ACCA P2 Revsion Pack June 2015

ACCA Paper P2 (International)

Corporate Reporting

Revision Pack June 2015

P 2 C O R P O R A T E R E P O R T I N G R E V IS I O N P A C K

© The Accountancy College Ltd All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of The Accountancy College Ltd.

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Must should could All these sequences are based on the following all taken from the revision kit:Q1 Q1 Q1 Q2

b/s i/s cfs Themed mix

Must Rose Marchant Angel Aron

Q3 Industry mix

Cate

Q4 current issues

Jones Whitebirk

Should Grange Ashanti Warrburt Norman Savage Verge Ethan High quality FI

Could Traveler Base Jocatt Panel Macaljoy Greenie Havana Transition Holcombe

But any question from q30 onwards is useful. The earlier questions are good, but your examiner is a forward thinking man, so earlier questions are often less useful.

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Four Day Revision Sequence These are the questions we will do together. Day

Subject

Kit Q

1

Financial instruments Pensions Group cfs Group B/S

44 24 77 Dec 2013 59

2(focus) 2(focus) 1(Groups) 1(Groups)

Aron Savage Angel Rose

2

Mixed Mixed Mixed Mixed

76 June 2013 69 52 84 June 2014

3(Mix) 3(Mix) 3(Mix) 3(Mix)

Verge Ethan Cate Aspire

3

SMEs Current issues Integrated reporting Current issues

58 Revision pack 16 Revision pack

4(Current) 4(Current) 4(Current) 4(Current)

Whitebirk Godzilla Jones GH Articles

4

Group B/S Groups B/S Group B/S

47 74 June 2013 87 Dec 2014

1(Groups) 1(Groups) 1(Groups)

Grange Traveller Joey

Standards Standards Standards Standards

Exam Q

Q Name

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Two Day Revision Sequence These are the questions we will do together. Day

Subject

Kit Q

Exam Q

Q Name

1

Financial instruments Pensions Group B/S Group cfs

43 12 58 77 Dec 2013

2(focus) 2(focus) 1(Groups) 1(Groups)

Aron Savage Rose Angel

2

Mixed Standards Mixed Standards Current issues Current issues

75 June 2013 68 June 2012 Revision pack Revision pack

3(Mix) 3(Mix) 4(Current) 4(Current)

Verge Ethan Godzilla GH Articles

Four evening online sequence These are the questions we will do together. Evening

Subject

Kit Q

Exam Q

Q Name

1

Financial instruments Pensions

43 12

2(focus) 2(focus)

Aron Savage

2

Group B/S Group cfs

58 77 Dec 2013

1(Groups) 1(Groups)

Rose Angel

3

Mixed Standards Mixed Standards

75 June 2013 68 June 2012

3(Mix) 3(Mix)

Verge Ethan

4

Current issues Current issues

Revision pack Revision pack

4(Current) 4(Current)

Godzilla GH Articles

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REVISION FOCUS The following revision sequence is comprehensive. The questions cover all the content. But as you are revising remember to go back to the class questions to ensure that the stuff you learnt in class is accessible to you in the exam. Then once you are comfortable with all the questions you have done with me, it is time to turn to the supplementary questions. The effect of this is that there are three bodies of questions with which you should be intimately familiar. In order of importance they are:(1)

the revision questions

(2)

the class questions

(3)

the supplementary questions.

Supplementary Questions The above revision sequence is intended to be largely comprehensive. In other words, there is little new to learn once you have repeated the above and the class questions until you know them. However, because I have done all the above for you first, if you limit yourself to the above then you will never have to think for yourself until you are in the exam. So, I suggest that all the more recent exam questions since December 2007 (question 30 in the kit) are all valid and will improve your chances of passing P2. It probably makes sense to work backwards from the more recent questions simply because of the examiners forward thinking brain being reflected in the exams the examiner sets. Also it probably makes sense to focus on the narrative questions from the B section as most students improve most noticeably in their narrative answers when they apply themselves to these questions as the exam approaches.

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RECENT EXAM CONTENT Q June 2011

Dec 2011

June 2012

Dec 2012

June 2013

Dec 2013

June 2014

Dec 2014

1 Rose

Traveler Straight b/s with segments and ethics

Minny B/S with lots of impairment

Trailer Complex b/s with lots and lots to do

Angel Accessible cfs with plenty to do and solid discussion on cash and ethics.

Marchant Challenging p/l very similar to earlier q Ashanti.

Joey Awkward b/s with sbp and ethics

2 Lockfine

Decany Horrid group restructure

Robby Group B/S with plenty going on, plus a difficult discussion of derecognitio n William Lovely mix of leases, pensions, sbp & provisions

Coate Messy mix with JV, intangibles and forex.

Verge Lovely mix question with segments revenue and other stuff

Havana Challenging mix question with leases revenue and other stuff.

Coatmin Challenging banking mix

3 Alexandra

Scramble Challenging mix with lots of intangibles

Ethan Technical mix of goodwill, dt, FVO and equity

Blackcutt Mix of nca with impairment, provisions and others.

Janne Good mix question with leasing FVM and other stuff

4 Grainger

Venue Lovely revenue developmen t

Royan Surprise subject of provisions

Jayach Lovely fvm.

Lizzer Solid current issues question on presentation and clutter

Bental Absolutely rock hard mix on debt reverse acquisitions and hedging!! Zack Solid current issues question on judgement and policies

Aspire Wide ranging mix question with a heavy slant towards currency. Minco Hard mix question with lots to talk about but getting really tough at end. Avco Good question on the mind bending problem of debt v equity.

Fairly straight b/s with a foreign sub and transfers

First time adoption

Classic mix question with usual suspects

Lovely FI question addressing IFRS9 and current issues

Kayte Challenging mix in shipping industry

Estoil Solid current issue on impairment

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EXAM TIPS The tips derived from the above are therefore as follows. Tips do not tend to change much from sitting to sitting because the same stuff stays current in the examiners mind for years. Use the above table to see if you agree with me. Maybe you have different gut feelings. Question

Top Tips

1 (groups) 2 (mix)

Position statement Cash flow statement Performance statement Usual suspects

3 (mix)

Usual suspects

4 (Current Issues)

Integrated reporting Equity accounting Framework & Sploci SMEs Leases Changes Groups (JA + Subs + Associates) Financial instrument impairment (see Q Grainger June 2011) Revenue (see Q Venue December 2011)

But watch out! All the above could be wrong. So make sure you go through all the revision questions, class questions and supplementary questions. Then you should still be fine.

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QUESTION SPOTTERS For those super obsessive question spotters amongst you, here is the full list of question one formats over recent years:Year

Sitting

Question

Subject

2014

D

Joey

b/s

2014

J

Marchant

i/s

2013

D

Angel

cfs

2013

J

Trailer

b/s

2012

D

Minny

b/s

2012

J

Robby

b/s

2011

D

Traveler

b/s

2011

J

Rose

b/s

2010

D

Jocatt

cfs

2010

J

Ashanti

i/s

2009

D

Grange

b/s

2009

J

Bravado

b/s

2008

D

Warrburt

cfs

2008

J

Ribby

b/s

2007

D

Beth

b/s

2007

J

Glove

b/s

2006

D

Andash

cfs

2006

J

Ejoy

i/s

2005

D

Lateral

b/s

2005

J

Jay

b/s

2004

D

AAP

cfs

2004

J

Memo

b/s

2003

D

Largo

b/s

2003

J

Base

i/s

Please feel free to make of that what you will!

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EXAM ADVICE Here is some very basic exam advice that despite its simplicity is often the difference between a pass and a fail: Question selection This is a tricky but important subject. The hardest question in the B section in recent past has been the mix question (also known as the industry question or the analysis question). So try and prepare yourself for all styles of question. Students during class tend to shy away from the current issues question because of its narrative content. But try to overcome this as this question is often the easiest on the paper. Reading time Use this to decide which questions to do and in which order. Then allocate your time on the question paper, so that you know to the very minute when your time is up on each question. Time Perhaps the most important advice of all is stick to the timings of questions. The examiner actively encourages markers to be very generous with weak answers and hard on excellent answers. This means if you have 8 out of 10, you are unlikely to persuade the marker to give away another mark. But in the first few lines of the next answer, the marker will be keen to give you marks. Completeness Closely related to the above is completeness. Make sure you answer 100 marks, especially those parts of the exam where you feel weak and know you are guessing. This leads to the next point. Write anything Obviously it is always best to write the correct answer. But if you really have no clue, write something anyway. Not only might you strike lucky and get the answer correct, you will also find markers are generous even when you are wrong. Requirements Really try to answer the requirements. A nice simple answer directly answering the question will always score higher than irrelevant technical wizardry. Write clearly The new online marking has many advantages, but one definite disadvantage is the quality of the image. Don’t worry, image quality is not bad. But it’s very definitely not the same as looking at the original scripts. This has no negative impact on clear scripts, but makes scribbled chaotic scrawl even harder to mark.

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Write big Another down side of online marking is the default image size. It’s about A5. That is, the scripts appear on the markers screens at half the original size that you see when you write the script on exam day. Markers can zoom in, but the functionality of this is jerky and so many markers like, where possible, to view a virtual page in its entirety. If you can make this possible for them, they will really appreciate it. You make this possible by writing big (and clear). Writing does not have to be enormous, but the classic 8 words per line looks just great on screen. Alternate lines This advice only applies to those who know they have a tendency to write small. If you are that student, then force yourself to write bigger by skipping every alternate line during your narrative answers. Number circles At the top of every page are the number circles. They are for you to communicate the question you are doing. Use the circles. Markers don’t want to guess which question you are answering. Question per page When starting a new question always start a new page. You can do this for each part of each question. I think this helps with clarity, but this is not vital. But every time you start a new question, you must start a new page. Blank pages The online system copes fine with blank pages. Try to keep them minimal, but use them if you find them useful. Continuity Once you start a question, try to finish it. Do the individual parts in any order. So for example, answering q3b followed by q3a followed by q3d followed by q3c is perfectly acceptable. But don’t throw q4a in the middle of that lot! Volume Write as much as you feel comfortable writing. Just make sure you answer all the questions in full and give the markers sufficient ideas to give you marks. Some students are unbelievably concise and score good marks in half a booklet (12 pages). Others need three booklets (24+6+6 pages). But if I can be so bold, I suggest you are looking to fill one booklet (24 pages). Balance Try to balance the effort to the number of marks. It is shocking to see the number of students who write twice as much for their 4 mark answer as they do for their 8 mark answer. Finally, good luck… Martin

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SMALL AND MEDIUM ENTITIES But another big political issue is the accounting for SMEs. It is widely accepted that IFRS are bulky and the presentation of fs using IFRS is a substantial bureaucratic burden. Large companies are big enough to shoulder this burden, but small and medium companies feel this expense disproportionately because of their size. So many countries have utilised a two tier accounting system widely called “big GAAP little GAAP” (generally accepted accounting principles). Each country has set a threshold above which companies are required to produce full fs using full IFRS (or equivalent) and below which companies are required to produce reduced fs with less disclosure. This makes SME accounting much cheaper in these countries. The IASB have until recently ignored this issue. However, following extreme pressure, they have reviewed the problem and a Standard has resulted. It proposes that all companies should be able to produce reduced fs, provided they are not public interest companies (that is, not quoted or offering financial services). So unless your company is quoted or offering financial services, then it is an SME and can produce reduced fs. However, the IFRS for SMEs has been widely criticised because the reduced fs are very little reduced from the full fs. This means that even if your company qualifies as SME, you will produce fs just as bulky as would have been required had your company failed to qualify.

Simplifications Some of the main simplification in the IFRS for SMEs are as follows:(1)

Goodwill recognition

Partial method recognition is required (see Basic Groups Chapter). (2)

Goodwill amortisation

Amortisation is required (over 10 years) to avoid the annual impairment test. (3)

PPE Model

Only the cost model is allowed. (4)

Investment Property Model

Only the fair value model is allowed. (5)

Borrowing Costs

The capitalisation of finance cost on PPE is not allowed. (6)

Development

Development is written off like research.

Article An article here written by the examiner gives more detail.

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ACOUNTING & BUSINESS The examiner writes monthly for A&B. articles.

Here is a selection of potentially relevant

For more articles by the examiner go to the ACCA CPD webpage and scroll down picking out the corporate reporting articles. Here is the link:http://www.accaglobal.com/gb/en/member/accounting-business/ab-cpd.html or just search “acca cpd”.

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INTEGRATED REPORTING Here is an article by Graham Holt. The International Integrated Reporting Council (IIRC) has recently released a framework for integrated reporting. This follows a three-month global consultation and trials in 25 countries. The framework establishes principles and concepts that govern the overall content of an integrated report. An integrated report sets out how the organisation's strategy, governance, performance and prospects lead to the creation of value. There is no benchmarking for the above matters and the report is aimed primarily at the private sector, but it could be adapted for public sector and not-for-profit organisations. The primary purpose of an integrated report is to explain to providers of financial capital how an organisation creates value over time. An integrated report benefits all stakeholders interested in a company's ability to create value, including employees, customers, suppliers, business partners, local communities, legislators, regulators and policymakers, although it is not directly aimed at all stakeholders. Providers of financial capital can have a significant effect on the capital allocation and attempting to aim the report at all stakeholders would be an impossible task and would reduce the focus and increase the length of the report. This would be contrary to the objectives of the report, which is value creation. Historical financial statements are essential in corporate reporting, particularly for compliance purposes, but do not provide meaningful information regarding business value. Users need a more forward-looking focus without the necessity of companies providing their own forecasts. Companies have recognised the benefits of showing a fuller picture of company value and a more holistic view of the organisation. The International Integrated Reporting Framework will encourage the preparation of a report that shows their performance against strategy, explains the various capitals used and affected, and gives a longer-term view of the organisation. The integrated report is creating the next generation of the annual report as it enables stakeholders to make a more informed assessment of the organisation and its prospects. CULTURE CHANGE The IIRC has set out a principle-based framework rather than specifying a detailed disclosure and measurement standard. This enables each company to set out its own report rather than adopt a checklist approach. The culture change should enable companies to communicate their value creation better than the often boilerplate disclosures under International Financial Reporting Standards (IFRS). The report acts as a platform to explain what creates the underlying value in a business and how management protects this value. This gives the report more business relevance than the compliance-led approach currently used. Integrated reporting will not replace other forms of reporting, but the vision is that preparers will pull together relevant information already produced to explain the key drivers of their business's value.

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Information will only be included in the report where it is material to the stakeholder's assessment of the business. There were concerns that the term 'materiality' had a certain legal connotation, with the result that some entities may feel they should include regulatory information in the integrated report. However, the IIRC concluded that the term should continue to be used in this context as it is well understood. The integrated report aims to provide an insight into the company's resources and relationships which are known as the capitals and how the company interacts with the external environment and the capitals to create value. These capitals can be financial, manufactured, intellectual, human, social and relationship, and natural capital, but companies need not adopt these classifications. The purpose of this framework is to establish principles and content that governs the report, and to explain the fundamental concepts that underpin them. The report should be concise, reliable and complete, including all material matters, both positive and negative, and presented in a balanced way without material error. KEY COMPONENTS Integrated reporting is built around the following key components: Organisational overview and the external environment under which it operates. Governance structure and how this supports its ability to create value. Business model. Risks and opportunities and how they are dealing with them and how they affect the company's ability to create value. Strategy and resource allocation. Performance and achievement of strategic objectives for the period and outcomes. Outlook and challenges facing the company and their implications. The basis of presentation needs to be determined, including what matters are to be included in the integrated report and how the elements are quantified or evaluated. The framework does not require discrete sections to be compiled in the report, but there should be a high-level review to ensure that all relevant aspects are included. The linkage across the above content can create a key storyline and can determine the major elements of the report, such that the information relevant to each company would be different. An integrated report should provide insight into the nature and quality of the organisation's relationships with its key stakeholders, including how and to what extent the organisation understands, takes into account and responds to their needs and interests. Furthermore, the report should be consistent over time to enable comparison with other entities. An integrated report may be prepared in response to existing compliance requirements; for example, a management commentary. Where that report is also prepared according to the framework or even beyond the framework, it can be considered an integrated report. An integrated report may be either a standalone report or be included as a distinguishable part of another report or communication. For example, it can be included in the company's financial statements.

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NATURE OF VALUE The IIRC considered the nature of value and value creation. These terms can include the total of all the capitals, the benefit captured by the company, the market value or cashflows of the organisation, and the successful achievement of the company's objectives. However, the conclusion reached was that the framework should not define value from any one particular perspective, because value depends upon the individual company's own perspective. It can be shown through movement of capital and can be defined as value created for the company or for others. An integrated report should not attempt to quantify value, as assessments of value are left to those using the report. Many respondents felt that there should be a requirement for a statement from those 'charged with governance' acknowledging their responsibility for the integrated report in order to ensure the reliability and credibility of the integrated report. Additionally it would increase the accountability for the content of the report. The IIRC feels that the inclusion of such a statement may result in additional liability concerns, such as inconsistency with regulatory requirements in certain jurisdictions and could lead to a higher level of legal liability. The IIRC also felt that the above issues might result in a slower take-up of the report and decided that those 'charged with governance' should, in time, be required to acknowledge their responsibility for the integrated report, while at the same time recognising that reports in which they were not involved would lack credibility. There has been discussion about whether the framework constitutes suitable criteria for report preparation and for assurance. The questions asked concerned measurement standards to be used for the information reported and how a preparer can ascertain the completeness of the report. FUTURE DISCLOSURES There were concerns over the ability to assess future disclosures, and recommendations were made that specific criteria should be used for measurement, the range of outcomes and the need for any confidence intervals to be disclosed. The preparation of an integrated report requires judgment, but there is a requirement for the report to describe its basis of preparation and presentation, including the significant frameworks and methods used to quantify or evaluate material matters. Also included is the disclosure of a summary of how the company determined the materiality limits and a description of the reporting boundaries. The IIRC has stated that the prescription of specific key KPIs (key performance indicators) and measurement methods is beyond the scope of a principles-based framework. The framework contains information on the principle-based approach and indicates that there is a need to include quantitative indicators whenever practicable and possible. Additionally, consistency of measurement methods across different reports is of paramount importance. There is outline guidance on the selection of suitable quantitative indicators.

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A company should consider how to describe the disclosures without causing a significant loss of competitive advantage. The entity will consider what advantage a competitor could actually gain from information in the integrated report, and will balance this against the need for disclosure. Companies struggle to communicate value through traditional reporting. The framework can prove an effective tool for businesses looking to shift their reporting focus from annual financial performance to long-term shareholder value creation. The framework will be attractive to companies who wish to develop their narrative reporting around the business model to explain how the business has been developed.

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EQUITY ACCOUNTING Here is another article by Graham Holt

With IAS 28 now in force, it’s a good time to consider how it affects you. But be prepared – not everything in the standard is as cut and dried as might be hoped, says Graham Holt In May 2011, the International Accounting Standards Board (IASB) issued a new version of IAS 28, Investments in Associates and Joint Ventures, that requires both joint ventures and associates to be equity-accounted. The standard is effective from 1 January 2013 and entities need to be aware of its implications, although the EU has endorsed IAS 28 from 1 January 2014. An associate is an entity in which the investor has significant influence, but which is neither a subsidiary nor a joint venture of the investor. 'Significant influence' is the power to participate in the financial and operating policy decisions of the investee, but not to control those policy decisions. It is presumed to exist when the investor holds at least 20% of the investee's voting power. If the holding is less than 20%, the entity will be presumed not to have significant influence unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not preclude an entity from having significant influence. Loss of influence An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels. A joint venture is defined as a joint arrangement where the parties in joint control have rights to the net assets of the joint arrangement. Associates and joint ventures are accounted for using the equity method unless they meet the criteria to be classified as 'held for sale' under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations. On initial recognition, the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor's share of the profit or loss of the investee after the date of acquisition. IFRS 9, Financial Instruments, does not apply to interests in associates and joint ventures that are accounted for using the equity method. Instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9 unless they currently give access to the returns associated with an ownership interest in an associate or a joint venture. An entity's interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and, generally, does not reflect the possible exercise or conversion of potential voting rights.

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Investments in associates or joint ventures are classified as non-current assets inclusive of goodwill on acquisition and presented as one-line items in the statement of financial position. The investment is tested for impairment in accordance with IAS 36, Impairment of Assets, as single assets, if there are impairment indicators under IAS 39, Financial Instruments: Recognition and Measurement. The entire carrying amount of the investment is tested for impairment as a single asset - that is, goodwill is not tested separately. The recoverable amount of an investment in an associate is assessed for each individual associate or joint venture, unless the associate or joint venture does not generate cashflows independently. IFRS 5 applies to associates and joint ventures that meet the classification criteria. Any portion of the investment that has not been classified as held for sale is still equity-accounted until the disposal. After disposal, if the retained interest continues to be an associate or joint venture, it is equity-accounted. Under the previous version of the standard, the cessation of significant interest or joint control triggered remeasurement of any retained investment even where significant influence was succeeded by joint control. IAS 28 now requires that any retained interest is not remeasured. If an entity's interest in an associate or joint venture is reduced but the equity method continues to be applied, then the entity reclassifies to profit or loss the proportion of the gain or loss previously recognised in other comprehensive income relative to that reduction in ownership interest. Consolidation parallels The IASB states that many of the procedures appropriate for equity accounting are similar to those for consolidation of entities and the concepts used in accounting for the acquisition of a subsidiary are also applicable to the acquisition of an associate or joint venture. However, it is not always appropriate to apply IFRS 10, Consolidated Financial Statements, or IFRS 3, Business Combinations. There is disagreement over whether equity accounting is a one-line consolidation or a valuation approach. When an associate is impairment-tested, it is treated as a single asset and not as a collection of assets as would be the case under acquisition accounting. Additionally as associates and joint ventures are not part of the group, not all of the consolidation principles will apply in the context of equity accounting. There is no definition of the cost of an associate or joint venture in IAS 28. There is debate over whether costs should be defined as including the purchase price and other costs directly attributable to the acquisition such as professional fees and other transaction costs. It might be appropriate to include transaction costs in the initial cost of an equity-accounted investment, but IFRS 3 would require these to be expensed if they relate to the acquisition of businesses. IFRS 9 includes directly attributable transaction costs in the initial value of the investment.

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IAS 28 states that profits and losses resulting from 'upstream' and 'downstream' transactions between an investor (including its consolidated subsidiaries) and an associate or joint venture are recognised only to the extent of the unrelated investors' interests in the associate or joint venture. Upstream transactions are sales of assets from an associate to the investor and downstream transactions are sales of assets by the investor to the associate. Elimination There is no specific guidance on how the elimination should be carried out but generally in the case of downstream transactions any unrealised gains should be eliminated against the carrying value of the associate. In the case of upstream transactions any unrealised gains could be eliminated either against the carrying value of the associate or against the asset transferred. The standards are currently unclear on whether this elimination also applies to unrealised gains and losses arising on transfer of subsidiaries, joint ventures and associates. An example would be where an investor sells its subsidiary to its associate and the question would be whether part of the gain on the transaction should be eliminated. There is an inconsistency between guidance dealing with the loss of control of a subsidiary and the restrictions on recognising gains and losses arising from sales of non-monetary assets to an associate or a joint venture. IFRS 10 requires recognition of both the realised gain on disposal and the unrealised holding gain on the retained interest. In contrast, IAS 28 requires gains or losses on the sale of a non-monetary asset to an associate or a joint venture to be recognised only to the extent of the other party's interest. The IASB accordingly issued an exposure draft in December 2012 stating that any gain or loss resulting from the sale of an asset that does not constitute a business between an investor and its associate or joint venture should be partially recognised. However, any gain or loss arising from the sale of an asset that does constitute a business between an investor and its associate or joint venture should be fully recognised. IFRS 3 defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return directly to investors or other owners, members or participants. Under the equity method, the investment is initially recognised at cost and adjusted to recognise the investor's share of the profit or loss and other comprehensive income (OCI) of the investee. Additionally, the investment is reduced by distributions received from the invest. However, IAS 28 is silent on how to treat other changes in the net assets of the investee in the investor's accounts, which might include:  issues of additional share capital to parties other than the investor;  buybacks of equity instruments from shareholders other than the investor;  writing of a put option over the investee's own equity instruments to other shareholders;  purchase or sale of non-controlling interests in the investee's subsidiaries'  equity-settled share-based payments.

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Inconsistent The IASB proposed in an exposure draft issued in November 2012 that an investor's share of certain net asset changes in the investee should be recognised in the investor's equity. The draft contains an alternative view by one board member who believes the amendment to be inconsistent with the concepts of IAS 1 and IFRS 10, and would cause serious conceptual confusion. This board member believes this short-term solution would not improve financial reporting and would undermine a basic concept of consolidated financial statements. The draft notes that an investor may discontinue the use of the equity method for various reasons including where the investment in the investee becomes a subsidiary or a financial asset. The draft proposes that an investor should reclassify to profit or loss the cumulative amount of other net asset changes previously recognised in the investor's equity when an investor discontinues the use of the equity method for any reason.

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REALIGNING THE FRAMEWORK By Graham Holt

Graham Holt examines the discussion paper on the conceptual framework for financial reporting issued by the IASB in July In July 2013 the International Accounting Standards Board (IASB) issued a discussion paper on a new version of its conceptual framework, which provides the fundamental basis for development of International Financial Reporting Standards (IFRS). The discussion paper gives users and preparers of financial statements an opportunity to offer input into the direction of financial reporting standards. The paper sets out the fundamental principles of accounting necessary to develop robust and consistent standards. While it lacks the immediacy of other IASB proposals, it will nevertheless be a significant long-term influence on the direction that accounting standards will take. The paper introduces revised thinking on the reporting of financial performance, the measurement of assets and liabilities, and presentation and disclosure. The paper proposes that the primary purpose of the framework - which underpins the accounting standards - is to identify consistent principles that the IASB can use in developing and revising those standards. The framework may also help in understanding and interpreting the standards. The IASB framework was originally published in the late 1980s. In 2010 two chapters of a new framework were issued: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. There are no plans for a fundamental reconsideration of these chapters. The concept of a reporting entity is not considered in the discussion paper because the exposure draft of 2010 is to be used, with related feedback, in developing guidance in this area. The discussion paper proposes to redefine assets and liabilities as: An asset is a present economic resource controlled by the entity because of past events. A liability is a present obligation of the entity to transfer an economic resource because of past events. An 'economic resource', it should be noted, is a right, or other source of value, that is capable of producing economic benefits. Currently the definitions of assets and liabilities require a probable expectation of future economic benefits or resource outflow. The IASB's initial view is that the definitions of assets and liabilities should not require an expected or probable inflow or outflow as it should be sufficient that a resource or obligation can produce or result in a transfer of economic benefits. Thus, a guarantee could qualify as a liability even though the obligation to transfer resources is conditional. However, the measurement of an asset or liability will be affected by the potential outcome. The IASB still believes that a liability should not be defined as limited to obligations that are enforceable against the entity.

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Under the discussion paper, constructive obligations would qualify as liabilities. Liabilities would not arise where there is an economic necessity to transfer an economic resource unless there is an obligation to do so. Thus a group reconstruction would not necessarily create a liability. However, the IASB believes that certain avoidable obligations could qualify as a liability - for example, directors' bonuses depending on employment conditions. No decision has been made on whether the definition of a liability should be limited to obligations that the entity has no practical ability to avoid or should include conditional obligations resulting from past events. The discussion paper sets out that the framework's definition of control should be in line with its definition of an asset. An entity controls an economic resource if it has the present ability to direct the resource's use so as to obtain economic benefits from it. The exposure draft on revenue recognition uses the phrase 'substantially all' when referring to benefits from the asset but the IASB feels this phrase in this context would be confusing as an entity would recognise only the rights which it controls. For example, if an entity has the right to use machinery on one working day per week, then it should recognise 20% of the economic benefits (assuming a five-day working week) as it does not have all or substantially all of the economic benefits of the machinery. The discussion paper proposes that equity remain defined as being equal to assets less liabilities. However, the paper does propose that an entity be required to present a detailed statement of changes in equity that provides more information regarding different classes of equity, and the transfers between these different classes. The distinction between equity and liabilities focuses on the definition of a liability. The current guidance on the difference between equity and liability is complicated. The paper identifies two types of approach: narrow equity and strict obligation. The narrow equity approach treats equity as being only the residual class issued, with changes in the measurement of other equity claims recognised in profit or loss. Under the strict obligation approach, all equity claims are classified as equity with obligations to deliver cash or assets being classified as liabilities. Any changes in the measurement of equity claims would be shown in the statement of changes in equity. If the latter approach were adopted, certain transactions (eg the issuance of a variable number of equity shares worth a fixed monetary amount) currently classed as liabilities would not be so designated because they do not involve an obligation to transfer cash or assets. The IASB has come to the view that the objective of measurement is to contribute to the faithful representation of relevant information about the resources of the entity, claims against the entity and changes in resources and claims, and about how efficiently and effectively the entity's management and governing board have discharged their responsibilities to use the entity's resources. The IASB believes that a single measurement basis may not provide the most relevant information for users.

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When selecting the measurement basis, the information that measurement will produce in both the statement of financial position and the statement of profit or loss and other comprehensive income (OCI) should be considered. Further, the selection of a measurement of a particular asset or a particular liability should depend on how that asset contributes to the entity's future cashflows and how the entity will settle or fulfil that liability. NARROW AND BROAD The current framework does not contain principles to determine the items to be recognised in profit or loss, and in OCI and whether, and when, items can be recycled from OCI to profit or loss. In terms of what items would be included in OCI, the paper proposes two approaches: 'narrow' and 'broad'. Under the narrow approach, OCI would include bridging items and mismatched remeasurements. OCI would be used to bridge a measurement difference between the statement of financial position and the statement of profit or loss. This would include, for example, investments in financial instruments with profit or losses reported through OCI. Mismatched remeasurements occur when the item of income or expense represents the effects of part of a linked set of assets, liabilities or past or planned transactions. It represents their effect so incompletely that, in the opinion of the IASB, the item provides little relevant information about the return the entity has made on its economic resources in the period. An example is a cashflow hedge where fair value gains and losses are deferred in OCI until the hedged transaction affects profit or loss. The paper suggests that under the narrow OCI approach, an entity should subsequently have to recycle amounts from OCI to profit or loss; and under the mismatched remeasurements approach the amount should be recycled when the item can be presented with the matched item. The issue that arises here is that, under the narrow approach, the treatment of certain items would be inconsistent with current IFRS - eg revaluation gains and losses for property, plant and equipment. The paper also sets out a third category - 'transitory remeasurements'. These are remeasurements of long-term assets and liabilities that are likely to reverse or significantly change over time. These items would be shown in OCI - for example, the remeasurement of a net defined pension benefit liability or asset. The IASB would decide in each IFRS whether a transitory remeasurement should be subsequently recycled. However, the IASB has not yet determined which approach it will use.

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RECOGNITION Recognition and derecognition deals with the principles and criteria for assets and liabilities to be included or removed from an entity's financial statements. The paper sets out to bring this into line with the principles used in IASB's current projects. It proposes that assets and liabilities should be recognised by an entity, unless that results in irrelevant information, the costs outweigh the benefits, or the measure of information does not represent the transaction faithfully enough. Derecognition is not currently addressed in the framework and the paper proposes derecognition should occur when the recognition criteria are no longer met. The question for the IASB is whether to replace the current concept based on the loss of the economic risks and benefits of the asset with the concept based on the loss of control over the legal rights comprised in the asset. A concept based on control over the legal rights could result in several items going off balance sheet. Proposed revisions to the disclosure framework include the objective of the primary financial statements, the objective of the notes to the financial statements, materiality and communication principles. The IASB has also identified both shortterm and long-term steps for addressing disclosure requirements in existing IFRS. These proposals are an attempt to make the conceptual framework a blueprint for developing consistent, high-quality, principles-based accounting standards. It is important that there is dialogue about the whole of IFRS and for the IASB to achieve buy-in to its core principles by enabling constituents to help shape the future of IFRS.

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SPLOCI This is essentially an extension of the framework article by Graham Holt

The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an entity's financial performance in a way that is useful to a wide range of users so they may attempt to assess the future net cash inflows of an entity. The statement should be classified and aggregated in a manner that makes it understandable and comparable. International Financial Reporting Standards (IFRS) currently require that the statement be presented as either one statement, being a combined statement of profit or loss and other comprehensive income, or two statements, being the statement of profit or loss and the statement of other comprehensive income. An entity has to show separately in OCI, those items which would be reclassified (recycled) to profit or loss and those items which would never be reclassified (recycled) to profit or loss. The related tax effects have to be allocated to these sections. Profit or loss includes all items of income or expense (including reclassification adjustments) except those items of income or expense that are recognised in OCI as required or permitted by IFRS. Reclassification adjustments are amounts recycled to profit or loss in the current period that were recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cashflow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits. However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified. A common misunderstanding is that the distinction is based on realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual level since the International Accounting Standards Board (IASB) is finding it difficult to find a sound conceptual basis. However, there is urgent need for some guidance around this issue. Opinions vary, but there is a feeling that OCI has become a 'dumping ground' for anything controversial because of a lack of clear definition of what should be included in the statement. Many users are thought to ignore OCI as the changes reported are not caused by the operating flows used for predictive purposes.

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Financial performance is not defined in the Conceptual Framework, but could be viewed as reflecting the value the entity has generated in the period and this can be assessed from other elements of the financial statements and not just the statement of comprehensive income. Examples would be the statement of cashflows and disclosures relating to operating segments. The presentation in profit or loss and OCI should allow a user to depict financial performance, including the amount, timing and uncertainty of the entity's future net cash inflows and how efficiently and effectively the entity's management have discharged their duties regarding the resources of the entity. There are several arguments for and against reclassification. If reclassification ceased, there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRSs. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS permits similar items to be recognised in either profit or loss or OCI. Those against reclassification argue that the recycled amounts add to the complexity of financial reporting, may lead to earnings management, and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period. The original logic for OCI was that it kept income-relevant items that possessed low reliability from contaminating the earnings number. Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of net income. The use of OCI as a temporary holding for cashflow hedging instruments and foreign currency translation is non-controversial. However, other treatments such as the policy of IFRS 9 to allow value changes in equity investments to go through OCI, are not accepted universally. US GAAP will require value changes in all equity investments to go through profit or loss. Accounting for actuarial gains and losses on defined benefit schemes are presented through OCI and certain large US corporations have been hit hard with the losses incurred on these schemes. The presentation of these items in OCI would have made no difference to the ultimate settled liability, but if they had been presented in profit or loss the problem may have been dealt with earlier. An assumption that an unrealised loss has little effect on the business is an incorrect one. The discussion paper on the Conceptual Framework considers three approaches to profit or loss and reclassification. The first approach prohibits reclassification. The other approaches, the narrow and broad approaches, require or permit reclassification. The narrow approach allows recognition in OCI for bridging items or mismatched remeasurements, while the broad approach has an additional category of 'transitory measurements' (for example, remeasurement of a defined benefit obligation), which would allow the IASB greater flexibility. The narrow approach significantly restricts the types of items that would be eligible to be presented in OCI and gives the IASB little discretion when developing or amending IFRSs.

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A bridging item arises where the IASB determines that the statement of comprehensive income would communicate more relevant information about financial performance if profit or loss reflected a different measurement basis from that reflected in the statement of financial position. For example, if a debt instrument is measured at fair value in the statement of financial position, but is recognised in profit or loss using amortised cost, then amounts previously reported in OCI should be reclassified into profit or loss on impairment or disposal of the debt instrument. The IASB argues that this is consistent with the amounts that would be recognised in profit or loss if the debt instrument were to be measured at amortised cost. A mismatched remeasurement arises where an item of income or expense represents an economic phenomenon so incompletely that presenting that item in profit or loss would provide information that has little relevance in assessing the entity's financial performance. An example of this is when a derivative is used to hedge a forecast transaction; changes in the fair value of the derivative may arise before the income or expense resulting from the forecast transaction. The argument is that before the results of the derivative and the hedged item can be matched together, any gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective and qualifies for hedge accounting, should be reported in OCI. Subsequently those gains or losses are reclassified into profit or loss when the forecast transaction affects profit or loss. This allows users to see the results of the hedging relationship. The IASB's preliminary view is that any requirement to present a profit or loss total or subtotal could also result in some items being reclassified. The commonly suggested attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the short/long-term or outside management control) are difficult to distil into a set of principles. Therefore, the IASB is suggesting two broad principles, namely: Profit or loss provides the primary source of information about the return an entity has made on its economic resources in a period. To support profit or loss, OCI should only be used if it makes profit or loss more relevant. The IASB feels that changes in cost-based measures and gains or losses resulting from initial recognition should not be presented in OCI and that the results of transactions, consumption and impairments of assets and fulfilment of liabilities should be recognised in profit or loss in the period in which they occur. As a performance measure, profit or loss is more used, although there are a number of other performance measures derived from the statement of profit or loss and OCI.

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IFRS FOR SMES Here is an article by Graham Holt.

The principal aim when developing accounting standards for small- to medium-sized enterprises (SMEs) is to provide a framework that generates relevant, reliable and useful information, which should provide a high-quality and understandable set of accounting standards suitable for SMEs. In July, the International Accounting Standards Board (IASB) issued IFRS for Small and Medium-Sized Entities (IFRS for SMEs). This standard provides an alternative framework that can be applied by eligible entities in place of the full set of International Financial Reporting Standards (IFRS). IFRS for SMEs is a self-contained standard, incorporating accounting principles based on existing IFRS, which have been simplified to suit the entities that fall within its scope. There are a number of accounting practices and disclosures that may not provide useful information for the users of SME financial statements. As a result, the standard does not address the following topics: Earnings per share Interim financial reporting Segment reporting Insurance (because entities that issue insurance contracts are not eligible to use the standard) Assets held for sale. In addition, there are certain accounting treatments that are not allowable under the standard. Examples are the revaluation model for property, plant and equipment and intangible assets, and proportionate consolidation for investments in jointly controlled entities. Generally, there are simpler methods of accounting available to SMEs than the disallowed accounting practices. The standard also eliminates the 'available-for-sale' and 'held-to maturity' classifications of IAS 39, Financial Instruments: Recognition and Measurement. All financial instruments are measured at amortised cost using the effective interest method, except that investments in non-convertible and non-puttable ordinary and preference shares that are publicly traded, or whose fair value can otherwise be measured reliably, are measured at fair value through profit or loss. All amortised cost instruments must be tested for impairment. At the same time, the standard simplifies the hedge accounting and derecognition requirements. However, SMEs can also choose to apply IAS 39 in full.

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The standard also contains a section on transition, which allows all of the exemptions in IFRS 1, First-Time Adoption of International Financial Reporting Standards. It also contains 'impracticability' exemptions for comparative information and the restatement of the opening statement of financial position. As a result of the above, IFRS require SMEs to comply with less than 10% of the volume of accounting requirements applicable to listed companies. What is an SME? There is no universally agreed definition of an SME. No single definition can capture all the dimensions of a small- or medium-sized enterprise, nor can it be expected to reflect the differences between firms, sectors, or countries at different levels of development. Most definitions based on size use measures such as number of employees, balance sheet total, or annual turnover. However, none of these measures apply well across national borders. IFRS for SMEs is intended for use by entities that have no public accountability (ie, their debt or equity instruments are not publicly traded). Ultimately, the decision regarding which entities should use IFRS for SMEs stays with national regulatory authorities and standard-setters. These bodies will often specify more detailed eligibility criteria. If an entity opts to use IFRS for SMEs, it must follow the standard in its entirety – it cannot cherry pick between the requirements of IFRS for SMEs and the full set. The IASB makes it clear that the prime users of IFRS are the capital markets. This means that IFRS are primarily designed for quoted companies and not SMEs. The vast majority of the world's companies are small and privately owned, and it could be argued that full International Financial Reporting Standards are not relevant to their needs or to their users. It is often thought that small business managers perceive the cost of compliance with accounting standards to be greater than their benefit. Because of this, the IFRS for SMEs makes numerous simplifications to the recognition, measurement and disclosure requirements in full IFRS. Examples of these simplifications are: Goodwill and other indefinite-life intangibles are amortised over their useful lives, but if useful life cannot be reliably estimated, then 10 years. A simplified calculation is allowed if measurement of defined benefit pension plan obligations (under the projected unit credit method) involve undue cost or effort. The cost model is permitted for investments in associates and joint ventures. The main argument for separate SME accounting standards is the undue cost burden of reporting, which is proportionately heavier for smaller firms. The cost of applying the full set of IFRS may simply not be justified on the basis of user needs. Further, much of the current reporting framework is based on the needs of large business, so SMEs perceive that the full statutory financial statements are less relevant to the users of SME accounts. SMEs also use financial statements for a narrower range of decisions, as they have less complex transactions and therefore less need for a sophisticated analysis of financial statements. Therefore, the disclosure requirements in the IFRS for SMEs are also substantially reduced.

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Differing approaches Those who argue against different reporting requirements for SMEs say the system could lead to a two-tier system of reporting. Entities should not be subject to different rules, which could give rise to different 'true and fair views'. There were a number of approaches that could have been taken to developing standards for SMEs. An alternative could have been for generally accepted accounting principles for SMEs to have been developed on a national basis, with IFRS focusing on accounting for listed company activities. However, the main issue here would be that the practices developed for SMEs may not have been consistent and may have lacked comparability across national boundaries. Also, if an SME wished to later list its shares on a capital market, the transition to IFRS could be harder. Under another approach, the exemptions given to smaller entities would have been prescribed in the mainstream accounting standard. For example, an appendix could have been included within the standard, detailing those exemptions given to smaller enterprises. Yet another approach would have been to introduce a separate standard comprising all the issues addressed in IFRS that were relevant to SMEs. As it stands IFRS for SMEs is a self-contained set of accounting principles, based on full IFRS, but simplified so that they are suitable for SMEs. The standard has been organised by topic with the intention that the standard is user-friendlier for preparers and users of SME financial statements. IFRS for SMEs and full IFRS are separate and distinct frameworks. Therefore, the standard for SMEs is by nature not an independently developed set of standards. It is based on recognised concepts and pervasive principles and it allows easier transition to full IFRS if the SME later becomes a public listed entity. In deciding on the modifications to make to IFRS, the needs of the users have been taken into account, as well as the costs and other burdens imposed upon SMEs by the IFRS. Relaxation of some of the measurement and recognition criteria in IFRS had to be made in order to achieve the reduction in these costs and burdens. Some disclosure requirements are intended to meet the needs of listed entities, or to assist users in making forecasts of the future. Users of financial statements of SMEs often do not make these kinds of forecasts. Small companies pursue different strategies, and their goals are more likely to be survival and stability rather than growth and profit maximisation. The stewardship function is often absent in small companies, with the accounts playing an agency role between the owner-manager and the bank. Where financial statements are prepared using the standard, the basis of presentation note and the auditor's report will refer to compliance with IFRS for SMEs. This reference may improve SME's access to capital. The standard also contains simplified language and explanations of the standards.

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The IASB has not set an effective date for the standard because the decision as to whether to adopt IFRS for SMEs is a matter for each jurisdiction. In the absence of specific guidance on a particular subject, an SME may, but is not required to, consider the requirements and guidance in full IFRS dealing with similar issues. The IASB has produced full implementation guidance for SMEs. IFRS for SMEs is a response to international demand from developed and emerging economies for a rigorous and common set of accounting standards for smaller and medium-sized enterprises that is much easier to use than the full set of IFRS. It should provide improved comparability for users of accounts while enhancing the overall confidence in the accounts of SMEs, and reduce the significant costs involved in maintaining standards on a national basis.

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LEASES As we wait for a definitive leasing standard, Graham Holt explores the original 2013 exposure draft and the current state of play

Leasing is an important activity for many organisations with the majority of leases not currently reported on a lessee’s statement of financial position. The existing accounting models for leases require lessees and lessors to classify their leases as either finance leases or operating leases and to account for those leases differently. The existing standards have been criticised for failing to meet the needs of users of financial statements because they do not always provide a faithful representation of leasing transactions. The exposure draft (ED), Leases (May 2013), attempted to solve the lease accounting problem by requiring an entity to classify leases into two types – type A and type B – and recognise both types on the statement of financial position. The ED was the result of a joint project by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Boards (FASB) (the boards).This article sets out the current deliberations of the boards as at the end of 2014 and, therefore, as such, the final leasing standard may vary from the discussions below. The ED sets out that type A leases would normally mean that the underlying asset is not property, while type B leases mean that the underlying asset is property. However, the entity classifies a lease other than a property lease as type B if the lease term is for an insignificant part of the total economic life of the asset; or the present value of the lease payments is insignificant relative to the fair value of the underlying asset at the lease’s commencement date. Conversely, the entity classifies a property lease as type A if the lease term is for the major part of the remaining economic life of the underlying asset; or the present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date. At this date, the lessee discounts the lease payments using the rate the lessor charges the lessee, or if that rate is unavailable, the lessee’s incremental borrowing rate. The lessee recognises the present value of lease payments as a liability. At the same time it recognises a right-of-use (ROU) asset equal to the lease liability, plus any lease payments made to the lessor at or before the commencement date, less any lease incentives received from the lessor; and any initial direct costs incurred by the lessee. After the commencement date, the liability is increased by the unwinding of interest and reduced by lease payments made to the lessor. A lessee will recognise in profit or loss, for type A leases, the unwinding of the discount on the lease liability as interest and the amortisation of the ROU asset and, for type B leases, the lease payments will be recognised in profit or loss on a straight-line basis over the lease term and reflected in profit or loss as a single lease cost. Following the feedback received on the ED, the FASB still remains supportive of the dual-model approach to bringing leases on to the statement of financial position.

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Under this approach, a lessee would account for most existing finance leases as type A leases and most existing operating leases as type B leases. Both type A and B leases result in the lessee recognising a ROU asset and a lease liability. However, the IASB has stated that feedback on the 2013 ED indicates that the dual model is too complex and, therefore, has opted currently for a single lessee model that is ‘easy to understand’. The IASB decided on a single approach for lessee accounting where a lessee would account for all leases as type A leases. The boards decided that a lessor should determine lease classification (type A or type B) on the basis of whether the lease is effectively a financing or a sale, rather than an operating lease. A lessor would make that determination by assessing whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset. A lessor will be required to apply an approach substantially equivalent to existing International Financial Reporting Standards (IFRS) finance lease accounting to all type A leases. A lease is currently defined by the boards as ‘a contract that conveys the right to use an asset for a period of time in exchange for consideration’. An entity would determine whether a contract contains a lease by assessing whether the use of the asset is either explicitly or implicitly specified and the customer controls the use of the asset. The definition of a lease does not require the customer to have the ability to derive the benefits from directing the use of an asset. The boards have decided that the leases guidance should not include specific requirements on materiality and retain the recognition and measurement exemption for a lessee’s short-term leases (12 months or less) with the IASB specifically favouring a similar exemption for leases of small assets for lessees. The boards have decided that, when determining the lease term, an entity should consider all relevant factors that may affect the decision to extend, or not to terminate, a lease. The lease term should only be reassessed when a significant event occurs or there is a significant change in circumstances that are within the control of the lessee. A lessor should not be required to reassess the lease term. Only variable lease payments that depend on an index or a rate should be included in the initial measurement of leases and the IASB has determined that reassessment of variable lease payments would only occur when the lessee remeasures the lease liability for other reasons. A lessor will not be required to reassess variable lease payments that depend on an index or a rate. The definition of the discount rate remains unchanged as the rate implicit in the lease, as does the requirement for a lessee to reassess the discount rate only when there is a change to either the lease term or the assessment of whether the lessee is (or is not) reasonably certain to exercise an option to purchase the asset. A lease modification for both a lessee and a lessor should be accounted for as a new lease, separate from the original lease, when: the lease grants the lessee an additional right-of-use not included in the original lease, and the additional right-of-use is priced commensurate with its standalone price in the context of that particular contract.

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In terms of the initial direct costs for both lessors and lessees, they should include only incremental costs that would not have incurred if the lease had not been executed. These include commissions or payments made to existing tenants to obtain the lease. A lessor in a type A lease should include initial direct costs in the initial measurement of the lease receivable and they should be taken into account in determining the rate implicit in the lease. A lessor in a type A lease who recognises selling profit at lease commencement should recognise initial direct costs as an expense. A lessor in a type B lease should expense such costs over the lease term on the same basis as lease income. A lessee should include initial direct costs in the initial measurement of the right-ofuse asset and amortise those costs over the lease term. The guidance in the ED has been retained for sale and leaseback transactions with a sale having to meet the requirements of a sale as set out in IFRS 15. A buyerlessor should account for the purchase of the underlying asset consistent with the guidance that would apply to the purchase of any non-financial asset. This article sets out the deliberations of the IASB/FASB as regards lease accounting at the end of December 2014. The IFRS is due for publication in 2015, but it seems that the FASB and IASB will have differing views on several recognition and measurement issues when the IFRS is finally published. There may yet however be further changes of opinion. Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School The FASB reThe FASB remains supportive of the dual-model approach to bringing leases on to the statement of financial position mains supportive of the dual-model approach to bringing leases on to the statement of financial position

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CHANGES By Graham Holt

The introduction of a new accounting standard or a change in an accounting standard can have a significant impact on an entity from an internal as well as an external perspective. As a result, the International Accounting Standards Board (IASB) has recently agreed to conduct an ‘effects analysis’ before publishing any International Financial Reporting Standard (IFRS). When the IASB issues a new or significantly amended IFRS, it changes the way in which financial statements show particular transactions or events. Changes in reporting requirements always come with a cost. The IASB uses discussion papers and the ‘basis for conclusions’ to explain the steps taken to ensure that a proposed IFRS has taken into account the costs and benefits of the new reporting practice that it introduces. WHAT’S THE IMPACT? The IASB considers a variety of matters prior to the issue of a standard. These matters include how the changes improve the comparability of financial information and the assessment of the effect on an entity’s future cashflows. Further considerations include whether the changes will result in better economic decision-making, the likely compliance costs for preparers, and the potential cost for users of extracting the data. On application of the new IFRS, investors will be provided with different information on which to base their decisions. Investors’ assessment of how management has discharged its stewardship responsibilities could be changed as could the cost of the entity’s capital. This, in turn, could affect how investors vote at a shareholder meeting or influence their investment decisions. New financial reporting requirements may call for the disclosure of information that is of competitive advantage to third parties, which would be a cost to the entity. A change in an accounting standard could result in some entities no longer investing in certain assets or change how they contract for some activities. For example, the comment letters on the exposure draft on leases suggest that some entities would change their leasing arrangements if operating leases had to be shown on the balance sheet with ‘adverse economic impacts including the loss of thousands of jobs’. Further IFRS-based financial statements are used in contracts or regulation. Banking agreements often specify maximum debt levels or financial ratios that refer to figures prepared in accordance with IFRS. New financial reporting requirements can affect those ratios, with potential breach of contracts. Many jurisdictions have regulation that restricts the amount that can be paid out in dividends, by reference to accounting profit. Further, some governments use IFRS numbers for statistical and economic planning purposes and the data as evidence for constraints on profitability in regulated industries.

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Taxation is often calculated on the profit measured for financial reporting purposes. Where IFRS is used as the basis for income tax, a change in a standard can affect the tax base. The economic consequences of the link of accounting with tax liabilities can be significant. If the US Financial Accounting Standards Board (FASB) were no longer to permit use of the last-in first-out (LIFO) method, companies using LIFO would have to pay income taxes sooner because of the higher cost of sales under LIFO. The impact has been estimated to be greater than US$80bn if the tax law was not changed. However, neither the FASB nor the IASB base accounting policy decisions on tax consequences. Some jurisdictions require an impact assessment before a new standard, or an amendment to a standard, is incorporated into the law. Such a review may take into account the increased administrative burden on entities in that country or its consistency with local company law. FINANCIAL STATEMENTS On a micro level, where new and revised pronouncements are applied for the first time, there can be an impact on the drafting of the financial statements. The financial statements will need to reflect the new recognition, measurement and disclosure requirements. For example IFRS 10, Consolidated financial statements, was amended for annual periods beginning on or after 1 January 2014. This amendment provides an exemption from consolidation of subsidiaries for entities that meet the definition of an ‘investment entity’, such as some investment funds. Instead, such entities measure their investment in certain subsidiaries at fair value through profit or loss in accordance with IFRS 9, Financial instruments, or IAS 39, Financial instruments: recognition and measurement. The consequences of this amendment will be far-reaching for those entities. IAS 8, Accounting policies, changes in accounting estimates and errors, contains a general requirement that changes in accounting policies are fully retrospectively applied. However, this does not apply where there are specific transitional provisions. For example, when first applying IFRS 15, Revenue from contracts with customers, entities should apply the standard in full for the current period, including retrospective application to all contracts that were not yet complete at the beginning of that period. For prior periods, the transition guidance allows entities an option to either: apply IFRS 15 in full to prior periods (some limited practical expedients are available) retain prior period figures as reported under the previous standards, recognising the cumulative effect of applying IFRS 15 as an adjustment to the opening balance of equity as at the date of the beginning of the current reporting period. Further, IAS 8 requires the disclosure of a number of matters about the new IFRS. These include the title of the IFRS, the nature of the change in accounting policy, a description of the transitional provisions, and the amount of the adjustment for each financial statement line item that is affected.

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Additionally, IAS 1, Presentation of financial statements, requires a third statement of financial position to be presented if the entity retrospectively applies an accounting policy, restates items or reclassifies items, and those adjustments had a material effect on the information in the statement of financial position at the beginning of the comparative period. IAS 33, Earnings per share, requires basic and diluted earnings per share (EPS) to be adjusted for the impacts of adjustments resulting from changes in accounting policies accounted for retrospectively, and IAS 8 requires the disclosure of the amount of such adjustments. Where there are new accounting policies, the impact on the interim financial statements will not be as great as on the year-end accounts. However, IAS 34, Interim financial reporting, requires disclosure of the nature and effect of any change in accounting policies and methods of computation. ENTITY ASSESSMENT The entity itself should prepare an impact assessment relating to the introduction of any new IFRS. There may be significant changes to processes, systems and controls, and management should communicate the impact to investors and other stakeholders. This would include plans for disclosing the effects of new accounting standards that are issued but not yet effective, as required by IAS 8. Audit committees have an important role in overseeing implementation of any new standard in their organisations. For example, under IFRS 15, an entity may need to evaluate its relationships with contract counterparties to determine whether a vendor-customer relationship exists. Existing revenue recognition policies will also need to be evaluated to determine whether any contracts within the scope of IFRS 15 will be affected by the new requirements. Where a new standard requires significantly more disclosures than current IFRS, the entity may want to understand whether it has sufficient information to satisfy the new disclosure requirements or whether new systems, processes and controls must be implemented to gather such information and ensure its accuracy. The entity should choose a path to implementation and establish responsibilities and deadlines. This may help to determine the accountability of the implementation team and allow management to identify gaps in resources. For example, IFRS 15 requires entities that select the full retrospective approach to apply the standard to each year presented in the financial statements. This will require entities to begin tracking revenue using the new standard from the current period to the effective date of 1 January 2017. IMPLEMENTATION TIME A key thing about recent standards is that the IASB has given entities a reasonable amount of time to plan implementation. For example IFRS 9, Financial instruments, has an effective date of 1 January 2018. However, insurance companies will need this time to plan their implementation. The new IFRS 9 standard includes revised guidance about the classification and measurement of financial assets, including a new expected credit loss model for calculating impairment. It also supplements the new general hedge accounting requirements that were published in 2013.

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Insurance companies will be greatly affected as they plan to adopt new standards on financial instruments and insurance contracts. However, before insurers reach conclusions about how they apply IFRS 9, they will want to consider its interaction with the forthcoming standard on insurance contracts. Accounting standards have economic effects, which can be beneficial for some entities and detrimental to others. The IASB’s evaluation of costs and benefits are by nature qualitative. The quantitative effects should be anticipated by entities as they are the ones that will feel them.

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TRANSPARENT AND CONSISTENT By Graham Holt

Transparency and the consistent application of IFRS in financial reporting are key to making financial markets work smoothly The European Securities and Markets Authority (ESMA) has recently published its annual statement defining the European common enforcement priorities for 2013 financial statements. The aim is to try to foster transparency and the consistent application of IFRS (International Financial Reporting Standards) to help the financial markets function. With the help of European national enforcers, ESMA has identified several financial reporting topics that should be considered in the preparation of the financial statements of listed companies for the year ending 31 December 2013. Those topics are: impairment of non-financial assets measurement and disclosure of post-employment benefit obligations fair value measurement and disclosure disclosures related to significant accounting policies, judgments and estimates measurement of financial instruments and disclosure of related risk with relevance to financial institutions. Not surprisingly, ESMA says that national regulators may also focus on additional relevant topics. It issued a similar statement a year ago and post-employment benefit obligations appears on both listings. ESMA builds on its 2012 statement by emphasising the need for transparency and the importance of appropriate and consistent application of recognition, measurement and disclosure principles. ESMA and the European national enforcers will monitor and assess the application of IFRS requirements relating to the items in this statement. These European common enforcement priorities will be incorporated into the reviews performed by national enforcers. The guidelines are not statutory, but ESMA hopes that awareness campaigns will lead national regulators to take account of the new priorities. The watchdog will also monitor national regulators' application of the priorities and will publish progress reviews to encourage national regulators to comply. Users of financial statement have expressed concerns over the use of 'boilerplate' disclosures for transactions that are not relevant or are immaterial to the entity. The view is that entities should disclose only applicable accounting policies and focus on entity-specific information rather than quoting extensively from IFRS. IMPAIRMENT OF NON-FINANCIAL ASSETS Continued slow economic growth in Europe could indicate that non-financial assets will continue to generate lower than expected cashflows especially in those industries experiencing a downturn in fortunes. In 2012, ESMA suggested paying particular attention to the valuation of goodwill and intangible assets with indefinite life spans.

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This year, it has again included the impairment of non-financial assets in the common enforcement priorities with a focus on certain specific areas. These areas are cashflow projections, disclosure of key assumptions and judgments, and appropriate disclosure of sensitivity analysis for material goodwill and intangible assets with indefinite useful lives. In measuring value-in-use, cashflow projections should be based on reasonable and supportable assumptions that represent the best estimate of the range of future economic conditions. IAS 36, Impairment of Assets, points out that greater weight should be given to external evidence when determining the best estimate of cashflow projections. IAS 36 says entities should assess the reasonableness of the assumptions on which cashflow projections are based. Each key assumption should be consistent with external sources of information, or how these assumptions differ from experience or external sources of information should be disclosed. ESMA considers that disclosures made by entities are often uninformative because they are only provided at an aggregate level and not at the level of the cashgenerating unit. Financial statements generally are not providing disclosures that are entity-specific or appropriately disaggregated. ESMA has reviewed 2012 financial statements, and the disclosures relating to the sensitivity analysis of goodwill or other intangible assets with indefinite useful lives are poor. IAS 36 requires disclosures on the sensitivity of the key assumptions to change when determining the recoverable amount. Entities have regularly used the assertion that 'no reasonable possible change in a key assumption would result in an impairment loss'. ESMA believes that this disclosure does not give users sufficient detail to allow them to assess sensitivity properly. MEASUREMENT OF POST-EMPLOYMENT BENEFIT OBLIGATIONS IAS 19, Employee Benefits, requires the discount rate applied to post-employment benefit obligations to be determined using market yields based on high-quality corporate bonds. 'High quality' reflects absolute credit quality and not that of a given collection of corporate bonds. The policy for determining the discount rate should be applied consistently over time and a reduction in the number of high-quality corporate bonds should not normally result in a change to this policy. The International Accounting Standards Board (IASB) has tentatively decided to amend IAS 19 to clarify that the depth of the bond market should be assessed and this should be at the currency level and not at the country level. In jurisdictions where there is no deep market in these bonds, the standard requires that market yields on government bonds should be used. ESMA expects issuers to use an approach consistent with this amendment. There is an additional reminder by ESMA regarding the importance of disclosing the significant actuarial assumptions used in determining the present value of the defined benefit obligation and the related sensitivity analysis. The discount rate is a significant actuarial assumption, the details of which should be disclosed together with any disaggregation information on plans and the fair value of the plan assets where the level of risk of those plans is different.

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FAIR VALUE ESMA has indicated that entities should assess the impact of the requirements of IFRS 13, Fair Value Measurement. In particular, the effect of non-performance risk should be reflected in the value of a liability. As an example, the fair value of a derivative liability should incorporate the entity's own credit risk. ESMA emphasises the need for proper recognition of counterparty credit risk when determining the fair value of financial instruments and providing relevant disclosure. IFRS 13 requires all valuation techniques to maximise the use of relevant observable inputs, which should be consistent with the asset or liability's characteristics. In some cases, a premium or discount to the market value may be applied but it should be consistent with the nature of the asset or liability. ESMA stresses the need to provide disclosures related to fair value, particularly when the measurement is based on significant unobservable inputs (level 3). The more unobservable the data, the more important that uncertainties are clearly identified. Further, IFRS 13 (and ESMA) requires entities to categorise measurements into each level of the fair value hierarchy. SIGNIFICANT ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES ESMA expects issuers to focus on the quality and completeness of disclosures relevant to the entity's financial statements. These should be entity-specific and not boilerplate. ESMA believes that disclosures could be improved in the following areas: significant accounting policies, judgments made by management, sources of estimation uncertainty, going concern, sensitivities, and new standards issued but not yet effective. Significant accounting policies and management judgments could be included in the financial statements in order of materiality and significance. IAS 1, Presentation of Financial Statements, requires disclosure of estimation uncertainties with a significant risk of being adjusted in the next year. ESMA reiterates that disclosure of new standards that have been issued but are not yet effective (IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors) is relevant where the new standard could have a material impact on the financial statements.

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TOPICS RELATED TO FINANCIAL INSTRUMENTS Transparency and comparability of financial reporting of financial institutions is in the interest of market participants. ESMA states that issuers should ensure that they meet the requirements of IFRS 7, Financial Instruments: Disclosures, for qualitative and quantitative disclosures and assess whether there is objective evidence of impairment while disclosing sufficient detail to provide a comprehensive picture of the liquidity risk and funding needs of the entity. Disclosures should enable users to evaluate the nature and extent of risks, and the elements related to the valuation of financial instruments, the latter reflecting economic reality. Experience during the financial crisis showed diverging accounting treatments in relation to forbearance practices. Forbaearance occurs where the terms of the loan are modified due to the borrower's financial difficulties. ESMA expects issuers to provide quantitative information on the effects of forbearance, enabling investors to assess the level of impairment of financial assets. ESMA also expects disclosure of the accounting policies applied to financial assets that have been assessed individually for impairment but for which no objective evidence of impairment was available. The purpose of this disclosure is to allow users to assess credit risk. Entities should also disclose the time bands in the maturity analysis and include maturity analysis of financial assets held for managing liquidity risk. ESMA is attempting to foster consistent application of accounting standards while ensuring the transparency and accuracy of financial information. As noted above, ESMA and the national regulators will monitor the application of the IFRS requirements outlined in the priorities, with national regulators incorporating them into their reviews and taking corrective actions where appropriate. Auditors and issuers ignore the guidance at their peril.

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Potential exam question: Godzilla Godzilla is considering partnering with two other businesses, Chimp and Lemur. Godzilla is a multinational conglomerate including high tech business and food stuffs. Chimp is a mass manufacturer. Lemur is a small manufacturer on the island of Madagascar. The proposal is to build high tech mass manufacturing plant in Madagascar to produce large volumes of computer components for worldwide sales. The new entity will be known as ‘Madagascar’. Godzilla will bring machines. Chimp will build the factory. Lemur will bring local knowledge. There are four structures being considered. But in all cases each of the partners will have the right to one third of the profits in the new business. The four options are:Option one The new entity will be incorporated. Each partner will hold one third of the shares. However, only Godzilla shares will have voting rights. The Chimp and Lemur shares will have equal ownership to the Godzilla shares but will have no voting power. Option two The new entity will be incorporated. Each partner will hold one third of the shares. All shares will have equal voting rights and equal ownership and all decisions must be made by majority vote. Option three The new entity will be incorporated. Each partner will hold one third of the shares. All shares will have equal voting rights and equal ownership but all decisions must be made by unanimous vote. Option four The new entity will not be incorporated. Each partner will have the right to one third of the profit. But each partner will continue to own their contributory assets. So Godzilla will continue to own the machines that it brings to the business. All the partners will have equal voting rights and equal ownership but all decisions must be made by unanimous vote. Required (a)(i) Explain the basis for accounting for joint arrangements required by IFRS11 Joint Arrangements. (3 marks) (a)(ii) Discuss the options above explaining how each option would be recognised by Godzilla group. (8 marks)

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Further Godzilla has two similar leases related to two buildings. Both contracts were signed at the year start and both involve three payments of $1million at the end of each accounting year. The first is related to offices in a prestigious old office block. The building is well maintained and under a preservation order. There is good reason to believe the building will continue in use for many years after the end of the lease. The second is related to a new warehouse that is scheduled for demolition immediately after the end of the lease. There are plans to build a supermarket on the site. A discount rate of 10% can be assumed throughout. Required (b)(i) Explain the principles of lease accounting under IAS17 and describe how those principles would apply to the two lease contract above. (5 marks) (b)(ii) Discuss the inconsistency of the principles in IAS17 with the framework for financial reporting. (3 marks) Godzilla is aware of development in the area of revenue and financial instrument impairment and other changes to IFRS. Required (c)

Discuss how changes in IFRS can effect entities. (6 marks) (25 marks)

Alright, I admit it, this is a fake question written to squeeze Three subjects into one question. Of course, a real current issues question has only one subject and 25 marks.

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IVORY TOWER IFRS COLUMN As you may know, I write the column on the development of IFRS for PQ magazine. These articles are targeted at students trying to get a feel for current issues and their corporate social responsibility angle. Here are a few recent editions. Please keep up with the column by signing up to receive PQ at pqaccountant.com. The articles are all aimed at giving P2 students a flavour of current issues, in order to give them the edge when addressing those tricky current issues questions in the P2 exam.

Winter 2012 Financial instruments and recycling The ivory tower column is moving to quarterly reporting; after all if quarterly reporting is good enough for Tesco’s then it is good enough for me. So that means every quarter I shall bring you news from the rarefied atmosphere around the International Accounting Standards Board (IASB) in London. I think I shall use the extra space to solve practical problems to illustrate IASB developments. I am going to start with Elton John. Imagine Elton John is thinking of coming back into football. He used to own Watford Football Club, you know. Well he decides he is interested in buying back the club he sold many years ago. But he knows things have moved on since the days that John Barnes was a young man in a Watford strip. He knows that his multiple millions are really small fry compared to the likes of Roman Abramovich. So he buys just 2% of the equity shares of Watford Football Club with a view to buying more and maybe all the equity if things work out. He pays £10k for the shares. By the year end the shares have risen in value to £13k. In the new year he starts to question his investment and by the first month end in the new year has decided that he wants out of football. The shares are now worth £14k. But perversely, because of the rising value, a buyer is hard to find. Eventually a month later Elton sells for £16k. Let us have a look at how this should be accounted for and the current issue hidden in the numbers. Firstly, I guess you know that the equity shares are financial instruments. FI are contracts that give rise to an asset in one entity and a liability or equity in another entity. Also I guess you can see that Elton has the asset (and Watford have the equity obligation). This means Elton must use the financial asset (FA) classification rules in International Financial Reporting Standard 9 (IFRS9) as follows:-

Cash flow characteristics test (Is the FA a simple loan?)

No

Yes Business model test (Is there intent to keep the FA?)

No

Yes Amortised cost

Fair value

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Of course, the equity investment is not a simple loan; it is not a loan asset at all. So the equity is carried at fair value. Now the default recognition for gains and losses on fair value changes is the income statement, which the IASB somewhat perversely call “profit or loss”, giving us the expression financial asset at fair value through profit or loss (FVPL). But hidden in IFRS9 is a special option to carry strategic equity at fair value through other comprehensive income (FVOCI). The OCI is an ugly wart like performance report growing off the bottom of the income statement that accommodates gains that are not allowed through the p/l. The classic example is revaluation gains on property plant and equipment. But now you know that strategic equity gains go there too. But there are two recognition criteria for strategic equity:(1) Strategic The entity must be able to show a strategic intent to keep the asset. (2) Equity The asset must be equity. Clearly the shares in Watford fulfil both criteria and so will be carried FVOCI. But what does that mean in this case? It means the rise in value in the year of purchase of £3k (13-10) will go through the OCI. It also means that the first £1k (14-13) will go to the new year OCI. It is at that point Elton changes his mind about the investment and at that point that the equity no longer fulfils the “strategic” criteria given above. So now the asset is classed FVPL and the final £2k gain goes into the income statement. Now comes the development issue. The gain of £2k that went through the income statement will end up in an equity bucket on the balance sheet called “retained earnings” (RE). But the two earlier gains of £1k from this year and £3k from last year went through the OCI. So they have been accumulated in an equity bucket called “other components of equity” (OCE). Now in old fashioned language this accumulated gain of £4k is described as “unrealised”. But now that the related asset has been sold the £4k is “realised” and must move to RE. In the old days of awful IAS39 this £4k was realised by the long route. It was taken off the balance sheet put into the income statement and thereby it would drop in RE. This was called “recycling”. But under the new IFRS9 the gain is simply moved from one equity reserve to the other directly on the balance sheet. So the £4k goes from OCE to RE.

Spring 2013 Property and performance The Ivory Tower is going to visit the world of property. I will start with 20 Fenchurch Street, also known as the “walkie talkie” because it is said to look like the walkie talkie telephones of Vietnam movies. For those of you who work in the City of London you will know it is the big fat tower that is wider at the top than the base. And you will know that whilst progress has been fast since it got above mud level last year, the building is notably unfinished. The building is owned by an investment property company. So let us ask “can the property be classified as an investment property?” The criteria for investment properties can be given by the following mnemonic:I C E

Investment The property must be held for gain or rent or both. Complete The property must be finished (otherwise it is work in progress) Empty The property must be unoccupied by the group (otherwise it is PPE)

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I think you can see straight away that the walkie talkie fails the middle criteria and so is classified as wip using construction contract accounting. Now that gets us started but to get into the weird twists and turns of property accounting it would be good to imagine two identical recently completed warehouses on an estate in Swindon. In this imaginary story both are owned by an investment company with a view to capital gain (let us call the company “Land”). The first building is full of building material owned by Land and the second is occupied by a retailer who use it as a distribution warehouse (let us say the retailer is Sainsbury’s). Both have risen in value by £100k during the year but Land want to carry both at cost. Land has the policy of carrying PPE property (property plant and equipment property) at fair value. Let us start by testing the first warehouse against the ICE criteria. This property fails the E criteria. Of course, the property does not need to be literally empty; but it does need to be empty of the group. This first warehouse is occupied by Land stock and so is classified as PPE property. PPE can be carried at cost or fair value (IAS16). There is a choice. But this choice must be applied consistently across a class of assets. And Land has already made their choice by selecting a fair value policy for PPE property. So the first warehouse must be capitalised then depreciated then revalued and the revaluation gain must go to the lower performance statement called Other Comprehensive Income (OCI). Now let us look at the second warehouse occupied by Sainsbury’s. All three of the ICE criteria are fulfilled. So the second warehouse is an investment property. In theory investment property can be carried at cost or fair value (IAS40). In theory there is a choice. But unlike in PPE, this choice is purely theoretical. The worldwide culture of carrying investment property at fair value is so strong that to deviate from this is to be seen as a maverick. So this too is carried at fair value. But there is no depreciation and the gain goes to the income statement. Well that is all the financial reporting sorted. Now let us travel to the Ivory Tower of the International Accounting Standards Board (IASB) and find out some of the things that drive them nuts about the property accounting that has been inherited from these old standards that themselves reflect older cultures. The first issue is choice. The choice of policies for PPE introduces inconsistency and the choice that is not really a choice at all for investment properties is just plain silly. So there should be no choice between alternatives in the standards. The second issue is the performance reporting and this is the one that really drives the IASB crazy. In the above, there are two property gains of £100k. The figures are the same because the two properties are identical. And yet one gain goes boldly and directly into the income statement (the investment property gain) and the other gets hidden away in the other comprehensive income (the ppe revaluation). This defies all logic and it was an area into which the IASB tried to introduce logic by proposing a single holistic performance report where similar gains are gathered together. Like a lot of good ideas, this idea proved too contentious and the IASB gave up.

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Summer 2013 Contingent liability inconsistency I have just won over £1 billion on the galactic lotto and foolishly I decide to sink some of the cash into football. So I buy Liverpool Football Club from Fenway. Not unreasonably, Fenway want to get some return if Liverpool get into the top four next season and qualify for Europe. They argue that any outstanding performance next season must be partly down to Fenway management. I accept, but I also want equivalent protection from an awful first season. So Fenway and I agree the following terms: £250m now in cash. £220m in one year if Liverpool finishes in the top half of the table next season (80%). £121m in two years if Liverpool finishes in the top four next season (15%).

The probabilities are given above and the net assets are valued at £230m at acquisition. I buy all the shares and so there is no non-controlling interest. The cost of capital is 10%. That is plenty enough information to calculate the goodwill which requires both consideration and net assets to be valued at fair value. I am not a massive fan of double entry but I think it will help me make my point. So here goes: Dr Cr Cr Cr

Consideration Bank Current liability (220x80%/1.1) Non-current liability (121x15%/1.12)

425 250 160 15

You probably know that the two liabilities represent contingent consideration liabilities and as said previously that is measured at fair value. So the goodwill is measured as follows: £m Fair value of consideration 425 Fair value of net assets (230) ___ Goodwill 195 ___ So far so good. But what I have not told you is that litigious claimants are trying to get their grubby hands on my winnings. There are two in particular. The first has an 80% chance of getting £220m in one year’s time and the second has a 15% chance of getting £121m in two years’ time. The timing and the probabilities are identical to those above for the contingent consideration. But these two are simple contingent liabilities and are not valued at fair value. Instead these liabilities use an on off switch style of recognition where probable outflows (>50%) are recognised in full and others are not recognised at all (being either disclosed or ignored altogether). So I ignore the second liability and recognise the first in full as follows: Dr Cr

Cost Current liabilities (220/1.1)

200 200

So when I draw up my balance sheet a few days after the acquisition I find that I have inconsistency between my liabilities. Of course, identical liabilities should be recognised the same but they are not. How did this ridiculous situation arise?

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What we have hit upon is the clash between IFRS3 on business combinations and IAS37 on provisions. The newer standard, IFRS3, was developed with getting a fair value for goodwill in mind and as a result used fair value for contingent consideration. The International Accounting Standards Board (IASB) thought nothing of this as it was both logical and in tune with a wider aim of getting all contingencies at fair value. But when the IASB actually came to roadshow their ideas on contingencies at fair value then a riot broke out in the ivory towers of financial reporting. The IASB thought maybe that it was the way that they had presented their ideas that was the problem. So they withdrew the project and later reissued a simplified proposal. But again it was roundly thrown back in their faces. So that was it. Game over. We now find ourselves in the bizarre situation where two identical liabilities are recognised differently depending on whether they are tied up in an acquisition or not.

Autumn 2013 Revenue The revenue project is hotting up again as it comes to a close. It has been a long and winding road to this point and I do not think any of us would benefit from a historical recap. But a little reminder of the issues and the proposal does seem to me to be overdue. So here goes. As usual I will use a question and answer to illustrate my points. Question: One Direction Simon Cowell has asked your company to make a movie about the boy band “One Direction”. The movie will be a mix of footage and interviews. The contract is for $2m but it is broken down into components. $600k is payable after the filming has been shot. Another $600k is payable after the editing is completed and approved by Simon Cowell. The final $800k is payable once the head of studio has agreed the film is ready. All the filming has been completed and most of the editing has been done. Simon Cowell is happy with the vast majority of the movie but would like a little more of Harry Styles and his bouncing bouffant in order to get the girls into a frothing frenzy. You have agreed and it will only be a few days before that content is in the movie and Simon approves and the film can go to the head of studio for final approval. However, the year end has fallen and you are required to recognize revenue for the current year. As mentioned all the hard work has been done. So you recognize 80% of $2m as revenue in what you see as a prudent estimate of work done. Required Discuss the above in the context of current and proposed revenue recognition. Answer Current revenue recognition Current rules under IAS18 have two models:Sale of goods: this is recognized at the point that risks and rewards flow. Sale of services: this is recognized over the period and so in accordance with completion.

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Intuition The two models are described as sale of goods and sale of services but really the pair are just the “at” model and the “over” model. IAS18 encourages preparers to use either model for goods or services depending on intuition and the circumstances of the revenue. You You have selected the “over” model. The reference to 80% means that you are recognizing the revenue over the period of the service and have concluded that 80% has been done. Perhaps without realizing it, you have drawn a parallel with constructing a movie over a period and constructing a hotel over a period. This is absolutely fine and accords with IAS18. Others But other companies with similar revenue recognize that revenue at the point that risks and rewards flow. And of those that use the “at” model, some will recognize at the point that Simon Cowell approves and others will recognize at the point that the head of studio approves. This is also true in the hotel building industry. Some hotel construction is recognized at the point that the customer accepts the new hotel. Problem And of course this is the point. IAS18 actually works quite well for preparers. But because it is so subjective there is great inconsistency in application leading to incomparability and creative accounting. Solution So the IASB propose to harden up revenue recognition. They are trying to replace subjectivity with objectivity. The IASB see the current focus on the performance statement as the issue and propose that the focus should move to the position statement. In essence they propose that the revenue should be measured by measuring the growth in the asset. Asset To paraphrase the framework “an asset is a present right to a future economic inflow”. In this context the key word is “right”. You have the right to the first $600k under the contract because you have finished the filming. But you do not have the right to the other two flows because the film has not been approved by either key player. Revenue So as your opening asset was zero at the year start and your closing asset is $600k then your revenue would be $600k under the proposed rules. But more significantly anyone else looking at your revenue and using the proposals would get the same answer thus showing that the subjectivity has gone leaving cold hard objectivity. Conclusion There it is; the revenue proposals in a nutshell. But I should be honest. I have stripped away all the fancy layers of complexity in the actual proposal to give you the key to this subject. Let me tell you there are more layers than an onion and its best to keep well away until the standard is finalized.

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Winter 2013 Integrated Reporting Everybody is talking about “integrated reporting”. There is even a funny little arrow symbol invented to jazz up the abbreviation as follows: . I am not one to refuse a bandwagon. So here goes my two pence worth. The International Integrated Reporting Council (IIRC) tells me that “ is a process that results in communication by an organization, most visibly a periodic integrated report, about value creation over time. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term.” That is a lot of fancy words, but what does it mean? Well essentially the IIRC are talking about the published annual report. Currently there is a culture of publishing the statutory financial statements in a pdf document with a management commentary appended. As the name suggests, the management commentary is the commentary of management on the fs plus their wider comments on strategy and corporate social responsibility (CSR). All the IIRC are doing is trying to encourage companies to publish annual reports that are “integrated”; in other words, annual reports that tell a clear useful story in a document that hangs together. Some entities like BP on the London Stock Exchange are brilliant at this already, perhaps because of a defensive reaction to their “dirty business” image. Some are improving like Telefonica the parent of O2 on the Madrid Stock Exchange. And some businesses are awful like Omnicom quoted on the New York Stock Exchange. Omnicom in particular have no excuse as they are the world’s biggest advertising agency and so should know how to tell a story. So what is new? Well this is the thing. As far as I can see, nothing is new, except maybe one element. This push for improved corporate reporting seems to have really captured the imagination of a few hard core believers; then spread to the press who have picked up on the story and now everybody is talking about it. I have not seen so much interest in annual report presentation since the management commentary first burst on the scene in the 1980s. In the 1980s companies like Sainsbury’s hit on the idea of explaining their numbers in a commentary. Of course the city boys and girls loved it and so there was a visible rise in the Sainsbury’s share price. So everybody got interested and soon everybody was doing it. But the commentary grew like a wild unmanaged garden and soon all consistency was lost and worse some businesses lost sight of the purpose of the commentary. Many interested parties had a bash at cleaning up; the IASB had a go, even the UK government took a bite, but all to no avail because there was not the motivation to improve or the profile for the story. But now there is and for the life of me I cannot figure out what is so special about the IIRC and their words. But who cares? They do appear to have captured imaginations and maybe the poorer annual reports will start to tell the story going forward.

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So let us look at what exactly the IIRC are saying. The IIRC have a framework in development which tells us that there are six guiding principles for the publication of one of these integrated reports:A Strategic focus and future orientation B Connectivity of information C Stakeholder responsiveness D Materiality and conciseness E Reliability and completeness F Consistency and comparability The IIRC also have core of a hundred trailblazers who have adopted the framework even though it is still in progress. But here is where the progress goes wobbly. Some of the trailblazers have published that really do lock in to the essence of holistic reporting. Companies like Marks & Spencer and our own ACCA clearly get it. But there is a huge swathe of trailblazers that seem to think that means CSR or sustainability reporting. Coca cola have a lovely report on the quality of the water going into their cans and Tata has some good stuff on their employment responsibilities. But the reports are not really integrated. I think this is a minor point, however. The big news is that the big businesses in the US and across the world really do seem interested in making their annual reports useful and that has to be good news for everybody.

Spring 2014 Policies I am in the mood to deliver a sermon. The subject will be “the same word can mean different things to different people”. This appears to be true in all walks of life. However, accounting appears to be particularly susceptible. Words like “debt”, “equity”, “gearing”, “bank”, “realised”, “operating” and “employee” mean different things to different accountants. If you have moved around in your career and have seen a few cultures then you will be familiar with this. However, if not then this little lesson might just save you a whole load of heartache. The word I am going to use to illustrate the point is “policy”. The particular problem with the word “policy” shows itself in stark relief when a student asks this deceptively tricky question: “I have changed my depreciation policy from straight line to reducing balance. Why does the text say this is not a change in policy? It obviously is a change in policy!” Goodness, I can feel myself quake. It is a horrible question with an even more horrible answer. But I think you deserve the answer in full technicolour. So I will do my best not to pull my punches. The word “policy” comes to us from the mists of time long before anyone had the bold idea of inventing accounting standards and trying to impose consistency. Back then you could do pretty much what you felt like with the numbers; but not quite. Essentially accountants had a wide range of choices for their financial reporting and the choices they made became known as “policies”. For example, in the context of leasing there was a choice between ignoring all finance resulting in pure operating lease accounting and accommodating some finance resulting in the mixed model of operating and finance lease accounting like we do today. Back before standards most companies chose pure operating lease accounting and that was their lease policy. But others chose the mixed model and that was their lease policy.

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Then along came International Accounting Standard (IAS) 8 and it required the disclosure of policies. So after IAS 8 accountants still had plenty of choice but had to say what choices they had applied. So a company using pure operating leases still could but had to say so. Then slowly, one by one, standards were issued and choices were closed until now there are almost no choices left. So after IAS 17, a company previously applying pure operating leases had to swap to the mixed model and their policy became the mixed model because that is what the standard says you must do and the policy choice disappeared. And so on with the policies for deferred tax, share based payment and depreciation. As each standard was issued the choice disappeared and companies had to align their policies with the standard. The idea of a policy as a choice has effectively gone. “Policy choice” has disappeared. But as this was going on a new and different meaning of “policy” sprang into use. This meaning is nowhere in the standards and everywhere in real life and this conflict is the root of the confusion. This new meaning is “policy formula”. This very different animal is all about volume, compromise and materiality. It is absolutely true to say that IAS 16 on depreciation contains no policy choice. You must depreciate an asset on an individual asset by asset basis over its life to match the cost with use. You must match cost with use. There is no choice. So matching cost with use is everybody’s policy choice. And many companies do just that. They simply look at each asset on an individual basis and estimate its use and thereby derive depreciation for each asset. But in big companies with lots of similar assets, a little trick called a “formula” is used. Say there are hundreds of machines that are similar and all last roughly five years, some more and some less. In that company the accountant might say “I shall depreciate all of them over five years”. Now this is in direct contradiction to IAS 16 which says that depreciation must be on an asset by asset basis. But here is the trick. The accountant comes back and says “I know that, but if I do as I propose, the error will be immaterial and therefore I can”. Neat trick. Now this becomes the company “formula”. So the policy is to match cost with use and the formula is the five year life compromise. Now say that same company realises that reducing balance would better reflect the matching of cost with use. Well then that company will keep its “policy” of matching cost to use and change its “formula” to reducing balance. Obviously that is a change of formula and not a change of policy. Now comes the rub. As you know, accountants who routinely use these “formula” in their accounting do not call them “formula”. They call them “policies”. You can now see this meaning is in direct contradiction to the standards. But these “formula” are still called “policies” just the same. Hence the problem. The original meaning of “policies” is in the context of “choice”. “Policy choice” is the meaning in the standards. The newer meaning of “policies” is in the context of “formula”. “Policy formula” is what most people mean by “policy” in the real world. So the standards have one meaning and people in the real world have another meaning for the same word. And this is common. So when someone uses a word and the context seems skewed then ask them to explain a little more and you might find they are using that word to mean something quite different to what you understand by that word. There is no need to correct them. But you can now understand them and save yourself a whole load of heartache. Here endth the lesson.

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Summer 2014 Sploci "Sploci". It is a beautiful Icelandic fishing village with chocolate box houses. I am joking. It is both a wonderful acronym and an admission of defeat. The letters stand for “Statement of Profit or Loss and Other Comprehensive Income”. It is the new name for the former “Comprehensive Income Statement”. The former name worked for me. It was punchy and it revealed intent. The IASB have long held a torch for a philosophy usually referred to as "position focus". It has served them well and helped solve problems like share based payment by suggesting that the way to measure the cost of sbp is to measure the obligation at each year end and from there measure the cost as the growth in the obligation. Position focus is canny stuff and I cannot resist suggesting that position focus maybe hard wired into our brains. You see the birth of writing is tangled up with the desire to express wealth at a point in time. Those ancient clay tablets measuring 31 units of wheat and 212 head of sheep from Euphrates cities with biblical names are nothing more than balance sheets. It seems nobody fussed too much about profit back then. But we do now. The IASB had been endeavouring to wean us off our obsession with profit; an obsession that drives our strategies and dominates our financial reporting. You see the next step from a “Comprehensive Income Statement” envisaged by the IASB was the “Performance Statement” communicating the performance as simply the categorised growth in position from one position statement to another. This statement would be unconcerned about measuring a single “profit” and would present a holistic picture of performance across broad fronts. That was the intent. But no longer. The idea of a “Performance Statement” appealed to the believers but appalled the markets. "Move away from profit - not on your life" the markets told the IASB. And the title SPLOCI is the admission of defeat, the white flag waving over the ivory towers of the IASB. "Ok. You can keep profit” say the IASB “and what is more you can call your profit statement ‘The Statement of Profit…. or loss’ to reinforce the profit focus”. But what exactly is profit? Everybody knows what it is until they come to define it. Indeed the chairman of the IASB Hans Hoogervorst asked the question “'Defining Profit or Loss and OCI... can it be done?” in the title of a recent seminar. I missed it – it was in Japan. But reading between the lines it is clear the answer from the urbane Mr Hoogervorst was “probably not”. He noted that the big brains at the Accounting Standards Advisory Forum had a bash at defining profit. He described their attempt as a “courageous effort” but noted with a wry smile that there was “very little consensus” on the meaning of profit. He is smooth, our chairman. But one thing he did say was that most commentators agree that profit is the bottom line of the Statement of Profit or Loss. So profit is no more than the sum of the stuff pumped through the p/l for the year. And most stuff does go through the p/l. But some stuff is not allowed through p/l because it is not “profit” and so has to be pumped through a dumping zone called “Other Comprehensive Income”. I use a silly little mnemonic to help me remember the five gains and losses that are banned from p/l and languish in the oci. It is as follows:-

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H

hedging –cash flow hedge gains

E

exchange on subs – forex gains on the retranslation of foreign subs

A

actuarial – remeasurement gains in pensions

P

ppe revaluations – gains on occupied properties

S

strategic equity – gains on financial assets classified FVOCI

“Heaps” – get it? The “heaps” heaps at the bottom of the p/l in a heap. Very funny Mr Jones. But why are these things driven from the p/l. What did they do wrong? Just about any argument you put forward can be shot down by example. The classic argument is that p/l items are near cash and oci items are far cash. But that argument is shot down by pointing out that a ppe revaluation gain on a property that you will sell next year goes through oci and an investment property gain on a property you will keep for a hundred years goes through p/l. Another classic argument is that the p/l items are “realised” and oci items are “unrealised”. But that fails because there is no definition of realised or unrealised. The IASB make some progress by using phrases like “bridging items”, “mismatched remeasurements” and “transitory remeasurements” to describe the oci items. But in the end the IASB rather dolefully admit that this is little more than fancy labelling for stuff we put through the oci because we do. The IASB seem to have concluded that the split between p/l and oci is necessarily arbitrary and are currently suggesting that the following best describes the mangled logic:



Profit or loss provides the primary source of information about the return an entity has made on its economic resources in a period.

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To support profit or loss, OCI should only be used if it makes profit or loss more relevant.

But this is itself is an admission of defeat as, of course, it must be the IASB that dictate what must go through the oci in order to make the “profit or loss more relevant”. And then there is “recycling”… don’t get me talking about recycling.

Autumn 2014 Equity accounting Equity accounting bores the living daylights out of me. In my usual sweeping and dogmatic manner I will gladly tell you that equity accounting is patently nonsense and should be replaced by investment accounting. Then I will refuse to debate the matter because it is nonsense. Well it appears I am out of step with the rest of the financial reporting universe who are happily debating equity accounting. So I guess I should give a flavour of the story. Equity accounting is the name given to the roll forward method used to account for associates and joint ventures. That is already a bad start as equity accounting has nothing to do with equity. Associates are defined by influence which is the power to participate in management policy. Joint ventures are incorporated joint arrangements defined by joint control which is the power to direct activities divided between two or more investors with unanimous voting. These tricky ideas of roll forward and joint control are best illustrated by example.

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The much hated "walkie talkie" building in central London is a joint venture. The two investors, Land Securities and Canary Wharf, share the company share capital 50%/50%. They have agreed that nothing happens to the building unless both agree. This consensus voting represents joint control and so this company is a joint arrangement. But there are two forms of joint arrangement; joint operation (JO) and joint venture (JV). The difference is a touch more subtle but essentially a JV is incorporated and a JO is unincorporated. So as the walkie talkie sits in a limited company the walkie talkie is a JV and is rolled forward using equity accounting. To explain these last two terms let us throw in a few numbers. Say you buy the Canary Wharf half share rights for £1000m at the year start then the walkie talkie becomes your JV and you will do equity accounting. Say the whole company grows by £200m over the year then you will carry £1100m (1000+50%*200) on your balance sheet for your JV at the year end. This accounting is called "roll forward" as it uses the idea that the balance now is what the balance was earlier rolled forward for the growth. Roll forward is used widely in accounting but when applied to an associate or JV roll forward is called "equity accounting". This way of looking at equity accounting is called the "valuation approach". It is by far the most common way of viewing the numbers and appears to be the viewpoint of the relevant Ifrs (Ias28). The valuation approach is saying "the jv is worth now what it was worth when you bought it plus the growth". The valuation approach appears to be trying to approximate year end fair value. Written like that the approach sounds quite reasonable but actually the above reveals equity accounting's biggest weakness. Many commentators looking at equity accounting, including the former chairman of the IASB David Tweedie, have responded as follows: "surely if you want fair value would it not be quicker and easier to use fair value?" They have a point. When equity accounting was devised 60 years ago fair value was hard to measure and guessing at fair value by using cost plus growth was reasonable. But now markets are far more liquid and there is even a whole Ifrs dedicated to the measurement of fair value (Ifrs13). It seems rude not to use it. So many commentators think equity accounting should be replaced by investment accounting where associates and JVs are carried at fair value with gains to profit or loss (fvpl under Ifrs9). This argument becomes more attractive once you start to look at the mechanics of equity accounting under pressure. Equity accounting starts to wobble with something as simple as a revaluation down in the associate and it falls apart if the associate has share based payment. But equity accounting may not be attempting a valuation. Equity accounting may be a one line consolidation. To get a feel for this I only need to give you one more number in the example above. Say the net assets of walkie talkie limited are £1400m in total at purchase at the year start. Then your goodwill in your JV is £300m (1000-50%*1400). So the year end carrying value of £1100m can be attained by the rather convoluted method of combining the unchanged goodwill with the grown net assets (300+50%{1400+200}). Written like that the one line consolidation approach is making my eyes go funny. So you can see why it is rarely used to calculate the carrying value. But it does show that there are two ways of looking at equity accounting. The IASB are asking first whether equity accounting is aiming to achieve a one line consolidation or a valuation and then they can develop a method that best delivers that aim.

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Spring 2015 Recycling ‘And then there is “recycling”… don’t get me talking about recycling’. In an article last year I ended with that phrase. But maybe you should get me talking about “recycling” as it is a current issue that everyone else is talking about. There is a wonderful Peppa Pig episode called “recycling” and even a lovely little tune to go. It is one of my son’s favourites and the tune is looping around my head as I write this. Have a look on YouTube if you have a mo. But recycling in corporate reporting does not involve keeping your plastic bottles in one bin and the glass in another. And recycling in corporate reporting is most certainly not a good thing. Recycling is the rerecognition of a previously recognised gain. There you go – that is all there is to recycling – but what a technical phrase this is. Gains and losses are reported through a performance statement called the Statement of Profit or Loss and Other Comprehensive Income or SPLOCI for short. As the “and” tells us, the SPLOCI is a compound report with two components: the P/L and the OCI. And as was discussed in the SPLOCI article, most gains and losses go through p/l except five as follows which go through the OCI:H

hedging –cash flow hedge gains

E

exchange on subs – forex gains on the retranslation of foreign subs

A

actuarial – remeasurement gains in pensions

P

ppe revaluations – gains on occupied properties

S

strategic equity – gains on financial assets classified FVOCI

As discussed in that earlier article, there is no underlying logic to the gains that are banished from the p/l and languish in the oci. It is just the way it is. And likewise there is no logic with recycling. The top two (hedging gains and forex gains on foreign subs) do recycle and the other three do not. But how does recycling work? As usual the best way to get a feel for the process is with an example. In year one, our imaginary entity makes a forex gain of $60m on a new foreign sub measured in the home currency and a ppe revaluation gain of $60m on the rise in the value of the new home factory. Both these gains go through OCI (Other Comprehensive Income) in the performance statement and both are accumulated in OCE (Other Components of Equity) on the position statement. Then at the start of year two the foreign sub and the home factory are both sold for $500m. Both the sub and the factory have an exit carrying value of $400m. So there is a profit on disposal of $100m to be reported in the p/l for each. But hang on; there is an accumulated $120m of gain in OCE related to these two sold items. You may know that there is a culture of interpreting the OCE as “unrealised” and “undistributable” because the gains in OCE are not represented by cash. But this $120m is represented by cash. Both the sub and the factory have been sold. So the $120m must move to the retained earnings (RE) where it is “realised” and “distributable”. So the $60m gain on the factory is simply moved from the OCE to the RE. The gain goes from one equity bucket to the other on the b/s with no fuss. No need to put the gain through this year’s performance because the gain already went through last year’s performance. And of course it made perfect sense to recognise the gain last year as it was last year that the factory rose in value. This is in perfect tune with sales. Sales are recognised in the year of the sale and not when the cash flows. If a sale happens just before the year end and the cash is received just after the new year start then we would not recognise the sale again in the year of cash receipt. Rerecognition would just be plain silly. Exactly. Now comes the tricky bit.

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We do rerecognise the $60m forex gain on the sale of the foreign sub. The $60m sitting in OCE representing the accumulated forex gains on the foreign sub are dragged out of the OCE and added to the actual profit on foreign sub disposal of $100m to give a reported profit on disposal of $160m in the p/l. The profit ends up in the RE, of course, which is fine. The problem is the recognition of the same gain twice. Once in the year of the gain and again in the year of the cash flow. The same $60m has appeared in both this year’s SPLOCI and last year’s SPLOCI. This rerecognition of gains and losses on foreign subs and cash flow hedges is called “recycling” and has been widely criticised. There appears to be no logic to the isolation of five gains that go through OCI and there appears to be less logic to the isolation of the two of those that later go through p/l. But it appears this culture is so entrenched that the IASB are powerless to reverse it. However, it has resulted in the cumbersome division of items in the oci between those that “will not be reclassified to profit” and those that “may be reclassified to profit”. You may have seen these phrases in the OCI and wondered what that was all about. Now you know.

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ACCA Paper P2 (International)

Corporate Reporting

Recent Past Paper Pack

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ACCA PAPER P2 (INT & UK) CORPORATE REPORTING Recent past paper pack The following is a pack of recent past p2 exam questions with answers to each. The typesetting is my own and horrendous. I am not a typesetter and it shows. The answers are my own also. They will certainly be good enough for any prize winner, but also it is almost certain there will be typos. Please inform me of any problems you see. Thanks, Martin Jones

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Question 75 Trailer (Q1 June 2013) Trailer, a public limited company, operates in the manufacturing sector. Trailer has investments in two other companies. The draft statements of financial position at 31 May 2013 are as follows: Trailer Park Caller $m $m $m Assets: Non-current assets Property, plant and equipment 1,440 1,100 1,300 Investments in subsidiaries Park 1,250 Caller 310 1,270 Financial assets 320 21 141 –––––– –––––– –––––– 3,320 2,391 1,441 –––––– –––––– –––––– Current assets 895 681 150 –––––– –––––– –––––– Total assets 4,215 3,072 1,591 –––––– –––––– –––––– Equity and liabilities: Share capital 1,750 1,210 800 Retained earnings 1,240 930 350 Other components of equity 125 80 95 –––––– –––––– –––––– Total equity 3,115 2,220 1,245 –––––– –––––– –––––– Non-current liabilities 985 765 150 –––––– –––––– –––––– Current liabilities 115 87 196 –––––– –––––– –––––– Total liabilities 1,100 852 346 –––––– –––––– –––––– Total equity and liabilities 4,215 3,072 1,591 –––––– –––––– –––––– The following information is relevant to the preparation of the group financial statements: 1. On 1 June 2011, Trailer acquired 14% of the equity interests of Caller for a cash consideration of $260 million and Park acquired 70% of the equity interests of Caller for a cash consideration of $1,270 million. At 1 June 2011, the identifiable net assets of Caller had a fair value of $990 million, retained earnings were $190 million and other components of equity were $52 million. At 1 June 2012, the identifiable net assets of Caller had a fair value of $1,150 million, retained earnings were $240 million and other components of equity were $70 million. The excess in fair value is due to non-depreciable land. The fair value of the 14% holding of Trailer in Caller was $280 million at 31 May 2012 and $310 million at 31 May 2013. The fair value of Park’s interest in Caller had not changed since acquisition.

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2. On 1 June 2012, Trailer acquired 60% of the equity interests of Park, a public limited company. The purchase consideration comprised cash of $1,250 million. On 1 June 2012, the fair value of the identifiable net assets acquired was $1,950 million and retained earnings of Park were $650 million and other components of equity were $55 million. The excess in fair value is due to non-depreciable land. It is the group’s policy to measure the non-controlling interest at acquisition at its proportionate share of the fair value of the subsidiary’s net assets. 3. Goodwill of Park and Caller was impairment tested at 31 May 2013. There was no impairment relating to Caller. The recoverable amount of the net assets of Park was $2,088 million. There was no impairment of the net assets of Park before this date and any impairment loss has been determined to relate to goodwill and property, plant and equipment. 4. Trailer has made a loan of $50 million to a charitable organisation for the building of new sporting facilities. The loan was made on 1 June 2012 and is repayable on maturity in three years’ time. Interest is to be charged one year in arrears at 3%, but Trailer assesses that an unsubsidised rate for such a loan would have been 6%. The only accounting entries which have been made for the year ended 31 May 2013 are the cash entries for the loan and interest received which have resulted in a balance of $48·5 million being shown as a financial asset. 5. On 1 June 2011, Trailer acquired office accommodation at a cost of $90 million with a 30year estimated useful life. During the year, the property market in the area slumped and the fair value of the accommodation fell to $75 million at 31 May 2012 and this was reflected in the financial statements. However, the market recovered unexpectedly quickly due to the announcement of major government investment in the area’s transport infrastructure. On 31 May 2013, the valuer advised Trailer that the offices should now be valued at $105 million. Trailer has charged depreciation for the year but has not taken account of the upward valuation of the offices. Trailer uses the revaluation model and records any valuation change when advised to do so. 6. Trailer has announced two major restructuring plans. The first plan is to reduce its capacity by the closure of some of its smaller factories, which have already been identified. This will lead to the redundancy of 500 employees, who have all individually been selected and communicated with. The costs of this plan are $9 million in redundancy costs, $4 million in retraining costs and $5 million in lease termination costs. The second plan is to re-organise the finance and information technology department over a one-year period but it does not commence for two years. The plan results in 20% of finance staff losing their jobs during the restructuring. The costs of this plan are $10 million in redundancy costs, $6 million in retraining costs and $7 million in equipment lease termination costs. No entries have been made in the financial statements for the above plans. 7. The following information relates to the group pension plan of Trailer: 1 June 2012 ($m) 31 May 2013 ($m) Fair value of plan assets 28 29 Actuarial value of defined benefit obligation 30 35 The contributions for the period received by the fund were $2 million and the employee benefits paid in the year amounted to $3 million. The discount rate to be used in any calculation is 5%. The current service cost for the period based on actuarial calculations is $1 million. The above figures have not been taken into account for the year ended 31 May 2013 except for the contributions paid which have been entered in cash and the defined benefit obligation. Required: (a) Prepare the group consolidated statement of financial position of Trailer as at 31 May 2013. (35 marks)

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(b) It is the Trailer group’s policy to measure the non-controlling interest (NCI) at acquisition at its proportionate share of the fair value of the subsidiary’s net assets. The directors of Trailer have used this policy for several years and do not know the implications, if any, of changing the policy to that of accounting for the NCI at fair value. The fair value of the NCI of Park at 1 June 2012 was $800 million. The fair value of the NCI of Caller, based upon the effective shareholdings, was $500 million at 1 June 2011 and $530 million at 1 June 2012. Required: Explain to the directors, with suitable calculations, the impact on the financial statements if goodwill was calculated using the fair value of the NCI. (9 marks) (c) The directors of Trailer are involved in takeover talks with another entity. In the discussions, one of the directors stated that there was no point in an accountant studying ethics because every accountant already has a set of moral beliefs that are followed and these are created by simply following generally accepted accounting practice. He further stated that in adopting a defensive approach to the takeover, there was no ethical issue in falsely declaring Trailer’s profits in the financial statements used for the discussions because, in his opinion, the takeover did not benefit the company, its executives or society as a whole. Required: Discuss the above views of the director regarding the fact that there is no point in an accountant studying ethics and that there was no ethical issue in the false disclosure of accounting profits. (6 marks) (50 marks) Question 76 Verge (Q2 June 2013) (a) In its annual financial statements for the year ended 31 March 2013, Verge, a public limited company, had identified the following operating segments: (i) Segment 1 local train operations (ii) Segment 2 inter-city train operations (iii) Segment 3 railway constructions The company disclosed two reportable segments. Segments 1 and 2 were aggregated into a single reportable operating segment. Operating segments 1 and 2 have been aggregated on the basis of their similar business characteristics, and the nature of their products and services. In the local train market, it is the local transport authority which awards the contract and pays Verge for its services. In the local train market, contracts are awarded following a competitive tender process, and the ticket prices paid by passengers are set by and paid to the transport authority. In the inter-city train market, ticket prices are set by Verge and the passengers pay Verge for the service provided. (5 marks) (b) Verge entered into a contract with a government body on 1 April 2011 to undertake maintenance services on a new railway line. The total revenue from the contract is $5 million over a three-year period. The contract states that $1 million will be paid at the commencement of the contract but although invoices will be subsequently sent at the end of each year, the government authority will only settle the subsequent amounts owing when the contract is completed. The invoices sent by Verge to date (including $1 million above) were as follows: Year ended 31 March 2012 $2·8 million Year ended 31 March 2013 $1·2 million The balance will be invoiced on 31 March 2014. Verge has only accounted for the initial payment in the financial statements to 31 March 2012 as no subsequent amounts are to be paid until 31 March 2014. The amounts of the invoices reflect the work undertaken in the period. Verge wishes to know how to account for the revenue on the contract in the financial statements to date. Market interest rates are currently at 6%. (6 marks)

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(c) In February 2012, an inter-city train did what appeared to be superficial damage to a storage facility of a local company. The directors of the company expressed an intention to sue Verge but in the absence of legal proceedings, Verge had not recognised a provision in its financial statements to 31 March 2012. In July 2012, Verge received notification for damages of $1·2m, which was based upon the estimated cost to repair the building. The local company claimed the building was much more than a storage facility as it was a valuable piece of architecture which had been damaged to a greater extent than was originally thought. The head of legal services advised Verge that the company was clearly negligent but the view obtained from an expert was that the value of the building was $800,000. Verge had an insurance policy that would cover the first $200,000 of such claims. After the financial statements for the year ended 31 March 2013 were authorised, the case came to court and the judge determined that the storage facility actually was a valuable piece of architecture. The court ruled that Verge was negligent and awarded $300,000 for the damage to the fabric of the facility. (6 marks) (d) Verge was given a building by a private individual in February 2012. The benefactor included a condition that it must be brought into use as a train museum in the interests of the local community or the asset (or a sum equivalent to the fair value of the asset) must be returned. The fair value of the asset was $1·5 million in February 2012. Verge took possession of the building in May 2012. However, it could not utilise the building in accordance with the condition until February 2013 as the building needed some refurbishment and adaptation and in order to fulfil the condition. Verge spent $1 million on refurbishment and adaptation. On 1 July 2012, Verge obtained a cash grant of $250,000 from the government. Part of the grant related to the creation of 20 jobs at the train museum by providing a subsidy of $5,000 per job created. The remainder of the grant related to capital expenditure on the project. At 31 March 2013, all of the new jobs had been created. (6 marks) Required: Advise Verge on how the above accounting issues should be dealt with in its financial statements for the years ending 31 March 2012 (where applicable) and 31 March 2013. Note: The mark allocation is shown against each of the four issues above. Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks) (25 marks) Question 77 Janne (Q3 June 2013) (a) Janne is a real estate company, which specialises in industrial property. Investment properties including those held for sale constitute more than 80% of its total assets. It is considering leasing land from Maret for a term of 30 years. Janne plans to use the land for its own office development but may hold the land for capital gain. The title will remain with Maret at the end of the initial lease term. Janne can lease the land indefinitely at a small immaterial rent at the end of the lease or may purchase the land at a 90% discount to the market value after the initial lease term. Janne is to pay Maret a premium of $3 million at the commencement of the lease, which equates to 70% of the value of the land. Additionally, an annual rental payment is to be made, based upon 4% of the market value of the land at the commencement of the lease, with a market rent review every five years. The rent review sets the rent at the higher of the current rent or 4% of the current value of the land. Land values have been rising for many years. Additionally, Janne is considering a suggestion by Maret to incorporate a clean break clause in the lease which will provide Janne with an option of terminating the agreement after 25 years without any further payment and also to include an early termination clause after 10 years that would require Janne to make a termination payment which would recover the lessor’s remaining investment. (12 marks)

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(b) Janne measures its industrial investment property using the fair value method, which is measured using the ‘new-build value less obsolescence’. Valuations are conducted by a member of the board of directors. In order to determine the obsolescence, the board member takes account of the age of the property and the nature of its use. According to the board, this method of calculation is complex but gives a very precise result, which is accepted by the industry. There are sales values for similar properties in similar locations available as well as market rent data per square metre for similar industrial buildings. (5 marks) (c) Janne operates through several subsidiaries and reported a subsidiary as held for sale in its annual financial statements for both 2012 and 2013. On 1 January 2012, the shareholders had, at a general meeting of the company, authorised management to sell all of its holding of shares in the subsidiary within the year. Janne had shown the subsidiary as an asset held for sale and presented it as a discontinued operation in the financial statements at 31 May 2012. This accounting treatment had been continued in Janne’s 2013 financial statements. Janne had made certain organisational changes during the year to 31 May 2013, which resulted in additional activities being transferred to the subsidiary. Also during the year to 31 May 2013, there had been draft agreements and some correspondence with investment bankers, which showed in principle only that the subsidiary was still for sale. (6 marks) Required: Advise Janne on how the above accounting issues should be dealt with in its financial statements. Note: The mark allocation is shown against each of the three issues above. Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks) (25 marks) Question 78 Lizzer (Q4 June 2013) (a) Developing a framework for disclosure is at the forefront of current debate and there are many bodies around the world attempting to establish an overarching framework to make financial statement disclosures more effective, coordinated and less redundant. It has been argued that instead of focusing on raising the quality of disclosures, these efforts have placed their emphasis almost exclusively on reducing the quantity of information. The belief is that excessive disclosure is burdensome and can overwhelm users. However, it could be argued that there is no such thing as too much ‘useful’ information for users. Required: (i) Discuss why it is important to ensure the optimal level of disclosure in annual reports, describing the reasons why users of annual reports may have found disclosure to be excessive in recent years. (9 marks) (ii) Describe the barriers, which may exist, to reducing excessive disclosure in annual reports. (6 marks)

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(b) The directors of Lizzer, a public limited company, have read various reports on excessive disclosure in the annual report. They have decided to take action and do not wish to disclose any further detail concerning the two instances below. (i) Lizzer is a debt issuer whose business is the securitisation of a portfolio of underlying investments and financing their purchase through the issuing of listed, limited recourse debt. The repayment of the debt is dependent upon the performance of the underlying investments. Debt-holders bear the ultimate risks and rewards of ownership of the underlying investments. Given the debt specific nature of the underlying investments, the risk profile of individual debt may differ. Lizzer does not consider its debt-holders as being amongst the primary users of the financial statements and, accordingly, does not wish to provide disclosure of the debt-holders’ exposure to risks in the financial statements, as distinct from the risks faced by the company’s shareholders, in accordance with IFRS 7 Financial Instruments: Disclosures. (4 marks) (ii) At the date of the financial statements, 31 January 2013, Lizzer’s liquidity position was quite poor, such that the directors described it as ‘unsatisfactory’ in the management report. During the first quarter of 2013, the situation worsened with the result that Lizzer was in breach of certain loan covenants at 31 March 2013. The financial statements were authorised for issue at the end of April 2013. The directors’ and auditor’s reports both emphasised the considerable risk of not being able to continue as a going concern. The notes to the financial statements indicated that there was ‘ample’ compliance with all loan covenants as at the date of the financial statements. No additional information about the loan covenants was included in the financial statements. Lizzer had been close to breaching the loan covenants in respect of free cash flows and equity ratio requirements at 31 January 2013. The directors of Lizzer felt that, given the existing information in the financial statements, any further disclosure would be excessive and confusing to users. (4 marks) Required: Discuss the directors’ view that no further information regarding the two instances above should be disclosed in the financial statements because it would be ‘excessive’. Note: The mark allocation is shown against each of the two instances above. Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks) (25 marks)

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Answer 75: Trailer (a)

Group structure

Of course, this is a vertical group and so the ownership in Caller (sub-sub) is complex:Direct

14%

Indirect (60% of 70%)

42% __

Controlling interest

56% __

Non-controlling interest (100%-56%)

44% __

Acquisition Of course we are doing the group position statement for Trailer. So we must look at the acquisitions from the perspective of Trailer. Trailer gets control in both Park and Caller on the same day, when Trailer buys the 60% in Park at the star of the current year. Net assets Acq SC RE OCE FVA (land) β{balance}

1210 650 55 35 ___

Park

Y/e

1210 930 80 35 ___

Caller Acq Y/e 800 240 70 40 ___

800 350 95 40 ___

1950 ___

2255 1150 1285 ___ ___ ___ Growth 305 135 __ __ (2 marks: 1 mark for each FVA) OCE growth (80-55)&(95-70) 25 25 RE growth β{balance} 280 110 __ __ Growth 305 135 __ __ Note: If split growth above is beyond you, then treat the whole growth as RE growth and you will lose nothing.

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Goodwill Caller 762 280 40% (40%)(1950) 780 506 (1950) (1150) ___ ___ Goodwill before 80 398 Impairment (80) (0) ___ ___ Goodwill after 0 398 ___ ___ (5 marks: 2 marks for Park goodwill before impairment and 3 marks for Caller) Impairment The impairment is horrible and well worth ignoring unless you fancy yourself as a superstar. There is more information on the impairment in the notes at the back of this answer. But look at (b) first. FV FV FV FV

of of of of

consideration previous NCI NA

% 60%

Working

Park 1250

Gross carrying value of CGU [gross gw+na] Notional Impairment β{balance}

% Working 42% (60%)(1270) 14% 44% (44%)(1150)

[80/60%+2255]

2388 (300) ____ 2088 ____

Recoverable value of CGU Goodwill impairment (first) PPE impairment (balance)

Notional 133 167 ____ 300 ____

Actual 80 167 ____ 247 ____

pure ci & no nci split ci/nci 60%/40%

(2 marks)

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Group position statement Non-current assets Goodwill (80-80imp + 398) Property plant and equipment [3840 +35FVA +40FVA -167imp+32.6para5] Financial assets [482-1.3para4] Current assets

Equity Share capital Retained earnings Other components of equity Non-controlling interest Non-current liabilities (1900+6para7) Current liabilities (398+14para6)

398 3781 481 1726 ____ 6386 ____ 1750 1255 170 893 1906 412 ___

6386 ___ (2 marks for transferring information on top of those allocated elsewhere) NCI Acquisition Growth Indirect Impairment NCI

Park Caller 780 506 [305(40%)] 122 [135(44%)] 59.4 [1270(40%)] (508) [167(40%)] (66.8) ___ ___ 327.2 565.4 ___ ___

___ 893 ___ (3 marks)

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Paragraph 4 Loan asset The receivable is a financial asset measured at amortised cost by discounting and unwinding: Initial fv Year cf df pv 1 1500 0.9434 1415 2 1500 0.8900 1335 3 51500 0.8396 43240 ___ Initial fv 45990 Initial cf 50000 ___ Loss on gift of cheap credit 4010 ___ Unwinding Year opening interest instalment closing 1 45990 2759 (1500) 47249 Recorded receivable (given) 48500 _____ Adjustment 1251 approximately _____ (4 marks) Paragraph 5 Offices The reversal is restricted to the historical nbv:Cost Depreciation (90/30years) Before Impairment (balance) Current opening Depreciation (75/29years) Before Reversal of impairment (balance) Historical nbv (90-3-3) Revaluation gain (balance) Current closing Sum rise in value (11.6+21)

90 (3) __ 87 (12) __ 75 (2.6) __ 72.4 11.6 __ 84 21 __ 105 __ 32.6 __

to last years p/l

to current p/l to current oci

(3 marks) Paragraph 6 Provision The first reorganisation is immanent. The employees have been told of their redundancy and I assume the lease termination clauses have been triggered. Retraining provisions are specifically prohibited and the whole of the second reorganisation can be ignored as too uncertain. Provision = 9+5 = 14 (1 marks)

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Paragraph 7 Pension Pension assets Market value at start of the year

28

Expected return on the assets (28)(5%)

1.4

Contributions

2

Benefits paid

(3)

Actuarial gain – balancing figure Market value at end of the year

0.6 29

Pension obligations Obligation at start of the year

30

Interest (30)(5%)

1.5

Service cost

1

Benefits paid

(3)

Actuarial loss – balancing figure Obligation at end of the year

5.5 35

The statement of financial position Pension assets Pension obligations Net pension (liability)

29 (30) (6)

The income statement Operating Service cost

(1)

Finance Finance cost (1.4-1.5) also (30-28)(10%)

(0.1)

Other Comprehensive Income Actuarial gain on assets

0.6

Actuarial (loss) on obligations

(5.5)

Net Actuarial (loss)

(4.9) (5 marks)

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Reserves Parent (1) loss on previous (310-280) (3) goodwill impairment [pure ci] (3) PPE impairment (60%)(167) (4) adjustment (loss-interest earned) (5) rise (6) reorganisation (7) pension Park 25(60%) 280(60%) Caller 25(56%) 110(56%)

RE 1240 (30) (80) (100) (1.3) 11.6 (14) (1.1)

OCE 125

21 (4.9) 15

168

14 61.6 ___ ___ 1254.8 170.1 ___ ___ (Max of 8 marks: 5 for RE & 3 for OCE: 1 mark per line restricted to max) Reserves note Note how the marking guide max of 8 marks means that it is pointless to split the growth between re and oce if you are picking up the other issues. But if you find split growth easy then do it. Goodwill note If you are sharp then you may be able to spot the deliberate double counting in the Park goodwill. If you are really sharp then you may realise that the best advice is to ignore this as it gets pretty complicated and earns you no marks. When Trailer pays $1250m for 60% of Park, Trailer is also buying 60% of the Park 70% in Caller. The examiner has been careful to tell you that the fv of the Caller shares has not changed since Park made the acquisition a year ago. So that means that the Park 70% of Caller is still worth $1270m. So buying 60% of that cost Trailer 60% of $1270m or $762. So when Trailer pays $1250m for the shares is Park, $762m is for the 60% of 70% of Caller and the rest $488m is for the 60% in Park itself. We are obliged to break the $1250m consideration into the two components because as the name suggests IFRS3 Business Combinations requires that we calculate a goodwill for each business acquired. We know that Caller is a separate business from Park because it has been living separately from Park until the Park acquisition. But the $1270m fv of 70% of Caller is included in the na fv of $1950m quoted by the examiner. Hence the compensating double counting. A more strict goodwill schedule would be as follows. But do not do the following in an exam because this is simply not the way things are done. Goodwill in strict mathematical format % Working FV of consideration 60% [1250-762] FV of NA 60% [(60%)(1950-1270)]

Park 488 (408) ___ Goodwill before 80 ___ You can see I have used the old net goodwill style calculation. I could now move to the new style calculation with a line for nci but the degree of rocket science goes up. So I think I will leave it there.

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Goodwill impairment note This is also really difficult and rarely examined and unless you think you can do it all in the 2 marks times 1.8 minutes per mark then the best advice is to forget about it. The impairment is a deep impairment meaning that it eats up all the goodwill and then continues to eat into the rest of the sub. The rules on this are described in IAS36 as follows; the goodwill impairment allocation goes against (1) specific assets (2) goodwill (3) remaining assets on a weighted average basis. You can see that the examiner has ignored the strict rules as just described and has impaired goodwill first until dead and then started on the specific asset of PPE. This is the opposite order to that described in the standard. So if the examiner is coming off the strict path then you know that this must be getting difficult. The problem relates to partial goodwill. You see partial goodwill or net goodwill is quoted on the balance sheet net of the nci component. The $80m we calculated is only the ci element of goodwill and not the whole goodwill. This is inconsistent with the rest of the balance sheet where PPE and all the other assets are quoted gross. The whole of PPE goes to the group bs as you know and not just the ci proportion. So now we find ourselves in the horrible position of trying to figure out what to do with and impairment that eats into two assets Goodwill and PPE when these two assets are quoted inconsistently one net and one gross. The traditional solution to this horrible problem is to gross up the goodwill to an notional gross goodwill based on the idea that if our 60% of goodwill is worth $80m then maybe the gross goodwill is worth $80m/60% or $133m. That then gives a gross carrying value of $2388m and a notional impairment of $300m. This then kills off the notional goodwill of $133m first and the rest $167m goes to real PPE. But the notional goodwill is just notional and as we only have an actual goodwill of $80m and that is what we knock off the top of the bs. Coming to the bottom of the bs we must be careful that goodwill is net (no nci) and PPE is gross (including nci). The double entry for the impairment is: Goodwill impairment Dr RE 80 Cr Goodwill 80 PPE impairment Dr RE (60%) 100 Dr NCI (40%) 67 Cr PPE 167

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(b)

Marking guide

1 mark per point of narrative to a maximum of 4 marks and 5 marks for the calculations. Goodwill FV FV FV FV

of of of of

consideration previous NCI NA

% 60%

Working

Park 1250

40%

(given)

800 (1950) ___ 100 (100) ___ 0 ___

Goodwill before Impairment Goodwill after Impairment Carrying value of CGU Impairment β{balance}

[gw+na]

% Working 42% (60%)(1270) 14% 44% (given)

[100+2255]

Recoverable value of CGU Goodwill impairment PPE impairment (balance)

Actual 100 167 ____ 267 ____

Caller 762 280 530 (1150) ___ 422 (0) ___ 422 ___ 2355 (267) ____ 2088 ____

split ci/nci 60%/40% split ci/nci 60%/40%

Policies The two policies are usually called full and partial goodwill. Full goodwill is based upon valuing nci at fv. Partial goodwill is based on valuing nci at the nci proportion of na. Choice In fact IFRS3 is so wobbly that according to the standard groups can apply full goodwill for one sub acquisition and partial goodwill for another sub acquisition in the same year. This inconsistency is unlikely to be deemed acceptable in real life but it is permitted by the standard. Size As you can see from the above, full goodwill is usually bigger than partial goodwill. In this case the difference is small. But in subs with lots of goodwill and a big nci then the difference between full and partial goodwill can be huge. NCI goodwill The technical difference between the two is that full goodwill includes the goodwill belonging to both ci and nci. The whole goodwill under group control is shown. Full goodwill has more intellectual merit because the rest of the bs from PPE down to liabilities is also shown in full. The partial goodwill only shows the goodwill owned by the ci and excludes the nci element.

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Impairment One practical effect of using full goodwill rather partial goodwill is that the impairment calculation is much easier as is shown by the numbers above. (c)

Marking guide

Usual 1 mark per valid point. Ethics All professional bodies have ethical guidelines. They are essentially all about selfpreservation. The great thing about being in a profession is you get relatively well paid for doing interesting stuff (sometimes!). The bad thing about being in a profession is that if one bad apple does some low down dirty stuff then the public tends to view the whole profession as low down and dirty. Ethical guidelines So the ACCA has issued guidance to keep us all on the straight and narrow. The ACCA has five particular components to ethical guidelines: P

professionalism

I

integrity

C

competence

C

confidentiality

O

objectivity

Point So the point of studying ethics from the perspective of the student is in order to get into the professional body. The point of making the student study ethics from the perspective of the professional body is in order to minimise the risk of letting a bad apple into the profession and mess things up for the existing members. Generally Accepted Accounting Practice As I see it, following GAAP (or IFRS as we accountants would call it these days) has got nothing to do with the ethics. The IFRS are the rules and principals of fr. The ethical guidelines are much broader. They advise on behaviour in all contexts and not only fr. False declaration The above phrase is just a cute way of saying “lying”. The director makes an interesting point. He is saying that it is right to lie if the end product is the survival of the group. He is arguing that the end justifies the means. The USA government argue the same thing about torturing prisoners in the war against terrorism. Ok that is really stepping it up, but you can see the connection. Conclusion Well the solution is easy for a professional accountant. He cannot lie in the fs to achieve a positive result. That would be a breach of integrity from the ethical guidelines and a breach of fiduciary duty from law.

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Answer 76: Verge This was a classic mix question requiring a mix of standards. Marking guide Usual 1 mark per valid point. (a) Segmental reporting The big idea behind segmental reporting is that it allows users to get a feel for the position and performance of the parts that make up the whole business. This should give investors a better feel for their investments, greater confidence in their directors and with a little luck result in a higher share price. Aggregation But as discussed in question 4 in this exam paper, it is important not to overwhelm the users with information. This is why the standard on segments gives advice on aggregation. Operating segments can be aggregated if they are similar. Similarities Segments can be deemed similar based on a host of factors such as the nature of the products, the way the products are made, the class of customer and the way the products are marketed. But the most useful single factor in identifying similarities between segments is the risk profile of the product revenues. Two segments with product revenues that are exposed to similar risks are similar segments. Local and inter-city There can be little doubt that the two above segments bear similarities. If people stop travelling by train then both segments will take a hit. So perhaps if Verge were a huge conglomerate that made computers and ships and provided banking and hospitals (like a Korean Chaebol) then aggregation of rail travel would make sense. Recommendation But Verge only does rail. Local and inter-city are different products with different risk profiles. One business is government regulated and the other not. One is primarily for daily commuters and the other for less frequent commuters. So I suggest all three are kept as separately reportable segments. The users will cope fine with three segments and it will help the users to understand Verge. (b) Construction contract The contract could be interpreted as a construction contract especially given segment 3 is called “railway construction”. The standard on construction (IAS11) is outstandingly vague on the definition of a construction contract. Here is the quote: “A construction contract is a contract specifically negotiated for construction”. Not very helpful. So if directors interpret the maintenance contract as construction then construction accounting would apply. Revenue recognition The scenario tells us that the invoices reflect the work done. So $2.8m should have been recognised last year and $1.2m would be recognised this year.

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Restatement But last year’s revenue was not recognised last year. This is clearly a material prior period error. So a prior period adjustment is required to restate the comparatives. Revenue But maintenance could also be interpreted as simple revenue in which case the main revenue standard would apply (IAS18). This has two models. Revenue at the point risks transfer for goods and revenue over the period for services. Services It seems appropriate to interpret the maintenance contract as a service contract. So the revenue over a period model would apply. The numbers would be very similar to those that apply to construction but there is a difference. Fair value IAS18 refers to fair value but IAS11 does not. So under IAS18 the figures would need discounting and unwinding. The first year revenue would be $1m plus $1.8/1.062. The current year revenue would be $1.2m/1.06. Current issue The above is a fantastic illustration of why the IASB have a development project on revenue. It is exactly this kind of inconsistency of revenue recognition dependent upon interpretation that has motivated the IASB to try to develop a comprehensive revenue standard. (c) Court ruling It is a shame that the court ruling came after the fs were authorised. If the ruling had come before then the information could have been used. But the ruling was after and so could not be used in the fs. Provision Provision recognition is required if the criteria are fulfilled:R

reasonably reliable estimate

O

obligation (legal or constructive)

T

probable transfer of economic benefit

Obliging event The obliging event was the accident and this happened last year. At this point all the criteria were fulfilled but based on the information available at the prior year end the outflow was estimated as immaterial because the damage was superficial. So no provision was provided for the year ended 2012. Restatement Restatement in the new year 2013 is only required if there is an error in the comparatives (or a change of policy). I think Verge were right to ignore the provision last year 2012 based on what was known last year. The provision was ignored because it appeared immaterial and not because Verge denied the obligation. Restatement is not permitted.

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Current year provision But clearly they do need a provision in the current year fs. We must not forget the $300k figure was not available at the time the fs were signed. So an educated guess is required. The $1,200k sounds like a cheeky overestimate by an injured party trying it on. So I think this should be ignored too. Perhaps our lawyers and engineers could get together to make an educated guess. Based on the entire building being worth $800k then perhaps 40% of $800k would be prudent without being excessive. Current year receivable If the receivable from the insurance company is virtually certain then the $200k debtor should be recognised. However, if the receivable is considered only probable then disclosure would apply. Contingencies An argument could be made that the outflow is a contingent liability and the inflow is a contingent asset. I have not applied this idea because it seems to me that Verge definitely has an obligation. (d) Gifts There is no standard on gifts. So the accounting for the gift of the building is open to various interpretations. Here is mine. Property plant and equipment Ppe is initially measured at cost then subsequently recognised at cost or fair value. The scenario does not say but as cost is the default policy generally then I shall assume cost. Cost To quote from the standard (IAS16) “Cost includes all costs necessary to bring the asset to working condition for its intended use”. And again to quote from the standard “Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction”. The property was purchased at no cost to Verge. So the building would hit the b/s at zero carrying value but then the $1m adaptation costs would be capitalised on top. Timing PPE should be recognised at the point that it becomes probable economic benefit of the asset will flow. I think the PPE should be recognised at the point Verge takes possession in May 2012. Early recognition is too early as the benefactor could change his mind. But later recognition is too late as even at the point of taking possession it is probable that Verge will do the work to fulfil the benefactor’s conditions even if it is not certain. Then from that point Verge will accumulate the adaptation costs on top of the zero cost. Depreciation Depreciation is the recognition of the cost of use. The building became available for use from February 2013. Since this is so close to the year end of 31 March 2013 then the depreciation may even be ignored on the grounds of materiality.

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Contingent liabilities The potential repayment of the $1.5m to the benefactor is a contingent liability. These are recognised roughly like this:Contingent liability

Contingent asset

Probable

provide

disclose

Possible

disclose

ignore

Remote

ignore

ignore

Evidence Verge has spent $1m adapting the building to make it safe as a museum. There seems very little chance that Verge will breach the covenant. I suggest the $1.5m potential outflow can be ignored. Revenue grant It seems that this money is for hiring the staff. So $100k will go first to liabilities and then $5k can be released to the p/l every time one of the twenty is hired. Capital grant It seems this money is for adapting the building. So $150k will go first to liabilities then a little bit will be released to p/l each year based on the life of the building adaptations.

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Answer 77: Janne This was another mix question. So there were two mix questions in June 2013. Marking guide Usual 1 mark per idea well expressed. (a) Leasing A finance lease transfers substantially all the risks and rewards of the related asset to the user. An operating lease does not. Land The simplest test is to look at the life of the lease by comparison to the life of the asset. Land life is infinite (well it goes on for as long as the planet anyway). So no matter how long a land lease is for, it is always very short compared to the land life. Other factors But in order to assess the substance of a lease, we must look at the whole deal and not just the initial rent period. Key clause The key clause in the Janne lease is what happens at the end of the 30 years. Janne can either continue to lease at an immaterial rent or buy at a massive discount. So that is what Janne will do; one then the other. Janne will continue to use the land for as long as it is useful then buy it and sell it to someone else. Conclusion The land lease is clearly a finance lease and the land and a corresponding liability will be brought onto the b/s at contract signature. The massive premium will be knocked off against the liability and subsequent instalments will then reduce the liability each year. Cash flow The cash flows are also indicative of a finance lease. The cash flow from Janne is 190% of the land value (4%x30years plus 70%). Of course, this ignores time value, but does show that the lessor is getting cash ample to cover the sale of the land. Break clauses in general Break clauses can change everything. A break clause that genuinely allows the user to just give back the asset midterm is often highly persuasive evidence of an operating lease. Break clauses in Janne lease But the Janne break clauses are both apparently useless. The 10 year clause requires Janne to pay everything left to pay on the remaining 20 years up front and then get nothing for the 190% of the land value. The 25 year clause sounds better because there is nothing further to pay. But if Janne decides it does not want the land towards the end of the lease then Janne would be far better off holding on for another 5 years and then buying the land and selling it.

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Comment So neither break clause effects the original conclusion that this is a finance lease. So now we must assess where the property goes within nca. Investment property criteria The following criteria must be fulfilled for the recognition of an investment property (IP): I

investment

The property must be held with an investment motive; that is capital gain or rental income or both. C

complete

The property must be finished. inventory). E

(Unfinished property is classified as wip within

empty

The property must be empty of the group. (Owner occupied property is classified as PPE). Recommendation I think I would recommend that Janne put the land straight into PPE on the basis that Janne plans to build its own offices on the land. But Janne could put the land into investment properties until the building starts as the land is not occupied until then. (b) Investment property accounting The IAS allows a theoretical choice between fair value and cost for ip. But in practice the culture of fv is so strong that Janne is well advised to follow an fv policy. Fair value Fair value is the transaction price between market participants at the measurement date. So fv is an exit price. Fair value measurement The standard outlines a hierarchy in which level 1 is preferred to level 2 and so on:Level 1

exact equivalent active market price

Level 2

approximately equivalent transaction price as a start point

Level 3

unobservable inputs into a model

Approaches There is also conflicting talk in the standard on approaches. There are three approaches to fvm says the standard; market based, income based and cost based. The standard is far from crystal clear, but seems to be saying that levels 1 and 2 are market based and are preferred to income based (DCF on future cash inflow) and cost based (replacement cost) which are level 3.

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New build value less obsolescence It is not clear how the above works. It sounds like a cost based approach to fv. However, whatever it is, it is a level 3 guess by directors and more reliable evidence is available below. Sales values of similar properties This is a level 2 observable input and Janne should use one of these transactions as a start point for estimating Janne ip fv. (c) Discontinued An operation is discontinued if it is closed or sold during the year or held for sale at the year end. Held for sale An operation is held for sale if it fulfils all these criteria: S

sells

There is a clear intent to sell A

available

The operation is genuinely available for immediate sale L

locate

The directors are actively locating a buyer E

expected

The sale is expected to be complete within 12 months Repeated classification There is nothing to prevent a sub being classified as held for sale at one year end and then being classified as held for sale at the next year end. But it does arouse suspicions. Correspondence There is a difficult phrase at the end of the scenario that seems to indicate that the directors are not really trying to sell the sub. The phrase goes like this “some correspondence with investment bankers showed in principle only that the subsidiary was still for sale.” Investment bankers are the agents that sell subs, like estate agents sell houses. It sounds like the directors were never really actively looking for a buyer. Conclusion I suggest the sub is not and never was held for sale. The current figures should reclassify the sub as continuing and the comparatives require restatement.

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Answer 78: Lizzer This was a lovely current issues question on presentation. Marking guide Of course, the usual 1 mark per idea applies. (a)(i) Optimal Striking a balance between too much disclosure and too little disclosure is a tricky business. It depends on the market expectations, the industry culture and the accounting standards amongst other things. Too much If there is too much disclosure then the users become overwhelmed and the preparer will struggle to get the central messages across. Example A good example can be drawn from segmental reporting. A broad business with say 30 segments would overburden a user with excessive “clutter” if all 30 were reported. This is why the standard on segments gives advice on aggregation into reportable segments. Too little If there is too little information then the user is left wanting more and the preparer will have to answer the users’ questions at the annual general meeting or suffer the consequences of a fall in share price. Example A good example can be taken from Lizzer below. The insufficient information on asset risks described in (b)(i) would result in both the equity and debt investors asking questions and result in both share and bond prices falling. Drivers Over recent years annual reports have become bigger and bigger. It is possible to point to the drivers that have pushed disclosure up. By the way, the annual report has two sections; the commentary and the fs and each has its problems. IFRS There can be little doubt that the increasing complexity and disclosure demands of the IFRS have driven excessive disclosure in fs. It does not help that the standards themselves are far from eloquent. The IFRS are a shining example of how not to communicate if you want to get your message across. Law Legislators around the world have put demands on annual report disclosure in an effort to make annual reports more robust. But the result has been the cutting and pasting of meaningless legal jargon from one company report to another in an effort to cover company backsides. This useless over disclosure is sometimes called “boiler plate” and is at its worst in USA commentary. There are sometimes more than 100 pages of this rubbish in USA annual reports.

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User Demand There is often a demand from institutional investors for more disclosure. Even though this leads to excessive disclosure and the overburdening of the user; these very users often ask for more. Preparer supply Perhaps understandably, preparers want to err on the side of caution and therefore disclose more than is strictly necessary. We live in a highly litigious world and it understandable that companies want to avoid being punished for under disclosure. Other drivers But of course, there are lots of other drivers pushing disclosure up. There are stock exchanges demanding more, there are governance codes, there are regulators (eg USA SEC), there are pressure groups (eg labour rights charities) and so on. (a)(ii) Barriers The problem is that once a culture builds up around a particular disclosure, it becomes very difficult to reverse this. This is why the IASB and others are trying to get a hold on the problem before it spirals out of control. The barriers to reduction in disclosure are the divers, looked at in a slightly different way. IFRS Once an IFRS is issued it takes an age to change it, even if it is rubbish. This is beautifully illustrated by IAS39. The development project to replace this standard still rumbles on many years after IAS39 was discredited. Law Law is perhaps worse. It can take many lifetimes to change the law even if it is so outdated as to become ridiculous. Only this year in 2013 France repealed a 200 year old law forbidding women to wear trousers. User Demand Once users get used to seeing a certain disclosure then it can become comforting, no matter that it is useless. Taking it away can really upset the very people benefiting from the reduction. Preparer supply Once the preparers have the staff in place to provide the disclosure then the preparer can be locked into a bureaucratic loop whereby the disclosure that the preparer discloses is what they disclose, no matter that it is unnecessary. Solutions The short term solution for preparers is to carefully arrange the annual report in a clear top down presentation so that the important messages get through in the fore and the boiler plate gets shunted to the back. The long term solution is for all the stakeholders to get together and decide what they really need. I cannot see that happening any time soon.

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(b)(i) Securitisation This is a highly specialised financial service. In a nutshell, Lizzer buys up a broad range of debt assets in one hand and sells a narrow range of debt assets with the other. So Lizzer gets a bucket load of cash from institutional lenders (like banks) and then passes it on to a wide range of borrowers (like start-up companies) and takes a cut in the middle. Complex As you can tell even from the above, the business is very complex and fraught with risk. In fact it was exactly this business under the label “subprime derivatives” that is often blamed for starting the financial crisis that led to the current recession of 2010 to 2012 that is coming to an end as I write this. Users Lizzer wants to hide from the debt lenders the risks relating to the debt borrowers. The excuse for this economy with the truth is that debt lenders are not primary users. Lizzer clearly views the shareholders as the only users of fs worth considering. But of course that view is way too limited. Obviously debt lenders are primary users as described by the framework for fr. IFRS7 Besides this debate is all irrelevant. The scenario clearly tells us that the risk disclosure is required by IFRS7. So that is the end of that debate. The risks must be disclosed. (b)(ii) Going concern Going concern is a tricky old area of financial reporting. But cutting to the essentials, a business is deemed a going concern if it is considered that the business will continue for the foreseeable future usually interpreted as 12 months. Going concern disclosure So a company is required to disclose any issues that might mean the business does not make it alive to the next year end. Ample The directors used the above phrase to describe the covenant clearance at the year end. But we know this to be a lie. The note should be rewritten to give a very clear idea of how the covenant works and exactly how close to breach the company was at the year end. Events after the reporting period Further the actual breach after the year end requires disclosure as a non-adjusting EARP. The going concern disclosure is completely inadequate.

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Question 79 Angel (Q1 December 2013) The following draft group financial statements relate to Angel, a public limited company: Angel Group: Statement of financial position as at 30 November 2013 30 November 30 November 2013 2012 $m $m Assets Non-current assets Property, plant and equipment 475 465 Goodwill 105 120 Other intangible assets 150 240 Investment in associate 80 – Financial assets 215 180 –––––– –––––– 1,025 1,005 –––––– –––––– Current assets Inventories 155 190 Trade receivables 125 180 Cash and cash equivalents 465 355 –––––– –––––– 745 725 –––––– –––––– Total assets 1,770 1,730 –––––– –––––– Equity and liabilities Share capital 850 625 Retained earnings 456 359 Other components of equity 29 20 –––––– –––––– 1,335 1,004 –––––– –––––– Non-controlling interest 90 65 –––––– –––––– Total equity 1,425 1,069 –––––– –––––– Non-current liabilities Long-term borrowings 26 57 Deferred tax 35 31 Retirement benefit liability 80 74 –––––– –––––– Total non-current liabilities 141 162 –––––– –––––– Current liabilities Trade payables 155 361 Current tax payable 49 138 –––––– –––––– Total current liabilities 204 499 –––––– –––––– Total liabilities 345 661 –––––– –––––– Total equity and liabilities 1,770 1,730 –––––– ––––––

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Angel Group: Statement of profit or loss and other comprehensive income for the year ended 30 November 2013 $m Revenue 1,238 Cost of sales (986) –––––– Gross profit 252 Other income 30 Administrative expenses (45) Other expenses (50) –––––– Operating profit 187 Finance costs (11) Share of profit of equity accounted investees (net of tax) 12 –––––– Profit before tax 188 Income tax expense (46) –––––– Profit for the year 142 –––––– Profit attributable to: Owners of parent 111 Non-controlling interest 31 –––––– 142 –––––– Other comprehensive income: Items that will not be reclassified to profit or loss Revaluation of property, plant and equipment 8 Actuarial losses on defined benefit plan (4) Tax relating to items not reclassified (2) –––––– Total items that will not be reclassified to profit or loss 2 –––––– Items that may be reclassified to profit or loss Financial assets 4 Tax relating to items that may be reclassified (1) –––––– Total items that may be reclassified subsequently to profit or loss 3 –––––– Other comprehensive income (net of tax) for the year 5 –––––– Total comprehensive income for year 147 –––––– Total comprehensive income attributable to: $m Owners of the parent 116 Non-controlling interest 31 ––––– 147 –––––

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Angel Group: Statement of changes in equity for the year ended 30 November 2013

Balance 1 December Share capital issued Dividends for year Total comprehensive income for the year Balance 30 November

Share capital

Retained earnings

$m 625 225 (10) –––– 850 ––––

Other components of equity revaluation reserve

Total

Noncontrolling interest

Total

$m 359

Other components of equity financial assets reserve $m 15

$m 5

$m 1,004 225

$m 65

(10) 107

3

6

116

(6) 31

$m 1,069 225 (16) 147

–––– 456 ––––

––– 18 –––

––– 11 –––

–––––– 1,335 ––––––

––– 90 –––

–––––– 1,425 ––––––

The following information relates to the financial statements of the Angel Group: (i) Angel decided to renovate a building which had a zero book value at 1 December 2012. As a result, $3 million was spent during the year on its renovation. On 30 November 2013, Angel received a cash grant of $2 million from the government to cover some of the refurbishment cost and the creation of new jobs which had resulted from the use of the building. The grant related equally to both job creation and renovation. The only elements recorded in the financial statements were a charge to revenue for the refurbishment of the building and the receipt of the cash grant, which has been credited to additions of property, plant and equipment (PPE). The building was revalued at 30 November 2013 at $7 million. Angel treats grant income on capitalbased projects as deferred income. (ii) On 1 December 2012, Angel acquired all of the share capital of Sweety for $30 million. The book values and fair values of the identifiable assets and liabilities of Sweety at the date of acquisition are set out below, together with their tax base. Goodwill arising on acquisition is not deductible for tax purposes. There were no other acquisitions in the period. The tax rate is 30%. The fair values in the table below have been reflected in the year-end balances of the Angel Group. Carrying values Tax base Fair values $million $million $million Property, plant and equipment 12 10 14 Inventory 5 4 6 Trade receivables 3 3 3 Cash and cash equivalents 2 2 2 –––– ––– ––– Total assets 22 19 25 Trade payables (4) (4) (4) Retirement benefit obligations (1) (1) Deferred tax liability (0·6) –––– ––– ––– Net assets at acquisition 16·4 15 20 –––– ––– –––

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(iii) The retirement benefit is classified as a long-term borrowing in the statement of financial position and comprises the following: $m Net obligation at 1 December 2012 74 Net interest cost 3 Current service cost 8 Contributions to scheme (9) Remeasurements – actuarial losses 4 ––– Net obligation at 30 November 2013 80 ––– The benefits paid in the period by the trustees of the scheme were $6 million. Angel had included the obligation assumed on the purchase of Sweety in current service cost above, although the charge to administrative expenses was correct in the statement of profit and loss and other comprehensive income. There were no tax implications regarding the retirement benefit obligation. The defined benefit cost is included in administrative expenses. (iv) The property, plant and equipment (PPE) comprises the following: Carrying value at 1 December 2012 Additions at cost including assets acquired on the purchase of subsidiary Gains on property revaluation Disposals Depreciation

$m 465 80 8 (49) (29) –––– Carrying value at 30 November 2013 475 –––– Angel has constructed a machine which is a qualifying asset under IAS 23 Borrowing Costs and has paid construction costs of $4 million. This amount has been charged to other expenses. Angel Group paid $11 million in interest in the year, which includes $1 million of interest which Angel wishes to capitalise under IAS 23. There was no deferred tax implication regarding this transaction. The disposal proceeds were $63 million. The gain on disposal is included in administrative expenses. (v) Angel purchased a 30% interest in an associate for cash on 1 December 2012. The net assets of the associate at the date of acquisition were $280 million. The associate made a profit after tax of $40 million and paid a dividend of $10 million out of these profits in the year ended 30 November 2013. (vi) An impairment test carried out at 30 November 2013 showed that goodwill and other intangible assets were impaired. The impairment of goodwill relates to 100% owned subsidiaries. (vii) The following schedule relates to the financial assets owned by Angel: $m 180 (26) 57 4 –––– Balance at 30 November 2013 215 –––– The sale proceeds of the financial assets were $40 million. Profit on the sale of the financial assets is included in ‘other income’ in the financial statements. Balance 1 December 2012 Less sales of financial assets at carrying value Add purchases of financial assets Add gain on revaluation of financial assets

(viii) The finance costs were all paid in cash in the period.

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Required: (a) Prepare a consolidated statement of cash flows using the indirect method for the Angel Group plc for the year ended 30 November 2013 in accordance with the requirements of IAS 7 Statement of Cash Flows. Note: The notes to the statement of cash flows are not required. (35 marks) (b) The directors of Angel are confused over several issues relating to IAS 7 Statement of Cash Flows. They wish to know the principles utilised by the International Accounting Standards Board in determining how cash flows are classified, including how entities determine the nature of the cash flows being analysed. They have entered into the following transactions after the year end and wish to know how to deal with them in a cash flow statement, as they are unsure of the meaning of the definition of cash and cash equivalents. Angel had decided after the year end to deposit the funds with the bank in two term deposit accounts as follows: (i) $3 million into a 12-month term account, earning 3·5% interest. The cash can be withdrawn by giving 14 days’ notice but Angel will incur a penalty, being the loss of all interest earned. (ii) $7 million into a 12-month term account earning 3% interest. The cash can be withdrawn by giving 21 days’ notice. Interest will be paid for the period of the deposit but if money is withdrawn, the interest will be at the rate of 2%, which is equivalent to the bank’s stated rate for short-term deposits. Angel is confident that it will not need to withdraw the cash from the higher-rate deposit within the term, but wants to keep easy access to the remaining $7 million to cover any working capital shortfalls which might arise. Required: Discuss the principles behind the classifications in the statements of cash flows whilst advising Angel on how to treat the two transactions above. (9 marks) (c) All accounting professionals are responsible for acting in the public interest, and for promoting professional ethics. The directors of Angel feel that when managing the affairs of a company the profit motive could conflict with the public interest and accounting ethics. In their view, the profit motive is more important than ethical behaviour and codes of ethics are irrelevant and unimportant. Required: Discuss the above views of the directors regarding the fact that codes of ethics are irrelevant and unimportant. (6 marks) (50 marks)

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Question 80 Havanna (Q2 December 2013) (a) Havanna owns a chain of health clubs and has entered into binding contracts with sports organisations, which earn income over given periods. The services rendered in return for such income include access to their database of members, and admission to health clubs, including the provision of coaching and other benefits. These contracts are for periods of between 9 and 18 months. Havanna feels that because it only assumes limited obligations under the contract mainly relating to the provision of coaching, this could not be seen as the rendering of services for accounting purposes. As a result, Havanna’s accounting policy for revenue recognition is to recognise the contract income in full at the date when the contract was signed. (6 marks) (b) In May 2013, Havanna decided to sell one of its regional business divisions through a mixed asset and share deal. The decision to sell the division at a price of $40 million was made public in November 2013 and gained shareholder approval in December 2013. It was decided that the payment of any agreed sale price could be deferred until 30 November 2015. The business division was presented as a disposal group in the statement of financial position as at 30 November 2013. At the initial classification of the division as held for sale, its net carrying amount was $90 million. In writing down the disposal group’s carrying amount, Havanna accounted for an impairment loss of $30 million which represented the difference between the carrying amount and value of the assets measured in accordance with applicable International Financial Reporting Standards (IFRS). In the financial statements at 30 November 2013, Havanna showed the following costs as provisions relating to the continuing operations. These costs were related to the business division being sold and were as follows: (i) A loss relating to a potential write-off of a trade receivable which had gone into liquidation. The trade receivable had sold the goods to a third party and the division had guaranteed the receipt of the sale proceeds; (ii) An expense relating to the discounting of the long-term receivable on the fixed amount of the sale price of the disposal group; (iii) A provision was charged which related to the expected transaction costs of the sale including legal advice and lawyer fees. The directors wish to know how to treat the above transactions. (9 marks) (c) Havanna has decided to sell its main office building to a third party and lease it back on a 10-year lease. The lease has been classified as an operating lease. The current fair value of the property is $5 million and the carrying value of the asset is $4·2 million. The market for property is very difficult in the jurisdiction and Havanna therefore requires guidance on the consequences of selling the office building at a range of prices. The following prices have been achieved in the market during the last few months for similar office buildings: (i) $5 million (ii) $6 million (iii) $4·8 million (iv) $4 million Havanna would like advice on how to account for the sale and leaseback, with an explanation of the effect which the different selling prices would have on the financial statements, assuming that the fair value of the property is $5 million. (8 marks) Required: Advise Havanna on how the above transactions should be dealt with in its financial statements with reference to International Financial Reporting Standards where appropriate. Note: The mark allocation is shown against each of the three issues above. Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks) (25 marks)

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Question 81 Bental (Q3 December 2013) (a) Bental, a listed bank, has a subsidiary, Hexal, which has two classes of shares, A and B. Ashares carry voting powers and B-shares are issued to meet Hexal’s regulatory requirements. Under the terms of a shareholders’ agreement, each shareholder is obliged to capitalise any dividends in the form of additional investment in B-shares. The shareholder agreement also stipulates that Bental agrees to buy the B-shares of the minority shareholders through a put option under the following conditions: – The minority shareholders can exercise their put options when their ownership in B-shares exceeds the regulatory requirement, or – The minority shareholders can exercise their put options every three years. The exercise price is the original cost paid by the shareholders. In Bental’s consolidated financial statements, the B-shares owned by minority shareholders are to be reported as a non-controlling interest. (7 marks) (b) Bental has entered into a number of swap arrangements. Some of these transactions qualified for cash flow hedge accounting in accordance with IAS 39 Financial Instruments: Recognition and Measurement. The hedges were considered to be effective. At 30 November 2013, Bental decided to cancel the hedging relationships and had to pay compensation. The forecast hedged transactions were still expected to occur and Bental recognised the entire amount of the compensation in profit or loss. Additionally, Bental also has an investment in a foreign entity over which it has significant influence and therefore accounts for the entity as an associate. The entity’s functional currency differs from Bental’s and in the consolidated financial statements, the associate’s results fluctuate with changes in the exchange rate. Bental wishes to designate the investment as a hedged item in a fair value hedge in its individual and consolidated financial statements. (6 marks) (c) On 1 September 2013, Bental entered into a business combination with another listed bank, Lental. The business combination has taken place in two stages, which were contingent upon each other. On 1 September 2013, Bental acquired 45% of the share capital and voting rights of Lental for cash. On 1 November 2013, Lental merged with Bental and Bental issued new Ashares to Lental’s shareholders for their 55% interest. On 31 August 2013, Bental had a market value of $70 million and Lental a market value of $90 million. Bental’s business represents 45% and Lental’s business 55% of the total value of the combined businesses. After the transaction, the former shareholders of Bental excluding those of Lental owned 51% and the former shareholders of Lental owned 49% of the votes of the combined entity. The Chief Operating Officer (COO) of Lental is the biggest individual owner of the combined entity with a 25% interest. The purchase agreement provides for a board of six directors for the combined entity, five of whom will be former board members of Bental with one seat reserved for a former board member of Lental. The board of directors nominates the members of the management team. The management comprised the COO and four other members, two from Bental and two from Lental. Under the terms of the purchase agreement, the COO of Lental is the COO of the combined entity. Bental proposes to account for the transaction as a business combination and identify Lental as the acquirer. (10 marks) Required: Discuss whether the accounting practices and policies outlined above are acceptable under International Financial Reporting Standards. Note: The mark allocation is shown against each of the three issues above. Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks) (25 marks)

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Question 82 Zack (Q4 December 2013) (a) Due to the complexity of International Financial Reporting Standards (IFRS), often judgements used at the time of transition to IFRS have resulted in prior period adjustments and changes in estimates being disclosed in financial statements. The selection of accounting policy and estimation techniques is intended to aid comparability and consistency in financial statements. However, IFRS also place particular emphasis on the need to take into account qualitative characteristics and the use of professional judgement when preparing the financial statements. Although IFRS may appear prescriptive, the achievement of all the objectives for a set of financial statements will rely on the skills of the preparer. Entities should follow the requirements of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors when selecting or changing accounting policies, changing estimation techniques, and correcting errors. However, the application of IAS 8 is additionally often dependent upon the application of materiality analysis to identify issues and guide reporting. Entities also often consider the acceptability of the use of hindsight in their reporting. Required: (i) Discuss how judgement and materiality play a significant part in the selection of an entity’s accounting policies. (ii) Discuss the circumstances where an entity may change its accounting policies, setting out how a change of accounting policy is applied and the difficulties faced by entities where a change in accounting policy is made. (iii) Discuss why the current treatment of prior period errors could lead to earnings management by companies, together with any further arguments against the current treatment. Note: The total marks will be split equally between each part. Credit will be given for relevant examples. (15 marks)

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(b) In 2013, Zack, a public limited company, commenced construction of a shopping centre. It considers that in order to fairly recognise the costs of its property, plant and equipment, it needs to enhance its accounting policies by capitalising borrowing costs incurred whilst the shopping centre is under construction. A review of past transactions suggests that there has been one other project involving assets with substantial construction periods where there would be a material misstatement of the asset balance if borrowing costs were not capitalised. This project was completed in the year ended 30 November 2012. Previously, Zack had expensed the borrowing costs as they were incurred. The borrowing costs which could be capitalised are $2 million for the 2012 asset and $3 million for the 2013 asset. A review of the depreciation schedules of the larger plant and equipment not affected by the above has resulted in Zack concluding that the basis on which these assets are depreciated would better reflect the resources consumed if calculations were on a reducing balance basis, rather than a straight-line basis. The revision would result in an increase in depreciation for the year to 30 November 2012 of $5 million, an increase for the year end 30 November 2013 of $6 million and an estimated increase for the year ending 30 November 2014 of $8 million. Additionally, Zack has discovered that its accruals systems for year-end creditors for the financial year 30 November 2012 processed certain accruals twice in the ledger. This meant that expenditure services were overstated in the financial statements by $2 million. However, Zack has since reviewed its final accounts systems and processes and has made appropriate changes and introduced additional internal controls to ensure that such estimation problems are unlikely to recur. All of the above transactions are material to Zack. Required: Discuss how the above events should be shown in the financial statements of Zack for the year ended 30 November 2013. (8 marks) Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks) (25 marks)

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Answer 79 Angel Cash Flow Statement Operating Profit before tax [188given +5machine (iv) +3refurb (i) +1job grant (i)] Equity accounted {share of associate pat} Finance Operating profit Inventory Receivables Payables Depreciation Disposal Impairment Defined benefit cost

[190-155+3] [180-125+3] [361-155+4] [ppe profit=63-49] + [fa profit=40-26] [gw=26.5 +intangible=90] [3interest +8given -1acquired]

Cash generated from operations Interest paid Tax paid Operating cash flow Investing Purchase of financial assets (vii) Sale of financial assets (vii) Associate dividend received (v) Associate purchase (v) Ppe additions (iv) [80given -14 acq(ii) +2grant(i)] Ppe disposals (iv) Machine (iv) [4 +1 borrowing cost(iv)] Contributions to pension investment (iii) Sub acquisition Cash in hand of incoming sub Renovation (i) Grant received for renovation Financing Share issue [850-625] Borrowing repayment [57-26] Parent dividend to controlling interest Non controlling interest dividend Cash flow {calculated from opening and closing below} Opening cash Closing cash Total marks

197 (12) 11 ____ 196 41 58 (210) 29 (28) 116.5 10 ____ 212.5 (11) (135.5) ____ 66

marks 3 1 1

1 1 1 1 2 2 1

1 3

(57) 40 3 (71) (68) 63 (5) (9) (30) 2 (3) 1

1 1 1 1 1 1 1 1 1 1 1 1

225 (31) (10) (6) ____ 110 355 ____ 465 ____

1 1 1 1 1

35

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Workings Goodwill Opening Closing Acquired [30 consideration given – {20 na given – 1.5 DT calculated below}] Impairment described in (vi) Intangible Opening Closing Impairment described in (vi) Associate Opening Closing i/s ($40m)(30%) from (v) and also given dividend ($10m)(305) from (v) Associate purchase Tax Opening ct Closing ct Opening dt Closing dt p/l oci oci acquisition deferred tax [20cv-15tb](30%) Tax paid

120 (105) 11.5 ____ 26.5 ____ 240 (150) ____ 90 ____ 0 (80) 12 (3) ____ (71) ____ 138 (49) 31 (35) 46 2 1 1.5 ____ 135.5 ____

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Further comments Full marks Note that the above scores full marks. Note that no other information than the above is required for full marks. Note that there is no narrative content in the answer to the numerical component of the exam. Note that I have provided no explanation of anything for full marks. So the comments below form no part of the required answer and only serve to explain some of the trickier elements of the above. Face of cfs Note the importance of the face of the cfs. The face of p/l or b/s is important in consolidation questions; but not quite so important. The face of the cfs is crucial. The examiner placed all the marks there. Of course, markers will look in your workings if you have made mistakes to award method marks. But the key is get all you can on the face. Reverse order It is usually best to do the examiners “following information” in reverse order from (viii) to (i). So this answer has that structure. Profit before tax It is unfortunate that the answer above necessarily starts with the adjustment to pbt because in the exam you would do the adjustment to pbt last. The 3 marks are 1 for copying the $188m and 2 further marks for the adjustments. These adjustments are very awkward and it is dubious whether they are even worth thinking about in the hour you have. Real life In real life, if you were working through your cfs and discovered that there was an error on renovations (i) and machine construction (iv) and grant accounting (i) that meant your p/l and b/s were wrong then you would stop doing the cfs then go back to restate the p/l and b/s finally coming back to the cfs to finish the cfs. So the challenge of restating pbt in the middle of a cfs is challenging because it is not something you would do in real life. I think it is a valid challenge and I think you must accept that all numerical questions have their challenges but it is reasonable to note that restating pbt in the middle of a cfs is not something accountants do in real life. Restated profit or loss Here is the restated p/l so you can see how the $197m pbt would be extracted in real life:Revenue Cost of sale Other income Administration Other expenses

1238 (983) 31 (45) [50 -4 to remove machine construction (iv)] (46) ____ Operating profit 195 Finance costs [11 -1 to remove borrowing cost and capitalise in ppe] (10) Associate 12 ____ Profit before tax 197 ____ Of course, it would be terrible exam technique to do any of the above in the exam as this restatement scores no marks and is time consuming. [986 -3 to remove the refurb(i)] [30 +1 for the jobs grant(i)]

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Restated cfs Restating the p/l as above means there must be a corresponding restatement of the operating section of the cfs as follows:Operating marks Profit before tax [188given +5machine (iv) +3refurb (i) +1job grant (i)] 197 3 Equity accounted {share of associate pat} (12) 1 Finance [11 -1 borrowing cost] 10 1 ____ Operating profit 195 Inventory [190-155+3] 41 1 Receivables [180-125+3] 58 1 Payables [361-155+4] (210) 1 Depreciation 29 1 Disposal [ppe profit=63-49] + [fa profit=40-26] (28) 2 Impairment [gw=26.5 +intangible=90] 116.5 2 Defined benefit cost [3interest +8given -1acquired] 10 1 ____ Cash generated from operations 211.5 Interest paid [11 -1 borrowing cost] (10) 1 Tax paid (135.5) 3 ____ Operating cash flow 66 ____ Note the slight change to the interest. Movements The movements given are also not quite right. The question tells you the movements are not quite right but to actually restate the movements in the exam would be another huge waste of time. But here are the true movements. PPE Actual ppe additions are $82m including the acquisition. Angel has $80m in their books because they have used net recognition instead of gross. Angel has set the credit balance of $2m against the actual additions of $82m to show $80m. So angel should gross up their balance sheet to put an extra $2m in the top and an extra $2m in the bottom for the income as follows:Dr ppe 2 Cr deferred income (liabilities) 1 Cr other income (and into retained earnings) 1 Further angel has made the error of bundling the additions with acquisitions. Here is ppe restated:Opening 465 Additions [actual total gross additions 82 -14 acq below] 68 Machine construction [4 construction +1 borrowing] 5 Renovation and refurbishment 3 Acquisition 14 Revaluation gains 8 Disposals (49) Depreciation (29) ____ Closing [475given +2 grant +5machine +3refurb] 485 ____

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Retirement benefit liability Here it is restated:Opening Interest Current service cost [8 -1 acq below] Acquisition Contributions Remeasurements

74 3 7 1 (9) 4 ____ Closing 80 ____ Hence you can see why we only add $10m back to operating profit. It is because only $10m (3+7) is in there. (1)(b) Marking guide The usual 1 mark per relevant point but with up to 2 marks for each deposit discussion. As usual the discussion can bring in any relevant ideas or examples. Classification Cfs are presented under three headings; operating, investing and financing. Classification is the process of putting a cash flow under a heading. So if you put a share issue into “financing” then you are said to have classified the cash flow as “financing”. Summary The standard on cfs (IAS7) is imprecise in its definitions, but roughly speaking operating flows relate to operations, investing flows relate to nca and financing flows relate to debt and equity. Deciding When deciding where to put a cash flow you should look at who paid or received the cash, where the cash went and what it was for. Subjective But this process is highly subjective. So it is common for two companies to put identical cash flows in quite different places. For example, the above cfs has the pension contribution in investing because the money goes into investments. But the cfs could have had the pension contribution in operating because the cash is eventually for employees. Cash and cash equivalents However there is one more class in a cfs that you hardly notice and that is cash itself. Cash is defined as notes and coins plus asset or overdraft current account. Cash equivalents are highly liquid highly stable investments that are so close to being cash that we may as well class them as cash. Meaning Highly stable means little change in fv from day to day. Highly liquid means the cash can be accessed quickly without undue penalty. The standard hints that quickly can be taken as within 3 months. Example fails So, for example, equity investments are highly liquid but fail the cash equivalent test because their fv is unstable. Locked in 12 month deposits are highly stable but fail because you cannot get at the cash quickly. But the deposits in the scenario are not locked in and so subjective analysis is required.

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Deposit (i) Both deposits are stable because the fv of deposit accounts hardly changes at all from day to day. In fact the fv of a deposit does not change much from year to year. But I think deposit (i) is a fail. I think deposit (i) is an investment and not cash. I think that the penalty of losing all interest accrued for withdrawal means that Angel would be very unlikely to treat the asset as a liquid cash balance. [But you could argue the opposite.] Meaning This means that when Havana put their money into deposit (i) then Havana would record a decrease in cash and an increase in investments and therefore an investing cash flow. Deposit (ii) This looks like a cash equivalent to me. The penalty for early withdrawal is small. So Angel would quite happily liquidate this cash equivalent and turn it into cash and not worry about losing 1% interest down to 2% from 3%. [But you can argue the opposite.] Meaning This means that when Havana put their money into deposit (ii) then Havana would record a decrease in cash and an increase in cash equivalents and therefore no cash flow at all. This is a movement from one cash bucket to another. (1)(c) Marking guide The usual 1 mark per idea well expressed applies. As ever, any idea will score provided it is relevant. In this case the discussion can be so wide ranging that almost anything will score. Ethics The ACCA have the following principles in their guidelines to ethics: Professionalism Integrity Competence Confidentiality Objectivity And all the other accounting bodies have something similar. CFO The chief financial officer will almost certainly be a qualified accountant. So the code of ethics should certainly be important to him or her at the very least. Profit motive It is widely accepted that profit is important in ethics. Of course, Karl Marx had other ideas. But there is a classic ethics model by a guy called Tucker that puts the question of profitability first on his list and this model is on the ACCA syllabus in p1. So it is clear the ACCA agree that profit is important. Corporate social responsibility (CSR) But there is more to ethics than profit. There are other considerations like legality, sustainability and honesty. And there is more to ethics than shareholders. There are employees, environment and society. These ideas about public interest and accounting ethics are often termed CSR.

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Conflict It is quite true that the profit motive does often conflict with public interest and accounting ethics and wider CSR. A really simple example is lying. All a company has to do to increase profit is to lie about its costs. Directors The directors sound quite selfish to me. So I do not think I would appeal to their honesty or their integrity or anything like that. I think I would appeal to their pocket. There is substantial evidence that companies that have good CSR are positively rated by shareholders and this is reflected in the share price. I think I would point this out to directors to illustrate the importance of ethics.

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Answer 80 Havanna Marking guide 1 mark per point. Any point drawing from the scenario will score. (a) Revenue There are two forms of revenue; Sale of goods This revenue is recognised at the point that risks and rewards transfer. Sale of services This revenue is recognised over the period of the service and so in accordance with completion in each period. Subjective It is true that the standard on revenue (IAS18) is subjective. It can sometimes be hard to know whether a revenue stream is goods or services. A classic example is film making. Some companies say this is a big intangible good delivered at a point in time. Other companies say that filming is a service and recognise the revenue over a period like a construction contract. Sports organisation The Havana revenue appears to have no ambiguity. It seems very clear that this is a service and that the revenue should be recognised over the period. Evidence The evidence is clear. The scenario says “services” and “over given periods” and “9 and 18 months”. This is very clear evidence in favour of recognition over the period. Effect The effect will be to throw revenue forward. Currently revenue is recognised at the start. So moving to recognition over the period will throw revenue forward. This will be particularly noticeable for revenue straddling a year end. Restatement It sounds like Havana have been doing their revenue incorrectly for a while. It seems likely that restatement of comparatives is required.

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(b) Disposal group The phrase “disposal group” is just another way of saying “discontinued operation”. So Havana has disclosed the outgoing regional business division as a discontinued operation. Discontinued operation An operation is discontinued if it is closed or sold during the year or held for sale at the year end. Held for sale requires the following criteria fulfilled: S sell: clear intent to sell A available: asset must be available for immediate sale L locate: actively locating a purchaser E expected: completion expected within 12 months Conclusion There is so much going on in this scenario that I will keep my assessment brief. I think it looks like the criteria are all fulfilled. The only thing I will say in detail is that the payment in November 2015 in two years is not a problem. It sounds like the completion will occur shortly after the year end and then the cash will come in much later. The point being that the sale completion is expected well within 12 months. Effect The effect of the discontinuance will be that the division revenue and costs will be netted down to net profit and slotted on a single line at the bottom of the profit or loss and labelled “discontinued” and the assets and liabilities will be netted down to a single line on the position statement and labelled “discontinued” (roughly speaking). Impairment And the discontinuance will trigger an impairment as follows: Carrying value 90 Impairment (balance) (50) ___ Recoverable value (given) 40 ___ Of course, this means the Havana impairment of $30m is not enough. Other issues But the scenario goes on to talk about other issues. All of these other issues must be sorted out first before the above impairment test. So in reality it appears likely that the final impairment test will have figures different to those above. (i) receivable This receivable sitting in the division must be written off before we start thinking about discontinuance. (ii) discounting I cannot tell for sure; but it sounds like Havana is confused about discounting and unwinding. The $40m that Havana will receive in two years from the current year end needs discounting down to the current year end fv. This will give a recoverable value which will be smaller than $40m because of the discounting. Then next year and the year after the receivable from the purchaser will unwind back up to the $40m. (iii) transaction costs Recoverable value used above means fv less costs to sell in this case. There is no value in use because Havana will not use the division. Havana will sell the division. The transaction costs are costs to sell. So the transaction costs will be recorded as costs to sell. This gives a reduction to the recoverable value which will give rise to an increase in the impairment above.

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(c) Leases There are two forms: Finance lease Risks and rewards transferred to user (lessee). Operating lease Risks and rewards not transferred. 10 years Really to make an adequate conclusion about the operating lease assumption we require the underlying life of the asset itself. But since most buildings last a lot longer than 10 years I am going to assume that the classification as an operating lease is reasonable. Sale and operating lease back The risks and rewards leave Havana during the sale and stay with the third party during the operating lease back. So the sale really is a sale and a profit on disposal must go into the p/l. Different selling prices Now this is where this gets messy. We are asked to consider what would be recorded depending on four alternative selling prices. Simple answer The simple answer would simply assume that the amount received represents the sale proceeds of the building and so the building would be derecognised and profits would be recorded as follows: Received Carrying value Profit 5 4.2 0.8 6 4.2 1.8 4.8 4.2 0.6 4 4.2 (0.2) Assumption This assumption is quite reasonable. If the property was sold for $6m for example then it would be reasonable to assume that $6m was the fv given that a similar building has been sold for that amount recently. But the question asks us to assume that the fv is $5m and therefore assume that only transaction (i) is at fair value. Transactions (i) and (iii) Transaction (iii) is at $4.8m and that is so close to $5m that I suggest we use the simple answer above for both (i) and (iii) based upon materiality. Transactions (ii) and (iv) If we assume the fv is $5m then both these two are $1m away from the fv. The standard (IAS17) tells us that this is a compound transaction and requires that we recognise the sale proceeds at the fv of the building giving the following messy double entry: Transaction (ii) Dr bank 6 Cr disposal sale proceeds [giving rise to a profit of 0.8] 5 Cr liability (balance) 1 Transaction (vi) Dr bank 4 Dr asset (balance) 1 Cr disposal sale proceeds [giving rise to a profit of 0.8] 5

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Release Then the asset or liability would be released to the p/l over 10 years. The idea behind this can be explained first by looking at transaction (ii). The idea is that it is assumed by the standard that if the cash received on disposal is higher than it should be then the operating lease rental paid would be higher too and the release of $100k credit from the position statement each year should compensate. The opposite logic applies to transaction (iv). Fair value But all this fancy accounting is highly dubious because the assumption of a fair value of exactly $5m to the $1 and nothing else in this volatile market is highly dubious. Fair value measurement There are three levels: 1 exact equivalent active market price 2 approximately equivalent transaction price 3 unobservable inputs into financial models Building fair value measurement The building fvm would use level 2 and I would say that applying level 2 to the four inputs between $4m and $6m would give a fair value of $5m +/- $1m. This means a fv of $5m give or take $1m and not a fair value of exactly $5m to the $1. I think messing with the $1m liability in (ii) and the $1m asset in (iv) is highly questionable in this case.

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Answer 81 Hexal Marking guide 1 mark per point. This is an enormously technical question. But there are still very few marks for dumping knowledge. As usual it is points drawn from the scenario that will score most marks. (a) Bental and Hexal Bental has a sub Hexal and Hexal has a messy share structure. Before we can decide what the group should do with the Hexal shares, we must decide what Hexal should do with the Hexal shares. Equity The problem with testing suspected equity is that financial reporting currently has no working definition of equity. So we are forced to test the suspected equity against the definition of a liability as a “present obligation to a future economic outflow” and look for a negative response. A-shares The scenario tells us nothing about the A-shares apart from the voting powers. So presumably we are expected to assume that the A-shares are equity and that Bental has a majority giving Bental control of Hexal. B-shares The scenario tells us lots about the B-shares and most of it is fairly complicated. But a feature that jumps out of the scenario is the B-shareholders rights to make Hexal hand over money. These rights to make Hexal hand over money are hidden in fancy words like “put option” and “exercise”. But what these fancy words mean is that the B-shareholders have the right to make Hexal hand over money. Rights and obligations So if the B-shareholders have the right to make Hexal hand over money then Hexal has the obligation to hand over money. So the B-shares contain obligations and are debt liabilities. Debt from Hexal perspective So Hexal will record the B-share debt in liabilities. Debt from Group perspective The parent asset in the B-shares will then be set against the sub liability in the B-shares leaving a group liability to outside B-shareholders in liabilities.

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(b) Hedging There are two types of hedging strategy and therefore two types of hedge accounting. The hedging strategies are subtle and undertaken by practiced derivative traders. The hedge accounting is arcane and undertaken by specialist hedge accountants. Cash flow hedge Usually, in a cf hedge, an entity bets against a risk of a future asset purchase costing more than expected by betting on the asset purchase costing more than expected. Then if the asset does cost more than expected at least the entity wins the bet and so breaks even. Fair value hedge Usually, in a fv hedge, the entity has the asset already but fears the asset value dropping. So the entity bets on the asset value dropping. Then if the asset value does drop at least the entity wins the bet and so breaks even. Swaps It is not crystal clear what is going on with the swaps. But it sounds like Bental used some swaps to set up a cash flow hedge and then changed its mind and paid off the derivative trader early. IAS39 It appears that whilst the hedge lived the hedge was hedging a risk. And it does sound like the risk transaction is still expected to occur soon. A reasonable interpretation of the scenario and the standard would suggest that the accumulated gain on the cash flow hedge derivative should stay in other components of equity until the risk transaction occurs. Associate There is a foreign associate in this story and presumably there is a foreign currency derivative set up so that the losses in the associate fv due to currency changes are matched by gains in the derivative. It sounds ripe for fair value hedge accounting but I think this would be unacceptable as the movements in the associate fv would have far more to do with the associate performance than the currency value. IAS39 The standard makes this decision easy for me by simply forbidding fair value hedging for associates.

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(c) Step acquisition The purchase of 45% to give influence and then 55% to give control is often referred to as a “step acquisition”. The mechanics of the accounting involve the acquirer being deemed to have sold the original 45% and then purchased 100% at the point of control. Merger The scenario describes the transaction as a “merger”. A merger is a business combination of roughly equal entities where the shareholders come together via a share swap. Acquisition The concept of a merger may exist in management strategy but it does not exist in financial reporting. The business combination must be viewed as an acquisition and one or other merging entity must be viewed as the acquirer. Lental The scenario tells us at the end that Bental proposes to view Lental as the acquirer. The evidence is contradictory and could be taken to indicate either as the acquirer. Control As you might imagine, the assessment of acquirer and acquired comes back to the central concept of control. Control is the power to direct activities (with exposure to variable returns). So we must look at who will direct the activities of the combined entity after the combination. Evidence (1) Shareholding Former Bental shareholders have 51% of the votes in the new combined entity and former Lental shareholders have only 49%. This means that the former Bental shareholders are in a position to out vote the former Lental shareholders. More significantly, former Bental shareholders can pass a majority resolution to hire and fire directors in the new combined entity or change strategy of the new combined entity. It is marginal but it looks like the former Bental shareholders dominate the combined entity. Evidence (2) Board The board of the new group is six of which five come from Bental. This is evidence that it is the Bental strategies that will survive the business combination and evidence that Bental is the acquirer. Evidence (3) COO The former COO of Lental is now the current COO of the combined group. This is evidence that it is the Lental way of doing business that will prevail. The current COO of the combined group is now a 25% owner of the combined group. This is more evidence that it will be Lental ideas that dominate the combined group. Evidence (4) Values The information about the values is just information about values and not information about control. But it can be used as corroborative evidence. This is because the history of mergers usually tells us that it is the bigger entity that dominates the combined entity. Lental was bigger than Bental whichever way you look at it. This is weak evidence that Lental is the acquirer. Conclusion The evidence is contradictory and so the conclusion is necessarily marginal. However, I suggest that Bental is the acquirer and Lental is the acquired. I suggest the evidence (1) and (2) above outweigh (3) and (4) above.

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Other ideas Here are some other ideas that could be discussed:Calculation of goodwill in step acquisition Accounting for the associate for the month Related party disclosure for COO And anything else relevant. Further points Here are further points to note that go beyond the 10 marks required:Numbers You may also notice that the numbers look very odd upon analysis. When Bental pay off 45% of the former Lental shareholders in cash then that leaves 55%. This 55% of former Lental shareholders then take 49% of the combined entity. But 100% of the former Bental shareholders take only 51% of the combined entity. Of course, this is partly because Bental was smaller than Lental, but only slightly smaller. Weird. Deeper If you dig even deeper then the numbers look stranger. After the first cash transaction and during the second share swap, Bental shareholders bring 100% of Bental and 45% of Lental to the table. But Lental shareholders only bring 55% of Lental. Bental shareholders bring so much and yet somehow Bental shareholders end up with only a 51% slice of the pie. AOL Time Warner But although the figures look bizarre, it is possible that something as crazy as this could happen in real life. The merger of AOL and Time Warner in 2001 was a similar transaction with Time Warner appearing to be the acquirer but AOL shareholders dominating the merged shareholding and AOL executives dominating the new board. And yet AOL were bringing next to nothing to the table. The former AOL shareholders did really well and got lucky but Time Warner current chief Jeff Bewkes believes the 2001 AOL merger was 'the biggest mistake in corporate history'. In fact, it is possible this scenario draws some inspiration from AOL Time Warner. Reverse acquisition By the way, it is possible to argue that Lental is the acquirer and that Bental is the acquired. This style of transaction is sometimes called a “reverse acquisition” because the apparent acquirer and acquired are the reverse of the actual acquirer and acquired. Mechanics If it is concluded that Lental is the acquirer then it is going to be very awkward accounting for this at ground level because it is Bental that actually spent the cash. However, the standard requires that the acquirer must calculate the goodwill on acquiring the acquired. So if Lental is considered the acquirer then Lental must calculate the goodwill on acquiring Bental. Tricky.

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Answer 82 Zack (a)(i) Accounting policies as choices (policy choices) The phrase “accounting policy” is very closely related to choice in IFRS. Some IFRS have choices between two different ways of measuring the same thing. The choice that a company makes on first encountering the problem then becomes their policy and must be applied consistently thereafter. Examples The two classic examples are between full and partial goodwill and between cost and fair value PPE. A company selecting full goodwill and cost PPE is said to have selected two accounting policies. Judgement The company is required to choose the policy that works best for the company to produce a true and fair view. This is where the judgement comes in. Accounting policies as practical compromises (policy formulae) But there is another meaning to the phrase “accounting policy”. This meaning relates to practical compromises in big companies and is best shown by example. Example Say there is a big company with loads of similar machines. They all have lives of roughly 5 years. Some will last more and others will last less than 5 years but on average the life is roughly 5 years. Of course the company should take every machine individually and apply the individual life to get individual depreciation. Many big companies do this and a policy is not required. But other big companies aggregate all the machines together and use an average life. This then becomes their policy. Materiality This is where materiality comes in. The aggregation described above is strictly wrong. The standard requires that each depreciating asset is depreciated individually. But if the error this aggregation produces is immaterial then the use of a policy becomes acceptable. Other ideas Students can also discuss:First time adoption Transition Qualitative characteristics Prescriptive IFRS New IFRS Choice in IAS40 for investment properties Choice in IAS20 for grants Stock fifo as another example of accounting policies as practical compromises The shocking fact that a policy for goodwill is not absolutely required as full or partial can be used on an acquisition by acquisition basis Or anything else.

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Further commentary IAS8 is less than perfect and frankly rather dated. But essentially the term “policy” is used by IAS8 exclusively in the context of choice. So only when a standard has choice would a company have a policy choice. So I have referred to this meaning of “policy” as “policy choice” above. Where there is no choice then company accounting policy must simply follow the standard. So there are effectively only four policy choices: IAS16 PPE cost or fv IFRS3 full or partial IAS40 IP fv or cost IAS20 Grant gross or net. IAS8 refers to this as “selection between allowed alternatives”. So only when there are allowed alternatives would a policy choice exist. The concept of the accounting policy as practical compromises does not exist in IFRS. Nowhere in IFRS is there the suggestion that you can have a policy for depreciation. And yet this is what immediately springs to mind when thinking of accounting policies. In fact, IAS16 is quite explicit that asset consumption is measured asset by asset and year by year. Further, nowhere in IFRS is there the suggestion that you can have a policy for revenue or deferred tax or provisions. In all cases you must simply follow the IFRS. And yet the term “policy” is regularly used in these contexts. Only IAS2 talks about practical compromises. IAS2 discusses practical compromises in the context of cost valuation for high volumes of stock. Of course, you know IAS2 talks about fifo and weighted average. But it does not call the selection of the measurement technique a “policy”. IAS2 calls the selection of the measurement technique a “cost formula”. So I have referred to this meaning of “policy” as “policy formulae” above. There is no such thing as a stock policy in IFRS and yet we often hear about a “fifo stock valuation policy”. It is no wonder that this word “policies” is so often misunderstood. (a)(ii) Consistency The most important requirement in policy application is consistency. So once a policy is selected then a change in policy should be very rare. Improvement However, a change in accounting policy is required if the change would result in an improvement in the fs. In particular, a change in policy should improve fs relevance. Example A good example is PPE. It is often argued that going from cost to fv is acceptable because the fs become more relevant. It is often argued that going from fv to cost is unacceptable as the fs become less relevant. Application Ideally the company should apply a change of accounting policy retrospectively. This means getting the figures how they would have been had the new policy always been the policy. This is a “difficulty” as it means digging around in ancient transactions. Restatement Also the comparatives need restatement. Calling this a “difficulty” is perhaps overstating the issue. But it is certainly time consuming.

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Other ideas Students may also discuss:Change of policy from change in IFRS Change of policies on first time adoption of IFRS Change of policies on first time adoption of IFRS for SMEs Disclosure Restatement of current opening balances Effect of PPA in socie Comparability The shocking fact that adopting IAS16 fv does not actually require restatement of comparatives! Or anything else. (a)(iii) Prior period errors These are exactly what they sound like. They are errors made in the prior period. Current treatment The current treatment is to put these errors through reserves and restate the comparatives. This process is often called “prior period adjustment” (PPA) or simply “restatement”. Materiality Like anything in financial reporting, a PPA is only accommodated if it is material. immaterial prior period errors must go through the current year’s figures.

So

Example Say a company incorporated to run an ocean liner forgot to depreciate the ocean liner last year. This would obviously be material. So the company would be required to restate comparatives to accommodate last year’s depreciation before charging this year's. Last year’s depreciation would be charged against this year’s opening reserves. Earnings management It is obvious where the opportunity for earnings management arises. The ocean liner could deliberately forget to charge depreciation in a year when profits are low and then pick up that depreciation through reserves the following year. Hindsight When assessing prior period errors companies should avoid hindsight. An error was an error if it was obviously wrong at the time. An entity that makes a reasonable estimate based on information available at the time has not made an error even if hindsight shows the estimate to be incorrect. This is simply a change in accounting estimate. Other ideas Students could also discuss:Auditors Creative accounting Ethics Suggesting prior period error accounting forbidden Or anything else.

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(b) Borrowing costs The company has changed its policy from expensing borrowing costs to capitalising borrowing costs. So restatement is required. Prior period error Actually it is probably better to describe this as a prior period error. The standard on borrowing costs (IAS23) has no choice. Zack never had a policy choice to make. Borrowing costs must be capitalised and they were not and this was wrong. Either way Zack still needs restatement. Restatement So the comparatives will be restated to pick up the $2m for the earlier asset and an adjustment will go through reserves. The current $3m will simply be capitalised. Depreciation This story is more difficult to be sure about. We are talking about an accounting policy as a practical compromise and we are talking about a change in our view of the consumption of asset value. There are two ways to view the same story. Alternative one If the earlier basis of depreciation was reasonable based upon the information available at the time then Zack have nothing to apologise for. So Zack would simply start reducing balance depreciation in the current year. The technical name for this is prospective treatment of a change in estimate. Alternative two But if it was always clear that reducing balance depreciation was right then straight line was wrong. So this is a prior period error and restatement would result and Zack would pick up all the figures in the scenario. The technical name for this is retrospective treatment of a prior period error. Accruals The double counting in last year’s accruals sounds like a simple prior period error and restatement is required. Effect The $2m would go through the reserves and the comparatives would show reduced liabilities and costs.

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Question 83 Marchant (Q1 June 2014) The following draft financial statements relate to Marchant, a public limited company. Marchant Group: Draft statements of profit or loss and other comprehensive income for the year ended 30 April 2014.

Profit or loss Revenue Cost of sales Gross profit Other income Administrative costs Other expenses Operating profit Finance costs Finance income Profit before tax Income tax expense Profit for the year Other comprehensive income Revaluation surplus Total comprehensive income for year

Marchant $m 400 (312) –––– 88 21 (15) (35) –––– 59 (5) 6 –––– 60 (19) –––– 41 –––– 10 –––– 51 ––––

Nathan $m 115 (65) –––– 50 7 (9) (19) –––– 29 (6) 5 –––– 28 (9) –––– 19 –––– –––– 19 ––––

Option $m 70 (36) ––– 34 2 (12) (8) ––– 16 (4) 8 ––– 20 (5) ––– 15 ––– ––– 15 –––

The following information is relevant to the preparation of the group statement of profit or loss and other comprehensive income: (i) On 1 May 2012, Marchant acquired 60% of the equity interests of Nathan, a public limited company. The purchase consideration comprised cash of $80 million and the fair value of the identifiable net assets acquired was $110 million at that date. The fair value of the noncontrolling interest (NCI) in Nathan was $45 million on 1 May 2012. Marchant wishes to use the ‘full goodwill’ method for all acquisitions. The share capital and retained earnings of Nathan were $25 million and $65 million respectively and other components of equity were $6 million at the date of acquisition. The excess of the fair value of the identifiable net assets at acquisition is due to non-depreciable land. Goodwill has been impairment tested annually and as at 30 April 2013 had reduced in value by 20%. However at 30 April 2014, the impairment of goodwill had reversed and goodwill was valued at $2 million above its original value. This upward change in value has already been included in above draft financial statements of Marchant prior to the preparation of the group accounts. (ii) Marchant disposed of an 8% equity interest in Nathan on 30 April 2014 for a cash consideration of $18 million and had accounted for the gain or loss in other income. The carrying value of the net assets of Nathan at 30 April 2014 was $120 million before any adjustments on consolidation. Marchant accounts for investments in subsidiaries using IFRS 9 Financial Instruments and has made an election to show gains and losses in other comprehensive income. The carrying value of the investment in Nathan was $90 million at 30 April 2013 and $95 million at 30 April 2014 before the disposal of the equity interest.

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(iii) Marchant acquired 60% of the equity interests of Option, a public limited company, on 30 April 2012. The purchase consideration was cash of $70 million. Option’s identifiable net assets were fair valued at $86 million and the NCI had a fair value of $28 million at that date. On 1 November 2013, Marchant disposed of a 40% equity interest in Option for a consideration of $50 million. Option’s identifiable net assets were $90 million and the value of the NCI was $34 million at the date of disposal. The remaining equity interest was fair valued at $40 million. After the disposal, Marchant exerts significant influence. Any increase in net assets since acquisition has been reported in profit or loss and the carrying value of the investment in Option had not changed since acquisition. Goodwill had been impairment tested and no impairment was required. No entries had been made in the financial statements of Marchant for this transaction other than for cash received. (iv) Marchant sold inventory to Nathan for $12 million at fair value. Marchant made a loss on the transaction of $2 million and Nathan still holds $8 million in inventory at the year end. (v) The following information relates to Marchant’s pension scheme: $m Plan assets at 1 May 2013 48 Defined benefit obligation at 1 May 2013 50 Service cost for year ended 30 April 2014 4 Discount rate at 1 May 2013 10% Re-measurement loss in year ended 30 April 2014 2 Past service cost 1 May 2013 3 The pension costs have not been accounted for in total comprehensive income. (vi) On 1 May 2012, Marchant purchased an item of property, plant and equipment for $12 million and this is being depreciated using the straight line basis over 10 years with a zero residual value. At 30 April 2013, the asset was revalued to $13 million but at 30 April 2014, the value of the asset had fallen to $7 million. Marchant uses the revaluation model to value its noncurrent assets. The effect of the revaluation at 30 April 2014 had not been taken into account in total comprehensive income but depreciation for the year had been charged. (vii) On 1 May 2012, Marchant made an award of 8,000 share options to each of its seven directors. The condition attached to the award is that the directors must remain employed by Marchant for three years. The fair value of each option at the grant date was $100 and the fair value of each option at 30 April 2014 was $110. At 30 April 2013, it was estimated that three directors would leave before the end of three years. Due to an economic downturn, the estimate of directors who were going to leave was revised to one director at 30 April 2014. The expense for the year as regards the share options had not been included in profit or loss for the current year and no directors had left by 30 April 2014. (viii) A loss on an effective cash flow hedge of Nathan of $3 million has been included in the subsidiary’s finance costs. (ix) Ignore the taxation effects of the above adjustments unless specified. Any expense adjustments should be amended in other expenses.

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Required: (a)(i) Prepare a consolidated statement of profit or loss and other comprehensive income for the year ended 30 April 2014 for the Marchant Group. (30 marks) (a)(ii) Explain, with suitable calculations, how the sale of the 8% interest in Nathan should be dealt with in the group statement of financial position at 30 April 2014. (5 marks) (b) The directors of Marchant have strong views on the usefulness of the financial statements after their move to International Financial Reporting Standards (IFRSs). They feel that IFRSs implement a fair value model. Nevertheless, they are of the opinion that IFRSs are failing users of financial statements as they do not reflect the financial value of an entity. Required: (b) Discuss the directors’ views above as regards the use of fair value in IFRSs and the fact that IFRSs do not reflect the financial value of an entity. (9 marks) (c) Marchant plans to update its production process and the directors feel that technology-led production is the only feasible way in which the company can remain competitive. Marchant operates from a leased property and the leasing arrangement was established in order to maximise taxation benefits. However, the financial statements have not shown a lease asset or liability to date. A new financial controller joined Marchant just after the financial year end of 30 April 2014 and is presently reviewing the financial statements to prepare for the upcoming audit and to begin making a loan application to finance the new technology. The financial controller feels that the lease relating to both the land and buildings should be treated as a finance lease but the finance director disagrees. The finance director does not wish to recognise the lease in the statement of financial position and therefore wishes to continue to treat it as an operating lease. The finance director feels that the lease does not meet the criteria for a finance lease, and it was made clear by the finance director that showing the lease as a finance lease could jeopardise the loan application. Required: (c) Discuss the ethical and professional issues which face the financial controller in the above situation. (6 marks) (50 marks) Question 84 Aspire (Q2 June 2014) Aspire, a public limited company, operates many of its activities overseas. The directors have asked for advice on the correct accounting treatment of several aspects of Aspire’s overseas operations. Aspire’s functional currency is the dollar. (a) Aspire has created a new subsidiary, which is incorporated in the same country as Aspire. The subsidiary has issued 2 million dinars of equity capital to Aspire, which paid for these shares in dinars. The subsidiary has also raised 100,000 dinars of equity capital from external sources and has deposited the whole of the capital with bank in an overseas country whose currency is the dinar. The capital is to be invested in dinar denominated bonds. The subsidiary has a small number of staff and its operating expenses, which are low, are incurred in dollars. The profits are under the control of Aspire. Any income from the investment is either passed on to Aspire in the form of a dividend or reinvested under instruction from Aspire. The subsidiary does not make any decisions as to where to place the investments. Aspire would like advice on how to determine the functional currency of the subsidiary. (7 marks)

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(b) Aspire has a foreign branch which has the same functional currency as Aspire. The branch’s taxable profits are determined in dinars. On 1 May 2013, the branch acquired a property for 6 million dinars. The property had an expected useful life of 12 years with a zero residual value. The asset is written off for tax purposes over eight years. The tax rate in Aspire’s jurisdiction is 30% and in the branch’s jurisdiction is 20%. The foreign branch uses the cost model for valuing its property and measures the tax base at the exchange rate at the reporting date. Aspire would like an explanation (including a calculation) as to why a deferred tax charge relating to the asset arises in the group financial statements for the year ended 30 April 2014 and the impact on the financial statements if the tax base had been translated at the historical rate. (6 marks) (c) On 1 May 2013, Aspire purchased 70% of a multi-national group whose functional currency was the dinar. The purchase consideration was $200 million. At acquisition, the net assets at cost were 1,000 million dinars. The fair values of the net assets were 1,100 million dinars and the fair value of the non-controlling interest was 250 million dinars. Aspire uses the full goodwill method. Aspire wishes to know how to deal with goodwill arising on the above acquisition in the group financial statements for the year ended 30 April 2014. (5 marks) (d) Aspire took out a foreign currency loan of 5 million dinars at a fixed interest rate of 8% on 1 May 2013. The interest is paid at the end of each year. The loan will be repaid after two years on 30 April 2015. The interest rate is the current market rate for similar two-year fixed interest loans. Aspire requires advice on how to account for the loan and interest in the financial statements for the year ended30 April 2014. (5 marks) Aspire has a financial statement year end of 30 April 2014 and the average currency exchange rate for the year is not materially different from the actual rate. Exchange rates $1 = dinars 1 May 2013 5 30 April 2014 6 Average exchange rate for year ended 30 April 2014 5.6 Required: Advise the directors of Aspire on their various requests above, showing suitable calculations where necessary. Note: The mark allocation is shown against each of the four issues above. Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks) (25 marks)

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Question 85 Minco (Q3 June 2014) (a) Minco is a major property developer which buys land for the construction of housing. One aspect of its business is to provide low-cost homes through the establishment of a separate entity, known as a housing association. Minco purchases land and transfers ownership to the housing association before construction starts. Minco sells rights to occupy the housing units to members of the public but the housing association is the legal owner of the building. The housing association enters into loan agreements with the bank to cover the costs of building the homes. However, Minco negotiates and acts as guarantor for the loan, and bears the risk of increases in the loan’s interest rate above a specified rate. Currently, the housing rights are normally all sold out on the completion of a project. Minco enters into discussions with a housing contractor regarding the construction of the housing units but the agreement is between the housing association and the contractor. Minco is responsible for any construction costs in excess of the amount stated in the contract and is responsible for paying the maintenance costs for any units not sold. Minco sets up the board of the housing association, which comprises one person representing Minco and two independent board members. Minco recognises income for the entire project when the land is transferred to the housing association. The income recognised is the difference between the total sales price for the finished housing units and the total estimated costs for construction of the units. Minco argues that the transfer of land represents a sale of goods which fulfils the revenue recognition criteria in IAS 18 Revenue. (7 marks) (b) Minco often sponsors professional tennis players in an attempt to improve its brand image. At the moment, it has a three-year agreement with a tennis player who is currently ranked in the world’s top ten players. The agreement is that the player receives a signing bonus of $20,000 and earns an annual amount of $50,000, paid at the end of each year for three years, provided that the player has competed in all the specified tournaments for each year. If the player wins a major tournament, she receives a bonus of 20% of the prize money won at the tournament. In return, the player is required to wear advertising logos on tennis apparel, play a specified number of tournaments and attend photo/film sessions for advertising purposes. The different payments are not interrelated. (5 marks) (c) Minco leased its head office during the current accounting period and the agreement terminates in six years’ time. There is a clause in the operating lease relating to the internal condition of the property at the termination of the lease. The clause states that the internal condition of the property should be identical to that at the outset of the lease. Minco has improved the building by adding another floor to part of the building during the current accounting period. There is also a clause which enables the landlord to recharge Minco for costs relating to the general disrepair of the building at the end of the lease. In addition, the landlord can recharge any costs of repairing the roof immediately. The landlord intends to replace part of the roof of the building during the current period. (5 marks)

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(d) Minco acquired a property for $4 million and annual depreciation of $300,000 is charged on the straight line basis. At the end of the previous financial year of 31 May 2013, when accumulated depreciation was $1 million, a further amount relating to an impairment loss of $350,000 was recognised, which resulted in the property being valued at its estimated value in use. On 1 October 2013, as a consequence of a proposed move to new premises, the property was classified as held for sale. At the time of classification as held for sale, the fair value less costs to sell was $2·4 million. At the date of the published interim financial statements, 1 December 2013, the property market had improved and the fair value less costs to sell was reassessed at $2·52 million and at the year end on 31 May 2014 it had improved even further, so that the fair value less costs to sell was$2·95 million. The property was sold on 5 June 2014 for $3 million. (6 marks) Required: Discuss how the above items should be dealt with in the financial statements of Minco. Note: The mark allocation is shown against each of the four issues above. Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks) (25 marks) Question 86 Avco (Q4 June 2014) (a) The difference between debt and equity in an entity’s statement of financial position is not easily distinguishable for preparers of financial statements. Some financial instruments may have both features, which can lead to inconsistency of reporting. The International Accounting Standards Board (IASB) has agreed that greater clarity may be required in its definitions of assets and liabilities for debt instruments. It is thought that defining the nature of liabilities would help the IASB’s thinking on the difference between financial instruments classified as equity and liabilities. Required: (i) Discuss the key classification differences between debt and equity under International Financial Reporting Standards. Note: Examples should be given to illustrate your answer. (9 marks) (ii) Explain why it is important for entities to understand the impact of the classification of a financial instrument as debt or equity in the financial statements. (5 marks) (b) The directors of Avco, a public limited company, are reviewing the financial statements of two entities which are acquisition targets, Cavor and Lidan. They have asked for clarification on the treatment of the following financial instruments within the financial statements of the entities. Cavor has two classes of shares: A and B shares. A shares are Cavor’s ordinary shares and are correctly classed as equity. B shares are not mandatorily redeemable shares but contain a call option allowing Cavor to repurchase them. Dividends are payable on the B shares if, and only if, dividends have been paid on the A ordinary shares. The terms of the B shares are such that dividends are payable at a rate equal to that of the A ordinary shares. Additionally, Cavor has also issued share options which give the counterparty rights to buy a fixed number of its B shares for a fixed amount of $10 million. The contract can be settled only by the issuance of shares for cash by Cavor.

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Lidan has in issue two classes of shares: A shares and B shares. A shares are correctly classified as equity. Two million B shares of nominal value of $1 each are in issue. The B shares are redeemable in two years’ time at the option of Lidan. Lidan has a choice as to the method of redemption of the B shares. It may either redeem the B shares for cash at their nominal value or it may issue one million A shares in settlement. A shares are currently valued at $10 per share. The lowest price for Lidan’s A shares since its formation has been $5 per share. Required: Discuss whether the above arrangements regarding the B shares of each of Cavor and Lidan should be treated as liabilities or equity in the financial statements of the respective issuing companies. (9 marks) Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks) (25 marks)

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Answer 83 Marchant (a)(i) Net assets Acq Transfer Growth Share capital 25} Retained earnings 65} 120 OCE 6} FVA(land)(balance) 14 14 ___ ___ ___ 110 134 24 ___ ___ ___ Given

Acq Disposal Growth

86 ___

90 ___

4 ___ (0marks!)

Goodwill Fv of consideration Fv of nci Fv of na Goodwill at acquisition Last year’s impairment (15)(20%) Goodwill opening & correct closing Incorrect reversal (balance) Incorrect closing goodwill (15+2)

N 80 45 (110) ___ 15 (3) ___ 12 5 ___ 17 ___

O 70 28 (86) ___ 12 ___

(3 marks) Transfer of ownership [(a)(ii) numbers] Carrying value (12 gw + 134 na) 146 Percentage 8% ___ Transfer 11.7 ___ Effect on controlling interest Transfer out (11.7) Consideration in 18 ___ Increase to OCE 6.3 ___ (3 of 5 marks for (a)(ii)) Transfer of ownership [(a)(ii) narrative] The 8% reduction in controlling interest ownership from 60% down to 52% results in a retention of control. The controlling interest still has control and the non controlling interest still have no influence. So reasonably enough the IASB argued this is not a partial sub disposal. They argued this is just the transfer of ownership from ci to nci. Effect on controlling interest The effect of the transfer to nci of $11.7m of ownership is easy enough. The nci just goes up by $11.7m. But the effect on the ci is counter intuitive. The ci also goes up. This is because the ci goes down by $11.7m as the transfer goes out but ci goes up by $18m as the consideration comes in. The net effect is the increase of $6.3m seen above. (2 of 5 marks for (a)(ii))

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Disposal [back to (a)(i)] Actual sale proceeds Deemed sale proceeds (fv of associate retained) Nci Na Gw Profit

50 40 34 (90) (12) ___ 22 ___ (3 marks)

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Statement of profit or loss

Revenue Cost of sales Gross profit Other income

M

N 12/12

400 (312)

21 (5.3)(i)

Administration

(15)

Operating expenses

(35) (5)(i) (7)(v) (2.6)(vi) (2.1)(vii)

Operating profit Associate (6/12)(15)(20%) Sub disposal Finance costs

1.5 22 (5) (0.2)(v)

O 12/12 115 (65)

adj

group marks 6/12 (2 marks for time apportion) 35 (18)

(12)(iv) 12(iv)

538 (1 mark) (383) (1 mark) ___ 155 23.7 (1 mark)

7

1

(9)

(6)

(30)

(19)

(4)

(74.7) (1 mark) (2 marks) (2 marks) (3 marks)

(6)

(2)

___ 74 1.5 (2 marks) 22 (10.2) (1 mark)

3(viii) Finance income Profit before tax Tax Profit after tax Non Controlling interest

6

5

4

(19) ___ 42.3

(9) ___ 22 *40% 8.8

(2.5) ___ 7.5 *40% 3

Profit attributable To parent members ___ ___ ___ Statement of other comprehensive income Revaluation surplus 10 (5)(i) Reversal of previous revaluation (1.96)(vi) Actuarial remeasurement (2) Cash flow hedge loss (3)(vii) ___ ___ ___ Other comprehensive 1 (3) 0 Income *40% *40% Non (1.2) 0 Controlling interest Other comprehensive Interest attributable to parent members Statement of comprehensive income Comprehensive income attributable to parent members (60-0.8) Non controlling interest (11.8-1.2) Comprehensive income (71.8-2)

15 ___ 102.3 (30.5) ___ 71.8 (11.8) (1 mark) ___ 60 ___ 5 (2) (2) (3) ___ (2)

(1 mark) (1 mark) (1 mark) (1 mark)

1.2 (1 mark) ___ (0.8) ___ 59.2 10.6 ___ 69.8 ___

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Working (i) parent fvoci The fv gain of $5m (95-90) must be pulled out of revaluation surplus to prevent double counting the sub. The parent gain of $5.3m on the disposal of shares [18-{(8%/60%)95}] from the parent point of view must be pulled out of other income to prevent double counting the sale of 8% that gives rise to the transfer recorded in (a)(ii). (2 marks given already on face of p/l) Working (iv) intercompany sales $12m removed from both sales and cost of sales. (2 marks given already on face of p/l) Working (v) pension The movement is as follows:Opening net liability (48-50) 2 Net pension finance (2)(10%) 0.2 to p/l (finance) Service cost (current 4 + past 3) 7 to p/l (operating) Actuarial remeasurement 2 to oci __ Closing net liability 11.2 __ (4 marks given already on face of p/l & oci) Working (vi) ppe The movement is as follows:Cost 12 Last year’s depreciation (12/10years) (1.2) __ Last year’s closing before revaluation 10.8 Last year’s revaluation (balance) 2.2 __ Current opening (given) 13 Current depreciation (13/9years) (1.44) __ Current closing before reversal 11.56 Reversal of revaluation (balance) (1.96) to oci __ Historical net book value (12-1.2-1.2) 9.6 Impairment (balance) (2.6) to p/l (operating) __ Closing (given) 7 __ (3 marks given already on face of p/l & oci) Note (vi) ppe Note that the reversal of the revaluation of $1.96m can also be derived as the remainder on the revaluation reserve at the current year end after the annual transfer from the revaluation reserve to the retained earnings [$1.96m = $2.2m(8/9)].

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Further note that the examiner assumed that the annual transfer had not occurred resulting in figures as follows:Cost 12 Last year’s depreciation (12/10years) (1.2) __ Last year’s closing before revaluation 10.8 Last year’s revaluation (balance) 2.2 __ Current opening (given) 13 Current depreciation (13/9years) (1.44) __ Current closing before reversal 11.56 Reversal of revaluation (unchanged revaluation reserve) (2.2) to oci __ Historical net book value (12-1.2-1.2) 9.36 Impairment (balance) (2.36) to p/l (operating) __ Closing (given) 7 __ Both alternatives were awarded full marks. Working (vii) options The movement is as follows:Opening (4x8k)($100)(1/3) Operating cost (balance) Closing (6x8k)($100)(2/3)

1.067 2.133 __ 3.2 __ (3 marks given already on face of p/l)

Working (viii) hedge loss This should simply come out of p/l and go into oci. (1 mark given already on face of p/l)

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(b) Marking guide The usual 1 mark for each point eloquently delivered applies. Fair value This is defined as the transaction price between market participants at the measurement date. Fair value measurement To help users measure fair value for unquoted assets the IFRS have the following hierarchy (IFRS13). The idea is that you should use the level with the lowest number: Level 1: an exact equivalent active market price Level 2: an approximately equivalent transaction price Level 3: a figure derived from using unobservable inputs into financial models. Use of fair value It is true that fv is used widely throughout fs. Many financial instruments are carried at fv. And similar ideas to fv apply in pensions accounting and impaired ppe. Use of historical cost But cost is also widely used in fs. There is ppe and stock. But even financial liabilities are usually carried at amortised cost meaning discounting and unwinding and this is certainly not fv. Mixed model The technical name for what we do now with some things at fv and others at cost is called “mixed accounting”. This mixed model comes to us from a long history of cost focus with a more recent move towards fv. Relevance and reliability The IASB have been moving fs towards fv for a number of years. The IASB accept that fv can sometimes have lower reliability than the equivalent historical cost. But the IASB continue to believe in fv because of its undoubted relevance. Financial value of an entity It is possible to invent an accounting system that does reflect the financial value of an entity. Here are some numbers to give a flavour of this radical idea. Say an entity has 100m shares on the stock exchange at $5 each at the year end and say the fv of the na was $150m at that point then a position statement could be produced like this: Goodwill {balance} Net assets

Equity ($5)(100m shares)

350 150 ___ 500 ___ 500 ___

Acceptance There is absolutely no chance a model like the above would be accepted by the markets for so many reasons. Here are two. Firstly the markets are deeply conservative and any change is resisted. Secondly the above model is deeply based upon position focus but the markets are deeply based upon profit focus.

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Result The result is that fs certainly do not reflect the financial value of the whole entity. Many items are not at fv and the extra value that the shareholders put on the equity over and above the na is ignored altogether. Market capitalisation But the fair value of the whole entity is not difficult to obtain. It is derived by looking at the share price at any point and multiplying by the number of shares. It is called the “market capitalisation” and is so widely available that it is dubious whether it is necessary to include in fs. Also it changes every minute and so its relevance in fs could be questioned. (c) Marking guide The usual 1 mark for each relevant point. Ethics A useful model for the analysis of ethics is the ACCA ethical principles: P professionalism I integrity C confidentiality C competence O objectivity Leases Lease accounting is a tricky subject because it is based on a subjective judgement of risks and rewards. A finance lease is one where the risks and rewards are transferred to the user and an operating lease is not. Land The principle reward from an asset is use. Generally, land lasts forever on human timescales, so no matter how long the lease; the lease life will be an infinitesimal proportion of that. So land is almost always an operating lease. Competence Frankly, this is fairly basic financial reporting. Anyone that knows anything about leases knows that land contracts are rarely finance leases. The financial controller appears not to know this and so the competence of the fc can be questioned. Buildings Analysing the buildings contract would be much harder than analysing the land contract in real life as it requires a judgement as to the building life and then another judgement as to whether the contract life is substantially all the building life. The analysis is impossible for us as the building life is not given. Objectivity As mentioned the judgement of the fc is questionable because of the lack of competence. But the judgement of the fd is also questionable because of a lack of objectivity. The fd is more concerned with a loan application than he is with the true and fair view of the fs. Gearing The issue is likely to be gearing. Gearing goes up if you class a lease as a finance lease from previous operating lease accounting. It is likely the potential lenders have a maximum gearing that they will lend into and it seems that Marchant is already close to this threshold even before the lease is considered.

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Answer 84 Aspire Marking guide The usual 1 mark for a clear relevant point. (a) Functional currency This is simply the currency in which an entity functions. It is the currency of the primary economic environment and is important because an entity initially prepares its fs in its functional currency. Presentational currency Then sometimes an entity presents its fs to shareholders in a different currency based on demand from the shareholders. This is common for foreign subs. For example, Starbucks (UK) initially prepares fs in UK£ and then translates to US$ to present to its USA parent. Factors The factors determining the functional currency are the currencies of the functions. So we look at the currency used for selling, buying, finance, employee payroll and so on. But there is a strong leaning towards the currency of selling. Two examples This is easy for Starbucks (UK). This entity does everything but perhaps buy coffee beans in UK£. So obviously the functional currency is UK£. The determination of the functional currency is less obvious for Marks & Spencer (Singapore) as finance and purchasing and expertise is all bought in UK£. But because the sales are all in S$ the functional currency is determined as the S$. Aspire sub But the determination of the functional currency of the Aspire sub is much harder again. This is because the sub does not really do anything. The sub does not have sales or purchases. Evidence for dinar All the sub appears to do is receive cash from the owners and put that cash into investments. However, it is clear that both these two functions are in dinar. The use of the $ is purely for operating expenses “which are low”. So it seems the sub functions in the dinar. Evidence for $ But the sub is described as “under the control of Aspire”. Of course, all subs are under the control of their parent, but it appears in this case to mean that Aspire manages the day to day investment strategy and the sub has no autonomy at all. So you could argue that the sub is just an investment vehicle and that a $ functional currency is appropriate. Conclusion I really think that this could be argued both ways. However, I lean towards the dinar as the functional currency as being the currency of the two main functions which are receiving cash from the owners and investing the cash on the dinar stock exchange. (b) Deferred tax Deferred tax is derived from two equations:Deferred tax

= temporary difference x tax rate

Temporary difference

= carrying value – tax base

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Carrying value The scenario tells us that foreign branch functions in $. So the foreign branch will have figures like this: $k Cost (D6000k/5) 1200 Depreciation (1200/12) (100) ____ Closing carrying value 1100 ____ Tax base But of course, the tax accountant in the foreign branch will be thinking in dinar: Dk Cost 6000 Capital allowance (6000/8) (750) ____ Closing tax base 5250 ____ Currency Our next problem is that these two are in different currencies. And it does not help that deferred tax is a fake liability and makes no sense. But deferred tax is required and so is a decision. As we are talking about a potential future obligation to a future economic outflow to a dinar land taxman then perhaps dinars are the way forward. CT rate The final problem is the corporation tax rate. Since the real corporation tax incurred by the foreign branch is at 20% then it follows this is the rate to apply to the dt. Deferred tax So the dt is: property (1100*6)

Dt (liability in dinar) Closing rate Dt (liability in $)

cv 6600

tb -5250

td =1350 *20% ___ D270k /6 ___ $45k ___

Deferred tax (alternative calculation) But equally, as deferred tax is purely a financial accounting adjustment and all the financial accounting is in $ then you could argue for going straight into $. So the dt is: cv tb td property (5250/6) 1100 -875 =225 *20% ___ Dt (liability) 45 ___

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(c) Currency conflict The goodwill is of course down in dinar land but the shareholders of the Aspire group are up in $ land. The usual solution to this problem is to measure the goodwill in its original currency and then translate that goodwill at the year end using the closing rate. This is just as you would do for any other asset like stock or ppe. Goodwill So the goodwill in dinar is as follows:FV of consideration ($200m*5) FV of nci FV of na Goodwill Position statement This then hits the group position statement as follows:Goodwill (D150m/6)

Dm 1000 250 (1100) ____ 150 ____

$25m

Retranslation However, there is a tricky detail here; the goodwill originally hit the balance sheet at the year start and is now being remeasured at the year end and so a forex loss is generated as follows:Dm rate $m Year end 150 6 25 Acquisition 150 5 (30) __ Loss (5) __ Hidden This loss of $5m is actually a component part of the loss on the retranslation of the cost of investment that is more familiar (see groups question Traveller from an earlier exam and other questions with foreign subs):Dm rate $m Year end 1000 6 167 Acquisition 1000 5 (200) __ Loss (33) __ This goes through OCI and into OCE (other comprehensive income and other components of equity). (d) Foreign loan This is a simple foreign loan of the parent itself and so the parent must use the parental currency to report the liability. This requires translation and retranslation to accommodate the change in the value measured in $. The fancy name for this is “retranslation of a foreign monetary item at the entity level”. Financial liability This is just a simple financial liability and so is carried at amortised cost, meaning discounting and unwinding. However, the cash flow interest rate paid and the discount rate taken from the current market rate at the start are the same. This means the initial fv of the loan is D5m. The present value of an 8% D5m loan discounted at 8% is D5m.

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Forex table Here are the numbers:Year start Year end Gain

Dm 5 5

rate 5 6

$m 1 (0.833) __ (0.167) __

Opening journal Perhaps some journals might show the flow. The initial recognition would be:Dr bank (D5m/5) Cr loan $1m Closing journal The retranslation would be:Dr Cr

loan |(decrease in loan from above table) forex gain (financing in p/l)

$1m

$0.167m $0.167m

Interest journal This could be done like this for simplicity given the immateriality:Dr interest cost $0.067 Cr bank (D5m*8%/6) $0.067 Alternative But really the interest strictly should be calculated at the average rate for the p/l over the year:Dr interest cost (D5m*8%/5) $0.08 Cr bank (D5m*8%/6) $0.067 Cr forex gain (financing in p/l) (calculated as the balance) $0.013

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Answer 85 Minco Marking Guide The usual 1 mark per valid point. (a) Housing Association The housing association is described as a “separate entity”. It is not clear who owns this entity but it does appear that we are being asked to assume housing association is outside the Minco group. Revenue So we use the revenue models to analyse the transfer of land: Sale of goods (the “at” model) Revenue is recognised when risks and rewards are transferred. Sale of services (the “over” model) Revenue is recognised over the period and therefore in line with completion. Land Minco are using the “at” model. Minco are using the sale of goods model for the land transfer. This does seem to be the right model for the land alone but it appears the model has been applied wrongly. Risks and rewards As stated above “revenue is recognised when the risks and rewards are transferred”. But it appears that risks and rewards have not been transferred. It appears the risks and rewards of the building project remain with Minco throughout and the land is a part of the building project. Evidence Minco sells the units. So it appears Minco gets the benefits of high sales volume and bears the risk of low sales volume via the maintenance responsibility. Also Minco bears the risk of loan interest rate rises. Further Minco faces the risk of loan default via the guarantee. Conclusion Minco should continue to recognise the land and Minco should recognise the project as a construction contract within Minco group fs. Control There is another way of looking at this which does not appear to be intended by the examiner as there is very little information about who owns the housing association and how it works. However, it does appear that Minco has the power to direct the activities of the housing association via the Minco director and the rights to negotiate with the buyers and the housing contractor. Alternative solution So maybe another way to get the project into the group fs is to allow the housing association to record the construction contract and then consolidate the housing association with Minco group fs. (b) Intangible An intangible is a present right to a future economic inflow that cannot be touched. Intangibles are recognised when measurable and are measurable when purchased.

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$20k The $20k appears to fit the criteria. The asset is clearly measurable at its purchase price of $20k and provides Minco with the right to require the tennis player to display the Minco logo for the next three years. $50k This is measurable but appears to be a payment for the player having worn the logo. The past tense here tells you that there is no future economic inflow. 20% The 20% is the same. It is a bonus paid to the player after having won the tournament. There is no future benefit to Minco. Conclusion So it appears that the $20k should be capitalised as an intangible and depreciated over three years and it appears that the other payments should be written off as incurred. This means the annual $50k is recognised as a liability and expense at the end of each year and the 20% is recognised as a liability and expense at the end of each tournament the player wins. (c) Lease accounting Lease accounting has two forms of lease. A finance lease involves the transfer of risks and rewards from the owner to the user and an operating lease does not. Six years To really be sure of the nature of the lease we need the life of the building as a whole. But we do not. But we do know that the contract is for six years and that most buildings last a lot longer than that. So it seems the risks and rewards of the building remain with the new owner and that this is an operating lease. Improvement The improvement results in some tricky accounting. The costs of the improvement are simply capitalised and depreciated over the six years. But the cost of removing the floor at the end of the lease must be discounted down to present value the point of improvement at the start of the lease. Asset & liability The discounted pv of the removal cost is then capitalised on top of the improvement costs at the top of the b/s and recognised as a liability at the bottom of the b/s. The asset is then depreciated over the six years and the liability is unwound over the period up to the cost of removal. Disrepair Minco should also recognise a liability for any damage. There is no mention of any damage and so this liability may be zero. Roof The examiner seems to have mixed up his words. His sentence says “the landlord intends to replace during the current period” but it should say either “the landlord has replaced during the current period just gone” or “the landlord intends to replace in the new year just started”. It is also not clear if the roof replacement is because the landlord feels like it or because the roof is damaged. I am going to guess that the examiner means the roof has been damaged and the repair will occur in the new year. So a liability will be recognised at the current year end and an expense will go the current p/l.

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(d) Issues There are a number of issues here. There is depreciation. There is held for sale. There is reversal of impairment. There is an event after the reporting period. Depreciation Depreciation reflects the cost of use and as most assets are used evenly over their lives depreciation is usually based on dividing the remaining carrying value over the remaining life. Strictly we should work out the asset life from the figures as 13.3years ($4m/$0.3m) and look carefully at remaining lives after impairment. But it appears the examiner wants us to ignore this point and stick with $300k per annum and $100k for the four months of June July August and September. Held for sale (HFS) There are criteria that must be fulfilled for a property to be classed as held for sale. But no information is given regarding the criteria and so it appears the examiner wants us to assume the property is held for sale without further thought. However, the rather odd Ifrs requirement that depreciation stops after classification as held for sale is relevant. Reversal of impairment At the end of last year the property went down in value. This was recognised as an impairment last year through p/l. This year the property went up in value. This is classed as a reversal of the impairment and the gain also goes through p/l. HNBV But the reversal is limited to the carrying value that would apply if there had been no down or up in value only depreciation. This is sometimes called historical net book value (HNBV). This is $2.9m from the point of HFS four months into the current year (4-1-0.1) and does not change over the following eight months because HFS do not depreciate. So we can ignore the HNBV at the first reversal because $2.52m is way below $2.9m but we accommodate the HNBV at the second reversal because $2.95m is above $2.9m. Events after the reporting period (EARP) The sale of the property for $3m shortly after the year end is excellent evidence that the fair value less cost to sell were roughly $2.95m at the year end. Further it may be worth disclosing that the asset held for sale at the year end was successfully sold shortly after.

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Movement The very complex movement in the property is as follows over the current year: $k Cost (three and one third years before the current year start) (given) 4000 Accumulated depreciation (given) (1000) ____ Last year’s closing balance before impairment 3000 Last year’s impairment (given) (350) to last year’s p/l ____ Current opening 2650 Four months depreciation from June to September (see above) (100) ____ Before further impairment 2550 Current impairment (150) to current p/l ____ Recoverable value at HFS (given) 2400 Two months depreciation for October and November because HFS (0) ____ Before first reversal 2400 Reversal of impairment (balance) 120 to current p/l ____ After first reversal (fvlcts given) 2520 Six months depreciation from December to May because HFS (0) ____ Before second reversal 2520 Reversal of impairment (balance) 380 to current p/l ____ HNBV (see above) 2900 Revaluation (see below) 0 ____ Closing 2900 to current b/s ____ Revaluation The revaluation recognised when the FVLCTS of $2.95m rises above the HNBV of $2.9m is zero. This can be identified in a couple of ways. First the scenario says nothing about revaluation. The default policy for ppe is cost. So the examiner’s silence means Minco have a cost policy for ppe making revaluation not permissible. Secondly, after a property is classified HFS it is now considered HFS and not property and HFS is always carried at the lower of its hfs entry value and the fvlcts.

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Answer 86 Avco Marking guide The usual 1 mark for each point clearly expressed. (a)(i) Problem Distinguishing between debt and equity in a going concern can be a problem for preparers of fs because debt is clearly defined but equity is not. Debt The word “debt” is not actually used much in IFRS. The word that is used is “liability” and liabilities are clearly defined in the framework for financial reporting as present obligations to future economic outflows. However, the culture is to call the debt/equity problem the “debt/equity problem” and not the “liability/equity problem” . It is just the way that this problem is expressed. Equity Equity is defined. It is just that the definition is not very useful in a going concern. Equity is defined as the residual when all the assets are liquidated and the liabilities are all paid off. The guys that get this residual are called “equity”. The trouble is that this definition only applies in liquidation and financial reporting applies only to going concerns and not to insolvent entities. Solution The IFRS solve this problem using a backhanded technique (IAS32). The technique requires that preparers test suspected equity for the properties of a liability and if they find none of those properties then the preparer classes the financial instrument as equity. The liability property that prepares should particularly look for is a present obligation to pay out cash in the future. Example debt A company has issued preference shares that require a 8% fixed dividend and repayment of the capital of $100m in five years. The obligations are obvious. This is debt. The liability is carried at amortised cost meaning discounting and unwinding. Example equity A company issues B shares that have no votes but the rights to dividends in equal proportion to the voting A shares and the right to the residual also in proportion to the voting A shares. However, the dividends are only paid if the directors deem a dividend appropriate. There are no present obligations to cash outflows. This is equity. Example both A company issues convertible bonds. The net inflow is $99m. There is an obligation to pay $6m per annum for three years and $100m in principal at the end of the third year. The discounted present value of the cash outflows is $91.5m. This is $91.5m of debt and $7.5m of equity. There is an obligation to repay the $91.5m via the cash outflows described. There is no obligation to repay the $7.5m. {These are the numbers from q Aron (b)(i)} Politics These complex financial intruments are rare these days. Preference shares, voteless equity and convertible bonds are messy and unattractive to buyers and so any entity foolish enough to offer these assets to the markets find that they cannot get buyers interested. So usually entities dealing with these fi are looking at ancient contracts from a world when exotic fi were the fashion.

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IASB The IASB have looked at this debt/equity issue in their current framework project and have come up with some clever suggestions for properly defining equity. But currently it is looking like the IASB will reaffirm the existing definition which is essentially a cash inflow for an fi that is not a liability. (a)(ii) Gearing Cutting straight to the chase, the issue is gearing. There are other issues. But the key issue is gearing. Misclassification of debt as equity or equity as debt effects the gearing. Ratio The classic definition of gearing is: Gearing

=

debt/(debt+equity)

It is obvious that misclassification of debt as equity results in a reported gearing lower than actual gearing. Creative accounting The debt/equity issue is messy and difficult and so it is possible for entities to make classification errors that are genuine mistakes. But an error that is deliberate and directed at reducing a high gearing is described as creative accounting and is not only in breach of IFRS but is also in breach of ethics. Dilution On the other hand, misclassification of debt as equity might annoy the existing equity as they might feel their ownership has been diluted and therefore take action to remove directors. Covenants Another issue is that misclassification of equity as debt might result in debt levels exceeding covenant maximums in agreements with other debt investors. (b) Cavor B shares option The call option is a right of Cavor. Cavor has the right to repurchase the B shares. The B shareholders have no right to make Cavor repurchase the shares. That right is called a put option and gives rise to an obligation against the issuer but this does not apply here. Cavor B shares dividends Cavor has no obligation to pay dividends to either the A or the B shareholders. There is no dividend obligation. Cavor B shares conclusion There is no present obligation to a future outflow. The Cavor B shares should be classed as equity by Cavor. Cavor issued options cash inflows Cavour will have received some cash from the option holder at issue. The amount may not be much but Cavour will have received something. This is the amount we must decide is debt or equity. The amount received up front is called the “premium” and is a quite separate inflow to the $10m exercise price that may or may not flow in depending on how the option holder feels at the end of the option life.

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Cavour issued option obligation Cavour do have an obligation. They have the obligation to hand over a fixed number of equity shares to the option holder if the option holder hands over $10m. But the equity shares are of course equity shares and have no obligations to cash outflow. Cavour issued option conclusion So Cavor have the obligation to hand over paper with no obligations to cash outflows. So the option paper itself has no obligation to cash outflows. So the current options are equity. Lidan choice The Lidan choice is no choice at all. Lidan can pay $1 in cash for each B share or half an A share for each B share. The half comes from the ratio of one million A shares for two million B shares. But a half A share is currently worth $5 and has never been below $2.50. So obviously Lidan will pay the $1 cash. Lidan option The Lidan option is to choose between paying off the B shares using cash or using equity. There is no option to simply let the B shares continue in existence. So effectively Lidan must pay $1 cash for each B share in two years. Lidan conclusion The obligation is clear. The B shares must be classed as a liability by Lidan.

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Question 87 Joey (Q1 December 2014) Joey, a public limited company, operates in the media sector. Joey has investments in two companies. The draft statements of financial position at 30 November 2014 are as follows: Joey

Margy

Hulty

$m

$m

$m

3,295

2,000

1,200

Assets: Non-current assets Property, plant and equipment Investments in subsidiaries and other investments Margy

1,675

Hulty

700

Current assets

985

861

150

6,655

2,861

1,350

850

1,020

600

3,340

980

350

250

80

40

Total equity

4,440

2,080

990

Non-current liabilities

1,895

675

200

320

106

160

Total liabilities

2,215

781

360

Total equity and liabilities

6,655

2,861

1,350

Total assets Equity and liabilities: Share capital Retained earnings Other components of equity

Current liabilities

The following information is relevant to the preparation of the group financial statements: (1) On 1 December 2011, Joey acquired 30% of the ordinary shares of Margy for a cash consideration of $600 million when the fair value of Margy's identifiable net assets was $1,840 million. Joey treated Margy as an associate and has equity accounted for Margy up to 1 December 2013. Joey's share of Margy's undistributed profit amounted to $90 million and its share of a revaluation gain amounted to $10 million. On 1 December 2013, Joey acquired a further 40% of the ordinary shares of Margy for a cash consideration of $975 million and gained control of the company. The cash consideration has been added to the equity accounted balance for Margy at 1 December 2013 to give the carrying amount at 30 November 2014. At 1 December 2013, the fair value of Margy's identifiable net assets was $2,250 million. At 1 December 2013, the fair value of the equity interest in Margy held by Joey before the business combination was $705 million and the fair value of the non-controlling interest of 30% was assessed as $620 million. The retained earnings and other components of equity of Margy at 1 December 2013 were $900 million and $70 million respectively. It is group policy to measure the non-controlling interest at fair value.

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(2) At the time of the business combination with Margy, Joey has included in the fair value of Margy's identifiable net assets, an unrecognised contingent liability of $6 million in respect of a warranty claim in progress against Margy. In March 2014, there was a revision of the estimate of the liability to $5 million. The amount has met the criteria to be recognised as a provision in current liabilities in the financial statements of Margy and the revision of the estimate is deemed to be a measurement period adjustment. (3) Additionally, buildings with a carrying amount of $200 million had been included in the fair valuation of Margy at 1 December 2013. The buildings have a remaining useful life of 20 years at 1 December 2013. However, Joey had commissioned an independent valuation of the buildings of Margy which was not complete at 1 December 2013 and therefore not considered in the fair value of the identifiable net assets at the acquisition date. The valuations were received on 1 April 2014 and resulted in a decrease of $40 million in the fair value of property, plant and equipment at the date of acquisition. This decrease does not affect the fair value of the non-controlling interest at acquisition and has not been entered into the financial statements of Margy. Buildings are depreciated on the straight-line basis and it is group policy to leave revaluation gains on disposal in equity. The excess of the fair value of the net assets over their carrying value, at 1 December 2013, is due to an increase in the value of non-depreciable land and the contingent liability. (4) On 1 December 2013, Joey acquired 80% of the equity interests of Hulty, a private entity, in exchange for cash of $700 million. Because the former owners of Hulty needed to dispose of the investment quickly, they did not have sufficient time to market the investment to many potential buyers. The fair value of the identifiable net assets was $960 million. Joey determined that the fair value of the 20% noncontrolling interest in Hulty at that date was $250 million. Joey reviewed the procedures used to identify and measure the assets acquired and liabilities assumed and to measure the fair value of both the non-controlling interest and the consideration transferred. After that review, Hulty determined that the procedures and resulting measures were appropriate. The retained earnings and other components of equity of Hulty at 1 December 2013 were $300 million and $40 million respectively. The excess in fair value is due to an unrecognised franchise right, which Joey had granted to Hulty on 1 December 2012 for five years. At the time of the acquisition, the franchise right could be sold for its market price. It is group policy to measure the non-controlling interest at fair value. All goodwill arising on acquisitions has been impairment tested with no impairment being required. (5) Joey is looking to expand into publishing and entered into an arrangement with Content Publishing (CP), a public limited company, on 1 December 2013. CP will provide content for a range of books and online publications. CP is entitled to a royalty calculated as 10% of sales and 30% of gross profit of the publications. Joey has sole responsibility for all printing, binding, and platform maintenance of the online website. The agreement states that key strategic sales and marketing decisions must be agreed jointly. Joey selects the content to be covered in the publications but CP has the right of veto over this content. However on 1 June 2014, Joey and CP decided to set up a legal entity, JCP, with equal shares and voting rights. CP continues to contribute content into JCP but does not receive royalties. Joey continues the printing, binding and platform maintenance. The sales and cost of sales in the period were $5 million and $2 million respectively. The whole of the sale proceeds and the costs of sales were recorded in Joey's financial statements with no accounting entries being made for JCP or amounts due to CP.

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Joey currently funds the operations. Assume that the sales and costs accrue evenly throughout the year and that all of the transactions relating to JCP have been in cash. (6) At 30 November 2013, Joey carried a property in its statement of financial position at its revalued amount of $14 million in accordance with IAS 16 Property, Plant and Equipment. Depreciation is charged at $300,000 per year on the straight line basis. In March 2014, the management decided to sell the property and it was advertised for sale. By 31 March 2014, the sale was considered to be highly probable and the criteria for IFRS 5 Non-current Assets Held for Sale and Discontinued Operations were met at this date. At that date, the asset's fair value was $15·4 million and its value in use was $15·8 million. Costs to sell the asset were estimated at $300,000. On 30 November 2014, the property was sold for $15·6 million. The transactions regarding the property are deemed to be material and no entries have been made in the financial statements regarding this property since 30 November 2013 as the cash receipts from the sale were not received until December 2014. Required: (a) Prepare the group consolidated statement of financial position of Joey as at 30 November 2014. (35 marks) The Joey Group wishes to expand its operations. As part of this expansion, it has granted options to the employees of Margy and Hulty over its own shares as at 7 December 2014. The awards vest immediately. Joey is not proposing to make a charge to the subsidiaries for these options. Joey does not know how to account for this transaction in its own, the subsidiaries, and the group financial statements. Required: (b) Explain to Joey how the above transaction should be dealt with in its own, the subsidiaries, and the group financial statements. (8 marks) Joey's directors feel that they need a significant injection of capital in order to modernise plant and equipment as the company has been promised new orders if it can produce goods to an international quality. The bank's current lending policies require borrowers to demonstrate good projected cash flow, as well as a level of profitability which would indicate that repayments would be made. However, the current projected cash flow statement would not satisfy the bank's criteria for lending. The directors have told the bank that the company is in an excellent financial position, that the financial results and cash flow projections will meet the criteria and that the chief accountant will forward a report to this effect shortly. The chief accountant has only recently joined Joey and has openly stated that he cannot afford to lose his job because of his financial commitments. Required: (c) Discuss the potential ethical conflicts which may arise in the above scenario and the ethical principles which would guide how a professional accountant should respond in this situation. (7 marks) (50 marks)

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Question 88 Coatmin (Q2 December 2014) (a) Coatmin is a government-controlled bank. Coatmin was taken over by the government during the recent financial crisis. Coatmin does not directly trade with other government-controlled banks but has underwritten the development of the nationally owned railway and postal service. The directors of Coatmin are concerned about the volume and cost of disclosing its related party interests because they extend theoretically to all other government-controlled enterprises and banks. They wish general advice on the nature and importance of the disclosure of related party relationships and specific advice on the disclosure of the above relationships in the financial statements. (5 marks) (b) At the start of the financial year to 30 November 2013, Coatmin gave a financial guarantee contract on behalf of one of its subsidiaries, a charitable organisation, committing it to repay the principal amount of $60 million if the subsidiary defaulted on any payments due under a loan. The loan related to the financing of the construction of new office premises and has a term of three years. It is being repaid by equal annual instalments of principal with the first payment having been paid. Coatmin has not secured any compensation in return for giving the guarantee, but assessed that it had a fair value of $1·2 million. The guarantee is measured at fair value through profit or loss. The guarantee was given on the basis that it was probable that it would not be called upon. At 30 November 2014, Coatmin became aware of the fact that the subsidiary was having financial difficulties with the result that it has not paid the second instalment of principal. It is assessed that it is probable that the guarantee will now be called. However, just before the signing of the financial statements for the year ended 30 November 2014, the subsidiary secured a donation which enabled it to make the second repayment before the guarantee was called upon. It is now anticipated that the subsidiary will be able to meet the final payment. Discounting is immaterial and the fair value of the guarantee is higher than the value determined under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Coatmin wishes to know the principles behind accounting for the above guarantee under IFRS and how the transaction would be accounted for in the financial records. (7 marks) (c) Coatmin's creditworthiness has been worsening but it has entered into an interest rate swap agreement which acts as a hedge against a $2 million 2% bond issue which matures on 31 May 2016. The notional amount of the swap is $2 million with settlement every 12 months. The start date of the swap was 1 December 2013 and it matures on 31 May 2016. The swap is enacted for nil consideration. Coatmin receives interest at 1·75% a year and pays on the basis of the 12-month LIBOR rate. At inception, Coatmin designates the swap as a hedge in the variability in the fair value of the bond issue.

Fixed interest bond Interest rate swap

Fair value 1 December 2013 $000 2,000

Fair value 30 November 2014 $000 1,910

Nil

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Coatmin wishes to know the circumstances in which it can use hedge accounting and needs advice on the use of hedge accounting for the above transactions. (7 marks)

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(d) Coatmin provides loans to customers and funds the loans by selling bonds in the market. The liability is designated as at fair value through profit or loss. The bonds have a fair value decrease of $50 million in the year to 30 November 2014 of which $5 million relates to the reduction in Coatmin's creditworthiness. The directors of Coatmin would like advice on how to account for this movement. (4 marks) Required: Discuss, with suitable calculations where necessary, the accounting treatment of the above transactions in the financial statements of Coatmin. Note: The mark allocation is shown against each of the questions above. Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks) (25 marks) Question 89 Kayte (Q3 December 2014) (a) Kayte operates in the shipping industry and owns vessels for transportation. In June 2014, Kayte acquired Ceemone whose assets were entirely investments in small companies. The small companies each owned and operated one or two shipping vessels. There were no employees in Ceemone or the small companies. At the acquisition date, there were only limited activities related to managing the small companies as most activities were outsourced. All the personnel in Ceemone were employed by a separate management company. The companies owning the vessels had an agreement with the management company concerning assistance with chartering, purchase and sale of vessels and any technical management. The management company used a shipbroker to assist with some of these tasks. The agreement with the management company can be terminated with a months’ notice. Kayte accounted for the investment in Ceemone as an asset acquisition. The consideration paid and related transaction costs were recognised as the acquisition price of the vessels. Kayte argued that the vessels were only passive investments and that Ceemone did not own a business consisting of processes, since all activities regarding commercial and technical management were outsourced to the management company. As a result, the acquisition was accounted for as if the vessels were acquired on a stand-alone basis. Additionally, Kayte had borrowed heavily to purchase some vessels and was struggling to meet its debt obligations. Kayte had sold some of these vessels but in some cases, the bank did not wish Kayte to sell the vessel. In these cases, the vessel was transferred to a new entity, in which the bank retained a variable interest based upon the level of the indebtedness. Kayte's directors felt that the entity was a subsidiary of the bank and are uncertain as to whether they have complied with the requirements of IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements as regards the above transactions. (12 marks)

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(b) Kayte's vessels constitute a material part of its total assets. The economic life of the vessels is estimated to be 30 years, but the useful life of some of the vessels is only 10 years because Kayte's policy is to sell these vessels when they are 10 years old. Kayte estimated the residual value of these vessels at sale to be half of acquisition cost and this value was assumed to be constant during their useful life. Kayte argued that the estimates of residual value used were conservative in view of an immature market with a high degree of uncertainty and presented documentation which indicated some vessels were being sold for a price considerably above carrying value. Broker valuations of the residual value were considerably higher than those used by Kayte. Kayte argued against broker valuations on the grounds that it would result in greater volatility in reporting. Kayte keeps some of the vessels for the whole 30 years and these vessels are required to undergo an engine overhaul in dry dock every 10 years to restore their service potential, hence the reason why some of the vessels are sold. The residual value of the vessels kept for 30 years is based upon the steel value of the vessel at the end of its economic life. At the time of purchase, the service potential which will be required to be restored by the engine overhaul is measured based on the cost as if it had been performed at the time of the purchase of the vessel. In the current period, one of the vessels had to have its engine totally replaced after only eight years. Normally, engines last for the 30-year economic life if overhauled every 10 years. Additionally, one type of vessel was having its funnels replaced after 15 years but the funnels had not been depreciated separately. (11 marks) Required: Discuss the accounting treatment of the above transactions in the financial statements of Kayte. Note: The mark allocation is shown against each of the elements above. Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks) (25 marks)

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Question 90 Estoil (Q4 December 2014) (a) An assessment of accounting practices for asset impairments is especially important in the context of financial reporting quality in that it requires the exercise of considerable management judgment and reporting discretion. The importance of this issue is heightened during periods of ongoing economic uncertainty as a result of the need for companies to reflect the loss of economic value in a timely fashion through the mechanism of asset write-downs. There are many factors which can affect the quality of impairment accounting and disclosures. These factors include changes in circumstance in the reporting period, the market capitalisation of the entity, the allocation of goodwill to cash generating units, valuation issues and the nature of the disclosures. Required: Discuss the importance and significance of the above factors when conducting an impairment test under IAS 36 Impairment of Assets. (13 marks) (b)(i)

Estoil is an international company providing parts for the automotive industry. It operates in many different jurisdictions with different currencies. During 2014, Estoil experienced financial difficulties marked by a decline in revenue, a reorganisation and restructuring of the business and it reported a loss for the year. An impairment test of goodwill was performed but no impairment was recognised. Estoil applied one discount rate for all cash flows for all cash generating units (CGUs), irrespective of the currency in which the cash flows would be generated. The discount rate used was the weighted average cost of capital (WACC) and Estoil used the 10-year government bond rate for its jurisdiction as the risk free rate in this calculation. Additionally, Estoil built its model using a forecast denominated in the functional currency of the parent company. Estoil felt that any other approach would require a level of detail which was unrealistic and impracticable. Estoil argued that the different CGUs represented different risk profiles in the short term, but over a longer business cycle, there was no basis for claiming that their risk profiles were different.

(b)(ii) Fariole specialises in the communications sector with three main CGUs. Goodwill was a significant component of total assets. Fariole performed an impairment test of the CGUs. The cash flow projections were based on the most recent financial budgets approved by management. The realised cash flows for the CGUs were negative in 2014 and far below budgeted cash flows for that period. The directors had significantly raised cash flow forecasts for 2015 with little justification. The projected cash flows were calculated by adding back depreciation charges to the budgeted result for the period with expected changes in working capital and capital expenditure not taken into account. Required: Discuss the acceptability of the above accounting practices under IAS 36 Impairment of Assets. (10 marks) Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks) (25 marks)

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Q87 Joey (a) Note The following is the answer. Note the answer is very brief and contains no explanation. This is because there are no marks for explanation in this question. But detailed explanation is provided after this answer. And so this answer should be read together with that explanation. Net assets Acq

SC RE OCE FVA (liability) para2 FVA (PPE) para3 FVA (land)β para3 FVA (intangible)β para4

1020 900 70 (5) (40) 266

Ye

1020 980 80 (5) (38) 266

Growth

82β 10

Acq

Ye

600 300 40

600 350 40

Growth

45β 0

20 15 _____________________ ___________________ {2250+1para2-40para3} 2211 2303 92β 960 1005 45β _____________________ ___________________ (6 marks: 1 mark each for each fva and 1 mark each for each growth) (Note 6 marks for na is very unusual as there is usually only 2 marks) (Note that these marks could be given elsewhere as they were in the examiners answer) Goodwill Fv of consideration 40% 975 80% 700 30% 705 Fv of nci 30% 620 20% 250 Fv of na (2211) (960) _____ ____ Goodwill 89 (10) _____ ____ (6 marks: 4 marks and 2 marks) (Note that there is a mark in reserves for realising that the negative goodwill is a bargain and a gain) Group position statement Goodwill Property plant & equipment [6495-38fva+266fva-14para6] Intangible [15fva] Joint venture [0.75 para5] Current assets [1996 +15.3 para6]

89 6709 15 1 2011 _____ 8825 _____ Share capital 850 Retained earnings 3447 Other components of equity 258 Non controlling interest 907 Non current liabilities 2770 Current liabilities [586 +5fva +0.7 para5 +1.5 para5] 593 _____ 8825 _____ (5 further marks on top of those given below for transferring and consolidation)

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Nci acquisition acquisition sub growth (92)(30%) sub growth (45)(20%)

620 250 27.6 9 ___ 906.6 ___

(4 marks) (Note that 4 marks is really unusual for nci but that what the examiner gave) Reserves RE OCE Parent 3340 250 Para1 associate disposal gain [705 –{600+90+10}] 5 Para4 bargain 10 Sub growth M {RE} (82)(70%) 57.4 Sub growth M {OCE} (10)(70%) 7 Sub growth H {RE} (45)(80%) 36 Sub growth H {OCE} (0)(80%) 0 Para6 depreciation (0.1) Para6 revaluation gain 1.5 Para6 impairment (0.3) Para6 disposal profit 0.2 Para5 jo adjustment (0.7) Para5 jv adjustment (0.75) ____ ____ 3446.75 258.5 ____ ____ (8 marks) (Actually the examiner gave 10 marks here but we have 2 of those marks in our na working) Working 6 Movement in disposed ppe:Opening 14 Four months depreciation (4/12)(300k given) (0.1) to p/l __ Before revaluation 13.9 Revaluation gain 1.5β to oci __ Fair value (given) 15.4 Impairment upon reclassification to hfs (0.3) to p/l __ Fvlcts (15.4above -0.3 given) 15.1 Disposal profit 0.2β to p/l __ Net receivable (15.6-0.3 given) 15.3 __ (4 marks)

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Working 5 JO period journal Dr p/l Cr liability to CP

0.7 0.7

Liability to CP = (10%)(6/12)($5m) + (30%)(6/12)($5m-$2m) (1 mark) JV period journal Dr Joint venture Dr p/l Cr liability to JCP

0.75 0.75 1.5 (1 mark) (Total 35 marks)

Explanatory notes There are no marks for the following. The notes are here only to help you get your head around the tricky bits. Net assets Early on in the question we are told that the fv of na of M is $2250m at acquisition. But then we realise that this was just a guess on the day of acquisition and needs adjusting for the two discoveries; one in para2 and the other in para3. The para2 adjustment is twisted but not so bad when you see it. The original guess for the unrecorded liability was $6m but it turns out that was wrong and the liability is and always was just $5m. So the difference is $1m. But it is what you do with the $1m that is tricky. If the liabilities at acquisition were actually smaller then the na were bigger. Hence 2250+1. The para3 adjustment is similar. The original guess on ppe was out by an overstatement of $40m. So that means that the true fv of na is $40m smaller. Hence 2250+1-40. The fva of $38m at the year end is simply after deducting “negative depreciation” of $2m using a 20 year life. The para4 fva has a similar twist. The intangible fva is $20m calculated as a balance (β for balancing figure). The life of the asset from the asset life start was 5 years. But one of those years happened before Joey bought Hulty. So there are only four years left from the current year start giving depreciation of $5m and a remainder of $15m. The RE growth of $82m in M is the difference between the growth of $92m and the OCE growth of $10m. The RE growth is most certainly not the growth in RE (even though it looks like that in H because H is so simple). Goodwill Negative goodwill is called a “bargain” to clarify that it is good news for the buyer. Joey is getting Hulty cheap, as paragraph 4 highlights. So Joey records a gain to p/l. Working 6 PPE Paragraph 6 describes ppe in use for four months and then reclassified as held for sale (hfs) and then sold. The ppe must be revalued before it goes into hfs. This gives the revaluation gain. The reference to revaluation accounting across the group is annoyingly in paragraph 3 and not paragraph 6 where we really need it. Then once in hfs, then ppe hfs must be immediately impairment tested. There is no viu for hfs. Hfs is held for sale not use. So we find there is an immediate impairment equal to the costs to sale. This rather freaky result is the feature that interests the examiner. Then the exit carrying value is compared to the net sale proceeds to give a profit on disposal.

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Working 5 Joint Arrangement Paragraph 5 is outrageously complex. Given there are only 2 marks (!!!!) and therefore 3 minutes for this paragraph, it was probably best to ignore this paragraph altogether in the exam. Joint control Joint control is the power to direct activities divided between two or more investors with unanimous vote. Joint control is visible in the scenario in the phrases “decisions must be agreed jointly” and “CP has the right of veto”. So the new publishing business is a joint arrangement (JA). JO then JV But there are two form of JA identified by incorporation. A joint venture (JV) is incorporated. A joint operation (JO) is not. So the publishing business is a JO for six months and then a JV for six months. The problem is that Joey has completely ignored this and treated all the sales and all the costs and all the cash as if they were all Joey’s. JO accounting This simply aims to reflect the JO arrangement. Often proportional consolidation applies. But this JO is not even vaguely proportional. This JO is heavily weighted towards Joey with CP having only the right to the rather fiddly royalty based on percentages of sales and gp. JO period journal Hence, all Joey needs to do is recognise the royalty that Joey has ignored:Dr Cr

p/l liability to CP

0.7 0.7

Liability to CP = (10%)(6/12)($5m) + (30%)(6/12)($5m-$2m) JV accounting JV accounting is equity accounting. This means that JVs are essentially associates and associates are outsiders. The JV called “JCP” has a life of its own outside the Joey group but Joey has taken all the cash as if that cash belonged to Joey. It does not. The cash belongs to JCP. That gives the credit entry below. And this starts the double entry with a liability to JCP. But as mentioned the JV requires equity accounting. This means a share of profit going through the p/l and arriving at the b/s to land on top of the cost. But there are no set up costs. So $0.75m should be in both p/l and b/s. The $0.75m is Joey’s 50% of the $1.5m profit for the second six months. So to repeat, $0.75m should be in both p/l and b/s. And if Joey had done nothing then this would be easy. But Joey has taken the whole of the $1.5m profit to its p/l instead of the 50% share that it has by rights. So a debit to the p/l is required to reduce the Joey profit recognition. JV period journal The result is this journal:Dr Dr Cr

Joint venture {b/s} ($5m-$2m)(6/12)(50%) p/l liability to JCP

0.75 0.75 1.5

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True JV period journal Actually in real life this jv journal would be even more complicated as Joey has put $2.5m JCP sales into Joey sales and $1m JCP costs into Joey costs. Neither of these should be in Joey fs and both of which must be replaced by $0.75m for share of JV profit. Dr Dr Cr Cr Cr

Joint venture {b/s}($5m-$2m)(6/12)(50%) Sales {p/l} liability to JCP Joint venture {p/l} Costs {p/l}

0.75 2.5 1.5 0.75 1.0

(b) Marking guide As ever there is 1 mark for each relevant point clearly expressed. Share based payment Share based payment (sbp) costs are measured by calculating a sbp obligation at each year end:Sbp obligation = number of rights expected to vest x fair value x timing ratio Number of rights expected to vest This tricky estimate is based upon counting the number of employees still in the contract at each year end but then further deducting a guess for how many more employees are expected to leave before they get to the end of their sbp vesting period. Fair value The fair value depends upon the nature of the sbp:Options Share appreciation rights

settled in equity settled in cash

grant fv current fv

These are options and so we use grant fv. Timing ratio This is a simple ratio of the period to date over the vesting period. So if the employees are locked in for three years from 7 December 2014 just after our current year end then at next years end the ratio will be 1/3. But these options vest immediately. So the above equation collapses down as discussed below. Vest immediately Because the grant and vest day are the same day, the Joey group sbp obligation is as follows:Sbp obligation = number of rights vesting x fair value at grant/vest date Group accounting The group accounting will be fairly simple. The group fs will have an sbp option reserve in other components of equity (OCE) with a fv balance on 7 December 2014 and the cost will go into the p/l as an operating cost:Dr Cr

operating costs sbp option reserve [OCE]

{p/l} {b/s}

fv fv

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Sub employees But a problem arises because these are sub employees being motivated by potential parent shares. You can understand why this might occur. The employees do not want sub shares as they would be near impossible to sell. The employees would much rather have parent shares as Joey is a plc and presumably quoted. And the parent does not want to give away sub shares as this then starts to mess with the nci. Parent fs So the parent must record a sbp obligation in OCE as discussed but also record a receivable from the sub. This receivable could be recognised on top of the investment in sub. Sub fs And the sub must record a payable to the parent with a corresponding operating cost. On consolidation the receivable and payable will contra down to zero. Related party transactions As a side point, both sub and parent would have to record a related party transaction because they are transacting with each other. Indeed if any of the employees are influential directors, which seems likely, then even the group would need rpd. Corporate governance But there is a corporate governance issue here. The options are simply given to the employees and vest immediately. This means employees can leave the day after they get their options on 7 December 2014. The idea is to motivate the employees to push for expansion. This might work with some of the employees. But others will leave before the expansion starts but will benefit from the expansion without being a part of the expansion. This is why sbp is not usually done like this. Usually sbp does have a vesting period. (c) Marking guide 1 mark per point. Ethics A good model to analyse ethics for a professional accountant is the ACCA principles in the ACCA ethical guidelines:Professionalism Integrity Competence Confidentiality Objectivity Directors The directors are lying to the bank; to cut a long story short. It seems likely that the directors know perfectly well that the cash flow forecast (cff) will not satisfy the bank without manipulation. Integrity This is a breach of integrity. Integrity requires that we are honest in our dealings with others. The directors’ statement to the bank is dishonest. Competence Either that or this is a breach of competence. If the directors do not know what their cff says then they are incompetent.

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Professional accountant But the question asks us to discuss how “a professional accountant” should respond. Presumably the relevant professional accountant is the new chief accountant and he is in a very difficult position. Objectivity The chief accountant has stated that “he cannot afford to lose his job”. So in a conflict of interest between ethical interests and financial interests the chief accountant would side with the financial interests. This is already a breach of objectivity even before the chief accountant does anything. Practicalities But being a little more practical and reasonable about this, of course the chief accountant needs his job or else he would be sunning on the beach. Saying to an accountant that you cannot put yourself in a position in which you cannot afford to lose your job is like saying to an accountant that you cannot have children. Openly stated For me the daft mistake that the chief accountant has made is openly stating that he needs his job. He should have kept his big mouth shut. Now he is playing into the hands of his directors. Action So now I must discuss what action the chief accountant should take when the directors come to him and ask him to manipulate the cff. First he should do his best to persuade his directors that honesty is the best course of action. Alternative finance Then the chief should help the directors look for alternative finance. Maybe the current bank is not the best deal. Maybe issuing debt or equity is the way. Email In conclusion the chief accountant should try his best to retain his ethics throughout. But as a word of advice on evidence, the chief accountant should make sure he confirms every word said aloud in email as directors like this can be very slippery when the trouble hits the fan.

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Q88 Coatmin Marking guide There is 1 mark per relevant point throughout. (a) Related party disclosure Transactions between parties related by control or influence must be disclosed. Related parties include subs and parents and directors and pension schemes. But any entity connected to Coatmin by an unbroken chain of control or influence would qualify. Common control Coatmin is not in a group with the other banks, by the way. A group has a parent at the top and a government is not a parent. The rather lovely expression used to describe the situation is “common control”. The same also applies to entities with a billionaire at the top like Richard Branson sitting on top of the Virgin common control portfolio. Related parties But the other banks are related parties. The government controls Coatmin and the government controls the other banks. But Coatmin should stop worrying as there are no transactions to disclose with these other entities under common control. Underwritten loans But the underwritten loans are quite a different thing. Of course Coatmin should disclose this relationship with the railway and the post. It is a related party transaction. But also it is a possible contingent liability. And disclosure may even be required under law as it is in the UK. China Actually IAS24 was recently watered down to exclude rpt through the government. This change was requested by China. In China many entities are related via the government. The USA often cite this change as proof that the IASB is swayed by national governments. The USA has a point. But they also have a damned cheek given that they have spent years and years manipulating the IASB themselves. It seems the USA government do not like it when the IASB listens to other governments. Financial guarantee Actually the underwriting obligation is in a class called “financial guarantees” and these are carried fvpl as discussed below. But even though the examiner examined two financial guarantees right next to each other in (a) and (b) the examiner appears to have missed this point in his answer. This shows just how hard and specialist this question is. Maybe the examiner was focussing purely on disclosure. (b) Group fs The scenario describes a loan guarantee between a parent and a sub. For the purposes of the group fs it makes no difference whether the $60m loan is viewed as being the liability of the sub or the parent. Either way the group owes $60m to the lender. Coatmin However, the question asks us to discuss this in the fs of “Coatmin”. This phrase could mean the group. But it could also mean the parent as a single entity. From this second perspective the sub is just an outsider. From this second perspective Coatmin has guaranteed the repayment of a loan from an outsider to a lender. Related party transaction So the first thing to say is that the guarantee is an rpt and requires disclosure in the Coatmin fs.

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Contingent liabilities The second thing to note is that the guarantee is a contingent liability of $60m. It is a liability of $60m that will only flow out if the sub cannot pay. Contingent liabilities are recorded roughly as follows (IAS37):Probable provide Possible disclose Remote ignore Possible contingent liability At last year’s end the chances of an outflow would probably be best described as possible. So this is further evidence that the guarantee must be disclosed. Financial guarantee And if this were simply a “product guarantee” then that would be the end of the story. But this is a “financial guarantee” and these are carried fvpl (IFRS9) and not as simple contingent liabilities. Frankly unless you work in a bank in the financial guarantees department there is no way you could know this specialist knowledge. Except one. The examiner tells you in the question. Financial liability IFRS9 looks at financial guarantees like this. The guarantee is a financial liability as soon as it is signed. The guarantee confers obligations onto Coatmin even if the guarantee is not expected to be called. The point is that the guarantee may be called even if it is not thought likely. The obligation is effectively in a class called “derivatives” and should be carried fvpl as described in the scenario. In fact the more specific name for this class is “credit derivatives”. Derivatives Derivatives derive their value from an underlying something. In this case the underlying something is the health of the sub. If the health of the sub goes down then the chances of breach go up and the fv of the guarantee goes up too. The opposite is true if the health of the sub goes up. Movement So the movement in the guarantee liability measured at fv would be approximately as follows:-

Opening at the start of last year To p/l Opening at start of this year To p/l Closing at end of this year

$m 1.2 (0.4) __ 0.8 (0.4) __ 0.4 __

given balance below balance below

Subsequent fair value The $0.8m above at the current year start is a guess. The scenario tells us that the loan is being paid in three equal instalments (of $20m each) and that the first has been paid (at last years end). So it makes sense that the fv of the guarantee liability has dropped by a third given that the principal owed by the sub has dropped by a third. The $0.4m at the current year end is another guess using the same logic.

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Difficulties Now we must decide how to deal with the “difficulties”. This is very tricky because at the year end the sub looks like it is in real trouble and it looks like the remaining $40m owed by the sub will be paid by Coatmin. Then a few days later a donor comes to the rescue and the sub is back on the tracks. Decision What we must decide is whether the donor rescue after the year end was hovering in the background at the year end or alternatively that the donor was unaware of the subs troubles at the year end and the sub was on its own at that time. Events after the reporting period The ifrs on EARP (IAS10) is not much help. All that says is that an adjusting event is an event that reveals after the year end a condition that was already in existence at the year end. The problem is that we have no idea if the donor was hovering over the sub like a guardian angel at the year end. Conclusion My guess is that the donor is unlikely to have made the donation without being ready to step in earlier. So the guarantee that looked likely to be called at the year end never was likely to be called because the donor was in the background ready to pick up the pieces. So the closing liability of $0.4m above would be recognised as such on the Coatmin b/s. Adjusting EARP The technical name of the above logic is “adjusting EARP”. In the draft fs the accountants would have pushed the guarantee liability up to $40m at the year end based on what they knew then. But later the accountants would have adjusted the guarantee liability back down to $0.4m when they realised that the donor would step in. (c) Issue The word “issue” tells us that the debt is the financial liability of Coatmin. And financial liabilities default into amortised cost. So the debt liability is carried at amortised cost. Hedging This is the process of betting against yourself. When an entity faces a risk that it cannot easily avoid then the entity can cancel out this risk by setting up an equal and opposite risk. This is called hedging and it uses derivatives. Example For example if an entity must buy coffee but fears that the price of coffee will rise before the coffee ripens then the entity can bet on the price of coffee rising. If the price does go up as feared then the entity will lose on the coffee purchase but win on the derivative bet and so end up net neutral. Risk And that is a basic rule of hedging. There must be a risk or there cannot be a hedge against that risk. The risk might be the fear of coffee prices rising or the fear that a foreign debt liability will grow in size when translated into the home currency or the fear that variable interest will rise with a rise in base rate. There has to be a risk.

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Fixed rate bond But there is no risk in the fixed rate bond. Coatmin has contracted to pay $40k next year (2% of $2m) and another $40k plus the $2m principal the following year. There is no chance that Coatmin might pay more in interest because it is fixed and there is no chance that Coatmin will pay more in principal because it is fixed. This is not a variable rate loan. This is not a foreign loan. There is no risk. Conclusion So that is the end of that. Coatmin cannot do hedge accounting because there is no hedging because there is no risk. Effect But the swap still exists and must be accounted for. The swap is simply recognised as a regular speculative derivative using fvpl:$k Opening liability 0 To p/l 203 ___ Closing liability 203 ___ Prospective and retrospective The technical name for looking at a hedge to see if it makes sense is “prospective and retrospective testing”. All this means is that you have to check that there is a hedging relationship between the risk item and the derivative at the start and then test again at each year end looking backwards to see that the hedging worked out roughly as expected. IAS39 By the way, under old IAS39 there was a test of hedge effectiveness that required the ratio of loss/gain to be within a range of 80% to 125%. This test no longer applies under IFRS9. Comment Hedging is an odd subject. Not only is it conceptually challenging, it is also common that two people looking at the same problem will view the issues differently. Even though one person may see no risk and feel no need for hedging; another person might see a risk and feel the need to hedge. In real life real companies do hedge fixed cash outflow obligations. And then they apply hedge accounting. And then the auditors accept that. Even in those real companies some of the treasury guys will think their own hedging is odd and disagree with the treasury guy doing the hedges. So it is possible to do hedging in the strangest situations and in the oddest ways. So all that you can do in an exam is look at the problem in your own way and say what you think and avoid being dogmatic. Further comment Hedging is also very complex. To illustrate the point, it can be noted that it appears the examiner has an internal conflict within his question. The question says that Coatmin’s credit worthiness has been worsening. The question also says that the movement in the fv of the bond is less than the movement in the swap. But this is the wrong way around. If Coatmin’s credit worthiness is worsening then the bond fv movement should be greater than the swap fv movement. That would certainly be more normal anyhow. If this is baffling then use it as further proof that hedging is very complex. You may not even know what a swap is and may never have heard of LIBOR. So the best solution is to learn what little you can and apply it as best as you can if hedging comes up in your exam.

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(d) Financial liabilities Fl are generally carried at amortised cost. It is very rare for fl to be carried at fv. But we are told that this is the case in this case and so there can be no debate. FVO The classic circumstance under which a bond liability can end up fv is in an fvo (fair value option). When there is a fa at fv and a related fl at amortised cost then this mismatch can be annoying. So IFRS9 allows both to be carried at fv. Some banks use the fvo occasionally. Maybe this bond liability is in an fvo. Own credit problem When an fl is at fv and the issuer gets into trouble a freaky thing happens. Imagine you issue debt to the market and then find yourself in financial difficulties then obviously the market will down grade your borrowing and the fa on the market will fall in value. But their fa is your fl. So the fv of your fl also falls. But this is good news. It is good to have a smaller fl. It generates a gain. So you end up with a gain for getting into trouble. This counterintuitive freak is called the “own credit problem”. OCI The IASB went around and around thinking of all sorts of exotic solutions to the own credit problem. In the end the IASB just kept it simple. Gains on fl from own credit deterioration go to oci and the rest goes to p/l as usual. So for Coatmin $5m goes to oci and $45m goes to p/l.

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Q89 Kayte Marking guide 1 mark per point. But only 12 good points are requires for 12 marks. (a) Control Control is the power to direct activities and gives rise to a sub that is consolidated with the parent. Acquisition It is not crystal clear, but it appears that Kayte buys all the equity of Ceemone that in turn owns all the equity of the little companies that own the ships. So Kayte now control the ships and Kayte can do what Kayte likes with the ships. This is control and the transaction is an acquisition. Management company The existence of the management company seems at first to challenge Kayte control. But Kayte can sack the management company anytime with only a month’s notice. So Kayte has the power to direct activities even though it delegates the actual activities to the management company. Asset acquisition Now we look at whether this is a sub acquisition or an asset acquisition. The phrase “asset acquisition” means Kayte is accounting for the purchase of the entire equity of Ceemone with all its little subs as the purchase of a whole load of ships. Nothing more. Just ships. Kayte is ignoring that Ceemone is a business and recording the following simple double entry:Dr Cr

ships (ppe) bank

x x

Business combinations What we have to do is work out if that is right. We need to assess whether there has been a business combination. The ifrs dealing with acquisitions and subsidiaries and goodwill is called “business combinations” (IFRS3) and the title is intended to be meaningful. The idea is that a sub acquisition occurs when two businesses come together. Business A business is defined as an entity that does something. It must have inputs and processes and outputs. Ceemone Ceemone has the following:Inputs there are ships and shipbrokers and management and customers goods. Processes the ships ride across oceans. Output the product is the movement of customers’ goods. Conclusion Ceemone is a business and the purchase of Ceemone must be recorded as the acquisition of a sub resulting in goodwill. That is the main difference between an acquisition and an asset purchase. The first has goodwill and the second does not.

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Goodwill And that leads to another way of analysing the scenario. Acquisitions have goodwill measured as follows:Fv of consideration x Fv of nci x Fv of na (x) __ Goodwill xx __ People The ifrs on goodwill (IFRS3) does not say what goodwill actually is. But the ifrs does make it clear that goodwill is the things that are in the sub that are not na. Subs have people and people are not in na. So goodwill is often expressed as being the fv of the people relationships with the sub at acquisition. This means suppliers and bankers and employees but most particularly goodwill means the customers and their loyalty. Application It is because Ceemone has moved it employees into a management company that Kayte has assumed Ceemone is not a business. Kayte thinks Ceemone has no people relationships. But this is not true. Ceemone still has a supplier of employees in the form of the separate management company. And Ceemone has other suppliers supplying ship broking and fuel and insurance, no doubt. But also even though the scenario does not say it, Ceemone is sure to have customers too, and their loyalty could be quite valuable. Ceemone has people relationships. Conclusion The conclusion is the same. Ceemone has people relationships summed up the phrase “goodwill” and Kayte has bought these relationships and needs to recognise this goodwill through a sub acquisition also known as a business combination. Employees I think that Kayte has got mixed up because Kayte thinks its own employees are inside Kayte. Kayte sees a difference because Ceemone employees are outside Ceemone. Kayte thinks Ceemone has no people relationships. But Kayte has it wrong. All people are outsiders. Even employees working directly for a company are outsiders. They are suppliers of labour just like the suppliers of stock and the suppliers of finance. All these guys are outsiders. That is why their costs appear on the group p/l and their liabilities appear on the group b/s. It is the people’s loyalty that is inside the entity. It is the people’s relationship that is inside Ceemone. And that gives rise to goodwill. Differences There may not be much difference in the numbers generated by sub acquisition accounting when compared to asset purchase accounting. Either way the fv of the ships themselves will dominate the story. Goodwill is a difference, of course. And transaction costs are written off on sub acquisition but capitalised on asset purchase. But these two may be small compared to the huge fv of a portfolio of ships. Control again To help us with the additional element we will need to look again at control. Control is the power to direct activities and gives rise to a sub. It is also the concept we must use to identify a disposal.

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New entity The scenario tells us that Kayte has transferred some vessels to a new entity “in which the bank retained a variable interest based upon the level of indebtedness”. It is hard to know what this phrase means. But it appears to be talking about bank ownership rather than bank power to direct activities. Analysis Given that the scenario says nothing about the bank's ability to direct activities, I will assume that the bank does not have this power. This makes sense I think because I doubt a bank would know how to direct the activities of a shipping company. Conclusion So it sounds like Kayte has retained control over the ships in the new entity and has control over the entity itself. So there is no disposal and the new entity and the ships should be consolidated in Kayte group fs. NCI But it does sound like the transaction has given some ownership to the bank. I get this idea from the phrase “variable interest based upon the level of indebtedness”. This does sound like the introduction of nci where previously there was none. In fact it sounds like nci changes from day to day based upon the level of indebtedness on that day. This would be horrible to try to recognise. Bank loan Of course it is quite possible that I am reading too much into the phrase “variable interest based upon the level of indebtedness”. This may not mean nci. This could simply imply a secured bank loan. (b) Depreciation Depreciation is defined as the consumption of ppe value over useful life. More particularly depreciation each year is the remaining depreciable value divided by the remaining useful life. Depreciable value is defined as carrying value less residual value (IAS16). Residual value Residual value is the value of the ppe at the end of its useful life. For many assets this is literally zero as the asset is thrown away at the end of its life. For many other assets residual value is immaterial as the asset is scrapped for very little. But for some assets like ships the residual value is high. Scrap ships are valuable because of the metal they contain. Ship residual value Residual value is particularly easy to picture for a ship. It is the value of the ship at the point it is towed away to the scrap yard to be broken down having done its last trip at sea. Broker valuations Also it makes sense to use the broker valuations of scrap value as it will be brokers that broker the deal to scrap the ship at its life end. The valuations will be volatile unfortunately. That is because metal is a commodity in which the price goes up and down. This means the depreciation will be slightly different each year. But this is no big deal. Lots of things are different each year.

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Fair value measurement FVM and the hierarchy could be useful to the debate about the residual value measurement:Level 1 exact equivalent active market price Level 2 approximately equivalent transaction price Level 3 unobservable inputs into financial models Application It sounds like the brokers are using level 2 inputs for their estimate of residual value (fvm based on similar ship sales). Whereas it sounds like the directors are using level 3 (making up their fvm based on conservative models but it is hard to tell where directors are getting their figures from). This is more evidence that the brokers’ estimates of residual value are likely to be more appropriate. Useful life But Kayte has the right idea about life. The life used in depreciation is the life of the asset in Kayte possession. This idea is called “useful life” in order to distinguish it from “economic life” which is the whole asset life to scrap. And the residual value is the value that Kayte expects to get when Kayte sells. 10 year vessels It sounds like Kayte has the management strategy of selling certain specific classes of ship after 10 years. If this is the case then these 10 year vessels should be separated from the general fleet and depreciated down to a 10 year old ship residual value over 10 years. Alternative interpretation But the scenario could be telling me that all ships are purchased for use for 30 years but that sometimes some of these ships come in for their 10 year maintenance looking so awful that Kayte decides to sell rather than bother with the maintenance. If this is the case then 30 years would be used across the whole fleet. Effect So Kayte must recalculate the depreciation using the appropriate useful asset life and the brokers estimate as residual value. Disaggregation Moving to the second paragraph now, when one asset has got components with different lives, strictly the asset should be separated into those components and depreciated using those component lives. In many assets this does not apply or is pointless because of materiality. But ships cost millions. So disaggregation is required. Funnels Perhaps the easiest to start with is the funnels. The vessels with funnel lives of 15 years must be disaggregated. The funnel should be depreciated over 15 years and the body over 30 years. Engines But it does sound like the engines generally do last the full 30 years. The fact that only one engine failed altogether this year probably supports this; especially if there are hundreds of ships in the fleet. Maintenance So it seems reasonable to depreciate the vessels over 30 years including the engines and charge the 10 year service to the p/l as maintenance.

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Alternative However, if the 10 year maintenance cost is so big that it is almost equivalent to buying a new engine then an alternative is suggested by the ifrs (IAS16). The engine is depreciated over ten years and then the 10 year service cost is depreciated over years 11 to 20 and the 20 year service is depreciated over years 21 to 30. Q90 Estoil (a) Marking guide The usual 1 mark per relevant point applies. Impairment An impairment occurs when the carrying value of an asset is above the recoverable value defined as the higher of viu and fvlcts (value in use and fair value less costs to sell). Goodwill impairment testing An impairment test is required annually on goodwill. Annual goodwill testing is required because goodwill is carried without depreciation. Most groups test all their goodwill at the year end. But because goodwill testing is onerous some groups stagger their testing over the year doing a few each month end. Other asset impairment testing Other asset impairment tests are required when there is an indication of impairment. This can be anything that could indicate the asset is in trouble. But obvious indicators include the following:Damage Frequent maintenance Idle time Fall in market value Fall in related product demand Cash generating unit Ideally all assets should be tested individually. So a rental car damaged by a customer should be assessed in isolation. But some assets have no individual viu. A machine in the middle of a factory line has no individual viu. Indeed the machine is useless without the machine before and after in the factory line. These machines are tested collectively in a collective called the cash generating unit (cgu). Judgement I will now look at the words in the introduction. The involvement of “judgement” in impairment testing is almost endless. Management must decide on whether assets can be tested individually or within a cgu. Then management must judge the operating cash flow forecast figures and discount rate to produce viu. Then management must judge fair value and separately judge costs to sell to give fvlcts. Discretion Then directors must use their “discretion” for disclosure. The directors must decide whether the impairments are considered exceptional and how the impairment policy should be disclosed. ESMA Indeed the European Securities and Markets Authority (ESMA) has conducted research in this area and found that the worst component of EU impairment testing is the disclosure. Many groups have disclosure that is so bad that it is impossible to tell whether the impairment testing is in accordance with the IAS.

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Economic uncertainty I guess the term “economic uncertainty” means recession. We are in a recession now that has been dragging on since 2009 and clearly that effects impairment testing. In a recession impairment testing needs to be particularly rigorous because many assets will be working at lower than optimal production volume because of the decrease in demand. This means most assets should be tested and means honesty about viu is required. Timely The reference to the word “timely” in the introduction is a reference to the timing of impairment testing. Impairment tests are required at any time there is an indication of impairment. Management may be tempted to conduct impairment tests only at the year end. But this could be insufficient if there are indications of impairment in the middle of the year. Example If a sub is supplying a single customer and that single customer gets into trouble in the middle of the year then it is obvious that the receivable must be tested for impairment immediately. There is no excuse for waiting until the year end. But what is less obvious is that the whole cgu should be tested at the same time. It is likely that the goodwill and maybe the machines are impaired too. Changes in circumstance (1) law The phrase “change in circumstance” is such a broad phrase that it could be taken to mean almost anything. One change in circumstance that would certainly cause trouble would be legislation in a regulated industry. For example a sub manufacturing medicine would certainly require cgu impairment testing if the government legislated against that medicine. Change in circumstance (2) commodity prices Another change in circumstance that would cause trouble would be a change in commodity prices. For example a sub that drilled for oil would certainly need a cgu impairment test if the price in oil halved overnight. This would be especially true if the oilfield was only marginally economic in the first place. Market capitalisation (1) meaning This term means entity share price multiplied by the number of shares. It is the market value of the group based on the trading at any point in time. It does not represent what most shareholders think the group is worth. Obviously the shareholders who are not trading think the group is worth more and that is why they are holding their shares. But market capitalisation does give a flavour of value. Market capitalisation (2) impairment testing This is relevant to impairment testing in this way. If the carrying value of the whole group is greater than the market capitalisation of the whole group then it is possible the whole group is impaired and this would trigger wide ranging impairment testing across the whole group, cgu by cgu. Conclusion The above discussion shows that impairment testing requires judgement in application and discretion in disclosure. The above discussion also indicates why commentators like ESMA suspect that the actual impairment testing on the ground by EU groups is insufficient in today’s struggling world economy. (b) Marking guide 1 mark per point.

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(i) Goodwill Goodwill is the classic example of an asset that cannot be impairment tested in isolation. Goodwill is the classic example of an asset that must be tested as part of a cgu impairment test. The cgu tested would be the sub related to each goodwill. Recoverable value Recoverable value is the higher of fvlcts and viu. Discounting applies only to viu. So the reference to discounting in the scenario is a reference to discounting the sub cash flow forecast figures down to viu. But of course each sub is different and so a sub by sub discount rate should be used. WACC And that is the problem. Instead of doing a sub by sub viu using a discount rate appropriate to each sub, Estoil have used group WACC uniformly throughout. This ignores that each sub will face differing risks dependent upon the economy in each country. Currency Also the currency of the impairment test is incorrect. The goodwill down in each sub is just another asset down in each sub and should be tested in the sub first. The testing of foreign goodwill is no different than the testing of foreign machines in that respect. Impracticable Estoil argues that an impairment test down in each sub using a sub appropriate discount rate in a sub appropriate currency is “impracticable”. Presumably Estoil means that this is a lot of hard work. Of course this is no excuse for doing a half-hearted impairment test. Many big groups with lots of foreign subs solve this problem by delegating the impairment testing down to the subs themselves and making them do the hard work. (ii) VIU This scenario again relates to inappropriate calculation of viu. This time the viu calculations are hopelessly inadequate and far worse than those in Estoil above. Budgets Viu is based upon budgets. In order to calculate viu an entity should produce cash flow forecasts (cff) for each cgu and then discount down to present value using an appropriate risk adjusted discount rate that recognises the risks inherent in those cash flows. Guidance The ifrs does not stipulate in detail exactly how to produce cff. But the ifrs does require that the budgets should be reasonable and supported by a history of actual cash flows. The Fariole cff fulfil neither requirement. Indeed the cff sound like hopeless fantasy. Adding back depreciation The scenario tells us that the budget cff are just budget profit with depreciation added back. This is no way to do a cff. A cff should be projected cash inflows less projected cash outflows and there should be sufficient detail to see where the cash is coming from and where the cash is going. Realised cash flows The scenario also tells us that the actual recent cash flows were way below the budget. This is more evidence that the calculation of viu is hopeless fantasy. The impairment tests need reperforming.

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