approaches to accounting for intangibles. We reproduce key differences here in summarised form (though consult the textbook for exceptions to the rule). IASB (IAS)

FASB (USA)

Capitalise and amortise R&D costs, if certain criteria met

allowed

disallowed

Write off R&D costs immediately (expense)

allowed

required

Possibility of restating intangible assets to fair value

allowed

disallowed

Activity 8.3 Drawing on principles from the IASB’s conceptual framework in Chapter 2 and from arguments presented in this chapter and your textbook (e.g. Activity 8.2), 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

200

Chapter 8: Intangible assets: goodwill and R&D

In other words, you should construct a table with the following: i) Purchased goodwill

ii) Internally generated goodwill

iii) Research & Development

(iv) All other intangible assets

a)

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

b)

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

c)

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

d)

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

e)

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Strengths: Limitations:

Issue

Treatment

Reminder of learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • define intangible assets, R&D and goodwill • describe and explain the accounting treatment of intangibles, R&D and goodwill • explain the process of impairment reviews and its relationship to deprival values • describe the effect of intangible assets, R&D and goodwill for both the consolidated accounts and ratio analysis • compare and contrast the capitalisation and amortisation of goodwill and immediate write-off against reserves previously permitted in the UK under SSAP 22, and discuss managers’ motives for choosing the immediate write-off option • describe the areas of subjectivity and difficulty in relation to the intangibles’ assets, development expenditure and goodwill • discuss the continued problem with FRS 10 in relation to goodwill and intangibles.

Sample examination question Question 8.1 Over the years, the accounting requirements for purchased goodwill in the UK have changed considerably, from SSAP 22 Accounting for Goodwill (1984) to IAS 22 Business Combinations (1998) to IFRS 3 Business Combinations (2004). These standards have quite different approaches to account for the cost of purchased goodwill in financial statements. i. State three different methods of accounting for purchased goodwill (it is not a requirement of this question for you to link these methods to a specific UK or International Accounting Standard). For each method you state, you would need to describe the accounting adjustments (if any) needed on the balance sheet and/or the income statement. ii. What are the key arguments for and against each of the three methods you have described above? 201

91 Financial reporting

Notes

202

Chapter 9: Accounting for inventories and construction contracts

Chapter 9: Accounting for inventories and construction contracts Aims of the chapter This chapter considers accounting for inventories and construction contracts. For many years the principal objective of inventory measurement has been the proper determination of income through the process of matching cost with related revenues within HCA. So, a primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised (IAS 2).

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • identify the different categories of inventory • discuss the importance of inventory valuation in the income statement and balance sheet • discuss and calculate the different methods of inventory valuation • describe what ‘cost’ includes and some areas of uncertainty • explain construction contracts and their accounting: why they are treated differently; their profit recognition.

Essential reading International Financial Reporting, Chapter 15.

Further reading Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Financial Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458] Chapter 16. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498] Chapter 6.

Relevant IASC/IASB standards IAS 2 Inventories. IAS 11 Construction Contracts.

Components of inventory • Inventory is a current asset which can be divided into five categories: • goods or other assets purchased for resale • consumable stores • raw materials and components purchased for incorporation into products for sale • products and services in intermediate stages of completion • finished goods. 203

91 Financial reporting

Typically, most of these categories will be evident for manufacturing companies (in the notes to the accounts or balance sheet) whereas wholesalers and retailers will deal only in finished goods for resale. In addition, inventory will include construction contract balances discussed below where appropriate.

Implications of inventory for the accounts When accounting for inventory you deal with both the cost of goods sold figure (charged to the income statement) and the current asset inventory (recorded in the balance sheet). The cost of goods is: Opening inventory (in the opening balance sheet) + Purchases (during the year) – Closing inventory (in the closing balance sheet). Under HCA, inventory measurement determines the level of income by matching costs with revenues. Before considering inventory valuation a simple revision example illustrates the impact of inventory on the accounts.

Illustrative example Jinous set up a simple retail operation to buy and sell sets of tables and chairs. At the beginning of the year she has no inventory. During the year she buys two identical sets of tables and chairs for £2,000 and £3,000 respectively. At the year-end she sells one of the identical sets for £3,200. The question is: What is the profit for the year and what is the closing inventory balance? Depending on which table and chairs she sells, she will show one of: a. a profit of £1,200 and inventory of £3,000 (a gross margin of 37.5% = 1,200/3,200) b. a profit of £200 and inventory of £2,000 (a gross margin of 6.25% = 200/3,200) A

B

£

£

3,200

3,200

–

–

5,000

5,000

5,000

5,000

(3,000)

(2,000)

2,000

3,000

1,200

200

Sales revenue Cost of sales Opening inventory Purchases Less closing inventory Gross profit Activity 9.1

If you were a potential investor in Jinous’s company, how would you view these two scenarios? Two main issues arise from this example: 1. What method of inventory valuation is used? 2. What components are included within cost (e.g. Jinous had to pay to varnish each set of table and chairs before selling them, would this be included)? 204

Chapter 9: Accounting for inventories and construction contracts

Inventory valuation Inventories shall be measured at the lower of cost and net realisable value (IAS 2, para. 9). This must be determined for each separate item of inventory. Look at the following example: A company has the following four products in its inventory. What would be the value according to IAS 2? Product

Cost

NRV

1

100

150

2

150

200

3

160

140

4

200

160

Total

610

650

If the products were not separated into separate items, the balance sheet value would be £610 (i.e. total cost is less than total NRV). However, following the separate item rule the balance sheet figure should only be £550, that is, product 1 £100, product 2 £150, product 3 £140 and product 4 £160.

Inventory valuation: cost flow assumptions In many industries it is not practicable for accounting systems to track inventory movements individually, so companies aggregate the number or quantity of the inventory used and multiply this by the price paid for them. However, as we know following the discussion on changing price levels, the price paid for each inventory item may be different. Consequently, in order to simplify the determination of cost systematic bases have been developed for the recognition of the cost of sales, founded on assumptions about movement: • specific identification/actual cost • first-in-first-out (FIFO) • last-in-last-out (LIFO) • weighted average. All of these are discussed further below.

Inventory valuation: methods The subject guide for 25 Principles of accounting introduces some of the different methods of inventory valuation. Briefly, some possible inventory valuation methods are: • Actual cost. A specific cost is attached to each item of inventory, resulting in a match of costs with revenues. As noted, in many cases this would not be practicable. However, in some industries it may be (for example in the antiques trade or car sales with a few items of individually identifiable/unique inventory bought at a high value). • First-in-first-out (FIFO). The cost of the oldest inventory is charged to income first and the most recent cost of inventory is recorded in the balance sheet (scenario A in the Jinous example). This method is probably often a close approximation to the physical flow of goods (for example, a company selling perishable goods would obviously sell the earliest purchased inventory first). This method is acceptable for UK tax (and financial reporting purposes.)

205

91 Financial reporting

• Last-in-last-out (LIFO). The cost of the most recent inventory is charged to income first and the oldest cost of inventory is recorded in the balance sheet (scenario B in the Jinous example). Essentially, therefore, LIFO is an attempt towards RC accounting for the income statement, but it produces an out-of-date cost in the balance sheet. LIFO is not allowed after IAS 2’s revision (2003). It is not acceptable in the UK for tax purposes. • Weighted average cost: the weighted average cost of all inventory. This is used a great deal by organisations with high volumes of identical or near-identical inventory (in the Jinous example the profit would be £700 and the closing inventory would be £2,500). In times of low inflation and/or where inventory turnover is relatively quick, the result of employing weighted average cost differs little from FIFO. This method is also permitted by IAS 2. • Standard cost. A predetermined cost per unit. • Replacement cost. Inventory is recorded at current rather than actual cost. • Current selling price. Inventory is recorded at current selling price rather than actual cost. This has been mooted in relation to fair value accounting and is discussed below. Activity 9.2 a. Review the different methods of inventory valuation discussed in the subject guide for unit 25 Principles of accounting. b. Why do you think the UK tax authorities accept FIFO but not LIFO? c. Yazd Plc makes the following purchases and sales of identical rugs in July (and there are no opening inventories). Purchases: 1 July

100 rugs @ £10.00

1 July

100 rugs @ £9.80

15 July

50 rugs @ £9.60

20 July

100 rugs @ £9.40

Sales: 10 July

80 rugs

14 July

100 rugs

30 July

90 rugs

Determine the cost of goods sold and the closing inventory at 30 July using FIFO, LIFO and weighted average. The solution to part (c) of this activity is given in Appendix 2.

Inventory valuation: definitions Definition of cost Once a method is selected for a company’s accounting policy, the components of cost still need to be ascertained. In the Jinuos example ‘cost’ refers to the price paid for the finished inventory, but manufacturers buy raw materials and convert them to finished goods. For instance, if Jinous varnished the table and chairs she will incur expenditure on labour, other materials (varnish) and possibly overheads. 206

Chapter 9: Accounting for inventories and construction contracts

IAS 2, para. 10 defines cost of inventories: The cost of inventories should comprise all costs of purchases, cost of conversion and other costs incurred in bringing the inventories to their present location and condition.

The cost of conversion is explained in paras. 12–14. In simplified terms this includes direct labour plus a systematic allocation of fixed and variable manufacturing overheads (e.g. depreciation, indirect materials, maintenance, etc.). Further explanation of cost is given in para. 11: The cost of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the enterprise from the taxing authority) and transport, handling and other cost directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the cost of purchase.

Note that IAS 2 does not permit the following items to be included as components of cost: • abnormal waste • storage costs • administrative overheads unrelated to production • selling costs • foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency • interest cost when inventories are purchased with deferred settlement terms.

Definition of net realisable value IAS 2, para. 6 defines net realisable value as: the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

Activity 9.3 BLC Plc mines copper. This sells at £49 per ounce but £0.70 per ounce must be paid for delivery costs. During the year the following transactions take place: • BLC mines 100,000 ounces of copper at a direct cost, paid in cash, of £35 per ounce. Depreciation of the mine, on a unit of depletion basis, amounts to £630,000; depreciation of the mining equipment, on a straight-line basis, is £70,000. Administrative overheads amount to £78,000. • 40,000 ounces are sold for £4,940,000 and delivery costs of £42,000 are paid. a. Show the profit/loss, the cost of sales and the closing inventory value at the end of the year in accordance with IAS 2. b. How would the mined copper appear in the balance sheet if the selling price fell to £42 per ounce at the end of the year (ceteris paribus)1? What would income for the year be? Solutions to this activity are given in Appendix 2.

1

‘Ceteris paribus’ means other things being equal.

207

91 Financial reporting

Implications of fair value accounting One question that will inevitably be asked sooner or later is whether the gradual move towards a system of accounting that recognises an ever-broadening range of assets and liabilities in the balance sheet at fair values, will ultimately see the measurement of stocks [inventories] at fair value as well? (Ernst & Young, 2001)

Following the discussion of the IASB’s conceptual framework (FPPFS) (see Chapter 2), fair value accounting for inventories is a real possibility. The framework does not consider the realisation concept important and enshrines the recognition criteria, which implies that unperformed contracts should be recognised.

Construction contracts Accounting for construction contracts is covered in IAS 11. IAS 11 defines a construction contract as ‘a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.’ Construction contracts need special accounting treatment compared to other forms of inventory ‘as the nature of activity undertaken in such contracts is different’ and, the date at which the contract activity is entered into and the date when the activity is completed, usually fall into different accounting periods. Therefore, the primary issue in accounting for construction contracts is the allocation of contract revenue and contract costs to the accounting periods in which construction work is performed and how to value the construction contract in the balance sheet. The issue of profit recognition is key because if the realisation concept is applied strictly then the profit will only be recognised on completion of the contract. Companies with significant construction contracts will have ‘lumpy’ profits. Thus construction contracts relate to the manufacture or construction of a single substantial asset (e.g. shipbuilding, roads) or a combination of assets, with the duration of the contract falling into different accounting periods and usually lasting for more than one year.

Profit recognition methods There are two basic methods of accounting for construction contracts: the completed contract and the percentage-of-completion method. The completed contract method delays the recognition of profit until completion. This has historically been more common in prudent countries such as Germany but is not permitted by IAS 11.

Percentage of completion method IAS 11 requires the percentage of completion method to be used for construction contracts. ‘Where the outcome of the contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract at the balance sheet date.’

208

Chapter 9: Accounting for inventories and construction contracts

Contract revenue should comprise (IAS 11, para. 11): • the initial amount of revenue agreed in the contract, and • variations in contract work claims and incentive payments: • to the extent that it is probable that they will result in revenue; and • they are capable of being reliably measured. Contract cost should comprise (IAS 11, para. 16): • costs that relate directly to the specific contract • costs that are attributable to contract activity in general and can be allocated to the contract • such other costs as are specifically chargeable to the customer under the terms of the contract. IAS 11 identifies a number of costs that may not be charged to the contract costs, including general administration costs not specified in the contract, selling costs, research and development costs not specified and depreciation of idle assets not used on a specific contract. The stage of completion of a contract is determined by the method that measures reliably the work performed to date. There are a number of accepted methods for calculating attributable profit based on different views of what constitutes the ‘amount of work done’: • proportion that costs incurred for work performed to date bear to total estimated costs • surveys of work performed • or completion of a physical proportion of the contract work. One of the obvious difficulties of this method is determining the basis for calculating attributable profit. Depending on the basis selected for ‘amount of work done’, the attributable profit could be allocated by very different proportions across the years of the construction contract. Attributable profit is that part of the total profit estimated to arise over the whole contract that reflects the work performed up to the balance sheet date.2 In the income statement this profit will be represented by recording turnover and related costs. This method thus spreads out anticipated profit over the life of the contract in proportion to the amount of work carried out, to arrive at the attributable profit. For example, using the ‘proportion that costs incurred for work performed to date bear to total estimated costs’, the attributable profit recognised each year is equal to:

2 Allowing for any known inequalities of profitability during the various stages of the contract.

[(Cost incurred in the year ÷ total estimated cost) × total expected profit] – profit already recognised. When the outcome of a construction contract cannot be estimated reliably: • revenue is recognised only to the extent of the contract costs incurred that it is probable will be recoverable, and • contract costs shall be recognised as an expense in the period in which they are incurred. IAS 11 requires that ‘when it is probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately.’

Balance sheet entries: the percentage of completion method In addition to the computation of the attributable profit, construction contracts generate other entries in the balance sheet: 209

91 Financial reporting

• Trade receivables: the net amount of costs incurred plus recognised profits less the sum of recognised losses and progress billings. • Trade payables: payments on account exceeding amounts matched with turnover are offset against construction contract balances. • Inventory: ‘construction contract balances’ represent the cost of a construction contract less amounts transferred to cost of sales, less foreseeable losses and less payments on account not matched with turnover. • Provisions for liabilities and charges: these can be included when provisions for foreseeable losses exceed the costs incurred (after transfers to cost of sales).

Accounting for construction contracts: an example Construction contracts should be accounted for as follows, assessing them on a contract-by-contract basis. The example below is taken from Appendix 3 to the UK’sSSAP 9 (revised), amended for terminology to reflect IAS 11. (SSAP 9 is broadly similar to the requirements set out in IAS 11.) Contracts Data (£)

Total

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 Contract costs relating to future activity

110

510

450

250

100

1,420

0

60

100

0

45

Progress billings

100

600

400

150

80

Estimated cost to complete

90

290

100

140

50

670

Contract value

250

1,000

600

300

120

2,270

Total contract cost

200

800

550

390

150

2,090

50

200

50

(90)

(30)

180

Profit/loss on contract

Solution: income statement Notes a. An appropriate proportion of total contract value should be recognised as turnover each year (see contracts 1–5). b. The costs incurred in reaching that stage of completion should be matched with that turnover as cost of sales (see contracts 1–5). c. 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). This should be included as part of cost of sales. See contracts 4 and 5:

210

1,330

Chapter 9: Accounting for inventories and construction contracts Contracts Income statement (£)

Total

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

(40)

(30)

(70)

(90)

(30)

15

Provision for losses on contracts Gross profit (loss)

35

70

30

Solution: balance sheet If the amount recognised as revenue exceeds the progress billings, the excess should be classified as an ‘amount recoverable on contracts’ and shown as a trade receivable. See contracts 1 and 2 Any costs to date not transferred to cost of sales under (b) above should be carried forward in the balance sheet as a current assets ‘construction contract balance’ under inventories (but subject to (f) and (g) below). See contracts 2, 3 and 5. Any foreseeable loss charged to cost of sales under (c) above should be deducted first from any related construction contract balance (thus reducing it to net realisable value), then any excess of foreseeable loss over that construction contract balance should be shown as an accrual (under creditors) or as a provision for liabilities and charges (see contracts 4 and 5). If the payments on account exceed the amount shown as turnover, the excess should be deducted from any related construction contract balance (after first deducting from the construction contract balance any related foreseeable loss under (f) above) and any residual excess should be shown as ‘payments on account’ under creditors. See contracts 2, 3 and 5. After allowing for the effects of (e), (f) and (g), any construction contract balances appear in the balance sheet as ‘Construction contract balances’ under Inventories. A note should separately disclose the balance of: i. net cost less foreseeable losses ii. applicable payments to account. Contracts Balance sheet workings (£) Contract revenue recognised Less: progress billings Trade receivable: amount recoverable on contracts Advances received Trade receivable: amount recoverable on contracts

1

2

3

4

5

145 100

520 600

380 400

200 150

55 80

45 (80)

(20)

(25)

(125)

50 60

100

Foreseeable losses 45

taken to BS

50

45

Add: costs relating to future activity classified as trade receivables

Creditors: payments on account

Total

60

100

45 (40)

(30)

10

15

230

211

91 Financial reporting

This example can be summarised as: Income statement (£) Revenue Cost of sales Provision for losses

1,300 1,215 70

Gross Profit

1,285 15

Balance sheet (£) Current assets Trade receivables: ‘amount recoverable on contracts’

230

Creditors due within one year Advances received on contracts

125

Net impact of contract on working capital

105

Activity 9.4 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 £’000

Z £’000

Contract price

4,000

6,000

Cost of work certified (recognised)

1,400

4,400

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

Costs carried forward

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 onethird 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 balance sheet of Handy Plc at 31 December 2010 in accordance with standard accounting practice. Solutions to this activity are given in Appendix 2.

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Chapter 9: Accounting for inventories and construction contracts

Reminder of learning outcomes Having completed this chapter, and the Essential readings and activities, you should be able to: • identify the different categories of inventory • discuss the importance of inventory valuation in the income statement and balance sheet • discuss and calculate the different methods of inventory valuation • describe what ‘cost’ includes and some areas of uncertainty • explain construction contracts and their accounting: why they are treated differently; their profit recognition.

Sample examination question Question 9.1 Tom Plc has two construction contracts underway – A and B. A began on 1 January 2010. B began on 1 August 2010. The position on each contract at 31 December 2010 was as follows: A £’000

B £’000

Contract price

8,000

4,000

Cost of work recognised (certified)

5,100

600

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

Costs carried forward

Contract A provided for the sum of £500,000 to be paid in advance by the client on 1 January 2010; this is included in the payments on account shown above. The cost of work certified represents 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. Tom’s accounting policy recognises no profit until a contract is one-third complete by value. Thereafter it recognises each year a proportion of total expected profit. This is 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. a. Show how each of these contracts will be reflected in the income statement and balance sheet of Tom Plc at 31 December 2010 in accordance with standard accounting practice. b. Comment on the application of the ‘prudence concept’ in relation to standard accounting practice for inventories and construction contracts. Solutions to this question are available in Appendix 2.

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91 Financial reporting

Notes

214

Chapter 10: Accounting for equity and liabilities

Chapter 10: Accounting for equity and liabilities Aims of the chapter This chapter considers accounting for equity and liabilities. We consider those liabilities appearing on the balance sheet, those appearing in the notes and those not appearing at all.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • discuss capital and reserves • demonstrate the accounting treatment for an equity issue • discuss long- and short-term debt • demonstrate the accounting treatment for debt and the calculation of finance costs • explain why some liabilities are not on the balance sheet (i.e. contingent liabilities and off-balance sheet financing) • describe the effect of post-balance sheet events.

Essential reading International Financial Reporting, Chapters 16 and 18.

Further reading Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An Assessment of the Effective Annual Rate Method as a Basis for Making Accounting Allocations’, Journal of Business Finance & Accounting 20(1) 1993, pp.56–63. Holmes, G., A. Sugden and P. Gee Interpreting Company Reports and Accounts. (Harlow: Prentice Hall, 2008) tenth edition [ISBN 9780273711414]. Chapters 4, 10 and 11. Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498] Chapters 7–9 and 18. Macve, R. ‘Accounting for Long-Term Loans’, in B. Carsberg and S. Dev (eds) External Financial Reporting (Harlow: Prentice Hall, 1984).

Relevant IASs/IFRs standards IFRS 7 Financial Instruments: Disclosure. IAS 10 Events After The Balance Sheet Date. IAS 32 Financial Instruments: Presentation. IAS 37 Provisions, Contingent Liabilities and Contingent Assets. IAS 39 Financial Instruments: Recognition and Measurement.

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91 Financial reporting

Share capital and reserves Shareholders’ funds consist of issued share capital stated at nominal value, distributable reserves and non-distributable reserves. The share capital can be divided into equity (i.e. ordinary shares) and non-equity (i.e. preference shares). In this section we consider ordinary and preference shares, and the distinction between distributable and non-distributable reserves. In the following section we illustrate the accounting treatment of shares issued at premium.

Ordinary shares These shares carry the main risk and are entitled to the residual profit after any fixed interest or fixed dividend to investors has been paid. IAS 33 (FRS 22) Earnings Per Share, para. 5 defines an ordinary share as ‘an equity instrument that is subordinate to all other classes of equity instruments’. Para 6 states: Ordinary shares participate in the net profit for the period only after other types of shares such as preference shares have participated. An entity may have more than one class of ordinary shares. Ordinary shares of the same class have the same rights to receive dividends.

In some countries such as the UK, a distinction is made between those shares authorised for issue (maximum number of all classes of shares which a company is allowed to issue) and those shares that have actually been issued (the nominal value of each class of share actually issued).

Share premium The share premium account records the difference between the nominal value (par value) of shares issued and the fair value of the consideration received. Share premium accounts are not explicitly covered by any IAS/ IFRS. In the UK the use of the share premium account is governed by the Companies Act 1985, and it can only be used for specific purposes: • to pay up fully paid bonus shares • to write off preliminary expenses • to write off expenses of any issue of shares or debentures • to write off commission paid or discount allowed on any issue of shares or debentures to provide for the premium payable on any redemption of debentures. Activity 10.1 Why do you think the UK uses this treatment for premiums? Why is the premium not credited to the income statement?

Preference shares These shares usually – there are a whole range of different types – have a fixed rate dividend and the shareholders receive dividends before the ordinary shareholders. They are thus considered less risky than ordinary shares. If a company were to go out of business, preference shareholders would be entitled to repayment before the shareholders but after 216

Chapter 10: Accounting for equity and liabilities

debenture holders. Generally, preference shareholders will be repaid at par value – the price at which the shares were issued. Some preference shares are known as cumulative. Shareholders are entitled to receive any dividends not paid in previous years. Companies are not obliged to pay dividends on preference shares if there are insufficient earnings in any particular year. Holding cumulative preference shares thus guarantees the eventual payment of these dividends in arrears before the payment of dividends on ordinary shares, provided that the company returns to profit in subsequent years.

Distributable and non-distributable reserves Distributable reserves are those reserves which can be distributed as dividends. Only realised profits can be legally distributed to shareholders in cash or non-cash form. The retained profit figure in the balance sheet (a revenue reserve) is distributable except for any unrealised element. However, there are great difficulties associated with the definition of what represents realised profits. Here are two (of numerous) descriptions of realisation: 1. It might refer to cases where the receipt of cash is reasonably certain (likelihood of cash flow). 2. It might focus on those cases where profit can be assessed with reasonable certainty (reliability of measurement). The IASB’s FPPFS, discussed in Chapter 2, does not refer to realisation. Non-distributable reserves include the share premium account, the capital redemption reserve,1 the revaluation surplus, and any other reserves that are specifically named as non-distributable in the company’s Memorandum of Association or Articles of Association.

Long-term debt and short-term debt There are a number of different types of borrowing that you may see in the published accounts of a large company such as a UK Plc (some might be in foreign currency), including: • Debentures, unsecured loan capital: these are bought and sold like shares and are available to investors. • Hybrid securities: these are financial/capital instruments which combine features of both debt and equity. One example is convertible capital bonds – this is a form of debt that can be converted into equity shares at some time in the future. These hybrid securities have been accounted for in different ways in the past, but following the introduction of IFRS 7 they are now required to be included with liabilities (discussed below).

1

This reserve is created as a result of the company purchasing its own shares in circumstances that result in a reduction of its share capital. It is a reserve that cannot be distributed to the shareholders and thus ensures the maintenance of the capital base of the company, and hence protects any creditors.

• Loans, both long-term and short-term, from banks and other financial institutions. • Bank overdrafts.

Accounting issues: equity or liability? Accounting for equity and liabilities had not been particularly controversial. However, over the past 25 years there has been considerable growth in the range of capital instruments available for raising finance, which often resulted in the distinction between equity and liabilities becoming somewhat blurred. Accounting failed to keep pace with the development of these complex instruments.2 This increased complexity has led to difficulties in the recognition, measurement and disclosure of

2

For example, how should an instrument having characteristics of both debt and equity be accounted for? As equity or under the heading of liabilities?

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91 Financial reporting

financial instruments. For example, many people argued that redeemable preference shares are, in substance, more akin to debt than equity and should be treated as such irrespective of their legal nature, or that a bond that gives the holder the option to redeem, or convert it into ordinary shares, may be argued to be more in the nature of equity than debt. This area is both complex and controversial. Many items falling within it were previously carried off-balance sheet, leaving shareholders lacking key information on the true nature of operations from the financial statements. The IASB decided to consider the area under two separate standards: IFRS 7 Financial Instruments: Disclosure (which replaced IAS 32) and IAS 39 Financial Instruments: Recognition and Measurement. The choice of accounting treatments seems to be based fundamentally upon whether you choose economic substance or its legal form. The IASB states the following in the FPPFS, para. 35: If information is to represent faithfully transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction).

This was incorporated into IAS 32, which stated: The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments.

Activity 10.2 Does the definition of equity and liabilities in the FPPFS help with the classification of preference shares? The objective of IAS 39 is to establish principles for recognising and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items. Requirements for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities are in IAS 32 Financial Instruments: Presentation. Requirements for disclosing information about financial instruments are in IFRS 7 Financial Instruments: Disclosures. IAS 32 defines a financial instrument as ‘any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity’. 218

Chapter 10: Accounting for equity and liabilities

This is a very wide definition. It includes not only the primary instruments discussed above but also secondary or derivative instruments:3 A financial instrument may require the entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index… The issuer of such an instrument does not have the unconditional right to avoid delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). Therefore, it is a financial liability of the issuer unless:

3

For example futures, option swaps and so on. These are covered in FRS 13 Derivatives and Other Financial Instruments: Disclosure. They are not covered in this subject guide.

a. the part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine; or b. the issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer.

Convertible financial instruments IAS 32 states that when a derivative financial instrument gives one party a choice over how it is settled (e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument.

Classification of financial instruments IAS 32 classifies financial instruments into financial assets, financial liabilities and equity instruments. It defines these elements as follows. 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 219

91 Financial reporting

for a fixed 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. A financial liability is: any liability that is: a. a contractual obligation: i. to deliver cash or another financial asset to another entity; or ii. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or b. 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 deliver 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 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.

Accounting for the issue of equity IAS 32 states that transaction costs of an equity transaction shall be accounted for as a deduction from equity, net of any related income tax benefit. IAS 39 and FRS 4 require the net proceeds from the issue of equity shares to be credited to shareholders’ funds. By net proceeds is meant the fair value of the consideration received after deducting the costs incurred directly in connection with the issue of the shares. What this means is that, since the nominal value of the shares issued must be credited to the share capital account, and any premium on the issue credited to the share premium account, the issue costs must be charged directly to shareholders’ funds. They will normally be charged against the share premium account, if one exists. If there is no share premium account, they will be charged against another reserve – normally the retained profit reserve. They are not to be charged against the current year’s income statement because they are regarded as integral to a transaction with owners of the company.

Accounting for debt Immediately after the issue of the debt, the amount of the liability should be shown as the amount of the net proceeds of issue. ‘Net proceeds’ is the fair value of the consideration received after deducting issue costs incurred directly in connection with the issue of debt. Finance costs are the difference between the net proceeds of debt and the total amount of the payments the issuer has to make in respect of debt. Finance costs of the debt are to be allocated to periods over the term of the debt at a constant rate on the carrying amount, and are to be charged in the income statement; this is achieved by use of the actuarial method. (Special rules apply to investment companies, not dealt with here.) The carrying amount of debt should be increased by the finance costs for the period and reduced by payments made in respect of the debt in that period (though 220

Chapter 10: Accounting for equity and liabilities

the standard does allow accrued finance charges to be included in accruals rather than in the carrying amount of debt if they have accrued in one period and will be paid in cash in the next). The allocation of finance costs to periods under IAS 39 involves using the ‘effective rate of interest’4 rather than the nominal value. This is calculated by finding the rate of interest that makes the PV of all future payments in respect of the debt equal to the net proceeds of issue. IAS 39 defines this as follows: The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (for example, prepayment, call and similar options) but shall not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see IAS 18), transaction costs, and all other premiums or discounts.

4

Also known as the ‘effective yield’ or the ‘periodic rate’, and equivalent to the ‘rate implicit in the lease’ under SSAP 21. See Chapter 7.

Example On 1 January 2008 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 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 (l+r)6

= £835,000

This is the same as 80,000 + 80,000 + 80,000 + 80,000 + 80,000 + 80,000 + 100,000 = (1 + r)

(1 + r)2

(1 + r) 3

(1 + r)4

(1 + r)5

(1 + r)6

(1 + r)6

£835,000

This can be solved to show that r equals 12% per annum. The debt liability and finance charges will be analysed as follows: Year

Opening balance

Finance charge @ 12%

Payment made

Closing balance

(1)

(2) = (1) × 12%

(3)

(4) = (2) – (3) + (1)

2008

835,500

100,260

80,000

855,760

2009

855,760

102,960

80,000

878,450

2010

878,450

105,415

80,000

903,865

2011

903,865

108,465

80,000

932,330

2012

932,330

111,880

80,000

964,210

2013

964,210

115,790

80,000

1,000,000 221

91 Financial reporting

The sum of £1,000,000 would then be repaid on 31 December 2013. The finance charge is debited to the income statement. This charge includes the nominal interest on the debt (i.e. we do not charge both the finance charge and interest at 8%).

Implications of debt and equity When analysing a company, there are a number of ratios which consider its debt.5 Financial structure ratios (referred to as debt/equity, gearing and leverage) all compare equity with debt financing used by a company to assess its riskiness. Interest cover considers the ability of a company to pay its interest commitments from profit before interest.

Example: 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). Saunders Plc

French Plc

£200,000

£100,000

Debt

–

£100,000

Total

£200,000

£200,000

Saunders Plc

French Plc

Equity (£1 shares)

Good year

Bad year

Good year

Bad year

100,000

20,000

100,000

20,000

–

–

(15,000)

(15,000)

PBT

100,000

20,000

85,000

5,000

Tax (35%)

(35,000)

(7,000)

(29,750)

(1,750)

65,000

13,000

55,250

3,250

32.5 pence

6.5 pence

55.25 pence

3.25 pence

PBIT Interest (15%)

Earnings EPS

• This shows that: • The EPS for Saunders Plc in a good year is 32.5p (65,000/200,000). • The EPS for French Plc in a good year is 55.25p (55,250/100,000). • The EPS for Saunders Plc in a bad year is 6.5p (13,000/200,000). The EPS for French Plc in a bad year is 3.25p (3,250/100,000). In other words, there is higher volatility in the EPS for the shareholders of the geared company (i.e. the company with some debt). High levels of debt tend to be viewed unfavourably by many investors so companies might try to keep some debt off the balance sheet. Consequently users should look through the notes to the accounts for signs of contingent liabilities, post-balance sheet events and offbalance sheet financing.

222

5

The debt will be disaggregated in the notes to the accounts according to when it falls due.

Chapter 10: Accounting for equity and liabilities

Contingent liabilities Contingencies refer to conditions existing at the balance sheet date where outcomes depend on the occurrence or non-occurrence of one or more uncertain events. IAS 37 deals with contingencies defining them as either: a. a possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity’s control; or b. a present obligation that arises from past events but is not recognised because: i.

it is not probable that an outflow of resource embodying economic benefits will be required to settle the obligation; or

ii. the amount of the obligation cannot be measured with sufficient reliability.

Contingencies are not normal uncertainties (e.g. fixed asset lives, the provision of bad debts) but cover uncertainties such as litigation against the company and guarantees of overdrafts. One of the main subjective decisions affecting accounting for contingencies is the likelihood of the outcome. Where the outcome is probable a provision should be established (if the amount can be estimated); where the outcome is possible but not probable, details should be disclosed; where the outcome is remote there is no need for disclosure. There is potential to include large contingent liabilities in the notes (or not at all) depending upon the assessment of the likely outcome. Ernst and Young (1999) p.1,663 summarised the treatment of contingent liabilities by assigning approximate probabilities to the likelihood of outcomes. This is reproduced below (modified): Likelihood of outcome

Approximate probability

Accounting treatment

Virtually certain

95%

Probable

50–95%

A provision is recognised. Disclosures are required for the provision – that is, this is not a contingent liability

Possible but not probable 5–50%

No provision is recognised. Disclosures are required for the contingent liability

Remote

No provision is recognised and no disclosure is required

PV. Given that the NRV is lower than the RC, the deprival value would be equal to the NRV of £340,000. Activity 4.13 The realised holding gain would be on the six T-shirts you had sold and therefore would equal (6×2) = £12 The unrealised holding gains are from the four remaining T-shirts that you still own and this would equal (4×2) = £8 CCA income statement £ Sales

90 (6 units @ £15)

Cost of sales

72 (6 units @ RC)

Current operating profit

18

Realised holding gain

12

Profit

30

CCA balance sheet a/c £ Cash

90

Inventory

48 (4 units @ RC) 138

Capital

100

Profit

30

Unrealised holding gains

8 138

Activity 4.14 Review the discussion, in this chapter, on capital maintenance concepts and holding gains and losses. Activity 4.15 Calculating the AEC 600,000 + 42,000 × a2  0.1 + 45,000a2  0.1 v2 + 50,000 v5 – 20,000 v5 a5 0.10 = £199,000 (to the nearest £’000) 260

Appendix 2: Solutions to activities and sample examination questions

2008

2009

2010

45,000

45,000

50,000

2011 onwards

Have budget Operating costs Scrap receipt

(20,000)

Replacement AEC

199,000 45,000

45,000

30,000

199,000

Replace at AEC

199,000

199,000

199,000

199,000

Difference

154,000

154,000

169,000

–

Have Not budget

Present value of difference = £394,000 (to the nearest £’000) Since the AEC is lower than the annual gross sales revenue of £250,000 it is worth replacing the asset. Therefore deprival value equals replacement cost of £394,000. Activity 4.16 Calculating the AEC 650,000 + 42,000 × a2  0.1 + 45,000a2  0.1 v2 + 50,000 v5 – 20,000 v5 a5  0.10 = £213,000 (to the nearest £’000) 2008

2009

2010

45,000

45,000

50,000

2011

onwards Have budget Operating costs Scrap receipt

(20,000)

Replacement AEC

213,000 45,000

45,000

30,000

213,000

Replace at AEC

213,000

213,000

213,000

213,000

Difference

168,000

168,000

183,000

–

Have Not budget

Present value of difference = £429,000 (to the nearest £’000) Since the AEC is still lower than the annual gross sales revenue of £250,000 it is worth replacing the asset. Therefore deprival value equals replacement cost of £429,000. Activity 4.17 a.

Calculating the AEC 620,000 + 30,000 × a6 0.1 + 35,000v1 + 15,000 v3 – 17,000 v6 a6 0.10 = £180,000 (to the nearest £’000) This is the annual equivalent cost allowing for the fact that every year in which replacement takes place there will be a loss of revenue of £35,000.

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91 Financial reporting

Have budget Operating costs Scrap receipt Replacement AEC Have Not budget Replace at AEC Difference

2009

2010

45,000

50,000 (20,000)

2011 onwards

45,000

30,000

180,000 180,000

180,000 135,000

180,000 150,000

180,000 –

Present value of difference = £247,000 (to the nearest £’000) Since the AEC is still lower than the annual gross sales revenue of £250,000 it is worth replacing the asset. Therefore deprival value equals replacement cost of £247,000 = deprival value at 31 December 2008. b. If sales revenue fell to £150,000 per annum from 1 January 2009 and was not expected to increase, replacement of the asset would no longer be justified (since AEC is higher than revenue). Deprival value would therefore be the higher of the net realisable value of the existing plant and the present value of the plant’s future net cash flows. The net realisable value of the existing plant = £20,000 The future net cash flows are: 2009: 150,000 – 45,000 = £105,000 2010: 150,000 – 30,000 = £120,000 The present values of these is: 105,000v1 + 120,000v2 = £194,565 Deprival at 31 December 2008 would therefore be £194,565.

Sample examination question 4.1 CPP income statement for the year ended 31 December 2010 £CPP Sales Less cost of sales: Opening inventory Further purchases Less closing inventory Gross profit Less expenses Depreciation Sundry expenses

142,000 895,692 1,037,692 147,259

£CPP 1,201,538

890,433 311,105

28,400 158,385 186,785

Operating profit Gain on short-term monetary items Dividends Interim dividend paid Retained profit

262

124,320 10,921 9,466 125,775

Appendix 2: Solutions to activities and sample examination questions

Balance sheet as at 31 December 2010 £CPP Non-current assets – NBV Current assets Inventories Trade receivables Creditors due within one year Bank overdraft Trade creditors

£CPP 255,600

147,259 185,000 332,259 10,000 174,000 184,000

Net current assets

148,259 403,859

Shareholders’ funds Ordinary share of £1 Share premium account Income statement

236,667 41,417 125,775 403,859

Workings: Gain on net short-term monetary items Date Items £HCA

£CPP

01/01/2010

Ordinary share issue

240,000

284,000

01/01/2010

Preliminary expenses

(5,000)

(5,917)

01/01/2010

Purchase of non-current assets (via cash and credit)

(240,000)

(284,000)

01/01/2010 30/06/2010 30/06/2010

Inventory Sales (via cash and credit) Further purchases

(120,000) 1,100,000 (820,000)

(142,000) 1,201,538 (895,692)

30/06/2010

Sundry expenses

(145,000)

(158,384)

31/10/2010

Interim dividend

(9,000)

(9,466)

31/12/2010

Balance

(1,000)

(9,921)

Difference between £HCA and £CPP

Gain = 10,921

Sample examination question 6.1 AEC of new widget plant. Note: you may also adjust for the extra output of ‘new’ in the AEC calculation instead of in the Have and Have Not budget, giving an AEC of £290,000. This wil l give the same answer. AEC =

550 + 180 a6 0.1 – 10v6 a60.1

AEC = £305,000 p.a.

263

91 Financial reporting

Have budget Year ended 31 Dec Operating costs of ‘old’

2009

2010 200

Overhaul

2011 200

2012 200

2013

15

Removal costs

20

Adapt building for ‘new’

25

AEC of ‘new’

–

–

–

–

305

–

215

200

245

305

305

305

305

305

–

(15)

(15)

(15)

–

25

75

90

45

–

Have Not budget Adapt building for ‘new’

25

AEC of ‘new’ Extra output of ‘new’ Difference PV of difference

25 + 75v1 + 90v2 + 45v3 = 201,400 (say 201,000)

(= cost of replacing services of existing asset) Gadget machine 2010

2011

2012

Revenues

135

120

105

Operating costs

115

115

115

20

5

(10)

Net revenues

Replacement is not worthwhile, nor is it worth continuing to use after 2003. Use for two years then sell for £12,000: PV = 20v1 + 17v2 = £32,250 This is > NRV, therefore DV = PV = £32,250

264

Appendix 2: Solutions to activities and sample examination questions

Chapter 5 Sample examination question 5.1 a. Acquisition 2007 £m Balance sheets Tangible non-current assets Goodwill arising on consolidation

1,432 240 1,672

Net current assets

280 1,952

Loan capital

360 1,592

Ordinary shares of £1

480

Share premium account

680

Reserve arising on merger Income statement

– 432 1,592

Income statements Turnover

3,300

Cost of sales

1,840

Gross profit

1,460

Other expenses

1,088

Profit before taxation

372

Taxation

140

Profit for the financial year

232

Dividends

120

Retained profits

112

EPS

52.7p

265

91 Financial reporting

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 £720 million. The fair value of net assets acquired is: £m Net equity of Gidget at 31 December Proportion of profits to 30 June 2007: Excess of fair value over book value of tangible non-current assets

340 40 = (1/2 × 80) 140 520

Goodwill arising on consolidation is therefore £240 million (capitalised subject to an impairment review). The calculation of EPS for 2007 is based on the average number of Widget shares in issue during 2007 for £440 million. Merger accounting b. Although merger accounting was originally seen as providing a way of accounting for business combinations between relatively equal parties, it had come to be used in the UK in a wide variety of circumstances. Indeed, it was argued that merger accounting was positively abused, in order to give misleading impressions of the performance of companies that chose to grow through acquisition rather than organically. In the present case, Widget, which at the start of 2007 had a market capitalisation of £3,600 million, has acquired (merged with?) Gidget, whose market capitalisation was then only £240 million. For merger accounting to be used FRS 6 now requires that the relative sizes of the combining entities are not so disparate that one party dominates the combined entity by virtue of its relative size (which has been a requirement for some time in the USA). FRS 6 says that a party would be presumed to dominate if it is more than 50% larger than the other party to the combination, judged by the relative proportions of the equity of the combined entity attributable to the shareholders of each of the combining parties. By this test this transaction would not be regarded as a merger; however the presumption may be rebutted in some circumstances. (Note that FRS 6 also asks that certain other conditions are satisfied before permitting the use of merger accounting; we do not have sufficient information in this case to check all of them.) The principle effects of using merger accounting are: 1. The assets of the acquired company come into the consolidated balance sheet at book value rather than fair value. In this case, use of merger accounting allows Widget to conceal differences between book value and fair values for the tangible non-current assets. Should these assets be sold later, Widget would be able to recognise the appreciation that occurred before the merger as part of its profits. Under acquisition accounting, however, it is necessary to recalculate the depreciation charge, and here Widget ends up with a further £8 million in debit to its consolidated income statement for 2007, and presumably £16 million in a full year. 2. No goodwill arises on consolidation. In this case, acquisition accounting gives rise to goodwill of £240 million, which is capitalised and subject to an impairment review; there is no impact on profit, just the balance sheet values. 266

Appendix 2: Solutions to activities and sample examination questions

3. A full year’s figures for both companies are included in the consolidated income statement, and the comparative figures are restated on the basis that the merger had always been in force (unlike with acquisition accounting where Widget only takes half of Gidget’s profits due to the acquisition taking place half-way through the year). The effect of this on Widget is to make its performance seem more spectacular than under acquisition accounting. Growth in earnings per share (an indicator considered very important by modern management, whether rightly or wrongly) for the group under acquisition accounting is 25%. But under merger accounting, growth in EPS is higher, at 53%. This is because Widget effectively takes credit for the profit turn-around at Gidget, which was already well underway at the time of the merger, since the 2006 comparatives reflect the poor performance of Gidget in that year. 4. Where a company with a higher price/earnings ratio acquires one with a lower price/earnings ratio, and uses merger accounting, then normally the earnings per share after reflecting the merger are greater than those that would have been shown if the merger had not taken place (although this does not hold if the acquirer pays a substantial premium over market value). In this case, merger accounting has increased the earnings per share of Widget from 52.7p to 58p. If the P/E ratio remains unchanged, the share price of the acquirer will rise. Sample examination question 5.2 a. Basis of consolidation (i) investment; (ii) associate; (iii) PC; (iv) FC Basis of consolidation (i)

(ii)

(iii)

(iv)

Balance sheets at as 31 December 2007 Investment properties at valuation Investment in BestProp at cost Net current assets/(liabilities)

£m 400 8 80

£m 400 16 80

£m 496 – 72

£m 640 – 60

Loan capital

488 120

496 120

568 192

700 300

Net assets Outside shareholders’ interest

368 –

376 –

376 –

400 24

368

376

376

376

160 140 68

160 156 60

160 156 60

160 156 60

366

376

376

376

Share capital Revaluation surplus Income statement

267

91 Financial reporting

Income statement for the year 2007 Rents receivable less expenses Share of associated company Interest payable – group – associate

28 – (10) –

28 4 (10) –

32 – (22) (12)

38 – (40) –

Profit/(loss) before taxation Taxation charge

18 (4)

10 (4)

10 (4)

(2) (4)

Profit/(loss) after taxation Outside shareholders’ interest

14 –

6 –

6 –

(6) 12

Profit attributable to shareholders of Top-of-Props Plc

14

6

6

6

b. While equity accounting may work in a straightforward manner where the associated company is small in relation to the investing company and the associated company’s accounts do not show any marked peculiarities, in the present situation this does not hold true. BestProp is a very severely geared company – it is showing a deficit on income statement (although the value of the company is rising because of the appreciation of the underlying property investment) – and Top-of-Prop, although having only 40% equity interest in BestProp, has an effective 100% responsibility for its liabilities, since it has fully guaranteed BestProp’s loan capital. Reflecting the investment in BestProp at cost £8 million gives the shareholders of Top-of-Prop little idea of the importance of this associate. Top-of-Prop would have to disclose its contingent liability under the guarantee of BestProp’s indebtedness in its own accounts, but there is no specific requirement in such circumstances to give any details of the assets underlying its investment in BestProp. It may well be that the auditors of Top-of-Prop would consider that Top-of-Prop’s accounts would fail to give a true and fair view unless information about BestProp’s assets and liabilities were disclosed, but this still raises the question of the best form that such disclosure might take. In the situation outlined, Top-of-Prop would present its investment in BestProp in accordance with FRS 18, using equity accounting (note that the use of equity accounting assumes that the accounts of Top-of-Prop are group accounts). The effect of this is to show the investment on Top-of-Prop’s consolidated balance sheet at cost plus Top-of-Prop’s share of BestProp’s post-acquisition reserves (revaluation surplus as well as income statement) less any post-acquisition dividends received. Top-of-Prop’s consolidated income statement includes Top-of-Prop’s share of BestProp’s profit and loss, rather than any dividends received. In the present case, accounting for the investment in BestProp at cost does not reflect any part of BestProp’s loss in Top-of-Prop’s accounts (given that BestProp’s property has appreciated by more than its loss, there is no reason for Top-of-Prop to write its investment down). Accounting methods (ii), (iii) and (iv) all leave Top-of-Prop with the same consolidated equity of £376 million. However, the balance sheet and profit and loss disclosure are markedly different, and this can be highlighted particularly by calculating a gearing ration for Top-of-Prop: Basis Loan/total assets

(i)

(ii)

(iii)

(iv)

120/488

120/496

192/568

300/700

= 24.6%

= 24.2%

= 33.8%

= 42.9%

Because BestProp is almost totally financed by debt, the more that is brought onto Top-of-Prop’s balance sheet, the higher will be the reported gearing. Given Top-of268

Appendix 2: Solutions to activities and sample examination questions

Prop’s guarantee of BestProp’s debt, it might be argued that users of Top-of-Prop’s financial statements would gain a fairer view of Top-of-Prop’s financial position from the full consolidation than by relegating the contingent liability over £180 million to a note. On the other hand, the full consolidation gives shareholders in Top-of-Prop a clearer idea of the total value of properties in which they have an interest. In a highly geared investment, an important ratio is interest cover, and this again varies substantially according to the accounting method used: Basis Profit before interest/ interest payable

(i)

(ii)

(iii)

(iv)

28/10

32/22

32/22

38/40

= 2.8

= 1.45

= 1.45

= 0.95

Ultimately, Top-of-Prop must generate sufficient cash flows itself and in BestProp to service not only its own debt but also that of BestProp. The full consolidation makes it clear that the total net revenue of £38 million was insufficient to meet the interest outflow of £40 million. Equity accounting, which reflects the investing company’s share of profit or loss in the group accounts but does not include the associate’s assets and liabilities in the group balance sheet, tends to have a disproportionate impact on ratios involving a comparison of the income statement and balance sheet. The effect of including Top-of-Prop’s share of BestProp’s loss can be shown by calculating a return on total assets measure: Basis

(i)

(ii)

(iii)

(iv)

Profit before interest/ 28/488 total assets

32/496

32/568

38/700

= 5.7%

= 6.5%

= 5.6%

= 5.4%

In this situation, the equity accounting approach reflects the ‘bad news’ of BestProp’s loss while not revealing the ‘good news’ of BestProp’s underlying assets. In the reverse situation, where the associated company makes a profit, equity accounting has a disproportionately favourable impact on performance ratios. This is a situation where a case can be made for any of the accounting methods. However, it is worth considering whether the accounting problem can be avoided by more disclosure in notes to the accounts. The limitation of the accounting is mitigated by the fact that FRS 9 also now requires various note disclosures about the investor’s share of associates’ turnover, profit before tax, tax, profit after tax, non-current assets, current assets, liabilities due within one year and liabilities due after more than one year, where the investing company’s share of the associate’s (or associates’) underlying gross assets and liabilities, turnover or operating results exceeds certain thresholds (15% and 25% of related group items). As BestProp is large relative to Top-of-Prop, some or all these disclosures would also be required here.

Chapter 6 Activity 6.1 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.

269

91 Financial reporting

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. Activities 6.5 and 6.6 Closing rate method Income statement for Dunfor year ended 31 December 2007 $ Sales

$ Exchange rate 48,000

12

20,000

12

1,667

Less closing inventory

(4,000)

12

(333)

(16,000)

£ 4,000

Purchases

Cost of goods sold

(1,334)

Gross profit

32,000

12

2,666

Expenses

(4,000)

12

(333)

(20,000)

12

(1,667)

Depreciation Net profit

Balance brought forward Profit for the year Exchange difference

8,000

£– £666 (£23,333) (£22,667)

270

£

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)

666

Appendix 2: Solutions to activities and sample examination questions

Sample examination question 6.1 Temporal rate method Balance sheet for Dunfor as at 31 December 2011 $ Exchange rate Non-current assets (NBV) 80,000 10 Current assets: Inventory 8,000 10 Trade receivables 21,000 5 Cash 98,000 5 127,000

800 4200 19,600 24,600

Total net assets:

207,000

32,600

Share capital Retained profit Total equity:

200,000 7,000 207,000

10 (= balancing figure)

£ 8,000

20,000 12,600 32,600

Income statement for Dunfor for year ended 31 December 2011 $ $ Exchange rate £ £ Sales 42,000 8 5,250 Purchases 20,000 10 2,000 Less closing inventory 8,000 10 800 Cost of goods sold 12,000 1,200 Gross profit 30,000 4,050 Less: Expenses 3,000 8 375 Less: Depreciation 20,000 10 2,000 23,000 2375 Translation gain/loss 10,925 Net profit 7,000 12,600 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 Factors determining the functional currency: • currency that mainly influences sales prices for goods and services, and of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services • the currency in which funds from financing activities are generated • the currency in which receipts from operating activities are usually retained.

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91 Financial reporting

Chapter 7 Activity 7.2 2b (b) –4,000 is the profit on disposals. Activity 7.3 D1t0 = 4,021 V1t0 = 9,179 V0t0 = 12,000 Hicks income number1 ex ante

= D1t0 + V1t0 – V0t0 = 4,021 + 9,179 – 12,000 = 1,200 (or V0t0 × r = 12,000 × 10%)

Activity 7.4 a. The constant annual revenue required to recover the original investment together with interest at 10% per annum is equal to [the initial outlay plus the present value of any periodic outlays less the present value of scrap] divided by the annuity factor for the number of years of the asset’s life. Here it equals: 25,000 – 3,0005 (1.1) = 23,137 = 6,104 approx. a50.1 3.7907 b. Summarised income statement Year:

1

2

3

4

5

Operating cash flows

6,104

6,104

6,104

6,104

6,104

Depreciation

3,604

3,964

4,361

4,797

5,277

2,500

2,140

1,743

1,307

827

Interest on cash deposit with parent company

–

360

757

1,193

1,673

Net profit paid as dividend to parent company

2,500

2,500

2,500

2,500

2,500

Workings: Calculation of depreciation and interest on cash Annuity

WDV

Interest

of asset at

on WDV

start of year

at start of

Depreciation

Cash

Interest

charge for on deposit

cash on

year

deposit

year Year 1

6,104

25,000

2,500

3,604

–

–

Year 2

6,104

21,396

2,140

3,964

3,604

360

Year 3

6,104

17,432

1,743

4,361

7,568

757

Year 4

6,104

13,071

1,307

4,797

11,929

1,193

Year 5

5,104

8,274

827

5,277

16,726

1,673

(The annual depreciation charge is equal to the amount of the annuity less interest on the written-down value of the asset at the start of the year.)

272

Appendix 2: Solutions to activities and sample examination questions

Activity 7.5 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 payments

1/01/10 1/01/10 1/04/10 1/07/10 1/10/10 1/01/11 1/04/11 1/07/11 1/10/11

Finance Repayment charge of capital

3,864 3,864 3,864 3,864 3,864 3,864 3,864 3,864

1,384 1,310 1,233 1,154 1,073 989 903

3,864 2,480 2,554 2,631 2,710 2,791 2,875 2,961

Obligation under finance lease 50,000 46,136 43,656 41,102 38,471 35,761 32,970 30,095 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 2006) 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 Depreciation

£5,081 £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 Obligation under finance lease

£1,154 £11,337

In creditors after more than one year: Obligation under finance lease

£27,134

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. 273

91 Financial reporting

Fair value = Initial obligation under finance lease = £3,420 a20 (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 payments

01/01/10 31/03/10 30/06/10 30/09/10 31/12/10 31/03/11 30/06/11 30/09/11 31/12/11

Finance Repayment charge of capital

2,420 2,420 2,420 2,420 2,420 2,420 2,420 2,420

1,080 1,040 998 956 912 867 820 772

1,340 1,380 1,422 1,464 1,508 1,553 1,600 1,648

Obligation under finance lease 36,000 34,660 33,280 31,858 30,394 28,886 27,333 25,733 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 assets 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 7.6 The charges to the income statement would be £20,000 in both 2010 and 2011. Sample examination question 7.1 Given that the annual cash flow to be earned is constant, the annual revenue necessary to earn the required rate of return and to recover the investment will be calculated as in Activity 9.4. Here, the only outlay is the initial investment and there is no scrap value. Working to the nearest £’000, the amount of the annuity is therefore: £2,000,000 = £204,000 9.8181 To calculate the depreciation charge on a discounted present value basis in years 10 and 20 it is necessary to ascertain the written-down value of the equipment at the start of each of those years (i.e. at the end of year 9 and 19). Those may be ascertained as follows: WDV at end of year 9 = £204,000 a110.08 = £1,456,000 (nearest £’000) WDV at the end of year 19 = £204,000 a10.08 = £189,000 (nearest £’000) 274

Appendix 2: Solutions to activities and sample examination questions

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 (a gain 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 writtendown 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.

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.

275

91 Financial reporting

Sample examination question 7.2 Income statement year ended 31 December 2010 Revenues Depreciation

Apple

Pear

Banana

Kiwi

Orange

18,000

18,000

18,000

18,000

18,000

5,000

5,000

5,000

2,850

Rent Other operating costs Operating profit

8,850 6,750

6,750

6,750

6,750

6,750

11,750

11,750

15,600

11,750

9,600

6,250

6,250

2,400

6,250

8,400

6,000

6,000

250

2,400

45,000

47,150

Interest

6,000

Finance charge Net profit

6,250

250

2,400

Balance sheets 31 December 2010 Non-current assets at NBV

45,000

45,000

Net current assets

31,250

25,250

22,400

19,208

19,208

76,250

70,250

22,400

64,208

66,358

43,958

43,958

Debentures

50,000

Obligation under finance lease Share capital Profit Rate of return on initial equity

76,250

20,250

22,400

20,250

22,400

70,000

20,000

20,000

20,000

20,000

6,250

250

2,400

250

2,400

76,250

20,250

22,400

20,250

22,400

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 276

Appendix 2: Solutions to activities and sample examination questions

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. 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 account, 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 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 2007 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 Annuity – interest on opening value = £8,850 – £6,000 = £2,850 In each case the net current assets are arrived at by taking the initial working capital of £20,000 plus revenues, less operating expenses less, where appropriate, rental payments and interest; for Kiwi and Orange it is also net of £3,192 obligation under finance lease due within one year.

277

91 Financial reporting

Chapter 8 Sample examination question 8.1 Different methods of accounting for purchased goodwill: i. Keep goodwill on b/s unchanged (no amortisation and no impairment) - historical ii. Writing off goodwill directly to reserves in year of acquisition (not via income statement) – SSAP 2 iii. Writing off goodwill to the income statement in year of acquisition - SSAP 22 iv. Amortising goodwill over expected life - SSAP 22 / IAS 22 – IAS 38 v. Not amortise but check goodwill annually for impairment – IFRS 3 i. Wrong to keep purchased goodwill unchanged as its value will decline with time; value maybe sustained through investment, but this is ‘internally generated goodwill’, which is not allowed to be capitalised; most goodwill in industry will eventually deteriorate. ii. Loss of goodwill does not occur at acquisition but over a longer period; not following the matching concept. iii. Does have advantage over (ii) in showing a charge on P&L, but doesn’t follow matching concept of goodwill life expectancy. iv. Follows matching concept, but two problems - defining the life of goodwill (companies want longer life to minimise charge) and method of amortisation (reducing v straight line - follow patterns observed in industry). v. Income Statement approach will suggest expense charged over the life of the asset (i.e. depreciation/amortisation) but Balance Sheet approach suggests that expense only occurs when the asset has been impaired and no longer able to maintain previous output - matching concept not followed.

278

Appendix 2: Solutions to activities and sample examination questions

Chapter 9 Activity 9.2 part c FIFO Date

Purchases Units

Sales

Price Total (£)

1

100 10.00

1

100

9.80

14

20

20

100

100

100

9.60

9.40

9.40

Price Total (£)

100

10.00

1,000

100

9.80

980

20

10.00

200

100

9.80

980

20

9.80

196

20

9.80

196

50

9.60

480

20

9.80

196

50

9.60

480

20

9.80

196

50

9.60

480

100

9.40

940

80

9.40

752

80 10.00

800

20 10.00

200

80

784

9.80

940

940

90

350

Units

480

30

Total

Price Total(£)

980

80

50

Units

Closing inventory

1,000

10

15

Units

Cost of sales

3,400

270

20

9.80

196

50

9.60

480

20

9.40

188

270

2,648

80

752

279

91 Financial reporting

FIFO Date

Purchases Units

Sales

Price Total (£)

1

100 10.00

1

100

9.80

14

20

100

100

9.60

9.40

280

Price Total (£)

80

20

9.80

100

10.00

1,000

100

9.80

980

100

10.00

1,000

20

9.80

196

20

10.0

200

20

10.0

200

50

9.60

480

20

10.0

200

50

9.60

480

100

9.40

940

20

10.0

200

50

9.60

480

10

9.40

94

784

9.80

196

80 10.00

800

940

90

350

Units

480

30

Total

Price Total(£)

980

80

50

Units

Closing inventory

1,000

10

15

Units

Cost of sales

3,400

270

90

270

9.40

846

2,626

80

744

Appendix 2: Solutions to activities and sample examination questions

FIFO Date

Purchases Units

Sales

Price Total (£)

1

100 10.00

1

100

9.80

14

20

100

100

9.60

9.40

Price Total (£)

80 100

9.80 9.90

100

10.00

1,000

100

9.80

980

200

9.90

1,980

120

9.90

1,188

20

9.9

198

20

9.90

198

50

9.60

480

70

9.68

678

70

9.68

678

100

9.40

940

170

9.52

1,618

80

9.52

762

80

9.52

762

792 990

940

90 350

Units

480

30 Total

Price Total(£)

980

80

50

Units

Closing inventory

1,000

10

15

Units

Cost of sales

3,400

270

90 270

9.52 9.52

857 2,639

281

91 Financial reporting

Activity 9.3 a. £’000

£’000

Sales

3,000

Cost of sales Mined copper, 100,000 oz @ £42

4,200

Closing inventory, 40,000 oz @ £42

1,680

2,520 480

Administrative overheads

78

Delivery costs

42

120

Net profit

360

Closing inventory, as above, £1,680,000 Workings: Under SSAP 9 production overheads should be included in the valuation of inventory. Thus: Cost of inventory = direct cost Plus depletion of mine

£35 per ounce 630,000 100,000

Plus depreciation of mining equipment

£6.3 per ounce

70,000 100,000

£0.7 per ounce £42 per ounce

b. If the selling price fell to £42 per ounce the net realisable value, after providing for delivery cost, would be £41.30 per ounce. The balance sheet value for inventory would be £1,652,000 (since inventory is valued at the lower of cost and net realisable value). Income for the year would be: Net profit (as above)

360,000

Less difference between cost and NRV Cost

1,680,000

NRV

1,652,000

28,000 332,000

282

Appendix 2: Solutions to activities and sample examination questions

Activity 9.4 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

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

£600

(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 In inventories and work in progress: Construction contract cost Provision for loss

£400 £100 £100 —

The balance of the provision for losses will appear as: Provision for liabilities and charges

£300

283

91 Financial reporting

Sample examination question 9.1 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 amongst 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

£50

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: 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 cost carried forwards: 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 284

Appendix 2: Solutions to activities and sample examination questions

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’.

Chapter 10 Sample examination question 10.1 a. The rate of interest implicit in this financing arrangement is found by solving for r such that: 22,000 aØr+ 1,100,000 = 836,500 (l + r)5 It is found that r equals 8% per annum. The debt liability and finance charges will be analysed as follows: Year

Opening balance

Finance charge @ 8%

Payment made

Closing balance

(1)

(2) = ((1) × 8%)

(3)

(4) = (2) – (3) + (1)

31/12/2006

836,500

66,920

22,000

881,420

31/12/2007

881,420

70,514

22,000

929,934

31/12/2008

929,934

74,395

22,000

982,329

31/12/2009

982,329

78,586

22,000

1,038,915

31/12/2010

1,038,915

83,113

22,000

1,100,028

Rounding

(28)

(28)

373,500

1,100,000

IAS 39 (FRS 4) requires the net liability (column 4) (equal to ‘present value of debenture’) to be shown in the balance sheet. For example, for 2007 you could therefore directly compute: Opening balance:

£881,420

Interest accrued (8%):

£ 70,514 £951,934

Interest paid

£(22,000)

Closing balance

£929,934

b. See for instance the discussion in Macve (1984) and Draper et al. (1993). c. 31/12/09 Remaining payments @ new current yield of 10% 2009: 22,000 × 0.9091

= 20,000

2010: 1,122,000 × 0.8264

= 927,273

Loan balance: ‘Gain’

982,329 35,056

285

91 Financial reporting

If Gump bought in the debentures then it could show a gain of £35,056. However, if Gump has to raise fresh money to replace this loan, then to borrow £947,273 will cost 10% (e.g. this could be satisfied by committing to the same promise of future payment to debenture holders as at present, so there is no cash flow improvement (see Hicks)). d. Before IAS 39 (FRS 4) it would normally have been treated as an extraordinary item (as in the USA under SFAS 4). Under IAS 39 (FRS 4), it will normally be included in the income statement, possibly shown as exceptional if material. (Under the proposals discussed in the ASB’s November 1995 exposure draft of the Statement of Principles (but not picked up in the final statement, December 1999) and July 1996 discussion paper on Derivatives, it would be taken to the Statement of total recognised gains and losses.) Arguably there is no gain at all – see the discussion on Hicks measures of income in this subject guide.

Chapter 12 Sample examination question 12.1 The correct answer is the final statement. Although the quick ratio has decreased, we cannot identify the exact cause (or combination) without further information.

286

Appendix 3: Example of eight-column paper as provided in the examination

Appendix 2

Appendix 3: Example of eight-column accounting paper

291 287