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The Institute of Chartered Accountants of Bangladesh
FINANCIAL ACCOUNTING Professional Stage Application Level
Study Manual www.icab.org.bd
Financial Accounting The Institute of Chartered Accountants of Bangladesh Professional Stage These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales ISBN: 978-1-84152-837-3 First edition 2009 All rights reserved. No part of this publication may be reproduced in any form or by any means or stored in any retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without prior permission of the publisher.
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© The Institute of Chartered Accountants in England and Wales, March 2009
Welcome
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Contents
Introduction
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Specification grid for Financial Accounting
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The learning materials
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Study guide
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Getting help
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Syllabus and learning outcomes
xix
Skills assessment guide
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Accounting and reporting concepts 1.
Conceptual and regulatory framework
1
Preparation of single entity financial statements 2.
Format of financial statements
41
3.
Cash flow statements
81
4.
Reporting financial performance
119
5.
Property, plant and equipment
157
6.
Intangible assets
211
7.
Revenue and inventories
239
8.
Leases
273
9.
Provisions, contingencies and events after the balance sheet date
317
Preparation of consolidated financial statements 10. Group accounts: basic principles
361
11. Group accounts: consolidated balance sheet
385
12. Group accounts: consolidated statements of financial performance
435
13. Group accounts: associates
479
14. Group accounts: disposals
519
15. Business combinations, consolidated financial statements and associates
563
16. Group cash flow statements
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Appendix: BFRS financial statements
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INTRODUCTION
1 Introduction 1.1
What is Financial Accounting and how does it fit within the Professional Stage? Structure The syllabus has been designed to develop core technical, commercial, and ethical skills and knowledge in a structured and rigorous manner. The diagram below shows the fourteen modules at the Professional Stage, where the focus is on the acquisition and application of technical skills and knowledge, and the Advanced Stage which comprises three technical modules and the Case Study.
The knowledge base In the Accounting paper you will have been introduced to the double entry system of recording transactions and the preparation of non-complex financial statements. Progression to application level The Financial Accounting module develops these basic principles covered in Accounting, looking at the preparation of single entity financial statements in more complex situations and also introduces the issue of group financial statements. Progression to advanced stage The Financial & Corporate Reporting paper then takes these issues a step further, enabling students to prepare extracts from financial statements for entities undertaking a wide range of accounting transactions. The emphasis is also on understanding financial information as well as preparation with analysis and interpretation a key feature. This paper also aims to ensure that students can apply technical knowledge and professional skills to resolve real-life compliance issues faced by businesses – including the accounting treatment of complex corporate reporting issues, for financial instruments and mergers and acquisitions. The above illustrates how the knowledge of financial accounting gives a platform from which a progression of skills and accounting expertise is developed.
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Financial accounting
1.2
Services provided by professional accountants Professional accountants should be able to:
Explain the contribution and inherent limitations of financial statements in meeting stakeholders’ needs for financial information and apply the International Accounting Standards Board’s (IASB) conceptual framework for financial reporting
Prepare and present financial statements from accounting data for single entities, whether organised in corporate or in other forms, in conformity with BFRS
Identify the circumstances in which entities are required to present consolidated financial statements and prepare and present them in conformity with BFRS
2 Specification grid for Financial Accounting 2.1
Module aim To enable students to prepare a complete set of financial statements for single entities and for groups in conformity with International Financial Reporting Standards (BFRS).
2.2
Specification grid This grid shows the relative weightings of subjects within this module and should guide the relative study time spent on each. Over time the marks available in the assessment will equate to the weightings below, while slight variations may occur in individual assessments to enable suitably rigorous questions to be set. Weighting (%) 10 55 35 100
1 Accounting and reporting concepts 2 Preparation of single entity financial statements 3 Preparation of consolidated financial statements
Your exam will consist of Part one
– 5 - 15 short form questions (worth 1 - 4 marks each)
20 marks
Part two
– 4 questions (each worth around 20 marks each)
80 marks
Time available
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2.5 hours
INTRODUCTION
3 The learning materials You will find the learning materials are structured as follows:
Title page Contents page Introduction. This includes –
a review of the subject to set the context
–
a list of the top level learning outcomes for this subject area entitled 'Services provided by professional accountants' (set with reference to what a newly qualified accountant would be expected to do as part of their job)
The specification grid for Financial Accounting
A brief note about the learning materials
Study Guide. This includes –
hints and tips on how to approach studying for your CA exams
–
guidance on how to approach studying with this study manual
–
a detailed study guide suggesting how you should study each chapter of this study manual and identifying the essential points in each chapter
Information on how to obtain help with your studies
The detailed syllabus and learning outcomes
Information on the Faculties and special interest groups
Each chapter has the following components where relevant:
Introduction – – – – –
Learning objectives Practical significance Stop and think Working context Syllabus links
Examination context
Chapter topics
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
The technical reference section is designed to assist you when you are working in the office. It should help you to know where to look for further information on the topics covered. You will not be examined on the contents of this section in your examination.
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Financial accounting
4 Study guide 4.1
Help yourself study for your CA exams Exams for professional bodies such as the ICAB are very different from those you have taken at college or university. You will be under greater time pressure before the exam – as you may be combining your study with work. Here are some hints and tips.
The right approach 1
2
Develop the right attitude Believe in yourself
Yes, there is a lot to learn. But thousands have succeeded before and you can too.
Remember why you're doing it
You are studying for a good reason: to advance your career.
Focus on the exam Read through the Syllabus and Study Guide
3
These tell you what you are expected to know and are supplemented by Examination context sections in the text.
The right method See the whole picture
Use your own words
Keeping in mind how all the detail you need to know fits into the whole picture will help you understand it better.
The Introduction of each chapter puts the material in context.
The Learning objectives, Section overviews and Examination context sections show you what you need to grasp.
To absorb the information (and to practise your written communication skills), you need to put it into your own words.
Give yourself cues to jog your memory
4
The Study Manual uses bold to highlight key points.
Try colour coding with a highlighter pen. Write key points on cards.
The right recap Review, review, review
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Take notes. Answer the questions in each chapter. Draw mindmaps. Try 'teaching' a subject to a colleague or friend.
Regularly reviewing a topic in summary form can fix it in your memory. The Study Manual helps you review in many ways.
Chapter summary will help you to recall each study session.
The Self-test actively tests your grasp of the essentials.
Go through the Examples in each chapter a second or third time.
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INTRODUCTION
4.2
Study cycle The best way to approach this Study Manual is to tackle the chapters in order. We will look in detail at how to approach each chapter below but as a general guide, taking into account your individual learning style, you could follow this sequence for each chapter. Key study steps Step 1 Topic list
Activity The topic list is shown in the contents for each chapter and helps you navigate each part of the book; each numbered topic is a numbered section in the chapter.
Step 2 Introduction
This sets your objectives for study by giving you the big picture in terms of the context of the chapter. The content is referenced to the Study guide, and Examination context guidance shows what the examiners are looking for. The Introduction tells you why the topics covered in the chapter need to be studied.
Step 3 Section overviews
Section overviews give you a quick summary of the content of each of the main chapter sections. They can also be used at the end of each chapter to help you review each chapter quickly.
Step 4 Explanations
Proceed methodically through each chapter, particularly focusing on areas highlighted as significant in the chapter introduction or study guide.
Step 5 Note taking
Take brief notes, if you wish. Don't copy out too much. Remember that being able to record something yourself is a sign of being able to understand it. Your notes can be in whatever format you find most helpful; lists, diagrams, mindmaps.
Step 6 Examples
Work through the examples very carefully as they illustrate key knowledge and techniques.
Step 7 Answers
Check yours against the suggested solutions, and make sure you understand any discrepancies.
Step 8 Chapter summary Step 9 Self-test Step 10
Review it carefully, to make sure you have grasped the significance of all the important points in the chapter. Use the Self-test to check how much you have remembered of the topics covered. Ensure you have ticked off the Learning Objectives.
Learning objectives
Moving on... When you are ready to start revising, you should still refer back to this Study Manual.
As a source of reference.
As a way to review (the Section overviews, Examination context, Chapter summaries and Self-test questions help you here).
Remember to keep careful hold of this Study Manual – you will find it invaluable in your work. The technical reference section has been designed to help you in the workplace by directing you to where you can find further information on the topics studied.
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Financial accounting
4.3
Detailed study guide Use this schedule and your exam timetable to plan the dates on which you will complete each study period below: Study period
Approach
Essential points
1
Chapter 1 sets out the conceptual and regulatory framework which will form the basis of the rest of the chapters in this manual. As you read through the chapter try to ensure that you understand how the various elements of the framework fit together rather than getting bogged down in the specific details.
Bases of accounting
BFRS Framework: qualitative characteristics
BFRS Framework: definitions of assets and liabilities
Proformas for:
Read section 8 carefully which deals with not-forprofit entities. You will not have come across this type of entity before in your accounting studies. Complete the Interactive questions and attempt the Self-test questions. 2
Chapter 2 is an important chapter as it introduces formats for the balance sheet, income statement and statement of changes in equity. These will form the basis of all accounts preparation questions. Read through the chapter carefully paying particular attention to the formats. You must be able to reproduce these. You may also find it useful to refer to the Appendix at the end of the manual which includes a proforma set of financial statements.
–
Balance sheet
–
Income statement
–
Statement of changes in equity
Also notice sections 4.2 and 5.2. This type of detail may be tested in OT questions. Section 9 deals with the presentation of not-forprofit entities. Read through this section carefully. 3
Chapter 3 deals with the preparation of the cash flow statement. The emphasis here is on technique so you must work through the worked examples and Interactive questions. Read through section 8 carefully and review the worked example. You may also find it useful to refer to the cash flow statement in the Appendix at the end of the manual. Finally, you should attempt the Self-test questions to confirm your understanding of this topic.
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Presentation of a cash flow statement
Technique for preparation of a cash flow statement
Due date
INTRODUCTION
Study period
Approach
Essential points
4
Chapter 4 is a very technical chapter so you will need to work through it methodically. Read through sections 1-8 carefully, noting the difference in treatment in a change of accounting policy and a change in accounting estimate.
Treatment of a change in accounting policy
Definition and presentation of a discontinued operation
Accounting for revaluations
Accounting for impairments
Disposals
Disclosure
Treatment of purchased intangibles
Treatment of internally generated intangibles
Goodwill
Due date
Section 7 deals with the treatment of discontinued operations. Make sure that you understand what constitutes a discontinued operation and how this is presented in the financial statements. Attempt Interactive question 1 to confirm your understanding of this topic. Read through section 8 and 9. In section 8 notice the link between BAS 32 Financial Instruments: Presentation and BFRS Framework. You should then attempt all the Self-test questions. 5
You will have covered the basic accounting treatment of property, plant and equipment in your Accounting studies. Chapter 5 however, puts the topic into the context of the relevant accounting standards. Read through the chapter carefully taking particular note of the Worked examples and Interactive questions as these demonstrate how the standards should be applied. Also note the disclosure requirements. These are important as written test questions are likely to focus on the preparation of financial statements or extracts. Read section 10. These differences may be examined in OT questions.
6
Read through Chapter 6 carefully. In section 1 note how the underlying principles of BFRS Framework are reflected in BAS 38. Make sure you understand the accounting treatment of both purchased and internally generated assets. Section 9 introduces the topic of goodwill which will be covered in more detail in Chapters 10-15. You should attempt all Interactive questions and Self-test questions to confirm your understanding of this topic.
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Financial accounting Study period
Approach
Essential points
7
Read through sections 1 and 2 of Chapter 7 and attempt Interactive question 1. Pay particular attention to section 2.8 which demonstrates how the concepts of BAS 18 Revenue apply to specific types of transactions. Then try Interactive questions 2 and 3.
Revenue recognition
Definition of cost of inventories
Cost formulae
Definition of net realisable value
Definition of a finance lease
Treatment and disclosure of a finance lease
Treatment and disclosure of an operating lease
The remainder of this chapter then deals with inventories. You will have covered the basic principles involved in your Accounting studies so much of this will be revision. Notice however that the manual puts the topic into the context of BAS 2 Inventories. Complete Interactive question 4. You should also try all the Self-test questions to confirm your understanding of these topics. 8
Chapter 8 deals with the accounting treatment of leases. Make sure that you can distinguish between a finance lease and an operating lease and that you understand the importance of the concept of substance over form. Much of the rest of the chapter concerns the accounting treatment of finance leases. Work through the Worked examples and Interactive questions carefully as these demonstrate the key points. Note in particular the impact of the timing of the payments of the finance lease instalments, i.e. in arrears or in advance. You also need to be familiar with the disclosure requirements as a written test question on this topic is likely to require extracts from the financial statements. The treatment of operating leases is more straightforward. Read through section 7, again paying particular attention to the disclosure requirements. Attempt all the Self-test questions paying particular attention to the written test question from the Sample Paper.
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Due date
INTRODUCTION
Study period
Approach
9
Read through sections 1-5 of Chapter 9 on provisions, noting in particular the definition of a liability and the link with BFRS Framework. Make sure you understand the recognition criteria in section 2.2. Section 4 introduces a number of specific applications of the principles of the standard. You should read through these carefully and attempt Interactive question 3.
Essential points
Due date
Sections 6 and 7 deal with contingencies. Review the definitions of a contingent asset and a contingent liability and ensure that you understand the accounting treatment of these. Interactive questions 4 and 5 will help you to confirm your understanding. Then move on to Section 8. This topic is reasonably straightforward. The key point is the distinction between adjusting and non-adjusting events after the balance sheet date. Also note the treatment of dividends on equity shares proposed or declared after the balance sheet date. You should attempt all the Self-test questions including the written test question from the Sample Paper. 10
Chapter 10 is the first in a series of chapters on group accounts. The aim of this chapter is to set down the broad principles which are applied when preparing group financial statements. Work through this chapter carefully reviewing the Worked examples and completing the Interactive questions. It is important that you do not move on to the next chapter until you have a good understanding of these concepts.
Definition of a group
Single entity concept
Reflecting control and ownership
Treatment of goodwill
Consolidated balance sheet workings
Cancellation of intragroup balances
Unrealised profit on intra-group trading
Fair value adjustments
Attempt the Self-test questions and review the solutions carefully. 11
Chapter 11 applies the principles introduced in Chapter 10 to the consolidated balance sheet specifically. It is a detailed but important chapter so you will need to work through it carefully. As you read through the individual sections and work through the Interactive questions notice the way in which a technique is developed. This technique is the key to answering written test questions on this topic. This is summarised in section 3. Sections 5-8 introduce a number of consolidation adjustments. These may feature in both written test and the OT sections of the paper so review these carefully. Review the Worked examples and attempt the Interactive questions to ensure that you have a good grasp of these adjustments. Then attempt the Self-test questions to confirm your understanding.
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Financial accounting Study period
Approach
Essential points
12
Chapter 12 applies the basic principles introduced in Chapter 10 to the consolidated income statement and consolidated statement of changes in equity.
Consolidated income statement workings
Intra-group transactions and unrealised profit on trading transactions
Mid-year acquisitions
Consolidated statement of changes in equity
Definition of associate/ significant influence
Equity method in consolidated income statement/balance sheet
Read through sections 1-6 on the consolidated income statement. Notice that the issues raised are essentially the same as those you will have covered in the previous chapter but now considered from the perspective of the consolidated income statement. Also notice the emphasis on technique. Proforma workings are provided in section 3 which you should follow for all written test questions. Then move on to section 7. Review the worked example carefully taking particular note of the minority interest column. Work through Interactive questions 5 and 6. Attempt the Self-test questions to confirm your understanding of the topics covered in this chapter. 13
Chapter 13 deals with the treatment of the associate in the consolidated financial statements. Read through section 1, paying particular attention to the definition of significant influence. Then move on to the equity method in sections 2 and 3. Review these sections carefully working through Interactive question 1 and 2. Make sure that you understand the difference between this method and the consolidation technique used for subsidiaries. Then move on to section 4. This covers the specific issue of associate’s losses which could be examined in a short-form question. Work through section 5. This is a little tricky so review this carefully and use the Interactive questions to help you. Make sure that you appreciate that the treatment of unrealised profits will depend on whether the associate or the parent is the selling company.
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Due date
INTRODUCTION
Study period
Approach
Essential points
14
Chapter 14 covers a lot of technical detail, dealing with the disposal of subsidiaries and associates. You may find the summary table at the end of the chapter useful as it provides an overview of the topic. Refer back to it as you work through the chapter.
Calculation of group profit or loss on disposal
Impact of full and part disposal on the consolidated financial statements
Sections 2-6 cover the disposal of a subsidiary. Read through the notes but pay particular attention to the Worked examples and the Interactive questions as these demonstrate the key issues. For each of the disposal possibilities try to ensure that you can calculate the group profit or loss on disposal and that you understand the implications for the consolidated financial statements. Also notice that the full disposal of a subsidiary constitutes a discontinued activity which should be disclosed as such.
Due date
You should find section 7 more straightforward as many of the principles are similar to those you will have seen in sections 1-6. Read section 7.2 carefully, in particular the way in which the resulting trade investment is calculated in the consolidated statement of financial position. Review the Worked example. Attempt the Self-test questions to confirm that you have a good grasp of this topic.
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Financial accounting Study period
Approach
Essential points
15
In Chapters 10-14 the emphasis has been on the mechanics of preparing consolidated financial statements. Chapter 15 puts this method into the context of the relevant financial reporting standards. As such you will find that you are familiar with many of the points which are made.
Identifying the acquirer and the means by which control is achieved
Fair value of consideration
Sections 2-8 cover BFRS 3 Business Combinations. Note in particular the definition of the acquirer in section 3 and the ways in which one entity may control another. Sections 4-7 then go on to deal with fair values and goodwill including the way in which fair value is attributed to the cost of the combination and the assets acquired. These sections are important so work through them carefully. Attempt Interactive questions 1and 2 to confirm your understanding.
Fair value of net assets acquired
Goodwill
Impact of finance leases
Dividends paid to the minority interest
Dividends received from associates
Acquisitions/disposals of subsidiaries/associates
Briefly review section 9. As you will see many of the points made in BAS 27 Consolidated and Separate Financial Statements are very similar to those in BFRS 3. Then move on to section 10. You should be familiar with the points made here from your study of Chapter 13. You should attempt the Self-test questions to confirm your understanding of this topic. 16
In Chapter 16 the topic of the cash flow statement is revisited but from the group perspective. Section 1 provides a brief revision of the material covered in Chapter 3. Read over this and/or return to Chapter 3 if you require more detailed revision. Section 1 also introduces the impact of finance leases in the individual cash flow statement. Try Interactive question 1. Then go on to section 2 which covers the group cash flow statement. Notice that many of the issues addressed in Chapter 3 are still relevant, however in the consolidated cash flow statement there are a number of additional matters to consider. The technique of calculating the cash flow information required, primarily through the use of T accounts is important so make sure that you work through the Worked examples and Interactive questions carefully. Attempt the Self-test questions to confirm your understanding of this topic.
Revision phase Your revision will be centred around using the questions in the ICAB Revision Question Bank.
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Due date
INTRODUCTION
5 Getting help Firstly, if you are receiving structured tuition, make sure you know how and when you can contact your tutors for extra help. Identify a work colleague who is qualified, or has at least passed the paper you are studying for, who is willing to help if you have questions. Form a group with a small number of other students, you can help each other and study together, providing informal support. Call +88 (02) 9112672 or 9115340, or email
[email protected] with non-technical queries. Watch the ICAB website for future support initiatives.
6 Syllabus and learning outcomes The following learning outcomes should be read in conjunction with the Financial Reporting table in Section 6.1.
1
Accounting and reporting concepts Candidates will be able to explain the contribution and inherent limitations of financial statements in meeting stakeholders’ needs for financial information and apply the International Accounting Standards Board’s conceptual framework for financial reporting. In the assessment, candidates may be required to: (a)
discuss the purpose of accounting regulations, standards and other requirements
(b) explain the objectives of financial statements, giving appropriate examples (c)
explain the qualitative characteristics of financial information and the constraints on such information, using appropriate examples to illustrate the explanation
(d) identify the financial effects of transactions in accordance with the IASB Framework, which has been adopted by ICAB as BFRS Framework
2
(e)
explain the differences between financial statements produced using the accrual basis and those produced using the bases of cash accounting and break-up, performing simple calculations to illustrate the differences
(f)
explain, in non-technical language, the different bases of measurement of the elements of the financial statements and the different definitions of capital and capital maintenance used in accrual basis financial statements, illustrating the explanation with simple calculations and examples
(g)
explain and demonstrate the concepts and principles surrounding the consolidation of financial statements.
Preparation of single entity financial statements Candidates will be able to prepare and present financial statements from accounting data for single entities, whether organised in corporate or in other forms, in conformity with BFRS requirements. In the assessment, candidates may be required to: (a)
identify and describe the circumstances in which an entity is required to prepare and present statutory financial statements
(b) identify the laws, regulations, accounting standards and other requirements applicable to the statutory financial statements of an entity
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Financial accounting (c)
prepare and present the financial statements, or extracts therefrom, of an entity according to its accounting policies and appropriate international financial reporting standards
(d) identify the circumstances in which the use of BFRS and International Public Sector Accounting Standards (IPSASs) for not-for-profit entities might be required (e)
3
calculate from financial and other data the amounts to be included in the equity section of the balance sheet of a not-for-profit entity in accordance with its accounting policies and the appropriate financial reporting framework.
Preparation of consolidated financial statements Candidates will be able to identify the circumstances in which entities are required to present consolidated financial statements and prepare and present them in conformity with BFRS. In the assessment, candidates may be required to: (a)
identify and describe the circumstances in which an entity is required to prepare and present consolidated financial statements
(b) identify the laws, regulations, accounting standards and other requirements applicable to the legal entity and consolidated financial statements of an entity (c)
identify from financial and other data any subsidiary or associate of an entity according to the international financial reporting framework
(d) calculate from financial and other data the amounts to be included in an entity’s consolidated financial statements in respect of its new, continuing and discontinuing interests in subsidiaries and associates according to the international financial reporting framework (e)
6.1
prepare and present the consolidated financial statements (including a consolidated cash flow statement), or extracts therefrom, of an entity in accordance with its accounting policies and the international financial reporting framework, using calculated amounts and other information.
Technical knowledge The tables contained in this section show the technical knowledge covered in the CA syllabus by module. The level of knowledge required in the relevant Professional Stage module and at the Advanced Stage is shown. The knowledge levels are defined as follows: Level D An awareness of the scope of the standard. Level C A general knowledge with a basic understanding of the subject matter and training in its application sufficient to identify significant issues and evaluate their potential implications or impact. Level B A working knowledge with a broad understanding of the subject matter and a level of experience in the application thereof sufficient to apply the subject matter in straightforward circumstances. Level A A thorough knowledge with a solid understanding of the subject matter and experience in the application thereof sufficient to exercise reasonable professional judgement in the application of the subject matter in those circumstances generally encountered by Chartered Accountants. Key to other symbols:
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the knowledge level reached is assumed to be continued
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INTRODUCTION
Financial Reporting
Advanced Stage
Preface to Bangladesh Financial Reporting Standards
A
Framework for Preparation and Presentation of Financial Statements
A
A
BAS 2 Inventories
A
BAS 7 Cash Flow Statements
A
A
A
BAS 11 Construction Contracts
A
BAS 12 Income Taxes
C
A
BAS 14 Segment Reporting (see note 1)
A
Accounting
Financial Accounting
Professional Stage Title
BAS 1 Presentation of Financial Statements
BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors BAS 10 Events after the Balance Sheet Date
B
B
BAS 16 Property, Plant and Equipment
A
BAS 17 Leases
A
BAS 18 Revenue
A
BAS 19 Employee Benefits
A
BAS 20 Accounting for Government Grants and Disclosure of Government Assistance
A
BAS 21 The Effects of Change in Foreign Exchange Rates
A
BAS 23 Borrowing Costs (see note 2)
A
BAS 24 Related Party Disclosures
A
BAS 26 Accounting and Reporting by Retirement Benefit Plans
D
BAS 27 Consolidated and Separate Financial Statements
A
BAS 28 Investments in Associates
A
BAS 29 Financial Reporting in Hyperinflationary Economies
D
BAS 31 Interests in Joint Ventures BAS 32 Financial Instruments: Presentation
C
BAS 33 Earnings per Share
A
A
B
A
BAS 34 Interim Financial Reporting
A
BAS 36 Impairment of Assets
B
A
BAS 37 Provisions, Contingent Liabilities and Contingent Assets
A
BAS 38 Intangible Assets
B
A
BAS 39 Financial Instruments: Recognition and Measurement
C
C
A
A
BAS 40 Investment Property
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Financial Reporting
Title
Financial Accounting
Accounting
Professional Stage
Advanced Stage
Financial accounting
BAS 41 Agriculture
D
BFRS 1 First-Time Adoption of BFRS
A
BFRS 2 Share-based Payment
A
BFRS 3 Business Combinations
A
BFRS 4 Insurance Contracts BFRS 5 Non-current Assets Held for Sale and Discontinued Operations
D
B
A
BFRS 6 Exploration for and Evaluation of Mineral Resources
D
BFRS 7 Financial Instruments: Disclosures
B
A
BFRS 8 Operating Segments (see note 1)
C
C
Note 1
Candidates are expected to have knowledge to level A of BAS 14 Segment Reporting and to have a C level knowledge of BFRS 8 Operating Segments. Knowledge of BFRS 8 is limited to the key points of the standard and the principal changes from BAS 14 as outlined in 2010/2011 edition of the learning materials.
Note 2
The version of BAS 23 Borrowing Costs in issue on 1 January 2007 is examinable. Candidates are expected to know the key points of the revised standard issued on 29 March 2007 and the changes from the earlier version as outlined in the 2010/2011 edition of the learning materials.
7 Skills assessment guide 7.1
Introduction As a Chartered Accountant in the business world, you will require the knowledge and skills to interpret financial and other numerical and business data, and communicate the underlying issues to your clients. In a similar way to the required knowledge, the CA syllabus has been designed to develop your professional skills in a progressive manner. These skills are broadly categorised as:
7.2
Assimilating and using information Structuring problems and solutions Applying judgement Drawing conclusions and making recommendations
Assessing your professional skills Set out below is a pictorial representation of the different mix of knowledge and skills that will be assessed in the examinations that comprise the CA qualification.
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Technical Knowledge
INTRODUCTION
Initial Professional Development
F&CR TAX
AA&A
ITA FA
CL&P
ETHICS
A&A
BA
Case Study
FM PS - K BS
Skills
In the seven Knowledge Modules of the Professional Stage, you will have experienced a limited amount of skills assessment, generally 'Assimilating and using information'. Most of the questions were set in a context that required you to identify the piece of knowledge that was being assessed. In the Application Modules of the Professional Stage, the context of the examination will be simple business situations, from which you will be required to determine the relevant information to answer the questions. To be successful in the Financial Accounting examination, you will need a strong core of subject knowledge and a good understanding of how this knowledge should be applied in simple situations. You will be expected to apply your judgement to determine the relevance and importance of the different information provided and to recommend suitable courses of action.
7.3
Assessment grids The following pages set out the learning outcomes for Financial Accounting that are addressed under each of the four skills areas. In addition, for each skills area, there is a description of:
The specific skills that are assessed How these skills are assessed
Using these grids will enable you to determine how the examination paper will be structured and to consider whether your knowledge of Financial Accounting is sufficiently strong to enable you to apply it in the required manner.
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Financial accounting Learning outcomes
Assessed skills
How skills are assessed
Assimilating and using information 1a Discuss the purpose of accounting regulations and standards 1b and 1c Explain the objectives and characteristics of financial statements
Reading and understanding subject matter Accessing, evaluating and managing information provided in a few defined sources Operating to a brief in structured situations
1e and 1f Explain the different bases for preparing, and measuring elements of, financial statements 1g Explain the principles surrounding the consolidation of financial statements
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Questions will contain both structured and unstructured detail that candidates have to demonstrate an understanding of Requirements will include: Explaining the contribution and inherent limitations of financial statements Applying elements of the BFRS framework for financial reporting
INTRODUCTION
Learning outcomes
Assessed skills
How skills are assessed
Structuring problems and solutions 1d Identify the financial effects of transactions 2a and 3a Identify when an entity is required to prepare statutory financial statements 2b and 3b Identify the accounting standards etc applicable to statutory financial statements 2e Identify the circumstances in which the use of BFRS and IPSASs might be required for not-forprofit entities 3c Identify a subsidiary or associate of an entity 2c and 3e Prepare and present the financial statements, or extracts, of an entity 2f Calculate the amounts to be included in the equity section of the balance sheet of a not-for-profit entity 3d Calculate the amounts to be included in an entity’s consolidated financial statements in respect of its new, continuing and discontinuing interests in subsidiaries and associates
Understanding data and information given: identifying and understanding issues arising in straight forward scenarios Using the data and information given: understanding requirements, analysing data and information to support requirement Drawing upon technical and professional knowledge learnt to analyse issues Applying knowledge from different technical areas: analysing problems that combine technical skills in a single disciplinary environment Using new concepts: evaluating new ideas and concepts
Requirements will include: Explaining the contribution and inherent limitations of financial statements in meeting users’ needs Applying elements of the BFRS framework for financial reporting Applying knowledge of financial reporting standards: – Financial statement presentation, including cash flow statements – Business combinations – Intangibles – Tangible non-current assets – Valuations and impairments – Associates – Provisions and contingencies – Capital instruments – Post-balance sheet events – Accounting policies and estimates – Leases – Revenue recognition Adjusting and presenting financial data for single entity and consolidated financial statements under BFRS Preparing and presenting financial statements from accounting data in conformity with BFRS for: – Single entities, whether organised in corporate or in other forms – Entities requiring consolidated financial statements
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Financial accounting Learning outcomes
Assessed skills
How skills are assessed
Applying judgement Not assessed Drawing conclusions and making recommendations Preparing, describing, outlining the advice, report, notes required in a given straight-forward situation Presenting a basic or routine memorandum or briefing note in writing in a clear and concise style
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Explaining accounting and reporting concepts in non-technical language to non-financial management.
CA in Bangladesh www.facebook.com/CAinBD
chapter 1
Conceptual and regulatory framework Contents Introduction Examination context Topic List 1
Financial statements
2
Purpose and use of financial statements
3
Bases of accounting
4
BFRS Framework
5
International Accounting Standards Committee Foundation (IASCF)
6
Bangladesh Financial Reporting Standards (BFRS)
7
Inherent limitations of financial statements
8
Not-for-profit entities
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Explain the nature of financial reporting
Explain the objectives of financial statements
Discuss the conceptual and regulatory framework affecting the preparation of financial statements
Discuss the importance of BFRS Framework
Apply the principles of BFRS Framework, including the qualitative characteristics of financial information, the elements of financial statements, recognition and measurement of the elements
Explain and demonstrate the differences between financial statements produced using: –
The accrual basis
–
Cash accounting
–
The break-up basis
Explain and illustrate the different definitions of capital and capital maintenance
Explain the regulatory framework affecting not-for-profit entities
Tick off
Specific syllabus references for this chapter are: 1a, b, c, d, e, f, 2e.
Practical significance The way that items and transactions are treated and presented in the financial statements may affect an investor's perception of the position and performance of an entity. Whilst individual accounting standards can be developed to deal with specific issues it is also important that there is a framework that sets out the wider purposes that accounting standards are intended to achieve. This helps to ensure that standards are consistent and not overly affected by political influence or self-interest groups. The International Accounting Standards Board's Framework for the Preparation and Presentation of Financial Statements (IASB Framework), which has been adopted by ICAB without any changes is known as BFRS Framework. The framework attempts to provide this framework in the context of International Accounting Standards and International Financial Reporting Standards (jointly referred to from this point as 'IFRS'/ BFRS in Bangladesh). It does so by setting out consistent principles which form the basis for the development of detailed requirements in IFRS.
Stop and think What do you think are the advantages of a principles based approach to the setting of accounting standards?
Working context In the working environment you are unlikely to be consciously aware of the effect of the issues covered by this chapter. They are important nevertheless as these principles underpin all the financial statements which you will prepare or audit.
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Syllabus links The issues covered by this chapter and particularly the principles introduced by BFRS Framework are a fundamental part of the Financial Accounting syllabus. Throughout the rest of the text we will make reference to the way that the Framework affects the way that specific transactions are accounted for and presented. These principles will be further developed in Financial Reporting and at the Advanced Stage.
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Financial accounting
Examination context
Exam requirements Accounting and reporting concepts constitute 10% of the syllabus. This area of the syllabus is likely to be examined in the written test section of the paper in conjunction with another topic, rather than in its own right. For example, in a question on tangible non-current assets you could be asked to consider how the definition of an asset affects the recognition of certain expenses as capital or revenue items. Part (a) of question 4 in the sample paper required an explanation and discussion of the concept of substance over form in the context of the topic of leasing. You could also be asked to discuss the objectives of financial information and the qualitative characteristics which make information useful. Again this would typically be part (b) or (c) of a longer question rather than the main focus of the question. Alternatively, or in addition, this topic could be examined in the short-form questions in the paper. In the examination, candidates may be required to:
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Discuss the purpose of accounting regulations and standards for both profit-making and not-for-profit entities
Explain, with examples, the objectives of financial statements
Explain the qualitative characteristics of financial information and the constraints on such information
Describe the financial effects of the application of the definitions of BFRS Framework
Perform simple calculations to demonstrate the difference between the accrual basis, cash accounting and the break-up basis
Explain the different concepts of capital maintenance
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1 Financial statements Section overview
In Bangladesh financial statements must: – –
1.1
Be prepared in accordance with Companies Act and BFRS Give a true and fair view
What is financial accounting? Financial accounting is the process of identifying, measuring and communicating economic information to others so that they may make decisions on the basis of that information and assess the stewardship of the entity's management. Financial accounting involves:
Recording transactions undertaken by a business entity Grouping similar transactions together which are appropriate to the business Presenting periodic results.
The Financial Accounting syllabus focuses on the preparation of published financial information. Typically, this information is made available annually or half-yearly (sometimes quarterly) and is presented in formats laid down or approved by governments in each national jurisdiction. (The Financial Reporting syllabus deals with more complex reporting issues and analysis and interpretation.) By contrast, management accounting or reporting is internal reporting for the use of the management of a business itself. Internal management information can be tailored to management's own needs and provided in whatever detail and at whatever frequency (e.g. continuous real-time information) management decides. General principles relating to financial accounting are set out in BFRS Framework for the Preparation and Presentation of Financial Statements (Framework), which is explained further below.
1.2
Entity Most accounting requirements are written with a view to use by any type of accounting entity, including companies and other forms of organisation, such as partnership. In this text, the term 'company' is often used, because the main focus of the Financial Accounting syllabus is on the accounts of companies and groups of companies.
1.3
Financial statements The principal means of providing financial information to external users is the annual financial statements. Financial statements are the accountant's summary of the performance of an entity over a particular period and of its position at the end of that period. A complete set of financial statements comprises:
The balance sheet (a statement of financial position) The income statement (a statement of financial performance) The statement of changes in equity (another statement of financial performance) The statement of changes in financial position (usually in the form of a cash flow statement) Notes to the financial statements
The notes to the financial statements include:
Accounting policies, i.e. the specific principles, conventions, rules and practices applied in order to reflect the effects of transactions and other events in the financial statements.
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Financial accounting
Detailed financial and narrative information supporting the information in the primary financial statements.
Other information not reflected in the financial statements, but which is important to users in making their assessments.
The individual elements that are included in the financial statements are covered in detail later in this chapter.
1.4
Requirement to produce financial statements Limited liability companies are required by law to prepare and publish financial statements annually. The form and content may be regulated primarily by national legislation, and in most cases must also comply with Financial Reporting Standards. In Bangladesh, all companies must comply with the provisions of the Companies Act 1994 (CA 1994). The provisions of the Act are relevant for the purpose of the Financial Accounting exam and therefore this Study Manual refers to the Companies Act 1994 throughout. The key impact of this is as follows:
1.5
Every registered company is required to prepare a balance sheet and profit and loss account for each financial year which gives a true and fair view.
The financial statements must comply with Schedule XI to CA 1994 as regards format and additional information provided by way of notes. Therefore the only disclosures covered by this text in Chapter 2 are those currently contained in schedule XI.
Specialised entities, such as financial institutions, insurance companies, co-operatives, NGOs and public sector entities must comply with the rules, requirements of the relevant regulatory bodies.
Financial reporting standards In most cases company financial statements must also comply with relevant Financial Reporting Standards and other professional guidance. In Bangladesh these are as follows.
Accounting Standards These include Bangladesh Financial Reporting Standards (BFRSs which are issued by the International Accounting Standards Board (IASB) as IASs and IFRSs and adopted by ICAB as BASs and BFRSs.
These learning materials assume the preparation of financial statements in accordance with BFRS.
1.6
True and fair view In Bangladesh there is a Companies Act requirement that financial statements should present 'a true and fair view.' This term is not defined in the Companies Act or Accounting Standards. Truth is usually seen as an objective concept reflecting factual accuracy within the bounds of materiality. Fairness is usually seen as meaning that the view given is objective and unbiased. True and fair is usually defined in terms of accounting concepts. This means:
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Compliance with Accounting Standards (which can be overridden on true and fair grounds only very rarely)
Adherence to the requirements of the Companies Act 1994, including its true and fair override (see below)
In the absence of more specific requirements, application of general accounting principles and fundamental concepts and, where appropriate, adherence to accepted industry practices.
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Points to note
CA 1994 uses the term 'a true and fair view' rather than 'the true and fair view' because it is possible for there to be more than one true and fair view. For example, financial statements based on historical cost can be true and fair, as can financial statements which incorporate revaluations.
What constitutes a true and fair view can then be restricted by stating that where a choice of treatments or methods is permitted, the one selected should be the most appropriate to the company’s circumstances. This restriction is likely to ensure compliance with the spirit and underlying intentions of requirements, not just with the letter of them.
A further restriction is that financial statements should reflect the economic position of the company, thereby reflecting the substance of transactions (i.e. commercial reality), not merely their legal form. In most cases this will be achieved by adhering to Accounting Standards. (We will look at substance in more detail in section 4 below).
The equivalent international term to a true and fair view is 'fair presentation.' We will look at this in detail in Chapter 2.
2 Purpose and use of financial statements Section overview
Financial statements are used to make economic decisions by a wide range of users.
All users require information regarding: – – –
2.1
Financial position Financial performance, and Changes in financial position.
Users and their information needs The form and content of financial statements must be influenced by the use to which they are put. Nearly everybody using them does so when making economic decisions such as those to:
Decide when to buy, hold or sell shares. Assess the stewardship or accountability of management. Assess an entity's ability to provide benefits to employees. Assess security for amounts lent to the entity.
Much of the information needed for these different decisions is in fact common to them all. Financial statements aimed at meeting these common needs of a wide range of users are known as 'general purpose' financial statements. BFRS Framework identifies the following users of financial statements and their specific information needs. (We will look at BFRS Framework in more detail in Section 4 of this chapter). Users
Need information to
Present and potential investors
Employees
Assess their employer's stability and profitability
Assess their employer's ability to provide remuneration, employment opportunities and retirement and other benefits
Make investment decisions, therefore need information on: – Risk and return on investment – Ability of entity to pay dividends
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Financial accounting Lenders
Assess whether loans will be repaid, and related interest will be paid, when due
Suppliers and other trade payables
Assess the likelihood of being paid when due
Customers
Assess whether entity will continue in existence – important where customers have a long-term involvement with, or are dependent on, the entity, e.g. where there are product warranties or where specialist parts may be needed
Governments and their agencies
Assess allocation of resources and, therefore, activities of entities
Assist in regulating activities
Assess taxation
Provide a basis for national statistics
Assess trends and recent developments in the entity's prosperity and its activities – important where the entity makes a substantial contribution to a local economy, e.g. by providing employment and using local suppliers
The public
In most cases the users will need to analyse the financial statements in order to obtain the information they need. This might include the calculation of accounting ratios. (The calculation of accounting ratios and the analysis of those ratios is covered in the Financial Reporting syllabus.)
2.2
Objective of financial statements The objective of financial statements is to provide information about the reporting entity's financial position and financial performance that is useful to a wide range of users in making economic decisions. This objective can usually be met by focusing exclusively on the information needs of present and potential investors. This is because much of the financial information that is relevant to investors will also be relevant to other users.
2.3
Accountability of management Management also has a stewardship role, in that it is accountable for the safe-keeping of the entity’s resources and for their proper, efficient and profitable use. Providers of risk capital are interested in information that helps them to assess how effectively management has fulfilled this role, but again this assessment is made only as the basis for economic decisions, such as those about investments and the reappointment/ replacement of management. Financial reporting helps management to meet its need to be accountable to shareholders, and also to other stakeholders (e.g. employees or lenders), by providing information that is useful to the users in making economic decisions. However, financial statements cannot provide the complete set of information required for assessing the stewardship of management (see section 7 ‘Inherent Limitations of Financial Statements’ later in this chapter).
2.4
Financial position, performance and changes in financial position All economic decisions are based on an evaluation of an entity’s ability to generate cash and of the timing and certainty of its generation. Information about the entity’s financial position, performance and changes in financial position provides the foundation on which to base such decisions.
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Financial position An entity's financial position covers:
The economic resources it controls Its financial structure (i.e. debt and share finance) Its liquidity and solvency and Its capacity to adapt to changes in the environment in which it operates
Investors require information on financial position because it helps in assessing:
The entity's ability to generate cash in the future
How future cash flows will be distributed among those with an interest in, or claims on, the entity
Requirements for future finance and ability to raise that finance
The ability to meet financial commitments as they fall due
Information about financial position is primarily provided in a balance sheet.
2.4.2
Financial performance The profit earned in a period is used as the measure of financial performance, where profit is calculated as income less expenses. Information about performance and variability of performance is useful in:
Assessing potential changes in the entity's economic resources in the future Predicting the entity's capacity to generate cash from its existing resource base, and Forming judgements about the effectiveness with which additional resources might be employed.
Information on financial performance is provided by:
2.4.3
The income statement, and The statement of changes in equity.
Changes in financial position Changes in financial position can be analysed under the headings of investing, financing and operating activities and are usually shown in a cash flow statement. Cash flow information is largely free from the more judgemental allocation and measurement issues (i.e. in which period to include things and at what amount) that arise when items are included in the balance sheet or performance statements. For example, depreciation of non-current assets involves judgement and estimation as to the period over which to charge depreciation. Cash flow information excludes non-cash items such as depreciation. Cash flow information is therefore seen as being factual in nature, and hence more reliable than other sources of information. Information on the generation and use of cash is useful in evaluating the entity’s ability to generate cash and its needs to use what is generated.
2.4.4
Notes and supplementary schedules Notes and schedules attached to financial statements can provide additional information relevant to users, for example the non-current assets note (see Chapter 2).
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3 Bases of accounting Section overview
There are four bases of accounting which you need to be familiar with: – – – –
3.1
Accrual basis Going concern basis Cash basis Break-up basis
The accrual basis of accounting and going concern are referred to by BFRS Framework as 'underlying assumptions'.
Accrual basis Under this basis of accounting, transactions are recognised when they occur, not when the related cash flows into or out of the entity. You will be familiar with this basis from your Accounting studies. Examples of the importance of this basis are as follows:
Sales are recorded in the period in which the risks and rewards of ownership pass from seller to buyer, not when the seller receives full payment. While this basis has no effect on the timing of the recognition of cash sales, it does mean that credit sales are recorded earlier than if the cash basis of accounting was used. When credit sales are recognised, a receivable is set up in the entity's books.
Expenses are recognised in the period when the goods or services are consumed, not when they are paid for. An amount payable will be set up in the entity's books for credit purchases, again leading to earlier recognition than if the cash basis was used.
The consumption of non-current assets, such as plant and machinery, is recognised over the period during which they are used by the entity (i.e. the asset is depreciated), not in the year of purchase as they would be under the cash basis of accounting.
Financial statements prepared on this basis provide information both about past transactions involving cash and about future resources flowing into the entity (when customers pay up) and flowing out of it (when suppliers are paid). They are therefore more useful for the making of economic decisions than those produced on the cash basis.
3.2
Going concern basis The accrual basis of accounting assumes that an entity is a going concern. Under this basis, financial statements are prepared on the assumption that the entity will continue in operation for the foreseeable future, in that management has neither the intention nor the need to liquidate the entity by selling all its assets, paying off all its liabilities and distributing any surplus to the owners. Examples of the importance of this basis are as follows:
The measurement of receivables from trade customers is made on the basis that there is no time limit over which management will chase slow payers. If the entity were to cease operation in, say, three months, a number of balances might have to be regarded as bad debts
The measurement of non-current assets is made on the basis that they can be utilised throughout their planned life. Otherwise, they would have to be valued at what they could immediately be sold for, which might not be very much, in the case of assets used in markets where there is excess capacity.
The accrual basis and going concern are referred to by BFRS Framework as 'underlying assumptions'.
3.3
Cash basis The cash basis of accounting is not used in the preparation of a company balance sheet and income statement as it is not allowed by BFRS, although the cash effect of transactions is presented in the form of a
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cash flow statement. (We will look at the cash flow statement in Chapter 3.) The cash basis may be used however, for small unincorporated entities, for example clubs and societies. In many ways the cash basis of accounting is very simple. Only the cash impact of a transaction is recorded. Examples of the impact of this are as follows:
Sales are recorded in the period in which the seller receives full payment. For credit sales this will delay the recognition of the transaction.
Purchases are recorded in the period in which goods are paid for rather than the period in which the goods are purchased. For credit purchases this will delay the recognition of the purchase.
The purchase of a capital asset is treated as a cash outflow at the point that the cash consideration is paid. No subsequent adjustment is made for depreciation as this has no impact on the cash balance of the business.
Worked example: Comparison of accrual basis and cash basis Joe Co buys 100 T-shirts in January at CU3.50 each. The purchase is made for cash. During January 30 T-shirts are sold for cash at CU7.00 each. Using accrual based accounting the results for January would be as follows: Revenue (30 × CU7) Cost of sales Purchases (100 × CU3.50) Closing inventory (70 × CU3.50)
CU
CU 210
350 (245) (105) 105
Profit Using cash accounting the results for January would be as follows: Revenue (30 × CU7) Cost of sales (100 × CU3.50) Loss
CU 210 (350) (140)
Notice that there is an overall loss of CU140 using cash accounting even though there is a profit for the month of CU105 using the accrual basis. The difference of CU245 is the value of the closing inventories which is carried forward as an asset under accrual based accounting.
3.4
Break-up basis As we saw in section 3.2 one of the key assumptions made in accrual based accounting is that the business will continue as a going concern. However, this will not necessarily always be the case. There may be an intention or need to sell off the assets of the business. Such a sale typically arises where the business is in financial difficulties and needs the cash to pay its creditors. Where this is the case an alternative method of accounting must be used (in accordance with BAS 1 Presentation of Financial Statements). In these circumstances the financial statements will be prepared on a break-up basis. The effect of this is seen primarily in the balance sheet as follows:
Classification of assets All assets and liabilities would be classified as current rather than non-current.
Valuation of assets Assets would be valued on the basis of the recoverable amount on sale. This is likely to be substantially lower than the carrying amount of assets held under historical cost accounting.
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4 BFRS Framework Section overview
BFRS Framework for the Preparation and Presentation of Financial Statements (Framework) is the conceptual framework upon which all BASs and BFRSs are based. It determines: – –
4.1
How financial statements are prepared, and The information they contain.
Conceptual Framework The Framework consists of a Preface and an Introduction followed by a number of chapters:
The objective of financial statements Underlying assumptions Qualitative characteristics of financial statements The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance
In this chapter we have already introduced some of the concepts dealt with by the Framework. We will now look specifically at each section in turn.
4.2
Preface The Preface to the Framework points out the fundamental reason why financial statements are produced worldwide, i.e. to satisfy the requirements of external users, but that practice varies due to the individual pressures in each country. These pressures may be social, political, economic or legal, but they result in variations in practice from country to country including:
The form of the statements The definition of their component parts (assets, liabilities, etc) The criteria for recognition of items Scope and disclosure of financial statements.
It is these differences which the IASB wishes to narrow by harmonising all aspects of financial statements, including the regulations governing accounting standards and their preparation and presentation. The Preface also emphasises the way the financial statements are used to make economic decisions. We looked at these decisions previously in Section 2.1.
4.3
Introduction The Introduction provides a list of the purposes of the Framework:
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Provide those who are interested in the work of the IASB with information about its approach to the formulation of IASs (now IFRSs).
Assist the Board of the IASB in the development of future IASs and in its review of existing IASs.
Assist the Board of the IASB in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IASs.
Assist national standard-setting bodies in developing national standards.
Assist preparers of financial statements in applying IASs and in dealing with topics that have yet to form the subject of an IAS.
Assist auditors in forming an opinion as to whether financial statements conform with IASs.
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Assist users of financial statements in interpreting the information contained in financial statements prepared in conformity with IASs.
The Framework is not an IFRS and so does not overrule any individual IFRS. In the (rare) case of conflict between an IFRS and the Framework, the IFRS will prevail. These cases will diminish over time as the Framework will be used as a guide in the production of future IFRSs. The Framework itself will be revised occasionally depending on the experience of the IASB in using it. The Introduction also considers users and their information needs. We have already looked at this in section 2.1 of this chapter.
4.4 4.4.1
Qualitative characteristics of financial statements Overview The Framework states that qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability. The key issues can be summarised as follows: Qualitative characteristics
Understandability Relevance
Reliability
Nature Materiality
Comparability Consistency Disclosure
Faithful representation
Substance over form
Prudence
Completeness
Constraints
Timeliness
Cost v benefit
Balance between characteristics
Results in fair presentation
4.4.2
Understandability Users must be able to understand financial statements. They are assumed to have some business, economic and accounting knowledge and to be able to apply themselves to study the information properly. Complex
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Financial accounting matters should not be left out of financial statements simply due to its difficulty if it is relevant information.
4.4.3
Relevance Relevant information is both predictive and confirmatory. These roles are interrelated.
Definition Relevance: Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.
Information on financial position and performance is often used to predict future position and performance and other things of interest to the user, e.g. likely dividend, wage rises. The manner of presentation will enhance the ability to make predictions, e.g. by highlighting unusual items. Materiality The relevance of information is affected by its nature and its materiality.
Definition Materiality: Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
Information may be judged relevant simply because of its nature (e.g. remuneration of management). In other cases, both the nature and materiality of the information are important. Materiality is not a primary qualitative characteristic itself (like reliability or relevance), because it is merely a threshold or cut-off point.
4.4.4
Reliability Information must also be reliable to be useful. The user must be able to depend on it being a faithful representation.
Definition Reliability: Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.
Even if information is relevant, if it is very unreliable it may be misleading to recognise it, e.g. a disputed claim for damages in a legal action. Faithful representation Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the transactions or finding an appropriate method of measurement or presentation. Where measurement of the financial effects of an item is so uncertain, entities should not recognise such an item. For example, although there is usually no doubt as to the existence of internally generated goodwill, there is considerable doubt as to its true value, i.e. it cannot be measured reliably. Therefore BAS 38 Intangible Assets prohibits the recognition of such goodwill (see Chapter 6).
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Substance over form Faithful representation of a transaction is only possible if it is accounted for according to its substance and economic reality, not with its legal form.
Definition Substance over form: The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.
Most transactions are reasonably straightforward and their substance, i.e. commercial effect, is the same as their strict legal form. However, in some instances this is not the case as can be seen in the following worked example.
Worked example: Sale and repurchase agreement A Ltd sells goods to B Ltd for CU10,000, but undertakes to repurchase the goods from B Ltd in 12 months’ time for CU11,000. The legal form of the transaction is that A has sold goods to B as it has transferred legal title. To reflect the legal form, A Ltd would record a sale and show the resulting profit, if any, in its income statement. In 12 months’ time when legal title is regained, A Ltd would record a purchase. There would be no liability to B Ltd in A Ltd’s balance sheet until the goods are repurchased. The above treatment does not provide a faithful representation because it does not reflect the economic substance of the transaction. After all, A Ltd is under an obligation from the outset to repurchase the goods and A Ltd bears the risk that those goods will be obsolete and unsaleable in a year’s time. The substance is that B Ltd has made a secured loan to A Ltd of CU10,000 plus interest of CU1,000. To reflect substance, A Ltd should continue to show the goods as an asset in inventories (at cost or net realisable value, if lower) and should include a liability to B Ltd of CU10,000 in payables. A Ltd should accrue for the interest over the duration of the loan. When A Ltd pays CU11,000 to regain legal title, this should be treated as a repayment of the loan plus accrued interest.
Other examples of accounting for substance:
Leases Accounting for finance leases under BAS 17 Leases (which is covered in Chapter 8) is an example of the application of substance as the lessee includes the asset on its balance sheet even though the legal form of a lease is that of renting the asset, not buying it.
Group financial statements Group financial statements are covered in detail in Chapters 10 to 16. The central principle underlying group accounts is that a group of companies is treated as though it were a single entity, even though each company within the group is itself a separate legal entity.
Neutrality Information must be free from bias to be reliable. Neutrality is lost if the financial statements are prepared so as to influence the user to make a judgement or decision in order to achieve a predetermined outcome.
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Financial accounting Prudence Uncertainties exist in the preparation of financial information, e.g. the collectability of doubtful receivables. These uncertainties are recognised through disclosure and through the application of prudence. Prudence involves exercising a degree of caution when making judgements in conditions of uncertainty. Prudence does not, however, allow the creation of hidden reserves or excessive provisions, understatement of assets or income or overstatement of liabilities or expenses. Completeness Financial information must be complete, within the restrictions of materiality and cost, to be reliable. Omission may cause information to be misleading.
4.4.5
Comparability Users must be able to compare an entity's financial statements: (a)
Through time to identify trends.
(b) With other entities’ statements, to evaluate their relative financial position, performance and changes in financial position. The consistency of treatment is therefore important across like items over time, within the entity and across all entities. The disclosure of accounting policies is particularly important here. Users must be able to distinguish between different accounting policies in order to be able to make a valid comparison of similar items in the accounts of different entities. Comparability is not the same as uniformity. Entities should change accounting policies if those policies become inappropriate. Corresponding information for preceding periods should be shown to enable comparison over time.
4.4.6
Constraints on useful information (a)
Timeliness Information may become irrelevant if there is a delay in reporting it. There is a balance between timeliness and the provision of reliable information. Information may be reported on a timely basis when not all aspects of the transaction are known, thus compromising reliability. If every detail of a transaction is known, it may be too late to publish the information because it has become irrelevant. The overriding consideration is how best to satisfy the economic decision-making needs of the users.
(b) Balance between benefits and cost This is a pervasive constraint, not a qualitative characteristic. When information is provided, its benefits must exceed the costs of obtaining and presenting it. This is a subjective area and there are other difficulties: others, not the intended users, may gain a benefit; also the cost may be paid by someone other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers and users should be aware of the constraint. (c)
Balance between qualitative characteristics A trade-off between qualitative characteristics is often necessary, the aim being to achieve an appropriate balance to meet the objective of financial statements. It is a matter for professional judgement as to the relative importance of these characteristics in each individual case. Relevance v reliability The most relevant information may not always be the most reliable. For example, an entity may be facing a potential liability as a result of a legal claim. The outcome of the claim may not be sufficiently reliable to recognise a provision in the financial statements. However, information about the claim would be relevant to the users of the financial statements as it would provide information about future
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liabilities. The conflict between relevance and reliability here is normally resolved through disclosure of the facts involved. Understandability v relevance Relevant information may not always be the most understandable. This is particularly true where the information involves complex issues. In this situation relevance would take priority. It would not be appropriate to omit information simply because it was difficult to understand. Faithful recognition v completeness In some cases faithful recognition may override the characteristic of completeness. For example, as discussed in section 4.4.4, internally generated goodwill is not recognised as its measurement is uncertain.
4.4.7
True and fair view/fair presentation The Framework does not attempt to define these concepts directly. It does state, however, that the application of the principal 'qualitative' characteristics and of appropriate accounting standards will usually result in financial statements which show a true and fair view, or are presented fairly. (We will look at these terms in more detail in Chapter 2).
4.5 4.5.1
The elements of financial statements Overview Transactions and other events are grouped together in broad classes and in this way their financial effects are shown in the financial statements. These broad classes are the elements of financial statements. The Framework lays out these elements as follows.
Elements of financial statements
Financial position in the balance sheet
Performance in the income statement
Assets Liabilities Equity
Income Expenses
Contributions from equity participants and distributions to them are also shown in the statement of changes in equity.
4.5.2
Definitions of elements Element
Definition
Comment
Asset
A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Technically, the asset is the access to future economic benefits (e.g. cash generation) not the underlying item of property itself (e.g. a machine).
Liability
A present obligation of the entity arising from past events, the settlement of which is expected to lead to the outflow from the entity of resources embodying economic benefits.
An obligation implies that the entity is not free to avoid the outflow of resources.
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Financial accounting Element
Definition
Comment
Equity
The residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets.
Equity = ownership interest = net assets. For a company, this usually comprises shareholders’ funds (i.e. capital and reserves).
Income
Increases in economic benefits in the form of asset increases/liability decreases not resulting from contributions from equity participants.
Income comprises revenue and gains, including all recognised gains on nonrevenue items (e.g. revaluations of non-current assets).
Expenses
Decreases in economic benefits in the form of asset decreases/liability increases not resulting from distributions to equity participants.
Expenses includes losses, including all recognised losses on non-revenue items (such as write-downs of noncurrent assets).
Note the way that the changes in economic benefits resulting from asset and liability increases and decreases are used to define:
Income, and Expenses.
This arises from the ‘balance sheet approach’ adopted by BFRS Framework which treats performance statements, such as the income statement, as a means of reconciling changes in the financial position amounts shown in the balance sheet. These key definitions of ‘asset’ and ‘liability’ will be referred to again and again in these learning materials, because they form the foundation on which so many accounting standards are based. It is very important that you can reproduce these definitions accurately and quickly.
4.5.3
Assets We can look in more detail at the components of the definitions given above. Assets must give rise to future economic benefits, either alone or in conjunction with other items.
Definition Future economic benefit: The potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost of production.
In simple terms, an item is an asset if:
It is cash or the right to cash in future, e.g. a receivable, or a right to services that may be used to generate cash, e.g. a prepayment.
or
It can be used to generate cash or meet liabilities, e.g. a tangible or intangible non-current asset.
The existence of an asset, particularly in terms of control, is not reliant on:
Physical form (hence intangible assets such as patents and copyrights may meet the definition of an asset and appear on the balance sheet – even though they have no physical substance). Legal ownership (hence some leased assets, even though not legally owned by the company, may be included as assets on the balance sheet. (See Chapter 8)).
Transactions or events in the past give rise to assets. Those expected to occur in future do not in themselves give rise to assets.
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4.5.4
1
Liabilities Again we look more closely at some aspects of the definition. An essential feature of a liability is that the entity has a present obligation.
Definition Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.
As seen above, obligations may be:
Legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case with amounts payable for goods and services received
The result of business practice. For example, even though a company has no legal obligation to do so, it may have a policy of rectifying faults in its products even after the warranty period has expired.
A management decision (to acquire an asset, for example) does not in itself create an obligation, because it can be reversed. But a management decision implemented in a way which creates expectations in the minds of customers, suppliers or employees, such as the warranty example above, becomes an obligation. This is sometimes described as a constructive obligation. This issue is covered more fully in Chapter 9 in the context of the recognition of provisions. Liabilities must arise from past transactions or events. For example, the sale of goods is the past transaction which allows the recognition of repair warranty provisions. Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. In practice, most liabilities will be met in cash but this is not essential.
Interactive question 1: Asset or liability? Question (a)
[Difficulty level: Easy] Fill in your answer
Oak Ltd has purchased a patent for CU40,000. The patent gives the company sole use of a particular manufacturing process which will save CU6,000 a year for the next five years.
(b) Elm Ltd paid John Brown CU20,000 to set up a car repair shop, on condition that priority treatment is given to cars from the company's fleet. (c)
Sycamore Ltd provides a warranty with every washing machine sold.
See Answer at the end of this chapter.
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4.5.5
Equity Equity is the residual of assets less liabilities, so the amount at which it is shown is dependent on the measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares. Equity may be sub-classified in the balance sheet providing information which is relevant to the decisionmaking needs of the users. This will indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. In practical terms, the important distinction between liabilities and equity is that creditors have the right to insist that the transfer of economic resources is made to them regardless of the entity's financial position, but owners do not. All decisions about payments to owners (such as dividends or share capital buy-back) are at the discretion of management.
4.5.6
Performance Profit is used as a measure of performance, or as a basis for other measures (e.g. EPS). It depends directly on the measurement of income and expenses, which in turn depend (in part) on the concepts of capital and capital maintenance adopted. Income and expenses can be presented in different ways in the income statement, to provide information relevant for economic decision-making. For example, an income statement could distinguish between income and expenses which relate to continuing operations and those which do not. Items of income and expense can be distinguished from each other or combined with each other. Income Both revenue and gains are included in the definition of income. Revenue arises in the course of ordinary activities of an entity. (We will look at revenue in more detail in Chapter 7.)
Definition Gains: Increases in economic benefits. As such they are no different in nature from revenue.
Gains include those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, e.g. on revaluation of non-current assets. A revaluation gives rise to an increase or decrease in equity. Although these increases and decreases meet the definitions of income and expenses they are not included in the income statement under certain concepts of capital maintenance, however, but are included in equity. (In your Accounting studies you will have seen that a gain on revaluation is recognised in a revaluation reserve.) Expenses As with income, the definition of expenses includes losses as well as those expenses that arise in the course of ordinary activities of an entity.
Definition Losses: Decreases in economic benefits. As such they are no different in nature from other expenses.
Losses will include those arising on the disposal of non-current assets. The definition of expenses will also include unrealised losses. You will come across examples of these in your Financial Reporting and Advanced Stage studies.
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4.6 4.6.1
1
Recognition of elements in financial statements Meaning of recognised An item is recognised when it is included in the balance sheet or income statement.
Definition Recognition: The process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the following criteria for recognition:
It is probable that any future economic benefit associated with the item will flow to or from the entity, and
The item has a cost or value that can be measured with reliability.
Points to note: (1) Regard must be given to materiality (see section 4.4.3 above). (2) An item which fails to meet these criteria at one time may meet it subsequently. (3) An item which fails to meet the criteria may merit disclosure in the notes to the financial statements. (This is dealt with in more detail by BAS 37 Provisions, Contingent Liabilities and Contingent Assets which is covered in Chapter 9).
4.6.2
Probability of future economic benefits Probability here refers to the degree of uncertainty that the future economic benefits associated with an item will flow to or from the entity. This must be judged on the basis of the characteristics of the entity's environment and the evidence available when the financial statements are prepared. The Framework does not give a definition of 'probable'. A working definition is 'more likely than not'.
4.6.3
Reliability of measurement The cost or value of an item in many cases must be estimated. The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. Where no reasonable estimate can be made, the item should not be recognised (although its existence should be disclosed in the notes.)
4.6.4
Recognition of items We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the definition of recognition given above. Item
Recognised in
When
Asset
The balance sheet
It is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
Liability
The balance sheet
It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
Income
The income statement
An increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.
Expenses The income statement
A decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
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Financial accounting Points to note: (1) There is a direct association between expenses being recognised in the income statement and the generation of income. This is commonly referred to as the accrual or matching concept. However, the application of the accrual concept does not permit recognition of assets or liabilities in the balance sheet which do not meet the appropriate definition. (2) Expenses should be recognised immediately in the income statement when expenditure is not expected to result in the generation of future economic benefits. (3) An expense should also be recognised immediately when a liability is incurred without the corresponding recognition of an asset.
4.7
Measurement in financial statements For an item or transaction to be recognised in an entity's financial statements it needs to be measured as a monetary amount. BFRS uses several different measurement bases but the Framework refers to just four. The four measurement bases referred to in BFRS Framework are:
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.
Realisable (settlement) value. –
Realisable value. The amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal.
–
Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Present value. A current estimate of the present discounted value of the future net cash flows in the normal course of business.
Historical cost is the most commonly adopted measurement basis, but this is usually combined with other bases, e.g. an historical cost basis may be modified by the revaluation of land and buildings.
4.8
Capital and capital maintenance The final section of BFRS Framework is devoted to a brief discussion of the different concepts of capital and capital maintenance, pointing out that:
4.8.1
The choice between them should be made on the basis of the needs of users of financial statements. The IASB has no present intention of prescribing a particular model.
Financial capital and capital maintenance Definition Financial capital maintenance: Under a financial concept of capital, such as invested money or invested purchasing power capital is synonymous with the net assets or equity of the entity.
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The financial concept of capital is adopted by most entities. This concept measures capital as the equity in the balance sheet. Profit is only earned in an accounting period if the equity at the end of the period is greater than it was at the start, having excluded the effects of distributions to or contributions from the owners during the period. Monetary measure of capital Financial capital is usually measured in monetary terms, i.e. the CU sterling or the euro. This is the concept applied in historical cost accounting. This measure can be quite stable over short periods of years, but is debased by even quite low rates of general inflation over longer periods, such as 20 years. So comparisons between capital now and capital 20 years ago are invalid, because the measurement instrument is not constant. Constant purchasing power A variant on the monetary measure of financial capital is the constant purchasing power measure. On this basis, the opening capital (i.e. equity) is uprated by the change in a broadly based price index, often a retail prices index, over the year. Also, the transactions during the year are uprated by the change in the same index. A profit is only earned if the capital at the end of the year exceeds these uprated values. (The value of the uprating is taken to equity, but is not regarded as a profit, merely a ‘capital maintenance’ adjustment.) So this capital maintenance adjustment can be thought of as an additional expense in the income statement. Comparisons over a 20-year period will be more valid if the capital 20 years ago is uprated for general inflation over that 20-year period. But there is no reason why inflation measured by a retail prices index should be at all close to the inflation experienced by an individual company.
4.8.2
Physical capital and capital maintenance Definition Physical capital maintenance: Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.
This concept looks behind monetary values, to the underlying physical productive capacity of the entity. It is based on the approach that an entity is nothing other than a means of producing saleable outputs, so a profit is earned only after that productive capacity has been maintained by a ‘capital maintenance’ adjustment. (Again, the capital maintenance adjustment is taken to equity and is treated as an additional expense in the income statement.) Comparisons over 20 years should be more valid than under a monetary approach to capital. The difficulties in this approach lie in making the capital maintenance adjustment. It is basically a current cost approach, normal practice being to use industry-specific indices of movements in non-current assets, rather than go to the expense of annual revaluations by professional valuers. The difficulties lie in finding indices appropriate to the productive capacity of a particular entity.
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Financial accounting
Worked example: Capital maintenance concepts Meercat Ltd purchased 20,000 electrical components on 1 January 20X7 for CU10 each. They were all sold on 31 December 20X7 for CU250,000. On that date the replacement cost of an electrical component was CU11.50. The general rate of inflation as measured by the general price index was 12% during the year. Profit could be calculated as follows:
Revenue
Financial capital maintenance (monetary terms)
Financial capital maintenance (constant purchasing power)
Physical capital maintenance
CU
CU
CU
250,000
250,000
250,000
Cost of sales 20,000 × 10
(200,000)
20,000 × 11.2
(224,000)
20,000 × 11.5 Profit
(230,000) 50,000
26,000
20,000
5 International Accounting Standards Committee Foundation (IASCF) Section overview
5.1
The IASCF is the parent entity of the IASB. The IASB is responsible for setting accounting standards.
The IASCF IASCF was formed in March 2001 as a not-for-profit corporation and is the parent entity of the IASB. The IASCF is an independent organisation and its trustees exercise oversight and raise necessary funding for the IASB to carry out its role as standard setter. It also oversees the work of the International Financial Reporting, Interpretations Committee (IFRIC) and the Standards Advisory Council (SAC). These are organised as follows:
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IASCF is responsible for: Funding Appointment of members of IASB, SAC and IFRIC
IASB is responsible for: All technical matters in general In particular, the preparation and issue of international accounting standards
SAC is responsible for: Input on IASB's agenda Input on IASB's project timetable and priorities Advice on standard-setting projects Supporting IASB in promotion/adoption of IFRS throughout the world
IFRIC is responsible for: Interpretation and application of international accounting standards
5.2
Membership Membership of the IASCF has been designed so that it represents an international group of preparers and users, who become IASCF trustees. The selection process of the 19 trustees takes into account geographical factors and professional background. IASCF trustees appoint the IASB members.
5.3
The IASB The IASB is responsible for setting accounting standards. It is made up of 14 members (12 full-time and two part-time members) coming from nine countries. They have a variety of backgrounds and include:
5.4
Auditors Preparers of financial statements Users of financial statements, and Academics
Objectives of the IASB The Preface to International Financial Reporting Standards states that the objectives of the IASB are as follows:
To develop in the public interest, a single set of high-quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the various capital markets of the world and other users of the information to make economic decisions.
To promote the use and rigorous application of those standards, and
To work actively with national standard-setters to bring about convergence of national accounting standards and IFRS to high quality solutions.
The issue of convergence is very topical. A number of exercises are being undertaken at the moment aiming to bring national and international accounting standards into line.
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Financial accounting
6 International Financial Reporting Standards (IFRS) Section overview
6.1
The influence of IFRS is growing.
They aim to ensure that like transactions and events are treated consistently.
In Bangladesh ICAB has adopted all IASs and IFRSs issued by IASB with the exception of IAS 29 as at 30/6/2009.
The purpose of accounting standards The overall purpose of accounting standards is to identify proper accounting practices for the preparation of financial statements. Accounting standards create a common understanding between users and preparers on how particular items, for example the valuation of property, are treated. Financial statements should therefore comply with all applicable accounting standards.
6.2
Application of IFRS Within each individual country local regulations govern, to a greater or lesser degree, the issue of financial statements. These local regulations include accounting standards issued by the national regulatory bodies or professional accountancy bodies in the country concerned. Over the last 25 years however, the influence of IFRS on national accounting requirements and practices has been growing. For example:
6.3
For accounting periods commencing on or after 1 January 2005, all EU companies whose securities are traded on a regulated public market such as the London Stock Exchange, must prepare their consolidated accounts in accordance with IFRS. (Note that although group financial statements must follow IFRS the individual financial statements do not need to.)
In the UK unquoted companies are permitted (but not required) to adopt IFRS (see section 1.5).
In Bangladesh ICAB has adopted all IASs and IFRSs issued by the IASB as BASs and BFRSs, with no changes, with the exception of IAS 29, Financial Reporting in Hyperinflationary Economies, which has not been adopted as at 30/06/2009.
Setting of IFRS The overall agenda of the IASB will initially be set by discussion with the SAC. The process for developing an individual standard would involve the following steps.
Step 1 During the early stages of a project, IASB may establish an Advisory Committee to give advice on issues arising in the project. Consultation with the Advisory Committee and the SAC occurs throughout the project.
Step 2 IASB may develop and publish a Discussion Document for public comment.
Step 3 Following the receipt and review of comments, IASB would develop and publish an Exposure Draft for public comment.
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Step 4 Following the receipt and review of comments, the IASB would issue a final International Financial Reporting Standard. The period of exposure for public comment is normally 90 days. However, in exceptional circumstances, proposals may be issued with a comment period of 60 days. Draft IFRIC Interpretations are exposed for a 60-day comment period.
6.4
Scope and authority of IFRS The Preface to IFRS makes the following points:
IFRS apply to all general purpose financial statements i.e. those directed towards the common information needs of a wide range of users.
The IASB's objective is to require like transactions and events to be accounted for in a like way.
It recognises that the IASC (the predecessor to the IASB) permitted different treatments (benchmark treatment and allowed alternative treatment) for like transactions and events. Where these still exist either treatment would constitute compliance with IFRS.
Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the main principles, but both types have equal authority.
Any limitation of the applicability of a specific IFRS is made clear in that standard. IFRSs are not intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS lays out its scope at the beginning of the standard.
7 Inherent limitations of financial statements Section overview
7.1
There are limitations inherent in financial statements, including the fact that they are: –
A conventionalised representation, involving classification, aggregation and the allocation of items to particular accounting periods
–
Historical (backward-looking), and
–
Based almost exclusively on financial data.
Conventionalised representation Financial statements are highly standardised in terms of their overall format and presentation although businesses are very diverse in their nature. This may limit the usefulness of the information. Financial statements are highly aggregated in that information on a great many transactions and balances is combined into a few figures in the accounts, which can often make it difficult for the reader to evaluate the components of the business. Allocation issues include, for example, the application of the accrual concept and depreciation of noncurrent assets, where management’s judgements and estimates affect the period in which expenses or income are recognised.
7.2
Backward-looking Financial statements are backward-looking whereas most users of financial information base their decisions on expectations about the future. Financial statements contribute towards this by helping to
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Financial accounting identify trends and by confirming the accuracy of previous expectations, but cannot realistically provide the complete information set required for all economic decisions by all users.
7.3
Omission of non-financial information By their nature, financial statements contain financial information. They do not generally include nonfinancial data such as:
Narrative description of the major operations. Discussion of business risks and opportunities. Narrative analysis of the entity’s performance and prospects. Management policies and how the business is governed and controlled.
Financial statements include the elements as defined in BFRS Framework. This means that items which do not meet those definitions are not included. For example, the value of the entity’s internally generated goodwill i.e. through its reputation, loyalty and expertise of its management and employees, or its client portfolio. While some companies do experiment with different types of disclosure for such items, these disclosures are considered unsuitable for inclusion in the financial statements (precisely because such items do not fall within its definition of assets).
7.4
Other sources of information Some of the limitations of financial statements are addressed in the other information which is often provided along with the financial statements, especially by large companies, such as operating and financial reviews and the Chairman’s statement. Note that other information provided with financial statements is outside the scope of the Financial Accounting syllabus. There are also many other sources of information available to at least some users of financial statements, for example:
In owner-managed businesses, the owners have access to internal management information because they are the management. This information is, potentially, available on a continuous real-time basis and may include: – – –
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Future plans for the business Budgets or forecasts Management accounts, including, for example, divisional analysis
Banks will often obtain additional access to entity information under the terms of loan agreements.
Potential investors (e.g. if they are planning to take a major stake or even a controlling interest) will often negotiate additional access to corporate information.
Publicly available information, such as entity brochures and publicity material (e.g. press releases)
Brokers’ reports on major companies, and
Press reports and other media coverage (e.g. television or internet).
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8 Not-for-profit entities Section overview
8.1
Not-for-profit entities include NGOs, clubs, and public sector organisations. Reporting requirements will vary depending on the nature of the entity.
Not-for-profit entities The objective of most company directors is to manage the shareholders' investment. In a majority of cases this will mean creating a profit. However, this is not always the case. For some entities their primary purpose is to provide a service rather than to make a profit.
Interactive question 2: Not-for-profit entities
[Difficulty level: Easy]
List as many types of not-for-profit organisations as you can. See Answer at the end of this chapter.
As this exercise has demonstrated not-for-profit entities include a broad range of organisations involved in very different activities. Not-for-profit entities also vary considerably in size from the local rugby club to an internationally renowned charity.
8.2
Reporting requirements Many of the organisations mentioned above may be companies. In this case they will need to prepare financial statements and have them audited in accordance with local legislation and accounting regulation. In Bangladesh this would include compliance with the Companies Act and BFRSs. For unincorporated entities the reporting requirements are normally less onerous, although best practice would be to follow BFRSs. In addition, many not-for-profit organisations will need to comply with regulations specific to their sector. For example in Bangladesh, NGOs are required to comply with the Foreign Donations Rules (FDRs), 1978.
8.3
International public sector accounting standards International Public Sector Accounting Standards (IPSAS) are issued by the International Public Sector Accounting Standards Board (IPSASB). The objective of IPSASB is to:
Develop high quality public sector financial reporting standards.
Facilitate convergence of international and national standards.
Enhance the quality and uniformity of financial reporting.
Currently there is no requirement for IPSAS to be adopted and in jurisdictions where national standards already exist since it is the local regulation which will be applied. The IPSASB however, envisage an increasing role for IPSAS in future, particularly in the following areas:
Assisting national standard-setters in the development of new standards and the revision of existing standards.
Being applied in jurisdictions where there is no national legislation.
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Summary and Self-test
Summary
Regulated by: Local legislation FDRs IPSAS
Self-test Answer the following questions 1
Which of the following is the best description of why BFRS Framework requires financial statements to be prepared on the basis of accrual accounting? A B C D
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As a result of the 'substance over form' requirement So as to be prudent Because it is the most objective basis Because it presents both past transactions and future obligations
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2
1
The following relate to the going concern assumption. (1) (2) (3) (4)
The entity has no need to liquidate The entity has no intention to liquidate The entity has no need to curtail materially its scale of operations The entity has no intention to curtail materially its scale of operations
Which of the above are the best description of the conditions which BFRS Framework identifies as necessary if the going concern basis is to be used for the preparation of financial statements? A B C D 3
According to BFRS Framework which of the following is one of the qualitative characteristics which make information in financial statements useful? A B C D
4
5
6
(1), (2) and (3) only (1), (2) and (4) only (1), (3) and (4) only (1), (2), (3) and (4)
True and fair view Comparability Timeliness Historical cost
Which of the following is the closest approximation to BFRS Framework’s definition of an asset? A
A resource controlled by the entity from which future economic benefits are expected which can be measured reliably
B
A resource controlled by the entity as a result of past events from which future economic benefits are expected which can be measured reliably
C
A resource controlled by the entity from which future economic benefits are expected
D
A resource controlled by the entity as a result of past events from which future economic benefits are expected
Which of the following is the closest approximation to BFRS Framework’s definition of a liability? A
A legal obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits
B
An obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits which can be measured reliably
C
An obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits
D
A legal obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits which can be measured reliably
Future settlement is an essential part of BFRS Framework’s definition of a liability. Which of the following best describes the way that settlement may occur? A
Payment of cash
B
Payment of cash or transfer of other assets
C
Payment of cash or transfer of other assets or replacement of the obligation with another obligation
D
Payment of cash or transfer of other assets or replacement of the obligation with another obligation or conversion of the obligation to equity
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8
9
Which of the following is the closest approximation to BFRS Framework’s definition of income? A
Increase in assets
B
Increase in assets or decrease in liabilities
C
Increase in assets or decrease in liabilities, other than those relating to transactions with equity participants
D
Increase in assets, other than those relating to transactions with equity participants
Which of the following is the closest approximation to BFRS Framework’s requirement as to when an asset or liability should be recognised? A
It is probable that future economic benefits will flow to or from the entity and the item’s cost or value can be estimated
B
It is probable that future economic benefits will flow to or from the entity and the item’s cost or value can be measured reliably
C
The item’s cost or value can be measured reliably
D
The item’s cost or value can be estimated
Which of the following statements is true in respect of International Public Sector Accounting Standards (IPSAS)? A B C D
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Currently there is no requirement for IPSAS to be adopted by public sector entities IPSAS must be adopted by public sector entities where there are no national standards Both IPSAS and national standards must be adopted by public sector entities None of the above statements is correct
TRADITIONAL FRUITS LTD Traditional Fruits Ltd, a Herefordshire based fruit bottling and canning company, is looking to expand its operations. The directors are hoping to increase the range of preserved fruit products and in doing so will need to invest in new equipment. They are also hoping to open a new facility in the South East near to the fruit farms of Kent and Surrey. The finance director has been asked to prepare a résumé of the financial performance of the company in order that possible providers of finance can assess the future potential of the company. The finance director wants to address all issues in her résumé and has asked for your assistance. Requirements Prepare brief notes for the finance director, addressing each of the following and using BFRS Framework as a source of reference. (a)
Identify potential providers of finance for Traditional Fruits Ltd and their information requirements in respect of financial statements.
(b) Explain the terms 'performance' and 'position' and identify which of the financial statements will assist the user in evaluating performance and position. (c)
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Indicate why, for decision-making purposes, the financial statements alone are insufficient.
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CONCEPTUAL AND REGULATORY FRAMEWORK
11
1
DAVIES AND SAYERS LTD Davies and Sayers Ltd (D&S Ltd) is a well-known publisher of children’s educational books. The finance director, Carol Roberts, is known for her commercial acumen rather than her technical ability. She is therefore seeking your advice on two particular accounting issues. (1) Value of head of publishing D&S Ltd have recently appointed a new head of publishing, Jane Lindsay. Jane recently worked for a key competitor, Surridge and Hughes Ltd (S&H Ltd). Jane is extremely popular amongst the leading authors in the market and is sure to attract the services of certain authors currently working for S&H Ltd. Carol believes that Jane is therefore of great value to D&S Ltd and that such value should therefore be recognised in the balance sheet in the form of an asset. (2) Provision for alleged breach of copyright Carol is aware that Poppy Anderson, one of D&S Ltd’s authors, is being accused of 'including ideas in her texts that have previously been published'. Carol is certain a legal case will ensue and therefore, being prudent, wishes to recognise a liability in the accounts now for any damages that are likely to arise. Requirements Using BFRS Framework (a)
Define the terms 'asset', 'liability' and 'recognised'.
(b) Prepare brief notes for Carol Roberts, discussing whether the above result in an asset or liability and whether or not they should be recognised in the financial statements. Note: You are not required to refer to specific BFRSs that may be relevant. Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Financial accounting
Technical reference Point to note: The whole of BFRS Framework (Frame) and Preface to International Financial Reporting Standards (Preface) is examinable. The paragraphs listed below are the key references you should be familiar with. 1 Purpose and use of financial statements
Users’ core need is for information for making economic decisions
Objective is to provide information on financial position, financial performance and changes in financial position
Frame (12)
Financial position:
Frame (16)
– Resources controlled – Financial structure – Liquidity and solvency – Capacity to adapt to changes Financial performance, measured as profit = income less expenses:
Frame (17)
– Potential changes to resources in the future – Capacity to generate cash from existing resource base – Effectiveness with which additional resources might be employed Changes in financial position:
Frame (18)
– Ability to generate cash – Needs to use what is generated Notes and schedules:
Frame (21)
– –
Frame (Preface)
Risks and uncertainties Resources and obligations not recognised in financial statements
2 Underlying assumptions
Accrual basis
Frame (22)
Going concern
Frame (23)
3 Qualitative characteristics of financial statements
To be useful, information needs to have the attributes of: –
Understandability
Frame (25)
–
Relevance, to include:
Frame (26)
Materiality
Frame (29)
Reliability, to include:
Frame (31)
Faithful representation
Frame (33)
Substance over form
Frame (35)
Neutrality
Frame (36)
Prudence
Frame (37)
–
Realised/unrealised –
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Comparability
Application of these should result in a true and fair view/fair presentation
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Frame (39) Frame (46)
CONCEPTUAL AND REGULATORY FRAMEWORK
1
4 Elements of financial statements
Asset: a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity
Frame (49)
Liability: a present obligation of the entity arising from past events, the settlement of which is expected to lead to the outflow from the entity of resources embodying economic benefits
Frame (49)
Equity: the residual interest in assets less liabilities, i.e. net assets
Frame (49)
Income (comprising revenue and gains): increases in economic benefits in the form of asset increases/liability decreases, other than contributions from equity
Frame (70, 7475)
Expenses (including losses): decreases in economic benefits in the form of asset decreases/liability increases, other than distributions to equity
Frame (70, 7879)
5 Recognition
Assets and liabilities are recognised in financial statements if: – –
Frame (83)
It is probable that any future economic benefit associated with the item will flow to or from the entity, and Its cost or value can be measured with reliability
6 Measurement
Historical cost Current cost Realisable value Present value
Frame (100)
7 Capital maintenance
Financial capital:
– Monetary – Constant purchasing power Physical capital
Frame (104)
8 IASB
Objectives
Scope and authority
Process
Preface (6) Preface (7-17) Preface (18)
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Financial accounting
Answers to Self-test 1
D
2
D
3
B
4
D
5
C
6
D
7
C
8
B
9
A
10
TRADITIONAL FRUITS LTD (a)
Potential providers of finance
The existing shareholders of the company and potential new shareholders – through a new issue of share capital.
Existing and future lenders and creditors to the company.
Information requirements
The profit before interest of Traditional Fruits Ltd (TF Ltd), to determine risk.
The trend of profitability of TF Ltd together with a history of dividend payments. This will enable them to assess return and risk of their investment.
The financial structure of TF Ltd, to determine the level of debt finance as a measure of risk.
TF Ltd's liquidity or ability to pay out dividends and redeem share capital.
TF Ltd's ability to generate cash and the timing and certainty of its generation.
The liquidity of TF Ltd and its ability to repay interest and capital instalments.
The existing level of debt and any security over that debt.
(b) Performance and position and the financial statements which assist in evaluation Performance The financial performance of a company comprises the return it obtains on the resources it controls. Performance can be measured in terms of the profits of the company and its ability to generate cash flows. Management will be assessed on their skill in achieving the highest level of performance, given the resources available to them. Information on performance can be found in
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The income statement. The statement of changes in equity. The cash flow statement.
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CONCEPTUAL AND REGULATORY FRAMEWORK
1
Position The financial position of the company is evaluated by reference to
The economic resources (assets and liabilities) it controls. Its capital structure, i.e. its level of debt finance and shareholders’ funds. Its liquidity and solvency.
The user of the financial statements can then make assessments on the level of risk, ability to generate cash, the likely distribution of this cash and the ability of the company to adapt to changing circumstances. The balance sheet is the prime source of information on a company’s position but the cash flow statement will also indicate a company’s cash position over a period of time. (c)
Financial statements – inherent limitations as a tool of decision-making Financial statements are prepared by reference to a relatively rigid set of accounting standards applicable to all companies, regardless of the sectors of the economy they operate in. As a result, information for individual and specialised companies may not be forthcoming. Further, the preparation of financial statements is based on estimates and judgements by the management and therefore are not a source of totally reliable information. Financial statements primarily use the historical cost convention. They can identify trends from the past which may be relevant to the future, but they are not forecasts and are therefore less helpful when making predictions. In deciding whether or not to invest in a company, a decision-maker will also want access to nonfinancial data not contained in the financial statements such as
11
A discussion of business risks and opportunities An evaluation of the quality of management A narrative analysis of position and performance
DAVIES AND SAYERS LTD (a)
Terms Asset An asset is
A resource controlled by the entity As a result of past events, and From which future economic benefits are expected to flow into the entity.
Legal ownership is not an essential part of the definition of an asset, even though such ownership is indicative that the control criterion has been met. But the key is whether the entity controls a resource, so having the continued use of an item will often be sufficient evidence of control. Liability A liability is
A present obligation of the entity
Arising from past events
The settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
An obligation arises from a legally-enforceable contract, but it may also result from an entity’s normal business practices.
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Financial accounting Recognised Recognition means that an item is recorded in the financial statements. An asset or liability is recognised if
It is probable that any future economic benefit associated with the item will flow to or from the entity, and
The cost or value can be measured with reliability.
(b) Notes for Carol Roberts (1) Value of head of publishing Existence of an asset If you apply the definition of an asset from BFRS Framework to the head of publishing, Jane Lindsay, it is possible to argue that she has the characteristics of an asset. As a full-time employee, Jane is likely to have a contract which was signed prior to the balance sheet date. The legal contract will prevent Jane working for any other company, giving D&S Ltd unrestricted access to any benefits she may provide. If Jane is able to persuade new authors to join the D&S team, she is creating a flow of future economic benefits – on the assumption that the authors’ new work will prove salesworthy. However, there is uncertainty over
The enforceability of Jane’s contract: she may recruit new authors to D&S Ltd, but within a short period of time might leave and join a new company; her authors are then likely to follow her.
The revenue stream to result from the new authors: they have not as yet been recruited and it is only possible that they will be; there are also no guarantees as to the quality of their future work and therefore the level of revenue they are likely to generate.
Therefore, at this stage we cannot conclude that an asset exists. Recognition of the asset An item is recognised when it is included in the financial statements at a monetary value. Carol Roberts is proposing to include Jane Lindsay as an asset in the balance sheet. However, certain criteria should be applied prior to recognition.
Is there sufficient evidence of the existence of the asset? Can the asset be measured at a monetary amount with sufficient reliability?
(2) Provision for breach of copyright Existence of a liability At this stage Poppy Anderson has been accused of breach of copyright. From the information given, there is no opinion from lawyers as to the strength of the case or estimate of the possible value of any claim. Therefore, whilst a past transaction has allegedly occurred, there is insufficient evidence of, and uncertainty over, whether an obligation exists. Recognition of the liability To recognise the liability in the financial statements there must be sufficient evidence of the existence of the liability and it should be probable that economic benefit will flow from the entity. In this case, there is insufficient evidence of a liability and we are unable to reliably measure any potential liability. The case is at far too early a stage to estimate the possible loss. It would therefore be overprudent and inappropriate to recognise the liability in the financial statements.
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CONCEPTUAL AND REGULATORY FRAMEWORK
1
Answers to Interactive questions
Answer to Interactive question 1 Question (a)
Answer
Oak Ltd has purchased a patent for CU40,000. The patent gives the company sole use of a particular manufacturing process which will save CU6,000 a year for the next five years.
This is an asset, albeit an intangible one. There is a past event, control and future economic benefit (through cost saving).
(b) Elm Ltd paid John Brown CU20,000 to set up a car repair shop, on condition that priority treatment is given to cars from the company's fleet.
This cannot be classed as an asset. Elm Ltd has no control over the car repair shop and it is difficult to argue that there are future economic benefits.
(c)
This is a liability. The business has an obligation to fulfil the terms of the warranty. The liability would be recognised when the warranty is issued rather than when a claim is made.
Sycamore Ltd provides a warranty with every washing machine sold.
Answer to Interactive question 2
NGOs Friendly societies Public sector hospitals Public sector schools Clubs Associations Local councils Public services Trade unions Societies Housing associations
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© The Institute of Chartered Accountants in England and Wales, March 2009
chapter 2
Format of financial statements Contents Introduction Examination context Topic List 1
BAS 1 Presentation of Financial Statements
2
Overall considerations
3
Structure and content: general points
4
Balance sheet
5
Income statement
6
Statement of changes in equity
7
Notes to the financial statements
8
Minority interest
9
Not-for-profit entities
Summary and Self-test Technical reference Answers to self-test
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Financial accounting
Introduction
Learning objectives
Explain the purpose and principles underlying BAS 1 Presentation of Financial Statements
Prepare and present the financial statements (or extracts), of an entity according to its accounting policies and appropriate BFRSs
Prepare simple extracts from financial statements in accordance with Companies Act and BFRS
Calculate the amounts to be included in the equity section of the balance sheet of a not-forprofit entity
Tick off
Specific syllabus references for this chapter are: 2b, c, e.
Practical significance The way that financial information is presented to shareholders and other users is a fundamental part of financial accounting. Recent corporate scandals have increased public concern as to the adequacy of transparency in financial statements. Accounting standards provide guidance on presentation, although no system of rules can cover all eventualities. To ensure that financial statements are prepared to an adequate level it is important that entities are provided with a basic framework for the preparation of their financial statements. The information produced needs to reflect fairly the results of the business but also enable the shareholders to make comparisons year on year and with the results of other companies. Therefore, information needs to be presented in an understandable and consistent manner. This is achieved through the broad standardisation of the structure of financial statements. BAS 1 Presentation of Financial Statements provides a basic framework but still allows a degree of flexibility so that formats and headings can be adapted so that information is presented in a way that aids understanding.
Stop and think Can you think of any advantages and disadvantages of standardised formats for financial statements?
Working context You will have come across financial statements in the context of your working life. They are a fundamental part of accounting, audit and tax services. It is less likely these days that you will have had to prepare financial statements yourselves as this process is largely computerised. However, in order to understand financial information you need to know the basis on which the information has been prepared. Some of you may have come across not-for-profit organisations including NGOs, clubs and societies. This type of entity may have to comply with additional regulations, for example the Foreign Donations Rules 1978.
Syllabus links You will have been introduced to the basics of company accounts in the Accounting paper. In this paper however, you are expected to have a much more detailed understanding of the preparation of financial statements and a thorough knowledge of the regulation in this area. This knowledge will be assumed in both the Financial Reporting paper and at the Advanced Stage.
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FORMAT OF FINANCIAL STATEMENTS
2
Examination context
Exam requirements The ability to prepare financial statements for an individual entity is a fundamental part of the Financial Accounting syllabus and has a syllabus weighting of 55% (including the cash flow statement). It will therefore be examined in the written test section of the paper in some form at every sitting and would also be examined in OTs. A typical written test question would involve the preparation of a company balance sheet or income statement from a trial balance. You may also be asked to make adjustments based on additional information and/or to produce notes. Alternatively you could be asked to produce extracts to the financial statements. For example, as part of a question on non-current assets you could be asked to produce the disclosure note which would support the balance in the balance sheet. Not-for-profit entities are likely to be examined less frequently as you are only expected to have an overview of this topic. This topic could be examined in the OT section or as part of a broader question on the balance sheet presentation of equity. In the examination, candidates may be required to:
Discuss the way BAS 1 builds on the principles contained in BFRS Framework, including the following matters: – – – –
Fair/faithful presentation Accrual basis Going concern Materiality
Draft, in accordance with BAS 1: – – – –
A balance sheet, distinguishing between current and non-current items An income statement A statement of changes in equity Notes to the financial statements
Prepare the equity section of the balance sheet of a not-for-profit entity from financial and other data
Prepare extracts from the financial statements in accordance with Companies Act and BFRS
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Financial accounting
1 BAS 1 Presentation of Financial Statements Section overview
BAS 1 applies to all general purpose financial statements.
Financial statements provide information about: – – –
1.1
Financial position Financial performance Cash flows.
Objective BAS 1 Presentation of Financial Statements prescribes the basis for the presentation of financial statements, so as to ensure comparability with:
The entity's own financial statements of previous periods, and The financial statements of other entities.
BAS 1 must be applied to all general purpose financial statements prepared in accordance with BFRSs, i.e. those intended to meet the needs of users who are not in a position to demand reports tailored to their specific needs. BAS 1 is concerned with overall considerations about the minimum content of a set of financial statements; detailed rules about recognition, measurement and disclosures of specific transactions are then contained in other standards. Whilst the terminology used was designed for profit-orientated businesses, it can be used, with modifications, for not-for-profit activities.
1.2
Purpose of financial statements The objective of general purpose financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. They also show the result of management stewardship of the resources of the entity. (This is very similar to the purpose stated by the Framework covered in Chapter 1). In order to achieve this, information is provided about the following aspects of the entity's results:
Assets Liabilities Equity Income and expenses (including gains and losses) Other changes in equity, and Cash flows
Additional information is contained in the notes.
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FORMAT OF FINANCIAL STATEMENTS
1.3
2
Components of financial statements
Summary of major cash inflows and outflows. Dealt with in BAS 7 (see Chapter 3)
Although the financial statements may be included as part of a wider document BAS 1 requires that they should be clearly identified and distinguished from other information presented.
2 Overall considerations Section overview
Much of the material in this section details the specific application within financial statements of the general principles dealt with in the BFRS Framework which was introduced in Chapter 1. These include: – – – –
2.1
Fair presentation Going concern Accrual basis of accounting Materiality
The technical summary at the end of this chapter refers you to both the relevant paragraphs of BAS 1 and of the Framework.
Fair presentation Financial statements should present fairly the financial position, financial performance and cash flows of an entity.
Definition Fair presentation: Requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. Compliance with BFRS is presumed to result in financial statements that achieve a fair presentation.
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Financial accounting BAS 1 expands on this principle as follows:
Compliance with BFRS should be disclosed.
Financial statements can only be described as complying with BFRS if they comply with all the requirements of BFRS.
Use of inappropriate accounting policies cannot be rectified either by disclosure or explanatory material.
In rare circumstances management may conclude that compliance with a requirement of a BFRS would be misleading. When the regulatory framework allows, the entity should depart from this requirement and disclose this fact and provide details of its effect. There are very few, if any, circumstances where compliance will be as fundamentally misleading. Where the regulatory framework does not allow departure disclosure is required to reduce the perceived misleading aspects of compliance. In practice this would be extremely rare.
2.2
Going concern As we saw in Chapter 1 going concern is referred to by the Framework as an underlying assumption. It means that an entity is normally viewed as continuing in operation for the foreseeable future. Financial statements are prepared on the going concern basis unless management either intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. BAS 1 makes the following points:
In assessing whether the entity is a going concern management must look at least twelve months into the future measured from the balance sheet date (not from the date the financial statements are approved.)
Uncertainties that may cast significant doubt on the entity's ability to continue should be disclosed.
If the going concern assumption is not followed that fact must be disclosed together with: – –
2.3
The basis on which financial statements have been prepared The reasons why the entity is not considered to be a going concern
Accrual basis of accounting Financial statements other than the cash flow statement, must be prepared on the accrual basis of accounting. This is the Framework's other underlying assumption.
Definition Accrual basis of accounting: Items are recognised as assets, liabilities, equity, income and expenses when they satisfy the definitions and recognition criteria for those elements in the Framework.
Point to note: The definition refers to the definitions and recognition criteria of the Framework. The effect is that:
Transactions are recognised when they occur (and not when the relevant cash is received or paid). They are recorded in the financial statements of the periods to which they relate.
According to the accrual assumption, then, in computing profit, revenue earned must be matched against the expenditure incurred in earning it. (This issue will be considered further when BAS 18 Revenue is dealt with in Chapter 7.)
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2.4
2
Consistency of preparation To maintain consistency, the presentation and classification of items in the financial statements should stay the same from one period to the next. There are two exceptions to this:
There is a significant change in the nature and operations or a review of the financial statements presentation which indicates a more appropriate presentation. (This change is only allowed if the resulting information is reliable and more relevant than the previous presentation. If two presentations are equally appropriate then the current presentation must be retained.)
A change in presentation is required by a BFRS.
Where a change of presentation and classification is made, figures for the previous period must be restated on the new basis, unless this is impracticable (i.e. not possible 'after making every reasonable effort').
Worked example: Consistency Compare the following two income statements prepared for a sole trader who wishes to show them to the bank manager to justify continuation of an overdraft facility. Year ended 31 December 20X6 CU
Sales revenue Less production costs selling and administration
10,000 7,000
CU 25,150 17,000 8,150 1,000 7,150
Gross profit Less interest charges Profit after interest Year ended 31 December 20X7
CU 22,165 10,990 11,175 3,175 8,000
Sales revenue less selling costs Less production costs Gross profit Less administration and interest Net profit Which accounting concept is being ignored here? Justify your choice. How do you think the changes in the format of these financial statements affect the quality of the accounting information presented?
Solution The accounting assumption breached here is that of consistency. This concept holds that accounting information should be presented in a way that facilitates comparisons from period to period. In the income statement for 20X6 sales revenue is shown separately from selling costs. Also interest and administration charges are treated separately. The new format is poor in itself, as we cannot know whether any future change in 'sales revenue less selling costs' is due to an increase in sales revenue or a decline in selling costs. A similar criticism can be levelled at the lumping together of administration costs and interest charges. It is impossible to divide the two. (In fact BAS 1 states that material balances should not be aggregated (see section 2.5 below). It is not possible to 'rewrite' 20X6's accounts in terms of 20X7, because we do not know the breakdown in 20X6 between selling and administration costs. The business's bank manager will not, therefore, be able to assess the business's performance, and might wonder if the sole trader has 'something to hide'. Thus the value of this accounting information is severely affected.
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Financial accounting
2.5
Materiality and aggregation Each material class of items should be presented separately in the financial statements. Amounts which are immaterial can be aggregated with amounts of a similar nature or function and need not be presented separately.
Definition Materiality: Omissions or misstatement of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.
An error which is too trivial to affect anyone's understanding of the financial statements is referred to as immaterial. However, the cumulative effects of many errors should also be taken into account. A number of immaterial errors taken together could be material to the financial statements as a whole. In preparing financial statements it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive detail. Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb (for example to define material items as those with a value greater than 5% of the net profit disclosed by the financial statements). But some items disclosed in financial statements are regarded as particularly sensitive and even a very small misstatement of such an item would be regarded as a material error. An example in the financial statements of a limited liability company might be the amount of remuneration paid to directors of the company. The assessment of an item as material or immaterial may affect its treatment in the financial statements. For example, the income statement of a business will show the expenses incurred by the business grouped under suitable captions (heating and lighting expenses, rent and property taxes etc). However, in the case of very small expenses it may be appropriate to lump them together under a caption such as 'sundry expenses', because a more detailed breakdown would be inappropriate for such immaterial amounts. In assessing whether or not an item is material, it is not only the amount of the item which needs to be considered. The context is also important.
Worked example: Materiality If a balance sheet shows non-current assets of CU2 million and inventories of CU30,000 an error of CU20,000 in the depreciation calculations might not be regarded as material, whereas an error of CU20,000 in the inventory valuation probably would be. In other words, the total of which the erroneous item forms part must be considered. If a business has a bank loan of CU50,000 and a CU55,000 balance on bank deposit account, it might well be regarded as a material misstatement if these two amounts were displayed on the balance sheet as 'cash at bank CU5,000'. In other words, incorrect presentation may amount to material misstatement even if there is no monetary error. Users are assumed to have a personal knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.
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2.6
2
Offsetting BAS 1 does not allow assets and liabilities to be offset against each other unless such a treatment is required or permitted by another BFRS. Income and expenses can be offset only when:
2.7
A BFRS requires/permits it, or
Gains, losses and related expenses arising from the same/similar transactions are not material (in aggregate).
Comparative information BAS 1 requires comparative information to be disclosed for the previous period for all numerical information, unless another BFRS permits/requires otherwise. Comparatives should also be given in narrative information where relevant to an understanding of the current period's financial statements. Comparatives should be reclassified when the presentation or classification of items in the financial statements is amended.
2.8
Disclosure of accounting policies There should be a specific section for accounting policies in the notes to the financial statements and the following should be disclosed there.
Measurement bases used in preparing the financial statements Each specific accounting policy necessary for a proper understanding of the financial statements
To be clear and understandable it is essential that financial statements should disclose the accounting policies used in their preparation. This is because policies may vary, not only from entity to entity, but also from country to country. As an aid to users, all the major accounting policies used should be disclosed in the same place. This is normally referred to as the accounting policy note.
3 Structure and content: general points Section overview
3.1
In addition to giving substantial guidance on the form and content of published financial statements BAS 1 also covers a number of general points: –
The profit or loss must be calculated after taking account of all income and expense in the period (unless a standard or interpretation requires otherwise)
–
Recommended formats are given but they are not mandatory
–
Readers of annual reports must be able to distinguish between the financial statements and other information
–
Financial statements should be prepared at least annually
–
Financial statements should be produced within six months of the balance sheet date.
Profit or loss for the period The income statement is the most significant indicator of a company's financial performance. So it is important to ensure that it is not misleading. BAS 1 stipulates that all items of income and expense recognised in a period shall be included in profit or loss unless a Standard or an Interpretation requires otherwise. Circumstances where items may be excluded from profit or loss for the current year include the correction of errors and the effect of changes in accounting policies. These are covered in BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (which is covered in Chapter 4). © The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting
3.2
How items are disclosed BAS 1 specifies disclosures of certain items in certain ways:
Some items must appear on the face of the balance sheet or income statement
Other items can appear in a note to the financial statements instead
Illustrative formats are given which enterprises may or may not follow, depending on their circumstances.
Obviously, disclosures specified by other standards must also be made, and we will mention the necessary disclosures when we cover each BAS or BFRS in turn. Disclosures in both BAS 1 and other BAS or BFRS must be made either on the face of the statement or in the notes unless otherwise stated, i.e. disclosures cannot be made in an accompanying commentary or report.
3.3
Identification of financial statements As a result of the above point, it is most important that enterprises distinguish the financial statements very clearly from any other information published with them. This is because all BASs/BFRSs apply only to the financial statements (i.e. the main statements and related notes), so readers of the annual report must be able to differentiate between the parts of the report which are prepared under BFRS, and other parts which are not. The enterprise should identify each component of the financial statements very clearly. BAS 1 also requires disclosure of the following information in a prominent position. If necessary it should be repeated wherever it is felt to be of use to the reader in his understanding of the information presented.
Name of the reporting enterprise (or other means of identification) Whether the accounts cover the single entity only or a group of entities The balance sheet date or the period covered by the financial statements (as appropriate) The reporting currency The level of rounding used in presenting the figures in the financial statements
Judgement must be used to determine the best method of presenting this information. In particular, the standard suggests that the approach to this will be very different when the financial statements are communicated electronically. The level of rounding is important, as presenting figures in thousands or millions of units makes the figures more understandable. The level of rounding must be disclosed, however, and it should not obscure necessary details or make the information less relevant.
3.4
Reporting period It is normal for entities to present financial statements annually and BAS 1 states that they should be prepared at least as often as this. If (unusually) an entity's balance sheet date is changed, for whatever reason, the period for which the statements are presented will be less or more than one year. In such cases the entity should also disclose:
3.5
The reason(s) why a period other than one year is used, and
The fact that the comparative figures given are not in fact comparable (in particular for the income statement, changes in equity, cash flows and related notes).
Timeliness If the publication of financial statements is delayed too long after the balance sheet date, their usefulness will be severely diminished. The standard states that entities should be able to produce their financial statements within six months of the balance sheet date. An entity with consistently complex operations cannot use this as a reason for its failure to report on a timely basis. In addition, local legislation and market regulation may impose specific deadlines on certain enterprises.
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3.6
2
Proforma accounts BAS 1 looks at the balance sheet and the income statement. We will not give all the detailed disclosures as some are outside the scope of your syllabus. Instead we will look at a 'proforma' set of accounts based on the Guidance on Implementing BAS 1 which accompanies the Standard. Note the description of this guidance as 'not part' of BAS 1 which means that it is not mandatory. So it shows ways in which financial statements may be presented.
4 Balance sheet Section overview
4.1
BAS 1 provides guidance on the layout of the balance sheet. BAS 1 specifies that certain items must be shown on the face of the balance sheet. Other information is required on the face of the balance sheet or in the notes. Both assets and liabilities must be separately classified as current and non-current.
Balance sheet format BAS 1 suggests a format for the balance sheet although it does not prescribe the order or format in which the items listed should be presented. The balance sheet layout below is consistent with the minimum requirements of BAS 1 and will be used throughout this study manual. PROFORMA BALANCE SHEET XYZ Ltd – Balance sheet as at [date] CUm ASSETS Non-current assets Property, plant and equipment Intangibles Investments Current assets Inventories Trade and other receivables Investments Cash and cash equivalents Non-current assets held for sale Total assets
CUm
X X X X X X X X X X
X X
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Financial accounting CUm
X X X X X X X
Minority interest
X
Equity
X
Non-current liabilities Preference share capital (redeemable) Finance lease liabilities Borrowings Current liabilities Trade and other payables Taxation Provisions Borrowings Finance lease liabilities
X X X X X X X X X
Total equity and liabilities
4.2
CUm
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Preference share capital (irredeemable) Share premium account Revaluation reserve General reserve Retained earnings Attributable to equity holders of XYZ Ltd
X X
Information which must appear on the face of the balance sheet BAS 1 specifies various items which must appear on the face of the balance sheet as a minimum disclosure.
Property, plant and equipment Investment property Intangible assets Financial assets Investments accounted for using the equity method (see Chapter 13) Assets classified as held for sale Inventories Trade and other receivables Cash and cash equivalents Trade and other payables Provisions Financial liabilities Current tax liabilities Minority interest Issued capital and reserves
Any other line items, headings or sub-totals should be shown on the face of the balance sheet when it is necessary for an understanding of the entity's financial position. This decision depends on judgements based on the assessment of the following factors.
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Nature and liquidity of assets and their materiality. Thus goodwill and assets arising from development expenditure will be presented separately, as will monetary/non-monetary assets and current/non-current assets.
Function within the entity. Operating and financial assets, inventories, receivables and cash and cash equivalents are therefore shown separately.
Amounts, nature and timing of liabilities. Interest-bearing and non-interest-bearing liabilities and provisions will be shown separately, classified as current or non-current as appropriate.
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The standard also requires separate presentation where different measurement bases are used for assets and liabilities which differ in nature or function. According to BAS 16 Property, Plant and Equipment, for example, it is permitted to carry certain items of property, plant and equipment at cost or at a revalued amount. Property, plant and equipment may therefore be split to show classes held at historical cost separately from those that have been revalued.
4.3
Information presented either on the face of the balance sheet or by note Certain pieces of information may be presented either on the face of the balance sheet or in the notes to the financial statements. These comprise:
4.4
Further sub-classification of line items on the face. Disclosures will vary from item to item, which will in part depend on the requirements of BFRS. For example, tangible assets are classified by class as required by BAS 16 Property, Plant and Equipment.
Details about each class of share capital.
Details about each reserve within equity.
The current/non-current distinction An entity must present current and non-current assets and liabilities as separate classifications on the face of the balance sheet. This is to separate current assets from fixed assets and amounts due within one year from amounts due after more than one year. An alternative liquidity presentation which lists assets by reference to how closely they approximate to cash is permitted but only where this provides more reliable information, e.g. in the case of a financial institution such as a bank. For all businesses which have a clearly identifiable operating cycle, it is the current/non-current presentation which is more meaningful, so this is the one which must be used. (See section 4.5 below). In either case, the entity should disclose any portion of an asset or liability which is expected to be recovered or settled after more than twelve months.
Worked example: Amount receivable For an amount receivable which is due in instalments over 18 months, the portion due after more than twelve months must be disclosed.
4.5
Operating cycle Definition Operating cycle: The time between the acquisition of assets for processing and their realisation in cash or cash equivalents.
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Financial accounting The typical operating cycle of a manufacturing business is shown in Figure 2.1.
WIP
Finished goods
Figure 2.1: Operating cycle of a manufacturing business This is an important term as it forms part of the definitions of current assets and current liabilities.
4.6
Current assets Definition Current asset: An asset shall be classified as current when it satisfies any of the following criteria:
It is expected to be realised in, or is intended for sale or consumption in, the entity's normal operating cycle
It is held primarily for the purpose of being traded
It is expected to be realised within twelve months after the balance sheet date, or
It is cash or a cash equivalent (as defined in BAS 7 Cash Flow Statements), unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the balance sheet date.
All other assets should be classified as non-current assets.
Current assets therefore include inventories and trade receivables that are sold, consumed and realised as part of the normal operating cycle. This is the case even where they are not expected to be realised within twelve months. It is the operating cycle which is the key. Current assets will also include marketable securities if they are expected to be realised within twelve months of the balance sheet date. If expected to be realised later, they should be included in non-current assets. Point to note: There is no specific definition of non-current assets. These are merely all assets which are not current assets.
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4.7
2
Current liabilities Definition Current liability: A liability shall be classified as current when it satisfies any of the following criteria:
It is expected to be settled in the entity's normal operating cycle
It is held primarily for the purpose of being traded
It is due to be settled within twelve months after the balance sheet date, or
The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the balance sheet date.
All other liabilities should be classified as non-current liabilities.
The categorisation of current liabilities is very similar to that of current assets. Thus, some current liabilities are part of the working capital used in the normal operating cycle of the business (i.e. trade payables and accruals for employee and other operating costs). Such items will be classed as current liabilities even where they are due to be settled more than twelve months after the balance sheet date. There are also current liabilities which are not settled as part of the normal operating cycle, but which are due to be settled within twelve months of the balance sheet date. These include bank overdrafts, income taxes, other non-trade payables and the current portion of interest-bearing liabilities. Any interest-bearing liabilities that are used to finance working capital on a long-term basis, and that are not due for settlement within twelve months, should be classed as non-current liabilities.
5 Income statement Section overview
5.1
BAS 1 suggests two formats for the income statement. BAS 1 specifies that certain items must be shown on the face of the income statement. Other information is required on the face of the income statement or in the notes.
Income statement formats BAS 1 suggests two possible formats for the income statement, the difference between them being the classification of expenses:
By function, or By nature
Point to note: The income statement classifying expenses by function is more common in practice and will therefore be tested more frequently in the exam than the income statement classifying expenses by nature.
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Financial accounting XYZ Ltd – Income Statement for the year ended [date] Illustrating the classification of expenses by function Continuing operations Revenue Cost of sales Gross profit Other operating income Distribution costs Administrative expenses Profit/loss from operations Finance cost Investment income Share of profit/(losses) of associates Profit/(loss) before tax Income tax expense Profit/(loss) for the period from continuing operations Discontinued operations Profit/(loss) for the period from discontinued operations Profit/(loss) for the period Attributable to: Equity holders of XYZ Ltd Minority interest
CUm X (X) X X (X) (X) X (X) X X X (X) X (X) X X X X X
Point to note: The sub-total 'profit/loss from operations' is not a current requirement of BAS 1. These Learning Materials use this description as it is used in practice and is not prohibited by BAS 1. PROFORMA INCOME STATEMENT XYZ Ltd – Income Statement for the year ended [date] Illustrating the classification of expenses by nature Continuing operations Revenue Other operating income Changes in inventories of finished goods and work in progress Work performed by the enterprise and capitalised Raw materials and consumables used Employee benefits expense Depreciation and amortisation expense Impairment of property, plant and equipment Other expenses Profit/loss from operations Finance costs Investment income Share of profit/(losses) of associates Profit/(loss) before tax Income tax expense Profit/(loss) for the period from continuing operations Discontinued operations Profit/(loss) for the period from discontinued operations Profit/(loss) for the period Attributable to: Equity holders of XYZ Ltd Minority interest
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CUm X X (X) X (X) (X) (X) (X) (X) X (X) X X X (X) X (X) X X X X
FORMAT OF FINANCIAL STATEMENTS
5.2
2
Information presented on the face of the income statement The standard lists the following as the minimum to be disclosed on the face of the income statement.
Revenue
Finance costs
Share of profits and losses of associates accounted for using the equity method (we will look at associates in Chapter 13)
Income tax expense
A single amount comprising the total of:
–
The post-tax profit or loss of discontinued operations
–
The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets constituting the discontinued operation
Profit or loss
The following items must be disclosed on the face of the income statement as allocations of profit or loss for the period.
Profit or loss attributable to minority interest Profit or loss attributable to equity holders of the parent
The allocated amounts must not be presented as items of income or expense. (These issues relate to group accounts, covered later in this text.) Point to note: Income and expense items can only be offset in certain circumstances (see section 2.6).
5.3
Analysis of expenses An analysis of expenses must be shown either on the face of the income statement (as above, which is encouraged by the standard) or by note, using a classification based on either the nature of the expenses or their function. This sub-classification of expenses indicates a range of components of financial performance; these may differ in terms of stability, potential for gain or loss and predictability. Function of expense/cost of sales method
Expenses are classified according to their function as part of cost of sales, distribution or administrative activities. This method often gives more relevant information for users, but the allocation of expenses by function requires the use of judgement and can be arbitrary. Consequently, perhaps, when this method is used, entities should disclose additional information on the nature of expenses, including staff costs, and depreciation and amortisation expense.
Nature of expense method
Expenses are not reallocated amongst various functions within the entity, but are aggregated in the income statement according to their nature (e.g. purchase of materials, depreciation, wages and salaries, transport costs). This may be the easiest method for smaller entities.
Which of the above methods is chosen by an entity will depend on historical and industry factors, and also the nature of the organisation. The choice of method should fairly reflect the main elements of the entity's performance. These Learning Materials will use the functional analysis in accordance with past UK practice. (It is also more likely to be examined than the nature of expenses method.)
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5.4
Other information presented either on the face of the income statement or in the notes These comprise:
'Exceptional items' These are material items of income and expense which should be disclosed separately. These include:
–
Write downs of inventories to NRV
–
Write down of property, plant and equipment to recoverable amount
–
Disposals of property, plant and equipment
–
Restructuring of the activities of an entity and reversals of any provisions for the cost of restructuring
–
Disposals of investments
–
Discontinued operations
–
Litigation settlements
–
Other reversals of provisions
Details, including per share amounts, of dividends recognised in the financial statements. Point to note: It is now best practice that dividends paid are not shown in the income statement; instead they are shown in the statement of changes in equity.
6 Statement of changes in equity Section overview
6.1
The statement of changes in equity shows the total recognised income and expenses for the period.
Statement of changes in equity The income statement is framed as a straightforward measure of financial performance, in that it shows how the profit or loss for the period has arisen. It is then necessary to link this result with income/expenses in the period which are not shown in the income statement to arrive at the total recognised income and expense for the period. The statement making the link is the statement of changes in equity. This must be presented as a separate component of the financial statements not just included in the notes. The following should be shown on the face of the statement:
The profit or loss for the period
Each item of income and expense for the period that, as required by other standards, has been recognised directly in equity rather than in the income statement
The total income or expense for the period (being the sum of the first two items listed above) showing separately the total amounts attributable to equity holders of the parent and to the minority interest, and
The effect of changes in accounting policy or correction of errors for each component of equity where these have been recognised during the period in accordance with BAS 8 (see Chapter 4).
There is also a need to report transactions between the entity and its shareholders, so dividends paid out and any new capital paid in. This can be included in the notes or in the statement of changes in equity. These Learning Materials follow the second alternative and a suggested the layout is shown below.
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CUm
XYZ Ltd – Statement of Changes in Equity for the year ended [Date]
CUm
CUm
CUm
CUm
Attributable to the Equity Holders of XYZ Ltd
CUm
CUm
CUm
CUm
FORMAT OF FINANCIAL STATEMENTS
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7 Notes to the financial statements Section overview
7.1
Certain items need to be disclosed by way of note.
Contents of notes The notes to the financial statements will amplify the information given in the balance sheet, income statement and statement of changes in equity. We have already noted above the information which BAS 1 allows to be shown by note rather than on the face of the statements. To some extent, then, the contents of the notes will be determined by the level of detail shown on the face of the statements.
7.2
Structure The notes to the financial statements should perform the following functions:
Provide information about the basis on which the financial statements were prepared and which specific accounting policies were chosen and applied to significant transactions/events.
Disclose any information, not shown elsewhere in the financial statements, which is required by BFRSs.
Show any additional information that is necessary for a fair presentation which is not shown on the face of the financial statements.
The way the notes are presented is important. They should be set out in a systematic manner and cross-referenced back to the related figure(s) in the balance sheet, income statement, cash flow statement or statement of changes in equity. Notes to the financial statements will amplify the information shown therein by giving the following:
More detailed analysis or breakdowns of figures in the statements.
Narrative information explaining figures in the statements.
Additional information where items are not included in the financial statements, e.g. contingent liabilities and commitments.
BAS 1 suggests a certain order for the notes to the financial statements. This will assist users when comparing the statements of different entities. (Remember, comparability is one of the qualitative characteristics of useful information.)
Statement of compliance with BFRSs.
Summary of significant accounting policies applied.
Supporting information for items presented on the face of each financial statement in the same order as the financial statements and each line item within them.
Other disclosures, e.g.: – –
Contingent liabilities, commitments and other financial disclosures Non-financial disclosures
The order of specific items may have to be varied occasionally, but a systematic structure is still required.
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7.3
2
Disclosure of accounting policies The accounting policies section should describe the following.
The measurement basis (or bases) used in preparing the financial statements.
The other accounting policies used, as required for a proper understanding of the financial statements.
The judgements, apart from those involving estimations, made by management in applying the accounting policies.
The key assumptions made about the future and other key sources of estimation uncertainty which carry a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
This information may be shown in the notes or sometimes as a separate component of the financial statements. The information on measurement bases used is obviously fundamental to an understanding of the financial statements. Where more than one basis is used, it should be stated to which assets or liabilities each basis has been applied.
7.4
Other disclosures An entity must disclose in the notes:
The amount of dividends proposed or declared before the financial statements were authorised for issue but not recognised as a distribution to equity holders during the period, and the amount per share.
The amount of any cumulative preference dividends not recognised.
BAS 1 ends by listing some specific disclosures which will always be required if they are not shown elsewhere in the financial statements.
The domicile and legal form of the entity, its country of incorporation and the address of the registered office (or, if different, principal place of business).
A description of the nature of the entity's operations and its principal activities.
The name of the parent entity and the ultimate parent entity of the group.
8 Minority interest Section overview
The following amounts must be split between the minority interest and the amount attributable to the equity holders of the parent: – – –
Equity Profit or loss for the period Total income and expense for the period.
A parent company may own less than 100% of a subsidiary, in which case the amount not owned is described as the minority interest. The detail of how to account for such holdings is dealt with in Chapter 10 onwards, so for the moment it is only necessary to note that:
On the face of the balance sheet, equity must be split between the minority interest and the amount attributable to the equity holders of the parent.
On the face of the income statement, the allocation must be shown of the profit or loss for the period between the minority interest and the equity holders of the parent.
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In the statement of changes in equity, the total income and expense for the period must be split between the minority interest and the amount attributable to the equity holders of the parent.
This treatment is consistent with the BFRS Framework's definitions of the elements within financial statements. As there is no present obligation arising out of past events to settle the amount due to the minority interest, it cannot be classified as a liability; instead it must be part of equity, which is the residual once liabilities have been deducted from assets.
9 Not-for-profit entities Section overview
9.1
IPSAS 1 Presentation of Financial Statements provides guidance on the presentation of financial information for public sector bodies.
Presentation of financial statements A complete set of financial statements produced in accordance with IPSAS 1 comprise:
9.2
Statement of financial position Statement of financial performance Statement of changes in net assets/equity Cash flow statement, and Accounting policies and notes to the financial statements.
Statement of financial position This is essentially a balance sheet. The following example is provided by IPSAS 1. Public Sector Entity – Statement of Financial Position as of 31 December 20X2
Assets Current assets Cash and cash equivalents Receivables Inventories Prepayments Investments Non-current assets Receivables Investments Other financial assets Infrastructure, plant and equipment Land and buildings Intangible assets Other non-financial assets
20X2 CU’000 X X X X X
20X1 CU’000
X X X X X X X
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20X1 CU’000
X X X X X X
Total assets
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20X2 CU’000
X X
X X X X X X X X
X X
FORMAT OF FINANCIAL STATEMENTS
20X2 CU’000
Liabilities Current liabilities Payables Short-term borrowings Current portion of borrowing Provisions Employee benefits
X X X X X
Non-current liabilities Payables Borrowings Provisions Employee benefits
X X X X
Total liabilities Net assets Net Assets/Equity Capital contributed by other government entities Reserves Accumulated surpluses/(deficits) Minority interest Total net assets/equity
9.3
X X X
20X2 CU’000
20X1 CU’000
X
X X X
X X X
X X X X X X X X X
X X X
2
20X1 CU’000
X
X X X
X X X
Statement of financial performance This is essentially an income statement. The following example is provided by IPSAS 1. Public sector entity – Statement of Financial Performance for the year ended 31 December 20X2 (illustrating the classification of expenses by function) 20X2 20X1 CU’000 CU’000 Operating revenue Taxes X X Fees, fines, penalties and licences X X Revenue from exchange transactions X X Transfers from other government entities X X Total operating revenue X X Operating expenses General public services Defence Public order and safety Education Health Social protection Housing and community amenities Recreational, cultural and religion Economic affairs Environmental protection Total operating expenses
X X X X X X X X X X X
X X X X X X X X X X X
Surplus/(deficit) from operating activities Finance costs Gains on sale of property, plant and equipment Total non-operating revenue/(expenses)
X (X) X (X)
X (X) X (X)
Surplus/(deficit) from continuing activities Minority interest share of surplus/(deficit)
X (X)
X (X)
X
X
Net surplus/(deficit) for the period
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Summary and Self-test
Financial Statements
Summary
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Self-test Answer the following questions 1
According to BAS 1 Presentation of Financial Statements, which of the following must be recognised in the income statement? A B C D
2
3
4
Equity dividends paid Revaluation gains Depreciation Effects of a change in accounting policy
Which of the following form the components of a full set of financial statements according to BAS 1 Presentation of Financial Statements? (1) (2) (3) (4) (5) (6)
Balance sheet Income statement Statement of changes in equity Cash flow statement Accounting policy note Explanatory notes
A B C D
All of them (1), (2), (3) and (4) only (1), (2), (3), (4) and (5) only (1), (2) and (4) only
Which of the following must be presented on the face of the income statement according to BAS 1 Presentation of Financial Statements? (1) (2) (3) (4)
Tax expense Revenue Finance cost Depreciation expense
A B C D
(1), (2), (3) and (4) (1), (2) and (3) only (1), (3) and (4) only (2) and (4) only
In accordance with BFRS what typically comprises the first line of the income statement and profit and loss account? A B C D
Revenue Turnover Sales Income
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Financial accounting 5
The income statement of Bell Holdings Ltd showed a profit of CU183,000 for the year ended 30 June 20X7. During the year the following transactions occurred. (1) Equity dividends of CU18,000. (2) Capitalised borrowing costs of CU45,000 were written off directly to retained earnings as a result of a change in accounting policy. (3) Property with a carrying amount of CU60,000 was revalued to CU135,000, which gave rise to additional depreciation of CU8,000. The total equity balance brought forward at 1 July 20X6 from the statement of changes in equity was CU2,123,000. In accordance with BAS 1 Presentation of Financial Statements what is the total equity balance at 30 June 20X7 in the statement of changes in equity? A B C D
6
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CU2,336,000 CU2,318,000 CU2,381,000 CU2,310,000
Which of the following constitutes a complete set of financial statements in accordance with IPSAS 1 Presentation of Financial Statements? (1) (2) (3) (4) (5)
Statement of financial position Statement of financial performance Statement of changes in net assets/equity Cash flow statement Accounting policies and notes to the financial statements
A B C D
(1) and (3) only (1), (2) and (4) only (3) and (5) only All of them
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RADICAL LTD
2
(Note: this question is included to provide practice of basic techniques)
After closing off the profit and loss account for the year ended 30 September 20Y2 the following draft balance sheet was extracted from the nominal ledger of Radical Ltd. Balance sheet at 30 September 20Y2
Ordinary share capital Preference share capital (irredeemable) 9% Loan stock Trade creditors Aggregate depreciation at 1 October 20Y1 Freehold buildings Motor vehicles Provision for bad debts Profit and loss account Share premium account Corporation tax at 31% Disposals of fixed assets (see note (2))
Stocks on hand, at cost Trade debtors Cash in hand Balance at bank 42,735 Fixed assets at cost 1 October 20Y1 Freehold buildings Motor vehicles Ordinary shares in Midland Bank Ltd, at cost Prepayments Additions to fixed assets (see note (2))
Credits CU 250,000 100,000 150,000 64,700 2,500 117,830 13,420 198,885 52,400 26,750 8,000 984,485 Debits CU 192,734 172,062 2,431 105,000 377,845 22,632 2,596 66,450 984,485
You also obtain the following information. (1) The balance on corporation tax account was due for payment nine months after the year end. (2) Additional motor vehicles were purchased during the year at a cost of CU40,450, and additions to freehold property were CU26,000. Cars which had cost CU11,500 had been disposed of for CU8,000 when their book value had been CU6,200. (3) Depreciation has still to be charged for the year as follows. Freehold buildings Motor vehicles
CU2,500 CU84,000
Requirement Prepare the company’s balance sheet as at 30 September 20Y2.
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Financial accounting 8
HENDON LTD
(Note: this question is included to provide practice of basic techniques)
For the year ended 15 July 20Y8 the accountant of Hendon Ltd has closed each of the ledger accounts to arrive at the following balances. At 16 July 20Y7 Inventories Profit and loss account Provision for depreciation Freehold buildings Motor vehicles Plant and machinery Rental income Sales Trade receivables Purchases Trade payables Discounts Allowed Received Sundry business expenses Wages Salaries Office Directors’ remuneration Dividends Declared and paid Received Interest Paid Received Freehold land Freehold buildings Motor vehicles Plant and machinery 10% debentures 14 July 20Y9 14 July 20Z5 Share premium account 25p ordinary shares Investments Bank (debit) New share issue account
CU 180,900 170,555 20,000 28,000 22,100 12,120 962,300 112,870 777,200 210,800 53,400 27,405 73,500 74,000 10,000 30,000 40,000 20,000 12,500 10,000 70,000 160,000 124,200 74,300 35,000 90,000 66,000 200,000 58,000 61,410 38,000
Following a physical count closing inventories were determined to be CU210,000. In addition the accountant discovers the following. (1) The debenture interest is payable in arrears on 14 July until maturity. (2) One motor vehicle, stated in the accounts at cost of CU8,000 with accumulated depreciation of CU2,000, was stolen during the year. The insurance company has agreed to pay CU7,000 in full settlement. No entries have been made in the books in respect of this matter. (3) The company depreciates assets using the reducing balance method. The relevant rates are as follows. Freehold buildings Plant and machinery Motor vehicles
2% 10% 25%
Freehold land is not depreciated. (4) During the year the company issued 40,000 25p ordinary shares at 95 pence each. The proceeds have been credited to the new shares issue account and still need to be properly accounted for.
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Requirements Prepare an income statement for the year ended 15 July 20Y8 and a balance sheet as at 15 July 20Y8. Note: Ignore comparatives and taxation. 9
OSCAR LTD The following trial balance has been extracted from the books of account of Oscar Ltd as at 31 March 20X8. Administrative expenses Ordinary share capital Trade receivables Bank overdraft Provision for warranty costs Distribution costs Non-current asset investments Investment income Finance cost Freehold land and buildings at cost Plant and equipment At cost Accumulated depreciation (at 31 March 20X8) Retained earnings (at 1 April 20X7) Purchases Inventories (at 1 April 20X7) Trade payables Revenue 20X7 final dividend paid 20X8 interim dividend paid
CU'000 210
CU'000 600
470
80 205
420 560 75
10 200 550
220 180
960 150
260 2,010 65 35 3,630
3,630
Additional information (1) Inventories at 31 March 20X8 were valued at CU160,000. (2) The following items are already included in the balances listed in this trial balance.
Depreciation charge for the year Employee benefits
Distribution costs CU'000 27 150
Administrative expenses CU'000 5 80
(3) The income tax charge for the year is estimated at CU74,000. (4) The warranty provision is to be increased by CU16,000, charged to administrative expenses. (5) Staff bonuses totalling CU40,000 are to be provided for, charged equally to distribution costs and administrative expenses. (6) The freehold land and buildings were bought on the last day of the accounting period at a bargain price. They are to be revalued to CU280,000. (7) In May 20X8 a final dividend for 20X8 of 10p per share was proposed on each of the company’s 600,000 ordinary shares. Requirement Prepare Oscar Ltd’s income statement and statement of changes in equity for the year to 31 March 20X8, a balance sheet at that date and notes in accordance with the requirements of BAS 1 Presentation of Financial Statements to the extent the information is available. (12 marks)
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Financial accounting 10
MORTIMER LTD The following trial balance was extracted from the books of Mortimer Ltd, a manufacturing company, as at 31 August 20X9. Accruals Administrative expenses Bank deposit Bank current account Bank loan Bank interest Warranty provision Distribution expenses Land and buildings Cost Depreciation Loan interest Mortgage Mortgage interest Plant and machinery Cost Depreciation Prepayments Retained earnings General reserve Purchases Trade payables Revenue Trade receivables Ordinary share capital Share premium account Inventories, as at 31 August 20X8
CU 4,000
CU 153,000 20,000 4,000
58,000 5,000 19,000 175,000 840,000 166,000
8,000
90,000 14,000 714,000 368,000
2,000
138,000 21,000 2,678,000 80,000 3,290,000 105,000 382,000 199,000 107,000 4,820,000
4,820,000
You also obtain the following information. (1) Depreciation is to be provided on the straight-line method on buildings at 2% per annum and on plant and machinery at 20% pa. The cost of buildings at 31 August 20X9 was CU650,000. (2) Inventories at 31 August 20X9 comprised raw materials CU113,000, work in progress CU12,000 and finished goods CU54,000. (3) The original mortgage of CU225,000 was taken out on 1 September 20X0 for a term of 15 years, repayable in equal monthly instalments on the 25th day of each month. (4) The bank loan was granted on 1 May 20X6 for a fixed term of ten years. (5) Provision is to be made for income tax of CU68,000, based on the results of the year. (6) A transfer of CU21,000 was made to the general reserve during the year. Requirements (a)
Prepare Mortimer Ltd's income statement and statement of changes in equity for the year ended 31 August 20X9 and balance sheet at that date in accordance with the requirements of BAS 1 Presentation of Financial Statements to the extent the information is available. You are not required to produce any notes thereto. (18 marks)
(b) Explain the concept of 'fair presentation'.
(3 marks) (21 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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2
Technical reference Point to note: The whole of BAS 1 is examinable with the exception of paragraphs 124A-124C and IG5 and IG6. The paragraphs listed below are the key references you should be familiar with. 1 BAS 1
Applies to all general purpose financial statements.
Links back to much in the BFRS Framework: Fair/faithful presentation
–
Going concern
BAS 1 (23-24) Frame (23)
–
Accrual basis of accounting
BAS 1 (25-26) Frame (22)
–
Consistency of presentation
BAS 1 (27-28) Frame (39-41)
–
Materiality and aggregation
BAS 1 (29-31) Frame (29-30)
–
Offsetting
BAS 1 (32-35)
–
Comparative information
BAS 1 (36-41) Frame (42)
Presentation and disclosure rules apply only to material items
Balance sheet:
BAS 1 (13) Frame (33-35, 46)
–
BAS 1 (2-5)
–
Layout as in proforma above
–
Distinction between current and non-current
–
Linked to the operating cycle of the business, not just the next 12 months
–
Some items must be on the face, others can be in the notes
BAS 1 (31 and 11)
BAS 1 (51)
BAS 1 (68-76)
Income statement: –
Layout as in proformas above
–
Some items must be on the face, others can be in the notes
–
No extraordinary items
–
No dividends paid or payable
–
Allocate net profit for the period between parent company equity holders and minority interest
BAS 1 (81-87) BAS 1 (85)
Statement of changes in equity: –
Layout as in proforma above
–
Revaluation surpluses shown here
–
Dividends declared by balance sheet date
BAS 1 (82) BAS 1 (96-99)
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Notes –
What must be included
BAS 1 (103)
–
The systematic manner in which it must be disclosed
BAS 1 (104)
–
The disclosure of the measurement bases (e.g. historical cost, fair value) and the other accounting policies used. Note the matters which an entity must consider when deciding what to disclose
BAS 1 (108)
–
The judgements made by management in applying the accounting policies
BAS 1 (113)
–
The key measurement assumptions made about the future which carry the significant risk of causing a material adjustment to assets and liabilities
BAS 1 (116)
–
The disclosure of ordinary dividends proposed or declared after the period end and not recognised in the accounting period. Such dividends do not fall within the definition of a liability at the period end, so cannot be recognised until the next accounting period
BAS 1 (125)
–
The disclosure of registration details about the entity, its operations and activities and, if it is in a group of companies, its parent and ultimate parent company
BAS 1 (126)
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Answers to Self-test 1
C
Depreciation should be charged to the income statement, the other items should be taken to the statement of changes in equity.
2
A
Per BAS 1 paragraph 8.
3
B
All items should be shown on the face of the income statement except depreciation which may be disclosed in a note (BAS 1 paragraph 88).
4
A
Although BAS 1 allows amendment according to the entity's transactions (BAS 1 paragraph 81 and 71(b)).
5
B
The additional depreciation of CU8,000 will have already been charged in the income statement. Equity CU 2,078,000 183,000 (18,000) 75,000 2,318,000
B/f (2,123,000 – 45,000) Profit Dividends Revaluation (135,000 – 60,000) 6
D
Per IPSAS 1
7
RADICAL LTD Balance sheet as at 30 September 20Y2 CU
CU
ASSETS Non-current assets Property, plant and equipment (W5) Investments
336,265 22,632 358,897
Current assets Inventories Trade and other receivables (W1) Prepayments Cash and cash equivalents (W3)
192,734 158,642 2,596 45,166 399,138 758,035
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Preference share capital Share premium Accumulated profits/losses (W2)
250,000 100,000 52,400 114,185 516,585
Non-current liabilities Interest-bearing borrowings
150,000
Current liabilities Trade and other payables Tax payable
64,700 26,750
Total equity and liabilities
91,540 758,035
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Financial accounting WORKINGS (1) Trade and other receivables CU 172,062 (13,420) 158,642
Trade debtors Less Provision (2) Accumulated profits/losses
CU 173,885 (86,500) 1,800 89,185
Per draft Less Depreciation charge (2,500 + 84,000) Add Profit on sale of cars (8,000 – 6,200) (3) Cash and cash equivalents
CU 2,431 42,735 45,166
In hand At bank (4) Property, plant and equipment
Cost or valuation B/f Additions Disposals C/f Accumulated depreciation B/f Charge Disposals C/f
Freehold buildings CU 105,000 26,000 – 131,000
Motor vehicles CU 377,845 40,450 (11,500) 406,795
CU 2,500 2,500 – 5,000
CU 117,830 84,000 (5,300) 96,530
(5) Analysis of property, plant and equipment Cost or valuation
Fixed assets Freehold buildings Motor vehicles 8
Net book value
(W4) CU
Accumulated depreciation (W4) CU
131,000 406,795 537,795
5,000 196,530 201,530
126,000 210,265 336,265
HENDON LTD Income statement for the year ended 15 July 20Y8 Revenue Cost of sales (W8) Gross profit Other operating income Distribution costs (W8) Administrative expenses (W8) Profit/loss from operations Finance cost (W2) Investment income Net profit/loss for the period
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CU 962,300 (753,320) 208,980 39,525 (21,550) (243,700) (16,745) (12,500) 30,000 755
CU
FORMAT OF FINANCIAL STATEMENTS
2
Balance sheet as at 15 July 20Y8 CU
CU
ASSETS Non-current assets Property, plant and equipment Investments Current assets Inventories Trade and other receivables (W9) Cash and cash equivalents
321,830 58,000 379,830 210,000 119,870 61,410 391,280 771,110
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (W4) Share premium (W5) Accumulated profits/losses (W6)
210,000 94,000 131,310 435,310
Non-current liabilities Interest-bearing borrowings
90,000
Current liabilities Trade and other payables Short-term borrowings
210,800 35,000 245,800 771,110
Total equity and liabilities WORKINGS (1) Accumulated depreciation
Freehold (160,000 – 20,000) 2%) Vehicles (((124,200 – 8,000) – (28,000 – 2,000)) 25%) Plant (74,300 – 22,100) 10%
CU 2,800 22,550 5,220
B/f CU 20,000 28,000 22,100
Disposals CU – (2,000) –
C/f 22,800 48,550 27,320
(2) Finance cost 20Y9 debentures (35,000 10%) 20Z5 debentures (90,000 10%)
CU 3,500 9,000 12,500
All interest due has been paid in year. (3) Cost of property, plant and equipment Freehold (70,000 + 160,000)) Vehicles (124,200 – 8,000)
CU 230,000 116,200
(4) Ordinary share capital Per TB New issue (40,000 25p)
CU 200,000 10,000 210,000
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Financial accounting (5) Share premium CU 66,000 28,000 94,000
Per TB New issue ((95p – 25p) 40,000) (6)
ACCUMULATED PROFITS/LOSSES Dividends C/d
CU 40,000 131,310 171,310
CU 170,555 755 171,310
B/d Profit for the period
(7) Trade and other receivables CU 112,870 7,000 119,870
Trade receivables Insurance claim (8) Analysis of expenses Cost of sales Opening stock Purchases Discounts allowed Closing stock Plant and machinery – depreciation charge (W1) Motor vehicles – depreciation charge (W1) Freehold buildings – depreciation charge (W1) Profit on disposal of fixed assets Expenses
CU 180,900 777,200 (210,000) 5,220
Distribution costs CU
Administrative expenses CU 53,400
22,550 2,800 (1,000)
753,320
21,550
187,500 243,700
(9) Analysis of property, plant and equipment
Fixed assets Freehold buildings Motor vehicles Plant and machinery 9
Cost or valuation (W3) CU 230,000 116,200 74,300 420,500
Net book value CU 207,200 67,650 46,980 321,830
OSCAR LTD Financial statements Income statement for the year ended 31 March 20X8 Revenue Cost of sales (960 + 150 – 160) Gross profit Distribution costs (420 + 20) Administrative expenses (210 + 16 + 20) Profit from operations Finance cost Investment income Profit before tax Income tax Profit for the year
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Accumulated depreciation (W1) CU 22,800 48,550 27,320 98,670
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CU'000 2,010 (950) 1,060 (440) (246) 374 (10) 75 439 (74) 365
FORMAT OF FINANCIAL STATEMENTS
Statement of changes in equity for the year ended 31 March 20X8 Ordinary share Revaluation capital reserve CU'000 CU'000 Attributable to the equity holders of Oscar Ltd Recognised directly in equity Revaluation of non-current assets – 80 Profit for the year – – Total recognised income and expense for the period – 80 20X7 final dividend – – 20X8 interim dividend – – – 80 Balance brought forward 600 – Balance carried forward 600 80 Notes
2
Retained earnings CU'000 – 365 365 (65) (35) 265 180 445
(1) The profit from operations is arrived at after charging CU'000 32 270
Depreciation (27 + 5) Employee benefits (150 + 80 + 40) (2) A final dividend for 20X8 of CU60,000 (10p per share) is proposed. Balance sheet as at 31 March 20X8 ASSETS Non-current assets Property, plant and equipment (200 + 550 + 80 – 220) Investments Current assets Inventories Trade and other receivables
CU'000
CU'000 610 560 1,170
160 470 630 1,800
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Revaluation reserve Retained earnings Equity Non-current liabilities Provision for warranty costs (205 + 16) Current liabilities Trade and other payables (260 + 40) Taxation Borrowings Total equity and liabilities
600 80 445 1,125 221 300 74 80
454 1,800
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MORTIMER LTD (a)
Financial statements Income statement for the year ended 31 August 20X9 CU 3,290,000 (2,748,800) 541,200 (175,000) (166,000) 200,200 (22,000) 5,000 183,200 (68,000) 115,200
Revenue Cost of sales (W1) Gross profit Distribution costs (W1) Administrative expenses (W1) Profit from operations Finance cost (W1) Investment income Profit before tax Income tax Profit for the period Statement of changes in equity for the year ended 31 August 20X9 Attributable to the equity holders of Mortimer Ltd Recognised directly in equity Transfer between reserves Total recognised directly in equity Profit for the period Total recognised income and expense for the period Balance brought forward (W3) Balance carried forward
Ordinary share capital CU
Share premium account CU
General reserve CU
Retained earnings CU
Total CU
– –
– –
21,000 21,000
(21,000) (21,000)
– –
– –
– –
– 21,000
115,200 94,200
115,200 115,200
382,000 382,000
199,000 199,000
– 21,000
159,000 253,200
740,000 855,200
Balance sheet as at 31 August 20X9 CU ASSETS Non-current assets Property, plant and equipment (W2) Current assets Inventories (W1) Trade and other receivables (105,000 + 2,000) Cash and cash equivalents (20,000 + 4,000) Total assets
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CU 864,200
179,000 107,000 24,000 310,000 1,174,200
FORMAT OF FINANCIAL STATEMENTS
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account General reserve Retained earnings
CU
2
CU 382,000 199,000 21,000 253,200
Attributable to equity holders of Mortimer Ltd Non-current liabilities Borrowings (90,000 – 15,000 + 58,000) Current liabilities Trade and other payables (4,000 + 80,000) Tax Provisions Borrowings 225,000 15 Total equity and liabilities
855,200 133,000 84,000 68,000 19,000 15,000
186,000 1,174,200
(b) Fair presentation and a true and fair view BAS 1 Presentation of Financial Statements describes the concept of fair presentation. Fair presentation involves:
Representing faithfully the effect of transactions, other events and conditions, and In accordance with the definitions and recognition criteria in BFRS Framework.
This is developed by stating that the application of BFRS, Interpretations and additional disclosures will result in fair presentation. True could be approximated to ‘represent faithfully’ and fair to ‘fair presentation’. BAS 1 links them by stating that compliance with standards will give a fair presentation. BAS 1 requires the financial statements to present fairly the financial position and performance of an entity rather than a true and fair view. 'Present fairly' is further described as representing faithfully the effects of transactions and as a result there is unlikely to be a difference between the two. Whilst not dealing with the concepts directly, BFRS Framework uses the descriptions of fair presentation and true and fair view interchangeably in its discussion of the application of the principal qualitative characteristics of financial information. WORKINGS (1) Allocation of expenses
Per Q Loan interest Mortgage interest Opening inventories Depreciation Plant (714,000 x 20%) Buildings (650,000 x 2%) Closing inventories (113,000 + 12,000 + 54,000)
Cost of sales CU 2,678,000
Distribution CU 175,000
Administration CU 153,000
8,000 14,000
107,000 142,800 (179,000) 2,748,800
Finance cost CU
13,000 175,000
166,000
22,000
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Financial accounting (2) Property, plant and equipment
Cost Depreciation At 1 September 20X8 Charge for the year (W1) At 31 August 20X9 Carrying amount
Land and buildings CU 840,000
Plant and machinery CU 714,000
166,000 13,000 179,000 661,000
368,000 142,800 510,800 203,200
Total CU
864,200
(3) Retained earnings b/f Per trial balance Add transfer to general reserve already made Retained earnings at start of year
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CU 138,000 21,000 159,000
chapter 3
Cash flow statements Contents Introduction Examination context Topic List 1
Cash flow information
2
Presentation of a cash flow statement
3
Operating activities
4
Investing activities
5
Financing activities
6
Disclosures
7
Preparing a cash flow statement
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Tick off
Prepare the cash flow statement of an individual entity in accordance with BAS 7
Specific syllabus references for this chapter are: 2a, b, c.
Practical significance It has been argued that 'profit' does not always give a useful or meaningful picture of a company's operations. Readers of a company's financial statements might even be misled by a reported profit figure. (a)
Shareholders might believe that if a company makes a profit after tax of, say, CU100,000 then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong.
(b) Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This opinion may not be correct: the ability to pay wages depends on the availability of cash. (c)
Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due. Such payments might include 'revenue' items such as material purchases, wages, interest and taxation etc, but also capital payments for new non-current assets and the repayment of loan capital when this falls due (for example on the redemption of debentures).
From these examples, it may be apparent that a company's performance and prospects depend not so much on the 'profits' earned in a period, but more realistically on liquidity or cash flows.
Stop and think Can you think of some possible disadvantages of cash flow accounting?
Working context As we will see the preparation of the cash flow statement is very dependent on information contained in the income statement and balance sheet. This is not just an accounting issue however, but will also have an impact on the amount of audit work which will need to be carried out on these balances. Audit work on the cash flow statement can be more limited than that carried out on the income statement and balance sheet as the cash flows are derived from balance sheet and income statement balances which have already been subjected to detailed audit procedures.
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Syllabus links This is the first time that you will have come across a cash flow statement in your studies. However, as you will see in the rest of the chapter, most of the information needed to produce a cash flow statement is contained in the income statement and balance sheet, both of which you will be familiar with from your Accounting studies. The topic also relates to the underlying assumptions of accounting which were discussed in Chapter 1, in particular the distinction between accrual accounting and cash accounting. In this chapter we introduce the preparation of the cash flow statement of the individual company. Chapter 16 covers the preparation of group cash flow statements. Both of these aspects are also highly relevant in the Financial & Corporate Reporting paper and at the Advanced Stage, where the emphasis will change from preparation to analysis and interpretation.
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Financial accounting
Examination context
Exam requirements As 55% of the syllabus deals with the preparation of single company financial statements, and this includes the cash flow statement, it is likely that this topic will be examined regularly. In an examination you would either be asked to prepare a full cash flow statement or to prepare cash flow statement extracts and/or to answer a number short-form questions. In the examination, candidates may be required to:
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Prepare and present a cash flow statement for an individual entity in accordance with BAS 7 Cash Flow Statements
Prepare extracts from the cash flow statement of an individual entity.
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1 Cash flow information Section overview
1.1
The cash flow statement shows movements in cash and cash equivalents. All entities are required to produce a cash flow statement.
Objective of BAS 7 The objective of BAS 7 Cash Flow Statements is to provide historical information about changes in cash and cash equivalents, classifying cash flows between operating, investing and financing activities. This will provide information to users of financial statements about the entity's ability to generate cash and cash equivalents, as well as indicating the cash needs of the entity.
Definition Cash flows: These are inflows and outflows of cash and cash equivalents.
1.2
Scope A cash flow statement should be presented as an integral part of an entity's financial statements. All types of entity can provide useful information about cash flows as the need for cash is universal, whatever the nature of their revenue-producing activities. Therefore all entities are required by the standard to produce a cash flow statement.
1.3
Benefits of cash flow information Cash flow statements should be used in conjunction with the rest of the financial statements. Users can gain further appreciation of:
The change in net assets
The entity's financial position (liquidity and solvency)
The entity's ability to adapt to changing circumstances and opportunities by affecting the amount and timing of cash flows
Cash flow statements enhance comparability as they are not affected by differing accounting policies used for the same type of transactions or events. Cash flow information of a historical nature can be used as an indicator of the amount, timing and certainty of future cash flows. Past forecast cash flow information can be checked for accuracy as actual figures emerge. The relationship between profit and net cash flow and the impact of changing prices can be analysed over time.
1.4
Cash and cash equivalents The cash flow statement shows movements in cash and cash equivalents.
Definitions Cash: Comprises cash on hand and demand deposits. Cash equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value.
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Financial accounting BAS 7 expands on the definition of cash equivalents: they are not held for investment or other long-term purposes, but rather to meet short-term cash commitments. To fulfil the above definition, an investment's maturity date should normally be within three months from its acquisition date. It would usually be the case then that equity investments (i.e. shares in other companies) are not cash equivalents. An exception would be where preference shares were acquired with a very close maturity date. Points to note: (1) Loans and other borrowings from banks are classified as financing activities. In some countries, however, bank overdrafts are repayable on demand and are treated as part of an entity's total cash management system. In these circumstances an overdrawn balance will be included in cash and cash equivalents. Such banking arrangements are characterised by a balance which fluctuates between overdrawn and credit. In the absence of other information you should assume, in the exam, that bank overdrafts are repayable on demand and should therefore be classed as cash and cash equivalents. (2) Movements between different types of cash and cash equivalent are not included in cash flows. The investment of surplus cash in cash equivalents is part of cash management, not part of operating, investing or financing activities.
2 Presentation of a cash flow statement Section overview
Cash flows are classified as: – – –
2.1
Operating activities Investing activities, and Financing activities.
Presentation BAS 7 requires cash flow statements to report cash flows during the period classified by:
2.2
Operating activities: These are primarily derived from the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.
Investing activities: These are the cash flows derived from acquisition and disposal of non-current assets and other investments not included in cash equivalents.
Financing activities: These are activities that result in changes in the size and composition of the equity capital and borrowings of the entity.
Example of a cash flow statement We will look at the procedure for preparing a cash flow statement later in this chapter, but first, we will look at a proforma adapted from the example given in the standard.
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Cash flow statement Year ended 31 December 20X7 CUm Cash flows from operating activities Cash generated from operations Interest paid Income taxes paid
CUm
2,730 (270) (900)
Net cash from operating activities
1,560
Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of property, plant and equipment Interest received Dividends received
(900) 20 200 200
Net cash used in investing activities
(480)
Cash flows from financing activities Proceeds from issue of share capital Proceeds from issue of long-term borrowings Dividends paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period
250 250 (1,290) (790) 290 120 410
Points to note 1
The headings in italics are necessary to comply with the standard.
2
The information to prepare a cash flow statement can be obtained from the figures in the
Balance sheet at the start of the period Balance sheet at the end of the period Income statement for the period Supporting notes
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Financial accounting
3 Operating activities Section overview
Cash flows from operating activities are primarily derived from the principal revenue producing activities of the entity.
There are two methods for calculating and analysing cash generated from operations: – –
3.1
The direct method The indirect method
Cash generated from operations is adjusted for payments of interest and income tax to arrive at net cash from operating activities.
Operating activities This is perhaps the key part of the cash flow statement because it shows whether, and to what extent, companies can generate cash from their operations as other cash inflows may be non-recurring. It is these operating cash flows which must, in the end pay for all cash outflows relating to other activities, i.e. paying loan interest, dividends and so on. Most of the components of cash flows from operating activities will be those items which determine the net profit or loss of the entity, i.e. they relate to the main revenue-producing activities of the entity. The standard gives the following as examples of cash flows from operating activities.
Cash receipts from the sale of goods and the rendering of services. Cash receipts from royalties, fees, commissions and other revenue. Cash payments to suppliers for goods and services. Cash payments to and on behalf of employees.
Cash flows from interest paid and income taxes paid are also dealt with here.
3.2
Cash generated from operations BAS 7 allows two possible layouts for cash generated from operations
The indirect method The direct method.
The direct method is preferred by BAS 7 but not required. In practical terms the indirect method is likely to be easier and less time consuming to prepare and is more likely to be examined. In the exam you should use the indirect method unless the question specifies otherwise.
3.3
Indirect method Using the indirect method, cash generated from operations is calculated by performing a reconciliation between:
Profit before tax as reported in the income statement, and Cash generated from operations.
This reconciliation is produced as follows:
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Reconciliation of profit/loss before tax to cash generated from operations for the year ended 31 December 20X7 CU X X (X) X X X/(X) (X)/X (X)/X (X)/X (X)/X (X)/X (X)/X X
Profit/(loss) before tax Finance cost Investment income Depreciation charge Amortisation charge Loss/(profit) on disposal of non-current assets (Increase)/decrease in inventories (Increase)/decrease in trade and other receivables (Increase)/decrease in prepayments Increase/(decrease) in trade and other payables Increase/(decrease) in accruals Increase/(decrease) in provisions Cash generated from operations You should show this reconciliation as a note to the cash flow statement.
3.4
Explanation It is important that you understand why certain items are added and others are subtracted. Note the following points:
Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the income statement. It makes sense, therefore, to eliminate it by adding it back.
By the same logic a loss on disposal of a non-current asset (arising through underprovision of depreciation) needs to be added back, and a profit deducted.
An increase in inventories means less cash – the company has spent cash on buying inventory.
An increase in receivables means the company's debtors have not paid as much, and therefore there is less cash.
If the entity pays off payables, causing the figure to decrease, again there is less cash.
Worked example: Indirect method A business has the following balance sheet balances. 30 June 20X7 CU 3,200 2,900 800
Inventories Trade and other receivables Trade and other payables
30 June 20X6 CU 4,000 2,500 1,000
For the year ended 30 June 20X7 you also have the following information: Profit before tax Finance cost Investment income
CU 6,100 200 100
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Financial accounting
Solution Cash generated from operations would be calculated and disclosed as follows. Reconciliation of profit before tax to cash generated from operations for the year ended 30 June 20X7 CU 6,100 200 (100) 800 (400) (200) 6,400
Profit before tax Finance cost Investment income Decrease in inventories Increase in trade and other receivables Decrease in trade and other payables Cash generated from operations
3.5
Direct method Using the direct method, cash generated from operations would be analysed as follows and shown as a note to the cash flow statement: Gross operating cash flows for the year ended 31 December 20X7 Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations
CU X (X) (X)
Worked example: Direct method Hail Ltd commenced trading on 1 January 20X7 following a share issue which raised CU35,000. During the year the company entered into the following transactions:
Purchases from suppliers were CU19,500, of which CU2,550 was unpaid at the year end. Wages and salaries amounted to CU10,500, of which CU750 was unpaid at the year end. Sales revenue was CU29,400, including CU900 receivables at the year end.
Solution Cash generated from operations would be calculated and disclosed as follows: Gross operating cash flows for the year ended 31 December 20X7 Cash received from customers (29,400 – 900) Cash paid to suppliers and employees Cash generated from operations WORKING Cash paid to suppliers (19,500 – 2,550) Cash paid to and on behalf of employees (10,500 – 750) Cash paid to suppliers and employees
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CU 28,500 (26,700) (W) 1,800 CU 16,950 9,750 26,700
CASH FLOW STATEMENTS
3.6
3
Payments of interest and tax The adjustments in the cash flow statement to 'cash generated from operations' to arrive at 'net cash from operating activities' consist of payments of interest and income tax. A similar method can be used to calculate the cash flows for interest paid and income tax paid. For each item, the information available might be:
Opening balance at the start of the period (opening balance sheet) Income statement (the amount of the item, as reported) Closing balance at the end of the period (closing balance sheet)
The cash flow is a balancing figure obtained from these three figures. A T account can be used as a working.
Worked example: Interest paid A company’s financial statements show the following information: At 1 Jan 20X2 CU 54,000
Interest payable Interest charge
At 31 Dec 20X2 CU 63,000
For the year 20X2 CU 240,000
Interest paid is calculated as follows. INTEREST PAID Cash payment (balancing figure) Balance c/d
CU 231,000 63,000 294,000
Balance b/d Income statement
CU 54,000 240,000 294,000
Alternatively, this could be calculated as follows: (54,000 + 240,000 – 63,000) = CU231,000
A similar technique can be used to calculate payments of income tax in the year. The taxation payment refers to payments of income tax, not to payments of sales tax (VAT) or tax paid by employees. The opening and closing balance sheets will show a liability for income tax. The income tax charge for the year is shown on the face of the income statement. The figure for income taxes paid during the year is derived as a balancing figure.
Interactive question 1: Income tax
[Difficulty level: Easy]
A company had a liability for income tax at 31 December 20X6 of CU940,000 and a liability for income tax at 31 December 20X7 of CU1,125,000. The income tax charge for the year to 31 December 20X7 was CU1,270,000. What amount of income tax was paid during the year? INCOME TAX PAID CU
CU
See Answer at the end of this chapter.
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4 Investing activities Section overview
4.1
The cash flows in this section are those related to the acquisition or disposal of any non-current assets, and returns received in cash from investments.
Investing activities The cash flows classified under this heading show the extent of new investment in assets which will generate future income and cash flows. The standard gives the following examples of cash flows arising from investing activities.
4.2
Cash payments to acquire property, plant and equipment, intangibles and other non-current assets, including those relating to capitalised development costs and self-constructed property, plant and equipment
Cash receipts from sales of property, plant and equipment, intangibles and other non-current assets
Cash payments to acquire equity or debt of other entities
Cash receipts from sales of equity or debt of other entities
Interest received
Dividends received
Cash receipts from sales of property, plant and equipment A T account can be used for calculating the cash receipts from sales of property, plant and equipment (PPE). The company's accounts will include the amount of any profit or loss on disposal. A note to the accounts on non-current assets will show the cost and the accumulated depreciation for property, plant and equipment disposed of during the year. The cash received from the sale is the balancing figure in the T account. PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT Cost/valuation of asset disposed of Profit on disposal
CU X X X
Accumulated depreciation Loss on disposal Cash received (balancing figure)
CU X X X X
Worked example: Cash receipts from sale of PPE A company's balance sheet as at the beginning and the end of the year showed the following. Property, plant and equipment
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Cost At 1 January 20X7 Disposals At 31 December 20X7
CU 760,000 (240,000) 520,000
Depreciation At 1 January 20X7 Disposals Charge for year At 31 December 20X7
270,000 (180,000) (50,000) 140,000
Carrying amount At 31 December 20X7 At 31 December 20X6
380,000 490,000
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CASH FLOW STATEMENTS
3
The property, plant and equipment was disposed of at a loss of CU7,000. What was the cash flow from the disposal?
Solution The balancing figure can be obtained by constructing a disposal of property, plant and equipment account as a working. PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT CU 240,000
Cost
Accumulated depreciation Loss on disposal Cash received (balancing figure)
240,000
4.3
CU 180,000 7,000 53,000 240,000
Cash payments for purchase of property, plant and equipment Purchase of property, plant and equipment during a period can be calculated by means of a T account or a working table. PROPERTY, PLANT AND EQUIPMENT CU X X X X
Balance b/d Revaluation reserve Additions (balancing figure)
CU X
Disposals Balance c/d
Interactive question 2: Cash payments for PPE
X X [Difficulty level: Intermediate]
A company's accounts show that at 31 December 20X7, it had property, plant and equipment at cost or valuation of CU6,800,000. During the year, it disposed of assets that had a cost of CU850,000. It also revalued a freehold property upwards by CU300,000. At 31 December 20X6, the company's property, plant and equipment at cost or valuation had been CU5,100,000. What were purchases of property, plant and equipment during the year? PROPERTY, PLANT AND EQUIPMENT CU
CU
See Answer at the end of this chapter.
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4.4
Interest and dividends received Returns received in cash from investments will include interest and dividends received. The cash flows can be calculated by using an interest received or dividends received T account. Both T accounts are very similar and are prepared as follows: INTEREST/DIVIDENDS RECEIVED Balance b/d (receivable) Income statement
CU X X X
Cash receipt (balancing figure) Balance c/d (receivable)
Interactive question 3: Interest received
CU X X X
[Difficulty level: Easy]
A company had interest receivable of CU35,000 at the start of the year and interest receivable of CU42,000 at the end of the year. The income statement for the year shows interest income of CU90,000. What were the cash receipts for interest received in the year? INTEREST RECEIVED CU
CU
See Answer at the end of this chapter.
5 Financing activities Section overview
5.1
Financing cash flows comprise receipts from or repayments to external providers of finance.
Financing activities This section of the cash flow statement shows the share of cash which the entity's capital providers have claimed during the period. This is an indicator of likely future interest and dividend payments. The standard gives the following examples of cash flows which might arise under this heading.
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Cash proceeds from issuing shares
Cash payments to owners to acquire or redeem the entity's shares
Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings
Repayments of capital of amounts borrowed under finance leases (We will look at this issue in Chapter 16.)
Dividends paid
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CASH FLOW STATEMENTS
5.2
3
Cash received from issuing shares The amount of cash received from new issues of shares can usually be calculated from the opening and closing balance sheet figures for share capital and share premium. As a general rule: SHARE CAPITAL AND PREMIUM CU Balance c/d
X X
Balance b/d Cash receipt (balancing figure)
CU X X X
This rule does not apply fully when the company makes a bonus issue of shares during the year, and some of the new share capital is obtained by means of reducing a reserve account other than the share premium. To calculate cash receipts from share issues in the year, the amount transferred to share capital from the other reserve account should be subtracted.
Worked example: Cash received from share issue Rustler Ltd's annual accounts for the year to 31 December 20X7 show the following figures. At 31.12.X7 CU 6,750,000 12,800,000
Share capital: Ordinary shares of 50p Share premium
At 31.12.X6 CU 5,400,000 7,300,000
There were no bonus issues of shares during the year. What amount of cash was raised from shares issued during the year?
Solution SHARE CAPITAL AND PREMIUM CU Balance c/d (6,750,000 + 12,800,000)
19,550,000
Balance b/d (5,400,000 + 7,300,000) Cash receipt (balancing figure)
19,550,000
Interactive question 4: Bonus issue
CU 12,700,000 6,850,000 19,550,000
[Difficulty level: Intermediate]
Groat Ltd's accounts for the year to 31 December 20X7 show the following figures.
Share capital: Ordinary shares of 10p Share premium
At 31.12.X7 CU 22,500,000 900,000
At 31.12.X6 CU 10,000,000 4,800,000
The company made a one for two bonus issue of shares during the year. It used the share premium account and CU200,000 from retained earnings to do this. What amount of cash was raised from share issues during the year?
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Financial accounting SHARE CAPITAL AND PREMIUM CU
CU
See Answer at the end of this chapter.
5.3
Cash from issuing loan stock or raising a loan The cash derived from obtaining a new loan during the year or from issuing new loan stock or debentures should be apparent from a comparison of the opening and closing balance sheet figures for non-current interest-bearing borrowings. An increase during the year represents new financing, and should be taken as the amount of cash received from financing. It is important that all loans in the balance sheet should be taken into consideration in the calculation. There may be a loan that is within 12 months of repayment. If so, it will be included within current liabilities in the year-end balance sheet as ‘short-term borrowings’, when it would have been a noncurrent liability in the balance sheet at the start of the year. The loan has not been repaid during the year, merely re-classified from non-current liability to current liability.
5.4
Repayment of non-current interest-bearing borrowings In the same way, a reduction in interest-bearing borrowings indicates that a loan has been repaid, or that loan stock or debentures have been redeemed. It should be assumed that the loans are repaid or loan stock is redeemed for cash.
5.5
Dividends paid Cash flows from dividends paid should be disclosed separately. Dividends paid by the entity can be classified in one of two ways. (a)
As a financing cash flow, showing the cost of obtaining financial resources (as in the example cash flow statement in section 2 above). This is the presentation adopted in these Learning Materials.
(b) As a component of cash flows from operating activities so that users can assess the entity's ability to pay dividends out of operating cash flows. Cash flows for dividends paid can be calculated using a T account.
Worked example: Dividends paid A company has declared preference dividends for the year of CU7,000 (based on its 7% CU100,000 preference shares in issue). At the start of the year the balance sheet included a liability of CU3,500 for preference dividends payable. At the end of the year no amount was owing to preference shareholders in respect of dividends. The preference dividend paid for the year is not simply the CU7,000 declared and reflected in retained earnings as this amount needs to be adjusted for any opening and closing liabilities.
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3
DIVIDENDS PAID Cash payment (balancing figure) Balance c/d
CU 10,500 0 10,500
Balance b/d Retained earnings
CU 3,500 7,000 10,500
The cash paid during the year of CU10,500 is the second half year preference dividend due from last year and the whole of this year’s preference dividend (all paid during the year). Point to note: Any dividends for the year will be disclosed in the statement of changes in equity.
6 Disclosures Section overview
6.1
BAS 7 requires certain additional disclosures to accompany the cash flow statement.
Components of cash and cash equivalents The following disclosures are required:
6.2
The components of cash and cash equivalents.
A reconciliation showing the amounts in the cash flow statement reconciled with the equivalent items reported in the balance sheet.
The accounting policy used in deciding the items included in cash and cash equivalents (BAS 1).
Other disclosures All entities should disclose, together with a commentary by management, any other information likely to be of importance, for example:
6.3
Restrictions on the use of or access to any part of cash equivalents.
The amount of undrawn borrowing facilities which are available.
Cash flows which increased operating capacity compared to cash flows which merely maintained operating capacity.
Significant non-cash transactions Many investing and financing activities do not have a direct impact on current cash flows although they do affect the capital and asset structure of an entity. Significant 'non-cash transactions' should be disclosed. Examples include:
The acquisition of assets either by assuming directly related liabilities or by means of a finance lease The acquisition of an entity by means of an issue of equity shares
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Financial accounting
6.4
Example: Notes to the cash flow statement The following shows how the required disclosures would be presented. Note: Cash and cash equivalents Cash and cash equivalents consist of cash on hand and balances with banks, and investments in money market instruments. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts.
Cash on hand and balances with banks Short-term investments Cash and cash equivalents
20X7 CUm 40 370 410
20X6 CUm 25 95 120
The company has undrawn borrowing facilities of CU2,000m of which only CU700m may be used for future expansion. Note: Property, plant and equipment During the period the company acquired property, plant and equipment with an aggregate cost of CU1,250m of which CU900m was acquired by finance lease. Cash payments of CU350m were made to purchase property, plant and equipment.
7 Preparing a cash flow statement Section overview
7.1
This section gives you a step by step approach for preparing a cash flow statement.
Technique Worked example: Preparing a cash flow statement Able Ltd’s income statement and statement of changes in equity for the year ended 31 December 20X7 and balance sheets at 31 December 20X6 and 31 December 20X7 were as follows. ABLE LTD Income statement for the year ended 31 December 20X7 CU'000 Revenue Raw materials consumed Staff costs Depreciation Loss on disposal of non-current asset Profit from operations Finance cost Profit before tax Income tax Profit for the period
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CU'000 720
70 94 118 18 (300) 420 (28) 392 (124) 268
CASH FLOW STATEMENTS
3
ABLE LTD Balance sheets as at 31 December CU'000 ASSETS Non-current assets Cost Depreciation
20X7 CU'000
1,596 318
CU'000
1,560 224 1,278
Current assets Inventory Trade receivables Bank
24 76 48
EQUITY AND LIABILITIES Equity Share capital Share premium Retained earnings Non-current liabilities Long-term loans Current liabilities Trade payables Taxation Proposed dividend Total equity and liabilities
1,336 20 58 56
148 1,426
Total assets
20X6 CU'000
360 36 686
134 1,470
340 24 490 1,082
854
200
500
12 102 30
6 86 24 144 1,426
116 1,470
ABLE LTD Statement of changes in equity (extract) for the year ended 31 December 20X7 Retained earnings CU'000 268 (72) 490 686
Profit for the period Dividends on ordinary shares Balance brought forward Balance carried forward During the year, the company paid CU90,000 for a new piece of machinery.
Prepare a cash flow statement for Able Ltd for the year ended 31 December 20X7 in accordance with the requirements of BAS 7, using the indirect method. The reconciliation of profit before tax to cash generated from operations should be shown as a note.
Solution Step 1 Set out the proforma cash flow statement with the headings required by BAS 7 and the reconciliation note. You should leave plenty of space. Ideally, use three or more sheets of paper, one for the main statement, one for the notes and one for your workings. It is obviously essential to know the formats very well.
Step 2 Begin with the cash flows from operating activities as far as possible. You will usually have to calculate such items as depreciation, loss on sale of non-current assets, interest paid and tax paid. © The Institute of Chartered Accountants in England and Wales, March 2009
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Step 3 Calculate the cash flow figures for dividends paid, purchase or sale of non-current assets, issue of shares and repayment of loans if these are not already given to you (as they may be).
Step 4 If you are not given the profit figure, open up a working for the income statement. Using the opening and closing balances of retained earnings, the taxation charge and dividends paid and proposed, you will be able to calculate profit for the year as the balancing figure to put in the cash flows from operating activities section.
Step 5 You will now be able to complete the statement by slotting in the figures given or calculated. ABLE LTD Cash flow statement for the year ended 31 December 20X7 CU'000 Cash flows from operating activities Cash generated from operations (see note) Interest paid Tax paid (86 + 124 – 102) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of property, plant and equipment (W) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital (360 + 36 340 24) Long-term loans repaid (500 200) Dividends paid (72 – 30 + 24) Net cash used in financing activities Decrease in cash and cash equivalents Cash and cash equivalents at 1.1.X7 Cash and cash equivalents at 31.12.X7
CU'000
540 (28) (108) 404 (90) 12 (78) 32 (300) (66) (334) (8) 56 48
Note to the cash flow statement Reconciliation of profit before tax to cash generated from operations for the year ended 31 December 20X7 CU'000 392 118 18 28 (4) (18) 6 540
Profit before tax Depreciation charges Loss on sale of tangible non-current assets Interest expense Increase in inventories Increase in receivables Increase in payables Cash generated from operations WORKING Non-current asset disposals COST Balance b/d Purchases
100
CU'000 1,560 90 1,650
Balance c/d Disposals (balancing figure)
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CU'000 1,596 54 1,650
CASH FLOW STATEMENTS
3
ACCUMULATED DEPRECIATION Balance c/d Depreciation on disposals (balancing figure) NBV of disposals (54 – 24) Net loss reported Proceeds of disposals
CU'000 318 24 342
Balance b/d Charge for year
CU'000 224 118 342 30 (18) 12
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Summary and Self-test
Summary
Cash and Cash equivalents -
Cash comprises cash on hand and on demand deposits Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value
-
BAS 7 requires cash flows to be classified as follows
Self-test Answer the following questions 1
Which one of the following options best describes the objective of BAS 7 Cash Flow Statements? A B C D
2
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To aid comparison of cash flows between entities To assist users to understand the cash management and treasury practices of an entity To assist users to confirm the going concern of an entity To enable entities to report cash inflows and outflows analysed under standard headings
Which one of the following statements gives the best definition of cash equivalents as set out in BAS 7 Cash Flow Statements? A
Cash equivalents are cash, overdrafts, short-term deposits, options and other financial instruments and equities traded in an active market
B
Cash equivalents are short-term highly liquid investments subject to insignificant risks of change in value
C
Cash equivalents are readily disposable investments
D
Cash equivalents are investments which are traded in an active market
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CASH FLOW STATEMENTS
3
In a company's cash flow statement prepared in accordance with BAS 7 Cash Flow Statements, a revaluation of non-current assets during the year will be: A B C D
4
3
Entirely excluded Shown under cash flows from operating activities Disclosed under investing activities Shown as a cash inflow
Information concerning the non-current assets of Ealing Ltd is detailed in the table. During the year non-current assets which had cost CU80,000 and which had a net book value of CU30,000 were sold for CU20,000. Net cash from operating activities for the year was CU300,000. Start of year CU 180,000 (120,000) 60,000
Cost Aggregate depreciation Carrying amount
End of year CU 240,000 (140,000) 100,000
There was no other cash activity. As a result of the above, cash increased over the year by A B C D 5
CU240,000 CU260,000 CU320,000 CU180,000
Waterloo Ltd acquired a freehold building for cash, financed in full by issuing for cash 166,000 CU1 ordinary shares at a premium of CU2 per share. In its cash flow statement prepared in accordance with BAS 7 Cash Flow Statements this transaction should be stated as: A B C D
6
Inflow CU498,000, outflow nil Inflow nil, outflow nil Inflow CU498,000, outflow CU498,000 Inflow nil, outflow CU498,000
Information from the cash flow statement and related notes of Gresham Ltd for the year ended 31 December 20X1 can be found in the table below. Depreciation Profit on sale of property, plant and equipment Proceeds from sale of property, plant and equipment Purchase of property, plant and equipment
CU 30,000 5,000 20,000 25,000
If the net book value of property, plant and equipment was CU110,000 on 31 December 20X0, what was it on 31 December 20X1? A B C D 7
CU85,000 CU90,000 CU70,000 CU80,000
In a cash flow statement prepared under BFRS under which category of cash flow would interest paid usually be classified? A B C D
Cash flows from operating activities Cash flows from financing activities Returns on investments and servicing of finance Financing
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Financial accounting 8
ROXY LTD
(Note: this question is included to provide practice of basic techniques)
The financial statements of Roxy Ltd at 30 June were as follows. Balance sheet at 30 June 20Y8 CU
20Y8
ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade and other receivables Cash and cash equivalents
CU
20Y7
20,750 16,000 9,950 -
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Accumulated profits/losses Non-current liabilities Interest-bearing borrowings Current liabilities Bank overdrafts Trade and other payables Accruals Tax liabilities
CU
11,000 8,000 700 1,800
CU 14,000
11,000 2,700 1,300 25,950 46,700
15,000 29,000
3,000 16,200 19,200
3,000 3,800 6,800
6,000
10,000
21,500 46,700
11,000 200 1,000
12,200 29,000
Income statement (extracts) 20Y8 CU 15,400 (1,000) 14,400 (2,000) 12,400
Profit from operations Finance cost Profit before tax Tax Net profit for the year
20Y7 CU 5,900 (1,400) 4,500 (1,500) 3,000
Additional Information (1) An analysis of property, plant and equipment shows the following. 20Y8 CU Building Cost Depreciation Plant and machinery Cost Depreciation
20Y7 CU
22,000 (4,000)
CU 12,000 (1,000)
18,000 5,000 (2,250)
CU
2,750 20,750
11,000 5,000 (2,000)
3,000 14,000
(2) Machinery with a net book value of CU250 was sold at the beginning of 20Y8 for CU350. This machinery had originally cost CU1,000. (3) No dividends have been declared or paid in recent years.
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CASH FLOW STATEMENTS
3
(4) The accruals are in respect of interest payable. Requirement Under the indirect method, prepare a clash flow statement, together with a note reconciling profit before tax to cash generated from operations for the year ended 30 June 20Y8. 9
MIDDLESEX LTD
(Note: this question is included to provide practice of basic techniques)
The balance sheet of Middlesex Ltd as at 30 June 20Y8, including comparative figures, is given below. 20Y8 ASSETS Non-current assets Property, plant and equipment Less Depreciation
CU
12,000 29,000 20,000
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (CU1 shares) Share premium Revaluation reserves Accumulated profits Non-current liabilities Interest-bearing borrowings (12% debentures 20Z1) Current liabilities Provisions Trade and other payables Tax liabilities Accruals
CU
333,000 (70,000) 263,000 50,000 313,000
Investment Current assets Inventories Trade and other receivables Cash and cash equivalents
20Y7 CU
27,000 7,000 19,000
Total equity and liabilities
61,000 374,000
CU 311,000 (69,000) 242,000 242,000
11,000 27,000 10,000
48,000 290,000
95,000 15,000 12,000 149,000 271,000
50,000 10,000 12,000 115,000 187,000
50,000
60,000
53,000 374,000
2,000 19,000 3,000 19,000
43,000 290,000
You are also given the following information which is already reflected correctly in the accounts. (1) During the year a bonus issue of 1 for 10 was made on the ordinary shares in issue at 30 June 20Y7, utilising available profits. (2) New shares were issued on 1 July 20Y7. Part of the proceeds was used to redeem CU10,000 12% debentures 20Z1 at par. (3) During the year certain tangible non-current assets were disposed of for CU20,000. The assets had originally cost CU40,000 and had a net book value at the disposal date of CU18,000. (4) Trade and other payables include CU5,000 for 20Y8 relating to the fixed asset purchases. (5) The corporation tax charge for the year is CU7,000.
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Financial accounting Requirement Prepare a cash flow statement for the year ended 30 June 20Y8 and the note reconciling profit before tax with cash generated from operations. 10
Set out below are the financial statements of Emily Ltd. You are the financial controller, faced with the task of implementing BAS 7 Cash Flow Statements. EMILY LTD Income statement for the year ended 31 December 20X7 CU'000 2,553 (1,814) 739 (125) (264) 350 25 (75) 300 (140) 160
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit from operations Investment income Finance cost Profit before tax Income tax expense Profit for the period Balance sheets as at 31 December ASSETS Non-current assets Property, plant and equipment Intangibles Investments Current assets Inventories Receivables Short-term investments Cash in hand Total assets EQUITY AND LIABILITIES Equity Share capital (CU1 ordinary shares) Share premium Revaluation reserve Retained earnings Non-current liabilities Long-term loan Current liabilities Trade payables Bank overdraft Taxation Dividends proposed Total equity and liabilities
20X7 CU'000
20X6 CU'000
380 250 –
305 200 25
150 390 50 2 1,222
102 315 – 1 948
200 160 100 160
150 150 91 100
170
50
127 85 120 100 1,222
119 98 110 80 948
Statement of changes in equity for the year ended 31 December 20X7 (extract)
Profit for the period Dividends on ordinary shares Balance brought forward Balance carried forward
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Retained earnings CU'000 160 (100) 100 160
CASH FLOW STATEMENTS
3
The following information is available. (a)
The proceeds of the sale of non-current asset investments amounted to CU30,000.
(b) Fixtures and fittings, with an original cost of CU85,000 and a net book value of CU45,000, were sold for CU32,000 during the year. (c)
The following information relates to property, plant and equipment. 31.12.20X7 CU'000 720 340 380
Cost Accumulated depreciation Net book value
31.12.20X6 CU'000 595 290 305
(d) 50,000 CU1 ordinary shares were issued during the year at a premium of 20p per share. (e)
The short-term investments are highly liquid and are close to maturity.
Requirement Prepare a cash flow statement for the year to 31 December 20X7 using the indirect method laid out in BAS 7 Cash Flow Statements. The reconciliation of profit before tax to cash generated from operations should be shown as a note. Your answer should also include an analysis of cash and cash equivalent balances. 11
HATCHBACK MOTOR COMPONENTS LTD Hatchback Motor Components Ltd has prepared the summarised accounts as set out below. Income statements for the years ended 30 April 20X7 CU'000 74,680 (51,595) 23,085 (17,681) 5,404 (2,634) 2,770
Revenue Cost of sales Gross profit Distribution and administrative costs Profit before tax Tax Net profit for the period
20X6 CU'000 69,937 (47,468) 22,469 (16,920) 5,549 (1,093) 4,456
Balance sheets at 30 April ASSETS Non-current assets Property, plant and equipment Investments Current assets Inventories Trade and other receivables Cash and cash equivalents Total assets
CU'000
20X7 CU'000
CU'000
30,946 7,100 38,046 16,487 12,347 863
20X6 CU'000 25,141 – 25,141
15,892 8,104 724 29,697 67,743
24,720 49,861
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Financial accounting 20X7 CU'000
20X6 CU'000
Non-current liabilities
13,000 12,500 7,450 24,776 57,726 3,250
10,000 5,000 2,650 22,856 40,506 4,250
Current liabilities Total equity and liabilities
6,767 67,743
5,105 49,861
20X7 CU'000 25,100 5,846 30,946
20X6 CU'000 19,780 5,361 25,141
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (CU1 ordinary shares) Share premium Revaluation reserve Retained earnings
Notes relating to the accounts (1) Analysis of property, plant and equipment Freehold buildings Fixtures and fittings
(2) Depreciation has not been provided on freehold buildings. During the year a professional revaluation – taking account of additions during the year – has been incorporated into the books of account. There were no disposals during the year. (3) Additions to fixtures and fittings during the year totalled CU1,365,000 at cost. There were no disposals. (4) Current liabilities
Trade and other payables Accruals Tax liability
20X7 CU'000 2,771 1,200 2,796 6,767
20X6 CU'000 2,632 1,235 1,238 5,105
Taxation provided at 30 April 20X6 was settled at a figure lower than the amount provided. (5) During the year the company made a rights issue of shares on the basis of three new shares for every ten shares held at a price of CU3.50 per share. Pending the purchase of new plant part of the proceeds of the issue has been invested in shares in other UK companies. Requirement Prepare a cash flow statement in accordance with BAS 7 Cash Flow Statements under the indirect method, for the year ended 30 April 20X7. Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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3
Technical reference Point to note: All of BAS 7 is examinable with the exception of paragraphs 24-28, 38 and Appendix B. The paragraphs listed below are the key references you should be familiar with. (Paragraph references relating to the treatment of leased assets in the cash flow statement and consolidated cash flow statements are dealt with in Chapter 16). 1 Objective of the cash flow statement
The cash flow statement should show the historical changes in cash and cash equivalents.
Cash comprises cash on hand and demand deposits.
BAS 7(6)
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value.
BAS 7(6)
2 Presentation of a cash flow statement
Cash flows should be classified by operating, investing and financing activities.
Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity.
There are two methods of presentation for cash flows from operating activities
Appendix A BAS 7(10) BAS 7(13–14)
–
Direct method
BAS 7(19)
–
Indirect method
BAS 7(20)
Cash flows from investing activities are those related to the acquisition or disposal of any non-current assets, or trade investments together with returns received in cash from investments (i.e. dividends and interest received).
Financing activities include:
BAS 7(16)
–
Cash proceeds from issuing shares
– –
Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings Cash repayments of amounts borrowed
–
Repayment of capital of amounts borrowed under finance leases
–
Dividends paid to shareholders
3 Disclosures
BAS 7(50)
Components of cash and cash equivalents.
Reconciliation of the amounts in the cash flow statement with the equivalent balance in the balance sheet.
Information (together with a commentary) which may be relevant to the users.
The cash flow statement does not record non-cash transactions. Significant noncash transactions should be disclosed.
Appendix A
BAS 7(43)
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Answers to Self-test 1
D
To enable entities to report cash inflows and outflows analysed under standard headings. (BAS 7).
2
B
Cash equivalents are short-term highly liquid investments subject to insignificant risks of changes in value.
3
A
A revaluation of non-current assets during the year will be entirely excluded. Revaluations have no cash flow implications.
4
D
The correct answer is CU180,000. NON-CURRENT ASSETS – COST Balance b/d Therefore purchases
CU 180,000 140,000 320,000
Disposals Balance c/d
CU 80,000 240,000 320,000
DEPRECIATION CU Disposals Balance c/d
Balance b/d Therefore charge
50,000 140,000 190,000
CU 120,000 70,000 190,000
DISPOSALS Cost
CU 80,000
Accumulated depreciation Proceeds Therefore loss
80,000 Cash from operations Cash inflow: Disposal proceeds Cash outflow: purchases of non-current assets Therefore net cash increase
CU 50,000 20,000 10,000 80,000 CU 300,000 20,000 320,000 (140,000) 180,000
Note that adjustments for depreciation and loss on disposal will already be included in net cash from operating activities. 5
C
Inflow CU498,000, outflow CU498,000. The outflow is classified under 'Purchase of property, plant and equipment'. The inflow is classified under 'Proceeds from issuance of share capital'.
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6
B
3
CU90,000 PROPERTY (NBV) Balance b/d Additions
CU 110,000 25,000
CU 30,000 15,000 90,000 135,000
Depreciation Disposals (NBV) Balance c/d
135,000 7
A
8
(BAS 7) ROXY LTD Cash flow statement for year ended 30 June 20Y8 CU Cash flows from operating activities Cash generated from operations Interest paid (W5) Tax paid (W4) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W1) Proceeds from sale of property, plant and equipment (W3) Net cash used in investing activities Cash flows from financing activities Redemption of non-current interest-bearing borrowings Net cash used in financing activities Net change in cash and cash equivalents Cash and cash equivalents brought forward Cash and cash equivalents carried forward
CU 4,050 (500) (1,200) 2,350
(11,000) 350 (10,650) (4,000) (4,000) (12,300) 1,300 (11,000)
Reconciliation of profit/loss before tax to cash generated from operations fro the year ended 30 June 20Y8 Profit/loss before tax Finance cost Property, plant and equipment – depreciation charge (W2) Profit/loss on disposal of property, plant and equipment (W3) Change in inventories (W6) Change in trade and other receivables (W6) Change in trade and other payables Cash generated from operations
CU 14,400 1,000 4,000 (100) (5,000) (7,250) (3,000) 4,050
WORKINGS (1)
PROPERTY, PLANT AND EQUIPMENT – COST OR VALUATION B/f (5,000 + 12,000) Additions (β)
(2)
CU 17,000 11,000 28,000
Disposal C/f (5,000 + 22000)
CU 1,000 27,000 28,000
PROPERTY, PLANT AND EQUIPMENT – ACCUMULATED DEPRECIATION Disposal (1,000 – 250) C/f (4,000 + 2,250
CU 750 6,250 7,000
B/f (1,000 + 2000 Depreciation charge for the year (β)
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CU 3,000 4,000 7,000
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(3)
PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT Cos Profit on sale
(4)
CU 750 350 1,100
Accumulated depreciation Proceeds
PROPERTY, PLANT AND EQUIPMENT – COST OR VALUATION Cash paid (β) C/f
(5)
CU 1,000 100 1,100
CU 1,200 1,800 3,000
CU 1,000 2,000 3,000
B/f Income statement
PROPERTY, PLANT AND EQUIPMENT – COST OR VALUATION Cash paid (β) C/f
CU 500 700 1,200
CU 200 1,000 1,200
B/f Income statement
(6) Changes in current items Inventories (16,000 – 11,000) Receivables (9,950 – 2700) Payables (11,000 – 8,000) 9
CU (5,000) (7,250) (3,000)
MIDDLESEX LTD Cash flow statement for the year ended 30 June 20Y8 CU Cash flows from operating activities Cash generated from operations Interest paid Tax paid (W2) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W3) Proceeds from sale of property, plant and equipment (W3) Purchase of investments
71,000 (6,000) (3,000) 62,000 (57,000) 20,000 (50,000)
Net cash used in investing activities Cash flows from financing activities Issues of ordinary shares (W4) Redemption of non-current interest-bearing borrowings Net cash used in financing activities Net change in cash and cash equivalents Cash and cash equivalents brought forward Cash and cash equivalents carried forward
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CU
(87,000) 45,000 (10,000) 35,000 10,000 10,000 20,000
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3
Reconciliation's of profit/loss before tax to net cash generated from operations for the year ended 30 June 20Y8 Profit/loss before tax (W7) Finance cost (W6) Property, plant and equipment – depreciation charge (W1) Profit/loss on disposal of property, plant and equipment Change in inventories (W5) Change in trade and other receivables (W5) Change in trade and other payables (W5) Change in provision Cash generated from operations WORKINGS (1)
PROPERTY, PLANT AND EQUIPMENT – ACCUMULATED DEPRECIATION CU 22,000 70,000 92,000
Disposal (40,000 – 18,000) C/f
(2)
B/f Charge for year (β)
CU 69,000 23,000 92,000
TAX PAID CU 3,000 7,000 10,000
Cash (β) C/f
(3)
CU 46,000 6,000 23,000 (2,000) (1,000) (3,000) (2,000) (2000) 71,000
B/f Charge for year
CU 3,000 7,000 10,000
PROPERTY, PLANT AND EQUIPMENT – COST OR VALUATION CU 311,000 57,000 5,000 373,000
B/f Additions (β) C/f
(4)
Disposal C/f
CU 40,000 333,000 373,000
SHARE CAPITAL AND PREMIUM CU
C/f (95,000 + 15,000)
110,000 373,000
B/f (50,000 + 10,000) Accumulated profit/losses (bonus issue) (50,000 ÷ 10) Cash (β)
CU 60,000 5,000 45,000 110,000
(5) Changes in current items Inventories (12,000 – 11,000) Receivables (29,000 – 27,000) Payables (27,000 – 5,000 – 19,000)
CU (1,000) (2,000) 3,000
(6) Finance cost CU50,000 x 12% = CU6,000
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ACCUMULATED PROFIT/LOSS Bonus issue Corporation tax C/f
10
CU 5,000 7,000 149,000 161,000
B/f Net profit for the period (β)
CU 115,000 46,000 161,000
EMILY LTD Cash flow statement for the year ended 31 December 20X7 CU'000 Cash flows from operating activities Cash generated from operations Interest paid Tax paid (110 + 140 – 120) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W2) Purchase of intangible non-current assets Proceeds from sale of property, plant and equipment Proceeds from sale of non-current asset investments Interest received Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Long-term loan Dividends paid (100 + 80 – 100) Net cash from financing activities Increase in cash and cash equivalents (Note) Cash and cash equivalents at 1.1.X7 (Note) Cash and cash equivalents at 31.12.X7 (Note)
CU'000
333 (75) (130) 128 (201) (50) 32 30 25 (164) 60 120 (80) 100 64 (97) (33)
Notes to the cash flow statement Reconciliation of profit before tax to net cash generated from operations for the year ended 31 December 20X7 CU'000 Profit before tax 300 Depreciation charge (W1) 90 Loss on sale of property, plant and equipment (45 – 32) 13 Profit on sale of non-current asset investments (5) Investment income (25) Finance cost 75 Increase in inventories (48) Increase in receivables (75) Increase in payables 8 Cash generated from operations 333 Analysis of the balances of cash and cash equivalents as shown in the balance sheet
Cash in hand Short term investments Bank overdraft
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20X7 CU'000 2 50 (85) (33)
20X6 CU'000 1 – (98) (97)
Change in year CU'000 1 50 13 64
CASH FLOW STATEMENTS
3
WORKINGS (1) Depreciation charge ACCUMULATED DEPRECIATION CU’000 Depreciation on assets sold (85 – 45) Balance c/d
40 340 380
CU’000 290
Balance b/d Charge for year (balancing figure)
90 380
(2) Purchase of property, plant and equipment PROPERTY, PLANT AND EQUIPMENT (COST) CU'000 595 9 201 805
1.1.X7 Balance b/d Revaluation (100 91) Purchases (balancing figure) 11
CU'000 85
Disposals 31.12.X7 Balance c/d
720 805
HATCHBACK MOTOR COMPONENTS LTD Cash flow statement for the year ended 30 April 20X7 Cash flows from operating activities Cash generated from operations Tax paid (W4) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W3) Purchase of investments Net cash used in investing activities Cash flows from financing activities Proceeds from issue of ordinary shares (W2) Redemption of non-current interest-bearing borrowings Dividends paid (W5) Net cash from financing activities Net change in cash and cash equivalents Cash and cash equivalents brought forward Cash and cash equivalents carried forward
CU
CU 1,550,000 (1,076,000) 474,000
(1,885,000) (7,100,000) (8,985,000) 10,500,000 (1,000,000) (850,000) 8,650,000 139,000 724,000 863,000
Note to the cash flow statement Reconciliation of profit before tax to cash generated from operations for the year ended 30 April 20X7 CU Profit before tax 5,404,000 Property, plant and equipment – depreciation charge (W1) 880,000 Increase in inventories (W6) (595,000) Increase in trade and other receivables (W6) (4,243,000) Increase in trade and other payables (W6) 139,000 Decrease in accruals (35,000) Cash generated from operations 1,550,000 WORKINGS (1)
FIXTURES AND FITTINGS (AT NBV) Balance b/d Additions
CU 5,361,000 1,365,000 6,726,000
Balance c/d Depreciation charge ()
CU 5,846,000 880,000 6,726,000
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SHARE CAPITAL AND PREMIUM CU Balance c/d (13,000,000 + 12,500,000)
(3)
CU
25,500,000 25,500,000
Balance b/d (10,000,000 + 5,000,000) Cash received ()
15,000,000 10,500,000 25,500,000
FREEHOLD BUILDINGS Balance b/d Revaluation surplus (7,450 – 2,650) Additions ()
CU 19,780,000
Balance c/d
4,800,000 520,000 25,100,000
CU 25,100,000
25,100,000
Total additions = 520,000 + 1,365,000 = CU 1,885,000 (4)
TAX PAID Cash paid () Balance c/d
(5)
CU 1,076,000 2,796,000 3,872,000
Balance b/d Income statement
CU 1,238,000 2,634,000 3,872,000
RETAINED EARNINGS Dividends paid () Balance c/d
CU 850,000 24,776,000 25,626,000
Balance b/d Net profit for the period
CU 22,856,000 2,770,000 25,626,000
(6) Changes in current items Inventories (16,487 – 15,892) Receivables (12,347 – 8,104) Payables (2,771 – 2,632) Accruals (1,235 – 1,200)
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CU (595,000) (4,243,000) 139,000 (35,000)
CASH FLOW STATEMENTS
3
Answers to Interactive questions
Answer to Interactive question 1 INCOME TAX PAID Cash payment (balancing figure) Balance c/d
CU 1,085,000 1,125,000 2,210,000
Balance b/d Income statement
CU 940,000 1,270,000 2,210,000
Alternatively this could be calculated as follows: (CU940,000 + CU1,270,000 – CU1,125,000) = CU1,085,000
Answer to Interactive question 2 PROPERTY, PLANT AND EQUIPMENT Balance b/d Revaluation reserve Additions (balance)
CU 5,100,000 300,000 2,250,000 7,650,000
Disposals Balance c/d
CU 850,000 6,800,000 7,650,000
The company started the year with PPE at cost or valuation of CU5,100,000 and revalued an asset upward by CU300,000. It bought a further CU2,250,000 of PPE, giving a total of CU7,650,000 at cost or valuation. However, there was disposals of PPE with a cost of CU850,000, bringing the year-end figure down to CU6,800,000.
Answer to Interactive question 3 INTEREST RECEIVED Balance b/d Income statement
CU 35,000 90,000 125,000
Cash received (balancing figure) Balance c/d
CU 83,000 42,000 125,000
Answer to Interactive question 4 SHARE CAPITAL AND PREMIUM CU Balance b/d
23,400,000 23,400,000
Balance b/d Accumulated profits/losses Cash received (balance)
CU 14,800,000 200,000 8,400,000 23,400,000
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chapter 4
Reporting financial performance Contents Introduction Examination context Topic List 1
BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
2
Accounting policies
3
Changes in accounting policies
4
Changes in accounting estimates
5
Prior period errors
6
Impracticability
7
BFRS 5 and discontinued operations
8
BAS 32 Financial Instruments: Presentation
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive question
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Introduction
Learning objectives
Understand the purpose and principles underlying BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
Understand how accounting policies are selected and applied
Apply accounting requirements for: –
Changes in accounting policies
–
Changes in accounting estimates
–
Prior period errors
Disclose the results of a discontinued operation in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations
Classify financial instruments in accordance with BAS 32 Financial Instruments: Presentation as:
–
Financial assets
–
Financial liabilities
–
Equity instruments
Tick off
Prepare simple extracts from financial statements in accordance with Companies Act and BFRS
Specific syllabus references for this chapter are: 2d.
Practical significance Shareholders are interested in the future performance of the business in which they have invested. The difficulty they have is in obtaining reliable information. It could be argued that a profit forecast would be the most relevant information to a shareholder in this situation due to its predictive nature but this will often be unreliable. The compromise is to present historic information in a way that enables the user to identify the recurring trend in the profits of the entity's continuing activities. This is achieved by BFRS 5 Non-current Assets Held for Sale and Discontinued Operations as it requires the results of activities which will not be continued into the future to be shown separately. It is also important that financial information is presented in such a way that it is not misleading. This could happen through an inadvertent lack of consistency or it could arise as a result of deliberate manipulation. BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors addresses this issue by restricting the circumstances in which accounting policies can be changed, for example, it is not possible to change the policy to achieve a particular accounting outcome. BAS 32 Financial Instruments: Presentation also addresses the issue of consistency in the guidance it provides on the classification of financial instruments. Under BAS 32 financial instruments are classified according to their substance, with the related finance costs to match, either as debt or equity.
Stop and think Separate disclosure of discontinued operations enables the user to assess the impact of this on current and future results. Can you think of any other ways that historical information can be used predictively?
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Working context You are likely to come across accounting policies in your work, particularly in the context of the audit engagement. For example, in the audit of non-current assets you would be expected to consider whether the accounting policy:
Is appropriate for the type of asset Has been applied consistently Has been applied correctly Has been adequately disclosed
Many of you may also have been involved in the audit of inventories. Again here, the accounting policy adopted by the company is a key consideration.
Syllabus links In the Accounting paper you will have looked briefly at BAS 8 in the context of preparing company accounts. In this paper those basic principles are developed. A detailed understanding of this standard will be assumed in the Financial & Corporate Reporting paper. Both BFRS 5 and BAS 32 are introduced at this level. The more complex aspects of these standards will be covered in Financial & Corporate Reporting.
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Examination context
Exam requirements The topics covered in this chapter are unlikely to be the main focus of an individual written test question but they could be examined in combination with a number of other matters or as part of a mixed topic question. For example, changes in accounting estimates could be examined as part of a question on noncurrent assets. Prior period adjustments or an analysis of discontinued operations could be included in a question where you are asked to draft financial statements. These topics could also feature in the shortform question section of the paper. In the examination, candidates may be required to:
Prepare financial statements or extracts including adjustments for: – – –
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Changes in accounting policies Changes in accounting estimates Prior period adjustments
Identify the circumstances in which an operation would meet the BFRS 5 definition of a discontinued operation.
Prepare financial statements or extracts including simple financial instruments.
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1 BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Section overview
BAS 8 is intended to enhance: – – –
1.1
Relevance Reliability Comparability.
Introduction The objective of BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is to prescribe the criteria for selecting and changing accounting policies, together with the accounting treatment and disclosure of changes in accounting policies, changes in accounting estimates and correction of error. This enhances relevance, reliability and comparability. BAS 8 achieves this objective by ensuring that:
Information is available about the accounting policies adopted by different entities.
Different entities adopt a common approach to the distinction between a change in accounting policy and a change in an accounting estimate.
The scope for accounting policy changes is constrained.
Changes in accounting policies, changes in accounting estimates and corrections of errors are dealt with in a comparable manner by different entities.
2 Accounting policies Section overview
2.1
Management is responsible for selecting accounting policies which are relevant, reliable and consistent.
Selecting accounting policies Definition Accounting policies: The specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.
Accounting policies are normally developed by reference to the applicable BFRS or Interpretation together with any relevant Implementation Guidance issued by the IASB. The exception to this is where the effect of applying the accounting policy set out in the BFRS is immaterial. Where there is no applicable BFRS or Interpretation management should use its judgement in developing an accounting policy ensuring that the resulting information is relevant and reliable. In practical terms management should refer to:
The requirements and guidance in BFRS/Interpretations dealing with similar and related issues.
The basic principles set down in the Framework, for example, the recognition criteria and measurement concepts for assets, liabilities and expenses.
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Financial accounting Management may also consider the most recent pronouncements of other standard setting bodies that use a similar conceptual framework to develop standards, other accounting literature and accepted industry practices if these do not conflict with the sources above.
2.2
Consistency of accounting policies Once selected, accounting policies should be applied consistently for similar transactions, other events and conditions. The exception to this is where a BFRS requires or allows categorisation of items where different policies may be applied to each category.
3 Changes in accounting policies Section overview
3.1
A change in accounting policy must be applied retrospectively.
Introduction The same accounting policies are usually adopted from period to period, to enhance comparability thereby allowing users to analyse trends over time in profit, cash flows and financial position. Changes in accounting policy will therefore be rare and should only be made if the change
Is required by a BAS or a BFRS (or an Interpretation of a BAS or BFRS)
Will result in a more appropriate presentation of events or transactions in the financial statements of the entity (a voluntary change).
The standard highlights two types of event which do not constitute changes in accounting policy.
Adopting an accounting policy for a new type of transaction or event not dealt with previously by the entity.
Adopting a new accounting policy for a transaction or event which has not occurred in the past or which was not material.
In the case of tangible non-current assets, if a policy of revaluation is adopted for the first time then this is treated, not as a change of accounting policy under BAS 8, but as a revaluation under BAS 16 Property, Plant and Equipment (see Chapter 5). The following paragraphs do not therefore apply to a change in policy to adopt revaluations.
3.2
Changes in accounting policy A change in accounting policy must be applied retrospectively.
Definition Retrospective application: Applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied.
In other words, at the earliest date such transactions or events occurred, the policy is applied from that date. Any resulting adjustment should be reported as an adjustment to the opening balance of retained earnings. Comparative information should be restated unless it is impracticable to do so (see section 6 below).
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This means that all comparative information must be restated as if the new policy had always been in force, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the earliest period presented. The steps needed to make the retrospective adjustment are:
Step 1 Restate the opening balances for the current year, by applying the new policy to the opening balance sheet (i.e. the previous period's closing balance sheet).
Step 2 Calculate the difference between the figure for capital and reserves in the revised opening balance sheet and the figure as originally published. This difference is the amount of the adjustment made in the statement of changes in equity to the reserves brought forward at the start of the current period.
Step 3 Apply the new policy in the current period and to the closing balance sheet.
Step 4 Restate the comparatives for the prior period by applying steps (1) to (3) to the prior period values.
Step 5 Prepare the note explaining the reason for the change and giving other details (see section 3.4 below). Although BAS 8 requires retrospective adjustment for changes in accounting policy it recognises that there may be circumstances where it is impracticable to determine the effect in a specific period or on a cumulative basis. Where this is the case the policy should be applied retrospectively to the earliest period for which it is practicable to do so. In the rare circumstance where it is impracticable to restate retrospectively any financial results the new policy should be applied prospectively. (Impracticality is dealt with in more detail in section 6 below.)
Definition Prospective application of a change in accounting policy: applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed.
3.3
Adoption of a new BFRS Where a new BFRS is adopted, BAS 8 requires any transitional provisions in the new BFRS itself to be followed. If none are given in the BFRS which is being adopted, then the entity should follow the general principles of BAS 8.
3.4
Disclosure Certain disclosures are required when a change in accounting policy has a material effect on the current period or any prior period presented, or when it may have a material effect in subsequent periods.
Nature of the change
Reasons for the change (why more reliable and relevant)
Amount of the adjustment for the current period and for each prior period presented for each line item
Amount of the adjustment relating to periods prior to those included in the comparative information
The fact that comparative information has been restated or that it is impracticable to do so
An entity should also disclose information relevant to assessing the impact of new BFRS on the financial statements where these have not yet come into force. © The Institute of Chartered Accountants in England and Wales, March 2009g
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3.5
Borrowing costs In recent years the IASB has revised a number of accounting standards removing the majority of accounting policy choices. The only remaining choice is in respect of finance costs on borrowing. Under BAS 23 Borrowing Costs, borrowing costs may be capitalised as part of a qualifying asset in specific circumstances (as opposed to being expensed in the period in which they are incurred). BAS 23 per se is not examinable in the Financial Accounting paper but you should be aware of this issue in the context of accounting policy choices. The following worked example demonstrates the treatment of the change in accounting policy for borrowing costs.
Worked example: Change in accounting policy Multi Ltd commenced trading three years ago, on 1 January 20X5. Its draft balance sheet at 31 December 20X7 and its final balance sheets for the two previous years are as follows:
Non-current assets Property, plant and equipment Other Current assets Capital Reserves Non-current liabilities Current liabilities
20X7 CUm
20X6 CUm
20X5 CUm
231 169 400 800 1,200
230 120 350 800 1,150
180 120 300 800 1,100
100 450 550 200 450 1,200
100 400 500 200 450 1,150
100 350 450 200 450 1,100
20X7 CUm 230 80 10 320 (89) 231
20X6 CUm 180 90 10 280 (50) 230
20X5 CUm 0 180 20 200 (20) 180
Additional information is available as follows: 1
The profit for each of the three years was CU50m.
2
The movements on property, plant and equipment were as follows:
Brought forward Direct cost of additions Interest capitalised Depreciation Carried forward 3
Property, plant and equipment is depreciated at the rate of 10% of cost per annum. The directors now believe that more relevant information would be provided if interest was not capitalised, so the decision has been made to change the accounting policy and to recognise all interest as an expense in the year in which it is incurred.
Prepare the revised balance sheets at 31 December 20X7 and 20X6, together with extracts from the statement of changes in equity for each of the two years then ended.
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Solution BALANCE SHEET Non-current assets Property, plant and equipment (W3) Other Current assets Capital Reserves (per SCE extract below) Non-current liabilities Current liabilities Statement of changes in equity (extracts) Reserves brought forward – as reported Adjustment – to write off capitalised interest brought forward (W1) As restated Profit for the year (W2) Reserves carried forward
20X7 CUm
20X6 CUm
200 169 369 800 1,169
205 120 325 800 1,125
100 419 519 200 450 1,169
100 375 475 200 450 1,125
20X7 CUm 400 (25) 375 44 419
20X6 CUm 350 (18) 332 43 375
20X6 CUm 10
20X5 CUm 20 (2)
WORKINGS (1) Adjustment re capitalised interest
Amount capitalised in the year Depreciation charge (10% 20) Depreciation charge (10% (20 + 10)) Depreciation charge (10% (20 + 10 + 10)) Reserves adjustment/asset write-down Cumulative
20X7 CUm 10
(3) (4) 6
7
18
31
25
18
(2) Adjustment to reported profits
Profit for year before adjustment Profit adjustment (W1) Profit for year restated
20X7 CUm 50 (6) 44
20X6 CUm 50 (7) 43
20X7 CUm 231
20X6 CUm 230 (25)
(3) PPE restated
As originally stated Write-down (7 + 18) Write-down (6 + 7 + 18) Restated
(31) 200
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Financial accounting Point to note The five steps referred to in section 3.2 above have been applied in this example as follows:
Step 1 The opening balance for PPE is revised by recalculating the 20X6 closing balance sheet balance (W3).
Step 2 The difference between the figure for capital and reserves in the revised opening balance sheet and the figure as originally published is calculated in W1. Note that the cumulative adjustment at the end of 20X6 appears as the adjustment to reserves brought forward at the beginning of 20X7 in the statement of changes in equity.
Step 3 The new policy is applied in the current period and the closing balance sheet. In W2 20X7 profits are reduced by CU6m. In W3 PPE is reduced by the cumulative additional depreciation (CU31m).
Step 4 Comparatives are restated. The closing PPE balance for 20X6 is restated (see W3). Reserves brought forward are restated for 20X6 in the statement of changes in equity by CU18m. Profit for 20X6 is restated by CU7m (see W2).
Step 5 Disclosures as described in section 3.4 would be provided.
4 Changes in accounting estimates Section overview
4.1
A change in accounting estimates should be applied prospectively.
Accounting estimates Definition Change in accounting estimate: An adjustment of the carrying amount of an asset or a liability or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors.
Estimates arise in relation to business activities because of the uncertainties inherent within them. Judgements are made based on the latest available, reliable information. The use of such estimates is a necessary part of the preparation of financial statements and does not undermine their reliability. Here are some examples of accounting estimates.
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A necessary bad debt allowance Useful lives of depreciable assets Adjustment for obsolescence of inventory
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4.2
4
Accounting treatment The rule here is that the effect of a change in an accounting estimate should be included in the determination of net profit or loss in:
The period of the change, if the change affects that period only, or The period of the change and future periods, if the change affects both
Changes may occur in the circumstances which were in force at the time the estimate was calculated, or perhaps additional information or subsequent developments have come to light. An example of a change in accounting estimate which affects only the current period is the bad debt estimate. However, a revision in the life over which an asset is depreciated would affect both the current and future periods, via the amount of the depreciation expense. The effect of a change in an accounting estimate should be included in the same income statement classification as was used previously for the estimate. This rule helps to ensure consistency between the financial statements of different periods. The effect of a change in an accounting estimate is to be recognised prospectively.
Definition Prospective application of recognising the effect of a change in accounting estimate: Recognising the effect of the change in the accounting estimate in the current and future periods affected by the change.
4.3
Disclosure Where a change in an accounting estimate has a material effect in the current period (or which is expected to have a material effect in subsequent periods) the following should be disclosed.
Nature of the change in accounting estimate Amount of change (if impracticable to estimate, this fact should be disclosed)
Worked example: Change in accounting estimate Taking the example of a machine tool with an original cost of CU100,000, an originally estimated useful life of 10 years and an originally estimated residual value of CUnil, the annual straight line depreciation charge will be CU10,000 per annum and the carrying amount after three years will be CU70,000. If in the fourth year it is decided that as a result of changes in market conditions the remaining useful life is only three years (so a total of six years), then the depreciation charge in that year (and in the next two years) will be the carrying amount brought forward ÷ the revised remaining useful life, so CU70,000 ÷ 3 = CU23,333. There is no question of going back to restate the depreciation charge for the past three years. The effect of the change (in this case an increase in the annual depreciation charge from CU10,000 to CU23,333) in the current year and the next two years must be disclosed.
4.4
Changes in policy versus changes in estimate It can be difficult sometimes to distinguish between changes in accounting policies and changes in accounting estimates. When there is doubt as to which type of change it is, BAS 8 requires it to be treated as a change in accounting estimate based upon new information.
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5 Prior period errors Section overview
5.1
Prior period errors should be corrected by retrospective restatement.
Introduction Errors may be discovered during a current period which relate to a prior period. If immaterial, these errors can be corrected through net profit or loss for the current period. Where they are material prior period errors, however, this is not appropriate.
Definition Prior period errors: Are omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that:
Was available when financial statements for those periods were authorised for issue.
Could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.
5.2
Accounting treatment Prior period errors should be corrected retrospectively.
Definition Retrospective restatement: Correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred.
This involves:
Either restating the comparative amounts for the prior period(s) in which the error occurred,
Or, if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented
so that the financial statements are presented as if the error had never occurred. Only where it is impracticable to determine the cumulative effect of an error on prior periods can an entity correct a prior period error prospectively. (See section 6.)
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5.3
4
Disclosures Various disclosures are required:
Nature of the prior period error.
For each prior period, to the extent practicable, the amount of the correction for each financial statement line item affected.
The amount of the correction at the beginning of the earliest prior period presented.
If retrospective restatement is impracticable for a particular prior period, the circumstances that led to the existence of that condition and a description of how and from when the error has been corrected.
Subsequent periods need not repeat these disclosures.
6 Impracticability Section overview
6.1
There may be practical limitations on retrospective application of changes in accounting policy and prior period errors.
Issue As we have already mentioned, in some cases it may be impracticable to make retrospective adjustments for changes in accounting policies or prior period errors.
Definition Impracticable: Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. It is impracticable to apply a change in an accounting policy retrospectively or to make a retrospective restatement to correct an error if one of the following apply.
The effects of the retrospective application or retrospective restatement are not determinable.
The retrospective application or retrospective restatement requires assumptions about what management's intent would have been in that period.
The retrospective application or retrospective restatement requires significant estimates of amounts and it is impossible to distinguish objectively information about those estimates that: –
Provides evidence of circumstances that existed on the date(s) at which the transaction, other event or condition occurred; and
–
Would have been available when the financial statements for that prior period were authorised for issue, from other information.
Where it is impracticable to determine the period-specific or cumulative effects of:
Retrospective application of a changed accounting policy Prior period errors ranking for retrospective restatement
then no retrospective adjustments are made. 'Impracticable' is defined in the same way as in BAS 1. It is important not to use hindsight but to identify information for earlier periods which not only reflects the circumstances at the earlier date but also would have been available at that earlier date. If such information is not identifiable, then it is impracticable to make retrospective application or restatement.
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7 BFRS 5 and discontinued operations Section overview
7.1
The results of discontinued operations should be presented separately on the face of the income statement.
The problem The ability to predict the future performance of an entity is hampered when the financial statements include activities which as a result of sale or closure will not continue into the future. While figures inclusive of those activities are a fair measure of past performance, they do not form a good basis for predicting the future cash flows, earnings-generating capacity and financial position. Separating out data about discontinued activities benefits users of financial statements, but leads to difficulties in defining such operations and in deciding when a discontinuance comes about. This problem is addressed by BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
7.2
The objectives of BFRS 5 regarding discontinued operations Part of BFRS 5 is designed to deal with the problem by requiring entities to disclose in the income and cash flow statements the results of discontinued operations separately from those of continuing operations and to make certain balance sheet disclosures. This chapter only deals with BFRS 5's definition of discontinued operations and its disclosure requirements; the other aspects are concerned with measurement and recognition of profits and losses on non-current assets held for sale and these are covered in Chapter 5. There are two parts of the Chapter 5 coverage which are relevant to the disclosure rules dealt with in this chapter:
7.3
The key criterion for the classification of a non-current asset as held for sale is that it is highly probable that it will be finally sold within 12 months of classification.
A non-current asset held for sale is measured at the lower of carrying amount and fair value less costs to sell. The effect is that if fair value less costs to sell is lower than the carrying amount of the asset, then the loss is recognised at the time the decision is made to dispose of the asset, not when the disposal actually takes place.
Discontinued operations Definitions Discontinued operation: A component of an entity that has either been disposed of, or is classified as held for sale, and
Represents a separate major line of business or geographical area of operations,
Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations, or
Is a subsidiary acquired exclusively with a view to resale.
Component of an entity : Operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.
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As already noted, the separation of information about discontinued activities benefits users of financial statements by providing them with information about continuing operations which they can use as the basis for predicting the future cash flows, earnings-generating capacity and financial position. Management is therefore faced with the temptation to classify continuing, but underperforming, operations as discontinued, so that their performance does not act as a drag on the figures used as a basis for future predictions. This is why the definition of a discontinued operation is so important, but applying that definition requires difficult judgements. Consider the following:
7.4
The abrupt cessation of several products within an ongoing line of business: presumably a line of business must be defined by reference to the requirement in the definition for a component to be 'distinguished operationally and for financial reporting purposes'. But how many products have to be stopped before the line of business itself is stopped?
Selling a subsidiary whose activities are similar to those of other group companies: how should 'similar' be defined?
When does a discontinuance come about? BFRS 5 does not set out specific criteria for when a discontinuance comes about, despite its importance in terms of defining the accounting period in which disclosures must first be made. Instead, it relies on the definition of a discontinued operation, but this comes in two parts; it is a component of the entity which:
Has been disposed of. In this case, the disclosures will first be made in the accounting period in which the disposal takes place, or
Is held for sale. In this case the disclosures will first be made in the accounting period in which the decision to dispose of it is made, provided that it is highly probable that it will be sold within 12 months of classification.
If a business decides to discontinue operations and the non-current assets supporting these operations are to be abandoned (so scrapped or just closed down) rather than sold, the carrying amount of the assets will not be recovered principally through sale. So these assets cannot be classified as held for sale. As a result, these operations should not be disclosed as discontinued until the underlying assets actually cease to be used. Points to note Operations supported by assets which become idle because they are temporarily taken out of use may not be described as discontinued. This includes, for example, assets that are mothballed and may be brought back into use if market conditions improve.
7.5
Presenting discontinued operations: income statement and cash flow statement An entity should disclose a single amount on the face of the income statement comprising the total of:
The post-tax profit or loss of discontinued operations, and Any post-tax gain or loss on related assets
An entity should also disclose an analysis of this single amount into
The revenue, expenses and pre-tax profit or loss of discontinued operations The related income tax expense Post-tax gain or loss on related assets
This analysis may be presented either:
On the face of the income statement, or In the notes
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Financial accounting If it is presented on the face of the income statement it should be presented in a section identified as relating to discontinued operations, i.e. separately from continuing operations. (This analysis is not required where the discontinued operation is a newly acquired subsidiary that has been classified as held for sale.) The disclosure of discontinued operations adopted in these Learning Materials is in line with Example 11 in the (non-mandatory) Guidance on Implementing BFRS 5. The main part of the income statement is described as 'continuing operations', with the single amount in respect of 'discontinued operations' being brought in just above 'profit/(loss) for the period'. XYZ LTD – Income statement for the year ended [date] CUm Continuing operations Revenue Cost of sales … … Share of profits/(losses) of associates Profit/(loss) before tax Income tax expense Profit/(loss) for the period from continuing operations Discontinued operations Profit/(loss) for the period from discontinued operations Profit/(loss) for the period
X (X) … … X X (X) X (X) X
The additional information is then included in a note to the income statement. In the cash flow statement an entity should disclose the net cash flows attributable to the:
Operating Investing, and Financing
activities of discontinued operations. These disclosures may be presented either on the face of the cash flow statement or in the notes. Points to note
7.6
1
The results and cash flows for any prior periods shown as comparative figures must be restated to be consistent with the continuing/discontinued classification in the current period. As an example, operations discontinued in the year ended 31 December 20X7 will have been presented as continuing in the 20X6 financial statements but will be re-presented as discontinued in the 20X6 comparative figures included in the 20X7 financial statements.
2
Some narrative descriptions are also required. Although this part of the BFRS does not specifically mention discontinued operations, it includes them through its requirement for these narratives in respect of non-current assets disposed of or classified as held for sale; many discontinued operations will include such non-current assets.
3
If in the current period there are adjustments to be made to operations discontinued in prior periods, their effect must be shown separately from the figures for operations discontinued in the current period. Examples are given of the sort of adjustments which may have to be made.
4
If a part of the business is discontinued but it does not meet the criteria for a discontinued operation (i.e. it cannot be clearly distinguished), then its results must be included in those from continuing operations.
Presenting discontinued operations: balance sheet If the operation has finally been discontinued and all its assets have been disposed of, there will be nothing relating to the discontinued operation still in the balance sheet. So there will be no balance sheet disclosures.
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If non-current assets held for sale have not been finally disposed of, they must be shown in the balance sheet separately from all other assets. In these circumstances there will be a separate line item immediately below the sub-total for current assets for the non-current assets held for sale. If an operation is being discontinued, then any non-current assets related to it will now be held with a view to disposal and it will be inappropriate for them to be shown as non-current assets. The previous classification is retained for non-current assets being abandoned because, by definition, they are not held for sale. Point to note: any non-current assets now held for sale are not reclassified as held for sale in the balance sheets for any prior periods shown as comparative figures.
7.7
Link with other BASs As has already been noted, the part of BFRS 5 dealt with in this chapter is concerned purely with disclosure, not about recognition or measurement. But a decision to discontinue an operation would normally require management to immediately consider the recognition and measurement requirements of:
BAS 36 Impairment of Assets (dealt with in Chapter 5) which may require an immediate reduction in the carrying amount of non-current assets.
BAS 37 Provisions, Contingent Liabilities and Contingent Assets (dealt with in Chapter 9) which may require the recognition of provisions for reorganisation and restructuring costs.
It is also the case that, even if a component being disposed of or abandoned has to be treated as a continuing operation (because it does not meet all of the conditions for being classified as a discontinued operation), management should still consider whether the requirements of BAS 36 and BAS 37, together with that of BAS 1 (dealt with in Chapter 3) to make separate disclosure of 'exceptional' items, should be applied to that continuing operation.
Worked example: Business closure On 20 October 20X7 the directors of a parent company made a public announcement of plans to close a steel works. The closure means that the group will no longer carry out this type of operation, which until recently has represented about 10% of its total revenue. The works will be gradually shut down over a period of several months, with complete closure expected in July 20X8. At 31 December output had been significantly reduced and some redundancies had already taken place. The cash flows, revenues and expenses relating to the steel works can be clearly distinguished from those of the subsidiary’s other operations. How should the closure be treated in the financial statements for the year ended 31 December 20X7?
Solution Because the steel works is being closed, rather than sold, it cannot be classified as ‘held for sale’. In addition, the steel works is not a discontinued operation. Although at 31 December 20X7 the group was firmly committed to the closure, this has not yet taken place and therefore the steel works must be included in continuing operations. Information about the planned closure should be disclosed in the notes to the financial statements.
Interactive question 1: Grey Ltd
[Difficulty level: Exam standard]
The income statement for Grey Ltd for the year ended 31 December 20X7 is as follows: Revenue Cost of sales Gross profit Distribution costs Administrative expenses
CU 300,000 (100,000) 200,000 (40,000) (90,000)
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Financial accounting Profit before tax Income tax expense Profit for the period
70,000 (21,000) 49,000
On 30 September 20X7 the company classified a manufacturing division as held for sale. It satisfies the definition of a discontinued operation in accordance with BFRS 5. The results of the division are as follows: CU 32,000 (15,000) (12,000) (10,000)
Revenue Cost of sales Distribution costs Administrative expenses These balances have been included in the income statement of Grey Ltd above. Requirement Show how the discontinued operation would be treated in the income statement. Fill in the proforma below.
CU Continuing operations Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit before tax Income tax expense Profit for the period from continuing operations Discontinued operations Loss for the period from discontinued operations Profit for the period WORKING Continuing operations CU
Discontinued operations CU
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit /(loss) from operations Income tax Net profit/(loss) for period See Answer at the end of this chapter.
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Financial instruments should be classified as financial assets, financial liabilities or equity. Classification should be based on the substance of the contractual arrangement.
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8.1
4
The issue If you read the financial press you will probably be aware of the rapid international expansion in the use of financial instruments. These vary from straightforward, traditional instruments, e.g. bonds, through to various forms of so-called derivative instruments. As these instruments have been developed over time difficulties have arisen regarding their presentation and measurement.
8.2
Elements of financial statements BFRS Framework defines the elements of financial statements which relate to the measurement of financial position as:
Assets, which are resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Liabilities, which are present obligations of the entity arising from past events, the settlement of which is expected to lead to the outflow from the entity of resources embodying economic benefits.
Equity, which is the residual of assets less liabilities.
The key to applying these definitions is being able to distinguish one from the other in practical terms. In some cases, this will be straightforward, so for example, it is easy to see that a bank loan would be a liability. However, in more complex cases (which will be covered in Financial Reporting) making this distinction may be more difficult.
8.3
BAS 32 Financial Instruments: Presentation BAS 32 Presentation is designed to address the kind of problem mentioned above.
Definition Financial instrument: Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
Financial instruments should be classified as either:
Financial assets Financial liabilities, or Equity
Definition Financial asset: Any asset that is:
Cash
An equity instrument of another entity
A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favourable to the entity, or
A contract that will or may be settled in the entity's own equity instruments and is: –
A non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments, or
–
A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments.
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Financial accounting Financial liability: Any liability that is:
A contractual obligation: –
To deliver cash or another financial asset to another entity, or
–
To exchange financial instruments with another entity under conditions that are potentially unfavourable, or
A contract that will or may be settled in the entity's own equity instruments and is: –
A non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments, or
–
A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments.
Equity instrument: Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
We should clarify some points arising from these definitions. Firstly, one or two terms above should be themselves defined.
A 'contract' need not be in writing, but it must comprise an agreement that has 'clear economic consequences' and which the parties to it cannot avoid, usually because the agreement is enforceable in law.
An 'entity' here could be an individual, partnership, incorporated body or government agency.
The definitions of financial assets and financial liabilities may seem rather circular, referring as they do to the terms financial asset and financial instrument. The point is that there may be a chain of contractual rights and obligations, but it will lead ultimately to the receipt or payment of cash or the acquisition or issue of an equity instrument. Examples of financial assets include:
Trade receivables Options Shares (when held as an investment)
Examples of financial liabilities include:
Trade payables Debenture loans payable Redeemable preference (non-equity) shares Forward contracts standing at a loss
As we have already noted, financial instruments include both of the following.
Primary instruments: e.g. receivables, payables and equity securities.
Derivative instruments: e.g. financial options, futures and forwards, interest rate swaps and currency swaps.
BAS 32 makes it clear that the following items are not financial instruments.
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Physical assets, e.g. inventories, property, plant and equipment, leased assets and intangible assets (patents, trademarks etc).
Prepaid expenses, deferred revenue and most warranty obligations.
Liabilities or assets that are not contractual in nature.
Contractual rights/obligations that do not involve transfer of a financial asset, e.g. commodity futures contracts.
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Worked example: Definitions List the reasons why physical assets and prepaid expenses do not qualify as financial instruments.
Solution Refer to the definitions of financial assets and liabilities given above. (a)
Physical assets: control of these creates an opportunity to generate an inflow of cash or other assets, but it does not give rise to a present right to receive cash or other financial assets.
(b) Prepaid expenses, etc: the future economic benefit is the receipt of goods/services rather than the right to receive cash or other financial assets.
8.4
Liabilities and equity Financial instruments should be presented according to their substance, not merely their legal form. This classification is made at the time the instrument is first issued and is not revised subsequently. The classification of a financial instrument as a liability or as equity depends on the following:
The substance of the contractual arrangement on initial recognition The definitions of a financial liability and an equity instrument
How should a financial liability be distinguished from an equity instrument? The critical feature of a liability is an obligation to transfer economic benefit. Therefore, the financial instrument is a financial liability if there is:
A contractual obligation on the issuer to deliver cash/another financial asset, or A contractual right for the holder to receive cash/another financial asset.
Where this feature is not met, then the financial instrument is an equity instrument.
Worked example: Classification of financial instruments Alpha Ltd issues 100,000 CU1 ordinary shares. These would be classified as an equity instrument:
8.5
The shareholders own an equity instrument because although they own a residual interest in the company, they have no contractual right to demand any of it to be delivered to them, e.g. by way of dividend.
The company has issued an equity instrument because it has no contractual obligation to distribute that residual interest.
Preference shares Preference shares provide the holder with the right to receive:
An annual dividend (usually a predetermined and unchanging amount).
A fixed amount on the ultimate liquidation of the company or at an earlier date if the shares are redeemable.
BAS 32 treats most preference shares as liabilities. This is because they are, in substance, loans. Fixed annual dividend Fixed amount on redemption/liquidation
= =
'interest' 'repayment of loan'
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Financial accounting In practical terms preference shares are only treated as part of equity when:
They will never be redeemed, or
The redemption is solely at the option of the issuer and the terms are such that it is very unlikely at the time of issue that the issuer will ever decide on redemption.
For the purposes of your exam, if you are told that preference shares are irredeemable you should treat them as equity.
8.6
Interest and dividends The costs of servicing the financing of a company must be treated consistently with the way that the underlying instrument has been treated:
8.7
Dividends on ordinary shares and irredeemable preference shares will be shown as an appropriation of profit (in the statement of changes in equity)
The cost of servicing loans will be shown as interest payable (in the income statement)
Dividends on redeemable preference shares will be shown alongside interest payable as part of the finance cost (in the income statement).
Offsetting a financial asset and a financial liability It may be the case that one entity both owes money to and is due money from another entity. A frequently occurring example of this is where a company has several accounts with a single bank, some of which are in credit and some overdrawn. The presentation issue is whether these amounts should be shown separately or whether they should be netted off against each other and a single figure for the resulting net asset (or liability) shown. BAS 32 looks to see whether there is a legally enforceable right to make the set off. But it then goes further, by taking account of the entity’s intentions. If there is a legal right to make a set off and the entity intends to settle the amounts on a net basis, then the set off must be made. On this basis an entity with credit and overdrawn bank balances would not set them off against each other (even if it had the legal right to do so) because in the normal course of business it is keeping these accounts separate, so it cannot claim that it 'intends' to settle on a net basis.
8.8
8.9
Other points
Instead of cancelling any of its own shares it may have bought back, an entity may hold them for reissue. In this case they are described as ‘treasury shares’ and are deducted from equity, not shown amongst the entity’s assets.
Transaction costs associated with the issue of equity are to be deducted from equity, but only where these costs are incremental. So the fixed cost of in-house legal and/or finance teams cannot be treated in this way, but should be recognised in profit or loss as incurred.
Measurement of financial instruments Measurement of financial instruments is dealt with by BAS 39 Financial Instruments: Recognition and Measurement. In simple terms, financial instruments are initially measured at the fair value of the consideration given or received (i.e. cost) plus (in most cases) transaction costs that are directly attributable to the acquisition of the financial instrument. The detail of this accounting standard is outside the scope of the Financial Accounting syllabus.
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Summary and Self-test
Summary
BAS 8
BFRS 5
BAS 32
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Financial accounting
Self-test Answer the following questions 1
During the year to 30 September 20X6, the following events occurred in relation to Pipe Ltd. (1) A claim for tax relief, submitted in 20X3, was rejected by the General Commissioners of HMRC. No appeal will be made. The resulting liability of CU15,000 was not provided at 30 September 20X5, since the company had expected the claim to succeed. (2) The company had decided to capitalise borrowing costs in the cost of its non-current assets for the first time in 20X6. The net effect at 30 September 20X5 would have been CU5,000. (3) A cut-off error in respect of inventories at 30 September 20X5 was discovered which would have reduced the carrying amount of inventories by CU24,000. This error is material but not fundamental. (4) Non-current assets which had been written down to their estimated realisable value of CU17,000 at 30 September 20X5 were sold for CU7,000. How much should be accounted for retrospectively as an adjustment to retained earnings brought forward at 1 October 20X5? A B C D
2
CU10,000 (decrease) CU19,000 (decrease) CU29,000 (decrease) CU34,000 (decrease)
When considering BFRS 5 Non-current Assets Held for Sale and Discontinued Operations, which of the following statements is true? (1) A discontinued operation must have been disposed of by the balance sheet date. (2) A discontinued operation must be a separate major line of business or geographical area of operation. (3) A discontinued operation must be clearly distinguished operationally and for financial reporting purposes. A B C D
3
(1), (2) and (3) (1) and (2) only (2) and (3) only (1) and (3) only
During the financial year Alphabet Ltd carried out a reorganisation as follows. Division X, a Dhaka division whose operations are being terminated and transferred to another Dhaka division producing the same product. Division Y, the sole operator in Asia whose business is being sold externally to the group. Activity W, (part of Division Z) whose operations have been closed down. W's results have not been reported separately. Which of the following could be a discontinued operation according to BFRS 5 Non-current Assets Held for Sale and Discontinued Operations? A B C D
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Division X only Division Y only Division X and Division Y only Division X, Division Y and Activity W
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5
4
When an entity decides to classify an operation as discontinued in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations, what factors must be considered? (1) (2) (3) (4)
Whether there is a need for any restructuring provisions. Whether there is a need for an impairment review of assets being disposed of. The effect of termination on employees such as redundancy and pension costs. The effect of disposal on tangible non-current assets.
A B C D
All factors must be considered Only factors (1) and (2) must be considered Only factors (2) and (4) must be considered Only factors (1), (2) and (4) must be considered
During the year to 30 April 20X9 Grant Ltd carried out a major reorganisation of its activities as follows. Maynard was closed down on 1 January 20X9. Maynard was the only manufacturing division of the company, and as a result of the closure Grant's only activity will be the retail of artists equipment. On 30 March 20X9 it was decided to sell Lytton, the only division that operated in Europe. The company were confident of a sale within the year. The sale actually took place on 15 July 20X9. The activities carried on by Hobhouse were terminated during the period. Hobhouse was one of a number of smaller divisions which operated from the same location as the main headquarters of Grant. All these divisions use the same central accounting system and operating costs are allocated between them for the purpose of the management accounts. The accounts for the year ended 30 April 20X9 were approved on 7 July 20X9. Which of these divisions should be classified as discontinued operations in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations in the financial statements of Grant Ltd for the year ended 30 April 20X9? A B C D
6
Under the definitions in BAS 32 Financial Instruments: Presentation, which of the following is not a financial instrument? A B C D
7
Inventories Trade receivables Redeemable preference shares Forward contracts
A company has CU500,000 4% redeemable preference shares in issue. According to BAS 32 Financial Instruments: Presentation, where will the dividend charge for the year be shown in the income statement? A B C D
8
Maynard only Maynard and Lytton only Maynard, Lytton and Hobhouse None of them
Dividends received Interest received Dividends paid Interest paid
According to BAS 32 Financial Instruments: Presentation, what is the correct treatment for dividends on redeemable preference shares and dividends on ordinary shares in financial statements? A
All dividends are recognised in the income statement as an expense
B
All paid dividends are recognised in the income statement as an expense and no proposed dividends are recognised
C
Preference dividends and equity dividends paid are recognised in the statement of changes in equity
D
Preference dividends are recognised in the income statement and equity dividends paid are recognised in the statement of changes in equity
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Oxford Ltd has CU6m of 6% redeemable preference shares in issue. They are redeemable on 31 December 20X5. In accordance with BAS 32 Financial Instruments: Presentation where are these disclosed on the balance sheet in the year ended 31 December 20X3? A B C D
10
Non-current liabilities Current liabilities Equity Non-current assets
WESTERN ENTERPRISES LTD Western Enterprises Ltd wholesales and distributes toys and models and provides distribution services to other organisations. The following balances have been extracted from its books of account of at 31 December 20X3. Ordinary shares 5% redeemable preference shares Share premium account Revaluation reserve Retained earnings at 1 January 20X3 Revenue Purchases Inventories at 1 January 20X3 Staff costs – distribution Staff costs – administration Depreciation charge for the year Freehold land and buildings Distribution equipment Other plant and equipment General expenses Interest receivable Interest payable Taxation – charge for the year Paid dividends Ordinary shares – final regarding 20X2 Ordinary shares – interim regarding 20X3 5% redeemable preference shares – for 20X3 Patent rights
CU'000 800 200 350 400 2,000 11,899 8,935 974 270 352
Freehold land and buildings Distribution equipment – cost Other plant and equipment – cost Accumulated depreciation at 31 December 20X3 Freehold land and buildings Distribution equipment Other plant and equipment Trade receivables Trade payables Cash and cash equivalents Tax liability
30 116 160 432 41 35 336 60 30 10 200 1,500 800 1,400 30 320 250 1,600 850 300 400
Additional information (1) Included in revenue are invoices totalling CU120,000 in relation to distribution services rendered under a contract to a customer who is very unhappy with the quality of the services provided. The overall outcome of the contract is uncertain and management believes that of the CU90,000 costs incurred to date under the contract, probably only CU65,000 will be reimbursed by this customer. (2) The patent was acquired during the year. Amortisation of CU20,000 should be charged to administrative expenses.
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(3) Inventories at 31 December 20X3 were valued at CU1,304,000. (4) Costs not specifically attributable to one of the income statement expense headings should be split 50:50 between distribution costs and administrative expenses. (5) The freehold land and buildings were revalued on 1 January 20X3 and the surplus of CU400,000 over its previous carrying amount of CU1,100,000 (cost CU1,200,000 and accumulated depreciation CU100,000) has been recognised in the revaluation reserve. The depreciation charge for the year increased by CU8,000 as a result of the revaluation. (6) General expenses include a material bad debt write off of CU100,000. (7) A final ordinary share dividend for 20X3 of CU50,000 was proposed in May 20X4, payable on 28 June 20X4. (8) CU450,000 cash was received during the year as a result of a rights issue of ordinary shares. The nominal value of the shares issued was CU100,000. (9) On 1 June 20X3 the company made the decision to sell its loss-making soft toy division as a result of severe competition from the Far East. The company is confident that the closure will be completed by 30 April 20X4. The division’s operations represent in 20X3 10% of revenue (after all adjustments), 15% of cost of sales, 10% of distribution costs and 20% of administrative expenses. No balance sheet disclosures are necessary. Requirement Prepare Western Enterprises Ltd’s income statement and statement of changes in equity for the year to 31 December 20X3, a balance sheet at that date and movements schedules and notes in accordance with the requirements of BFRS, to the extent the information is available. (20 marks) 11
WOODSEATS LTD There are issues about the presentation of financial instruments in the balance sheet of an entity in relation to their classification as liabilities and equity and to the related interest, dividends, losses and gains. The objective of BAS 32 Financial Instruments: Presentation is to address this problem by establishing principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. On 1 January 20X3 Woodseats Ltd had only ordinary shares in issue. During the year ended 31 December 20X3 Woodseats Ltd entered into the following financing transactions. (1) On 1 January 20X3 Woodseats Ltd issued 20 million 8% CU1 preference shares at par. The preference shares are redeemable at par on 30 June 20X8. The appropriate dividend in respect of these shares was paid on 31 December 20X3. (2) On 30 June 20X3 Woodseats Ltd issued 10 million 12% CU1 irredeemable preference shares at par. The appropriate dividend in respect of these shares was paid on 31 December 20X3. On 31 December 20X3 Woodseats Ltd decided to change its accounting policy in respect of the capitalisation of interest. Previously, Woodseats Ltd had capitalised interest within property, plant and equipment and amortised those costs. It has now decided to write off such costs to cost of sales as incurred. The net book value of such interest included in the draft balance sheet was as follows. At 1 January 20X3 Costs incurred Amortisation charge At 31 December 20X3
CUm 4.5 2.0 (0.5) 6.0
The draft profit for 20X3, before adjusting for capitalised interest, was CU15 million. Retained earnings at 1 January 20X3 were CU75 million.
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Financial accounting Requirements (a)
Describe the concept of 'substance over form' and its application to the presentation of financial liabilities under BAS 32 Financial Instruments: Presentation. (4 marks)
(b) Prepare extracts from the financial statements of Woodseats Ltd for the year ended 31 December 20X3 to the extent the information is available, showing how the above would be reflected in those financial statements. Notes to the accounts are not required. Ignore taxation.
(8 marks) (12 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Technical reference Point to note: The following sets out the examinability of the standards covered in this chapter. BAS 8
All examinable
BFRS 5
References to disposal groups and implementation guidance (except 11 and 12) are not examinable
BAS 32
Only paragraphs 2, 4, 8-11, 13-18, 35-46, Appendix paragraphs AG1AG12 and AG25-AG26 are examinable.
The paragraphs listed below are the key references you should be familiar with. 1 Accounting policies
Definition
BAS 8 (5)
Developed by reference to the relevant Standard/Interpretation where this is applicable
BAS 8 (7)
Otherwise judgement applied
BAS 8 (10)
Selection and application should be consistent
BAS 8 (13)
2 Change in accounting policies
Only allowed if: – –
BAS 8 (14)
Required by a Standard/Interpretation, or Results in relevant and more reliable information BAS 8 (19-22)
Changes should be applied: –
In accordance with transitional provisions, or
–
Retrospectively if there are no transitional provisions or the change is voluntary
Retrospective application is applying a new accounting policy as if that policy had always been applied
If impracticable to determine the period specific effects: – –
BAS 8 (5)
BAS 8 (23-27)
Apply the new accounting policy from the earliest period for which retrospective application is practicable Disclose this fact
3 Changes in accounting estimates
Definition
Changes relating to assets, liabilities or equity are adjusted in the period of change
BAS 8 (37)
All other changes should be applied prospectively:
BAS 8 (36)
– –
In the period of change In the period of change and future periods if both are affected
Disclosure: – –
BAS 8 (5)
BAS 8 (39)
Nature of change Amount
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Definition
Correct retrospectively in the first set of financial statements authorised for issue after their discovery
BAS 8 (42)
Disclose
BAS 8 (49)
– Nature of the prior period error – Amount of the correction for each prior period presented – Amount of the correction at the beginning of the earliest period presented If impracticable to determine the period-specific effects or the cumulative effect of the error: – –
BAS 8 (5)
BAS 8 (49)
Correct the error from the earliest period/date practicable Disclose this fact
5 Discontinued operations
Definition
BFRS 5 (31-32)
Disclosures on the face of the income statement:
BFRS 5 (33(a))
–
A single amount comprising the total of:
The post-tax profit or loss of discontinued operations, and The post-tax gain or loss recognised on related assets Disclosures on the face or in the notes: –
BFRS 5 (33(b) (c))
An analysis of the single amount on the face
Comparative figures must be restated
BFRS 5 (34)
Narrative disclosures are also required
BFRS 5 (41)
If part of the business is discontinued but it does not meet the criteria then its results must be included in those from continuing operations
BFRS 5 (37)
6 Financial instruments
Definition
BAS 32 (11)
Financial instruments should be classified as:
BAS 32 (11)
– – –
Financial assets Financial liabilities Equity
Classification should take account of the substance of the instrument
BAS 32 (15)
The critical feature of a liability is an obligation to transfer economic benefit
BAS 32 (17)
Where there is no contractual obligation to deliver cash or another asset the instrument is an equity instrument
BAS 32 (16(a))
A preference share that:
BAS 32 (16(a))
– –
Provides for mandatory redemption by the issuer, or Gives the holder the right to require the issuer to redeem the instrument
is a financial liability
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A preference share that: –
Is irredeemable, or
–
Is redeemable but redemption is solely at the option of the issuer and is unlikely to take place
is an equity instrument
Interest and dividends –
These must be treated consistently with the way that the underlying instrument has been treated
Offsetting a financial asset and a financial liability
BAS 32 (42)
–
set off must be made where there is a legal right to set off and the entity intends to settle on a net basis Other issues
–
Incremental transaction costs are deducted from equity
BAS 32 (37)
7 Measurement of financial instruments
Financial instruments are initially measured at fair value
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Answers to Self-test 1
B
Under BFRS items (1) and (4) arise from normal estimation errors and are recognised in the current accounting period. Item (2) results from a change of accounting policy and increases retained earnings brought forward by CU5,000. Item (3) results from an error which reduces retained earnings brought forward by CU24,000. There is a net reduction of CU19,000.
2
C
In order to be classified as discontinued, a component must either have been disposed of or be held for sale (provided that it is highly probable that it will be sold within 12 months of classification (BFRS 5 paragraph 8)).
3
B
Division X is not a discontinued operation as a separate line of business is not being terminated – production is shifting from one division to another. Division Y could be a discontinued operation as a geographical area of operations is being sold. Activity W is not discontinued, as it cannot be separately distinguished for financial reporting purposes.
4
A
The effect of the discontinuance can be far reaching and may trigger reviews required by other standards.
5
B
Maynard amounts to the withdrawal from a particular line of business. Lytton amounts to the withdrawal from a geographical area of operation. The date of sale is irrelevant.
6
A
Per BAS 32 paragraph 11
7
D
The cost of servicing the financing company are treated consistently with the way the underlying instrument has been treated. Per BAS 32 paragraph 36.
8
D
Equity dividends paid are recognised in the statement of changes in equity. Equity dividends proposed after the year-end are not a liability at the balance sheet date so are not recognised. Dividends on redeemable preference shares are recognised in the income statement as a finance cost.
9
A
Redeemable preference shares are treated as a financial liability, not as part of equity. They are redeemable more than 12 months after the balance sheet date.
10
WESTERN ENTERPRISES LTD Income statement for the year ended 31 December 20X3 CU'000 Continuing operations Revenue (W3) Cost of sales (W3) Gross profit Distribution costs (W3) Administrative expenses (W3) Profit from operations Finance cost (35 + 10) Investment income Profit before tax Income tax Profit for the period from continuing operations Discontinued operations Loss for the period from discontinued operations (W3) Profit for the period
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10,660 (7,314) 3,346 (627) (546) 2,173 (45) 41 2,169 (336) 1,833 (314) 1,519
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Statement of changes in equity for the year ended 31 December 20X3
Recognised directly in equity Revaluation of non-current assets Transfer regarding depreciation on revaluation Total recognised directly in equity Profit for the period Total recognised income and expenditure for the period Issue of shares 20X2 final dividend 20X3 interim dividend Balance brought forward Balance carried forward
Ordinary share capital CU'000
Share premium CU000
Revaluation reserve CU000
Retained earnings CU000
Total CU000
–
400
–
–
400
– – –
– – –
(8) 392 –
8 8 1,519
– 400 1,519
– 100 – – 100 700 800
– 350 – – 350 – 350
392 – – – 392 – 392
1,527 – (60) (30) 1,437 2,000 3,437
1,919 450 (60) (30) 2,279 2,700 4,979
Notes (1) The profit from operations is arrived at after charging CU'000 Depreciation (30 + 116 + 160) 306 Amortisation of intangibles 20 Employee benefits (270 + 352) 622 Exceptional bad debt 100 (2) A final ordinary share dividend for 20X3 of CU50,000 is proposed for payment on 28 June 20X4. (3) On 1 June 20X3 the company classified its soft toy division as held for sale. The division had been loss-making for some time due to severe competition from the Far East. It is expected that the closure will be complete by 30 April 20X4. Amounts in CU000 attributable to this division in 20X3 were: revenue CU1,184, expenses CU1,498 and pre-tax loss CU314. Balance sheet as at 31 December 20X3 CU'000 ASSETS Non-current assets Property, plant and equipment (see note) Intangibles (see note) Current assets Inventories Trade and other receivables (1,600 – 55 (W1)) Cash and cash equivalents Total assets
CU'000 3,100 180 3,280
1,304 1,545 300 3,149 6,429
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Financial accounting CU000 EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium Revaluation reserve Retained earnings Equity Non-current liabilities Preference share capital Current liabilities Trade and other payables Taxation
CU000 800 350 392 3,437 4,979 200
850 400 1,250 6,429
Total equity and liabilities PROPERTY, PLANT AND EQUIPMENT Freehold land and buildings CU'000
Distribution equipment CU'000
Other plant and equipment CU'000
Total CU'000
1,200 300 1,500
800 – 800
1,400 – 1,400
3,400 300 3,700
204 – 116 320
90 – 160 250
480 596
1,150 1,310
Cost or valuation At 1 January 20X3 Revaluation At 31 December 20X3 Depreciation At 1 January 20X3 Revaluation adjustment Charge for the year At 31 December 20X3 Carrying amount At 31 December 20X3 At 1 January 20X3
100 (100) 30 30 1,470 1,100
394 (100) 306 600 3,100 3,006 CU'000
INTANGIBLES Cost at 31 December 20X3 Amortisation Carrying amount at 31 December 20X3 This patent was acquired during the year
200 (20) 180
WORKINGS (1) Revenue and trade receivables CU'000 Per list of balances Adjustment regarding contract under dispute Included in revenue Costs recoverable Adjustments to revenue and trade receivables
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120 (65)
CU'000 11,899
(55) 11,844
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(2) Analysis of expenses
Opening inventories Purchases Staff costs Depreciation Land and buildings Distribution equipment Other PPE General expenses Amortisation of patent Closing inventories
Cost of sales CU'000 974 8,935
(1,304) 8,605
Distribution costs CU'000
Administrative expenses CU'000
270
352
15 116 80 216
15
697
80 216 20 683
(3) Continuing/discontinued analysis
Revenue (W1 – 90:10) Cost of sales (W2 – 85:15) Gross profit Distribution costs (W2 – 90:10) Administrative expenses (W2 – 80:20) Profit/(loss) from operations Finance cost (35 + 10) Investment income Profit/(loss) before tax Income tax Net profit/(loss) for the period 11
Continuing operations CU'000 10,660 (7,314) 3,346 (627) (546) 2,173 (45) 41 2,169 (336) 1,833
Discontinued operations CU'000 1,184 (1,291) (107) (70) (137) (314) – – (314) – (314)
Total CU'000 11,844 (8,605) 3,239 (697) (683) 1,859 (45) 41 1,855 (336) 1,519
WOODSEATS LTD (a)
Substance over form and the presentation of financial liabilities under BAS 32 Financial Instruments: Presentation Under BFRS Framework for the Preparation and Presentation of Financial Statements, if information is to faithfully represent transactions, it is necessary for transactions to be presented in accordance with their substance and economic reality. The substance is not always consistent with the legal form of a transaction. This is often the case when an arrangement involves a number of linked transactions or components. BAS 32 uses the substance of a financial liability rather than its legal form to determine the balance sheet classification. Some financial instruments take the legal form of equity but are liabilities in substance as they include contractual obligations to transfer economic benefits to the holder. This approach is consistent with the definition of a liability in BFRS Framework and such financial liabilities are classified in liabilities and not equity. More complex financial instruments may combine features of both equity instruments and financial liabilities. BAS 32 looks at the substance of the components of the instrument and classifies them separately.
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Financial accounting (b) Financial statement extracts Balance sheet as at 31 December 20X3 CUm EQUITY AND LIABILITIES Capital and reserves Preference share capital (irredeemable)
10
Non-current liabilities Preference share capital (redeemable)
20
Income statement for the year ended 31 December 20X3 CUm (2.0) (1.6)
Cost of sales Finance cost (20m × 8%) Statement of changes in equity for the year ended 31 December 20X3
Attributable to the equity holders of Woodseats Ltd Profit for the period (15 + 0.5 – 2) Total recognised income and expense for the period Issue of share capital Final dividends on irredeemable preference shares (10 × 12% × 6/12) Balance brought forward – as reported Adjustment to write off capitalised interest brought forward As restated Balance carried forward
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Preference share capital (irredeemable) CUm – –
Retained earnings CUm CUm 13.5 13.5
10.0 – 10.0 –
– (0.6) 75.0
12.9
(4.5) 10.0
70.5 83.4
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Answers to Interactive question
Answer to Interactive question 1 CU Continuing operations Revenue (300 – 32) Cost of sales (100 – 15) Gross profit Distribution costs (40 – 12) Administrative expenses (90 – 10) Profit before tax Income tax expense Profit for the period from continuing operations Discontinued operations Loss for the period from discontinued operations (32 – 15 – 12 – 10) Profit for the period
268,000 (85,000) 183,000 (28,000) (80,000) 75,000 (21,000) 54,000 (5,000) 49,000
WORKING
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit /(loss) before tax Income tax Net profit/(loss) for period
Continuing operations CU 268,000 (85,000) 183,000 (28,000) (80,000) 75,000 (21,000) 54,000
Discontinued operations CU 32,000 (15,000) 17,000 (12,000) (10,000) (5,000) – (5,000)
Total CU 300,000 (100,000) 200,000 (40,000) (90,000) 70,000 (21,000) 49,000
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chapter 5
Property, plant and equipment Contents Introduction Examination context Topic List 1 Property, plant and equipment 2 Recognition of PPE 3 Measurement at recognition 4 Measurement of PPE after initial recognition 5 Accounting for revaluations 6 Depreciation 7 Impairment of assets 8 Derecognition of PPE 9 Disclosures Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Introduction
Learning objectives
Relate the treatment of property, plant and equipment to the principles in BFRS Framework
Identify the accounting standards which apply to the treatment of property, plant and equipment
Apply the accounting requirements for property, plant and equipment, including the effects of the following: –
Property, plant and equipment measured under the cost model
–
Property, plant and equipment measured under the revaluation model
–
Depreciation of property, plant and equipment
–
Impairment
–
Derecognition
–
Disclosure
Tick off
Specific syllabus references for this chapter are: 1b, 2b, c.
Practical significance Businesses operating in certain industries, for example manufacturing, typically have the use of substantial items of property, plant and equipment in their balance sheets. These are tangible assets (i.e. assets which have physical substance) such as freehold and leasehold land and buildings, plant and machinery and office equipment. They are used in the production or supply of goods and services or for administrative purposes. The management of these resources underpins the continued viability of a business and therefore represents a key feature of business prosperity. Depending on the nature of the business, property, plant and equipment can have a significant impact on the financial statements. Many of the associated decisions will involve the use of judgement. This is true, for example, of the distinction between revenue and capital expenditure. One of the principal manipulations alleged during the WorldCom scandal was the inappropriate capitalisation of expenses. Overstating of the value of non-current assets, either intentionally or unintentionally, can lead to the inflation of current earnings, which in turn can affect key performance indicators. It is important therefore that users of financial statements understand how the business uses its property, plant and equipment and how such assets are treated in the financial statements.
Stop and think Can you think of any other aspects of the accounting treatment of property, plant and equipment where judgement would be applied?
Working context If you are involved in audit it is highly likely that you have come across the audit of property, plant and equipment. The technical detail of auditing this area is covered in the Assurance paper. Typically the auditor will need to consider the following issues:
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Does the balance sheet include all the assets owned by the business (completeness)? Do all of the assets belong to the business (ownership)? Do all of the assets exist (existence)? Have the assets been valued correctly (depreciation, impairment, revaluation)?
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Have adequate disclosures been made?
Syllabus links In the Accounting paper you will have covered the basic double entry for the purchase of property, plant and equipment. You will have also covered basic depreciation, impairment and disposals. The main difference in the Financial Accounting paper is that these treatments are placed in the context of the accounting standards that relate to this topic. These include:
BAS 16 Property, Plant and Equipment BAS 36 Impairment of Assets BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
The Financial Accounting syllabus also covers in detail the alternative basis of accounting for property, plant and equipment referred to as the revaluation model. In the Accounting paper you will have covered the cost model, and will have been introduced to basic revaluations. BAS 36 and BFRS 5 will be covered in more detail in Financial & Corporate Reporting at the Advanced Stage.
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Examination context
Examination commentary Property, plant and equipment is likely to be a popular exam topic in the new syllabus in both the shortform question and written test sections of the paper. In the written test section this topic could be examined as part of a trial balance question where adjustments are required before the preparation of the balance sheet. It could also be examined in a question covering a number of accounting issues with the requirement to produce extracts from the financial statements. Alternatively it could be examined in its own right, allowing for a more detailed focus on the relevant accounting standards or a discussion of the related principles from BFRS Framework. In the examination, candidates may be required to:
Explain how BFRS Framework applies to the recognition of property, plant and equipment.
Prepare and present financial statements or extracts therefrom in accordance with: – – –
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BAS 16 Property, Plant and Equipment BAS 36 Impairment of Assets BFRS 5 Non-current Assets Held for Sale and Discontinued Operations
Prepare simple extracts from the financial statements in accordance with Companies Act and BFRS.
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1 Property, plant and equipment Section overview
1.1
BAS 16 Property, Plant and Equipment provides guidance on the accounting treatment of non-current tangible assets.
What are property, plant and equipment? Definition Property, plant and equipment: Tangible items that are both:
Held for use in the production or supply of goods or services, for rental to others or for administrative purposes.
Expected to be used during more than one period.
In practice this definition causes few problems. Property, plant and equipment (PPE) includes freehold and leasehold land and buildings and plant and machinery, and forms the major part of assets of certain types of business, such as manufacturing and transport businesses.
1.2
Non-current v current The main issue arising is whether the assets are used on a continuing basis in the company’s activities. For example, cars held for resale by a motor dealer are inventories (a current asset) whereas cars held for use by employees on company business are PPE.
1.3
BAS 16 Property, Plant and Equipment You will be familiar with some of the basic accounting issues affecting PPE from your Accounting syllabus. In the Financial Accounting syllabus you need to be able to deal with these in the context of BAS 16. The objective of BAS 16 is to prescribe in relation to PPE the accounting treatment for:
The recognition of assets The determination of their carrying amounts The depreciation charges and impairment losses relating to them.
This provides the users of financial statements with information about an entity's investment in its PPE and changes in such investments. BAS 16 should be followed when accounting for PPE unless another BAS or BFRS requires a different treatment, e.g. BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
1.4
Underlying principles The key elements in financial statements, identified in BFRS Framework, which are relevant to PPE are: Assets
Resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow into the entity.
Gains, which are a part of income
Increases in economic benefits through enhancements of assets or decreases in liabilities other than contributions from equity.
Losses, which are included in expenses
Decreases in economic benefits through depletions of assets or additional liabilities other than distributions to equity participants.
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2 Recognition of PPE Section overview
Items of PPE should be recognised where it is probable that future economic benefits will flow to the entity and their cost can be measured reliably.
Subsequent costs: – –
2.1
Repairs and maintenance expenditure should not be capitalised. Replacement parts should be capitalised.
Items of PPE may be separated into components, each with a separate useful life.
Recognition In this context, recognition simply means incorporation of the item in the entity's financial statements, in this case as a non-current asset. The recognition of PPE depends on two criteria both of which must be satisfied.
It is probable that future economic benefits associated with the item will flow to the entity.
The item's cost can be measured reliably.
Points to note: 1
2.2
The asset is not defined in terms of the tangible piece of PPE (e.g. a building or a piece of production machinery) but in terms of the economic benefits flowing from it:
So items acquired for safety or environmental reasons can be classed as PPE because they enable greater economic benefits to flow from other assets.
Legal ownership of an item of PPE is not necessary, as long as the economic benefits flowing from it are enjoyed. An item held under a finance lease (see Chapter 8) is treated as an asset belonging to the user of the item.
2
There is no definition of what constitutes an 'item of PPE'. It will be for each entity to develop its own definitions. It will be straightforward to decide that an individual motor vehicle should constitute an item. But when it comes to a blast furnace, should that be a single item or several items?
3
There is no mention of the 'acquisition' of an item of PPE. The whole of the definition revolves round the 'cost' of such an item. This means that the definition must be applied at any time over the life of the item of PPE when expenditure on it is incurred; it is not only applied on the initial acquisition or construction of the item.
Subsequent costs In terms of costs incurred subsequently to add to, replace part of, or service the item, the practical application is that:
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Repairs and maintenance expenditure should be recognised in profit or loss as incurred, because it is not probable that there will be future economic benefits flowing from it, over and above the benefits flowing from the cost originally recognised when the item was first acquired.
Replacement parts should be capitalised, provided the original cost of the items they replace is derecognised (i.e. treated as disposed of) at the time of the replacement. BAS 16 explains this in terms of the relining of a blast furnace at times when the remainder of the furnace does not need replacing and the replacement of the interior of an aircraft several times over the life of the airframe itself.
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2.3
5
Separate components This leads to the practice of treating the different parts of a bigger asset as separate components, with separate lives. These are then depreciated separately (see section 6 below), so that they are carried at their residual value over their useful lives, not the useful life of the overall asset. This component approach is also applied where regular major inspections of an asset are a condition of continuing to use it. The cost of each inspection is treated as a separate item of PPE, provided on original acquisition part of the purchase price was allocated as the cost of inspection and recognised in profit or loss over the period to the next inspection. If no separate inspection cost was incurred on original acquisition, this allocation may be made by reference to the estimated cost of the first inspection that is actually made.
3 Measurement at recognition Section overview
PPE should be measured at cost at recognition.
Elements of cost include: – – –
Cost is measured as: – –
3.1
Purchase price Directly attributable costs Estimate of dismantling and site restoration costs Cash or Fair value if PPE items are exchanged
Measurement at recognition An item of PPE qualifying for recognition is initially measured at its cost.
Definitions Cost: This 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. Fair value: This is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction.
3.2
Elements of cost of PPE The cost of a PPE item comprises:
Purchase price, including all non-recoverable duties and taxes but net of discounts.
Costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by the management.
The initial estimate of dismantling and site restoration costs.
Directly attributable costs include:
Employee benefits arising directly from construction or acquisition of the item.
Site preparation, delivery, installation and assembly costs, costs of testing, and professional fees (e.g. legal costs and architects' fees). © The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting But note that certain costs associated with the item cannot be included in its cost:
Some costs are excluded because they are not directly attributable to the item. Examples include: – – – –
The costs of opening a new facility The cost of introducing new products The cost of conducting business in a new location or with a new class of customer Administration and general overhead costs
Capitalisation ceases when the item is capable of operating in the manner intended. Costs incurred after this date have to be excluded. Examples include: – – –
Costs incurred when the item is not yet in use or is operated at less than full capacity Operating losses while demand for the output builds up (e.g. a new hotel) Reorganisation costs
Points to note 1
Costs of testing would include flight testing a new aircraft and testing for the satisfactory output of a new plant. In this latter case, any proceeds from selling product generated during testing are deducted from the cost of the plant.
2
Where activities are undertaken that are incidental to the development of the PPE item, any revenue and expenses are recognised in profit or loss, not taken into account in arriving at the cost of the item.
3
Where as a result of the acquisition of an item of PPE an obligation arises to dismantle it at the end of its useful life and/or to restore its site then that obligation must be recorded as a liability at the same time as the asset is recognised (e.g. the decommissioning costs of nuclear power stations). We will look at this issue again in Chapter 9.
4
In the case of self-constructed assets:
Internal profits and abnormal costs (e.g. those relating to design errors, wasted resources or industrial disputes) are excluded from cost.
Interest costs incurred during the course of construction may be included under BAS 23 Borrowing Costs, but inclusion is not mandatory (BAS 23 is not examinable in Financial Accounting).
Interactive question 1: Measuring cost
[Difficulty level: Intermediate]
A business incurs the following costs in relation to the construction of a new facility and the introduction to the market of its output: CU'000 Site preparation 400 Net income while site used as a car park, prior to construction commencing (50) Materials used, inclusive of CU0.3m recoverable VAT 2,000 Labour costs, inclusive of CU0.5m incurred when a labour dispute meant that no construction work was carried out 4,000 Testing of facility's processes 300 Sale of by-products produced as part of testing process (60) Consultancy fees re installation and assembly 500 Professional fees 450 Opening of facility 100 Overheads incurred: – Construction 800 – General 600 Relocation of staff to new facility 350 The following estimates have been made:
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1
The cost of having to dismantle the facility at the end of its useful life
750
2
The costs of each statutory safety inspection – the first due in 3 years
150
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3
5
While the overall life of the facility is 20 years, 40% of the costs other than those of safety inspections relate to items that will need replacing in 8 years.
Requirement Identify the total cost of the facility in accordance with BAS 16 and allocate it over the facility's components. Fill in the proforma below.
Solution Cost of facility Site preparation Net income while site used as a car park Materials used Labour costs Testing of facility's processes Sale of by-products Consultancy fees re installation and assembly Professional fees Opening of facility Overheads incurred: – Construction – General Relocation of staff to new facility Cost of dismantling facility
CU'000
Allocated to components:
See Answer at the end of this chapter.
3.3
Measurement of cost Cost is measured as the cash price at the time of recognition, with discounting if payment is deferred beyond normal credit terms. Where there is an exchange of items of PPE such that there is no cash price, cost should be measured at fair value. The exception to this is where:
The exchange transaction lacks commercial substance, for example where, the risk, timing and amount of the cash flows of the asset received differs from the risk, timing and amount of the cash flows of the asset transferred. or
The fair value of neither asset exchanged can be measured reliably
In this case the asset is measured at the carrying amount of the asset given up.
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4 Measurement of PPE after initial recognition Section overview
After initial recognition an item of PPE may be carried under: – –
4.1
The cost model, or The revaluation model
The two models BAS 16 sets out two models, without expressing a preference for either:
The cost model. An item of PPE is carried at cost (i.e. initial cost plus subsequent expenditure) less accumulated depreciation and impairment losses.
The revaluation model. An item of PPE is carried at the revalued amount, being fair value less accumulated depreciation and impairment losses.
The choice of model is an accounting policy choice, which must be applied across an entire class of PPE.
4.2
Fair value Fair value is normally taken to be market value: Land and buildings
Fair value is determined from market-based evidence by appraisal by professionally qualified valuers
Plant and equipment
Fair value is usually their market value determined by appraisal
Specialised items of property, plant and equipment (which are rarely sold)
Fair value is determined by using a depreciated replacement cost (as there is no market-based evidence of fair value)
Worked example: Depreciated replacement cost An asset that originally cost CU30,000 and is halfway through its useful life will have a carrying amount of 50% of cost = CU15,000; if it would cost CU40,000 to buy a replacement asset with the same operating characteristics, then the depreciated replacement cost would be 50% of the replacement cost = CU20,000.
4.3
Frequency of valuations Revaluations should be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. So, the frequency of the valuation depends on the volatility of the fair values of individual items of PPE. The more volatile the fair value, the more frequently revaluations should be carried out. The maximum interval mentioned is five years, but longer could be justified if movements were very small and slow. The requirement for periodic revaluations is designed to prevent companies from revaluing assets selectively.
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4.4
5
Classes of assets Definition Class of property, plant and equipment: A grouping of assets of a similar nature and use in an entity’s operations.
Where an item of PPE is revalued, all other assets in the same class should also be revalued. Again, this is designed to stop companies being selective about which items to revalue and to avoid financial statements including a mixture of costs and values for like items. BAS 16 provides examples of separate classes including the following:
Land Land and buildings Machinery Motor vehicles Furniture and fixtures Office equipment
5 Accounting for revaluations Section overview
5.1
Revaluation gains are taken directly to equity as part of the revaluation surplus.
Revaluation losses are recognised as an expense in profit or loss (i.e. in the income statement) unless they relate to an earlier revaluation surplus.
After revaluation, depreciation is based on the revalued amount.
An annual reserves transfer is allowed amounting to the excess of actual depreciation over the historical cost depreciation.
Increases in value The basic rule is that increases in value on a revaluation are credited directly to equity. The effect of this is that they:
Do not appear in the income statement. Do appear in the statement of changes in equity.
The exception is that where such an increase reverses an earlier revaluation decrease on the same asset that was recognised in profit or loss (see section 5.3 below), then the surplus should be recognised in profit or loss, but only to the extent of the previous decrease. In practice, the surplus is treated so that the overall effect is the same as if the original downward revaluation recognised in profit or loss had not occurred.
5.2
Accounting for increases in value The commonly adopted method of accounting for upward revaluations to fair value is to write the original cost to fair value and write back the accumulated depreciation to revaluation reserve.
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Worked example: Revaluation increase An entity acquires an item of PPE for CU50,000, which is depreciated over 20 years. Three years later the asset is revalued to CU60,000. The useful life has not changed. The revaluation will be accounted for as follows: CU 10,000 7,500
DR Asset value (balance sheet) DR Accumulated depreciation (50,000/20 3) CR Revaluation reserve
Interactive question 2: Revaluation
CU
17,500
[Difficulty level: Exam standard]
On 1 January 20X2, an asset has a carrying amount of CU100 and a remaining useful life of 10 years, with a nil residual value. The asset is revalued on that date to CU50 and the loss is recognised in profit or loss. The asset is depreciated straight-line over the next five years, giving a carrying amount of CU25 at 31 December 20X6. Then, on 1 January 20X7 when the remaining useful life is the unexpired 5 years, the asset is revalued to CU60. Requirement State how much of the revaluation gain on 1 January 20X7 is recognised directly in equity and how much is recognised in profit or loss. Fill in the proforma below.
Solution The revaluation gain on 1 January 20X7 is CU........................................ If the previous downward revaluation had not taken place the carrying amount on 31 December 20X6 would have been CU........................................ The 'excess' revaluation gain recognised directly in equity is CU........................................ The amount recognised in profit or loss is CU........................................ See Answer at the end of this chapter.
5.3
Decreases in value The basic rule is that decreases in value on a revaluation are recognised as an expense and charged to the income statement. The exception is where such a decrease reverses an earlier revaluation increase on the same asset that was recognised directly in equity and is held in the revaluation reserve, then the deficit should be recognised directly in equity, but only to the extent of the previous increase.
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Worked example: Revaluation decrease An item of land originally cost CU15,000. Two years ago it was revalued to CU20,000. Now the value has fallen to CU13,000. The double entry would be: CU 5,000 2,000
DR Revaluation reserve DR Income statement CR Asset value (balance sheet)
5.4
CU 7,000
Depreciation of revalued assets Where an asset has been revalued, the depreciation charge is based on the revalued amount, less residual value, from the date of revaluation. The asset’s residual value should also be re-estimated on revaluation.
Definition Residual value: The estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal if the asset were already of the age and in the condition expected at the end of its useful life.
The whole of the depreciation charge is recognised in profit or loss. None is recognised directly in the revaluation reserve. However, BAS 16 permits, and it is best practice to make, a transfer between reserves. The overall effect is that the income statement shows the economic benefit consumed, measured by reference to the revalued figure for the asset, but distributable profits (i.e. those out of which dividends may be declared) are not affected by extra depreciation on revalued assets. The transfer is recorded as follows: Amount of transfer = actual depreciation charged less equivalent charge based on original historical cost of asset Entry to record transfer: DR Revaluation reserve CR Retained earnings
X
X
This transfer is shown in the statement of changes in equity.
Worked example: Reserve transfer An item of PPE was purchased for CU800,000 on 1 January 20X6. It is estimated to have a useful life of 20 years and is depreciated on a straight-line basis. On 1 January 20X8 the asset is revalued to CU850,000. The useful life is unchanged. (Ignore residual value.) CU Actual depreciation for 20X8 based on revalued amount 850,000 18 Depreciation for 20X8 based on historical cost 800,000 20 Difference
47,222 (40,000) 7,222
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Financial accounting In the income statement for 20X8 a depreciation expense of CU47,222 will be charged. A reserve transfer may be performed as follows: DR Revaluation reserve CR Retained earnings
CU 7,222
CU 7,222
The closing balance on the revaluation reserve will therefore be as follows: Balance arising on revaluation (850 – 720) Transfer of retained earnings
5.5
CU 130,000 (7,222) 122,778
Disposal of revalued assets This is dealt with in section 8.4 below.
6 Depreciation Section overview
Depreciation is a means of spreading the cost of a non-current asset over its useful life.
Each significant part of an item of PPE must be depreciated separately.
Land should be accounted for separately from buildings.
Residual values and useful lives must be reviewed annually. Any change must be treated as a change in accounting estimate.
There are a number of different methods of depreciation: – – –
6.1
Straight-line Diminishing balance (= reducing balance) Sum of the units
Objective of depreciation Depreciation is an application of the accrual concept. Its objective is to charge to operating profit the cost of using PPE in each period, so that at the end of its useful life the whole of the cost has been written off. The cost of using an asset is the amount of economic benefits consumed. Depreciation does not relate to the value of an asset as it is a cost-allocation concept, not a measure of value changes. An increase in the current value of an asset does not itself justify not depreciating that asset. The means of recognising an increase in value of an asset is to revalue the asset, which is a separate issue from depreciation.
Definitions Depreciation: This is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount: The cost of an asset, or other amount substituted for cost, less its residual value. Useful life: This is:
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The period over which an asset is expected to be available for use by an entity, or The number of production or similar units expected to be obtained from the asset by an entity.
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6.2
5
Calculation and recognition Each significant part of an item of PPE must be depreciated separately, although they may be grouped together for depreciation charge purposes if they have the same useful lives and depreciation methods. So an aircraft's engines will be depreciated separately from its airframe when they have different useful lives. This is a natural consequence of the initial process of analysing the cost of an asset over its component parts (see section 2 above). Land and buildings are separable assets and accounted for separately, even when acquired together. Land usually has an infinite life, whereas buildings do not. So buildings are always depreciable assets, but land is not; the exception is that if the initial cost of land includes a provision for dismantlement and restoration (see section 3.2 above), then that part of its cost is depreciated over the period expected to benefit. The depreciation charge is recognised in profit or loss, unless it can be included in the cost of an asset. The valuation of inventories under BAS 2 Inventories includes depreciation charges on manufacturing PPE.
Interactive question 3: Calculating depreciation
[Difficulty level: Intermediate]
Requirement Using the costs from Interactive question 1 and assuming there are no residual values, calculate the annual depreciation charges for the facility. Fill in the proforma below. CU’000
See Answer at the end of this chapter.
6.3
Depreciable amount and depreciation period The residual value and useful life of an asset must be reviewed at least each year end; any change is a change in accounting estimate and must be accounted for prospectively under BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. The accounting policy remains one of taking account of residual values and useful lives; all that changes are the judgements as to what the values for these are.
Interactive question 4: Depreciation period
[Difficulty level: Intermediate]
An asset has a cost of CU1,000, useful life of 10 years and residual value of CU200. At the end of year 2 of its life, the remaining useful life was revised to 4 years, the residual value being unchanged. Requirement Calculate the depreciation charge for each of years 1 to 3 on the straight-line basis.
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Financial accounting Fill in the proforma below.
Solution Cost Accumulated depreciation Carrying amount Charge for the year (W)
Year 1 (CU)
Year 2 (CU)
Year 3 (CU)
WORKING
See Answer at the end of this chapter.
Points to note:
6.4
1
Depreciation continues to be recognised even if fair value (i.e. the open market price) is greater than the carrying amount. This is for two reasons: the entity has no intention of selling the asset (so market price is not relevant) and depreciation is, as has been noted, a cost-allocation concept, not a means of revaluing an asset;
2
Depreciation ceases if residual value exceeds the carrying amount. The reason is that there is no longer a depreciable amount.
Commencement of depreciation Depreciation should commence when the asset is in the location and condition necessary for it to be capable of operating in the manner intended. This is the case even if the asset is actually put into use at a later date. Depreciation continues even if the asset lies idle, for example as a result of a fall in market demand for its output. Depreciation only ceases when the asset is derecognised; the treatment of assets held for sale is dealt with in section 8 below.
6.5
Factors affecting useful life There are many factors affecting the useful life of an asset. These include:
Expected usage of the asset measured by reference to the asset's expected capacity or physical output.
Expected physical wear and tear.
Technical or commercial obsolescence arising from changes or improvements in production, or from a change in market demand.
Legal or similar limits on the use of the asset, such as expiry dates of related leases.
These factors should be considered by management on the initial assessment of the asset's useful life and on each subsequent annual review.
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6.6
5
Depreciation method BAS 16 requires that a systematic basis should be used to allocate the depreciable amount over the asset's useful life; the method should reflect the pattern in which the future economic benefits are consumed. A number of methods are identified, which you should be familiar with from your Accounting studies:
Straight-line, whereby there is a constant charge each year, on the assumption that equal amounts of economic benefit are consumed in each year of the asset's life.
Diminishing (or reducing) balance, whereby the depreciation rate is applied to the opening carrying amount. This method, which charges more depreciation in the early years of an asset's life than in later years, could be appropriate in circumstances where over its life the asset becomes less capable of producing a high-quality product.
Sum of the units, whereby the charge is calculated by reference to the output each year as a proportion of the total expected output over the asset's useful life.
Where the pattern of consumption of an asset's economic benefits is uncertain, a straight-line method of depreciation is usually adopted. In practice, this method is by far the most widely used.
6.7
Change in method Depreciation methods must be reviewed at least at each financial year end. A change in the pattern of consumption of economic benefits may demand a change to the method. Any changes are changes in an accounting estimate and are accounted for prospectively. The carrying amount of the asset is depreciated under the new method over the remaining useful life, beginning in the period in which the change is made in accordance with BAS 8.
Worked example: Change in depreciation method Bord Ltd has a 31 December year end. On 1 January 20X3 it bought a machine for CU100,000 and depreciated it at 15% per annum on the reducing balance basis. The residual value is nil. On 31 December 20X6, the machine will be included in Bord Ltd's accounts at the following amount: CU 100,000 (47,800) 52,200
Cost Accumulated depreciation Carrying amount
During 20X7, the company decided to change the basis of depreciation to straight-line over a total life of 10 years, i.e. six years remaining from 1 January 20X7. New annual charge from 20X7 =
6.8
52, 200 6
= CU8,700 per annum.
Impairment BAS 16 requires the provisions of BAS 36 Impairment of Assets to be applied. The provisions of BAS 36 are dealt with in the next section. Any compensation received from third parties for impaired PPE is recognised in profit or loss (where the impairment loss is charged), not set against the cost of the PPE item.
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7 Impairment of assets Section overview
An asset is impaired if its recoverable amount is less than its carrying amount.
The recoverable amount is the higher of: – –
7.1
The asset's fair value less costs to sell, and Its value in use.
Internal and external sources provide indications of possible impairment.
For assets held at historical cost an impairment loss should be charged in profit or loss (i.e. as an expense in the income statement).
For assets held at a revalued amount the impairment loss is treated as a revaluation decrease.
Objective and scope of BAS 36 Impairment of Assets Whenever an asset's recoverable amount falls to an amount less than its carrying amount, it is said to be impaired. Its carrying amount in the balance sheet is therefore reduced to this recoverable amount and, in most cases, an expense is recognised in the income statement. BAS 36 puts in place a detailed method for carrying out impairment reviews and related accounting treatments and disclosures. BAS 36 applies to all assets apart from those specifically excluded from the standard. It most commonly applies to assets such as property, plant and equipment accounted for in accordance with BAS 16 and intangible assets accounted for in accordance with BAS 38 Intangible Assets (we will look at intangible assets in Chapter 6). The standard also apples to some financial assets, namely subsidiaries, associates and joint ventures. Impairments of all other financial assets are accounted for in accordance with BAS 39 Financial Instruments: Recognition and Measurement, the detail of which is outside your syllabus.
7.2
Basic principle The basic principle underlying BAS 36 is relatively straightforward. If an asset's value in the financial statements is higher than its realistic value, measured as its 'recoverable amount', the asset is judged to have been impaired. The value of the asset should be reduced by the amount of the impairment loss. This loss should be written off against profit immediately. The main accounting issues to consider are therefore as follows: 1 2 3
7.3
How is it possible to identify when an impairment loss may have occurred? How should the recoverable amount of the asset be measured? How should an impairment loss be reported in the financial statements?
Indications of impairment An entity should assess at each balance sheet date whether there are any indications of impairment to any assets. The concept of materiality applies, and only material impairment needs to be identified. If there are indications of possible impairment, the entity is required to make a formal estimate of the recoverable amount of the assets concerned. In assessing such indications of a possible impairment, BAS 36 requires an entity to consider, as a minimum, the following:
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External sources of information: –
A fall in the asset's market value that is more significant than would normally be expected from passage of time over normal use.
–
A significant change in the technological, market, legal or economic environment of the business in which the assets are employed.
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–
An increase in market interest rates or market rates of return on investments likely to affect the discount rate used in calculating value in use.
–
The carrying amount of the entity's net assets being more than its market capitalisation.
5
Internal sources of information: –
Evidence of obsolescence or physical damage.
–
Adverse changes in the use to which the asset is put.
–
Indications that the economic performance of an asset is, or will be, worse than expected.
Even if there are no indications of impairment, the following assets must always be tested for impairment annually:
An intangible asset with an indefinite useful life Goodwill acquired in a business combination
(Intangible assets are covered in Chapter 6).
7.4
Measuring the recoverable amount of the asset Definition Recoverable amount of an asset: is the higher of:
7.4.1
Its fair value less costs to sell, and Its value in use
Fair value less costs to sell Definition Fair value less costs to sell: the amount obtainable from the sale of an asset in an arm's length transaction between knowledgeable, willing parties, less costs of disposal.
In other words an asset's fair value less costs to sell is the amount net of selling costs that could be obtained from the sale of the asset. Selling costs include sales transaction costs, such as legal expenses. A binding sales agreement is the best evidence of an asset’s fair value less costs to sell. Where there is no binding sales agreement the following bases will be used:
If there is an active market in the asset, the net selling price should be based on the market price less costs to sell, or on the price of recent transactions in similar assets.
If there is no active market in the asset it might be possible to estimate a net selling price using best estimates of what 'knowledgeable, willing parties' might pay in an arm's length transaction and deducting costs of disposal.
Selling costs cannot include any restructuring or reorganisation expenses, or any costs that have already been recognised in the financial statements as liabilities.
7.4.2
Value in use An asset's fair value less costs to sell is compared with its value in use in order to determine the recoverable amount (see section 7.4 above).
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Definition Value in use: the present value of the future cash flows expected to be derived from an asset.
The detailed guidance provided as to how to arrive at this value is not in the Financial Accounting syllabus, but the following general points should be noted:
Calculations should be based on reasonable and supportable assumptions.
Projections should be based on the most recent budgets etc approved by management over a maximum of five years, unless a longer period can be justified.
Inflows and outflows should be estimated separately, based upon the asset's current condition (so ignoring the benefits of restructurings not committed to and future performance enhancements).
Financing and tax costs should be excluded.
Account should be taken of net cash flows expected to arise on the asset's ultimate disposal.
Note the practical point that if one of the two elements in the recoverable amount has been estimated as in excess of the asset’s carrying amount, then the asset is not impaired and there is no need to estimate the value of the other element. So if fair value less cost to sell exceeds carrying amount, as it well might in the case of freehold and leasehold properties, then there is no need to estimate value in use. This is useful in relation to assets for which there is an active market, because fair values can be estimated quickly and cheaply.
7.5
Accounting treatment of impairments If the recoverable amount of an asset is less than the carrying amount, the difference is the impairment loss. It should be described as such in the financial statements but the accounting treatment is similar to increases and decreases arising on a revaluation (see section 5 above) whereby:
An impairment loss for assets at a historical cost is treated as a decrease on revaluation and is recognised as an expense in the income statement.
If the impairment loss relates to an asset that has previously been revalued, then it is treated as a revaluation decrease and not as an impairment loss. So in line with section 5.3 above it can first be set against any balance relating to the same asset standing on the revaluation reserve, with any excess being recognised in profit or loss.
Depreciation charges in future accounting periods will be set to write off the revised carrying amount, less residual value, over its remaining useful life.
In certain circumstances impairment losses incurred in one accounting period may be reversed in a later period, but the relevant rules are outside the Financial Accounting syllabus.
Worked example: Impairment The following details relate to a freehold property: Carrying amount (at date of revaluation) Revalued to Amount recognised in the revaluation reserve Current carrying amount Fair value Value in use The recoverable amount of the asset is CU800,000 (i.e. the higher of fair value and value in use). An impairment loss of CU700,000 has occurred (1,500,000 – 800,000)
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CU 1,000,000 1,600,000 600,000 1,500,000 600,000 800,000
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5
The impairment will be accounted for as follows: CU 600,000 100,000
DR Revaluation reserve DR Income statement CR Property (carrying amount)
7.6
CU 700,000
Disclosure For all impairments, disclosure must be made for each class of assets of:
The amount of any impairment loss recognised in profit or loss and the line item where it has been included.
The equivalent information about any impairment loss recognised directly in equity.
Note that compliance with the values part of this requirement will come through the BAS 16 reconciliation of opening and closing balance sheet asset values (see section 9 below). If an impairment loss for an individual asset is material to the financial statements as a whole, there must be additional disclosure of:
The events that led to the recognition of the loss.
The amount.
The nature of the asset.
Whether the recoverable amount is fair value less costs to sell or value in use.
The basis used to determine fair value less costs to sell (where the recoverable amount is fair value less costs to sell).
The discount rate used in the current estimate and any previous estimate of value in use (where the recoverable amount is value in use).
If impairment losses are material only in aggregate, then a reduced amount of additional information should be given. The following details must be disclosed:
The main classes of assets affected by impairment losses. The main events and circumstances that led to the recognition of these impairment losses.
8 Derecognition of PPE Section overview
When the decision is made to sell a non-current asset it should be classified as 'held for sale'.
An asset held for sale is valued at the lower of: – –
8.1
Its carrying amount. Its fair value less costs to sell.
No depreciation is charged on a held for sale asset.
General rule An item of PPE shall be removed from the balance sheet (i.e. derecognised) when it is disposed of or when no future economic benefits are expected from its use or disposal (i.e. it is abandoned). The gain or loss on the disposal of an item of PPE is included in the income statement of the period in which the derecognition occurs. The gain or loss is calculated as the difference between the net sale
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Financial accounting proceeds and the carrying amount, whether measured under the cost model or the revaluation model. Gains may not be included in revenue in the income statement. The process of selling an item of PPE involves the following stages:
Making the decision to sell the item. Putting the item on the market, agreeing the selling price and negotiating the contract for sale. Completing the sale.
The issue is at what stage through this process should any gain or loss on the sale be recognised. These matters are dealt with in BFRS 5 and there are different required treatments depending on whether the item of PPE is measured under the cost model or the revaluation model.
8.2
Disposal of PPE measured under the cost model Following the principle that any loss should be recognised immediately but any gain should only be recognised when it is realised, BFRS 5's requirements in respect of PPE measured under the cost model are that:
When the carrying amount of a non-current asset will be recovered principally through sale (rather than through continuing use), the asset must be classified as held for sale. In most cases, this classification will be made at the time of the decision to sell.
A non-current asset held for sale is measured at the lower of: – –
Its carrying amount Its fair value less costs to sell (i.e. its net selling price)
The effect is that any loss (i.e. where the former value exceeds the latter) is recognised at the time of classification as held for sale. But any gain (i.e. where the latter value exceeds the former) is not; instead it is recognised according to the general rule in section 8.1 above.
A non-current asset held for sale is presented separately from all other assets in the balance sheet. BFRS 5 does not specify where this 'separate presentation' should be made, but these learning materials follow the IASB's (non-mandatory) guidance on implementing BFRS 5 by presenting it immediately below the sub-total for current assets.
No depreciation is charged on a held for sale asset. The new valuation basis of fair value less costs to sell approximates to residual value, so there is now no depreciable amount.
The loss is an impairment loss, dealt with in the same way as other impairment losses under BAS 36.
On ultimate disposal, any difference between carrying amount and disposal proceeds is treated as a loss or gain under BAS 16, not as a further impairment loss or reversal of the original impairment loss.
Interactive question 5: Asset held for sale I
[Difficulty level: Intermediate]
An item of PPE was acquired on 1 January 20X5 at a cost of CU100,000. A residual value of CU10,000 and a useful life of 10 years was assumed for the purpose of depreciation charges. On 1 January 20X8 the asset was classified as held for sale. Its fair value was estimated at CU40,000 and the costs to sell at CU2,000. The asset was sold on 30 June 20X8 for CU38,000. Requirements (a) Show the journal entry to record the classification as held for sale. (b) Show the entry in the income statement for the year ended 31 December 20X8. (c) Describe how the answer to (b) would change if the sales proceeds on 30 June 20X8 were CU32,000. Fill in the proforma below.
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5
Solution (a)
Journal entry to record the classification as held for sale CU'000
1 January 20X8 DR PPE – accumulated depreciation DR Non-current assets held for sale DR Income statement (ß) CR PPE – cost
CU'000
(b) Income statement for the year ended 31 December 20X8 CU Impairment loss on reclassification of non-current assets as held for sale (c)
Income statement for the year ended 31 December 20X8 In the income statement:
See Answer at the end of this chapter.
Interactive question 6: Asset held for sale II
[Difficulty level: Intermediate]
These facts are as detailed in Interactive question 5, except that on classification as held for sale, the fair value was estimated at CU80,000 and the costs to sell at CU3,000. The asset was sold on 30 June 20X8 for CU77,000. Requirements (a) Show the journal entry to record the classification as held for sale. (b) Show the entry in the income statement for the year ended 31 December 20X8. Fill in the proforma below.
Solution (a)
Journal entry to record the classification as held for sale CU'000
CU'000
1 January 20X8 DR PPE – accumulated depreciation DR Non-current assets held for sale CR PPE – cost (b) Income statement for the year ended 31 December 20X8 CU'000 Gain on disposal of non-current assets held for sale See Answer at the end of this chapter.
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8.3
Classification as held for sale For the classification as held for sale to be made detailed criteria must be met:
The asset must be available for immediate sale in its present condition. Its sale must be highly probable (i.e. significantly more likely than probable).
For the sale to be highly probable:
Management must be committed to a plan to sell the asset.
There must be an active programme to locate a buyer.
The asset must be marketed for sale at a price that is reasonable in relation to its current fair value.
The sale should be expected to take place within one year from the date of classification.
It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
Other points to note:
8.4
1
An asset can still be classified as held for sale, even if the sale has not actually taken place within one year. However, the delay must have been caused by events or circumstances beyond the entity's control and there must be sufficient evidence that the entity is still committed to sell the asset.
2
If a balance sheet date intervenes between the classification as held for sale and the final disposal, fair value less costs to sell may have fallen below or risen above the figure used on original classification. Any fall is accounted for as a further impairment loss, while any rise goes to reduce the amount of the original impairment loss, but cannot write the asset's carrying amount above its original level.
3
The rules for disposal groups (where an operation comprising assets and liabilities is being sold) fall outside the Financial Accounting syllabus.
Disposal of PPE measured under the revaluation model For an item of PPE measured after recognition under the revaluation model and subsequently classified as held for sale, there is a different accounting treatment of the difference between carrying amount and fair value less costs to sell at the time of classification:
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Consistently with the accounting policy chosen, the asset must be revalued at fair value under BAS 16 immediately before the classification.
'Revaluation' means that either a gain or loss will be recognised (whereas, as explained in section 8.2, for assets measured under the cost method, only a loss is recognised at the time of classification). If the previous carrying amount is greater than fair value, there will be a loss; if it is less than fair value, there will be a gain.
Such a gain or loss is dealt with under BAS 16 (see section 5 above), so a gain is recognised in revaluation reserve (except to the extent it reverses a loss previously charged to the income statement) and a loss in the income statement (except to the extent it reverses a gain held in revaluation reserve).
Once revalued in this way, the measurement is then adjusted to the normal basis for held for sale assets, so fair value less costs to sell. The effect is that the costs to sell are immediately recognised in profit or loss as an impairment loss.
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PROPERTY, PLANT AND EQUIPMENT
Interactive question 7: Disposal of revalued PPE
5
[Difficulty level: Exam standard]
Land, which is not depreciated, was acquired on 1 January 20X2 at a cost of CU200,000 and revalued to CU250,000 on 1 January 20X5. On 1 January 20X8 the asset was classified as held for sale. Its fair value was estimated at CU235,000 and the costs to sell at CU5,000. Requirements (a) Show the journal entry to record the revaluation on 1 January 20X5. (b) Show the journal entry to record the classification as held for sale on 1 January 20X8. Fill in the proforma below.
Solution (a)
Journal entry to record the revaluation CU'000
CU'000
CU'000
CU'000
1 January 20X5 DR PPE – at valuation CR Revaluation reserve (b) Journal entry to record the classification as held for sale 1 January 20X8 DR Non-current assets held for sale – fair value less costs to sell DR Income statement – costs to sell DR Revaluation reserve CR PPE – at valuation See Answer at the end of this chapter.
8.5
Disposal and gains held in revaluation reserve If there is still a credit balance on the revaluation reserve relating to an asset that has been disposed of, this balance should be transferred to retained earnings as a reserve transfer (the same treatment and presentation as for the reserve transfer in respect of extra depreciation). The accounting entry is: DR Revaluation reserve
CUX
CR Retained earnings
CUX
Note that some argue that as the income statement is the document in which the profits of an entity are shown, it should, over time, include all the gains realised by an entity. They argue that the transfer of any credit balance on the revaluation reserve should therefore be to the income statement, not retained earnings, so the accounting entry should be: DR Revaluation reserve CR Income statement
CUX CUX
This technique of taking gains previously recognised in the statement of changes in equity back through the income statement is known as 'recycling' and is not permitted by BAS 16.
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Interactive question 8: Summary
[Difficulty level: Intermediate]
On 1 January 20X1, Tiger Ltd buys for CU120,000 an item of property, plant and equipment which has an estimated useful life of 20 years with no residual value. Tiger Ltd depreciates its non-current assets on a straight-line basis. Tiger Ltd's year-end is 31 December. On 31 December 20X3, the asset will be carried in the balance sheet as follows:
CU 120,000 (18,000) 102,000
Property, plant and equipment at cost Accumulated depreciation (3 (120,000 ÷ 20)) On 1 January 20X4, the asset is revalued to CU136,000. The total useful life remains unchanged.
On 1 January 20X8 the asset is classified as held for sale, its fair value being CU140,000 and its costs to sell CU3,000. On 1 May 20X8 the asset is sold for CU137,000. Requirements (a)
Show the journal to record the revaluation.
(b) Calculate the revised depreciation charge and show how it would be accounted for, including any permitted reserve transfers. (c)
Show the journal to record the classification as held for sale.
(d) Explain how these events will be recorded in the financial statements for the year ended 31 December 20X8. Fill in the proforma below.
Solution (a)
Journal to record the revaluation 1 January 20X4 DR PPE cost/valuation DR PPE accumulated depreciation CR Revaluation reserve
CU
CU
CU
CU
(b) Revised depreciation charge Annual charge from 20X4 onwards DR Income statement depreciation expense CR PPE accumulated depreciation Annual reserve transfer DR Revaluation reserve CR Retained earnings
Being the difference between the actual depreciation charge and the charge based on historical cost (........................................). Shown in the statement of changes in equity as follows:
Brought forward Profit for the year Transfer of realised profits Carried forward
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Revaluation reserve CU X –
Retained earnings CU X X
X
X
PROPERTY, PLANT AND EQUIPMENT
(c)
5
Journal to record classification as held for sale At 1 January 20X8, balances relating to the asset will be as follows: CU Property, plant and equipment at valuation Accumulated depreciation Carrying amount Revaluation reserve CU'000
CU'000
1 January 20X8 DR PPE – accumulated depreciation DR Non-current assets held for sale – fair value less costs to sell DR Income statement – costs to sell CR PPE – cost/valuation CR Revaluation reserve (ß) (d) Financial statements for the year ended 31 December 20X8 In the income statement: Remaining balance on revaluation reserve is transferred to accumulated profits reserve as a reserve transfer in the statement of changes in equity: Revaluation Retained reserve earnings CU CU Brought forward X X Retained profit for the year – X Transfer of realised profits Carried forward X X See Answer at the end of this chapter.
8.6
Abandonment of non-current assets All these requirements within BFRS 5 which we have looked at so far apply to non-current assets classified as held for sale because their carrying amounts will be recovered principally through a sale transaction. They do not apply to non-current assets which are to be abandoned, for example by being scrapped. Because there will be no sales proceeds, any recovery of the carrying amounts of such assets will principally be through continued use. Such assets continue to be measured and presented under BAS 16, with the effect that:
The assets remain classified within their existing non-current asset category.
Depreciation charges continue to be recognised.
Any profit or loss on abandonment is recognised at the time of abandonment rather than at the (usually earlier) time of the decision to abandon them.
BAS 16, not BFRS 5, also applies to the measurement and presentation of an asset taken out of use but not scheduled for disposal; this might be the case if demand for its outputs has temporarily fallen away.
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9 Disclosures Section overview
9.1
BAS 16 requires a number of detailed disclosures.
BAS 16 requirements As might be expected for items that form such a large part of many entities' balance sheets and where management has to make so many important judgements (e.g. re residual values and useful lives), the financial statements disclosure provisions are wide-ranging. All of the following may be shown for each class of PPE by way of note:
The measurement basis used (either cost model or revaluation model).
The depreciation methods.
The useful lives or depreciation rates.
Gross carrying amounts and accumulated depreciation at the start and end of the period.
A reconciliation of the net carrying amounts at the start and end of the period by reference to: – – – – – – –
Additions Disposals Acquisitions through business combinations The effects of revaluations Impairment losses Exchange differences (these fall outside the Financial Accounting syllabus) Other changes, e.g. assets classified as held for sale
Details of assets pledged as security for loans and of contractual commitments to acquire PPE.
Changes in accounting estimates in accordance with BAS 8.
For assets which have been revalued: –
The effective date(s).
–
Whether an independent valuer was involved.
–
The methods and significant assumptions underlying the fair value estimates.
–
The extent to which fair values were determined by reference to prices in active markets or recent arm's length transactions.
–
The carrying amount under the cost model.
–
The total revaluation surplus, together with any movements in the period.
There are further, voluntary disclosures. These include:
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The carrying amount of temporarily idle PPE
The gross carrying amount of any fully depreciated PPE that is still in use
The carrying amount of PPE retired from active use and not classified as held for sale in accordance with BFRS 5
When the cost model is used, the fair value of PPE when this is materially different from the carrying amount
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PROPERTY, PLANT AND EQUIPMENT
Interactive question 9: Disclosure
5
[Difficulty level: Exam standard]
1
RSBH Ltd’s balance sheet at its year end 31 December 20X6 includes the following property, plant and equipment amounts: Cost Accumulated Depreciation CU'000 CU'000 Freehold property 1,000 300 Plant and machinery 700 330 Fixtures and fittings 300 180
2
On 1 January 20X7 RSBH Ltd revalued its existing freehold property to its market value of CU1.2m and bought additional freehold property at a cost of CU100,000. As a result of no depreciation being charged on the land element, the effective rate of depreciation is 2% per annum on cost/valuation, assuming no residual value.
3
On 1 April 20X7 RSBH Ltd classified as held for sale plant and machinery with an original cost of CU360,000 and a carrying amount at 31 December 20X6 of CU100,000. It also bought plant and machinery at a cost of CU400,000. Depreciation is to be charged at the rate of 10% per annum on cost, assuming no residual value.
4
On 1 July 20X7 RSBH Ltd scrapped fixtures and fittings with an original cost of CU40,000 and accumulated depreciation at 31 December 20X6 of CU25,000 and bought new fixtures at a cost of CU80,000. Depreciation is to be charged at 15% per annum on cost, assuming no residual value.
Requirement Prepare the reconciliation of the carrying amount of property, plant and equipment at 1 January 20X7 with that at 31 December 20X7. Fill out the proforma below.
Solution RSBH Ltd: Reconciliation of opening and closing property, plant and equipment
Cost/valuation I January 20X7 Revaluation Additions Classified as held for sale Disposals At 31 December 20X7
Freehold Property CU'000
Plant and Machinery CU'000
Fixtures and Fittings CU'000
Total CU'000
Depreciation I January 20X7 Revaluation Charge for the year (W) Classified as held for sale (W) Disposals (W) At 31 December 20X7 Carrying amount 31 December 20X7 1 January 20X7
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Financial accounting WORKINGS Plant and Machinery CU'000 Depreciation charge for the year Items reclassified/disposed of during year Items owned throughout year Items acquired during year Accumulated depreciation on items reclassified/disposed of Brought forward Charge for year
See Answer at the end of the chapter
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Summary and Self-test
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Fixtures and Fittings CU'000
PROPERTY, PLANT AND EQUIPMENT
5
Summary
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Financial accounting
Self-test Answer the following questions. 1
2
Per BAS 16 Property, Plant and Equipment, which of the following should be capitalised as part of the cost of an asset? (1) (2) (3) (4)
Stamp duty Employee costs related to site selection activities Cost of site preparation and clearance Installation costs
A B C D
(1), (2) and (4) only (1) and (4) only (1), (3) and (4) only (2) and (3) only
Max Ltd has incurred the following expenditure in 20X0 in respect of its non-current assets. Servicing of plant and equipment Repainting of warehouse Modification of an item of plant in order to increase its capacity Upgrading of machine parts to improve quality of product
CU 25,000 40,000 12,000 7,500
In 20X0 what will be the charge for repairs and maintenance in the income statement in accordance with BAS 16 Property, Plant and Equipment? A B C D
CU19,500 CU25,000 CU65,000 CU59,500
Questions 3 and 4 Using the following information, answer questions 3 and 4. Lakeland purchased freehold land and buildings on 1 July 20W3 for CU380,000 including CU80,000 for the land. The buildings had been depreciated at the rate of 4% per annum on cost for each of the ten years to 30 June 20X3. On 1 July 20X3 the property was professionally revalued at CU800,000 including CU200,000 for the land, an amount which was reflected in the books. At 1 July 20X3 it was estimated that the building had a remaining useful life of twenty years and a residual value of CU100,000. 3
In accordance with BAS 16 Property, Plant and Equipment what should the surplus on revaluation be on 1 July 20X3? A B C D
4
In accordance with BAS 16 Property, Plant and Equipment what is the carrying amount of the freehold land and buildings on 30 June 20X4? A B C D
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CU420,000 CU540,000 CU572,000 CU620,000
CU760,000 CU765,000 CU770,000 CU775,000
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PROPERTY, PLANT AND EQUIPMENT
5
5
Baboon Ltd adopts the revaluation model for its property, plant and equipment. It has collected the following information. Existing Open use market value value CU CU Office building 250,000 300,000 Warehouse (1) 175,000 200,000 Warehouse (2) (which is classified as held for sale) 150,000 210,000 None of the above assets are considered to be impaired and costs to sell are immaterial. In accordance with BAS 16 Property, Plant and Equipment, at what total amount should the three properties be carried in Baboon Ltd’s balance sheet? A B C D
6
CU575,000 CU710,000 CU660,000 CU635,000
Paris Ltd has a freehold property carried at a revalued amount of CU175,000. Due to a slump in property prices its recoverable amount is now estimated to be only CU150,000. Its historical cost carrying amount is CU160,000. How should the above fall in value be reflected in the financial statements in accordance with BAS 16 Property, Plant and Equipment? Income statement A B C D
7
DR CU25,000 – DR CU10,000 DR CU15,000
Statement of changes in equity – DR CU25,000 DR CU15,000 DR CU10,000
On 1 June 20X6 Dempster Ltd bought a new factory. The building has an estimated useful life of 50 years, but the roof will require replacing after 25 years. The cost of replacement is currently CU100,000. The total price of the factory was CU1,000,000. In accordance with BAS 16 Property, Plant and Equipment what should the depreciation charge be for the year ended 31 May 20X7? A B C D
CU20,000 CU22,000 CU24,000 CU40,000
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Financial accounting 8
The following figures relate to an asset with a five-year life purchased on 1 January 20X1. Cost Residual value at acquisition Residual value at the end of 20X1 (taking into account current price changes)
CU 100,000 10,000 15,000
What amount will be recognised in the income statement as depreciation in the year to 31 December 20X1 in accordance with BFRS? A B C D 9
CU15,000 CU17,000 CU18,000 CU20,000
Thames Ltd depreciates plant and equipment at 20% per annum on a diminishing balance basis. All assets were purchased on 1 April 20X3. The carrying amount on 31 March 20X6 is CU20,000. In accordance with BAS 16 Property, Plant and Equipment what is the accumulated depreciation to the nearest thousand pounds as at that date? A B C D
10
CU15,000 CU19,000 CU30,000 CU39,000
On 1 January 20X1 Lydd Ltd purchased production machinery costing CU100,000, having an estimated useful life of twenty years and a residual value of CU2,000. On 1 January 20X7 the remaining useful life of the machinery is revised and estimated to be twenty-five years, with an unchanged residual value. In accordance with BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors what should the depreciation charge on the machinery be in the year ended 31 December 20X7? A B C D
11
CU3,226 CU3,161 CU2,824 CU2,744
Upton Ltd makes up its financial statements to 31 December each year. On 1 January 20X0 it bought a machine with a useful life of ten years for CU200,000 and started to depreciate it at 15% per annum on the diminishing balance basis. On 31 December 20X3 the accumulated depreciation was CU95,600 and the carrying amount CU104,400. During 20X4 the company changed the basis of depreciation to straight line. In accordance with BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors what is the correct accounting treatment to be adopted in the financial statements of Upton Ltd for the year ended 31 December 20X4? A B C D
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Depreciation charge CU10,440 Prior period adjustment Nil Depreciation charge CU17,400 Prior period adjustment Nil Depreciation charge CU20,000 Prior period adjustment CU15,600 Depreciation charge CU20,000 Exceptional item CU15,600
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12
5
During the year ended 31 March 20X3, Quark Ltd revalued its buildings by CU200,000 giving rise to an increase in the annual depreciation charge of CU5,000. In accordance with BAS 16 Property, Plant and Equipment which of the following statements about the disclosure of these items is true?
13
A
The statement of changes in equity will show an increase in the revaluation reserve of CU200,000 and a reserves transfer of CU5,000
B
The revaluation reserve in the statement of changes in equity will only disclose CU200,000 in respect of the revaluation
C
The income statement will only disclose an amount of CU200,000 in respect of the revaluation
D
The income statement will disclose an amount of CU200,000 in respect of the revaluation and an additional depreciation expense of CU5,000
Propane Ltd are undertaking an impairment review of assets following BAS 36 Impairment of Assets. Investigations have uncovered the following: Asset R has a carrying amount of CU60,000, a value in use of CU65,000 and a fair value less costs to sell of CU30,000. Asset Q has a carrying amount of CU100,000, a value in use of CU92,000 and a fair value less costs to sell of CU95,000. In accordance with BAS 36 Impairment of Assets what amount should be recognised as an impairment loss in relation to these two assets?
A B C D 14
R CU 30,000 25,000 5,000 –
Q CU 3,000 8,000 – 5,000
Gandalf Ltd has a year end of 31 December. On 30 October 20X4 it classified an item of plant as held for sale. At that date the plant had a carrying amount of CU13,200 and had been accounted for according to the cost model. Its fair value was estimated at CU11,100 and the costs to sell at CU500. On 15 December 20X4 the plant was sold for CU10,500. In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amounts should be recognised as impairment loss and loss on disposal in the income statement for the year to 31 December 20X4? Impairment loss Loss on disposal CU CU A Nil 2,700 B 2,100 600 C 2,600 100 D 2,700 Nil
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Financial accounting 15
Merlin Ltd has a year end of 30 June. On 1 October 20X3 it classified one of its leasehold properties as held for sale. At that date the property had a carrying amount of CU98,500 and had been accounted for according to the cost model. Its fair value was estimated at CU120,100 and the costs to sell at CU2,500. On 15 June 20X4 the property was sold for CU115,500. In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amounts should be recognised as gain on reclassification and gain on disposal in the income statement for the year to 30 June 20X4? Gain on Gain on reclassification disposal CU CU A Nil 17,000 B 9,100 7,900 C 11,600 5,400 D 17,000 Nil
16
Dumbledore Ltd has a year end of 30 June. On 1 June 20X5 it classified one of its freehold properties as held for sale. At that date the property had a carrying amount of CU567,000 and had been accounted for according to the revaluation model. Its fair value was estimated at CU725,000 and the costs to sell at CU3,000. In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amounts should be recognised in the financial statements for the year to 30 June 20X5? Income statement Gain on Impairment reclassification loss CU'000 CU'000 Nil 3 Nil Nil 155 3 158 Nil
A B C D
Revaluation reserve Revaluation gain CU'000 158 155 Nil Nil
Questions 17 and 18 Using the following information, answer questions 17 and 18. Arnold Ltd bought an asset on 1 October 20X1 for CU200,000. It was being depreciated over 20 years on the straight-line basis. On 1 October 20X3, the asset was revalued to CU270,000. Subsequently, on 30 September 20X7 the asset was classified as held for sale. Its fair value was estimated at CU190,000 with costs to sell of CU5,000. 17
In accordance with BAS 16 Property, Plant and Equipment what should the balance on the revaluation reserve be at the year end of 30 September 20X4? A B C D
18
In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what should the loss recognised in the income statement for the year ended 30 September 20X7 be on classification as held for sale? A B C D
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CU70,000 CU85,000 CU86,500 CU90,000
CUNil CU5,000 CU20,000 CU25,000
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19
5
The following information was disclosed in the financial statements of Maine Ltd for the year ended 31 December 20X2. Plant and equipment 20X2 20X1 CU CU Cost 735,000 576,000 Accumulated depreciation (265,000) (315,000) Carrying amount 470,000 261,000 During 20X2 Expenditure on plant and equipment Impairment loss on reclassification of old plant as held for sale Loss on the disposal of old plant Depreciation charge on plant and equipment
CU 512,000 50,000 57,000 143,000
In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what were the sales proceeds received on the disposal of the old plant? A B C D 20
CU53,000 CU153,000 CU246,000 CU267,000
The following information relates to the classification as held for sale of two machines by Halwell Ltd.
Cost Fair value less costs to sell Anticipated gain/(loss) on sale (based on fair value)
Machine 1 CU 120,000 90,000 30,000
Machine 2 CU 100,000 40,000 (20,000)
In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what was the total accumulated depreciation on both machines classified as held for sale? A B C D 21
CU80,000 CU100,000 CU120,000 CU140,000
On 1 January 20X2 Dulson Ltd purchased a freehold office block for CU2.5 million. At the date of acquisition the useful life was estimated to be 50 years and the residual value CU250,000. The company policy is to depreciate freehold property on the straight-line basis. On 31 December 20X7 the residual value of the offices was estimated at CU450,000 due to an increase in commercial property prices. The estimated useful life of the property remained unchanged. What amount will be recognised in the income statement as depreciation in respect of the freehold property in the year to 31 December 20X7 in accordance with BFRS? A B C D
22
CU45,000 CU40,556 CU50,000 CU36,500
Lakes Ltd owns an item of plant that has previously been revalued. There is currently a balance of CU50,000 in the revaluation reserve relating to this asset. At the end of December 20X7 the company performed an impairment review, which indicated that the item of plant was impaired as a result of the consumption of economic benefits. The impairment is estimated to be CU35,000. How will the impairment be recognised in the financial statements of Lakes Ltd for the year ended 31 December 20X7 in accordance with BFRS? A B
Charged as an expense in the income statement Set off against the balance on the revaluation reserve
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Financial accounting 23
PORSCHE LTD Porsche Ltd has the following non-current assets at 1 January 20X7. Cost Freehold factory Plant and equipment Motor vehicles Office equipment and fixtures
CU'000 1,440 1,968 449 888 4,745
Accumulated depreciation CU'000 144 257 194 583 1,178
Carrying amount CU'000 1,296 1,711 255 305 3,567
You are given the following information for the year ended 31 December 20X7. (1) The factory was acquired on 1 January 20X2 and is being depreciated over 50 years. (2) Depreciation is provided on cost on a straight-line basis. The rates used are 20% for fixtures and fittings, 25% for cars and 10% for equipment. (3) On 1 January 20X7 the factory was revalued to an open market value of CU2.2 million and an extension costing CU500,000 became available for use. (4) The directors decided to change the method of depreciating motor vehicles to 30% reducing balance to give a more relevant presentation of the results and of the financial position. (5) Two cars costing CU17,500 each were bought on 1 January 20X7. Plant and fittings for the factory extension cost CU75,000 and CU22,000 respectively. (6) When reviewing the expected lives of its non-current assets, the directors felt that it was necessary to reduce the remaining life of a two year old grinding machine to four years when it is expected to be sold for CU8,000 as scrap. The machine originally cost CU298,000 and at 1 January 20X7 had related accumulated depreciation of CU58,000. Requirements (a)
Prepare the disclosure notes for property, plant and equipment for the year ended 31 December 20X7 required by the BFRSs. (16 marks)
(b) Briefly explain the qualitative characteristics of financial information contained in BFRS Framework illustrating your answer with references to the provisions of BAS 16 Property, Plant and Equipment.(8 marks) (24 marks) 24
PLOVER LTD Plover Ltd is a car manufacturing group and during the year ended 30 September 20X9 the following transactions relating to property, plant and equipment took place. 1
New factory premises were finally completed and were ready for occupation on 1 March 20X9. Production was not transferred to the factory until 31 August 20X9 due to a dispute with the labour force arising from proposed redundancies. Capitalised costs relating to the factory were CU1.1 million (including land of CU600,000) at 1 October 20X8 and the following costs have been incurred since then. CU'000 Further construction costs 125 Additional legal fees 25 Management and supervision costs (allocation) 75
2
On 1 March 20X9, plant and machinery for a new highly computerised production and assembly line became available for use in the factory. The external costs relating to this were CU800,000 and in addition the company also incurred the following.
194
Labour costs of CU80,000 in installing the line (these were 20% higher than budgeted because of the impact of industrial disputes).
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PROPERTY, PLANT AND EQUIPMENT
3
Management and supervision costs (allocation) of CU15,000.
Start-up costs of CU30,000 incurred in testing the new process. CU20,000 of these were necessary to ensure the line operated correctly. The remaining CU10,000 was incurred when the directors held an 'open day' for their bankers to demonstrate the efficiency of the new system.
5
The company still owns and uses part of the old factory but on 30 September 20X9 it was classified as held for sale. It is expected to be sold by 31 December 20X9 for CU200,000 (after spending CU25,000 to generally improve the property). The carrying amount of the factory at 1 October 20X8 is CU310,000 (cost CU500,000). Depreciation rates are: Freehold land and buildings Plant and machinery
– –
2% per annum 20% per annum
Requirements (a)
Prepare balance sheet extracts in relation to the above as at 30 September 20X9 and draft the balance sheet note showing the movements on property, plant and equipment for the year (working to the nearest CU000). (10 marks)
(b) Calculate the impairment loss arising on classifying the old facility as held for sale.
(2 marks) (12 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Financial accounting
Technical reference Point to note: The following sets out the examinability of the standards covered in this chapter. BAS 16
All examinable
BAS 36
Paragraphs 1-64 (excluding paragraph 54), 126-128, and 130-131 are examinable. The Appendices are not examinable.
BFRS 5
References to disposal groups and implementation guidance (except paragraphs 11 and 12) are not examinable.
The paragraphs listed below are the key references you should be familiar with. 1 Property, plant and equipment recognition
Recognise items of PPE, provided future economic benefits and reliable measurement of cost. –
Initial costs to acquire or construct.
–
Subsequent costs to add to, replace part of, or service.
Separate into components, with different lives, e.g. inspections.
BAS 16 (7) BAS 16 (10)
BAS 16 (13)
2 Measurement at recognition
At cost.
BAS 16 (15)
–
Purchase price.
BAS 16 (16)
–
Costs directly attributable to bringing asset into location and condition necessary for it to be capable of working as intended, including testing.
–
Costs to dismantle/restore.
Some costs excluded because not directly attributable or after item is capable of working as intended, e.g. abnormal costs, general overheads, initial losses, internal profits.
Can include interest, but not compulsory.
BAS 16 (16-17) BAS 16 (16) BAS 16 (19-22)
BAS 16 (22)
3 Measurement after recognition
Choice of model: cost or revaluation to fair value.
Frequency: to ensure carrying amount not materially different from updated fair value.
BAS 16 (31)
–
BAS 16 (34)
Maximum interval 5 years?
All assets in a single class must be treated in the same way.
BAS 16 (29-31)
BAS 16 (36)
4 Accounting for revaluations
Gain direct to equity as part of revaluation reserve, so in statement of changes in equity, not income statement. –
If reverse previous decrease, take to income statement to extent of that decrease. Loss direct to income statement.
BAS 16 (39)
–
196
If reverse previous increase, take to revaluation reserve to extent of that increase. Depreciation charge based on revalued amount.
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BAS 16 (40)
PROPERTY, PLANT AND EQUIPMENT
Annual reserve transfer re excess of actual depreciation over historical cost depreciation.
5
BAS 16 (41)
5 Depreciation
Each significant part of PPE item depreciated separately.
BAS 16 (43)
Charge to profit or loss, unless included in inventory, construction contract or other PPE.
BAS 16 (48)
Depreciate depreciable amount (i.e. cost less residual value (RV)) over estimated useful life (UL).
BAS 16 (6)
–
BAS 16 (6)
–
RV is current estimate of disposal proceeds, net of disposal costs, if item already of the age and in the condition expected at the end of UL. UL is period over which asset expected to be available for use, commencing with when asset is available for use.
BAS 16 (6 and 55)
Method should allocate depreciable amount systematically over useful life, so as to reflect consumption of future economic benefits.
Annual reviews of RVs, ULs and depreciation methods.
BAS 16 (51 and 61)
–
BAS 16 (51 and 61)
Any changes accounted for prospectively.
BAS 16 (60-61)
6 Derecognition
Derecognise non-current asset when classified as held for sale or when no future economic benefits expected. –
BAS 16 (67)
Separate procedures where held for sale – see below
Proceeds less carrying amount (current NBV) taken to income statement.
Revalued assets: –
Recycling of gains on disposal not permitted.
–
Reserve transfer re previously recognised gains now realised.
BAS 16 (68)
BAS 16 (41)
BAS 16 (73,74 and 77)
7 Disclosures
Measurement bases.
Depreciation methods.
Useful lives or depreciation rates.
Gross, accumulated depreciation and net amounts at start and end of period.
Additions, disposals, acquisitions through business combinations, revaluations, impairments, depreciation, classification as held for sale.
Assets pledged as security for loans and contractual commitments to acquire PPE.
For revalued assets, the dates, whether independent valuer used, assumptions, reference to active markets/recent transactions, carrying amount under historical cost convention, revaluation surplus.
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Financial accounting 8 Impairment
At each reporting date assess whether indication of impairment: –
If so, estimate recoverable amount (RA).
–
RA is higher of fair value less costs to sell and value in use (present value of future cash flows in use and on disposal).
BAS 36 (9)
BAS 36 (6)
Review both external and internal information for evidence of impairment.
BAS 36 (12)
Calculation of value in use to be on reasonable and supportable bases.
BAS 36 (33)
Impairment loss where carrying amount exceeds RA.
BAS 36 (59)
Treat impairment loss as a revaluation loss: –
Treat as revaluation gain if impairment loss subsequently reversed.
Depreciate revised carrying amount over remaining useful life.
Disclosures: –
All impairments:
–
BAS 36 (60-61)
BAS 36 (63)
BAS 36 (126)
The amount of any impairment loss recognition/reversal in the income statement (and the line item where included) and in statement of changes in equity. If relevant, the reportable segment(s) to which recognition/reversal relates.
For a material impairment on an individual asset:
The events which led to the recognition/reversal.
The amount.
The nature of the asset and, if relevant, the reportable segment to which it belongs.
Whether the recoverable amount is the fair value less costs to sell or its value in use, with information about how it was calculated.
BAS 36 (130)
9 Non-current assets held for sale
Non-current asset classified as held for sale when carrying amount recovered principally through sale.
BFRS 5 (6)
–
BFRS 5 (7)
Must be available for immediate sale and sale (within 12 months of classification) must be highly probable.
–
BFRS 5 (12)
–
Any loss accounted for under BAS 36 (any gain is recognised on actual disposal).
BFRS 5 (20)
–
Not depreciated.
BFRS 5 (25)
BFRS 5 (15)
Presented separately from all other assets, immediately below the sub-total for current assets.
BFRS 5 (38)
Different rules if asset previously revalued:
BFRS 5 (18)
198
If meet criteria after balance sheet date, a non-adjusting event under BAS 10. Measured at lower of carrying amount and fair value less costs to sell.
–
Revalue before classification, with gain/loss accounted for under BAS 16.
–
Costs to sell = impairment loss.
Measurement and presentation of non-current assets to be abandoned per BAS 16, not BFRS 5.
© The Institute of Chartered Accountants in England and Wales, March 2009
BFRS 5 (13)
PROPERTY, PLANT AND EQUIPMENT
5
Answers to Self-test 1
C
2
C
Per BAS 16 paragraph 16.
CU 25,000 40,000 65,000
Servicing Repainting
Plant modification and upgrading creates future economic benefits from the asset and should be capitalised (BAS 16 paragraph 7). 3
B
4
D
Land CU'000 80
Cost on 1 July 20W3 Ten years' depreciation (300 4% 10)
80 120 200
Revaluation surplus Depreciation (600 – 100) / 20
200
5
B
Buildings CU'000 300
Total CU'000 380
(120) 180 420 600 (25) 575
(120) 260 540 800 (25) 775
Per BAS 16, under the revaluation model assets should be carried at fair value, which is usually open market value (BAS 16, paragraph 32). CU 300,000 200,000 210,000 710,000
Office building Warehouse 1 Warehouse 2*
* Since classified as held for sale, this would be presented separately from all other assets. 6
C
If an asset has previously been revalued, recognise the revaluation loss down to depreciated historic cost (175,000 – 160,000 = CU15,000) in the statement of changes in equity, the balance (160,000 – 150,000 = CU10,000) in the income statement (BAS 16 paragraph 40).
7
B
Each significant part of an item of PPE must be depreciated separately (BAS 16 paragraph 43). CU900,000/50 years = CU18,000 CU100,000/25 years = CU4,000 Total depreciation CU18,000 + CU4,000 = CU22,000
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Financial accounting 8
B
Residual value is the year-end estimate of the disposal value of the asset (BAS 16.51 and BAS 8.36(b)). (CU100,000 – CU15,000)/5 years = CU17,000
9
B
31 March 20X6 Carrying amount = CU20,000 31 March 20X5 20,000/0.8
= CU25,000
31 March 20X4 25,000/0.8
= CU31,250
31 March 20X3 31,250/0.8
= CU39,062
Accumulated depreciation
= (39,062 – 20,000) = 19,062, i.e. approximately CU19,000
10
D
Depreciable amount at 31 December 20X6 = (100,000 – 2,000) 14/20 = 68,600 Depreciation charge in 20X7 = 68,600 1/25 = CU2,744
11
B
At 1 January 20X4 the carrying amount was CU104,400 and remaining useful life was six years. Depreciation charge for 20X4 should be CU104,400/6 = CU17,400
12
A
The revaluation gain is taken to the revaluation reserve. The additional depreciation is transferred from retained earnings to the revaluation reserve.
13
D
An asset is impaired when the recoverable amount is lower than the carrying amount of the asset. To determine whether an asset is impaired, compare the recoverable amount to the carrying amount. The recoverable amount is the greater of the value in use and the fair value less costs to sell. Asset R is not impaired as recoverable amount is greater than carrying amount. Asset Q is impaired as recoverable amount of CU95,000 is lower than the carrying amount of CU100,000.
14
C
An impairment loss should be recognised when the asset is classified as held for sale. This will be the difference between the carrying amount (CU13,200) and its fair value less costs to sell (CU11,100 – CU500 = CU10,600). An impairment loss of CU2,600 (13,200 – 10,600) is therefore recognised at this point. When the asset is actually sold any further loss or gain is treated as a loss or gain on disposal. Here there is a further loss of CU100 (10,600 – 10,500).
15
A
Although an impairment loss is recognised when a non-current asset measured under BAS 16's cost model is classified as held for sale, any gain is only recognised when the asset is actually derecognised (i.e. sold). Hence the only gain recognised is that on sale of CU17,000 (115,500 – 98,500).
16
A
Where an asset has been held under the revaluation model and is subsequently classified as held for sale the asset must be revalued to fair value immediately before the reclassification. Any gain will be taken to the revaluation reserve and any loss to the income statement (except to the extent that it reverses a gain held in the revaluation reserve). So here, a revaluation gain is recognised of CU158,000 (725,000 – 567,000). Once revalued in this way, the measurement is then adjusted to the normal basis for held for sale assets, so fair value less costs to sell. The effect is that the costs to sell (here CU3,000) are recognised in the income statement as an impairment loss.
200
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PROPERTY, PLANT AND EQUIPMENT
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B
Revaluation reserve CU 90,000
Gain on revaluation (W) Reserve transfer New depreciation – old depreciation to 30/9/X4 Balance at 30/9/X4
5
270,000 200,000 – 20 18
(5,000) 85,000
WORKING CU 200,000 (20,000) 180,000 90,000 270,000
Cost Less Depreciation (200,000 2/20) NBV at revaluation Gain on revaluation Valuation 18
B At 30/9/X7 Revalued amount Depreciation (270,000 4/18) Carrying amount at disposal Revalue to fair value Loss to revaluation reserve
270,000 (60,000) 210,000 (190,000) 20,000
Revaluation reserve at 30/9/X4 Reserve transfer New depreciation – old depreciation (5,000 3) Revaluation reserve at 30/9/X7 Impairment loss Balance c/f (transfer to retained earnings on disposal)
85,000 (15,000) 70,000 (20,000) 50,000
Because there was a sufficient balance on the revaluation reserve in respect of this asset to which the loss could be charged, the only impairment loss taken to the income statement are the costs to sell of CU5,000. 19
A
B/f Additions
20
PLANT ACCOUNT (CARRYING AMOUNT) CU 261,000 Depreciation 512,000 Loss on disposal Impairment loss Disposal proceeds (ß) C/f 773,000
B Fair value less costs to sell Carrying amount (ß) Anticipated gain/(loss) on sale Cost Carrying amount Accumulated depreciation
CU 143,000 57,000 50,000 53,000 470,000 773,000 Machine 1 CU 90,000 (60,000) 30,000 120,000 (60,000) 60,000
Machine 2 CU 40,000 (60,000) (20,000) 100,000 (60,000) 40,000
Total accumulated depreciation CU60,000 + CU40,000 = CU100,000
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Financial accounting 21
B
Under BFRS Depreciation 20X7
2,500,000 – 225,000 – 450,000 45 22
B
23
PORSCHE LTD (a)
=
CU40,556
Notes to the financial statements for the year ended 31 December 20X7 (extracts) 1
Accounting policies Property, plant and equipment Freehold land and buildings are stated at a valuation. Other tangible non-current assets are stated at cost, together with any incidental expenses of acquisition. Depreciation is calculated so as to write off the net cost or valuation of tangible noncurrent assets over their expected useful lives. Depreciation charges commence when an asset becomes available for use. The rates and bases used are as follows.
2
Asset
% pa
Basis
Freehold land and buildings
2%
Straight-line
Plant and equipment
10%
Straight-line
Office equipment and fixtures
20%
Straight-line
Motor vehicles
30%
Reducing-balance
Profit from operations is stated after charging
CU 562,000
Depreciation of property, plant and equipment 3
Property, plant and equipment Freehold land and buildings Cost or valuation At 1 January 20X7 Additions Revaluations (W1) At 31 December 20X7 Depreciation At 1 January 20X7 Revaluation adjustment (W1) Charge for year At 31 December 20X7 Carrying amount At 31 December 20X7 At 1 January 20X7
202
CU000 1,440 500 760 2,700 144 ((144) 60 (W2) 60 2,640 1,296
Plant and equipment
Motor vehicles
CU000 1,968 75 – 2,043
CU000 449 35 – 484
257
194
– 233 (W5) 490 1,553 1,711
– 87 (W3) 281 203 255
Office equipment and fixtures CU000 888 22 – 910 583 – 182 (W4) 765 145 305
Total
CU000 4,745 632 760 6,137 1,178 (144) 562 1,596 4,541 3,567
(i)
Freehold land and buildings were valued for the purposes of the 20X7 accounts at open market value, with subsequent additions at cost. Their historical cost is CU1,940,000 (W6) and the related accumulated depreciation is CU183,000 (W6).
(ii)
The company’s depreciation policy on motor vehicles has been changed from a rate of 25% per annum on cost to a rate of 30% per annum on reducing balance in order to
© The Institute of Chartered Accountants in England and Wales, March 2009
PROPERTY, PLANT AND EQUIPMENT
5
give a more relevant presentation of the results and of the financial position. The effect of this change has been to reduce the depreciation charge for the year by CU34,000 (CU121,000 – CU87,000). (b) Qualitative characteristics and BAS 16 Understandability Information must be readily understandable to users so that they can perceive its significance. This is dependent on how information is presented and how it is categorised. For example, BAS 16 requires disclosures to be given by each class of property, plant and equipment so it will be clear what type of assets have been purchased during the year and what types of assets have been sold. If this information were merged over one class it would be less understandable. Relevance Information is relevant if it influences the economic decisions of users. The choice of the revaluation model as a measurement model in BAS 16 provides relevant information by showing up-to-date values. This will help give an indication as to what the entity's underlying assets are worth. Reliability Information is reliable if it is free from error or bias, complete and portrays events in a way that reflects their reality. Although the revaluation model gives relevant information this information is generally seen to be less reliable than the cost model – the other measurement model allowed by BAS 16. The cost model is based on historic costs, which are not the most relevant costs on which to base future decisions. However, historic cost is reliable being based on fact. Comparability Users must be able to compare information with that of previous periods or with that of another entity. Comparability is achieved via consistency and disclosure. BAS 16 allows comparability between the cost and the revaluation model (for example, to facilitate comparisons between two companies who have adopted different models) by requiring equivalent cost information to be disclosed under the revaluation model. It also requires disclosures (in accordance with BAS 8) of the effect of a change in an accounting estimate such as useful lives or depreciation rates. This facilitates comparison between different periods. WORKINGS (1) Freehold land and buildings revaluation DR Freehold land and buildings (ß) DR Accumulated depreciation (1,440 5 ÷ 50) Cr Revaluation reserve (2,200 – 1,296)
CU'000 760 144
CU'000 904
(2) Freehold land and buildings depreciation charge Valuation/cost at 1 January 20X7 Remaining useful life
Annual depreciation charge =
2,700, 000 45 years
CU2,700,000 45 years CU60,000
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Financial accounting (3)
Motor vehicles depreciation charge
CU'000 255 35 290 87
Carrying amount at 1 January 20X7 Additions Depreciation – reducing balance method @ 30% (4) Fixtures and fittings depreciation charge
CU'000 910 182
Cost at 31 December 20X7 Depreciation – straight-line method @ 20% (5) Plant and equipment depreciation charge
CU'000 1,968 (298) 75 1,745 175
Cost at 1 January 20X7 Less Grinding machine Add Purchases for factory extension Depreciation – straight-line method @ 10% Grinding machine – cost less residual value (298 – 8) Accumulated depreciation at 1 January 20X7 Carrying amount
290 (58) 232
The carrying amount must be written off over the machine's remaining useful life of four years. CU Depreciation charge
232, 000 4 years
58,000
Total depreciation charge for plant Grinding machine Other plant
CU000 58 175 233
(6) Historical cost depreciation on freehold land and buildings
CU'000 1,440 500 1,940 144 39 183
Cost at 1 January 20X7 Addition – extension Cost at 31 December 20X7 Accumulated depreciation at 1 January 20X7 Depreciation charge at 2% Accumulated depreciation at 31 December 20X7 24
PLOVER Ltd (a)
Financial statement extracts Balance sheet as at 30 September 20X9
CU'000
ASSETS Non-current assets Property, plant and equipment Current assets Non-current assets held for sale
204
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 2,026 X
X 175
X X
PROPERTY, PLANT AND EQUIPMENT
5
Notes to the financial statements Property, plant and equipment
Cost At 1 October 20X8 Additions (W1 & W2) Transfers Classified as held for sale At 30 September 20X9 Depreciation At 1 October 20X8 (W4) Charge for the year (W3) Classified as held for sale (W4) At 30 September 20X9 Carrying amount At 30 September 20X9 At 1 October 20X8
Factory premises
Plant and equipment
CU'000
CU'000
Assets in the course of construction CU'000
500 – 1,250 (500) 1,250
– 887 – – 887
190 18 (200) 8
– 103 – 103
– – – –
784 –
– 1,100
1,242 310
(b) Impairment loss Carrying amount brought forward Depreciation to 30 September (W3) Recoverable amount (200 – 25) Charge to income statement
1,100 150 (1,250) – –
Total
CU'000 1,600 1,037 – (500) 2,137 190 121 (200) 111 2,026 1,410 CU'000 310 (10) 300 (175) 125
WORKINGS (1) Additions to new factory Construction costs Legal fees (2) Additions to plant and equipment External costs Labour (80,000 100/120) Start-up costs (3) Depreciation New factory ((1,250 – 600) 2% 7/12) Old factory (500 2%) Plant and equipment (887 20% 7/12) (4) Old factory accumulated depreciation Brought forward at 1 October 20X8 (500 – 310) Charge for year (W3)
CU'000 125 25 150 CU'000 800 67 20 887 CU'000 8 10 18 103 CU'000 190 10 200
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Financial accounting
Answers to Interactive questions
Answer to Interactive question 1 Cost of facility Site preparation Net income while site used as a car park Materials used Labour costs Testing of facility's processes Sale of by-products Consultancy fees re installation and assembly Professional fees Opening of facility Overheads incurred: – Construction – General Relocation of staff to new facility Cost of dismantling facility Allocated to components: Safety inspection To be replaced in 8 years Remainder
Incidental, so taken to profit or loss (2,000 – 300) (4,000 – 500)
CU'000 400 – 1,700 3,500 300 (60) 500 450 – 800 – – 750 8,340
(40% (8,340 – 150))
150 3,276 4,914 8,340
Answer to Interactive question 2 The revaluation gain on 1 January 20X7 is CU35 (60 – 25). If the previous downward revaluation had not taken place the carrying amount on 31 December 20X6 would have been CU50 (CU100 less five years' depreciation at CU10 each year). The 'excess' revaluation gain recognised directly in equity is CU10 (60 – 50). The amount recognised in profit or loss is CU25 (50 – 25).
Answer to Interactive question 3 CU'000 Annual charge re: Over 3 years Over 8 years Over 20 years
206
(150 ÷ 3) (3,276 ÷ 8) (4,914 ÷ 20)
© The Institute of Chartered Accountants in England and Wales, March 2009
50 410 245 705
PROPERTY, PLANT AND EQUIPMENT
5
Answers to Interactive question 4 Year 1 CU 1,000 (80) 920
Cost Accumulated depreciation Carrying amount Charge for the year (W)
80
Year 2 CU 1,000 (160) 840 80
Year 3 CU 1,000 (320) 680 160
WORKING
1, 000 - 200
1, 000 - 200
840 - 200
10
10
4
Answer to Interactive question 5 (a)
Journal entry to record the classification as held for sale 1 January 20X8 DR PPE – accumulated depreciation (30% (100 – 10)) DR Non-current assets held for sale (40 – 2) DR Income statement () CR PPE – cost
CU'000 27 38 35
100
(b) Income statement for the year ended 31 December 20X8
CU'000 35
Impairment loss on reclassification of non-current assets as held for sale (c)
CU'000
Income statement for the year ended 31 December 20X8 With sales proceeds of CU32,000
The impairment loss would remain the same Loss on disposal of CU6,000 would be included.
Answer to Interactive question 6 (a)
Journal entry to record the classification as held for sale 1 January 20X8 DR PPE – accumulated depreciation (30% (100 – 10)) DR Non-current assets held for sale () CR PPE – cost
CU'000
CU'000
27 73 100
As fair value less costs to sell is greater than carrying amount, there is no impairment loss at the time of classification. (b) Income statement for the year ended 31 December 20X8 Gain on disposal of non-current assets held for sale (77 – 73)
CU'000 4
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Financial accounting
Answer to Interactive question 7 (a)
Journal entry to record the revaluation 1 January 20X5 DR PPE – at valuation CR Revaluation reserve
(b) Journal entry to record the classification as held for sale 1 January 20X8 DR Non-current assets held for sale – fair value less costs to sell (235 – 5) DR Income statement – costs to sell DR Revaluation reserve (250 – 235) CR PPE – at valuation
CU'000
CU'000
50 50 CU'000
CU'000
230 5 15 250
Answer to Interactive question 8 (a)
Journal to record the revaluation 1 January 20X4 DR PPE cost/valuation (136,000 - 120,000) DR PPE accumulated depreciation CR Revaluation reserve (136,000 - 102,000)
CU
CU
16,000 18,000 34,000
(b) Revised depreciation charge Annual charge from 20X4 onwards DR Income statement depreciation expense (136,000 ÷ 17) CR PPE accumulated depreciation Annual reserve transfer DR Revaluation reserve CR Retained earnings
CU 8,000
CU 8,000
2,000
2,000
Being the difference between the actual depreciation charge and the charge based on historical cost (CU6,000). Shown in the statement of changes in equity as follows:
Brought forward Profit for the year Transfer of realised profits Carried forward (c)
Revaluation reserve CU X – (2,000) X
Journal to record classification as held for sale At 1 January 20X8, balances relating to the asset will be as follows:
CU 136,000 (32,000) 104,000 26,000
Property, plant and equipment at valuation Accumulated depreciation (4 8,000) Carrying amount Revaluation reserve (34,000 – (4 2,000)) CU'000 1 January 20X8 DR PPE – accumulated depreciation DR Non-current assets held for sale – fair value less costs to sell DR Income statement – costs to sell CR PPE – cost/valuation CR Revaluation reserve (ß)
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000
32 137 3 172
208
Retained earnings CU X X 2,000 X
136 36 172
PROPERTY, PLANT AND EQUIPMENT
5
(d) Financial statements for the year ended 31 December 20X8 In the income statement:
A charge of CU3,000 will be made for the costs to sell, classified as an impairment loss. No profit or loss on disposal will be shown, as the asset is sold for its fair value less costs to sell.
Remaining balance on revaluation reserve is transferred to retained earnings as a reserve transfer in the statement of changes in equity: Revaluation Retained reserve earnings CU CU Brought forward X X Retained profit for the year – X Transfer of realised profits (26 + 36) (62,000) 62,000 Carried forward X X
Answer to Interactive question 9 RSBH Ltd: Reconciliation of opening and closing property, plant and equipment
Cost/valuation I January 20X7 Revaluation Additions Classified as held for sale Disposals At 31 December 20X7 Depreciation I January 20X7 Revaluation Charge for the year (W) Classified as held for sale (W) Disposals (W) At 31 December 20X7 Carrying amount 31 December 20X7 1 January 20X7
Freehold Property CU'000
Plant and Machinery CU'000
1,000 200 100 – – 1,300
700 – 400 (360) – 740
300 – 80 – (40) 340
2,000 200 580 (360) (40) 2,380
330 – 73 (269) – 134
180 – 48 – (28) 200
810 (300) 147 (269) (28) 360
606 370
140 120
300 (300) 26 – – 26 1,274 700
WORKINGS
Depreciation charge for the year Items reclassified/disposed of during year (360 10% 1/4) and (40 15% 1/2) Items owned throughout year ((700 – 360) 10%) and ((300 – 40) 15%) Items acquired during year (400 10% 3/4) and (80 15% 1/2) Accumulated depreciation on items reclassified/disposed of Brought forward Charge for year (360 10% 3/12)
Fixtures and Fittings CU'000
Plant and Machinery CU'000
Total CU'000
2,020 1,190 Fixtures and Fittings CU'000
9
3
34 30 73
39 6 48
260 9 269
25 3 28
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chapter 6
Intangible assets Contents Introduction Examination context Topic List 1 What are intangible assets? 2 BAS 38: objective and scope 3 The definition of intangible assets 4 Initial recognition and measurement 5 Internally generated assets 6 Measurement of intangible assets after recognition 7 Disposals 8 Disclosure 9 Goodwill Summary and Self-test Technical reference Answers to Self-test Answer to Interactive question
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Introduction
Learning objectives
Relate the treatment of intangible assets to the principles in BFRS Framework
Identify the accounting standards which apply to the treatment of intangible assets
Apply the accounting requirements for intangible assets, including the effects of the following: –
Separately acquired intangible assets
–
Intangible assets acquired as part of a business combination
–
Internally generated intangible assets including research and development expenditure
–
Internally generated and purchased goodwill
Tick off
Specific syllabus references for this chapter are: 1b, 2b, c.
Practical significance In recent years the recognition and measurement of intangible assets has been one of the most controversial areas of financial reporting. As the nature of business has changed intangible assets have become a significant part of the value of an entity. The most important assets for many businesses are now brands, market positions, knowledge capital and people, but these are rarely recognised in financial statements. Brand names such as Coca-Cola and Microsoft are, in many cases, an entity’s most valuable asset, but they are extremely difficult to value when they have been generated internally and over a period of time. Internally generated intangible assets that cannot be measured reliably are not recognised in the balance sheet because of the difficulties that surround their valuation. Bill Gates is said to estimate that 97% of the value of Microsoft is not recognised in the balance sheet as a result. In contrast to the treatment of internally generated intangibles, acquired intangibles are normally recognised in the balance sheet. For example, an entity that has acquired a brand, as opposed to internally generated an equally valuable brand, will recognise it, since a fair value can be attributed to it. As the acquirer has paid a price to acquire this brand, that price provides a reliable measure. This type of inconsistency has led to criticism that accounting practice in this area is unhelpful to users of financial statements and is out of date.
Stop and think Can you think of any other types of intangible assets that might add value to a business apart from those listed above?
Working context At this stage of your training it is less likely that you will have had practical experience of the issues affecting intangible assets. You may have come across some of the more common examples including development expenditure, patents and goodwill. However, the issues affecting recognition and valuation of these assets are often complex and would normally be dealt with by more senior members of the audit team.
Syllabus links In the Accounting paper you will have had an introduction to accounting for intangible assets. In this paper you are required to develop a sound understanding of the accounting guidance in this area, provided by BAS 38 Intangible Assets. The Financial Reporting syllabus will then develop some of the issues raised and in particular the impact that intangible assets can have on the way that financial information is interpreted.
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Examination context
Examination commentary Intangible assets could be examined in the written test section of the paper in the context of a question where there are a number of accounting issues to be considered in order to draft the relevant extracts to the accounts. Such a question could feature the treatment of research and development expenditure, goodwill or other intangibles. Intangibles could feature in an accounts question where financial statements are produced from a trial balance or could be examined within the context of group accounts (covered in Chapters 10-16 of this manual). Group accounts are most likely to focus on goodwill but the group accounts question in the sample paper also examined development expenditure in the context of group accounts. Questions could also focus on the way in which the accounting treatment of intangibles applies the principles of BFRS Framework. Alternatively, this topic could be examined via short-form questions. In the examination, candidates may be required to:
Explain how BFRS Framework applies to the recognition of intangible assets
Prepare and present financial statements or extracts therefrom in accordance with: – –
BAS 38 Intangible Assets BAS 36 Impairment of Assets
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1 What are intangible assets? Section overview
The key issues affecting intangible assets are: – –
1.1
Recognition – is the definition of an asset met? Measurement – can cost or value be measured reliably?
Intangibles Definition Intangible asset: An identifiable non-monetary asset without physical substance.
One of the principal distinctions between PPE and intangible assets is that whilst the former have physical substance, the latter do not. The following are examples of categories of expenditure that might be capitalised as an intangible asset:
Brand names Publishing titles Computer software Patents Copyrights Motion picture films Customer lists Fishing licences Import quotas Franchises Customer or supplier relationships Customer loyalty Market share Marketing rights
The key issue affecting the treatment of this type of expenditure is whether it should be recognised as an asset and if so, how it should be valued. BAS 38 Intangible Assets provides guidance in this area.
1.2
Underlying principles The underlying principles of BFRS Framework are reflected in BAS 38. The key element in financial statements, identified in BFRS Framework, which is relevant to intangible assets is:
Asset: a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Also relevant are the definitions of:
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Gains, which are a part of income: increases in economic benefits through enhancements of assets or decreases in liabilities other than contributions from equity
Losses, which are included in expenses: decreases in economic benefits through depletions of assets or additional liabilities other than distributions to equity
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and the recognition criteria set out in the Framework whereby an element is only recognised if:
It is probable that any future economic benefit associated with the item will flow to or from the entity The item has a cost or value that can be measured with reliability.
2 BAS 38: objective and scope Section overview
2.1
BAS 38 applies to all intangibles, the key exception being goodwill arising on a business combination.
Objective The objective of BAS 38 is to prescribe the treatment of intangible assets not covered by other BFRS, in terms of:
2.2
Recognition if, and only if, certain criteria are met Measurement provisions Disclosures
Scope BAS 38 applies to all intangible assets with certain exceptions. Examples of assets specifically excluded from BAS 38 include:
Goodwill arising on a business combination, which is accounted for under BFRS 3 Business Combinations.
Financial assets as defined in BAS 39 Financial Instruments: Recognition and Measurement.
Mineral rights, related exploration and development expenditure incurred.
3 The definition of intangible assets Section overview
An intangible asset must be: – –
3.1
'Identifiable' Under the control of the entity.
Identifiability As we saw in the definition in section 1.1 above an intangible asset must be 'identifiable'. BAS 38 includes this identifiability requirement to distinguish intangible assets from goodwill, which arises on the acquisition of a subsidiary. (We will look at the issue of goodwill in more detail in section 9 of this chapter.) An intangible asset is identifiable if it meets at least one of the two following criteria:
It is separable It arises from contractual or other legal rights
An asset is separable if it can be sold, transferred, exchanged, licensed or rented to another party on its own rather than as part of the business. It is likely that all of the examples of intangibles listed in section 1.1 are separable, in that the owner can sell them to others (even though some of them may fail other parts of the recognition test).
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Financial accounting Most of these examples also meet the second condition, that of arising from contractual or other legal rights. Clearly, patents, copyrights, motion picture films, fishing licences and import quotas arise from such rights. But this second condition is designed to cover items that are not separable, but are nevertheless valuable. The argument is that:
If in a group of assets most are tangible
If economic benefits cannot be obtained from the tangible assets without the transfer of a legal right and
If the legal right is of no benefit without the tangible assets to which they relate
then that legal right is non-separable but is still identifiable.
Worked example: Identifiability A company has a group of assets comprising unique PPE to produce a unique product and the right to be sole manufacturer and distributor of that product in a particular territory; the unique PPE is worthless without the distribution rights and vice versa, so the distribution rights are non-separable but still identifiable.
3.2
Control An intangible asset must also satisfy the basic definition of an asset. One of the characteristics of an asset (according to the definition in BFRS Framework) is that it is under the control of the entity. The entity must therefore be able to enjoy the future economic benefits from the asset, and prevent the access of others to those benefits. A legally enforceable right is evidence of such control, but not always a necessary condition. The following should be noted:
Control over technical knowledge or know-how only exists if it is protected by a legal right.
The skill of employees, arising out of the benefits of training costs, are most unlikely to be recognisable as an intangible asset, because an entity does not control the future actions of its staff.
Similarly, an entity normally has insufficient control over market share and customer loyalty for those to meet the definition of an intangible asset. However, the exception to this would be where the entity has the ability to exchange a customer relationship, for example, where a customer list can be traded, or separate rights provided for its use by a third party. This provides reliable evidence that the entity has control over the future economic benefits flowing from that relationship, and therefore meets the definition of an intangible asset.
4 Initial recognition and measurement Section overview
An intangible asset should be recognised if: – –
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It is probable that future economic benefits from the asset will flow to the entity. The cost of the asset can be measured reliably.
At recognition the intangible should be recognised at cost.
Separately acquired intangibles and intangibles acquired as part of a business combination are normally considered to meet the recognition criteria of BAS 38.
The key exception is goodwill recorded in the acquiree's balance sheet at the date of acquisition.
An intangible asset acquired as part of a business combination is recognised at fair value.
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Recognition: basic principle An item can only be recognised as an intangible asset if economic benefits are expected to flow in the future from ownership of the asset. Economic benefits may result in increased revenue, but may also result in the reduction of costs (cost savings). An intangible asset should be recognised if, and only if, both the following occur:
It is probable that the future economic benefits that are attributable to the asset will flow to the entity.
The cost can be measured reliably.
Management has to exercise judgement in assessing the degree of certainty attached to the flow of economic benefits to the entity, giving greater weight to external evidence. An intangible asset should be initially recognised at its cost.
4.2
Subsequent expenditure Subsequent expenditure is rarely recognised in the carrying amount of an asset. This is because in most cases the expenditure is incurred to maintain the expected future economic benefits embodied in an existing asset. In addition it is often difficult to attribute subsequent expenditure directly to a particular intangible asset rather than to the business as a whole.
4.3
Separately acquired intangible assets In most cases, separately acquired intangibles satisfy the BAS 38 recognition criteria. Brands, mastheads, publishing titles, licences, computer software, copyrights, patents and airport landing slots are all examples of assets that can be acquired externally and should be capitalised. As we saw in section 4.1 above an intangible asset is initially recorded at cost. Cost for these purposes comprises:
Purchase price (including duties and non-refundable taxes). Any directly attributable costs of preparing the asset for its intended use.
Directly attributable costs include:
Costs of employees working directly to bring the asset to its working condition. Legal and professional fees. Costs of testing.
The following expenditure is excluded from the cost of the intangible asset:
Costs of introducing a new product or service including costs of advertising and promotional activities.
Costs of conducting business in a new location or with a new class of customer (including staff training).
Administration and other general overhead costs.
(These expenses are also excluded from the cost of PPE.) Capitalisation of costs should cease when the asset is ready for use, irrespective of whether it is put into use immediately or not.
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Worked example: Cost of separately acquired intangibles Data Ltd acquires new technology that will revolutionise its current manufacturing process. Costs incurred are as follows: CU Original cost of new technology 1,200,000 Discount provided 120,000 Staff training incurred in operating the new process 60,000 Testing of the new manufacturing process 12,000 Losses incurred whilst other parts of the plant stood idle 24,000 The cost that should be capitalised as part of the intangible asset is: Cost Less discount Plus testing of process Total
4.4
CU 1,200,000 (120,000) 12,000 1,092,000
Intangible assets acquired as part of a business combination When an entity purchases another business entity the proceeds paid will normally exceed the value of the individual assets and liabilities bought. This excess is normally referred to as goodwill. BFRS 3 Business Combinations includes a list of items acquired in a business combination that should be recognised as intangible assets separately from goodwill, under five headings:
Marketing-related intangible assets, such as trademarks. Customer-related intangible assets, such as customer lists. Artistic-related intangible assets, such as motion picture films. Contract-based intangible assets, such as franchise agreements. Technology-based intangible assets, such as computer software.
The effect of recognising these intangible assets is to reduce to a minimum the amount ascribed to the goodwill arising on a business combination. (We will look at goodwill arising on a business combination in more detail in section 9.) Intangible assets acquired as part of a business combination are normally considered to meet the recognition criteria of BAS 38. The key exception to this is any goodwill recorded in the acquiree's balance sheet at the acquisition date. The cost of an intangible asset acquired as part of a business combination should be assessed at its fair value at the date it was acquired.
Definition Fair value: The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.
Fair value may be observable from an active market or recent similar transactions. Other methods may also be used. If fair value cannot be ascertained reliably, then the asset has failed to meet the recognition criteria. In this situation no separate intangible asset would be recognised, resulting in an increase in the value of goodwill arising on the business combination.
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Recognition of an expense Expenditure on intangibles must be recognised as an expense unless:
It is part of the cost of an asset which meets the recognition criteria; or
The item is acquired on a business combination and cannot be recognised as an asset. (This will form part of the goodwill arising at the acquisition date.)
Examples of expenditure which should be treated as an expense include:
Start up costs Training costs Advertising and promotional costs Business relocation and reorganisation costs
5 Internally generated assets Section overview
5.1
Internally generated goodwill should not be recognised.
Expenditure incurred in the research phase should be expensed as incurred.
Expenditure incurred in the development phase must be recognised as an intangible asset provided certain criteria are met.
BAS 38 prohibits the recognition of internally generated brands.
If recognised, internally generated assets should be recognised at cost.
Recognition of internally generated assets Internally generated goodwill should not be recognised as an asset. The key difficulties in deciding whether other internally generated intangible assets are to be recognised are:
Fixing the time when an identifiable asset comes into existence.
Measuring its costs reliably, as it is difficult to distinguish the costs of generating it from those of maintaining or enhancing the day-to-day operations of the business.
So additional requirements and guidance apply. The evolution of such assets is split into the research phase and the development phase. Note that these phases relate to all intangibles, not just what would normally be regarded as 'research and development expenditure'. Also note that when there is doubt regarding into which phase expenditure falls, it must be allocated to the research phase. This is an example of the application of the prudence concept.
5.2
Research phase All expenditure that arises in the research phase should be recognised as an expense when it is incurred. No costs will be recognised as an intangible asset. The rationale for this treatment is that at this stage there is insufficient certainty that the expenditure will generate future economic benefits. Examples of research costs include:
Activities aimed at obtaining new knowledge.
The search for, evaluation and final selection of applications of research findings or other knowledge.
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5.3
The search for alternatives for materials, devices, products, processes, systems or services.
The formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services.
Development phase Development costs may qualify for recognition as intangible assets provided that the following strict criteria can be demonstrated by the entity:
The technical feasibility of completing the intangible asset so that it will be available for use or sale.
Its intention to complete the intangible asset and use or sell it.
Its ability to use or sell the intangible asset.
How the intangible asset will generate probable future economic benefits. Among other things, the entity should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
Its ability to measure reliably the expenditure attributable to the intangible asset during its development.
If the above conditions are met development expenditure must be capitalised. In contrast with research costs, development costs are incurred at a later stage in a project, and the probability of success should be more apparent. Examples of development costs include the following.
5.4
The design, construction and testing of pre-production or pre-use prototypes and models.
The design of tools, jigs, moulds and dies involving new technology.
The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production.
The design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.
Other internally generated intangible assets The standard prohibits the recognition of internally generated brands, mastheads, publishing titles and customer lists and similar items as intangible assets. The reason for this is that these costs cannot be identified separately from the cost of developing the business as a whole. They can be seen as being component parts of internally generated goodwill, the recognition of which is also prohibited (see section 5.1).
5.5
Cost of an internally generated intangible asset If an internally generated intangible asset is recognised it should be measured at cost. The costs allocated to an internally generated intangible asset should be only costs that can be directly attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset for its intended use. Such costs include:
Materials and services consumed Employment costs of those directly engaged in generating the asset Legal and patent or licence registration fees
The principles underlying the costs that may or may not be included are similar to those for other noncurrent assets and inventory. The cost of an internally generated intangible asset is the sum of the expenditure incurred from the date when the intangible asset first meets the recognition criteria. If, as often happens, considerable costs have already been recognised as expenses before management could demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively recognised at a later date as part of the cost of an intangible asset.
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Worked example: Treatment of expenditure Douglas Ltd is developing a new production process. During 20X7, expenditure incurred was CU100,000, of which CU90,000 was incurred before 1 December 20X7 and CU10,000 between 1 December 20X7 and 31 December 20X7. Douglas Ltd can demonstrate that, at 1 December 20X7, the production process met the criteria for recognition as an intangible asset. The recoverable amount of the know-how embodied in the process is estimated to be CU50,000. How should the expenditure be treated?
Solution At the end of 20X7, the production process is recognised as an intangible asset at a cost of CU10,000. This is the expenditure incurred since the date when the recognition criteria were met, that is, 1 December 20X7. The CU90,000 expenditure incurred before 1 December 20X7 is expensed, because the recognition criteria were not met. It will never form part of the cost of the production process recognised in the balance sheet.
6 Measurement of intangible assets after recognition Section overview
After initial recognition an entity can choose between two models: – –
6.1
The cost model The revaluation model
In practice few intangible assets are revalued.
An intangible asset with a finite useful life should be amortised over this period.
An intangible asset with an indefinite useful life should not be amortised.
Cost model The standard allows two methods of valuation for intangible assets after they have been first recognised. Applying the cost model, an intangible asset should be carried at its cost, less any accumulated amortisation and any accumulated impairment losses.
6.2
Revaluation model The revaluation model allows an intangible asset to be carried at a revalued amount, which is its fair value at the date of revaluation, less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. Points to note 1
The fair value must be able to be measured reliably with reference to an active market in that type of asset. (See definition of an active market below.)
2
The entire class of intangible assets of that type must be revalued at the same time (to prevent selective revaluations).
3
If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset should be carried at its cost less any accumulated amortisation and impairment losses.
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Revaluations should be made with such regularity that the carrying amount does not differ from that which would be determined using fair value at the balance sheet date.
5
Where an intangible asset is revalued, subsequent amortisation is based on the revalued amount.
Definition Active market: A market in which all the following conditions exist:
The items traded are homogeneous Willing buyers and sellers can normally be found at any time Prices are available to the public
In practice there will not usually be an active market in an intangible asset; therefore the revaluation model will usually not be available. For example, although copyrights, publishing rights and film rights can be sold, each has a unique sale value. In such cases, revaluation to fair value would be inappropriate. A fair value might be obtainable, however, for assets such as fishing rights or quotas or taxi cab licences, where one is identical to the next.
6.3
Revaluation: accounting treatment The treatment of revaluation gains and losses for intangibles follow the same rules as for PPE (see Chapter 5). This can be summarised as follows:
Revaluation
Upwards
Downwards
Asset previously revalued downward
Asset not previously revalued downwards
Asset previously revalued upwards
Asset not previously revalued upwards
Increase up to value of previous downward revaluation: recognise in income statement Excess: recognise in revaluation reserve
Recognise increase in revaluation reserve
Decrease to value of previous upwards revaluation: recognise in revaluation reserve Excess: recognise in income statement
Recognise decrease in income statement
Worked example: Revaluation An intangible asset is carried by a company under the revaluation model. The asset was revalued by CU800 in 20X6, and there is a revaluation surplus of CU800 in the balance sheet. At the end of 20X7, the asset is valued again, and a downward revaluation of CU1,000 is required. State the accounting treatment for the downward revaluation.
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Solution In this example, the downward valuation of CU1,000 can first be set against the revaluation surplus of CU800. The revaluation surplus will be reduced to zero and a charge of CU200 made as an expense in the income statement in 20X7.
6.4
Useful life Under both measurement models an entity should assess the useful life of an intangible asset, which may be finite or indefinite. An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. Many factors are considered in determining the useful life of an intangible asset, including:
Expected usage Typical product life cycle Technical, technological, commercial or other types of obsolescence The stability of the industry Expected actions by competitors The level of maintenance expenditure required Legal or similar limits on the use of the asset, such as the expiry dates of related leases.
Computer software and many other intangible assets normally have short lives because they are susceptible to technological obsolescence. However, uncertainty does not justify choosing a life that is unrealistically short. The useful life of an intangible asset that arises from contractual or other legal rights should not exceed the period of the rights, but may be shorter depending on the period over which the entity expects to use the asset.
6.5
Amortisation period and amortisation method An intangible asset with a finite useful life should be amortised over its expected useful life.
Amortisation should start when the asset is available for use.
Amortisation should cease at the earlier of the date that the asset is classified as held for sale in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the date that the asset is derecognised.
The amortisation method used should reflect the pattern in which the asset's future economic benefits are consumed. If such a pattern cannot be predicted reliably, the straight-line method should be used.
The amortisation charge for each period should normally be recognised in profit or loss.
The residual value of an intangible asset with a finite useful life is assumed to be zero unless a third party is committed to buying the intangible asset at the end of its useful life or unless there is an active market for that type of asset (so that its expected residual value can be measured) and it is probable that there will be a market for the asset at the end of its useful life. The amortisation period and the amortisation method used for an intangible asset with a finite useful life should be reviewed at each financial year end.
6.6
Intangible assets with indefinite useful lives An intangible asset with an indefinite useful life should not be amortised. Instead the asset is reviewed annually to assess whether there has been a fall in its value in accordance with BAS 36 Impairment of Assets.
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7 Disposals Section overview
7.1
On disposal of an intangible asset the gain or loss is recognised in profit or loss.
Accounting treatment An intangible asset should be eliminated from the balance sheet when it is disposed of or when there is no further expected economic benefit from its future use. On disposal the gain or loss arising from the difference between the net disposal proceeds and the carrying amount of the asset should be taken to the income statement as a gain or loss on disposal.
8 Disclosure Section overview
BAS 38 requires detailed disclosures: – –
8.1
For each class of intangible asset For intangibles recorded at revalued amounts.
Disclosure requirements The standard has fairly extensive disclosure requirements for intangible assets. The financial statements should disclose the accounting policies for intangible assets that have been adopted. For each class of intangible assets, disclosure is required of the following distinguishing between internally-generated intangibles and other intangibles.
The method of amortisation used.
The useful life of the assets or the amortisation rates used.
The gross carrying amount, any accumulated amortisation (aggregated with accumulated impairment losses) as at the beginning and the end of the period.
The line item(s) of the income statement in which any amortisation of intangible assets is included.
A reconciliation of the carrying amount as at the beginning and at the end of the period (additions, retirements/disposals, revaluations, impairment losses, amortisation charge for the period).
The financial statements should also disclose the following.
In the case of intangible assets that are assessed as having an indefinite useful life, the carrying amounts and the reasons supporting the assessment of an indefinite useful life.
The carrying amount, nature and remaining amortisation period of any individual intangible asset that is material to the financial statements of the entity as a whole.
The existence (if any) and amounts of intangible assets whose title is restricted and of intangible assets that have been pledged as security for liabilities.
The amount of any contractual commitments for the future acquisition of intangible assets.
Where intangible assets are accounted for under the revaluation model, disclosure is required of the following by class of intangible assets.
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The effective date of the revaluation.
The carrying amount of revalued intangible assets.
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The carrying amount that would have been shown if the cost model had been used, and the amount of amortisation that would have been charged.
Also:
The amount of any revaluation surplus on intangible assets, as at the beginning and end of the period, and movements in the surplus during the year (and any restrictions on the distribution of the balance to shareholders).
The methods and significant assumptions applied in estimating the assets' fair values.
The amount of research and development expenditure that has been charged as an expense in the period.
Interactive question 1: Intangible assets
[Difficulty level: Intermediate]
In preparing its accounts for the year ended 30 June 20X7 NS Ltd has to deal with a number of matters. 1
An advertising campaign has just been completed at a cost of CU1.5m. The directors authorised this campaign on the basis of the evidence from NS Ltd's advertising agency that it would create CU4m of additional profits over the next two years.
2
A staff training programme has been carried out at a cost of CU250,000, the training consultants having demonstrated to the directors that the additional profits to the business over the next 12 months will be CU400,000.
3
A new product has been developed during the year. The expenditure totals CU1.2m, of which CU750,000 was incurred prior to 31 December 20X6, the date on which it became clear the product was technically feasible. The new product will be launched in the next three months and its recoverable amount is estimated at CU600,000.
Requirement Calculate the amounts which will appear as assets in NS Ltd's balance sheet at 30 June 20X7. Fill in the proforma below.
Solution The treatment in NS Ltd’s consolidated balance sheet at 30 June 20X7 will be as follows: 1
Advertising campaign: .......................................................................................................................................................................... ..........................................................................................................................................................................
2
Staff training programme: .......................................................................................................................................................................... ..........................................................................................................................................................................
3
New product: .......................................................................................................................................................................... .......................................................................................................................................................................... See Answer at the end of the chapter.
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9 Goodwill Section overview
9.1
Internally generated goodwill is not recognised. Purchased goodwill is recognised in the balance sheet of the acquirer at cost. Purchased goodwill is not amortised but is tested for impairment at least annually.
What is goodwill? Goodwill is created by good relationships between a business and its customers, for example:
By building up a reputation (by word of mouth perhaps) for high quality products or high standards of service.
By responding promptly and helpfully to queries and complaints from customers.
Through the personality of the staff and their attitudes to customers.
The value of goodwill to a business might be extremely significant. However, goodwill is not usually valued in the accounts of a business at all, and we should not normally expect to find an amount for goodwill in its balance sheet. On reflection, we might agree with this omission of goodwill from the accounts of a business. (a)
The goodwill is inherent in the business but it has not been paid for, and it does not have an 'objective' value. We can guess at what such goodwill is worth, but such guesswork would be a matter of individual opinion, and not based on hard facts.
(b) Goodwill changes from day to day. One act of bad customer relations might damage goodwill and one act of good relations might improve it. Staff with a favourable personality might retire or leave to find another job, to be replaced by staff who need time to find their feet in the job, etc. Since goodwill is continually changing in value, it cannot realistically be recorded in the accounts of the business. The result of this as we saw in section 5.1 is that internally generated goodwill should not be recognised as an asset.
9.2
Purchased goodwill There is one exception to the general rule that goodwill has no objective valuation. This is when a business is sold. People wishing to set up in business have a choice of how to do it – they can either buy their own long-term assets and inventory and set up their business from scratch, or they can buy up an existing business from a proprietor willing to sell it. When a buyer purchases an existing business, he will have to purchase not only its long-term assets and inventory (and perhaps take over its accounts payable and receivable too) but also the goodwill of the business. Purchased goodwill is shown in the acquirer's balance sheet because it has been paid for. It has no tangible substance, and so it is an intangible non-current asset.
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Worked example: Goodwill Andrew is a sole trader. At 31 December 20X7 he has total net assets in his balance sheet amounting to CU150,000. On 1 January 20X8 Brian purchases Andrew’s business for CU175,000. The summarised balance sheet of Brian at 1 January 20X8 would be as follows: Total net assets Intangible asset – goodwill (175 – 150)
CU 150,000 25,000 175,000
Capital introduced
175,000
Goodwill is calculated as the difference between the purchase consideration of CU175,000 and the value of the net assets acquired of CU150,000. The goodwill is recognised in the balance sheet of Brian as it is purchased goodwill. It would not have been recognised in the financial statements of Andrew.
9.3
BFRS 3 Business Combinations BFRS 3 covers the accounting treatment of goodwill acquired in a business combination. This includes goodwill arising on the purchase of both incorporated and unincorporated entities.
Definition Goodwill: Represents a payment made by the acquirer in anticipation of future economic benefits arising from assets that are not capable of being individually identified and separately recognised.
Points to note 1
Goodwill acquired in a business combination is recognised as an asset and is initially measured at cost. Cost is the excess of the cost of the combination over the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities.
2
After initial recognition goodwill acquired in a business combination is measured at cost less any accumulated impairment losses. It is not amortised. Instead it is tested for impairment at least annually, in accordance with BAS 36 Impairment of Assets.
3
A discount (i.e. 'negative' goodwill) arises when the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities exceeds the cost of the business combination.
4
A discount can arise as the result of errors in measuring the fair value of either the cost of the combination or the acquiree's identifiable net assets. It can also arise as the result of a bargain purchase.
5
Where there is an apparent discount, an entity should first reassess the amounts at which it has measured both the cost of the combination and the acquiree's identifiable net assets. This exercise should identify any errors.
6
Any discount remaining should be recognised immediately in profit or loss (that is, in the income statement).
We will look in more detail at the accounting treatment of goodwill in the context of group accounts in Chapters 10 – 15.
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Summary and Self-test
Summary
BAS 38 Intangible Assets
Not goodwill on business combination (BFRS 3)
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Self-test Answer the following questions. 1
The following statements relate to intangible assets. 1
An intangible asset should be amortised on a systematic basis over the asset’s useful life.
2
Internally generated goodwill may be carried on the balance sheet if the value can be determined with reasonable certainty.
3
Internally generated brands can never be recognised as intangible assets.
Which of the above statements are consistent with BAS 38 Intangible Assets? A B C D 2
1 and 2 only 1 and 3 only 2 only 3 only
During 20X7 War Ltd incurred the following expenditure on research and development activities, none of which related to the cost of tangible non-current assets. 1
CU20,000 on investigating methods of separating raw materials into chemicals A, B and C.
2
After the technical viability of converting chemical B into a new medicine for sensitive teeth had been proved, CU150,000 on the conversion process.
Commercial production and sales of the medicine commenced on 1 April 20X7 and are expected to produce steady profitable income during a 10-year period before being replaced. Adequate resources exist to achieve this. No commercial uses have been discovered for chemicals A and C. What is the maximum amount of development expenditure that may be carried forward at 31 December 20X8 in accordance with BAS 38 Intangible Assets? A B C D 3
Which of the following should be included in a company’s balance sheet as an intangible non-current asset under BAS 38 Intangible Assets? A B C D
4
CU123,750 CU129,250 CU138,750 CU144,917
Payment on account for patents Expenditure on completed research Brands developed by the company Internally-generated goodwill
Henna Ltd was incorporated on 1 January 20X6. At 31 December 20X6 the following items had arisen. 1 2 3 4 5
Purchase of laboratory equipment for research purposes Goodwill purchased for valuable consideration Goodwill created by the company Patents purchased for valuable consideration Costs incurred by the company in developing brands
CU80,000 CU100,000 CU80,000 CU70,000 CU60,000
Prior to amortisation, what amount should be carried as assets in the balance sheet of Henna Ltd at 31 December 20X6 in accordance with BAS 38 Intangible Assets? A B C D
CU310,000 CU250,000 CU230,000 CU170,000
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In accordance with BAS 38 Intangible Assets which of the following conditions would preclude any part of the development expenditure to which it relates being capitalised? A B C D
6
In accordance with BAS 38 Intangible Assets which of the following types of expenditure must be recognised as an expense in the year in which incurred? A B C D
7
8
The development is incomplete The benefits flowing from the completed development are expected to be greater than its cost Funds are unlikely to be available to complete the development The development is expected to give rise to more than one product
Tangible assets acquired in order to provide facilities for research and development activities Legal costs in connection with the registration of a patent Costs of searching for possible alternative products Salaries of personnel solely engaged in finalising a new product
Which of the following statements relating to internally generated intangibles are true in accordance with BAS 38 Intangible Assets? 1 2 3 4
Expenditure on training staff to operate the asset should not be capitalised Salaries of personnel directly engaged in generating the asset should be capitalised Internally generated customer lists should not be capitalised Costs of evaluating alternatives for new materials should be capitalised
A B C D
3 and 4 only 2 and 3 only 1 and 4 only 1, 2 and 3 only
MINBAD LTD Minbad Ltd is a company operating in media and communications. It owns a number of newspapers and monthly magazine titles, which were acquired when the company acquired the assets of Newsmedia. The consideration totalled CU130 million, of which CU100 million was attributed to identifiable net assets (CU60 million specifically for the newspaper and magazine titles). The acquisition occurred on 1 January 20X7. The newspaper and magazine titles are assessed as having indefinite lives. Goodwill arising on the acquisition is estimated to have a useful life of 20 years. However, an impairment review at 31 December 20X7 showed that goodwill had fallen in value by CU1 million during 20X7. The newspapers and magazines have all shown increasing circulation since the acquisition. Accordingly, in considering the financial statements to 31 December 20X7 the directors wish to revalue the titles to CU133 million, which represents the sum of amounts it is estimated could be realised if each title and its associated rights were sold separately in the market at 31 December 20X7. The directors estimate that this approximates closely to current cost. On 1 January 20X7 the company decided to expand its printing capacity by investing in new high tech machinery costing CU20 million. This machinery had been developed by a French company and Minbad Ltd had to pay CU20 million to acquire the patent allowing it sole use of the technology for ten years. In addition Minbad Ltd has also developed a range of greeting cards to be sold alongside, and advertised in, the monthly magazines. These cards will all be sold under a newly developed brand name which Minbad Ltd has spent CU6 million developing. Requirements (a)
Assuming that BAS 38 Intangible Assets and BFRS 3 Business Combinations are complied with, prepare the table of movements and accounting policy notes for intangible assets for inclusion in the financial statements of Minbad Ltd for the year ended 31 December 20X7. (6 marks)
(b) Comment on your treatment of Minbad Ltd's intangible assets in (a) above in the light of BFRS Framework. (5 marks) (11 marks)
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6
PHARMORIA LTD Pharmoria Ltd operates in the pharmaceutical business. The following information relates to the company's activities in research and development for the year ended 31 October 20X7. 1
Commercial production started on 1 June 20X3 for Formula A. By 31 October 20X6 CU43,000 had been capitalised in respect of development expenditure on this product. During the year a further CU10,000 was spent on development of this product. Pharmoria Ltd has taken out a patent in respect of Formula A which will last for ten years. Legal and administrative expenses in relation to this were CU2,000. In the current year, sales of Formula A amounted to CU50,000. Sales over the next three years are expected to be CU150,000, CU200,000 and CU100,000 respectively.
2
The development of Formula B is at an earlier stage. Although the company believes it has a reasonable expectation of future benefits from this project it has not as yet been able to demonstrate this with sufficient certainty. Expenditure on this project in the current year was CU20,000.
Requirements (a)
Calculate the total amount to be written off to the income statement in respect of the above in the year ended 31 October 20X7. (3 marks)
(b) Draft the table showing the movement on intangible assets which would appear in the notes to the financial statements of Pharmoria Ltd for the year ended 31 October 20X7. (6 marks) (9 marks) Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Technical reference Point to note: The following sets out the examinability of the standards covered in this chapter. BAS 38
All examinable except paragraphs 42-47 and the illustrative examples.
BFRS 3
All examinable except the following: paragraphs 10-13, 20-23, 58-60 and 65. Appendix B1-B3, B5, B7-B15 and the illustrative examples are also excluded.
The paragraphs listed below are the key references you should be familiar with. 1 Scope and definition
Scope of BAS 38: excludes what other BFRSs cover, e.g. goodwill on acquisition (BFRS 3).
BAS 38 (3)
Intangible asset: an identifiable, non-monetary asset without physical substance.
BAS 38 (8)
Identifiability the key:
BAS 38 (3)
–
Separable – could be sold separately from entity which owns
BAS 38 (8)
–
Arises from contractual or other legal rights.
Control is an essential part of the definition of an asset. Many items excluded because not controlled by a business: –
Staff (always)
–
Customers (very often).
BAS 38 (12) BAS 38 (13)
2 Recognition and initial measurement
Reliable measurement – the recognition criteria disallow:
BAS 38 (21)
–
Internally generated goodwill
BAS 38 (48)
–
Similar items such as internally generated brands, mastheads and customer lists Advertising.
BAS 38 (63)
–
Initial measurement at cost.
BAS 38 (24)
Separate acquisition:
BAS 38 (25)
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BAS 38 (69)
–
Always – future economic benefits are probable
–
Usually – cost reliably measurable
BAS 38 (26)
–
Cost includes licences, etc.
BAS 38 (27)
Part of business combination
BAS 38 (33)
–
Always – future economic benefits are probable
–
Almost always – cost reliably measurable
BAS 38 (35)
–
Cost = fair value
BAS 38 (33)
–
Includes acquiree's unrecognised intangibles, such as in-process research and development.
BAS 38 (34)
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Internally generated: at cost, but: –
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Research expenditure (seeking new knowledge) written off as incurred (including subsequent expenditure on business combination research) – Development expenditure (application of research findings) capitalised if it meets stringent conditions as to future economic benefit – Development expenditure includes materials, staff costs and licences but not general overheads – Only development expenditure incurred after recognition criteria met is to be capitalised. No subsequent capitalisation of earlier expenditure already recognised in profit or loss. Subsequent expenditure almost always written off, because most expenditure relates to maintenance, not enhancement, and is non-separable from that on business as a whole.
BAS 38 (65 and 42) BAS 38 (57 and 42)
BAS 38 (65 and 71)
BAS 38 (20)
3 Measurement after recognition
Cost or revaluation models
BAS 38 (72)
–
BAS 38 (75)
Revaluation only if active market (homogeneous products, always trading, prices available to public)
Useful life: –
Indefinite – no amortisation, but annual impairment and useful life reviews
–
Finite – annual amortisation, with impairment review if indication of impairment. Residual value almost always nil
BAS 38 (107-109) BAS 38 (97)
4 Disclosure
Disclosures specific to intangibles (otherwise follow BAS 16): –
Whether useful lives are indefinite or finite (in which case amortisation rates must be disclosed)
BAS 38 (118(a))
–
For intangibles with indefinite useful lives, their carrying amount and the reasons supporting the indefinite life assessment Individual assets material to financial statements as a whole
BAS 38 (122(a))
– –
Amount of research and development expenditure recognised as an expense in the period.
BAS 38 (122(b)) BAS 38 (126)
5 Goodwill
Purchased goodwill: non-current asset at cost
BFRS 3 (51)
No amortisation but subject to annual impairment reviews
BFRS 3 (54)
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Answers to Self-test 1
D 1 False – If the asset’s life is assessed as finite, this would be the case. However, if it is assessed as indefinite, there are no amortisation charges but annual impairment reviews. 2 False – Such goodwill may never be recognised. 3 True – Since these costs cannot be identified separately from the cost of developing the business as a whole (paragraphs 63-64).
2
A 1 Relates to research so must be written off as an expense. 2 Relates to development so should be capitalised once the recognition criteria (BAS 38 paragraph 57) are met. Capitalised as at 1 April 20X7 Amortised up 31 December 20X8 (21/120 ×150,000) C/f as at 31 December 20X8
3
CU 150,000 (26,250) 123,750
A Under BAS 38 B, C and D must be expensed.
4
B 1 Will be carried forward as property, plant and equipment under BAS 16. 2 and 4 Will be carried forward as intangible assets under BAS 38. 3 and 5 Cannot be carried forward – per BAS 38 (paragraphs 48 and 63).
5
C BAS 38 paragraph 57.
6
C A
Capitalised under BAS 16.
B and D Capitalised as part of the cost of an internally-generated intangible (BAS 38 paragraphs 66-67). 7
D 1, 2 and 3 are true per BAS 38 paragraphs 66-67 and 63. 4 Constitutes part of a research phase, so the costs cannot be capitalised (BAS 38 paragraph 54).
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6
MINBAD LTD (a)
Notes to the financial statements at 31 December 20X7 (extracts) Intangible assets
Cost At 1 January 20X7 Additions At 31 December 20X7 Amortisation/impairment At 1 January 20X7 Charge for year (20 ÷ 10) At 31 December 20X7 Carrying amount At 1 January 20X7 At 31 December 20X7
Goodwill
Patents
Publishing titles CUm
Total
CUm
CUm
– 30 30
– 20 20
– 60 60
– 110 110
– 1 1
– 2 2
– – –
– 3 3
– 29
– 18
– 60
– 107
CUm
Note. Of the additions during the year totalling CU110 million the goodwill and publishing titles resulted from a business combination. The patents were separately acquired. Accounting policy note Purchased intangibles are recognised at the fair value of consideration paid and separately from goodwill. Patents are amortised on a straight-line basis over the life of the legal agreement. Publishing titles are considered to have an indefinite life and are not amortised but are subject to annual impairment reviews. Goodwill is not amortised but is subject to annual impairment reviews. Note. This analysis shown under the heading 'Note' is required by BAS 38 paragraph 118 (e) (i) (b) BFRS Framework Under BFRS Framework an asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected. Here, Minbad Ltd has control over all the intangibles as it has either legally purchased them (the goodwill, newspaper titles and patents) or developed them internally (the brand). However, an additional requirement of the Framework is that items can only be recognised if
There is a probable inflow of economic benefits, and The cost/value can be measured reliably.
Acquired intangibles meet this requirement, but, as BAS 38 clearly identifies, it is not possible to separate out reliably the cost of internally generated brands from the costs to develop the business as a whole. Other sections of the Framework highlight the importance of providing relevant information to users of financial statements. It could be argued that users would find the value of internal intangibles of great relevance when assessing/evaluating a business. It would appear that with regard to intangibles, reliability has superseded relevance. With regard to the proposed revaluation, although under BAS 38 either the cost or revaluation model can be used, intangibles can only be revalued where there is an 'active market' for them. This must be a market where all items traded are homogeneous, which clearly cannot be true for assets such as magazine titles. Again this is consistent with the qualitative characteristic of reliability.
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PHARMORIA LTD (a)
Total amount to be written off to the income statement in the year ended 31 October 20X7 CU 20,000 5,300 200 25,500
Formula B (not yet qualifying as development phase) Amortisation of development costs (Formula A) (W) Amortisation of patent (2,000 ÷ 10) (b) Notes to the financial statements as at 31 October 20X7 (extracts) Intangible assets
Cost At 1 November 20X6 Additions At 31 October 20X7 Amortisation At 1 November 20X6 Charge for year At 31 October 20X7 Carrying amount At 1 November 20X6 At 31 October 20X7
Development costs CU
Patents
Total
CU
CU
43,000 10,000 53,000
– 2,000 2,000
43,000 12,000 55,000
– 5,300 5,300
– 200 200
– 5,500 5,500
43,000 47,700
– 1,800
43,000 49,500
WORKING Amortisation of development costs for Formula A Sales in year ÷ total sales CU53,000 5 months 50,000/(50,000 + 150,000 + 200,000 + 100,000) CU53,000 = CU5,300
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Answer to Interactive question
Answer to Interactive question 1 The treatment in NS Ltd’s consolidated balance sheet at 30 June 20X7 will be as follows: 1
Advertising campaign: no asset will be recognised, because it is not possible to identify future economic benefits that are attributable only to this campaign. The whole expenditure is recognised in profit or loss.
2
Staff training programme: no asset will be recognised, because staff are not under the control of NS Ltd and when staff leave, the benefits of the training, whatever they may be, also leave. The whole expenditure is recognised in profit or loss.
3
New product: the development expenditure appearing in the balance sheet will be measured at CU450,000. The expenditure prior to the date on which the product becomes technically feasible is recognised in profit or loss. The remaining CU450,000 is less than the recoverable amount, so no impairment issues arise.
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chapter 7
Revenue and inventories Contents Introduction Examination context Topic List 1
Introduction
2
BAS 18 Revenue
3
BAS 2 Inventories
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Introduction
Learning objectives
Relate the treatment of revenue to the principles in BFRS Framework
Understand and apply the main provisions of BAS 18 Revenue, which sets out the requirements in relation to the recognition and measurement of revenue, in particular – – –
Tick off
Sale of goods Rendering of services Investment income
Understand and apply the main provisions of BAS 2 Inventories, which sets out requirements in relation to the measurement of inventories
Specific syllabus references for this chapter are: 1b, 2b, c.
Practical significance Revenue The principal reason why profit-making businesses operate is to generate revenue. Revenue often represents one of the largest figures in the financial statements, and growth in revenue is often used as a key performance indicator by investors. In more traditional businesses the point at which revenue should be recognised is usually straightforward. However, in recent years as business transactions have become more complex this area of accounting has become more controversial with some companies adopting aggressive, and in some cases questionable, accounting policies for revenue recognition. The result of these policies can be seen in many of the high profile accounting scandals that we have seen in recent years. For example, the early success of many of the dot.com companies in the 1990s was the result of the manipulation of revenue leading to inflated profits. Capital markets need to have confidence in financial statements. This means that there must be a consistent approach to revenue recognition but also an approach which is able to deal with the wide range of transactions which currently exist. BAS 18 Revenue aims to provide this guidance. Inventories The significance of inventories to a business will largely depend on the nature of the business. For a manufacturing entity, for example, inventories are likely to be one of the most significant balances on the balance sheet, typically representing 10%-20% of total assets. By contrast a company in the services sector would typically hold small amounts of inventories. Where inventory does represent a significant asset one of the key business issues is risk. This includes the risk of poor inventory management leading to excessive amounts of capital being tied up, which in turn affects the cash flow of the business. Entities operating in a dynamic environment, such as the technology industry, can also face the problem of obsolescence. These business risks can cause issues for the valuation of inventories for accounting purposes. The valuation of inventories will involve management judgement. For example, decisions will need to be made about which costs to allocate to individual items of inventory and estimates may need to be made regarding estimated selling prices in order to establish net realisable value. These decisions will have an impact not only on the balance sheet value of the asset but will also have a direct impact on reported profits. BAS 2 Inventories provides guidance in this area.
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Stop and think What is the relationship between revenue recognition and inventories?
Working context Accounting for revenue and inventories is a complex area as there are many judgemental decisions which need to be made. As a result of this it is likely that more senior members of staff will be involved. If you work in audit you may have been involved in some aspects of this work, for example attending inventory counts.
Syllabus links Revenue You will have come across the accounting treatment of revenue in your earlier studies without necessarily being aware of this. In your Accounting studies you will have been introduced to the basic double entry for both a cash and a credit sale. With a credit sale the revenue is recognised in advance of the cash being received. The Financial Accounting syllabus builds on this basic knowledge by putting the topic into the context of BAS 18 Revenue. This sets out the basic principles of revenue recognition and introduces more complex transactions. Inventories In the Accounting paper you will have covered the basic principles of inventory valuation, i.e. inventory is valued at the lower of cost and net realisable value. You will also have dealt with the accounting entry for inventories as a year-end adjustment to a trial balance being: DR CR
Inventories (Balance sheet asset) Cost of sales (Income statement)
The Financial Accounting syllabus looks in more detail at the guidance provided by BAS 2 Inventories, particularly the calculation of cost and net realisable value. The related topic of construction contracts will be covered in the Financial & Corporate Reporting syllabus.
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Examination context
Examination commentary Revenue is most likely to feature in a mixed question or in a company accounts question where an income statement is produced from a trial balance. It may also be tested in the short-form question section of the paper. Inventories could be examined in both the short-form questions and the written test section of the paper. In the written test section it is possible that it could be examined in its own right although it is more likely to feature in a mixed question or a published accounts question. In the examination, candidates may be required to:
Prepare and present financial statements or extracts therefrom in accordance with: – –
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BAS 18 Revenue BAS 2 Inventories
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1 Introduction Section overview
Both revenue recognition and accounting for inventories are affected by the application of the accrual basis of accounting.
The key issue affecting revenue is the timing of recognition.
The key issue affecting inventories is the identification of which costs should be: – –
1.1
Carried forward in the balance sheet Expensed as part of cost of sales.
Background issues Financial statements are prepared on the underlying assumption of the accrual basis of accounting, whereby effects of transactions are recognised when they occur and not when the cash associated with them is received or paid. But this raises questions about when a transaction 'occurs':
Is it when the buyer takes possession of the goods, in circumstances where the contract for sale contains clauses that seek to ensure that ownership does not pass to the customer until the seller has been paid in full?
It is when services are provided, in circumstances where the seller undertakes to come back to do additional work without charge if needed, e.g. remedial work carried out by a building contractor?
When does the profit arise on the contract for the provision of services to a customer over time, such as under a maintenance contract of two years' duration? Only at the start, only in the middle, only at the end, or over the period of two years?
In addition there are issues about which costs to include in the balance sheet carrying amount for inventories.
Should the amount include only those variable costs that are incurred in the manufacture? After all, fixed costs are incurred regardless of volume of activity and perhaps should be recognised in profit or loss as incurred.
Or should the amounts include fixed costs? And if so, which? Should general administration costs be included?
Finally there is the issue of how to identify the cost of goods which must be removed from the carrying amount of inventories when they are sold:
Should it be the cost of the goods manufactured longest ago? Should it be the cost of those manufactured most recently? Or should some sort of average cost be used?
The timing of the recognition of revenue is critical to the timing of profits, while the amount of yearend inventories has a CU for CU effect on the profits earned in the period. So the way these are calculated is vital to any real understanding of the financial performance in the period.
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2 BAS 18 Revenue Section overview
Revenue is income arising in the normal course of an entity’s activities.
Revenue should be recognised when it is probable that future economic benefits will flow to the entity and when these benefits can be measured reliably.
BAS 18 Revenue provides guidance on the recognition of revenue arising in the following transactions: – – –
2.1
Sale of goods Rendering of services The use by others of entity assets yielding interest, royalties and dividends.
Although detailed rules apply to the above, generally revenue is recognised when the entity has transferred to the buyer the significant risks and rewards of ownership and when that revenue can be measured reliably.
Objective and scope BAS 18 prescribes the accounting treatment of revenue recognition in common types of transaction. It states that in general terms revenue should be recognised:
When it is probable that future economic benefits will flow to the entity and These benefits can be measured reliably.
BAS 18 applies to:
Sale of goods (manufactured items and items purchased for resale).
The rendering of services (which typically involves the performance by the entity of a contractually agreed task over an agreed period of time).
The use by others of entity assets yielding interest, royalties and dividends.
The standard specifically excludes various types of revenue arising from leases, insurance contracts, changes in value of financial instruments or other current assets, natural increases in agricultural assets and mineral ore extraction.
2.2
Revenue Income is defined in BFRS Framework as 'increases in economic benefits in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity.' Revenue is simply income arising in the ordinary course of an entity's activities and it may be called different names such as:
Sales Turnover Interest Dividends Royalties
Revenue is defined by BAS 18 as follows:
Definition Revenue: The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those flows result in increases in equity, other than increases relating to contributions from equity participants.
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Points to note
2.3
1
The reference to 'gross' inflow requires revenue to be shown gross of the costs associated with earning it (an example of the general prohibition against netting off in financial statements).
2
The reference to 'increases in equity' precludes the inclusion in revenue of amounts collected on behalf of others, e.g. sales tax (VAT in Bangladesh) and amounts collected by agents on behalf of a principal.
Measurement When a transaction takes place, the amount of revenue is usually decided by the agreement of the buyer and the seller. The revenue, however, should be measured at the fair value of the consideration received or receivable.
Definition Fair value: The amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arm's length transaction.
Fair value will take into account any trade discounts and volume rebates allowed by the seller. In straightforward situations the requirement to measure revenue at fair value provides few problems. So sales on credit terms of 30 days will be measured at the amount receivable in 30 days, net of all sales allowances such as quantity discounts. Problems can arise where much longer credit intervals are allowed.
Worked example: Deferred payment Comfy Couches Ltd sells an item of furniture to a customer on 1 September 20X7 for CU2,500 with a oneyear interest-free credit period. The fair value of the consideration receivable is CU2,294. (In other words, if the company tried to sell this debt, this is the amount it would expect to receive now.) In this case the transaction would be split into two components:
Interest revenue of CU206 (2,500 – 2,294), which would be recognised over the period of credit Sales revenue of CU2,294, which would be recognised on 1 September 20X7.
When goods or services are 'swapped' for those of similar nature and value, then no revenue is created (and no additional cost recorded), because all that is really taking place is the substitution of one good or service by something very similar. Such transactions are quite common in the sale of commodities. When the goods/services are dissimilar, then there are transactions which generate revenue and cost, measured by reference to the fair value of what is received.
2.4
Sale of goods Revenue should only be recognised when all of the following conditions are satisfied.
The entity has transferred the significant risks and rewards of ownership of the goods to the buyer.
The seller no longer has management involvement or effective control over the goods.
The amount of revenue can be measured reliably.
It is probable that the economic benefits associated with the transaction will flow to the entity.
The costs incurred in respect of the transaction can be measured reliably. © The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting Points to note 1
In most cases the transfer of risks and rewards of ownership coincides with the transfer of legal title, or the passing of possession to the buyer. This is the case for most retail sales.
2
If the entity retains significant risks of ownership, the transaction is not a sale and revenue is not recognised. Examples of this type of situation include the following:
3
When the seller retains some obligation for unsatisfactory performance which is outside a normal warranty cover.
If the receipt of the revenue from a particular sale depends on the buyer receiving revenue from his own sale of the goods.
When the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the seller (revenue should not be recognised until the installation has been completed).
It is possible for the seller to retain only an insignificant risk of ownership and for the sale and revenue to be recognised. Common examples include the following situations:
Where the seller retains title only to ensure collection of what is owed on the goods. Where an item may be returned and a refund provided.
4
The probability of the entity receiving the revenue arising from the transaction must be assessed. For example, in most cases revenue in relation to credit sales is recognised before actual payment is received. However, where collectability is called into doubt and recovery has ceased to be probable, the amount should be recognised as an expense and not an adjustment to revenue previously recognised.
5
Matching should take place, i.e. revenue and expenses relating to the same transaction should be recognised at the same time. In some cases expenses may need to be estimated at the date of sale, e.g. warranty costs. Where they cannot be estimated reliably, then revenue cannot be recognised; any consideration that has already been received is treated as a liability.
Worked example: Sale of goods Morgan Motors Ltd sells a car for CU15,000 with one year's free credit. There is a three-year manufacturer’s warranty on the vehicle. Revenue will be recognised at the time of sale, but:
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The CU15,000 receivable will be split between interest earned and the cash sale price.
The cash sale price will be recognised in the period the sale is made.
The interest income will be recognised over the period of free credit.
The production and selling costs of the car will be set against the cash sale price. At the same time a charge to the income statement will be made to set up a warranty provision for the expected costs of carrying out the expected amount of warranty work over the three-year warranty period.
Costs incurred on the warranty work over the three years will be charged to the provision, with any over-provision being written back (and any under-provision being charged) to the income statement.
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2.5
7
Rendering of services When the outcome of a transaction involving the rendering of services can be estimated reliably, the associated revenue should be recognised by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all of the following conditions are satisfied.
The amount of revenue can be measured reliably
It is probable that the economic benefits associated with the transaction will flow to the entity
The stage of completion of the transaction at the balance sheet date can be measured reliably
The costs incurred for the transaction and the costs to complete the transaction can be measured reliably
The recognition criteria above are similar to those for the sale of goods. One of the key differences is the need to be able to determine the stage of completion of the transaction. This is of particular relevance when the completion of a contract for services straddles more than one accounting period. The following methods of assessing the stage of completion are referred to in BAS 18: Surveys of work performed Services performed to date as a percentage of total services to be performed The proportion that costs incurred to date bear to the estimated total costs of the transaction.
Progress payments and advances received from customers often do not reflect the services performed. As a result it is normally inappropriate to recognise revenue based on payments received. If the overall outcome of a services transaction cannot be estimated reliably, then revenue is only recognised to the extent of those costs incurred that are recoverable from the client.
Interactive question 1: Rendering of services
[Difficulty level: Easy]
A CU210,000 fixed-price contract is entered into for the provision of services. At the end of 20X7, the first accounting period, the contract is thought to be 33% complete and costs of CU45,000 have been incurred in performing that 33% of the work. Requirements Calculate the revenue to be recognised in 20X7 on the alternative assumptions that: (a)
The costs to complete are reliably estimated at CU90,000; and
(b) The costs to complete cannot be reliably estimated and it is thought that CU40,000 of the costs incurred are recoverable from the customer. Fill in the proforma below. (a)
Cost to complete are CU90,000
(b) Cost to complete cannot be estimated reliably
See Answer at the end of the chapter.
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2.6
Investment income When others use the enterprise's assets yielding interest, royalties and dividends, the revenue should be recognised when: (a)
It is probable that the economic benefits associated with the transaction will flow to the enterprise and
(b) The amount of the revenue can be measured reliably. The revenue is recognised on the following bases.
2.7
Interest is recognised on a time proportion basis that takes into account the effective yield on the asset.
Royalties are recognised on an accrual basis in accordance with the substance of the relevant agreement.
Dividends are recognised when the shareholder's right to receive payment is established. This is usually when the dividends are declared.
Disclosure The following items should be disclosed.
The accounting policies adopted for the recognition of revenue, including the methods used to determine the stage of completion of transactions involving the rendering of services
The amount of each significant category of revenue recognised during the period including revenue arising from: – – – – –
The sale of goods The rendering of services Interest Royalties Dividends
The amount of revenue arising from exchanges of goods or services included in each significant category of revenue
Any contingent gains or losses, such as those relating to warranty costs, claims or penalties should be treated according to BAS 37 Provisions, Contingent Liabilities and Contingent Assets (covered in Chapter 9).
2.8
Practical application BAS 18 includes an appendix which demonstrates the application of its concepts to particular types of transactions. These include the following: Consignment sales
Under such arrangements, the buyer of the goods undertakes to sell them on, but on behalf of the original seller. So the buyer is effectively acting as an agent on behalf of the original seller. The original seller only recognises his sale when his buyer sells them on to a third party. This treatment also applies to sale and return transactions.
Lay away sales
Under these arrangements, the goods are only delivered once the final instalment has been received, so it is only then that the risks and rewards of ownership move from seller to buyer and revenue can be recognised. For example, with the recent launches of Harry Potter books, it has been common for customers to put down some money to reserve a copy. This will be recognised as revenue when the balance is paid up and the book is delivered to the customer.
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Sale and repurchase agreement
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This is an agreement whereby the seller concurrently agrees to repurchase the same goods at a later date, or where there are call or put options in place. The terms of the agreement need to be considered to determine whether there is a sale in substance. Where legal title has been transferred but the risks and rewards of ownership have been retained by the seller revenue is not recognised and the transaction is treated as a financing arrangement. (We looked at the principle of substance over form in Chapter 1.)
Subscriptions to publications
Where a series of publications is subscribed to and each publication is of a similar value, e.g. a monthly magazine, revenue is recognised on a straightline basis over the period in which the publications are despatched. Where the value of each publication varies revenue is recognised on the basis of the sales value of the item despatched in relation to the estimated sales value of all items covered by the subscription.
Servicing fees included in the price of the product
When an item's sales price includes 'free' servicing, revenue in relation to that servicing should be deferred and recognised over the servicing period. The amount deferred should be sufficient to cover both the cost of servicing and a reasonable profit.
Tuition fees
Revenue should be recognised over a period of time (the period of instruction), in line with the way the services are provided over that period of time.
Advertising commissions
Media commissions, e.g. payment for a series of adverts, should be recognised when the related advertisement or commercial appears before the public.
Note that the whole of this Appendix falls within the scope of the Financial Accounting syllabus, with the exception of paragraphs 9, 10, 13 and 14.
Interactive question 2: Sale and repurchase
[Difficulty level: Exam standard]
Builder Ltd specialises in building high quality executive flats in city centres. On 1 March 20X6 it sells a plot of building land to Finance Ltd, an unconnected company, for CU1.5m. Builder Ltd retains rights of access and supervision over the plot, the right to build on this land until 28 February 20X8 and the right to buy the plot back again on that date for CU1.9m. On 1 March 20X6 the plot is valued at CU2.5m. Requirement Explain how this sale transaction would be dealt with in Builder Ltd's financial statements for the year ended 28 February 20X7. See Answer at the end of this chapter.
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Interactive question 3: Servicing fees
[Difficulty level: Exam standard]
On the last day of its current accounting period, Computer Ltd completes the handover of a new system to a client and raises an invoice for CU800,000. This price includes after-sales support for the next two years, which is estimated to cost CU35,000 each year. Computer Ltd normally earns a gross profit margin of 17.5% on such support activity. Requirement Calculate the revenue to be included in Computer Ltd’s current year income statement in respect of this sale. Fill in the proforma below. After-sales support Remainder Total selling price So the revenue in the current year is
CU
See Answer at the end of this chapter.
3 BAS 2 Inventories Section overview
Inventories should be measured at the lower of cost and net realisable value (NRV).
Cost comprises the costs of: – – –
The comparison of cost and NRV should be performed on an item-by-item basis although similar items may be grouped together.
Where the cost of individual items cannot be determined a cost formula may be used. These are: – –
3.1
Purchase Conversion Bringing the inventories to their present location and condition.
First-in, first-out (FIFO) Weighted average cost.
When an item is sold it is recognised as an expense in the income statement together with the related revenue.
Objective and scope The objective of BAS 2 Inventories is to prescribe the accounting treatment for inventories. In particular it provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realisable value. BAS 2 applies to all inventories except the following:
Work in progress under construction contracts Financial instruments (e.g. shares, bonds) Biological assets
The treatment of the above are all outside the scope of the Financial Accounting syllabus. Certain inventories are exempt from the standard's measurement rules, i.e. those held by:
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Producers of agricultural, forest and mineral products Commodity-broker traders.
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3.2
7
Inventories Definition Inventories. Assets:
Held for sale in the ordinary course of business
In the process of production for such sale; or
In the form of materials or supplies to be consumed in the production process or in the rendering of services.
Inventories can include:
3.3
Goods purchased and held for resale Finished goods Work in progress being produced Raw materials awaiting use
Measurement of inventories Inventories should be measured at the lower of cost and net realisable value (NRV).
Definitions Cost: Comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Net realisable value: The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
A write-down of inventories would normally take place on an item-by-item basis, but similar or related items may be grouped together. This grouping is acceptable for, say, items in the same product line, but it is not acceptable to write-down inventories based on a whole classification (e.g. finished goods) or a whole business.
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Worked example: Measurement of inventories The following information relates to the inventories of a business with a year end of 31 December 20X5:
Manufacturing cost in 20X5 Revenue on sale in January 20X6 Selling costs incurred in January 20X6 Net realisable value Profit/(loss) Inventory value at 31 December 20X5, the lower of cost and net realisable value
Product A CUm 80
Product B CUm 60
110 (8) 102
50 (4) 46
22
(14)
80
46
Taking the lower of the two values ensures that:
Any profit earned is not recognised in advance of the item being sold
Any loss otherwise incurred in the future is recognised in the current accounting period through this write-down to below cost.
Points to note The comparison of cost and NRV is performed for each product separately.
3.4
Cost of inventories As we have seen from the definition of cost in section 3.3: The cost of inventories will consist of:
Cost of purchase Costs of conversion Other costs incurred in bringing the inventories to their present location and condition
Costs of purchase BAS 2 lists the following as comprising the costs of purchase of inventories.
Purchase price plus
Import duties and other taxes plus
Transport, handling and any other costs directly attributable to the acquisition of finished goods, services and materials less
Trade discounts, rebates and other similar amounts.
Costs of conversion Costs of conversion of inventories consist of two main parts.
Costs directly related to the units of production, e.g. direct materials, direct labour
Fixed and variable production overheads that are incurred in converting materials into finished goods, allocated on the basis of normal production capacity.
You may have come across the terms 'fixed production overheads' or 'variable production overheads' elsewhere in your studies.
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Definitions Fixed production overheads: Those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration. Variable production overheads: Those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and labour.
BAS 2 emphasises that fixed production overheads must be allocated to items of inventory on the basis of the normal capacity of the production facilities. This is an important point.
Normal capacity is the expected achievable production based on the average over several periods/seasons, under normal circumstances.
The above figure should take account of the capacity lost through planned maintenance.
If it approximates to the normal capacity then the actual level of production can be used.
The allocation of variable production overheads to each unit is based on the actual use of production facilities.
As a result:
Low production or idle plant will not result in a higher fixed overhead allocation to each unit.
Unallocated overheads must be recognised as an expense in the period in which they were incurred.
When production is abnormally high, the fixed production overhead allocated to each unit will be reduced, so avoiding inventories being stated at more than cost.
Worked example: Fixed production overheads A business plans for fixed production overheads of CU50,000 and annual production of 100,000 items in its financial year. So the planned overhead recovery rate is 50p per item. A fire at the factory results in production being only 75,000 units, with no saving in fixed production overheads. Inventory should still be valued on the basis of 50p per item, leading to a recovery of CU37,500 of overheads. The CU12,500 balance of overhead cost must be recognised as an expense in the year.
Other costs Any other costs should only be recognised if they are incurred in bringing the inventories to their present location and condition. BAS 2 lists types of cost that would not be included in cost of inventories. Instead, they should be recognised as an expense in the period in which they are incurred. These include:
Abnormal amounts of wasted materials, labour or other production costs
Storage costs (except costs that are necessary in the production process before a further production stage)
Administrative overheads not incurred to bring inventories to their present location and condition
Selling costs.
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Interactive question 4: Cost of inventories
[Difficulty level: Exam standard]
A manufacturing business incurs the following expenditure. Include in cost of inventories
Recognised as an expense as incurred
Supplier's gross price for raw materials Quantity discounts allowed by supplier Purchase taxes and duties charged by supplier and recoverable from taxing authorities Costs of transporting materials to the business' premises Labour costs directly incurred in the processing of raw materials Variable costs, such as power, incurred in the processing of raw materials Fixed production costs/overheads, such as rent for the processing factory and depreciation charges on the plant used in the processing Costs of holding finished goods in inventory Costs of transporting goods to customer on sale Purchase taxes charged to customer on sale Commission payable to salesmen on sale of the goods Allowance for bad and doubtful debts in relation to trade receivables Costs of accounts department Head office costs relating to the overall management of the business Requirement Identify in the table above the expenditures to be included in the cost of inventories and those to be recognised as an expense as incurred. Fill in the proforma above. Commentary on Interactive question 4
In terms of the normal operating cycle of a business, all costs up to the time goods are taken into inventory will be costs incurred in bringing items to their present location and condition. But all costs of holding goods in inventory, selling the goods and collecting outstanding receivables are not incurred for this reason; nor are the general costs of accounting for and managing the business.
Fixed production costs/overheads are to be included in inventory values, but only at the rates based upon normal levels of output. These rates should not be increased as a result of production being below expected levels, as a result of plant failures, for example.
See Answer at the end of this chapter.
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Techniques for the measurement of cost Two techniques are mentioned by the standard, both of which produce results that approximate to cost, and so both of which may be used for convenience. (a)
Standard costs: these are set up to take account of normal levels of raw materials used, labour time etc. They are reviewed and revised on a regular basis.
(b) Retail method: this is often used in the retail industry where there is a large turnover of inventory items, which nevertheless have similar profit margins. The only practical method of inventory valuation may be to take the total selling price of inventories and deduct an overall average profit margin, thus reducing the value to an approximation of cost. The percentage will take account of reduced price lines. Sometimes different percentages are applied on a departmental basis.
Worked example: Retail method A retailer identifies inventories at the end of an accounting period as follows:
Department A: inventories with a selling price of CU30,000. This department makes a 25% gross profit on its sales
Department B: inventories with a selling price of CU21,000. This department sets its selling prices at cost plus 50%.
Requirement Calculate the value of inventories in each department.
Solution Department A: Selling price of inventories CU30,000 less gross profit 25% = CU22,500 Department B: If selling price is cost plus 50%, then selling price must be 150% of cost and the gross profit margin must be 50/150 = 33.3% Selling price of inventories CU21,000 less gross profit 33.3% = CU14,000
3.5
Cost formulae It is possible to attribute specific costs to items that are not interchangeable and to items produced for specific projects or customers and it is these costs which are used in arriving at inventory valuations. But many inventories include items that are interchangeable with each other, in which case it is not possible to identify a specific cost for a specific item. In these cases, cost formulae should be used, which make assumptions about which of the items produced have been sold and which are still held in inventory, and therefore about the cost of inventory. Only two cost formulae are allowed under BAS 2: First-in, first-out (FIFO)
Weighted average cost
This assumes a physical flow of items whereby those produced earliest are the first to be sold. The items produced most recently are the ones in inventory, to be measured at the most recent production cost.
This formula calculates an average cost of production (either at the end of each period or after each new batch has been produced, depending on the circumstances of the company) and measures inventories at that average cost.
Points to note 1
The last-in, first-out (LIFO) formula (which makes an assumption about the physical flows of items that is the opposite of FIFO) is not permitted by BAS 2. The reasoning, not included in the BAS, is that LIFO is not a reliable representation of the actual flow of items into and out of inventory.
2
The same cost formula must be used for all inventories having a similar nature. This limitation on management choice is aimed to ensure that like items are accounted for in like ways.
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Worked example: Cost formulae A business produces and sells the following quantities of a product: Date 1 July 4 July 6 July 15 July 18 July 23 July 31 July
Opening inventory Production Sale Production Sale Production Closing inventory
Tonnes 10 8 -9 6 -11 4 8
CU Total 200 176
CU per tonne 20 22
144
24
104
26
The FIFO cost formula will result in closing inventory being made up of the most recent production, i.e. the 4 tonnes produced on 23 July (costing CU104) and 4 of the 6 tonnes produced in 15 July (at CU24 = CU96 cost). So closing inventory will be valued at CU200. Using the weighted average cost formula and calculating the average cost at the end of the period, the total cost of CU624 (CU200 + CU176 + CU144 + CU104) is divided by the total number of units of 28 (opening inventory of 10 plus production of 8 + 6 + 4), giving a weighted average cost of CU22.29 per tonne. Applied to closing inventory of 8 tonnes, this gives a valuation of CU178.
As average production costs are rising, the weighted average cost formula, which smoothes changes out, results in a slightly lower inventory value (and therefore lower period profit) than the FIFO formula which does not include any smoothing.
3.6
Net realisable value As a general rule assets should not be carried at amounts greater than those to be realised from their sale or use. This applies to inventory where NRV falls below cost. There are a number of reasons why this may be the case, including the following:
An increase in costs or a fall in selling price A physical deterioration in the condition of inventory Obsolescence of products A strategic decision to manufacture and sell products at a loss Errors in production or purchasing
Where NRV falls below cost the inventory is written down to its recoverable amount and the fall in value is charged to profit or loss, i.e. to the income statement. The write-down may be of such size, incidence or nature that it must be disclosed separately. Points to note
3.7
1
In the case of incomplete items, NRV must take account of costs to complete.
2
In the absence of a contractually agreed selling price, the best estimate must be made of the likely selling price and then appropriate deductions made from it.
3
Materials to be incorporated into a finished product should only be written down if that finished product will be sold at below its cost.
4
Net realisable value must be reassessed at the end of each period and compared again with cost. This may result in the reversal of all or part of the original write-down.
Recognition as an expense Once an item has been sold, it cannot remain in inventories as it no longer meets BFRS Framework definition of an asset. Its carrying amount is recognised as an expense in the accounting period in which the item is sold and the related revenue recognised.
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3.8
7
Disclosure The financial statements should disclose the following:
Accounting policies adopted in measuring inventories, including the cost formula used
Total carrying amount of inventories and the carrying amount in classifications appropriate to the entity (e.g. merchandise, production supplies, materials, work in progress, finished goods)
Carrying amount of inventories carried at fair value less costs to sell
The amount of inventories recognised as an expense in the period
The amount of any write-down of inventories recognised as an expense in the period
The amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as an expense in the period
Circumstances or events that led to the reversal of a write-down of inventories
Carrying amount of inventories pledged as security for liabilities
The financial statements must also disclose one of two things:
The cost of inventories recognised as an expense during the period.
The operating costs, applicable to revenues, recognised as an expense during the period, classified by their nature.
The choice reflects differences in the way the income statement can be presented (see Chapter 2).
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Summary and Self-test
Summary
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Self-test Answer the following questions. 1
Caplin sells two types of product to Webber, the sleigh and the sled. Webber sells the sleigh as an agent of Caplin receiving commission of 15% on selling price. Caplin sells the sled as principal at a gross margin of 30%. The following information relates to the year ended 30 September 20X8. Sleigh CU 200,000 60,000
Revenue Gross profit
Sled CU 75,000 22,500
According to BAS 18 Revenue what revenue should Webber recognise in total for sleighs and sleds for the year ended 30 September 20X8? A B C D 2
CU52,500 CU82,500 CU105,000 CU275,000
On 1 January 20X0, Alexander Ltd supplied goods to David Ltd for an agreed sum of CU600,000. This amount becomes payable on 31 December 20X2. David Ltd could have bought the goods for cash of CU450,000 on 1 January 20X0. The imputed rate of interest to discount the receivable to the cash sales price is 10%. In accordance with BAS 18 Revenue what should Alexander Ltd record in the income statement relating to this transaction for the year ended 31 December 20X0? Revenue Interest income CU CU A 450,000 45,000 B 600,000 – C 600,000 60,000 D 450,000 –
3
Oxford Ltd publishes a monthly magazine, which is sold for CU4.00 per issue with costs of CU2.00 per issue to produce. Oxford Ltd received CU48,000 in annual subscriptions and had produced four issues by the year end of 31 January 20X8. In accordance with BAS 18 Revenue what revenue in relation to the magazines should be recognised by Oxford Ltd for the year ended 31 January 20X8? A B C D
4
CU8,000 CU16,000 CU24,000 CU48,000
Southwell Ltd, a manufacturing company, sold a property with a carrying amount of CU4.5m for CU5m to Financier Ltd on 1 January 20X4. Southwell Ltd retains the right to occupy the property and has an option to repurchase the property in two years' time for CU6 million. Property prices are expected to rise and the current market value is CU8 million. The annual rate for 20% over two years is 9.5%. In accordance with BAS 18 Revenue what should be recognised in the financial statements relating to this transaction for the year ended 31 December 20X4? A B C D
Revenue CU5 million, profit on sale of asset CU0.5 million Non-current liability CU5 million, interest expense CU0.475 million Non-current liability of CU6 million Non-current liability CU5.475 million, interest CU0.475 million
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Financial accounting 5
Space Ltd sells a specialised piece of equipment to Planet Ltd on 1 September 20X7 for CU1.5m. Due to the specialised nature of the equipment, Space Ltd has agreed to provide a support service for the next two years. The cost to Space Ltd of providing this service will be CU120,000. Space Ltd usually earns a gross margin of 20% on such contracts. What revenue should be included in the income statement of Space Ltd for the year ended 31 December 20X7 according to BAS 18 Revenue? A B C D
6
CU1,500,000 CU1,525,000 CU1,620,000 CU1,650,000
DIY Ltd is a hardware store about to stock a new type of drill. Customer demand is high and DIY Ltd has started taking advance orders for the drill. The selling price of the drill will be CU50.00 and so far 100 customers have paid an initial advance deposit of CU5.00 per drill. DIY Ltd expects to make a 10% margin on the drill. At the year end, the drill is not yet in stock. What revenue should DIY Ltd recognise in the income statement for this transaction according to BAS 18 Revenue? A B C D
7
CUnil CU50 CU500 CU5,000
Major Ltd has entered into a contract for the provision of services over a two-year period. The total contract price is CU150,000. In the first year costs of CU60,000 have been incurred and 50% of the work has been completed. The contract has not progressed as expected and Major Ltd is not sure of the ultimate outcome, but believes that the costs incurred to date will be recovered from the customer. Major Ltd initially expected to earn a profit of CU20,000 on the contract. According to BAS 18 Revenue what revenue should be recognised in the first year of the contract? A B C D
8
CU40,000 CU60,000 CU65,000 CU75,000
White Goods Ltd sells an electrical appliance for CU2,400 on 1 October 20X7 making a mark up on cost of 20%. The customer is given a one-year interest-free credit period. The fair value of the consideration receivable in one year's time is CU2,202. In accordance with BAS 18 Revenue, what amount should the company recognise as revenue from the sale of the appliance in the income statement for the year ended 31 December 20X7? A B C D
9
CUnil CU2,000 CU2,202 CU2,400
Taunton Ltd manufactures spare parts for a range of agricultural equipment. These are sent from its Chittagong factory to its various distribution centres in Bangladesh and East Asia. According to BAS 2 Inventories, which of the following expenses should be included as part of the cost of finished goods inventories?
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A
Rectification costs of a lorry-load of parts that were badly damaged in an accident en route to one of the distribution centres
B
Expenses paid to the firm's lorry-drivers for transporting parts from the distribution centres to customers
C
Shipping costs for drivers and lorries to East Asia distribution centre
D
Subsistence and accommodation expenses relating to the return journey from East Asia
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7
Quick Ltd absorbs its production overheads on the basis of units produced. Cost data relating to units of production for the year to 31 December 20X3 are as follows. Material (for 10,000 units actually produced) Sub-contract labour Fixed production overheads
CU10,000 CU20,000 CU50,000
There are 1,000 units in inventories at the year end. Production was half the normal activity level. In accordance with BAS 2 Inventories the figure for inventories in the balance sheet on 31 December 20X3 should be: A B C D 11
CU4,000 CU4,500 CU5,500 CU8,000
There are a number of methods for determining purchase price or production cost of inventories. In addition to FIFO, BAS 2 Inventories allows A B C D
12
13
Both LIFO and weighted average cost Only LIFO Only weighted average cost Neither LIFO nor weighted average cost
For a retail trading company using a FIFO basis for the valuation of inventories, which of the following statements is correct according to BAS 2 Inventories? A
If the volume of inventories is unchanged in the year, and purchase prices are rising, there will be a net debit in the income statement in relation to changes in inventories during the year
B
If the volume of inventories increases during the year, and purchase prices are rising, there will be a net debit in the income statement in relation to changes in inventories during the year
C
If the volume of inventories decreases during the year, and purchase prices are falling, there will be a net credit in the income statement in relation to changes in inventories during the year
D
If the volume of inventories is unchanged during the year, and purchase prices are rising, there will be a net credit in the income statement in relation to changes in inventories during the year
In 20X5 when purchase prices are rising but physical inventory levels are remaining constant, Garth Ltd changes its accounting policy for identifying inventories from weighted average cost to FIFO. Will the 20X5 gross trading loss and net current liabilities at the end of the period be higher or lower under the new policy than if the previous policy had been retained? Gross trading loss Lower Lower Higher Higher
A B C D 14
Net current liabilities Lower Higher Lower Higher
The normal selling price of an item included in year end inventories is CU21 per unit. The item originally cost CU15 per unit, but could only be sold at the normal selling price after modifications were made after the year end at a cost of CU5 per unit. The scrap value of the item is CU11 per unit. Under BAS 2 Inventories the item should be included in the financial statements at A B C D
CU16 per unit CU15 per unit CU11 per unit CU10 per unit
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Hunt Ltd has prepared the following schedule of its inventories. Purchase price of raw materials CU 80 20 100
Item X Item Z
Attributable production overheads incurred CU 10 5 15
Attributable distribution overheads to be incurred CU 12 10 22
Expected selling price CU 85 40 125
According to BAS 2 Inventories what is the aggregate amount at which inventories should be stated in the balance sheet of Hunt Ltd? A B C D 16
CU98 CU103 CU120 CU125
Greenmore Ltd is making a product for a customer. The cost to date is CU35,000. Owing to a change in government regulations an additional CU12,000 will need to be spent before the product can be sold. The customer agrees to pay half of this. The initially agreed selling price was CU40,000. At what amount should inventories be carried in the financial statements of Greenmore Ltd according to BAS 2 Inventories? A B C D
17
CU40,000 CU35,000 CU34,000 CU28,000
On 31 December 20X8 Miskin Ltd had closing inventories of widgets that cost CU400,000. These were sold in February 20X9 for CU500,000. The following costs were incurred on disposal. Marketing costs Selling costs Distribution costs
CU50,000 CU50,000 CU50,000
On 31 December 20X8 Miskin Ltd also had closing work in progress of grommets with a standard cost of CU900,000. Relating to this work in progress were favourable variances of CU20,000 and adverse variances of CU10,000, neither relating to efficiency. In accordance with BAS 2 Inventories what is the total amount of inventories in the closing balance sheet? A B C D 18
CU1,240,000 CU1,260,000 CU1,290,000 CU1,310,000
PARSON LTD Parson Ltd has entered into the following transactions during the year ended 31 December 20X3. (1) On 1 October 20X3 Parson Ltd received CU400,000 in advance subscriptions. The subscriptions are for 20 monthly issues of a magazine published by Parson Ltd. Three issues of the magazine had been despatched by the year end. Each magazine is of the same value and costs approximately the same to produce. (2) A batch of unseasoned timber, which had cost CU250,000, was sold to Banko Ltd for CU100,000 on 1 January 20X3. Parson Ltd has an option to repurchase the timber in 10 years' time. The repurchase price will be CU100,000 plus interest charged at 8% per annum from 1 January 20X3 to the date of repurchase. The market value of the timber is expected to increase as it seasons.
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(3) Parson Ltd made a major sale on 1 January 20X3 for a fee of CU450,000, which related to a completed sale and after-sales support for three years. The cost of providing the after-sales support is estimated at CU50,000 per annum, and the mark-up on similar after-sales only contracts is 20% on cost. (4) The food division of Parson Ltd operates its retail outlets on a franchise basis. On 1 January 20X3 a new outlet was opened, the franchisee paying a fee of CU500,000 to cover the initial services. The franchise is for five years, and the franchisee will pay an additional annual fee of CU60,000 commencing on 1 January 20X3 to cover marketing, managerial and other support services provided by Parson Ltd during the franchise period. Parson Ltd has estimated that the cost of providing these services is CU80,000 per annum, and has achieved a gross margin of 20% on providing similar services on other contracts. Requirements (a)
Prepare extracts from Parson Ltd's financial statements for the year ended 31 December 20X3, clearly showing how each of the above would be reflected. Notes to the financial statements are not required. (12 marks)
(b) With reference to transaction (2) above explain the concept of 'substance over form'. (5 marks) (17 marks) 19
LATENTILE LTD Latentile Ltd is a newly-formed company, which uses a chemical process to manufacture a revolutionary new roof covering, which it sells at a mark up of 25% on cost. Its inventories consist of raw material, work in progress and finished goods, and at the end of its first year of trading it is having problems valuing inventories. You ascertain the following information. (1) Raw material (i)
The process needs at least 100,000 kgs of clay to continue working, but a physical inventory count reveals that the machinery contains 108,000 kgs.
(ii)
The original cost of the initial 100,000 kgs to set up the process was 30p per kg and you find an invoice to show that the last consignment of 20,000 kgs cost 31p per kg. All other consignments in the year (a total of 200,000 kgs) cost 32p per kg.
(2) Work in progress (i)
The work in progress is currently all 60% complete and you discover that there are 50,000 units currently going through the process.
(ii)
The total number of complete units for the period was, as anticipated, 800,000.
(iii) The costs for the process for the period were as follows. Raw materials Direct labour Factory overheads Administrative expenses attributable to production Distribution costs
CU'000 200 242 191 114 90
(3) Finished goods (i)
There were 70,000 units in inventories.
(ii)
Of (i) above, it was intended to sell 20,000 units at 75p per unit, a discount of one third on normal selling price, in a future promotional campaign (a further 10p per unit distribution cost is to be incurred).
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Financial accounting Requirements (a)
Explain how BAS 2 Inventories applies the accrual and the going concern bases of accounting. (6 marks)
(b) For each of the above categories of inventory, suggest a method of valuation and show the value as it would appear in the balance sheet. (6 marks) (c)
If the information regarding costs for the period were not available, suggest an alternative method of valuing finished goods. (2 marks) (14 marks)
Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Technical reference Point to note: The following sets out the examinability of the standards covered in this chapter. BAS 18
All paragraphs examinable except examples 9, 10, 13 & 14 in the Appendix.
BAS 2
All paragraphs examinable.
The paragraphs listed below are the key references you should be familiar with. 1 BAS 18 Revenue
Revenue recognised when:
BAS 18 Objective
–
Probable that future economic benefits will flow to the entity; and
–
These benefits can be measured reliably.
Apply principle of substance over form.
Revenue defined as gross inflows that result in increase in equity.
BAS 18 (7)
–
BAS 18 (8)
Sales taxes (e.g. VAT) and amounts collected by agent on behalf of principal are excluded.
Measured as fair value of consideration – discounted where appropriate.
Recognition of sale of goods: when buyer has obtained significant risks/rewards of ownership.
BAS 18 (14)
Recognition of rendering of services: can take account of stage of completion, if over a long period:
BAS 18 (20)
–
Include pro-rata costs and consider costs to complete;
–
If overall outcome cannot be estimated reliably, revenue limited to costs recoverable from customer.
Practical considerations, including 'free' servicing, where revenue deferred to cover both cost and reasonable profit.
BAS 18 (9-11)
BAS 18 (26) BAS 18 Appendix A (all but 9, 10, 13 and 14)
2 BAS 2 Inventories
Measurement and disclosure, but not recognition.
BAS 2 (1)
Inventories are to be measured at the lower of cost and net realisable value.
BAS 2 (9)
Cost = expenditure incurred in bringing the items to their present location and condition, so the cost of purchase and the cost of conversion.
BAS 2 (10)
–
BAS 2 (13)
Fixed costs included by reference to normal levels of activity.
Cost formulae: FIFO or weighted average. –
BAS 2 (25)
Use same formula for all inventories with similar nature.
Net realisable value takes costs to complete into account, as well as selling costs.
Disclosures include accounting policies, carrying amounts and amounts recognised as an expense.
BAS 2 (6) BAS 2 (36 and 38)
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Answers to Self-test 1
C Revenue recognised as agent (CU200,000 15%) Revenue recognised as principal Total revenue
CU 30,000 75,000 105,000
2
A
At the time of supply, revenue is recognised for the cash sale price of CU450,000. Interest will then be accrued until payment is made. For the year ended 31 December 20X0 the interest charge is CU450,000 10% = CU45,000.
3
B
Revenue for the magazines should be recognised over the period in which the magazines are despatched, provided the items are of similar value in each time period. Thus revenue recognised in the year ended 31 January 20X8 is CU48,000 4/12 = CU16,000.
4
D
The substance of this transaction is that of a secured loan as Southwell Ltd retain the risks and rewards of ownership and given that property prices are rising, it is highly likely that the repurchase option will be exercised. Initial loan: Interest: Total loan liability is CU5.475m
5
B
DR Cash CU5m CR Loan CU5m DR Interest (Income statement) (5m x 9.5%) CR Loan
CU0.475m CU0.475m
The sale of equipment of CU1.5m is recognised immediately. The provision of the support service is recognised over the period of service: 2 years. CU120,000/0.80 = CU150,000 total value of service contract. Recognised in current period: CU150,000/2 years 4/12 = CU25,000 Total revenue: CU1.5m + CU0.025m = CU1.525m
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6
A
Revenue is recognised when the drills are delivered to customers on payment of the final instalment. Until then no revenue should be recognised.
7
B
If the outcome cannot be estimated reliably then recognise revenue to the extent that expenses incurred are recoverable.
8
C
The fair value of the income receivable is recognised as income on 1 October 20X7. The difference between this and the sale proceeds (2,400 – 2,202 = 198) is treated as interest and will be recognised over the 12 month interest-free credit period.
9
C
Cost comprises all costs of purchase, conversion and other costs incurred in bringing the inventories to their present location and condition (BAS 2 paragraph 10). Only C meets this definition of costs. Abnormal costs such as A are effectively excluded by BAS 2 paragraph 16(a).
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C
7
CU
CU10,000 = 10,000 CU20,000 = 10,000 CU50,000 = (10,000 50%)
Material Labour Overheads*
1.0 2.0 2.5 CU5.5 1,000
CU5,500
* based on normal production capacity (BAS 2 paragraph 13) 11
C
BAS 2 (paragraph 25) only allows FIFO and weighted average cost.
12
D
13
A
Because prices are rising and physical inventory levels are constant, FIFO will produce a higher inventory figure than weighted average cost. Thus the trading loss and net current liabilities will both be lower than if the previous policy had been retained.
14
B
Inventories should be measured at the lower of cost and NRV. Cost = CU15 NRV = (21 – 5) = CU16
15
A
Inventories should be measured at the lower of cost and NRV. Cost CU 90 25
Item X Item Z 16
C
NRV CU 73 30
Lower CU 73 25 98
Cost = CU 35,000 NRV = 40,000 – 12,000 costs to complete + 6,000 customer contribution = CU 34,000
17
A NRV of widgets (500 – 50 – 50 – 50) Actual cost of grommets (900 – 20 + 10) Total inventories
18
CU'000 350 890 1,240
PARSON LTD (a)
Financial statement extracts Balance sheet as at 31 December 20X3 EQUITY AND LIABILITIES Non-current liabilities Borrowings (100,000 + 8,000) Deferred income (W2) Current liabilities Deferred income (W2) Income statement for the year ended 31 December 20X3 Revenue (W1) Finance cost (8% 100,000)
CU
108,000 280,000 340,000 CU 790,000 8,000
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Financial accounting (b) Transaction (2) and substance over form In a straightforward transaction its commercial effect is the same as its legal form. However, in more complex transactions the true substance of the transaction may be different from its legal form, with one party having the risks and rewards of ownership but another party having legal title to the asset. In such circumstances recording the legal form of the transaction would not be sufficient to provide a fair presentation in the financial statements. The financial statements must be presented fairly in order to meet the qualitative characteristic of reliability. This transaction appears unusual as the initial sale is below fair value, which raises questions about its substance. Parson Ltd has a call option significantly below the current fair value which is expected to increase over time. The terms of the transaction are that it is almost certain that the timber will be reacquired, hence this is essentially a sale and repurchase agreement. Parson Ltd has retained the risks and rewards of ownership, even though legal title has passed. The transaction is effectively a financing agreement secured on the timber, and does not give rise to revenue. The proceeds of CU100,000 are therefore recognised as borrowings in non-current liabilities. In the year to 31 December 20X3 Parson Ltd should recognise a finance cost of CU8,000 (8% of CU100,000) which will increase the borrowings. WORKINGS (1) Revenue
CU 60,000
Transaction (1) (3/20 400,000) Transaction (3) Sale (450,000 – (50,000 120% 3)) After-sales support Year 1 (50,000 120%) Transaction (4) Initial fee (500,000 – (40,000 (W2) 5)) Continuing fee Year 1 (80,000 100/80) (2) Deferred income Transaction (1) (400,000 12/20, 5/20) Transaction (3) (50,000 120% for Years 2 and 3) Transaction (4) (100,000 – 60,000 for Years 2 to 5) 19
270,000 60,000 300,000 100,000 790,000 Current CU 240,000 60,000 40,000 340,000
Non-current CU 100,000 60,000 120,000 280,000
LATENTILE LTD (a)
BAS 2 Accrual basis of accounting The cost of unsold or unconsumed inventories is incurred in the expectation of future economic benefits. When such benefits will not arise until a subsequent accounting period, the related costs should be carried forward and matched with the revenue when it arises. The recognition of yearend inventories achieves this carry forward. Going concern basis of accounting The very act of recognising closing inventories as assets implies that the business intends to continue in operational existence for the foreseeable future. If the business did not intend to continue trading, its inventories would have to be written off as an item of expenditure during the period, unless there was clear evidence that they could be sold as part of the breaking up of the business. In this case, the selling price should be determined and inventories measured at the lower of cost and net realisable value in the usual way.
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(b) Suggested methods of valuing inventories Given the limited information the following methods would be appropriate in the circumstances. Raw material BAS 2 allows either a first in, first out (FIFO) formula or a weighted average cost (WAC) formula. Given the fact that clay is presumably continually added to the machinery, WAC would seem the most appropriate basis. CU 100,000 kgs @ 30p 30,000 200,000 kgs @ 32p 64,000 20,000 kgs @ 31p 6,200 320,000 100,200 = 31.3p per kg Closing raw materials would therefore be measured at CU33,804 (108,000 31.3p). Work in progress This could be measured using a weighted average cost, given that total cost and total output are known. Total output (800,000 + (60% 50,000) Total costs (excluding distribution costs) Thus average cost per unit CU747,000 = 90p 830,000 Carrying amount of WIP (50,000 60% 90p)
830,000 units CU747,000
CU27,000
Finished goods Again, a weighted cost could be used of 90p per unit. This would be applicable to 50,000 units, with the remaining 20,000 units being measured at net realisable value of 65p (75p – 10p). CU 45,000 13,000 58,000
50,000 at 90p 20,000 at 65p Thus inventories would appear as follows. Raw material Work in progress Finished goods (c)
CU 33,804 27,000 58,000 118,804
Alternative valuation method for finished goods If details regarding total costs were not known, adjusted selling price could be used since the cost structure is known. Normal selling price (75p discounted price 3/2) Less Gross profit (112.5 25/125) Cost re 50,000
p 112.5 (22.5) 90.0
Thus finished goods inventories would be measured as before. BAS 2 allows the above practice, used by the retail industry, on the basis that the result can be a very close approximation to cost.
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Financial accounting
Answers to Interactive questions
Answer to Interactive question 1 (a)
Costs to complete are CU90,000 As each of the total revenue, the costs incurred and the costs to complete can be estimated reliably, revenue can be recognised by the percentage of completion method, so 33.3% of CU210,000 = CU70,000. Note. The project is profitable overall (total revenue CU210,000, total costs CU135,000), so no provision for a contract loss need be made.
(b) Costs to complete cannot be estimated reliably As the outcome of the overall contract cannot be estimated reliably, revenue is recognised to the extent of the costs incurred which are recoverable, i.e. CU40,000. The current period therefore recognises the contract loss to date of CU5,000.
Answer to Interactive question 2
In substance, this is a secured loan; no revenue should be recognised in the income statement.
Through the rights of access and supervision, together with the right to build on the land, Builder Ltd has retained the risks and rewards of ownership over the building plot, so should show it as an asset in its balance sheet.
The fact that the consideration for the sale on 1 March 20X6 is so far below the valuation is further evidence that the transaction is in substance a two-year loan, with the CU400,000 difference between the selling and repurchase prices being interest on the loan.
The right to repurchase in the future for much less than the current valuation (making the exercise of the repurchase right almost a certainty) is further evidence that this is not a real sale.
So Builder Ltd will show the building plot in its 28 February 20X7 balance sheet as a current asset (as it will be realised in the normal course of its operating cycle) at its original acquisition cost (not given in the Interactive Question).
In the same balance sheet it will show the CU1.5m received on 1 March 20X6 as a current liability (as it will be settled in the normal course of its operating cycle – the fact that it is repayable more than 12 months of the balance sheet date is not relevant), together with any unpaid part of the CU400,000 interest which is attributable to the first year of the loan.
The appropriate part of the total interest will be charged to the income statement for the year ended 28 February 20X7.
Answer to Interactive question 3 After-sales support (2 (35,000/82.5%)) Remainder Total selling price
CU 84,848 715,152 800,000
So the revenue in the current year is
715,152
This allocation is in line with BAS 18 Appendix paragraph 11.
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Answer to Interactive question 4 Include in cost of inventories Supplier's gross price for raw materials
Yes
Quantity discounts allowed by supplier
Yes
Purchase taxes and duties charged by supplier and recoverable from taxing authorities
n/a, because recoverable
Costs of transporting materials to the business' premises
Yes
Labour costs directly incurred in the processing of raw materials
Yes
Variable costs, such as power, incurred in the processing of raw materials
Yes
Fixed production costs/overheads, such as rent for the processing factory and depreciation charges on the plant used in the processing
Yes, but see commentary in text
Recognised as an expense as incurred
n/a, because recoverable
Costs of holding finished goods in inventory
Yes
Costs of transporting goods to customer on sale
Yes
Purchase taxes charged to customer on sale
Yes
Commission payable to salesmen on sale of the goods
Yes
Allowance for bad and doubtful debts in relation to trade receivables
Yes
Costs of accounts department
Yes
Head office costs relating to the overall management of the business
Yes
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chapter 8
Leases Contents Introduction Examination context Topic List 1
Obtaining non-current assets
2
Types of lease
3
Accounting for finance leases
4
Allocating and calculating finance charges
5
Disclosure
6
Finance leases: other issues
7
Operating leases
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Understand the purpose and principles underlying BAS 17 Leases
Classify leases as finance or operating and explain the classification
Apply accounting requirements for:
–
Finance leases, including initial recognition, allocation of finance charges and presentation and disclosure
–
Operating leases, including disclosures
Tick off
Prepare simple extracts from the financial statements in accordance with Companies Act and BFRS.
Specific syllabus references for this chapter are: 2c.
Practical significance Many companies spend large amounts of money on buildings, fittings and equipment, in order to carry on their business. However, it is possible to obtain the use of such assets in a number of different ways. The asset might be purchased outright for cash or by obtaining long or short-term finance. Alternatively, the asset might simply be rented. The commercial nature and accounting treatment of these transactions differ. In a leasing arrangement, a company acquires the use of an asset but also obtains financial support in the form of finance from the company which owns the asset. Historically, the accounting treatment of leases has been controversial. In the past some lease agreements were introduced by financing organisations that were made to look like rental agreements but where in fact the substance of the transaction was that a non-current asset was purchased on credit. These companies effectively 'owned' an asset and 'owed' a debt for its purchase, but showed neither the asset nor the liability on the balance sheet because they were not required to do so. Leasing transactions are extremely common so this is an important practical subject. Lease accounting is now regulated by BAS 17, which was introduced because of abuses in the use of lease accounting by companies described above. The debate on the accounting for leases, however, is ongoing and fundamental changes are expected in the future.
Stop and think Why do you think a company's management might wish to use leasing arrangements to give the appearance of renting rather than owning an asset?
Working context You may well come across leasing (and hire purchase) in the context of audit engagements. The technical detail of auditing leases is covered in the Audit and Assurance paper. However, typical procedures might involve verifying the agreements, reviewing the substance of the transactions and ensuring that these are correctly stated in the financial statements.
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Syllabus links In the Accounting paper, you covered the purchase of non-current assets and the relevant balance sheet entries. You will have also dealt with renting such assets and the relevant entries to the income statement. As you will see, many of these accounting entries will be relevant as you go on to consider finance leases and operating leases in this paper. In Financial Accounting you are only expected to be familiar with the accounting treatment of leases from the lessee's point of view (i.e. the user of the asset). Lessor accounting and sale and leaseback arrangements are covered in the Financial & Corporate Reporting syllabus. Lease accounting also raises the issue of substance over form which you will encounter in various contexts in this paper and in Financial & Corporate Reporting at the Advanced Stage.
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Examination context
Exam requirements Leasing could be examined as part of a mixed question, requiring you to calculate the value of finance leases in the balance sheet and the appropriate finance costs in the income statement. However, it could also be examined in its own right, perhaps including a discussion of the principle of substance over form. (The sample paper included this style of question on leasing.) This topic may also be examined by short-form question. In the examination, candidates may be required to:
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Explain and apply the principle of substance over form. Prepare and present financial statements or extracts therefrom in accordance with BAS 17 Leases.
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1 Obtaining non-current assets Section overview
1.1
Certain types of contracts where a company leases an asset from another company are very similar in substance to the outright purchase of that asset.
If these leases are accounted for in accordance with their strict legal form, a company’s assets and liabilities are likely to be understated.
Failing to record the true substance of the transaction is an example of 'off-balance sheet' financing.
BAS 17 Leases states that the substance of the transaction takes precedence over the legal form even if the legal title never passes from lessor to lessee.
Using assets There are many different ways of gaining use of an asset: for example, you can buy a car or hire it. In both cases, you are able to drive the car, but your rights over the car differ in each case. As far as this chapter is concerned in effect you have two choices. Buy the asset
Simply, you pay to own the asset, in order to access the benefits it can give you.
You are legally the owner of the asset (i.e. you have legal title.)
You can do what you like with it, and you get all the risks and rewards of owning the asset.
In the financial statements, the asset will be treated as a non-current asset. For relevant accounting issues, see Chapter 5. Of course, the company might pay for the asset a couple of months later, on standard credit terms. This is then a simple credit purchase. Hire or lease the asset
If you hire or lease an asset, you are paying someone else for the use of that asset. It is the owner’s property, but you are getting the benefits from using it. (In a hire purchase agreement, ownership only transfers to you once you have paid for it, and this is typically over a long period.) The accounting treatment depends on the circumstances: (a)
Say a company hires a car for one of its staff for a couple of days; the car is not an asset of the company, it is just being hired for a couple of days, and the owner retains the benefit of owning the car (e.g. to hire it out to other people) over the rest of the asset's useful life.
(b) However, a company might lease the car for a guaranteed period of three years or so, and has sole use of it, be responsible for maintaining it and so on. The company may also be obliged to enter a long-term agreement to pay the supplier. The company might end up owning the car at the end of the period. The example in (b) above shows that, for practical purposes, the company has acquired the use of a noncurrent asset, and all the risks and rewards of owning it. The car is being used as if it is a non-current asset, even though, legally speaking, it belongs to a third party. In many ways this is similar to purchasing the asset outright.
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1.2
Leasing agreements As we have said, one way by which businesses can obtain the use of an asset is by a leasing agreement.
Definition Lease: An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
In a leasing transaction, there is a contract between the lessor and the lessee for the hire of an asset.
The lessor is owner and supplier of the asset. The lessee is the user of the asset.
The lessor retains legal ownership but transfers to the lessee the right to use the asset for an agreed period of time in return for specified payments.
1.3
Substance over form It is a principle of accounting that the commercial substance of a transaction should be reflected in financial statements rather than the legal form. This is a consequence of BFRS Framework requirement to represent transactions faithfully. There are many types of leasing arrangements. By entering into certain sorts of lease, a company is, in effect, gaining the use of a non-current asset whilst incurring a long-term liability. Where the commercial substance of the transaction is the purchase of a non-current asset, this should be reflected in the accounting treatment despite the legal form of the rental agreement. BAS 17 gives guidance as to the accounting treatment depending on the terms of the leasing transaction, which are discussed in section 2.
2 Types of lease Section overview
278
BAS 17 recognises two types of lease: –
Finance leases, in which the risks and rewards of ownership are transferred from the lessor to the lessee, and
–
Operating leases: all other leases.
Inception is when the provisions are agreed: commencement is when the lessee can use the leased asset (and when the values agreed at inception are recognised in the financial statements).
For leases of land and buildings, land is normally treated as an operating lease, buildings as a finance lease.
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2.1
8
Classification of a lease As mentioned above, there are two types of leases.
Definition Finance lease: A lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. Operating lease: A lease other than a finance lease.
From these definitions you can see that the classification of a lease is based on the extent to which the risks and rewards of ownership lie with the legal owner, the lessor, or are transferred to the user, the lessee. If a lease transfers substantially all the risks and rewards normally associated with the ownership of an asset it should be classified as a finance lease. All other leases should be classified as operating leases. BAS 17 provides the following examples of the key risks and rewards incidental to ownership of an asset. Risk
Possibility of losses arising from:
Rewards
Potential gains arising from:
2.2
Idle capacity Technological obsolescence Falls in value due to changing economic conditions
Profitable use of the asset over its economic life Future sale of the asset where it has increased in value
Identifying finance leases BAS 17 also provides examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease. These include the following circumstances where:
The terms of the lease are such that ownership of the asset transfers to the lessee by the end of the lease term e.g. a hire purchase agreement
The lessee has the option to purchase the asset at such a price that it is reasonably certain from the outset that the option will be exercised
The lease term is for the major part of the economic life of the asset even if legal title is never transferred (see section 2.5 below).
At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset (see sections 2.3 and 2.4 below)
The leased assets are of such a specialised nature that only the lessee can use them without major modifications
Other indicators listed by BAS 17 that could also lead to the lease being classified as a finance lease are:
Whether cancellation losses are borne by the lessee
Whether fluctuations in fair value at the end of the lease accrue to the lessee
Whether the lessee has the option to extend the lease for a secondary period at a 'peppercorn rent'. (i.e. below market rent)
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2.3
Present value of the minimum lease payments A persuasive factor in classifying a lease as a finance lease is if at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
Definition Minimum lease payments: Payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with any amounts guaranteed by the lessee or by a party related to the lessee.
The minimum lease payments are what the lessee (or a party related to the lessee) has to make over the life of the lease. However, as these payments are some time in the future, a discount factor is applied to reach a 'present value' of these amounts, in other words a cash equivalent. This is then compared to the asset's fair value.
Definition Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
Worked example: Fair value Alpha Ltd agrees to pay Beta Ltd a sum of CU1,000 each year for four years, a total of CU4,000. Assuming prevailing interest rates at the time of the agreement were 5%, the present value would be CU3,546. If the present value at the date of the agreement is more than or 'substantially all' of the fair value then this would indicate a finance lease. Effectively, Alpha Ltd is buying an asset from Beta Ltd, who is providing loan finance.
Point to note In the examination you will not be expected to calculate the present value of the minimum lease payments. Where relevant the information in the question will include the discounted figure.
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Interactive question 1: What type of lease?
8
[Difficulty level: Easy]
Classify the following situations as finance or operating leases. You will have to do some thinking here. Question (a)
Fill in your answer
A company leases machine tools. Legal title is transferred after three years.
(b) A company leases a photocopier. The present value of minimum lease payments is CU2,000 but the fair value of the asset is CU10,000. (c)
A company leases a car for a sales representative for a five-year period, after which the car will have come to the end of its useful economic life.
(d) A company acquires some equipment made bespoke to its specifications. To sell the equipment to a third party would require substantial modification. See Answer at the end of this chapter.
2.4
When does a lease actually begin? A lease should be classified as operating or finance at inception. There is a difference between commencement and inception. Inception. This is when the terms of the lease, including the financial settlement, are agreed (which may be the contract signing date or, if earlier, the date when the main terms were agreed). For example, a company might agree to lease equipment, with agreed payments every year. However, it may be some time before the company uses the equipment – especially if it is new. At inception: – the lease is classified as a finance or operating lease – the values, in the case of a finance lease, are determined. Commencement. This is the date when the lessee can use the leased asset. For example, a company leasing a building may move in several months after the lease contract was agreed. The commencement date is also the date when the values determined at inception are recognised in the financial statements. In many cases, the dates are not far apart. Remember, however, that the value of the leased asset and consequent liability shown in the financial statements are normally those at the inception of the lease.
2.5
The lease term Once classified, the classification should remain throughout the lease term. In a leasing transaction, the lease term is the length of the agreement between lessor and lessee.
Definition Lease term: The non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.
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Financial accounting With a finance lease the lease term might be divided into two periods. Primary period
During the primary period the lease will either be non-cancellable or will be cancellable only under certain conditions, for example on the payment of a heavy settlement figure. The rentals payable during the primary period will be sufficient to repay to the lessor the cost of the equipment plus interest thereon.
Secondary period
The secondary period is usually cancellable at any time at the lessee's option. The rentals during the secondary period will be of a nominal amount. (sometimes referred to as a 'peppercorn rent') If the lessee wishes to terminate the lease during the secondary period, the equipment will be sold and substantially all of the sale proceeds will be paid to the lessee as a rebate of rentals.
2.6
Land and buildings Leases of land and buildings are classified as operating or finance leases in the same way as the leases of other assets. However due to the differing characteristics of land and buildings BAS 17 requires that the land and buildings elements of a single lease are considered separately for classification purposes. Land
A characteristic of land is that it normally has an indefinite economic life. As a result, a lease of land is normally treated as an operating lease (unless ownership of the land passes to the lessee during the lease term) as the lessee does not receive substantially all of the risks and rewards of ownership. Where land has a limited life e.g. where it is used as a landfill site it may be classified as a finance lease (depending on the assessment of any other relevant factors).
Buildings
As buildings normally have a finite economic life a lease of a building may be treated as a finance lease depending on the full terms of the lease (see sections 2.1 and 2.2 above).
Problem
Solution
How do you work out how much of the minimum lease payments to allocate to buildings and how much to land?
Work out the relative fair values of the leasehold interests at the inception of the lease, and split the payment according to these proportions.
What happens if you cannot allocate the minimum lease payments between land and buildings?
Treat everything as a finance lease (unless clear that both elements are operating leases.)
What happens if the land is immaterial?
Treat everything as buildings.
(See Worked example: Lease of land and buildings in section 8.)
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3 Accounting for finance leases Section overview
3.1
In the balance sheet, assets held under finance leases are treated as non-current assets and payables or finance lease liabilities.
The asset is depreciated and otherwise treated as any other non-current asset.
Lease payments reduce the liability and cover any accrued interest.
The lessee has to allocate the finance charge between accounting periods.
The finance charge is charged to the income statement.
Setting up balance sheet accounts BAS 17 requires that, when an asset changes hands under a finance lease, the accounting treatment should reflect the substance of the transaction. In the lessee's books therefore: DEBIT CREDIT
Asset account Payables: Finance lease liabilities
The amount to be recorded in this way is the lower of the fair value and the present value of the minimum lease payments at the inception of the lease
The initial deposit, if any, counts as one of the lease payments and hence is included in the cost of the asset. Points to note
3.2
1
The entries are made at the commencement of the lease term, with the values determined at inception (see section 2.4 above).
2
The present value of the minimum lease payments is derived by discounting them at the interest rate implicit in the lease. If it is not practicable to determine the interest rate implied in the lease, then the lessee's incremental borrowing rate can be used.
3
Initial direct costs can be treated as part of the cost of the asset – provided they are directly attributable to activities performed by the lessee to obtain the finance lease.
4
Although interest is payable under the lease, this is accrued over time. The justification is that the capital could, in theory, be paid off at any time, with cancellation charges. These charges could be avoided, so they are not a 'true' long term liability. Interest is therefore recognised as it accrues.
Depreciating the asset DEBIT CREDIT
Depreciation expense Accumulated depreciation
The asset should be depreciated over the shorter of the lease term or the asset's useful life
Points to note 1
Depreciation policies adopted should be consistent with other non-current assets.
2
As with other non-current assets, impairment reviews must be conducted in accordance with BAS 36 Impairment of Assets.
3
If there is reasonable certainty that the lessee will eventually own the asset, then it should be depreciated over its estimated useful life.
4
The lease term comprises the period for which the lessee has contracted to lease the asset and any further terms for which there is reasonable certainty at the inception of the lease that the lessee will exercise the option. (See section 2.5)
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3.3
Making the payment Every period, the payments are accounted for as follows. DEBIT Payables: Finance lease liabilities CREDIT Cash
3.4
Each lease payment is comprised partly of a repayment of capital and partly of an interest charge for the period. (See section 3.4 below)
Finance charge The finance charge is dealt with as follows. DEBIT
Income statement: Finance cost
CREDIT Payables: Finance lease liabilities
With the amount of the interest accrued over the period
4 Allocating and calculating finance charges Section overview
The two main methods of calculating the finance charge and allocating it to accounting periods are: – –
4.1
The actuarial method The sum of digits method.
How much interest is payable in total? This is relatively easy to calculate. Total lease payments Less initial cost of asset (as calculated in section 3.1) Total finance charge (= interest)
CU X (X) (X)
The finance charge is allocated to the income statement over the period for which the finance is provided, from the commencement of the lease term until the last payment is made. (If payments are made in advance, the last payment might be made before the end of the lease term.)
4.2
Allocating the interest charge to accounting periods BAS 17 requires the total finance charge to be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the outstanding lease obligation. As the lessee pays off the capital sum, the total capital owed falls from period to period. You would therefore also expect a reduction in the total interest payable, too, on the outstanding balance. For example, if you owe CU10,000 and pay 15%, the interest will be CU1,500. After you have paid off, say, CU8,000 of the capital, interest would be CU300 (on CU2,000). The monthly payments remain the same, but the mix of interest and capital changes over the life of the loan. There are three possible methods of allocating the interest. Actuarial method
Interest is charged at a constant percentage on the outstanding liability, thus matching interest to the 'loan' balance. This method is specified by BAS 17, as it is the most accurate. However, to apply it, the rate of interest implicit in the lease is required.
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'Sum of digits' method
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This method is a 'reasonable' approximation to the actuarial method where the implicit rate of interest is not known. The sum of digits method splits the total interest (without reference to a rate of interest) in such a way that the greater proportion falls in the earlier years. The procedure is as follows. (a)
Assign a digit to each instalment. The digit 1 should be assigned to the final instalment, 2 to the penultimate instalment and so on.
(b)
Add the digits. A quick method of adding the digits is to use the formula n(n 1) where n is the number of periods of borrowing. If there are twelve 2 instalments paid in arrears, then the sum of the digits will be 78. For this reason, the sum of the digits method is sometimes called the rule of 78.
(c)
Calculate the interest charge included in each instalment. Do this by multiplying the total interest accruing over the lease term by the fraction: Digit applicable to the instalment Sum of the digits
Straight line method
A constant amount of interest is charged each period, hence interest does not match the amount outstanding of the loan. Therefore this method is not normally allowed, except where the amounts involved are immaterial.
Worked example: Rentals in arrears A Ltd has a year end of 31 December. A finance lease commences on 1 January 20X1. Lease payments comprise three payments of CU10,000 annually, commencing on 31 December 20X1. The asset would have cost CU24,869 to buy outright. The implicit interest rate is 10%. You are required to calculate the interest charge and the year-end liability for each year of the lease under: (a) Straight line method (b) Actuarial method (c) Sum of digits method.
Solution Total finance charges to be allocated:
CU 30,000 (24,869) 5,131
Total lease payments Less initial cost of asset Total finance charge (interest) (a)
Straight line method Allocation of interest to periods: 20X1-20X3 =
5,131 = 1,710 3 CR Balance b/f
20X1 20X2 20X3
1 Jan CU 24,869 16,579 8,289
LEASE LIABILITY CR DR Interest Payment accrued 31 Dec 31 Dec CU CU 1,710 (10,000) 1,710 (10,000) 1,711 (10,000) 5,131 30,000
CR Capital balance c/f 31 Dec CU 16,579 8,289 –
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Financial accounting (b) Actuarial method CR Balance b/f 1 Jan CU 24,869 17,356 9,092
20X1 20X2 20X3 (c)
LEASE LIABILITY CR DR Interest Payment accrued 31 Dec @10% 31 Dec CU CU 2,487 (10,000) 1,736 (10,000) 908 (10,000) 5,131 30,000
CR Balance c/f 31 Dec CU 17,356 9,092 –
Sum of digits method Each period of borrowing is allocated a digit as follows: Period of borrowing Digit 1st (20X1) 3 2nd (20X2) 2 3rd (20X3) 1 6 Or using the formula
3 4 = 2
6
Point to note In this example, as the instalments are paid in arrears the number of periods of borrowing (n in the formula) are equal to the number of instalments. The CU5,131 interest charges can then be apportioned 1st period of borrowing 2nd period of borrowing 3rd period of borrowing
20X1 20X2 20X3
CU 2,566 1,710 855 5,131
CU5,131 3/6 CU5,131 2/6 CU5,131 1/6 LEASE LIABILITY CR CR Balance b/f Interest 1 Jan accrued 31 Dec CU CU 24,869 2,566 17,435 1,710 9,145 855 5,131
DR Payment 31 Dec CU (10,000) (10,000) (10,000) 30,000
CR Capital balance c/f 31 Dec CU 17,435 9,145 -
Point to note The year-end liability for 20X1 is CU17,435. This balance is all capital. Any interest which has accrued during the year has been settled by the first instalment because the instalment was paid on the last day of the year.
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4.3
8
Instalments in advance As we have seen in the examples above, interest accrues over time and is included in the payment at the end of each period of borrowing. However, where instalments are paid in advance:
The first instalment repays capital only as no time has yet elapsed for interest to accrue.
At the end of each accounting period the year-end liability will include capital and interest that has accrued to date but which has not been paid.
Worked example: Rentals in advance A Ltd has a year end of 31 December. A finance lease commences 1 January 20X1. Lease payments comprise four payments of CU10,000 annually, commencing on 1 January 20X1. The asset would have cost CU34,869 to buy outright. The interest rate implicit in the lease is 10%. Requirements Calculate the lease interest charge for each year of the lease under (a) (b)
Actuarial method Sum of digits method.
Using the actuarial method also calculate the year end liability for each year of the lease.
Solution CU 40,000 34,869 5,131
Total payments (4 10,000) Less cost of asset Total interest Point to note
The last payment is made on 1.1.X4. This is three years after the start of the lease. Therefore the ‘loan’ is in existence for three years and interest is charged over this period, i.e. in the income statement for 20X1, 20X2 and 20X3. (a)
Actuarial method
20X1 20X2 20X3 20X4
CR Balance b/f 1 Jan
DR Payment 1 Jan
CU 34,869 27,356 19,092 10,000
CU (10,000) (10,000) (10,000) (10,000) 40,000
LEASE LIABILITY CR Capital balance remaining 1 Jan CU 24,869 17,356 9,092 –
CR Interest accrued @10% 31 Dec CU 2,487 1,736 908 – 5,131
CR Balance c/f 31 Dec CU 27,356 19,092 10,000 –
Points to note 1
As the first instalment is paid on 1 January 20X1 it is purely a repayment of capital as no time has passed for interest to accrue.
2
The year-end liability is made up of the capital outstanding plus any interest accrued to date.
3
The payment of CU10,000 on 1 January 20X2 will pay the interest accrued in 20X1 (CU2,487) with the balance repaying capital.
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Financial accounting (b) Sum of digits Total interest = CU5,131 Each period of borrowing is allocated a digit as follows: Period of borrowing 1st (20X1 – settled by instalment 2) 2nd (20X2 – settled by instalment 3) 3rd (20X3 – settled by instalment 4)
Or using the formula,
Digit 3 2 1 6
3 4 = 2
6
Point to note In this case as the instalments are paid in advance the periods of borrowing (n in the formula) are the number of instalments minus one. The CU5,131 interest charges can then be apportioned. 1st period of borrowing 2nd period of borrowing 3rd period of borrowing
CU5,131 3/6 CU5,131 2/6 CU5,131 1/6
CU 2,566 1,710 855 5,131
The year-end liability would then be calculated using the same method as has been used for the actuarial method above. So for example at the end of 20X1 the liability would be CU27,435 calculated as follows: LEASE LIABILITY
20X1
CR Balance b/f 1 Jan CU 34,869
DR Payment 1 Jan CU (10,000)
CR Capital balance remaining 1 Jan CU 24,869
CR Interest accrued at 31 Dec CU 2,566
CR Balance c/f 31 Dec CU 27,435
5 Disclosure Section overview
The key balance sheet disclosures are: – –
5.1
The split and analysis of the finance lease liability. The carrying amount of non-current assets held under finance leases.
Balance sheet liability The balance sheet liability needs to be split between:
The current liability The non-current liability
Point to note The non-current liability will comprise only capital outstanding. No interest will be included as any interest due at the end of the next year will not yet have accrued.
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The steps to split the liability are therefore:
Step 1 Identify the capital balance remaining in one year's time. (This can be found in the lease calculation table.)
Step 2 Deduct the capital balance remaining in one year's time from the total liability at the balance sheet date. This will give the amount due within one year as a balancing figure.
Interactive question 2: Rentals in arrears
[Difficulty level: Exam standard]
Using the facts from the Worked example: Rentals in arrears, part (b), show the split of the lease liability at the end of 20X1. Fill in the gaps in the extract below. The lease liability extract from the Worked example: Rentals in arrears, part (b) is as follows: CR Balance b/f 1 Jan CU 24,869 17,356
20X1 (current period) 20X2 (future periods)
Lease liability CR DR Interest Payment accrued 31 Dec @10% 31 Dec CU CU 2,487 (10,000) 1,736 (10,000)
CR Capital balance c/f 31 Dec CU 17,356 9,092
Solution Total lease liability at 31 December 20X1 = CU
Capital > 1 year
< 1 year ()
= CU
= CU
See Answer at the end of this chapter.
Interactive question 3: Rentals in advance
[Difficulty level: Exam standard]
Requirement Using the facts from the Worked example: Rentals in advance, part (a), show the split of the lease liability at the end of 20X1. Fill in the gaps in the extract below. The lease liability extract from the Worked example: Rentals in advance, part (a) is as follows:
20X1 (current period) 20X2 (future periods)
CR Balance b/f 1 Jan
DR Payment 1 Jan
CU 34,869 27,356
CU (10,000) (10,000)
Lease liability CR Capital balance remaining 1 Jan CU 24,869 17,356
CR Interest accrued @10% 31 Dec CU 2,487 1,736
CR Balance c/f 31 Dec CU 27,356 19,092
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Financial accounting
Solution Total lease liability at 31 December 20X1 = CU
Capital > 1 year
< 1 year ()
= CU
= CU
See Answer at the end of this chapter.
5.2
Other disclosures Point to note The leased assets and lease liabilities may not be netted off against each other. Non-current assets
Disclosure must be made of the carrying amount of assets held under finance leases as follows: 'Of the total carrying amount of CUX, CUY relates to assets held under finance leases.'
All other BAS 16 Property, Plant and Equipment disclosures are required, together with BAS 36 impairment tests (both dealt with in Chapter 5).
Liabilities
Finance lease liabilities must be split between their current and non-current components (as we saw in section 5.1).
BAS 17 also requires disclosure of future lease payments, split between amounts due: – – –
Within one year Within two to five years After more than five years
This disclosure must be given both:
On a gross basis, i.e. showing gross future lease payments for each of the three categories, then deducting as a single figure the future periods’ finance charges to arrive at the net figure included in liabilities.
On a net basis, i.e. excluding from each of the three categories the finance charges allocated to future periods (and hence not yet accrued).
Interactive question 4: Disclosure
[Difficulty level: Exam standard]
The facts are as detailed in Interactive question 3. Requirement Show the disclosure of the analysis of finance lease liabilities at the end of 20X1 required by BAS 17.
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Complete the proforma below. (a)
Gross basis CU Finance lease liabilities include: Gross lease payments due within: One year Two to five years Less finance charges allocated to future periods
(b) Net basis CU Finance lease liabilities include: Amounts due within: One year Two to five years
See Answer at the end of this chapter.
Other disclosures
In the case of most entities, the BAS 1 Presentation of Financial Statements requirement to disclose significant accounting policies would result in the disclosure of the policy in respect of finance leases.
BAS 17 requires a general description of material leasing arrangements to be included.
6 Finance leases: other issues Section overview
Other issues include: – – –
6.1
Secondary periods and peppercorn rentals Non-annual payments Initial deposit.
Secondary periods and peppercorn rentals A finance lease may contain an option for the lessee to extend the lease for a secondary period at a nominal (‘peppercorn’) rental. This rental will be immaterial and can be ignored in the calculations. However, the optional extension period counts as part of the lease term if the lessee is reasonably certain at the outset to exercise the option to extend the lease. This therefore impacts on the depreciation calculations, because the secondary period is counted when identifying the asset's useful life. (See section 3.2)
6.2
Non-annual payments Many leases in practice have monthly, quarterly or six-monthly payments. The lease calculations must be performed for each credit period (interval between payments).
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6.3
Initial deposit A lease may include an initial deposit payment prior to the commencement of the regular lease payments. This initial payment counts as part of the minimum lease payments and therefore as part of the cost of the asset. In the lease calculations, deduct the initial deposit from the initial liability. The recording at the commencement of the lease term will therefore be in two steps:
Step 1 Record liability and non-current asset CU DR Non-current assets – cost CR Payables: Finance lease liabilities
CU
X X
Step 2 Reduce initial liability by amount of deposit paid CU DR Payables: Finance lease liabilities CR Cash
Interactive question 5: Summary
CU
X X [Difficulty level: Exam standard]
A company leases an asset on 1 January 20X1. The terms of the lease are to pay a non-refundable deposit of CU575 followed by seven annual instalments of CU2,000 payable in arrears. The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January 20X1 is CU10,000. Requirements Calculate the interest charge in the income statement and the finance lease liability in the balance sheet for the year ended 31 December 20X1 using the: (a) Actuarial method, where the interest rate implicit in the lease is 11%. (b) Sum of digits method. Fill in the proforma below. (a)
Actuarial method CU Income Statement (extract) Finance costs (Working) Balance Sheet (extract) Non-current liabilities Finance lease liability (Working) Current liabilities Finance lease liability (Working)
WORKINGS
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(b) Sum of digits method CU Income Statement (extract) Finance costs (W) Balance Sheet (extract) Non-current liabilities Finance lease liability (W) Current liabilities Finance lease liability (W)
WORKINGS
See Answer at the end of this chapter.
7 Operating leases Section overview
7.1
Operating lease rentals are charged to the income statement on a straight-line basis over the lease term.
Accounting for operating leases As we saw in section 2 an operating lease is a lease other than a finance lease. Operating leases do not really pose an accounting problem as the substance and the legal situation are the same, i.e. the lessee does not own the leased asset either legally or in substance. The lessee is simply renting the asset and the rental expense is charged to the income statement.
7.2
Balance sheet display and income statement charge BAS 17 requires the lease payments under an operating lease to be charged on a straight-line basis over the lease term, even if the payments are not made on such a basis, unless another systematic and rational basis is more representative of the time pattern of the user’s benefit. Hence, if lease payments are not made evenly, an accrual or prepayment will be recorded in the balance sheet.
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Financial accounting
Worked example: Operating leases Under an operating lease agreement, Williamson Ltd pays a non-returnable deposit of CU100,000 and then three years’ rental of CU100,000 per annum on the first day of each year. You are required to calculate the charge to the income statement for each year, and any balance in the balance sheet at the end of the first year.
Solution Income statement charge
=
100,000 300,000 3 years
= CU133,333 Balance sheet at end of year 1: Paid in year Charged in income statement Prepayment
CU 200,000 (133,333) 66,667
Point to note A premium paid for the lease of land and buildings would be treated in the same way as this non-returnable deposit.
7.3
Disclosures BAS 17 and other BASs require disclosure of:
The accounting policy for operating leases.
Operating lease payments charged as an expense for the period.
In respect only of non-cancellable operating leases, a commitments note showing the total lease payments that the lessee is committed to paying in the coming years, analysed by amounts due: – Within one year – Within two to five years – After more than five years
Note that this disclosure is both the same as and different from that for finance leases in section 5.2 above: – The disclosures are the same in terms of the time periods over which the payments must be analysed. – They are different in that for finance leases the analysis is of amounts appearing in the balance sheet within liabilities, whereas for operating leases the analysis is just of commitments. Note also that for operating leases there can be no separate disclosure of any equivalent of the finance charges for finance leases.
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A general description of significant leasing arrangements.
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Interactive question 6: Operating leases
8
[Difficulty level: Exam standard]
Stone Ltd has the following outstanding non-cancellable operating lease commitments at its balance sheet date:
Rental on buildings of CU100,000 per annum for 15 years Rental on plant of CU30,000 per annum for three years Rental on cars of CU40,000 for 11½ months.
Requirement Complete the operating lease commitment note to be included in Stone Ltd’s accounts. Fill in the proforma below. The minimum lease payments under non-cancellable operating leases are: CU Within one year Within two to five years After five years See Answer at the end of this chapter.
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Summary and Self-test
Summary
BAS 17 Leases standardises the accounting treatment and disclosure of assets held under lease. It follows the substance over form principle. BAS 17 recognises two types of lease.
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Self-test Answer the following questions. 1
Henry acquired a lorry on a finance lease. The details were as follows. Date of acquisition Cash price Deposit Quarterly lease payments
1 January 20X8 CU20,000 CU5,000 12 @ CU1,800
The charge for interest is to be spread over the three year period on the sum of digits basis. The payments are made on the last day of each quarter. In accordance with BAS 17 Leases how much interest would be allocated to the fifth quarterly payment? A B C D 2
CU700 CU677 CU550 CU423
Sam acquired a motor car on a finance lease. The details were as follows. Date of acquisition Cash price Deposit Monthly lease payments
1 July 20X6 CU5,000 CU1,000 24 @ CU200
The charge for interest, which is not material, is to be spread evenly over the 24 month period. The payments are made on the last day of each month. What is the total liability outstanding as on 1 January 20X7 in accordance with BAS 17 Leases? A B C D 3
CU4,000 CU3,600 CU3,000 CU2,800
On 1 January 20X7 Melon Ltd bought a machine on a finance lease. The terms of the contract were as follows. CU Cash price 18,000 Deposit (6,000) 12,000 Interest (9% for two years) 2,160 Balance – two annual payments commencing 31 December 20X7 14,160 The rate of interest implicit in the contract is approximately 12%. Applying the provisions of BAS 17 Leases the finance charge in the income statement for the year ended 31 December 20X7 is A B C D
4
CU1,080 CU1,440 CU1,620 CU2,160
BAS 17 Leases requires a lessee to capitalise a finance lease at the amount of the A B C D
Fair value Present value of the minimum lease payments Higher of fair value or present value of minimum lease payments Lower of fair value or present value of minimum lease payments
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Financial accounting 5
Alpha Ltd enters into a lease with Omega Ltd for an aircraft, which had a fair value of CU240,000 at the inception of the lease. The terms of the lease require Alpha Ltd to make ten annual lease payments of CU36,000 in arrears. Alpha Ltd is totally responsible for the maintenance of the aircraft, which has a useful life of approximately eleven years. The present value of the ten annual lease payments of CU36,000 discounted at the interest rate implicit in the lease is CU220,000. Applying the provisions of BAS 17 Leases to this lease, the property, plant and equipment of Alpha Ltd will increase by A B C D
6
CUnil CU220,000 CU240,000 CU360,000
Cambridge Ltd leases an asset on a five-year lease. The fair value of the asset is CU500,000, while the present value of the minimum lease payments derived by discounting at the rate of interest implicit in the lease is CU480,000. The asset has a five-year life, with Cambridge Ltd responsible for maintenance and insurance. The asset will be scrapped at the end of five years. Cambridge Ltd uses the sum of digits method of depreciation. In accordance with BAS 17 Leases what is the carrying amount of the asset in the accounts of Cambridge Ltd at the end of the second year? A B C D
7
CUnil CU192,000 CU200,000 CU288,000
On 1 January 20X3 Tile Ltd took out a finance lease to purchase production equipment with a cash price of CU750,000. The terms of the lease required five lease payments of CU200,000 to be paid annually in advance. These lease payments have been charged to the income statement as administrative expenses. The equipment is expected to have a five-year life with no residual value. The error in the treatment of the finance lease was discovered when preparing the financial statements for the year ended 31 December 20X5. Tile Ltd allocates interest on finance leases using the sum of digits method. All depreciation is on a straight-line basis. Applying the provisions of BAS 17 Leases to this lease what amount will be shown as an adjustment to retained earnings brought forward? A B C D
8
CU70,000 debit CU75,000 debit CU105,000 debit CU225,000 debit
Pont Ltd enters into a four-year operating lease on 1 January 20X6. Although the annual lease payments were originally agreed at CU50,000 a year, Pont Ltd managed to negotiate a lease 'holiday' and will pay nothing in 20X6. In accordance with BAS 17 Leases what should appear in the financial statements of Pont Ltd as at 31 December 20X7 in respect of the following? Rental Accrual charge to in the the income balance statement sheet A CUnil CUnil B CU50,000 CUnil C CU37,500 CU37,500 D CU37,500 CU25,000
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© The Institute of Chartered Accountants in England and Wales, March 2009
LEASES
9
8
SNOW LTD On 1 January 20X1 Snow Ltd entered into the following finance lease agreements. (1) Snow machine To lease a snow machine for five years from Slush Ltd. The snow machine cost Slush Ltd CU150,000 and is estimated to have a useful life of five years. Snow Ltd has agreed to make five annual payments of CU35,000, payable in advance, commencing on 1 January 20X1. The interest rate implicit in the lease is 8.36%. (2) Snowplough To lease a snowplough for three years from Ice Ltd. The machine had cost Ice Ltd CU35,000. A deposit of CU2,000 was payable on 1 January 20X1 followed by six half yearly payments of CU6,500, payable in arrears, commencing on 30 June 20X1. Finance charges are to be allocated on a sum of digits basis. Requirements (a)
Calculate the amounts to be included in the financial statements of Snow Ltd for the year ended 31 December 20X1 and draft the reconciliation note for property, plant and equipment, and the analysis of finance lease liabilities note required by BAS 17 Leases. (15 marks)
(b) Snow Ltd is also considering leasing new office buildings, built from low cost modular units, under a twenty year lease, paying CU21,000 annually on 1 January. The buildings have a useful life of twenty five years and Snow Ltd would be responsible for their upkeep and insurance. The fair values of the leasehold interest at the start of the lease are CU300,000 for the land and CU100,000 for the office units. Explain and illustrate how the above would be treated in accordance with BFRS. Any interest should be allocated using a sum of digits basis. (6 marks) (21 marks) 10
FEENEY LTD Feeney Ltd is considering replacing a piece of machinery that is coming towards the end of its life. Its value is negligible. The finance director has asked you for your advice as to the financial accounting and disclosure implications of each of the options. The new machine has a purchase price of CU80,000 and an estimated life of five years and will be acquired on the first day of next year. The options are given below. (1) Lease the machine for a two year period for a lease payment of CU2,000 per month in arrears. A non-refundable deposit of CU6,000 has to be paid on order. The lessor remains liable for maintenance. (2) Lease the machine for a five year period for a lease payment of CU9,900 half yearly in advance. Requirements Prepare a memorandum to the finance director, which: (a)
Explains the concept of 'substance over form' as set out in BFRS Framework and applied in BAS 17 Leases. (3 marks)
(b) Sets out the extent to which BAS 17 Leases provides information that is relevant, reliable, comparable and understandable. (4 marks) (c)
Briefly explains how each of the options should be accounted for and shows the figures to be included in the income statement and balance sheet for the first year. Allocate interest on an actuarial basis using an interest rate of 5% per half year. (11 marks) (18 marks)
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Financial accounting 11
RICHARDS LTD (Sample Paper) You are the financial controller for Richards Ltd a company listed on the London Stock Exchange. The Chairman has asked you to explain a number of matters relating to the substance of transactions and the reporting of lease transactions in financial statements. He has approached you as you have recently attended a number of training courses on BFRS and are in the process of preparing the draft financial statements for the year ended 31 May 20X6 in accordance with BFRS. Richards Ltd recently entered into a lease contract for a new piece of machinery. The new machine could have been purchased for a cash price of CU150,000. The terms of the lease are:
the lease is for four years
an initial deposit of CU30,000 was payable on 1 June 2005 followed by eight half-yearly payments thereafter of CU20,000 payable on the 1 December and 1 June each year, commencing on 1 December 20X5.
The estimated useful life of the equipment is four years. Richards Ltd uses the sum of the digits method to allocate finance charges on finance leases. Richards Ltd’s factory premise is held on a 25 year lease. The period of the lease is expected to be similar to the life of the factory building and at the end of the 25 years the land reverts back to the lessor. Requirements (a)
Prepare notes for a meeting with the Chairman, which: (i)
Explain the concept of 'substance over form', and
(ii)
Discuss the application of 'substance over form' and asset recognition to:
The accounting by a lessee for a finance lease; and The accounting by a lessee for an operating lease.
(7 marks)
(b) Prepare financial statement extracts and supporting disclosure notes that show how the machinery lease transaction should be presented in the financial statements of Richards Ltd for the year ended 31 May 20X6. (8 marks) (15 marks) Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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8
Technical reference Point to note: The following aspects of BAS 17 are not examinable: lessor accounting, sale and leaseback transactions, paragraphs 36-66 and the implementation guidance. The paragraphs listed below are the key references you should be familiar with. 1 Lease classification
If substantially all of the risks and rewards of ownership are transferred to the lessee, then a lease is a finance lease. Factors: –
Ownership passing at end of term
–
Bargain purchase option
–
Lease term the major part of asset's life
–
Very substantial charges for early cancellation
–
Peppercorn rent in secondary period
–
PV of minimum lease payments substantially all of asset’s fair value.
BAS 17(4) BAS 17(10-11)
BAS 17(10(d))
Otherwise, an operating lease.
Classify at inception.
BAS 17(13)
Land and buildings elements within a single lease are classified separately.
BAS 17(15)
Can be a lease even if lessor obliged to provide substantial services.
BAS 17(4)
BAS 17(3)
2 Finance lease
Non-current asset and liability for the asset's fair value (or PV of minimum lease payments, if lower):
BAS 17(20)
–
Measured at inception of lease
BAS 17(4)
–
Recognised at commencement of lease term.
BAS 17(4)
Depreciate asset over its useful life, or the lease term if shorter and no reasonable certainty that lessee will obtain ownership at end of lease.
BAS 17(27)
Consider whether BAS 36 impairment procedures needed.
BAS 17(30)
Debit lease payments to liability, without separating into capital and interest.
Charge lease interest to income statement and credit lease liability.
Charge interest so as to produce constant periodic rate of charge on reducing liability – approximations allowed.
Disclosures:
BAS 17(25)
–
Show carrying value of each class of leased assets
BAS 17(31)
–
In the balance sheet split the liability between current and non-current
BAS 17(23)
–
In a note, show analysis of total liability over amounts payable in 1, 2 to 5 and over 5 years, both gross and net of finance charges allocated to future periods
BAS 17(31(d))
–
General description of material leasing arrangements
BAS 17(31(e))
–
Other BAS 16 disclosures re leased PPE assets.
BAS 17(32)
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Financial accounting 3 Operating lease
302
Charge lease payments to income statement on straight-line basis, unless some other systematic basis is more representative of user’s benefit.
Disclosures:
BAS 17(33)
–
Lease payments charged as expense in the period
–
In a 'commitment' note, show analysis of amounts payable in 1, 2 to 5 and over 5 years, even though not recognised in balance sheet
BAS 17 (35(a))
–
General description of significant leasing arrangements
BAS 17(25(d))
© The Institute of Chartered Accountants in England and Wales, March 2009
BAS 17(35(c))
LEASES
8
Answers to Self-test 1
B
Sum of the digits for payments in arrears =
12 (12 1) 2
= 78 Total lease payments (12 CU1,800) Deposit Less capital (cash price)
CU 21,600 5,000 (20,000) 6,600
Fifth payment – Interest = 8/78 CU6,600 = CU677 2
C Total lease payments (24 CU200) Deposit Less capital (cash price) Total interest
CU 4,800 1,000 (5,000) 800
Interest per payment = 800/24 = CU33.3 Cash price Deposit Interest – 6 CU33.3 Payments – 6 CU200 Liability at 1 January 20X7
CU 5,000 1,000 4,000 200 (1,200) 3,000
3
B
Interest charge for 20X7 = 12% 12,000 = CU1,440
4
D
BAS 17 paragraph 20.
5
B
The information suggests that a transference of risks and rewards has taken place. Therefore the lease is a finance lease and should be capitalised at present value of minimum lease payments (as this is lower than fair value), i.e. CU220,000.
6
B
The terms of the agreement indicate that this is a finance lease. Initially recorded at present value of minimum lease payments 54 Years 1 and 2 depreciation 15 * 5 (5 1) * SOTD = = 15 2
CU 480,000 (288,000) 192,000
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Financial accounting 7
B CU000 1,000 (750) 250
Lease payments (5 200) Cash price Finance charge Sum of the digits over four periods = 10 Cumulative adjustment to profit at 1 January 20X5 CU'000
Lease payments charged to date (2 200) Depreciation to date (2 750/5) Finance charges to date 20X3 (250 4/10) 20X4 (250 3/10)
8
(300) (100) (75) (475) (75)
D Year 20X6 20X7 20X8 20X9
9
CU'000 400
Cash CU – 50,000 50,000 50,000 150,000
Expense CU 37,500 37,500 37,500 37,500 150,000
Accrual CU 37,500 25,000 12,500 –
SNOW LTD (a)
(i)
Amounts to be included in the financial statements of Snow Ltd for the year ended 31 December 20X1 Income statement Depreciation of leased assets Finance lease interest (1,714 + 1,429 + 9,614)(W1 & W2) Balance sheet Non-current assets Property, plant and equipment Current liabilities Finance lease liabilities (W3) Non-current liabilities Finance lease liabilities (W3)
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© The Institute of Chartered Accountants in England and Wales, March 2009
CU 41,667 12,757
143,333 46,000 101,757
LEASES
(ii)
8
Notes Property, plant and equipment Cost At 1 January 20X1 Additions (35,000 + 150,000) At 31 December 20X1 Accumulated depreciation At 1 January 20X1 35,000 150,000 Charge for year 5 3 At 31 December 20X1 Carrying amount At 31 December 20X1 At 1 January 20X1
Plant and machinery CU – 185,000 185,000
– 41,667 41,667 143,333 –
Analysis of finance lease liabilities Gross basis Finance lease liabilities include Gross lease payments due within: One year (CU35,000 + CU13,000) Two to five years (3 CU35,000) + CU13,000 Less finance charges allocated to future periods () Net basis Finance leases liabilities include Amounts due within: One year (W3) Two to five years (W3)
CU
48,000 118,000 166,000 (18,243) 147,757 46,000 101,757 147,757
(b) Lease of land and buildings – BFRS BAS 17 requires that the two elements of the lease (land and buildings) are classified separately. Because land has an infinite life that part of the lease will be classified as an operating lease. The buildings look to be a finance lease since Snow Ltd is responsible for upkeep and insurance and leases for twenty out of a twenty-five year useful life. No split is given for the lease payments of CU21,000 pa but BAS 17 provides that in this case the lease payments should be allocated according to fair values of the leasehold interests at the start of the lease. Therefore the CU21,000 will be split one quarter to the buildings (CU5,250) and three quarters to the land (CU15,750). Under BAS 17, at the end of Year 1 the financial statements will reflect the following in respect of this lease. Income statement Depreciation (100,000 ÷ 20) Operating lease rental Interest charge (W4)
CU 5,000 15,750 500
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Financial accounting Balance sheet CU
Non-current assets Property, plant and equipment (100,000 – 5,000) Non-current liabilities Finance lease liabilities (W4) Current liabilities Finance lease liabilities (W4)
95,000 90,000 5,250
WORKINGS (1) Snow machine Period ended
B/f CU 150,000 124,614
31 December 20X1 31 December 20X2
Payment
Capital
CU (35,000) (35,000)
CU 115,000 89,614
Interest @ 8.36% CU 9,614 7,492
C/f CU 124,614 97,106
Total liability CU124,614
Capital > 1 yr CU89,614
< 1 yr CU35,000 ()
(2) Snowplough (a)
Calculation of finance charge CU 2,000 39,000 (35,000) 6,000
Deposit Lease payments (6 6,500) Fair value of asset Finance charge
(b) Interest allocation SOD = =
n (n 1) 2 6 7 2
= 21 Period ended 30 June 20X1 31 December 20X1 30 June 20X2 31 December 20X2
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© The Institute of Chartered Accountants in England and Wales, March 2009
6/21 x 6,000 = 5/21 x 6,000 = 4/21 x 6,000 = 3/21 x 6,000 =
CU 1,714 1,429 1,143 857
LEASES
(c)
8
Liability table Period ended
B/f
Interest (W2b) CU 1,714 1,429 1,143 857
CU 33,000 28,214 23,143 17,786
30 June 20X1 31 December 20X1 30 June 20X2 31 December 20X2
Payment
Capital
CU (6,500) (6,500) (6,500) (6,500)
CU 28,214 23,143 17,786 12,143
Snowplough (W2) CU 11,000 12,143 23,143
Total CU 46,000 101,757 147,757
Interest CU 19/190 5,000 = 500 18/190 5,000 = 474
C/f CU 95,250 90,474
Total liability CU23,143
Capital > 1 yr CU12,143
< 1 yr CU11,000 ()
(3) Finance lease liabilities Snow machine (W1) CU 35,000 89,614 124,614
< 1 year > 1 year
(4) Lease of buildings Year
B/f CU 100,000 95,250
1 2
Payment CU (5,250) (5,250)
Capital CU 94,750 90,000
Total liability CU95,250
Capital > 1 yr CU90,000
< 1 yr CU5,250()
Total interest = (20 5,250) – 100,000 = CU5,000 SOD
=
n (n 1) 2
=
19 20 2
= 190
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Financial accounting 10
FEENEY LTD MEMORANDUM To From Date Subject
a)
Finance Director, Feeney Ltd Financial Accountant 30 March 20X4 Accounting and disclosure implications of replacement of machinery
'Substance over form' Leasing is an example of the application of the concept of 'substance over form' – a concept that BFRS Framework requires should be applied to all accounting areas. To account for substance, a company must record transactions so as to reflect their economic reality rather than merely their legal form. BAS 17 does this by requiring an analysis of who carries the risks and rewards of ownership; if the company's obligation as lessee to make payments under the lease has a similar commercial effect to borrowing the money and buying the asset outright, both BAS 17 and BFRS Framework require the accounts to reflect the asset and 'the related loan'.
(b) Information provided The key words 'relevant', 'reliable', 'comparable' and 'understandable' are concerned with the quality of financial information as discussed in BFRS Framework. They can be applied to BAS 17 as follows.
Relevant. Information is relevant if it can influence the economic decisions of users. By showing the true substance of finance leases, companies are forced to bring debt onto the balance sheet and this could influence other potential lenders. Also, the commitments note for operating leases and the liabilities note for finance leases have predictive value by warning lenders of existing contractual obligations and how long they are likely to last.
Reliable. To be reliable, information must faithfully represent a transaction, i.e. all the rights and liabilities arising from a transaction must be identified and assessed. BAS 17 clearly does this via its overriding requirement to account for substance.
Comparable. Comparability implies consistency between different companies and from year to year. BAS 17 gives detailed guidance on how to identify a finance lease. However, there will always be a certain element of subjectivity in assessing 'risks and rewards'. A key benefit of BAS 17 is that the financial statements of a company acquiring the use of an asset through a finance lease will be comparable, in terms of tangible assets, borrowings, gearing, return on capital employed, etc, with those of a company taking out a loan to acquire legal title to an asset. In addition, disclosure of the detailed accounting policy (including how interest is allocated) will assist in comparability.
308
Understandable. Although some users might assume that the assets in the balance sheet are owned by the company, the accounting policy note should explain the inclusion of leased assets. Also, preparers of accounts are entitled to assume that users have a reasonable level of knowledge.
© The Institute of Chartered Accountants in England and Wales, March 2009
LEASES
(c)
8
Accounting for each option Option (1)
Because the lease is only for two years and the asset has a life of five years, Feeney Ltd is not obtaining substantially all the rewards of ownership.
Because the lessor is liable for maintenance, Feeney Ltd is not bearing substantially all the risks of ownership.
This lease is therefore an operating lease and thus the asset is not capitalised nor the liability recognised in the balance sheet.
Income statement CU 27,000
Operating lease rental (W1) Balance sheet
CU 3,000
Trade and other receivables (W2)
Option (2)
As the machine will be leased for the whole of its life, it is an asset acquired under a finance lease.
BAS 17 requires the non-current asset to be capitalised (and depreciated over the shorter of the lease term and its useful life), a liability to be created, and certain detailed disclosures to be made.
Income statement CU 16,000 6,690
Depreciation (W3) Interest charge ((3,505 + 3,185) W4) Balance sheet Total property, plant and equipment held under finance leases Cost Depreciation (W3) Carrying amount
CU 80,000 (16,000) 64,000
Non-current liabilities Finance lease liabilities (W4)
49,940
Current liabilities Finance lease liabilities (W4)
16,950
WORKINGS (1) Rental
Total payable 6,000 (24 2,000) = CU27,000 per annum Life of lease 2 years (2) Operating lease prepayment DR Income statement DR Trade and other receivables CR Cash (6,000 + (12 2,000))
CU 27,000 3,000
CU 30,000
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Financial accounting (3) Depreciation
CU80,000 = CU16,000 5 years
(4) Lease creditor Year
Period
B/f
1 2 1 2
CU 80,000 73,605 66,890 59,840
1 2
Payment
Capital
CU (9,900) (9,900) (9,900) (9,900)
CU 70,100 63,705 56,990 49,940
Interest @ 5% CU 3,505 3,185 2,850 2,497
C/f CU 73,605 66,890 59,840 52,437
Total liability CU66,890
Capital > 1 yr CU49,940
11
< 1 yr CU16,950 ()
RICHARDS LTD (a)
(i)
In a straightforward transaction its commercial effect is the same as its legal form. However, in more complex transactions the true substance of the transaction may be different from its legal form, with one party having the risks and rewards of ownership but another party having legal title to the asset. In such circumstances recording the legal form of the transaction would not be sufficient to provide a fair presentation in the financial statements. The financial statements must be presented fairly in order to meet the qualitative characteristic of reliability. Where a transaction gives rise to an asset that asset should be recognised even if legally the entity does not own it. For example, where an entity has the sole use of an asset for the majority of its economic life the asset should be recognised in the entity’s financial statements even if legally it is owned by a third party.
(ii)
Finance lease Under a finance lease, the lessor retains the legal title to the asset. However, the lessee has use of the asset during substantially the whole of the asset’s useful life. During this period the lessee is controlling the asset and has the benefit of the economic benefits being generated from the asset’s use. In addition, the present value of the minimum lease payments amount to at least the fair value of the leased asset, thereby suggesting that the lessee is actually paying the current market price for the asset under a financing arrangement. The cost of the asset is therefore known. The legal title of the asset may or may not pass to the lessee at the end of the lease term. In essence the lessee has all the risks and rewards of ownership and therefore should recognise the leased asset on its balance sheet along with a liability even though it may not have legal title to the asset. Operating lease Under an operating lease, the lessee will have use of the asset for only part of its useful life and does not therefore have access to the economic benefits generated by the asset over its useful life.
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8
Under an operating lease the lease payments will be substantially less than the fair value of the asset and at the end of the lease term the asset may be used by the owner or leased to another third party. The lessee does not have the substantial risks and rewards of ownership and therefore the lessee does not recognise the asset or liability in its financial statements. The lessee will instead recognise the lease rentals on a straight-line basis over the period of the lease in its income statement. (b) Property, plant and equipment CU 150,000 (37,500) 112,500
Cost Accumulated depreciation (150,000 / 4 years) Net book value Current liabilities Finance lease liability (W3)
33,333
Non-current liabilities Finance lease liability (W3)
83,334
Gross basis Finance leases liabilities include: Gross lease payments due within: One year Two to five years
CU
Less finance charges allocated to future periods ()
40,000 100,000 140,000 (23,333) 116,667 (W3)
Net basis Finance leases liabilities include: Amounts due within: One year (W3) Two to five years (balancing figure)
CU 33,333 83,334 116,667 (W3)
WORKING (1) Finance charge CU 30,000 160,000 190,000 150,000 40,000
Deposit 8 bi-annual payments (20,000 x 8) Fair value Finance cost Sum of digits is 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 36
n(n 1) 2
(2) Allocation of interest Period 1 2 3 4
8/36 40,000 7/36 40,000 6/36 40,000 5/36 40,000
= = = =
Interest CU 8,889 7,778 6,667 5,556
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Financial accounting
(3) Liability table Period commencing 1 June 20X5 1 Dec 20X5 1 June 20X6 1 Dec 20X6
B/f CU 150,000 128,889 116,667 103,334
Payment CU (30,000) (20,000) (20,000) (20,000)
Capital CU 120,000 108,889 96,667 83,334
Total lease liability at 31 May 20X6 = CU116,667
Capital > 1 yr = CU83,334
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© The Institute of Chartered Accountants in England and Wales, March 2009
< 1 yr () = CU33,333
Interest (W2) CU 8,889 7,778 6,667 5,556
C/f CU 128,889 116,667 103,334 88,890
LEASES
8
Answers to Interactive questions
Answer to Interactive question 1 (a)
A company leases machine tools. Legal title is transferred after three years.
Finance lease, because title is transferred and the company enjoys the risks and rewards of ownership before-hand.
(b)
A company leases a photocopier. The PV of minimum lease payments is CU2,000 but the fair value of the asset is CU10,000.
Operating lease, as the fair value of the asset is a lot more than the minimum lease payments.
(c)
A company leases a car for a sales representative for a five-year period, after which the car will have come to the end of its useful economic life.
Finance lease
(d)
A company acquires some equipment made bespoke to its specifications. To sell the equipment to a third party would require substantial modification.
Finance lease
Answer to Interactive question 2 CR Balance b/f 1 Jan CU 24,869 17,356
20X1 (current period) 20X2 (future periods)
Lease liability CR DR Interest Payment accrued 31 Dec @10% 31 Dec CU CU 2,487 (10,000) 1,736 (10,000)
CR Capital balance c/f 31 Dec CU 17,356 9,092
Total lease liability at 31 December 20X1 = CU17,356
Capital > 1 year
< 1 year ()
= CU9,092
= CU8,264
Answer to Interactive question 3
20X1 (current period) 20X2 (future periods)
CR Balance b/f 1 Jan
DR Payment 1 Jan
CU 34,869 27,356
CU (10,000) (10,000)
Lease liability CR Capital balance remaining 1 Jan CU 24,869 17,356
CR Interest accrued @10% 31 Dec CU 2,487 1,736
CR Balance c/f 31 Dec CU 27,356 19,092
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Financial accounting Total lease liability at 31 December 20X1 = CU27,356
Capital > 1 year
< 1 year ()
= CU17,356
= CU10,000
Answer to Interactive question 4 (a)
Gross basis CU
Finance lease liabilities include: Gross lease payments due within: One year Two to five years
10,000 20,000 30,000 2,644 27,356
Less finance charges allocated to future periods (b) Net basis
CU
Finance lease liabilities include: Amounts due within: One year Two to five years
10,000 17,356 27,356
Answer to Interactive question 5 (a)
Actuarial method Income statement (extract) CU 1,037
Finance costs (Working) Balance sheet (extract)
CU Non-current liabilities Finance lease liability (Working)
7,393
Current liabilities Finance lease liability (Working)
1,069
WORKING
20X1 20X2
314
CR Bal b/f 1 Jan CU (10,000 – 575) = 9,425 8,462
CR Interest accrued at 11% CU 1,037 931
© The Institute of Chartered Accountants in England and Wales, March 2009
DR Payment 31 Dec CU (2,000) (2,000)
CR Bal c/f 31 Dec CU 8,462 7,393
LEASES
8
Total lease liability at 31 December 20X1 = CU8,462
Capital > 1 year
< 1 year
= CU7,393
= CU1,069 (balancing figure)
(b) Sum of digits method Income statement (extract) CU 1,144
Finance costs (W3) Balance sheet (extract)
CU
Non-current liabilities Finance lease liability (W3)
7,549
Current liabilities Finance lease liability (W3)
1,020
WORKINGS (1) Finance charge CU 14,575 (10,000) 4,575
Total payments (7 2,000) + 575 PVMLP
(2) Digit
n(n 1) 2
n = number of interest bearing instalments
7x8 = 28 2 (3) Finance lease liability
20X1 20X2
CR Bal b/f 1 Jan CU (10,000 - 575) = 9,425 8,569
CR Interest CU (7/28 x 4,575) = 1,144 (6/28 x 4,575) = 980
DR Payment 31 Dec CU (2,000) (2,000)
CR Bal c/f 31 Dec CU 8,569 7,549
Total lease liability at 31 December 20X1 = CU8,569
Capital > 1 year
< 1 year
= CU7,549
= CU1,020 (balancing figure)
Answer to Interactive question 6 The minimum lease payments under non-cancellable operating leases are: Within one year (CU100,000 + CU30,000 + CU40,000) Within two to five years ((CU100,000 x 4) + CU30,000 x 2) After more than five years (CU100,000 x 10)
CU 170,000 460,000 1,000,000 1,630,000
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© The Institute of Chartered Accountants in England and Wales, March 2009
chapter 9
Provisions, contingencies and events after the balance sheet date Contents Introduction Examination context Topic List 1
Provisions and contingencies
2
Provisions: definition and recognition
3
Measurement and subsequent treatment
4
Specific applications
5
Disclosures relating to provisions
6
Contingent liabilities
7
Contingent assets
8
BAS 10 Events After the Balance Sheet Date
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Explain the definitions and recognition criteria of BAS 37 Provisions, Contingent Liabilities and Contingent Assets within the context of BFRS Framework
Apply the accounting and disclosure requirements of BAS 37 including:
–
Recognition, measurement and disclosure of provisions; and
–
Disclosure of contingent liabilities and contingent assets
Tick off
Apply the accounting and disclosure requirements of BAS 10 Events After the Balance Sheet Date including the distinction between: –
Events after the balance sheet date that require adjustment; and
–
Those that require disclosure only
Specific syllabus references for this chapter are: 1d, 2b,c.
Practical significance In the past the manipulation of provisions has been seen as a means of managing earnings. This practice could be undertaken for a number of different reasons including the smoothing of earnings, meeting lenders’ expectations and enhancing business valuations. For example, in periods where performance has exceeded expectations an entity might be tempted to make a ‘rainy day’ provision. The provision set up in prosperous times would be released to increase profits in periods when results were not quite up to expectations. So called ‘Big bath’ provisions were common in the 1980s and 1990s. This involved making excessive provisions for future costs, particularly those involving a fundamental restructuring. When the costs were actually incurred the costs were charged against the provisions. Any excess provision could then be credited back to earnings uplifting future results. This practice often accompanied a change in senior management allowing the past management to be blamed for the need to restructure and the new management to be given credit for the apparently improved performance. BAS 37 Provisions, Contingent Liabilities and Contingent Assets provides guidance in this area and has restricted the use of provisions for creative accounting purposes. Guidance is provided on the type of provisions that can be made and the general principles surrounding recognition. Information which is relevant to the assessment of a business’s performance may occur after the balance sheet date. In most cases events which occur after this cut-off point would not be reflected in the financial statements. However, there are circumstances where the financial statements are adjusted to reflect events which took place after the balance sheet date. BAS 10 Events After the Balance Sheet Date provides guidance on this area.
Stop and think Can you think of any other ways in which accounting information can be manipulated?
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Working context Although we have said that the advent of BAS 37 has restricted the use of creative accounting in this area the recognition of provisions and contingencies still involves a significant amount of judgement, in particular over what might happen in the future. It is likely that the audit of these will be carried out by more senior members of the audit team. Review of subsequent events is also a key audit procedure as information obtained after the balance sheet date often provides valuable evidence regarding the circumstances at the year end. For example, information regarding the insolvency of a debtor which only came to light after the year end provides evidence regarding the recoverability of the receivables balance at the year end.
Syllabus links This topic is examinable at level A in the Financial Accounting syllabus so you will be expected to have a thorough knowledge and sound understanding of the subject matter. This level of knowledge will also be relevant to the Financial & Corporate Reporting paper at Advanced Stage.
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Examination context
Exam requirements Provisions, contingencies and events after the balance sheet date may be examined in the written test section of the paper or via short-form questions. Both types of questions are likely to be scenario based. Provisions and contingencies may also be examined in the context of BFRS Framework definitions and principles. In the examination, candidates may be required to:
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Explain BFRS Framework definitions and recognition principles and explain how they relate to BAS 37
Prepare extracts from the financial statements and notes to the financial statements in respect of provisions and contingencies
Prepare financial statements or extracts taking into account the effect of events after the balance sheet date
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1 Provisions and contingencies Section overview
1.1
BAS 37 Provisions, Contingent Liabilities and Contingent Assets provides guidance on when provisions and contingencies should be recognised and if so, at what amount.
Issues As we have seen in many of the previous chapters, amounts in the financial statements often result from the exercise of judgement, for example the carrying amount of property, plant and equipment. Accounting for provisions and contingencies, however, is particularly problematic due to the increased level of uncertainty. The key issues include:
Whether a provision or contingency should be recognised If it is recognised at what amount it should be recorded
The situation is further complicated by the fact that these decisions may be affected by events occurring after the balance sheet date.
1.2
BAS 37 Provisions, contingent liabilities and contingent assets Objective BAS 37 aims to ensure that:
Appropriate recognition criteria and measurement bases are applied to provisions, contingent assets and contingent liabilities; and
Sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.
Scope Although BAS 37 has wide scope, there are two limited exceptions: Executory contracts, except where the contract is onerous
Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. For example, an unfulfilled order for the purchase of goods, where at the balance sheet date, the goods have neither been delivered nor paid for. Onerous contracts are dealt with in more detail in section 4.2 of this chapter.
Where the accounting treatment is covered by another accounting standard
For example, BFRS 3 Business Combinations deals with the recognition of an acquiree’s contingent liabilities at the time of a business combination (see Chapter 15).
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2 Provisions: definition and recognition Section overview
A provision is recognised when all of the following conditions are met: – – –
2.1
A present obligation exists as a result of a past event An outflow of resources is probable The amount can be estimated reliably
Definition The key aim of BAS 37 is to ensure that provisions are only recognised when there are valid grounds for doing so.
Definitions A provision: is a liability of uncertain timing or amount. A liability: is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Points to note
2.2
1
BAS 37 views provisions as a sub-class of liabilities.
2
Provisions can be distinguished from other liabilities such as trade payables and accruals, because of the degree of uncertainty as to their timing or amount.
3
The definition of a liability used in BAS 37 is the same as the definition contained in BFRS Framework (see Chapter 1).
Recognition BAS 37 states that a provision should be recognised when:
An entity has a present obligation (legal or constructive) as a result of a past event
It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
A reliable estimate can be made of the amount of the obligation.
Points to note
2.3
1
If one or more of these criteria is not met, a provision is not recognised (although as we will see later in this chapter a contingent liability may exist).
2
The recognition criteria of BAS 37 are very similar to the criteria for the recognition of a liability contained in BFRS Framework (see Chapter 1). These also refer to the probable outflow of economic benefit and the need for reliable measurement.
A present obligation as a result of a past event To establish whether an entity has a present obligation which arose from a past event, identification of an 'obligating event' is required. An obligating event occurs where the entity has no realistic alternative to settling the obligation created by the event. BAS 37 recognises that this can occur:
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Where the settlement can be enforced by law; or
In the case of a constructive obligation, where the event creates valid expectations in other parties that the entity will discharge the obligation (see section 2.4 below).
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Points to note 1
The event must be past, i.e. it must have occurred at the balance sheet date. No provision is made for costs that may be incurred in the future but where no obligation yet exists.
2
Only obligations arising from past events existing independently of an entity’s future actions (i.e. the future conduct of its business) are recognised as provisions. If management can avoid incurring expenditure by changing the entity’s future operations, no provision arises.
3
An obligation always involves another party to whom the obligation is owed. However, the exact identity of that other party need not be known, e.g. the obligation may be to the public at large.
4
A board or management decision does not give rise to an obligation unless it has been communicated before the balance sheet date to those affected by it so as to raise a valid expectation that the entity will discharge its responsibilities. In the absence of such communication, the board could change its mind and hence would be under no obligation.
5
Sometimes, the existence of an obligation will be uncertain, e.g. where there is a legal dispute. In these cases, BAS 37 applies prudence by deeming a past event to give rise to a present obligation if it is more likely than not that an obligation exists at the balance sheet date. However, if it is possible rather than probable that an obligation exists, a contingent liability will exist, not a provision (see section 6 below).
Worked example: Present obligation as a result of a past event Company A carries out quarrying activities. A condition of the planning consent is that environmental damage caused by quarrying must be remedied on completion of the quarrying. In this case, an obligation exists independently of the company's future conduct in relation to damage already caused at the balance sheet date, because the company cannot avoid having to pay for remedial action. By contrast, no obligation exists in relation to expected further damage from continued quarrying because the company could decide not to quarry in the future. Company B operates aircraft that need periodic overhauls if they are to continue in operation. No obligation exists in relation to future overhauls because the company could decide to sell or scrap the aircraft rather than overhaul them.
2.4
Legal and constructive obligations You should be familiar with the concept of a legal obligation.
Definition Legal obligation: is an obligation that derives from:
A contract (through explicit or implicit terms) Legislation; or Other operation of law.
An example of a legal obligation would be a warranty provided at the time of sale to undertake necessary repairs for a specified period of time. A constructive obligation may be a less familiar term.
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Definition Constructive obligation: is an obligation that derives from an entity’s actions where:
By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
Constructive obligations are more difficult to identify with certainty than legal obligations. In practice they are recognised where the situation has much the same commercial effect as a legal obligation. In other words, in practice, the entity cannot avoid settling the obligation. For example there is likely to be a constructive obligation where failure to do something would result in unacceptable damage to an entity’s reputation or future business.
Worked example: Constructive obligation A retail store operates a policy of giving refunds to customers that goes beyond the company’s legal obligations. The policy is long established and widely known. It is likely that this policy creates a constructive obligation, as a significant breach of the policy would damage the company’s reputation considerably.
2.5
Probable outflow of resources A provision is recognised only where the obligation will lead to a probable outflow of resources. Probable is defined for these purposes as more likely than not to occur. In practical terms this means that there is a greater than 50% chance that an entity will have to transfer resource to another party. Point to note Where there are a number of similar obligations (e.g. product warranties) the probability should be based on considering the class of obligation as a whole.
Worked example: Probable outflow If a company has entered into a warranty obligation then the probability of outflow of economic benefits may well be extremely small in respect of one specific item. However, when considering the class of obligation as a whole, the probability of some outflow of economic benefits is likely to be much higher. If there is a greater than 50% probability of some transfer of economic benefits then a provision should be made for the expected amount.
2.6
Reliable estimate A provision should be recognised only if a reliable estimate of the obligation can be made. Points to note
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1
Where an entity can determine a range of possible outcomes, a sufficiently reliable estimate can be made, even if the exact amount cannot be quantified.
2
In the extremely rare case where no reliable estimate can be made, a liability exists that cannot be recognised. That liability is disclosed as a contingent liability. BAS 37 provides no example of such an extremely rare case. In effect, 'extremely rare' means, 'almost never'.
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3 Measurement and subsequent treatment Section overview
3.1
A provision should be measured at the best estimate of the expenditure required to settle the obligation.
Where there is a large population an expected value will be calculated.
The amount of the provision should be discounted where the time value of money is material.
Reimbursement should be recognised as a separate asset when it is virtually certain that it will be received.
Basic rule The amount provided should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. This is the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party at that time. In making a best estimate account should be taken of:
3.2
Information provided by events after the balance sheet date
Management judgement/experience of similar transactions
Guidance from independent experts
The risks and uncertainties surrounding the situation. Care is needed both to avoid understating provisions and to avoid excessively prudent provisioning.
Single obligation Uncertainties surrounding the amount to be recognised as a provision are dealt with by various means according to the circumstances.
Worked example: Single obligation If the expenditure for a single obligation is estimated at CU10,000 and there is a 55% chance of the expenditure being incurred, then CU10,000 is provided for. The process of estimating the amount involves two separate steps:
Step 1
Is it probable that there will be an outflow of economic resources (arising from a present obligation)? Yes, there is in this case, as there is a 55% probability.
Step 2
What reliable estimate can be made? CU10,000 in this case.
Points to note 1
An expected value calculation (see next section) is not relevant for a single obligation.
2
In measuring a single obligation, the single most likely outcome may be the best estimate, but if other possible outcomes are mostly higher (or mostly lower), the best estimate will be higher (or lower) than the individual most likely outcome.
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3.3
Expected values Where there is a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities, to arrive at the expected value.
Interactive question 1: Expected values
[Difficulty level: Exam standard]
X Ltd sells goods which carry a one-year repair warranty. If minor repairs were to be required for all goods sold in 20X7, the cost would be CU100,000. If major repairs were to be needed for all goods sold in 20X7, the cost would be CU500,000. X Ltd estimates that 80% of goods sold in 20X7 will have no defects, 15% will have minor defects and 5% will have major defects. Requirement Calculate the provision for repairs required at 31 December 20X7. See Answer at the end of this chapter.
3.4
Discounting Where the effect of the time value of money is material, the amount of the provision should be discounted. In other words it should be recorded at the present value of the expenditure required to settle the obligation. This is likely to be an issue when there is a significant period of time between the balance sheet date and settlement of the obligation. The discount rate used should be the pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. Point to note In the exam any present value figures would be given in a question. Discounting calculations will not be required until the Financial Reporting paper.
3.5
Future events Future events such as changes in technologies, efficiency improvements and changes in legislation may have a significant impact on the measurement of provisions. These should be taken into account where there is sufficient objective evidence that they will occur.
3.6
Expected disposal of assets Gains from the expected disposal of assets should not be taken into account in measuring a provision even if the expected disposal is closely linked to the event giving rise to the provision. Instead, such gains are accounted for under the relevant BFRS, i.e. BAS 16 Property, Plant and Equipment and BFRS 5 Non-current Assets Held for Sale and Discontinued Operations for PPE.
3.7
Reimbursements In some cases, an insurance company or a supplier under a warranty may reimburse all or part of a company’s expenditure to settle a provision. If so the reimbursement should be recognised only when it is virtually certain that reimbursement will be received if the entity settles the obligation. BAS 37 requires that the reimbursement should be:
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Treated as an asset in the balance sheet separate from the provision; and Recognised in the balance sheet at an amount not exceeding the amount of the provision.
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Points to note 1
Where an asset is recognised, it is presented separately from the liability, because in the unlikely event that the asset is not recovered, the company would still remain liable for its obligation.
2
In the income statement, the expense relating to a provision may be presented net of the amount recognised for a reimbursement.
3
Note the different approaches to the recognition of assets and liabilities throughout this standard. An asset can be recognised only if an inflow of resources is virtually certain (and therefore not contingent), whereas a liability is recognised if an outflow of resources is more likely than not to occur.
If the likelihood of receiving reimbursement is not virtually certain then the amount should be disclosed as a contingent asset, assuming that receipt is probable (see section 6 below).
3.8
Changes in provisions Provisions are inherently uncertain and BAS 37 requires that they should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If a transfer of economic benefit is no longer probable, the provision should be reversed.
3.9
Use of provisions BAS 37 specifies that a provision should be used only for expenditures for which the provision was originally recognised. If a provision is no longer required for its originally intended purpose, it should be reversed and not used to conceal the impact of other unrelated expenditure. The reversal is a change of accounting estimate and is recognised in profit or loss in the year of reversal. The entry to record the reversal is:
3.10
DR
Provisions
X
CR
Income statement for the year
X
Recognising an asset when recognising a provision In some cases, an obligation may arise from a past event before an entity has obtained economic benefits from the event concerned, but the entity reasonably expects to obtain such future benefits. In this case the amount of the provision is also recognised as an asset, to be written off over the period of the asset’s useful life. An example of this is the way that under BAS 16 a provision for the initial estimates of dismantling and removing an item of PPE and restoring the site on which it is located is included in the cost of the item.
Interactive question 2: Provision for environmental damage [Difficulty level: Exam standard] A company establishes a new quarry and has a legal obligation to restore environmental damage once quarrying is completed. Before rock can be extracted for sale, the overlying material (the overburden) must be removed, causing environmental damage. The overburden itself has no commercial value. The estimated cost of remedying the damage caused by removal of the overburden is CU50,000 (ignore discounting). Requirement Show and explain the accounting entry to record the provision for environmental damage rectification arising out of removal of the overburden.
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Financial accounting Fill in the proforma below. The entry to record the provision for environmental damage on removal of the overburden will be: DR CR See Answer at the end of this chapter.
4 Specific applications Section overview
4.1
Future operating losses should not be provided for.
A provision should be made for the unavoidable costs of meeting an onerous contract.
Provisions for a restructuring should only be made where there is an obligation at the balance sheet date.
Future operating losses Provisions should not be recognised for future operating losses as they do not meet the definition of a liability (as they arise from future, not past events) or the general recognition criteria set out in BAS 37. Point to note This treatment is consistent with that required under BFRS 3 for expected future losses of an acquired business (see Chapter 15). BFRS 3 specifies that such losses should not be taken into account when calculating any goodwill acquired in a business combination but must be dealt with as post-acquisition items in the group accounts.
4.2
Onerous contracts Definitions An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefit expected to be received under it. The unavoidable costs under a contract are the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it. In other words, it is the lowest net cost of exiting from the contract.
If an entity has a contract that is onerous, the present obligation under the contract should be recognised and measured as a provision. An example might be vacant leasehold property.
Worked example: Onerous contract A company rents a building under an operating lease, but vacates the building shortly before its year end, due to business relocation. The lease on the vacated building has three years to run and cannot be cancelled. The building cannot be sub-let.
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In this case, the conditions for making a provision are met as:
4.3
A present obligation exists as a result of a past event (the signing of the lease)
An outflow of resources embodying economic benefit in settlement is probable (rentals for the remainder of the lease term); and
The amount can be measured reliably (the future rentals, discounted if material).
Restructuring Definition A restructuring is a programme that is planned and controlled by management, and materially changes either:
The scope of a business undertaken by an entity; or The manner in which that business is conducted.
Examples of events that may fall under the definition of restructuring include:
Sale or termination of a line of business
Closure of business locations or the relocation of business activities
Changes in management structure
Fundamental reorganisations that have a material effect on the nature and focus of the entity’s operations.
Point to note The BAS 37 requirements apply to the recognition and measurement of provisions on discontinuance, as well as other restructurings. In the case of a discontinuance, BFRS 5 (dealt with in Chapter 4) provides additional disclosure requirements.
4.3.1
Criteria for making a provision The key accounting issue is whether, and if so, when, to recognise a provision for a planned restructuring. BAS 37 treats a restructuring as creating a constructive obligation (and therefore as requiring recognition as a provision) only when an entity:
Has a detailed formal plan identifying at least: – – – – –
The business concerned The principal locations The employees affected The expenditure required The timing; and
Has raised a valid expectation in those affected that it will carry out the restructuring by starting implementation or announcing its main features.
A management or board decision taken before the year end in itself does not give rise to a constructive obligation at the balance sheet date unless the entity has:
Already begun implementation; or Made a public announcement of the main features sufficient to establish a constructive obligation.
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Financial accounting Point to note A similar decision taken after, not before, the year end will normally require disclosure as a non-adjusting event after the balance sheet date, under BAS 10 (see section 8 below).
4.3.2
Measurement A provision should include only the direct expenditures arising from the restructuring, which are both:
Necessarily entailed by the restructuring; and Not associated with ongoing activities.
This therefore excludes indirect costs, for example retraining or relocating staff in a continuing operation. Provisions for future losses of the restructured operation are also not permitted, unless they relate to onerous contracts.
4.3.3
Sale of an operation Where an operation is to be sold, no obligation arises for the sale until the entity is committed to the sale, i.e. there is a binding sale agreement. A decision to sell does not itself create an obligation. Without a binding agreement, there is no past event independent of the entity’s future actions, as management may change its mind or be unable to find a purchaser.
4.4
Other examples Appendix C of BAS 37 includes a number of examples of the way in which the recognition criteria would be applied to specific situations. Several of these have already been referred to in this chapter. You should read through the Appendix and attempt Interactive question 4 below to confirm your understanding.
Interactive question 3: Provisions
[Difficulty level: Exam standard]
In which of the following circumstances might a provision be recognised? (a)
On 13 December 20X9 the board of an entity decided to close down a division. The accounting date of the company is 31 December. Before 31 December 20X9 the decision was not communicated to any of those affected and no other steps were taken to implement the decision.
(b) As (a) above except that the board agreed a detailed closure plan on 20 December 20X9 and details were given to customers and employees. (c)
A company is obliged to incur clean up costs for environmental damage (that has already been caused).
(d) A company intends to carry out future expenditure to operate in a particular way in the future. See Answer at the end of this chapter.
5 Disclosures relating to provisions Section overview
BAS 37 requires a number of numerical and narrative disclosures.
BAS 37 disclosures are examinable in full. The main requirements in relation to provisions are set out below. Note also that BAS 37 Appendix D includes disclosure examples.
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Key BAS 37 numerical disclosures for each class of provision are:
Carrying amounts at the beginning and end of the period
Movements during the period, including: – – – – –
Amounts provided Amounts used (i.e. incurred and charged against the provision) Unused amounts reversed Increases due to unwinding of a discount Effect of changes in the discount rate
Key BAS 37 narrative disclosures for each class of provision are:
A brief description of the obligation and expected timing of any outflows of resources embodying economic resources
An indication of the uncertainties involved
The amount of any expected reimbursement, including the amount of any asset that has been recognised
Point to note In extremely rare cases, disclosure may seriously prejudice the company’s position in a dispute with other parties on the subject matter of the provision. In such cases, the information need not be disclosed, but the general nature of the dispute, together with the reason why the information has not been disclosed, should be stated.
6 Contingent liabilities Section overview
6.1
Contingent liabilities should not be recognised but may require disclosure.
Definitions Definition A contingent liability is either:
A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity, or
A present obligation that arises from past events but is not recognised because: –
It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
–
The amount of the obligation cannot be measured with sufficient reliability.
Points to note 1
Note the distinction between a provision and a contingent liability. A contingent liability arises when some, but not all, of the criteria for recognising a provision are met. The criteria for recognising a provision were covered in section 2.2 above.
2
If an obligation is probable it is not a contingent liability – instead a provision is needed.
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6.2
Treatment of contingent liabilities Contingent liabilities should not be recognised in the financial statements, but may require disclosure (see section 6.3 below). Because contingent liabilities are inherently uncertain, they should be assessed continually to identify whether the criteria for recognising a provision have been met. If this occurs, a provision should be recognised in the period in which the criteria are met. This would represent a change of accounting estimate regarding the likely outcome of an uncertain situation.
6.3
Disclosure of contingent liabilities Unless the possibility of any outflow in settlement is remote, the following disclosures should be made for each class of contingent liability at the balance sheet date:
A brief description of its nature; and
Where practicable: – – –
An estimate of the financial effect (measured in the same way as a provision) An indication of the uncertainties; and The possibility of any reimbursement.
No specific guidance is provided in BAS 37 on the meaning of ‘remote’. In line with prudence, 'remote' should be interpreted as meaning extremely unlikely. This means that the probability of an event occurring should be so small that it can be ignored.
Worked example: Contingent liability A company has provided a guarantee to a third party which, if it were to be called on to honour it, would undermine the going concern basis. In such a situation, even a 5% or 10% chance that the guarantee will be enforced should not be considered remote as this could potentially destroy the entire company.
6.4
Exemption If the disclosure requirements of BAS 37 are not met because it is not practicable to do so, this fact should be stated. The same ‘seriously prejudicial’ disclosure exemption applies for contingent liabilities as for provisions (see section 5 above).
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6.5
9
Relationship between provisions and contingent liabilities This can be summarised in the following flow chart which has been reproduced from Appendix B of BAS 37.
7 Contingent assets Section overview
7.1
A contingent asset should not be recognised but should be disclosed where an inflow of benefits is probable.
Definition Definition A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
An example of a contingent asset is the possible gain arising from a pending legal action or other claim.
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7.2
Treatment of contingent assets A contingent asset must not be recognised. Only when the realisation of the related economic benefits is virtually certain should recognition take place because, at that point, the asset is no longer contingent. This is an application of the prudence concept. Contingent assets should be assessed continually to identify whether the uncertainty has been removed. If events confirm the existence of an asset, it should be recognised provided that it can be measured reliably.
7.3
Disclosure of contingent assets Where an inflow of economic benefits is probable, i.e. more likely than not, the contingent asset must be disclosed. The following information is required:
A brief description of the nature of the contingent asset An estimate of the financial effect
As for contingent liabilities, these disclosures may be avoided on the grounds that it is impractical to provide the information or would be seriously prejudicial to the entity.
Interactive question 4: BAS 37 definitions
[Difficulty level: Easy]
Identify which, if any, of the following circumstances falls within BAS 37's definitions of a provision, a contingent liability or a contingent asset, explaining your answer: Circumstance
Position under BAS 37
A contract of employment
A legal claim being pursued by an entity and which it is confident of winning
A legal claim being pursued against an entity but which the entity is confident of winning
A legal claim against an entity where the entity has accepted liability but the amount to be paid has not yet been agreed Legislation enacted but coming into effect next year which will require substantial retraining of staff The reinstatement of land once quarrying has ceased, where there is no legal obligation. The entity’s published policy in relation to environmental protection is that it will reinstate any environmental damage caused by its activities The reinstatement of land once quarrying has ceased, where there is no legal obligation, the entity has no published policy in relation to environmental protection and this is the first quarrying venture it has entered into
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Circumstance
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Position under BAS 37
Restructurings where the detailed plan has been developed, announced and agreed with employees’ representatives Restructurings where the detailed plan has been developed and announced
Restructurings where the detailed plan has been developed and agreed by the board, but no announcement has been made Future reinstatement work under guarantees to be provided to customers in relation to future sales
See Answer at the end of this chapter.
Interactive question 5: Application of BAS 37
[Difficulty level: Easy]
For each of the following circumstances identify when, if ever, an asset or liability should be recognised under BAS 37. In each case, is any disclosure required by BAS 37 prior to any asset/liability recognition? Circumstance
Application of BAS 37
A legal claim in relation to a past event is pursued against an entity over several years. The entity makes the following judgements about outflows of resources in settlement:
Year 1: there will be no outflow
Year 2: an outflow is remote
Year 3: an outflow is possible
Year 4: an outflow is probable
Year 5: an outflow is virtually certain
A legal claim in relation to a past event is pursued by an entity over several years. The entity makes the following judgements about inflows of resources in settlement:
Year 1: there will be no inflow
Year 2: an inflow is remote
Year 3: an inflow is possible
Year 4: an inflow is probable
Year 5: an inflow is virtually certain
See Answer at the end of this chapter.
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8 BAS 10 Events After the Balance Sheet Date Section overview
Events after the balance sheet date may be: – –
8.1
Adjusting events Non-adjusting events.
The effect of adjusting events should be reflected in the year end financial statements.
Where the effect of non-adjusting events is material they should be disclosed.
Purpose of BAS 10 Financial statements are prepared to the balance sheet date. The preparation of financial statements, however, will normally continue for a period after this date. During this time lag, events may occur which provide additional information that is relevant to the preparation of the financial statements. The objective of BAS 10 Events After the Balance Sheet Date is to prescribe when financial statements should be adjusted for these events and any disclosures that may be required.
8.2
Events after the balance sheet date Definition Events after the balance sheet date are those events, favourable and unfavourable, that occur between the balance sheet date and the date when the financial statements are authorised for issue.
Points to note 1
The date the financial statements are authorised for issue is the key cut off point. Any event which takes place after this date is outside the scope of BAS 10.
2
The process involved in authorising the financial statements may vary:
Where an entity is required to submit its financial statements to its shareholders for approval after the financial statements have been issued, the financial statements are authorised for issue on the date of issue (not the date when the shareholders approve the financial statements)
Where the management is required to issue the financial statements to a supervisory board (made up solely of non-executives) for approval, the financial statements are authorised for issue when the management authorises them for issue to the supervisory board
3
The date of authorisation may be after a preliminary announcement has been made of profits or other information.
4
The date on which the financial statements are authorised for issue must be disclosed, so that users know the date up to which events and transactions have been taken into account.
There are two different classes of events after the balance sheet date:
Adjusting events; and Non-adjusting events.
We will look at these in detail below.
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9
Adjusting events Definition Adjusting events: Those that provide evidence of conditions that existed at the balance sheet date.
As the name suggests adjusting events lead to the adjustment of the financial statements. They require either:
Adjustments to amounts already recognised in the financial statements; or Recognition of items which did not previously meet the recognition criteria.
Examples include:
The settlement of a court case outstanding at the balance sheet date. (This is an example of an event which might require either adjustment to an amount already recognised in the financial statements as a liability or the recognition of something which prior to that would have been only a contingent liability)
Bankruptcy of a customer, requiring adjustment to the amount receivable
Proceeds or other evidence concerning the net realisable value of inventories
Subsequent determination of the purchase price or of the proceeds of sale of assets purchased or sold before the year end
Worked example: Adjusting event A pressing machine with a budgeted carrying amount at 31 December 20X6 of CU20,000 is classified as held for sale in December 20X6. Its fair value less costs to sell is then estimated as CU18,000 and it is sold for CU16,500 on 28 February 20X7. The 20X6 financial statements are authorised for issue by the board on 15 March 20X7. The machine should be measured at CU16,500 in the 20X6 financial statements.
Point to note As the financial statements will have been adjusted for an adjusting event there is no specific requirement to disclose the event. However, where the adjusting event affects an item which was not previously recognised but was disclosed, the disclosure will need to be updated. For example, the contingent liability for damages under a court case may need to be updated for new information.
8.4
Non-adjusting events Definition Non-adjusting events. Those that are indicative of conditions that arose after the balance sheet date.
Examples include:
A fall in the market value of investments Plans to discontinue operations announced after the year end Major purchases of assets
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Losses on non-current assets or inventories as a result of a catastrophe such as fire or flood; Restructurings not provided for as they were announced after the year end.
Adjustments to amounts in the financial statements are not made to reflect non-adjusting events. However, where the effect of the non-adjusting event is material, such that non-disclosure could influence users’ economic decisions the following information should be provided in the notes to the financial statements for each event:
8.5
The nature of the event; and An estimate of the financial effect.
Dividends Dividends on equity shares proposed or declared after the balance sheet date should be treated as follows:
They cannot be shown as a liability as there is no obligation at the balance sheet date. The amount of dividends payable must be disclosed in the notes to the financial statements.
Interactive question 6: Dividends
[Difficulty level: Exam standard]
The recent financial calendar of RSB Ltd, a company with a 31 December year end, has included the following: Authorised by directors for issue
Approved in annual general meeting
28 February 20X6 28 February 20X7
3 May 20X6 4 May 20X7
Proposed by directors
Declared by directors
Approved in annual general meeting
28 February 20X6 31 August 20X6 28 February 20X7
No Yes No
Yes No Yes
Financial statements for 20X5 Financial statements for 20X6 Dividends on ordinary shares 20X5 final 20X6 interim 20X6 final Requirement
Identify how these dividends will be dealt with in RSB Ltd’s financial statements for 20X5, 20X6 and 20X7. Complete the proforma below. Financial statements for:
20X5
20X6
20X5 final dividend
20X6 interim dividend
20X6 final dividend
See Answer at the end of this chapter.
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20X7
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8.6
9
Going concern If management determines after the balance sheet date that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so, then the financial statements must not be prepared on the going concern basis. Points to note 1
Management intentions are taken into account.
2
A change from the going concern basis is so all-pervasive in its effects on financial statements that a fundamental change to the basis of accounting is required, not just adjustments to the figures prepared on the going concern basis. No guidance is given in any BFRS as to the basis of accounting which should be used in these circumstances, but it is likely that the break-up basis will be adopted (see Chapter 1). All assets will need to be measured at their net realisable values; amounts receivable from customers will need to take account of the period available for their collection – the shorter the period, the lower the value.
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Summary and Self-test
Summary
If not – outside scope of BAS 10
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Self-test Answer the following questions. 1
The directors of Robin Ltd (year end 31 December 20X6) were informed on 27 February 20X7 that a serious fire at one of the company’s factories had stopped production there for at least six months to come. On 3 March 20X7 the directors of Robin Ltd were informed that a major customer had gone into liquidation. The liquidator was pessimistic about the prospect of recovering anything for unsecured creditors. The financial statements for the year ended 31 December 20X6 were authorised for issue on 20 March 20X7. In accordance with BAS 10 Events After the Balance Sheet Date how should the two events be treated in the financial statements? A B C D
2
Fire Accrued in accounts Disclosed in notes Accrued in accounts Disclosed in notes
Liquidation Disclosed in notes Disclosed in notes Accrued in accounts Accrued in accounts
The following events took place between the balance sheet date and the date on which the financial statements were authorised for issue. Which event should be classified as an adjusting event in accordance with BAS 10 Events After the Balance Sheet Date? A B C D
3
The disclosure of a fraud that shows the financial statements were incorrect. The acquisition of a subsidiary A rights issue A dramatic fall in the value of an overseas investment due to movements in the exchange rate
Brick Ltd, Cement Ltd and Mortar Ltd are independent companies, each with a year end of 31 December. Each company is owed a substantial amount by Ladder Ltd. The debts arose on the following dates. Brick Ltd Cement Ltd Mortar Ltd
20 December 20X1 20 January 20X2 25 January 20X2
On 31 January 20X2 Ladder Ltd went into liquidation, and on 2 February 20X2, as a result of the amount which Ladder Ltd owed to it, Mortar Ltd went into liquidation. Ladder Ltd’s default will be regarded as an event requiring adjustment under BAS 10 Events After the Balance Sheet Date by A B C D
Brick Ltd Brick Ltd and Cement Ltd Brick Ltd and Mortar Ltd Brick Ltd, Cement Ltd and Mortar Ltd
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The directors of Laurel Ltd are reviewing the draft balance sheet at 31 December 20X2. The following events after the balance sheet date have been identified. (i)
On 1 February 20X3 a fraud perpetrated by the accounts receivable controller was discovered. Receivables recorded in November 20X2 were overstated by CU30,000.
(ii)
Property, plant and equipment with a carrying amount of CU25,000 was destroyed by a fire on 15 January 20X3. No insurance recovery is expected.
(iii) A claim brought by a customer which was under negotiation at the balance sheet date was settled in court on 12 January 20X3. A payment of CU20,000 in full settlement was made on 24 January 20X3. Which of these events would be regarded as an adjusting event according to BAS 10 Events After the Balance Sheet Date? A B C D 5
(i) and (ii) only (ii) and (iii) only (i) and (iii) only All three events
Which of the following would be a non-adjusting event after the balance sheet date when preparing financial statements at 31 December 20X9 according to BAS 10 Events After the Balance Sheet Date? (i)
A firework destroys part of the warehouse inventory in the early hours of 1 January 20Y0.
(ii)
An insurance claim is agreed on 3 January 20Y0 for a fire in December 20X9 which destroyed part of the inventory in another warehouse.
(iii) A customer goes into receivership as a result of a catastrophic fire in January 20Y0. (iv) Some inventory damaged by the fire in (i) above is sold in January 20Y0 at 10% of its cost price. A B C D 6
(i), (ii) and (iv) (i), (iii) and (iv) (ii), (iii) and (iv) (i), (ii) and (iii)
The following describe potential provisions. (i)
A provision to cover refunds. The company is in the retail sector and has a reputation for a 'no questions asked' policy on refunds.
(ii)
A provision to cover an onerous contract on an operating lease. The lease was on a building which the company has subsequently vacated. The lease cannot be terminated and cannot be relet.
Following BAS 37 Provisions, Contingent Liabilities and Contingent Assets, in which of the above situations would a company be required to recognise a provision in their accounts for the year ended 30 September 20X7? A B C D
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Neither situation Both situations Situation (i) only Situation (ii) only
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Porter Ltd is finalising its financial statements for the year ended 30 September 20X3. A former employee of Porter Ltd has initiated legal action for damages against the company after being summarily dismissed in October 20X3. Porter Ltd’s legal advisers feel that the employee will probably win the case and have given the company a reasonably accurate estimate of the damages which would be awarded. Porter Ltd has not decided whether to contest the case. In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets this item should be classified in the financial statements of Porter Ltd for the year ended 30 September 20X3 as A B C D
8
A non-adjusting event after the balance sheet date An adjusting event after the balance sheet date A contingent liability disclosed by way of note A provision
A company has a year end of 31 March 20X6. On 10 April 20X6 a decision is taken to sell a subsidiary company, creating a profit in the books of the parent company. Which of the statements below reflects the correct treatment of this item in the accounts of the company for the year ended 31 March 20X6?
9
A
The sale is an 'exceptional' item not expected to recur, and accordingly the profit should be disclosed in the income statement after the figure for profit/(loss) for the period
B
The sale of a subsidiary is a normal business decision taken by the main board of directors, and accordingly the profit arising should be included in the income statement but not separately disclosed
C
The sale is an event after the balance sheet date, and accordingly, in view of the potential impact on next year’s results, details of the event and the profit arising should be disclosed as a note to the financial statements
D
The sale is a contingency in view of the fact that it was uncertain at the balance sheet date, and accordingly details of the contingency and the profit arising should be disclosed as a note to the financial statements
Mulroon Ltd, a publishing company, is being sued for CU1 million in a libel action in respect of a book published in January 20X4. On 31 October 20X4, the balance sheet date, the directors believed that the claim had a 10% chance of success. On 30 November 20X4, the date the accounts were authorised for issue, the directors believed that the claim had a 30% chance of success. In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets in the financial statements to 31 October 20X4 the amount which should be accrued is A B C D
CUnil CU100,000 CU300,000 CU1,000,000
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Construction Ltd was awarded a contract to build a tunnel under the Thames river by a government department. Construction Ltd delegated some aspects of the contract to other companies. One of the sub-contractors, Underwater Ltd, was negligent in the performance of its contract with Construction Ltd, which caused delay in the completion of the tunnel. As a result of the delay, the government department is claiming damages of CU10 million against Construction Ltd. In turn, Construction Ltd has commenced proceedings against Underwater Ltd. The lawyers have advised Construction Ltd that both actions are likely to be successful. In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets how should Construction Ltd account for the legal claims?
A B C D 11
Claim against Construction Ltd Provide Provide Disclose Do nothing
Claim against Underwater Ltd Accrue Disclose Do nothing Do nothing
Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party and it is virtually certain that reimbursement will be received if the entity settles the provision, which of the following statements is true in accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets? (i)
The reimbursement may be offset against the provision in the balance sheet and the charge in the income statement.
(ii)
The reimbursement is recognised as a separate asset in the balance sheet and may be offset against the charge in the income statement.
(iii) The amount recognised for the expected reimbursement may not exceed the liability. (iv) The amount recognised for the expected reimbursement may exceed the liability. A B C D 12
(i) and (iii) only (i) and (iv) only (ii) and (iii) only (ii) and (iv) only
As a result of new banking regulations, Intrepid Ltd will need to retrain a large proportion of its financial services division in order to ensure continued compliance with banking regulations. At the balance sheet date no retraining of staff has taken place. However, the head of the financial services division has announced that he is committed to a completion of the retraining programme by the end of the following year. Carefree Ltd is also subject to the same banking regulations. By the year end Carefree Ltd has contracted a training organisation to undertake the retraining programme with a start date of 15 January, two weeks after the year end. Staff have been notified of their training session dates. In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets how should each company account for the cost of retraining their staff? A B C D
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Intrepid Ltd Provide Disclose Do nothing Do nothing
Carefree Ltd Provide Provide Provide Do nothing
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9
Woodhall Ltd supplies customers with major pieces of equipment. During 20X2 it supplied one item of equipment to Spa Ltd. The item failed and Spa Ltd has initiated a legal claim for damages against Woodhall Ltd. At 31 December 20X2 the matter remains unresolved. Woodhall Ltd’s legal advisors have advised that there is a 40% chance that the claim can be defended at no cost. Otherwise, damages are estimated at CU1 million. What provision should be recorded in the balance sheet at 31 December 20X2 in accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets? A B C D
14
CUnil CU400,000 CU600,000 CU1,000,000
On 1 January 20X2 Delta Ltd began working a new mine. Legislation requires the owner to restore any environmental damage at the end of the 3-year licence. The cost of restoration includes: (i)
The replacement of the landscape, which had to be removed before mining could commence. The restoration cost is estimated at CU6 million.
(ii)
Damage that is progressively created as mining progresses. The total cost of this damage is estimated at CU3 million. Environmental experts believe that the damage is created proportionately with time.
What provision for environmental remediation should be created at 31 December 20X2 in accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets? A B C D 15
CU3 million CU5 million CU6 million CU7 million
VACS LTD Vacs Ltd is a manufacturing company which prepares financial statements to 30 September each year. Before the draft financial statements for the year ended 30 September 20X3 can be finalised and approved by the directors, the following points need to be addressed. Draft net assets at 30 September 20X3 were CU2 million. (i)
Vacs Ltd has renewed the unlimited guarantee given in respect of the bank overdraft of a company in which it holds a significant investment. That company's overdraft amounted to CU300,000 at 30 September 20X3 and it has net assets of CU1 million.
(ii)
A former director, who was dismissed from the company’s service on 1 September 20X3 for acting outside his authority, has given notice of his intention to claim substantial damages for loss of office. On 1 November 20X3 a claim was received for CU150,000. The company’s legal advisers have been negotiating with the former director and believe that the claim will probably be settled at CU100,000.
(iii) On 15 November 20X3 the company sold its former head office building, Whitley Wood, for CU2.7 million. At the year end the building was unoccupied and Vacs Ltd had not intended to sell the property for at least another year. The building's carrying amount (based on cost less accumulated depreciation) was CU3.1 million at the year end. (iv) An overseas division of Vacs Ltd was nationalised in December 20X3. The overseas authorities have refused to pay any compensation. The net assets of the division have been valued at CU200,000 at the year end.
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Financial accounting Requirements (a)
Explain the definition of a liability from BFRS Framework in the context of accounting for provisions and contingencies. (6 marks)
(b) Prepare extracts from the balance sheet of Vacs Ltd as at 30 September 20X3, including any relevant notes to the financial statements. (10 marks) (16 marks) 16
PROVISO LTD Proviso Ltd is organised into several divisions. The following events relate to the year ended 31 December 20X2. (i)
The computer division supplied a computer to a customer during the year that exploded, causing a fire. Proviso Ltd is being sued for damages. Lawyers have advised that there is a 30% chance of successfully defending the claim. Otherwise the damages are expected to cost CU10 million (present value CU9.5 million). The lawyers have investigated the cause of the problem with a team of accident consultants. They have concluded that parts supplied to the computer division by Moor Ltd contributed to the fire. Lawyers have estimated that Moor Ltd’s contributory negligence amounted to 40% of the total damages. Negotiations have started with Moor Ltd and the lawyers believe that a claim is likely to succeed.
(ii)
On 15 December 20X2, the directors of Proviso Ltd minuted their decision to close the operations of the loss making space technology division. The decision and an outline of a plan were immediately announced to employees and a press release was issued. The closure, which began on 4 January 20X3, has an estimated date for completion, including the sale of the noncurrent assets of the division, of 30 June 20X3. The costs associated with the closure include the following. Employee redundancy costs Lease termination costs Relocating continuing staff to other divisions Impairment losses
CU'000 12,000 4,000 3,000 2,000 21,000
(iii) Proviso Ltd’s retail division provides two-year warranties to its customers. Experience has shown that, on average, 10% of sales from this division result in a warranty claim. Revenue from this division in 20X2 was CU8 million. At 1 January 20X2 Proviso Ltd had a warranty provision in place of CU1 million. During the year claims of CU600,000 were settled by the company. Requirement Prepare the provisions and contingencies notes for the financial statements of Proviso Ltd for the year ended 31 December 20X2. (10 marks)
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9
ARCHY LTD (Sample Paper) An extract from Archy Ltd’s nominal ledger at 30 April 20X6 is as follows: Administrative expenses Distribution costs Other operating costs Purchases Corporation tax charge for period Finance costs Sundry operating income Revenue Ordinary share capital - CU1 nominal value Trade and other receivables Inventories at 1 May 20X5 Bank account Freehold land and buildings Cost Accumulated depreciation at 30 April 20X5 Plant and equipment Cost Accumulated depreciation at 30 April 20X5 Intangible asset – carrying amount at 30 April 20X6 Retained earnings at 1 May 20X5 Bank loan (repayable on 1 June 20Y0) Trade and other payables
CU 950,000 509,000 22,000 2,875,000 227,000 9,000 5,700 5,350,000 1,000,000 55,700 1,670,000 15,000 900,000 36,000 102,800 36,400 68,000 813,300 100,000 62,100
The following additional information is available: (1) One of Archy Ltd's customers was declared bankrupt following the year end. The customer owed Archy Ltd CU12,500 at the year end. (2) A piece of plant costing CU56,000 on 1 May 20X3 had been sold on 30 April 20X6 for CU36,600. It first met the BFRS 5 Non-current Assets Held for Sale and Discontinued Operations criteria as a held for sale asset on the date of disposal. The proceeds were received on 10 May 20X6 and no adjustments have been made in respect of the disposal. The plant was being depreciated straight-line over eight years. Depreciation is charged on the remaining plant and machinery at 20% on cost and is presented as part of cost of sales. (3) Inventories at 31 May 20X6 were valued at CU1,820,000 before any adjustment for damaged items. At the year end inventory count it was discovered that one line of goods in the warehouse had been damaged. The count showed that 1,250 items had been damaged. The inventory was recorded at its cost of CU150 per item. However, following the damage the items have a scrap value of CU40 each. (4) The intangible asset is a brand which was acquired in 20X4 for CU68,000. The useful life of the brand is considered to be indefinite and therefore Archy Ltd carries out an annual impairment test each year to ensure that the brand’s carrying amount is recoverable. An expert has estimated the brand’s fair value less costs to sell is CU60,000 and the financial controller has estimated that the brand’s value in use is CU62,000. (5) The land and buildings were originally acquired on 1 May 20X2 for CU900,000 of which CU300,000 was allocated to the land element and this is the first valuation following the acquisition. Depreciation is charged straight-line on the property element based on a 50-year life and is presented as part of administrative expenses. A valuation of the land and buildings took place at the beginning of the period and has not yet been recognised in the nominal ledger. They were valued at CU1,400,000 of which CU460,000 relates to the land element. The remaining useful life remains unchanged.
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Financial accounting Archy Ltd makes a transfer between the revaluation reserve and retained earnings each period as a result of the revaluation in accordance with best practice. (6) A dividend of 15p per share was declared on 25 April 20X6 and paid shortly after the year end. Requirement Prepare an income statement for Archy Ltd for the year ended 30 April 20X6 and a balance sheet as at that date. (22 marks) Point to note You are not required to prepare notes to the financial statements. Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Technical reference Point to note All of BAS 10 and BAS 37 are examinable. The paragraphs listed below are the key references you should be familiar with. 1 Provisions – recognition
Provisions are liabilities of uncertain timing or amount.
BAS 37 (10)
A provision is recognised only when all of the following are met at balance sheet date:
BAS 37 (14)
–
A present obligation exists (legal or constructive) as a result of a past event
–
An outflow of resources embodying economic benefits in settlement is probable
–
Amount can be estimated reliably
There is a useful decision tree in Appendix B
BAS 37 (App B)
2 Provisions – measurement and use
Measure at best estimate of expenditure required to settle obligation at BS date.
BAS 37 (36)
Discount where material.
BAS 37 (45)
Do not take into account gains from expected disposal of assets.
BAS 37 (51)
Treat reimbursements as separate assets, recognised only where virtually certain, and only up to amount of provision.
BAS 37 (53)
–
BAS 37 (54)
Expense in income statement may be shown net of reimbursement
Review provisions at each BS date and adjust to current best estimate.
BAS 37 (59)
Use a provision only for the expenditures for which it was created.
BAS 37 (61)
3 Provisions – specific applications
Do not provide for future operating losses.
BAS 37 (63)
Provide for unavoidable costs of meeting onerous contracts.
BAS 37 (66)
Provide for restructuring only where legal or constructive obligation exists at BS date, and provision covers only costs: –
Necessarily entailed by restructuring; and
–
Not associated with ongoing activities.
No obligation arises on sale of an operation until there is a binding sale agreement.
A useful set of examples is given in Appendix C.
BAS 37 (72 & 80)
BAS 37 (78) BAS 37 (App C)
4 Contingent liabilities
A contingent liability is either: – –
BAS 37 (10)
A possible obligation arising from past events whose existence will be confirmed only by uncertain future events not wholly within the entity’s control; or A present obligation arising from past events not recognised because an outflow of resources embodying economic benefit is not probable or amount cannot be measured reliably. © The Institute of Chartered Accountants in England and Wales, March 2009
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Do not recognise contingent liabilities but disclose unless possibility of outflow is remote.
BAS 37 (27 & 86)
5 Contingent assets
A contingent asset is a possible asset arising from past events whose existence will be confirmed only by uncertain future events not wholly within the entity’s control.
Do not recognise contingent assets but disclose where inflow is probable (i.e. more likely than not).
BAS 37 (10)
BAS 37 (31 & 89)
6 Events after the balance sheet date
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Events after BS date are events occurring between BS date and date of authorisation of FS. Two categories are: –
Adjusting events, which provide evidence of conditions existing at BS date
–
Non-adjusting events, which are indicative of conditions arising after BS date
BAS 10 (3)
FS are adjusted for: –
Adjusting events
–
Non-adjusting events that indicate that going concern assumption is not appropriate
BAS 10 (8) BAS 10 (14)
Disclose, without adjustment, material non-adjusting events which could affect users’ economic decisions taken on the basis of the FS.
BAS 10 (21)
Disclose proposed equity dividends not declared by BS date – do not meet definition of liabilities.
BAS 1 (125)
Disclose date on which FS authorised for issue.
BAS 10 (17)
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Answers to Self-test 1
D
The fire is non-adjusting, whereas the liquidation is adjusting.
2
A
Only 'A' affects the conditions existing at the balance sheet date.
3
C
Brick Ltd
The debt arose before the year end, so this would be an adjusting event.
Cement Ltd
The debt arose after the year end, so that this would be a non-adjusting event.
Mortar Ltd
As for Cement Ltd – a non-adjusting event, but of such significance that Mortar Ltd is no longer a going concern. Thus adjustments will be made to the accounts.
4
C
BAS 10 paragraphs 9 and 22.
5
B
(i)
The destruction of the warehouse is caused by an event which took place after the balance sheet date therefore it is non-adjusting.
(ii)
The claim was outstanding at the balance sheet date, because the fire took place in December 20X9. The agreement on 3 January 20Y0 provides information about the outcome of the claim, therefore it is an adjusting event.
(iii) The cause of the customer going into receivership is due to an event which took place after the balance sheet date i.e. the fire in January 20Y0. This is therefore a non-adjusting event. (iv) The fall in value of the inventory is again due to the fire which occurred after the balance sheet date. At the balance sheet date the inventory was undamaged. Therefore the event is non-adjusting. 6
B
(i)
A constructive obligation exists as the company has built up a valid expectation in customers.
(ii)
The signing of the lease is a past event and when the lease becomes onerous, a provision should be made.
7
A
The legal action does not relate to conditions existing at the year end as the cause arose subsequently.
8
C
BAS 10 paragraph 22(a).
9
A
Loss is not probable, therefore no accrual required.
10
B
The claim against Construction Ltd represents a probable loss and should be provided for. The claim against Underwater Ltd represents a contingent asset which is probable and should be disclosed.
11
C
BAS 37 paragraph 53.
12
D
At the year end neither company has an obligation to pay for training as no training has been carried out.
13
D
If there is a 40% chance that the claim can be defended, there is a 60% (i.e. probable) chance that the company will have to pay damages of CU1 million.
14
D
BAS 37 paragraph 19.
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VACS LTD (a)
Definition of a liability and accounting for provisions and contingencies BFRS Framework defines a liability as:
A present obligation of the entity
Arising from past events
The settlement of which is expected to result in an outflow of resources which can be measured reliably.
This definition can be illustrated by looking at item (ii) in the question. The claim is a present obligation because settlement of the claim can be enforced by law. Ultimately, a court will decide whether or not an outflow of resources will result. The claim has arisen from past events because the action which gave rise to the claim (i.e. the dismissal) took place before the year end (even though the company was not aware of this claim until after the year end). Hence this claim potentially needs recognising as a provision (a liability of uncertain timing and amount) in the financial statements as at 30 September 20X3. If the event had not taken place until after the year end then it would not arise from past events and so no liability would be recognised (though disclosure as a non-adjusting post balance sheet event may be necessary). For the claim to be recognised it must be expected to result in an outflow of resources which can be measured reliably. BAS 37 effectively defines 'expected' as 'more likely than not'. Here, the claim is recognised at an amount of CU100,000 because the legal advisors believe the claim will 'probably be settled at CU100,000'. If the legal advisers believed that it was unlikely that the case would succeed (i.e. settlement is not probable) then the matter would not be recognised as a liability in the financial statements. However, disclosure as a contingent liability (contingent on the outcome of the future court case) would be necessary if the possibility of settlement was other than “remote”. A contingent liability therefore arises when some, but not all, of the criteria for recognising a provision are met. (b) Financial statement extracts Balance sheet as at 30 September 20X3 (extract) CU ASSETS Non-current assets Property, plant and equipment
3,100,000
EQUITY AND LIABILITIES Non-current liabilities Provisions (Note 1)
100,000
Notes to the financial statements as at 30 September 20X3 (extracts) (1) Provisions
At 1 October 20X2 Income statement charge At 30 September 20X3
Compensation claim CU – 100,000 100,000
This provision is in respect of a claim made by a director who was dismissed on 1 September 20X3 for acting outside his authority. It represents the amount at which the company’s legal advisers believe the claim will be settled.
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(2) Contingent liabilities The company has guaranteed the overdraft in respect of a company in which it holds a significant investment. It is not considered likely that this guarantee will be called upon. That company’s overdraft was CU300,000 at 30 September 20X3. (3) Events after the balance sheet date Following an offer made to the company after the year end, on 15 November 20X3 the company sold its former head office building for CU2.7 million, realising a loss of CU400,000. This loss will be reflected in the company’s financial statements to 30 September 20X4. In December 20X3 an overseas division was nationalised without compensation. A loss of CU200,000, in respect of the division’s net assets at 30 September 20X3, will be reflected in the company’s financial statements to 30 September 20X4. Point to note In part (a) it is not essential to use item (ii) in the question to illustrate. Any other appropriate example could have been used. 16
PROVISO LTD Notes to the financial statements as at 31 December 20X2 (extracts) (i)
Provisions
At 1 January 20X2 Utilised in the year Income statement charge (bal fig) At 31 December 20X2 (Ws 1 and 2)
Warranty provision
Compensation claim
CU'000 1,000 (600) 400 800
CU'000 – – 9,500 9,500
Provision for closure of division CU'000 – – 18,000 18,000
Total CU'000 1,000 (600) 27,900 28,300
The warranty provision is in respect of two-year warranties provided to customers. The provision is based on the level of past claims. The compensation claim provision is in respect of a claim made by a customer for damages as a result of a faulty computer supplied by the company. It represents the present value of the amount at which the company’s legal advisers believe the claim is likely to be settled. On 15 December 20X2, Proviso Ltd announced that it would be closing its loss making space technology division. Details of the closure have been fully communicated to those affected. The cost of the closure, which began on 4 January 20X3, is estimated at CU18 million and completion is expected by 30 June 20X3. (ii)
Contingent assets A counter-claim in respect of the compensation claim provided for above has been made against the supplier of parts for the affected computer. Lawyers have advised that this claim is likely to succeed and should amount to around 40% of the total damages (CU3.8 million).
WORKINGS (1) Provision for closure of division Employee redundancy costs Lease termination costs Impairment losses
CU'000 12,000 4,000 2,000 18,000
(2) Warranty provision CU8 million x 10% = CU800,000
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Financial accounting 17
ARCHY LTD (a)
Archy Ltd – Balance Sheet as at 30 April 20X6 CU ASSETS Non-current assets Property, plant & equipment ((1,400,000 – 20,000) + (46,800 – 31,760)) (W4) Intangible asset (W6)
CU
1,395,040 62,000 1,457,040
Current assets Inventories (1,820,000 – 137,500 (W1)) Trade receivables (55,700 – 12,500) Other receivables Cash and cash equivalents
1,682,500 43,200 36,600 15,000 1,777,300 3,234,340
Total assets EQUITY & LIABILITIES Capital & Reserves Ordinary share capital Revaluation reserve (536,000 – 8,000 (W2)) Retained earnings (W7) Equity Non-current liabilities Bank loan Current liabilities Trade and other payables Dividend payable (15p x 1,000,000)
1,000,000 528,000 1,394,240 2,922,240 100,000 62,100 150,000 212,100 3,234,340
Total equity and liabilities Archy Ltd – Income Statement for year ended 30 April 20X6 Revenue Cost of sales (W5) Gross profit Administrative expenses (950,000 + 20,000) Distribution costs Other operating costs (22,000 - 5,700 + 12,500 - 1,600 (W3) + 6,000 (W6)) Finance costs Profit before tax Taxation Net profit for the period
CU 5,350,000 (2,878,860) 2,471,140 (970,000) (509,000) (33,200) 958,940 (9,000) 949,940 (227,000) 722,940
WORKINGS (1) Inventory 1,250 x (CU150 - CU40) = CU137,500 write down (2) Revaluation reserve Freehold land & buildings Accumulated depreciation Net book value Valuation at 1 May 20X5 Revaluation reserve
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CU 900,000 (36,000) 864,000 1,400,000 536,000
(12,000 x 3 years)
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Depreciation on cost 600,000 / 50 years = 12,000 pa Depreciation on revalued amount (1,400,000 – 460,000) 940,000 / 47 years = 20,000 pa Transfer between reserves for additional depreciation 20,000 – 12,000 = 8,000 pa (3) Disposal of piece of machinery Machinery – cost
CU56,000
Accumulated depreciation
CU56,000 / 8 years = CU7,000 pa CU7,000 x 3 years = CU21,000
Net book value at disposal
CU56,000 - CU21,000 = CU35,000 CU 36,600 (35,000) 1,600
Proceeds Less: NBV Profit on disposal (4) Property, plant and equipment Freehold land and buildings Valuation Less depreciation (W2) Net book value
CU 1,400,000 (20,000) 1,380,000
Plant and equipment Cost Less disposal At 30 April 20X6
CU 102,800 (56,000) 46,800
Accumulated depreciation Less disposal Depreciation in year At 30 April 20X6
36,400 (21,000) 16,360 31,760
Depreciation charge in the year for plant and equipment: CU 9,360 7,000 16,360
20% x CU46,800 Plant disposed of Charge in year (5) Cost of sales Purchases Add: opening inventory Less: closing inventory Add: write down (W1) Add: plant & machinery depreciation
CU 2,875,000 1,670,000 (1,820,000) 137,500 2,862,500 16,360 2,878,860
(6) Intangible asset - impairment Recoverable amount is higher of: Value in use Fair value less costs to sell
CU 62,000 60,000
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Financial accounting Recoverable amount is therefore CU62,000 which is greater than carrying amount and hence an impairment has occurred. CU68,000 - CU62,000 = CU6,000 impairment loss (7) Retained earnings Trial balance Transfer from revaluation reserve Dividend declared Add: Profit for period
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CU 813,300 8,000 (150,000) 671,300 722,940 1,394,240
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Answers to Interactive questions
Answer to Interactive question 1 The expected cost of repairs will be: (80% 0) + (15% 100) + (5% 500) = CU40,000
Answer to Interactive question 2 The entry to record the provision for environmental damage on removal of the overburden will be: DR Non-current asset – Cost of establishing quarry CR Provision for environmental costs
CU50,000 CU50,000
When the overburden is removed, the company has yet to realise the economic benefits from extraction of the rock. However, the removal of the overburden is a past event giving rise to an obligation. Therefore a provision for restoration costs is recognised at this point. The debit entry is added to the non-current asset for the cost of establishing the quarry rather than being expensed immediately. The cost passes to the income statement as the asset for the establishment of the quarry is depreciated over its life.
Answer to Interactive question 3 (a)
No provision would be recognised as the decision had not been communicated by the year end.
(b) A provision would be made in the 20X9 financial statements. (c)
A provision for such costs would be made as the damage has already been caused.
(d) No present obligation exists and under BAS 37 no provision would be appropriate. This is because the entity could avoid the future expenditure by its future actions, maybe by changing its method of operation.
Answer to Interactive question 4 Circumstance
Position under BAS 37
A contract of employment
Obligations still have to be performed by both parties, so it is an executory contract. As there is no indication that it is an onerous contract, it falls outside the scope of BAS 37
A legal claim being pursued by an entity and which it is confident of winning
There is a possible asset and as the claim is being pursued, it must arise from past events. So a contingent asset
A legal claim being pursued against an entity but which the entity is confident of winning
There is a possible obligation and as the claim is being pursued, it must arise from past events. So a contingent liability
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Position under BAS 37
A legal claim against an entity where the entity has accepted liability but the amount to be paid has not yet been agreed
Liability has been admitted so the obligation exists and arises from past events. A provision
Legislation enacted but coming into effect next year which will require substantial retraining of staff
The obligation arises from future events (the legislation comes into force in the future) and both provisions and contingent liabilities require the obligation to arise from past events. Outside the scope of BAS 37
The reinstatement of land once quarrying has ceased, where there is no legal obligation. The entity’s published policy in relation to environmental protection is that it will reinstate any environmental damage caused by its activities
There is a constructive obligation. A provision
The reinstatement of land once quarrying has ceased, where there is no legal obligation. The entity has no published policy in relation to environmental protection and this is the first quarrying venture it has entered into
There is no obligation. Outside the scope of BAS 37
Restructurings where the detailed plan has been developed, announced and agreed with employees’ representatives
There is a constructive obligation. A provision
Restructurings where the detailed plan has been developed and announced
There is a constructive obligation. A provision
Restructurings where the detailed plan has been developed and agreed by the board, but no announcement has been made
There is no obligation as the board could reverse its decision and not announce it. Outside the scope of BAS 37
Future reinstatement work under guarantees to be provided to customers in relation to future sales
The obligation arises from future sales. Outside the scope of BAS 37
Answer to Interactive question 5
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Circumstance
Application of BAS 37
A legal claim in relation to a past event is pursued against an entity over several years. The entity makes the following judgements about outflows of resources in settlement:
This claim may result in the existence of a liability
Year 1: there will be no outflow
Year 1: neither recognition nor disclosure
Year 2: an outflow is remote
Year 2: neither recognition nor disclosure
Year 3: an outflow is possible
Year 3: contingent liability disclosed
Year 4: an outflow is probable
Year 4: provision recognised
Year 5: an outflow is virtually certain
Year 5: provision retained
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A legal claim in relation to a past event is pursued by an entity over several years. The entity makes the following judgements about inflows of resources in settlement:
9
This claim may result in the existence of an asset
Year 1: there will be no inflow
Year 1: neither recognition nor disclosure
Year 2: an inflow is remote
Year 2: neither recognition nor disclosure
Year 3: an inflow is possible
Year 3: neither recognition nor disclosure
Year 4: an inflow is probable
Year 4: contingent asset disclosed
Year 5: an inflow is virtually certain
Year 5: asset recognised
Answer to Interactive question 6 Financial statements for:
20X5
20X6
20X7
20X5 final dividend
In the notes
Charged to statement of changes in equity
N/a
20X6 interim dividend
N/a
Charged to statement of changes in equity
N/a
20X6 final dividend
N/a
In the notes
Charged to statement of changes in equity
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chapter 10
Group accounts: basic principles Contents Introduction Examination context Topic List 1
Context for group accounts
2
The single entity concept
3
Control and ownership
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Identify the financial effects of group accounting in the context of BFRS Framework
Explain and demonstrate the concepts and principles surrounding the consolidation of financial statements including: –
The single entity concept
–
Substance over form
–
The distinction between control and ownership
Identify and describe the circumstances in which an entity is required to prepare and present consolidated financial statements
Identify the laws, regulations and accounting standards applicable to the consolidated financial statements of an entity
Identify whether an entity should be treated as a subsidiary of a parent entity
Illustrate the application of the concepts and principles of consolidation through the preparation of simple consolidated balance sheets and consolidated income statements
Tick off
Specific syllabus references for this chapter are: 1d,e,g, 2a,b,c
Practical significance In very simple terms a group is a collection of entities, where one, the parent, controls the activities of the others, its subsidiaries. In these circumstances the group is required to produce ‘consolidated’ financial statements. These present the position and results of the individual companies as if they were one entity. Due to the nature of the business structure of a group, group accounts tend to be produced by larger organisations, many of which are listed companies. This increases the sensitivity of group accounts and the scrutiny to which they are subjected. The process by which financial statements are consolidated is a relatively mechanical procedure which in itself is not particularly contentious. However, there are many decisions which need to be made prior to the consolidation being executed. These have historically involved the application of judgement and in some cases have allowed for deliberate manipulation of the financial information. Examples of the issues include:
Whether an investment meets the definition of a subsidiary and should be accounted for as such
Whether there are circumstances when it might be appropriate to exclude a subsidiary from the consolidation process
The value at which the net assets and results of the subsidiary should be incorporated into the group accounts
Two accounting standards aim to deal with these issues:
BFRS 3 Business Combinations BAS 27 Consolidated and Separate Financial Statements
Stop and think From the shareholders’ point of view what do you think the benefits are of consolidated financial statements?
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Working context If you work in a small or medium-sized firm you may have been involved in the preparation of consolidated financial statements. This is normally a largely mechanical procedure involving the combination of the individual financial statements of the members of the group. A consolidation package may be prepared which presents the information contained in the individual financial statements in such a way that combination is straightforward. This process is often computerised. If you work in a large audit firm the a significant number of audit assignments are likely to involve the audit of a group of companies. In simple terms the audit of a group involves two key steps:
The financial statements of each individual entity within the group will be audited. The financial statements of the parent entity are audited by the ‘principal’ auditors. Those of the subsidiaries will be audited by ‘other’ auditors.
The consolidated financial statements (which are an amalgamation of the individual sets of financial statements) will be audited by the principal auditor. The principal auditor is responsible for the overall audit opinion on the consolidated financial statements.
You may have been involved in either of these steps.
Syllabus links Group accounts is a key part of the Financial Accounting syllabus with a syllabus weighting of 35%. The Financial Accounting syllabus covers:
Consolidated balance sheet (Chapter 11) Consolidated statements of financial performance (Chapter 12) Associates (Chapter 13) Disposals (Chapter 14) Consolidated cash flow statement (Chapter 16).
More complex issues are covered in the Financial Reporting paper and at the Advanced Stage including joint ventures and overseas subsidiaries, and the analysis and interpretation of group financial statements. This chapter introduces some of the key principles of group accounting. The concept of ‘substance over form’ is an important principle which we have already introduced as follows:
Chapter 1 in the context of BFRS Framework Chapter 7 in relation to sale and repurchase agreements Chapter 8 in relation to finance leases
This chapter also introduces some of the basic techniques of the preparation of consolidated accounts. It is important that you have a sound understanding of these as they are developed in subsequent chapters.
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Examination context
Exam requirements Because of the 35% weighting, group accounts will be examined in both the short-form question and written test sections of the paper. There will be at least one full question on group accounts in the written test section and group accounting could also form part of a mixed topic question and/or be tested via short-form questions. Whilst the majority of the marks are likely to be for the preparation of consolidated financial statements you could be asked to explain the principles of consolidation and the way in which they apply to the consolidation process. You may also be asked to explain these issues in the context of BFRS Framework. In the examination, candidates may be required to:
Explain and demonstrate the concepts and principles surrounding the consolidation of financial statements including: – – –
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The single entity concept Substance over form The distinction between control and ownership
Prepare the consolidated balance sheet or income statement (or extracts) including the results of the parent entity and one or more subsidiaries.
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1 Context for group accounts Section overview
1.1
A group includes a parent and one or more subsidiaries. A subsidiary is an entity controlled by the parent. Forming a group is a means of organising a business. Group accounts ‘consolidate’ the results of the individual companies.
What is a group? In simple terms a group is created where one company, the parent (P) buys shares in another company, the subsidiary (S), such that the parent company controls the subsidiary. A group may include one or many subsidiaries. Shareholders
P Ltd
S1 Ltd
S2 Ltd
S3 Ltd
The shareholders (owners) of P Ltd may be individuals and/or institutions such as pension funds.
1.2
What is a subsidiary? Definition A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).
Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Control is presumed where the parent acquires more than 50% of the other entity’s voting rights, unless it can be demonstrated otherwise. In certain circumstances control may be achieved by other means. We will look at these circumstances in Chapter 15. For now we will assume that if a parent holds more than 50% of the ordinary shares in another entity this constitutes control. (Voting rights are normally attached to ordinary shares.)
1.3
Why form a group? A business may operate in several different markets with different characteristics. These different markets will present different issues for management to address in terms of operations and finance and so on. It would be possible for different activities to be carried out within a single limited company, where separate divisions could be established for each activity. The owners would then receive one set of accounts for that company, reflecting all its activities.
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Financial accounting Alternatively, each activity could be carried out within a separate company (the subsidiaries), each of which is controlled by the parent. There are a number of reasons why the business might be structured in this way:
1.4
Accountability of each group of managers can be made more precise, as they can be identified more easily with the activities of the subsidiary which employs them
Financing may be made easier, as lenders can see audited financial statements for the individual company for which they are providing finance
The assets of one subsidiary can be pledged as security for its borrowings, leaving the assets of other subsidiaries unpledged
Disposal of a business may be made easier
Why prepare group accounts? This is best illustrated by the following worked example.
Worked example: Why prepare group accounts? P Ltd (the parent) does not trade on its own account. Its only major asset is the ownership of all the shares in S Ltd (the subsidiary) and its only income is dividends from S Ltd. Income statements for the last 12 months (ignoring tax):
Revenue Cost of sales
P Ltd CUm – –
S Ltd CUm 100 (85)
Gross profit Other costs
– (1)
15 (40)
Loss from operations Dividends receivable
(1) 11
(25) –
Profits/(loss) for the period
10
(25)
P Ltd CUm 10 (6)
S Ltd CUm (25) (11)
Statement of changes in equity (extract) for the last 12 months:
Net profit/(loss) Dividends declared Retained profit/(loss) for the period Brought forward
4 1
(36) 45
Carried forward
5
9
Without provisions requiring the preparation of group accounts (which put together, i.e. 'consolidate', the activities of the parent and subsidiaries), the owners would only legally be entitled to receive the financial statements of the parent company as an individual company. In this case, they could well think that things were going well, because the dividend income for the period covers the expenses of P Ltd and provides for a CU6m dividend. They would not be aware that:
The CU11m dividend income all came from profits earned by S Ltd in previous years The trading activity controlled by P Ltd's management is currently loss-making
As will be demonstrated later in this chapter, the effect of consolidation is to produce a fair picture of P Ltd and S Ltd taken together, which is that on revenue of CU100m (S Ltd only), there is a loss for the year of CU26m (S Ltd's net loss of CU25m plus P Ltd's other costs of CU1m).
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10
Accounting principles The key issue underlying group accounts is therefore the need to reflect the economic substance (see Chapter 1) of the relationship between companies where one (a parent) has control over another (a subsidiary), which together comprise a group. Producing consolidated accounts that present the group as though it were a single economic entity reflects this economic substance. As we will see in section 3, the consolidated accounts also reflect another key principle (dealt with in BFRS Framework – see Chapter 1), that of the distinction between:
The resources controlled and the results they produce; and The ownership of those resources and results.
Point to note The terms ‘group accounts’, 'consolidated accounts’, ‘group financial statements’ and ‘consolidated financial statements’ can be thought of as meaning the same thing and are used interchangeably in the accounting world.
1.6
Composition of group accounts Group accounts comprise:
Consolidated balance sheet (CBS) Consolidated income statement (CIS) Consolidated statement of changes in equity (CSCE) Consolidated cash flow statement Notes to the accounts and comparative figures
Points to note
1.7
1
The consolidated balance sheet is presented in addition to the parent’s own individual balance sheet.
2
The consolidated income statement is usually presented instead of the parent’s own individual income statement.
3
The parent’s own balance sheet shows its investment in subsidiaries in non-current asset investments (usually at cost).
4
The parent’s own individual income statement shows the dividend income received and receivable from subsidiaries.
Summary of investments A parent may hold other investments apart from subsidiaries. These can be summarised as follows: Investment
Criterion
Treatment in group accounts
Subsidiary
Control (>50%)
Consolidation
Associate (See Chapter 13)
Significant influence (20%+)
Equity method
Investment
Asset held for accretion of wealth
Usually at cost
This chapter and Chapters 11-14 and 16 deal with the underlying principles and techniques involved in the preparation of group accounts. Chapter 15 deals with the relevant accounting standards which provide the regulatory backing for the principles illustrated. These include:
BFRS 3 Business Combinations BAS 27 Consolidated and Separate Financial Statements BAS 28 Investments in Associates
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2 The single entity concept Section overview
2.1
Group accounts are prepared on the basis that the parent and subsidiaries are a single entity.
This reflects the economic substance of the group arrangement.
The investment in a subsidiary’s shares shown in the parent’s own balance sheet is replaced in the consolidated balance sheet by the net assets of the subsidiary.
The dividend income from the subsidiary recorded in the parent’s own income statement is replaced in the consolidated income statement by the subsidiary's revenues and costs.
The effect of consolidation Group accounts consolidate the results and net assets of group members to present the group to the parent’s shareholders as a single economic entity. This reflects the economic substance and contrasts with the legal form, where each company is a separate legal person.
Parent Controls (>50%)
GROUP – Single Entity
Subsidiary The effect of consolidation can be illustrated by comparing buying an unincorporated business from its existing proprietor with buying a controlling interest in a company from its existing shareholders.
2.2
Buying an unincorporated business When a company invests in an unincorporated business, it pays cash to the proprietor and in exchange acquires legal title to all the assets and all the liabilities (i.e. the net assets) of the business.
Worked example: Buying an unincorporated business Draft balance sheets of Panther Ltd and Seal, a sole trader, at 31 December 20X1 are as follows:
Cash Sundry other assets Share capital/Capital Retained earnings Equity Liabilities
Panther Ltd CU 4,000 13,000 17,000
Seal CU – 6,000 6,000
2,000 12,000 14,000 3,000 17,000
4,000 – 4,000 2,000 6,000
Panther Ltd then buys the net assets and business of Seal on 31 December 20X1 for CU4,000 in cash. In 20X2 Panther Ltd itself made sales of CU6,000 with costs of CU4,500. Panther Ltd also carried on Seal's trade, which made sales of CU3,000 with costs of CU1,000. There are no other changes in net assets in 20X2. You are required to prepare the income statement of Panther Ltd for the year ended 31 December 20X2, reflecting the above information.
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Solution Panther Ltd Income statement for the year ended 31 December 20X2 CU 9,000 (5,500) 3,500
Revenue (6,000 + 3,000) Costs (4,500 + 1,000) Profit Balance sheets as at 31 December
Sundry other assets (20X1: 13,000 + 6,000) (20X2: P (13,000 + 6,000 – 4,500) + S (6,000 + 3,000 – 1,000)) Share capital (P only) Retained earnings (20X1: P only) (20X2: P (12,000 + 6,000 – 4,500) + S post-acq (3,000 – 1,000)) Equity Liabilities Total equity and liabilities
20X1 CU 19,000
20X2 CU 22,500
2,000 12,000
2,000 15,500
14,000 5,000 19,000
17,500 5,000 22,500
Points to note
2.3
1
Seal's net assets at the date of acquisition are incorporated into Panther Ltd's books and Panther Ltd's cash is reduced by the cost of the acquisition.
2
All Seal's trading in 20X2 (and the increase in net assets attributable to it) is recorded in Panther Ltd's books.
Buying a company When a company (A Ltd) invests in another company (B Ltd) the legal position is very different. Companies have their own legal identity separate from that of their owners. The investing company therefore pays cash to B Ltd’s shareholders to buy their shares. It does not acquire legal title to the net assets of B Ltd; this remains with B Ltd.
Worked example: Buying a company Draft balance sheets of Panther Ltd and Seal Ltd at 31 December 20X1 are as follows:
Cash Sundry other assets Share capital Retained earnings Equity Liabilities
Panther Ltd CU 4,000 13,000 17,000 2,000 12,000 14,000 3,000 17,000
Seal Ltd CU – 6,000 6,000 1,000 3,000 4,000 2,000 6,000
Panther Ltd then buys all the shares of Seal Ltd on 31 December 20X1 for CU4,000 in cash. In 20X2 Panther Ltd itself made sales of CU6,000 with costs of CU4,500. Seal Ltd continued to trade and made sales of CU3,000 with costs of CU1,000. There are no other changes to net assets in 20X2.
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Financial accounting You are required to: (a)
Prepare the balance sheets as at 31 December 20X1 and 20X2 for Panther Ltd, Seal Ltd and the Panther Ltd group, reflecting the above information.
(b) Prepare the income statements for the year ended 31 December 20X2 for Panther Ltd, Seal Ltd and the Panther Ltd group, reflecting the above information.
Solution (a)
Balance sheets as at
Investment in Seal Ltd Sundry other assets Share capital Retained earnings Equity Liabilities Total equity and liabilities
31 December 20X1 Panther Seal ConsoliLtd Ltd dated CU CU CU 4,000 – – 13,000 6,000 19,000 17,000 6,000 19,000
31 December 20X2 Panther Seal ConsoliLtd Ltd dated CU CU CU 4,000 – – 14,500 8,000 22,500 18,500 8,000 22,500
2,000 12,000 14,000 3,000 17,000
2,000 13,500 15,500 3,000 18,500
1,000 3,000 4,000 2,000 6,000
2,000 12,000 14,000 5,000 19,000
1,000 5,000 6,000 2,000 8,000
2,000 15,500 17,500 5,000 22,500
(b) Income statements for the year ended 31 December 20X2
Revenue Costs Profit
Panther Ltd CU 6,000 (4,500) 1,500
Seal Ltd CU 3,000 (1,000) 2,000
Consolidated CU 9,000 (5,500) 3,500
Points to note
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1
The investment in the shares of Seal Ltd in Panther Ltd's books has been replaced by the underlying net assets of Seal Ltd. The net assets of Seal Ltd at the date of acquisition (represented by its share capital and reserves at that date) are cancelled out against the investment in Panther Ltd's books. (Note that the situation where the net assets of a subsidiary at acquisition do not equal the cost of investment is covered in Chapter 11.)
2
As the net assets of Seal Ltd increase post-acquisition (an increase attributable to Panther Ltd's control of Seal Ltd) this increase has been reflected in net assets and retained earnings.
3
The profits of Seal Ltd are combined with those of Panther Ltd in the consolidated accounts from the date of acquisition, as post-acquisition profits of the subsidiary are earned under the parent's control. This is also reflected in the consolidated balance sheet, where group retained earnings include Seal Ltd's post-acquisition retained earnings.
4
Consolidated balance sheets and income statements have been produced.
5
These are the same as those produced when Seal Ltd was unincorporated. This is because Panther Ltd and Seal Ltd have been treated, not as two separate legal entities, but as a single entity.
6
The two companies can be viewed as a single entity because Panther Ltd (the parent) controls Seal Ltd, its subsidiary. Together the companies form a group.
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Summary So far we have looked at the following key points:
Group = parent (P) + subsidiary(ies) (S) Subsidiary(ies) = undertaking(s) under P’s control The objective of group accounts is to present a true and fair view of the group to P's shareholders Mechanics of consolidation: –
The investment in S shown in P’s own balance sheet is replaced in the consolidated balance sheet (CBS) by the line-by-line addition of S’s net assets to P’s to show the group’s resources
–
Dividend income in P’s own income statement is replaced in the consolidated income statement (CIS) by the line-by-line addition of S’s revenue and costs to P’s to show the group’s performance
–
The investment in S in P’s balance sheet is cancelled out against S’s share capital and reserves at acquisition
3 Control and ownership Section overview
3.1
Group accounts reflect both control and ownership.
Ownership of more than 50% of the ordinary shares in a subsidiary normally gives control to the parent.
The net assets and results not owned by the parent are reflected in the minority interest.
Control Usually a holding of over 50% of the ordinary shares in S will give P control of S. As we saw in Section 1, control means the ability to direct financial and operating policies of S with a view to gaining economic benefits from its activities. This is an extension of the basic concept of control, introduced in Chapter 1 in the context of the definition of assets. In an individual company, the assets are under the direct control of the company. In a group, the subsidiary’s assets are under indirect control through the parent’s control of the subsidiary.
3.2
Ownership Equity, as defined in Chapter 1, is the residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets. It is also described as the ownership interest. In an individual company’s accounts, there is only one ownership interest, i.e. that of the shareholders in that individual company, represented by the capital and reserves (which equals net assets). In a group, it is possible for the parent to have control of a subsidiary without owning 100% of it. That part of S’s net assets and results included in the consolidation which is not owned by P is owned by the minority interest (MI).
Worked example: Ownership P Ltd owns 75% of the ordinary shares of S Ltd. In this case, P Ltd controls 100% of S Ltd as it owns more than 50% of the ordinary shares. However, P Ltd only owns 75%. The MI owns the remaining 25%.
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Financial accounting In group accounts, the ownership interest of both P’s shareholders and the MI needs to be reflected, and the part of the group net assets in which P’s shareholders do not have the ownership interest needs to be distinguished from that in which they do. As both P’s shareholders and the MI own equity (in (P + S) and S, respectively), the sum of their respective ownership interests is described as equity in the consolidated balance sheet.
3.3
Reflecting control and ownership in group accounts When preparing the consolidated accounts, P’s control of S and the ownership interest of P and MI in S need to be reflected. Group accounts reflect both control and ownership. CBS
Consolidated balance sheet (CBS) Assets (P + S (100%) – intra-group items)
CU X
Control
X
Ownership Capital and reserves Share capital (P only)
X
Reserves (P + (P% × S post-acquisition)) Attributable to equity holders of P
X X
Minority interest (MI% × S's net assets) Equity Liabilities
Shows resources under group's control as a single entity; and
Shows ownership split between
X X X X
Parent co's share
Minority interest share
(Ownership: P% = P's share; MI% = MI share) Consolidated income statement (CIS) Revenue (P + S (100%) – intra-group items)
Profit after tax (PAT) (Control) Ownership Attributable to: Equity holders of P (ß) Minority interest (MI% × S's PAT)
CIS CU X
X
X X X
Shows revenue and expenses under group's control as a single entity and
Shows PAT split between
(Ownership: P% = P's share; MI% = MI share) Parent co's share
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Minority interest share
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3.4
10
Reserves The CBS includes P's reserves plus P’s share of S’s post acquisition reserves, as these reserves are generated under P’s control. S’s reserves at acquisition (pre-acquisition reserves), along with its share capital, are cancelled against P’s cost of investment in S. The same basic calculation is used for each reserve separately (e.g. revaluation reserve, retained earnings). The following interactive question brings together the points we have made so far.
Interactive question 1: Control and ownership
[Difficulty level: Easy]
The balance sheets of two companies at 31 December 20X7 are as follows: Austin Ltd CU
Reed Ltd CU
Current assets Total assets
80,000 12,000 92,000 58,000 150,000
8,000 – 8,000 13,000 21,000
Capital and reserves Called up share capital Retained earnings Equity Liabilities Total equity and liabilities
100,000 30,000 130,000 20,000 150,000
10,000 5,000 15,000 6,000 21,000
Non-current assets Property, plant and equipment Investments: Shares in Reed Ltd
Austin Ltd acquired 80% of Reed Ltd on 31 December 20X7. Requirement Prepare the consolidated balance sheet of Austin Ltd as at 31 December 20X7. Fill in the proforma below. Austin Ltd: Consolidated balance sheet as at 31 December 20X7 CU Non-current assets Property, plant and equipment Current assets Total assets Capital and reserves Called up share capital (Austin Ltd only) Retained earnings Attributable to equity holders of Austin Ltd Minority interest Equity Liabilities Total equity and liabilities Points to note 1
Austin Ltd controls the assets and liabilities of Reed Ltd. The CBS reflects this.
2
The equity section of the CBS reflects ownership (80% by Austin Ltd and 20% by the minority interest).
3
Austin Ltd's investment is cancelled against the net assets (i.e. assets less liabilities) of Reed Ltd at acquisition (12,000 – (80% (10,000 + 5,000))).
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The remaining net assets are owned by the minority interest.
5
Retained earnings are Austin Ltd's only, because Reed Ltd has, as yet, earned nothing under Austin Ltd's control. All of Reed Ltd's retained earnings are pre-acquisition.
See Answer at the end of this chapter.
Interactive question 2: Control and ownership
[Difficulty level: Easy]
Continuing from the facts in Interactive question 1, in the year ended 31 December 20X8 the two companies traded as follows.
Revenue Costs Profit
Austin Ltd CU 20,000 (15,000) 5,000
Reed Ltd CU 5,000 (3,000) 2,000
The balance sheets as at 31 December 20X8 are as follows. Austin Ltd CU Non-current assets Property, plant and equipment Investments: Shares in Reed Ltd
Reed Ltd CU
Current assets Total assets
82,000 12,000 94,000 81,000 175,000
9,000 – 9,000 20,000 29,000
Capital and reserves Called up share capital Retained earnings Equity Liabilities Total equity and liabilities
100,000 35,000 135,000 40,000 175,000
10,000 7,000 17,000 12,000 29,000
Requirement Prepare the consolidated income statement of Austin Ltd for the year ended 31 December 20X8 and the consolidated balance sheet at that date. Fill in the proforma below. Austin Ltd Consolidated income statement for the year ended 31 December 20X8 CU Revenue Costs Profit Attributable to: Equity holders of Austin Ltd Minority interest
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Consolidated balance sheet as at 31 December 20X8 CU Non-current assets Property, plant and equipment Current assets Total assets Capital and reserves Called up share capital Retained earnings Attributable to equity holders of Austin Ltd Minority interest Equity Liabilities Total equity and liabilities Points to note Consolidated income statement 1
Down to 'Profit after tax' this reflects control.
2
To reflect ownership, this profit is then allocated between the minority interest (in Reed Ltd) and the equity holders of Austin Ltd (Austin Ltd's profit plus that part of Reed Ltd's profit (80%) owned by Austin Ltd).
Consolidated balance sheet 1
The assets and liabilities in the balance sheet represent control.
2
The equity part of the CBS represents ownership. This time the retained earnings are Austin Ltd's plus that part of Reed Ltd's (80%) that has arisen since acquisition, i.e. post-acquisition earnings. The minority interest owns their share of Reed Ltd's equity at the balance sheet date.
See Answer at the end of this chapter.
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Summary and Self-test
Summary
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Self-test 1
Vaynor Ltd acquired 100,000 ordinary shares in Weeton Ltd and 40,000 ordinary shares in Yarlet Ltd some years ago. Extracts from the balance sheets of the three companies as on 30 September 20X7 were as follows. Vaynor Ltd CU'000 500
Weeton Ltd CU'000 100
Yarlet Ltd CU'000 50
Ordinary shares of CU1 each Retained earnings 90 40 70 At acquisition Weeton Ltd had retained losses of CU10,000 and Yarlet Ltd had retained earnings of CU30,000. The consolidated retained earnings of Vaynor Ltd on 30 September 20X7 were A B C D 2
CU162,000 CU170,000 CU172,000 CU180,000
Constable Ltd owns 10% of Turner Ltd which it treats as a trade investment. Constable Ltd also owns 60% of Whistler Ltd. Constable Ltd has held both of these shareholdings for more than one year. Revenue of each company for the year ended 30 June 20X2 was as follows. CUm Constable Ltd 400 Turner Ltd 200 Whistler Ltd 100 What figure should be shown as revenue in the consolidated income statement of Constable Ltd? A B C D
3
CU460m CU500m CU520m CU700m
ANDRESS LTD The income statement and balance sheet for the year 20X0 for Andress Ltd and Bacall Ltd are given below. Income statements for the year ended 31 December 20X0
Revenue Cost of sales Gross profit Expenses and tax Profit
Andress Ltd CU 10,000 (6,000) 4,000 (3,000) 1,000
Bacall Ltd CU 7,000 (2,000) 5,000 (2,000) 3,000
Andress Ltd CU
Bacall Ltd CU
Balance sheets as at 31 December 20X0
ASSETS Non-current assets Property, plant and equipment Investments (3,200 shares in Bacall Ltd at cost) Current assets Total assets
25,300 3,200 28,500 22,500 51,000
9,000 – 9,000 7,000 16,000
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EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings Equity Non-current liabilities Current liabilities Total equity and liabilities
Andress Ltd CU
Bacall Ltd CU
10,000 4,000 2,000 16,000 10,000 25,000 51,000
4,000 – 7,000 11,000 2,000 3,000 16,000
Andress Ltd has owned 80% of Bacall Ltd since incorporation. Requirement Prepare, for Andress Ltd, the consolidated income statement for the year ended 31 December 20X0 and the consolidated balance sheet at that date. 4
CRAWFORD LTD PART 1 The balance sheets and income statements for Crawford Ltd and Dietrich Ltd are given below. Balance sheets as at 30 June 20X0 Crawford Ltd CU ASSETS Non-current assets Property, plant and equipment Investments (2,000 CU1 shares in Dietrich Ltd at cost)
Dietrich Ltd CU
27,000 2,000
12,500 –
Current assets Total assets
29,000 25,000 54,000
12,500 12,000 24,500
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings Equity Non-current liabilities Current liabilities Total equity and liabilities
20,000 6,000 9,000 35,000 12,000 7,000 54,000
3,000 – 14,000 17,000 – 7,500 24,500
Crawford Ltd acquired its shares in Dietrich five years ago when Dietrich's earnings were nil. At the start of the current year retained earnings were CU2,000 and CU4,000 respectively. Income statement for the year ended 30 June 20X0
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit from operations Finance cost Profit before tax Tax Profit for the period
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Crawford Ltd CU 24,000 (9,000) 15,000 (2,300) (1,500) 11,200 (1,200) 10,000 (3,000) 7,000
Dietrich Ltd CU 30,000 (11,000) 19,000 (1,300) (2,700) 15,000 – 15,000 (5,000) 10,000
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10
Requirement (a)
Briefly explain the objectives of producing group accounts.
(3 marks)
(b) Briefly explain the following words/phrases. (i) Single entity (ii) Control (iii) Equity (c)
(6 marks)
Prepare, for Crawford Ltd, the consolidated income statement and the statement of changes in equity (in so far as it relates to retained earnings and the minority interest) for the year ended 30 June 20X0 and the consolidated balance sheet at that date. (12 marks) (21 marks)
Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Financial accounting
Technical reference For a comprehensive Technical reference section, covering all aspects of group accounts (except group cash flow statements) see Chapter 15.
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Answers to Self-test 1
C Vaynor Ltd Weeton Ltd ((40 + 10) × 100%) Yarlet Ltd ((70 – 30) × 80%)
2
B CUm 400 100 500
Constable Ltd Whistler Ltd 3
CU'000 90 50 32 172
ANDRESS LTD Consolidated income statement for the year ended 31 December 20X0 Revenue (10,000 + 7,000) Cost of sales (6,000 + 2,000) Gross profit Expenses and tax (3,000 + 2,000) Profit Attributable to Equity holders of Andress Ltd (ß) Minority interest (20% × 3,000)
CU 17,000 (8,000) 9,000 (5,000) 4,000 3,400 600 4,000
Consolidated balance sheet as at 31 December 20X0 CU ASSETS Non-current assets Property, plant and equipment (25,300 + 9,000) Current assets (22,500 + 7,000) Total assets
34,300 29,500 63,800
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings (2,000 + (80% × 7,000)) Attributable to equity holders of Andress Ltd Minority interest (20% × 11,000) Equity Non-current liabilities (10,000 + 2,000) Current liabilities (25,000 + 3,000) Total equity and liabilities
10,000 4,000 7,600 21,600 2,200 23,800 12,000 28,000 63,800
Point to note No goodwill arises on the acquisition of Bacall Ltd as the shares were acquired at nominal value (80% x 4,000 = CU3,200) on incorporation.
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Financial accounting 4
CRAWFORD LTD (a)
The objectives of producing group accounts Group accounts aim to reflect substance, i.e. if one company controls another, they effectively operate as a single economic entity. Therefore, the parent, or controlling company, should provide information about the economic activities of the group by preparing consolidated accounts. These will show the economic resources controlled by the group, the obligations of the group and the results achieved with those resources. The overall aim is to present the results and state of affairs of the group as if they were those of a single entity.
(b) Terms (i)
Single entity The single entity concept focuses on the existence of the group as an economic unit (as discussed above). This contrasts with legal form where each group company is actually a separate legal person.
(ii)
Control Control is the ability to direct the financial and operating activities of another company. In an individual company the assets are under the direct control of that company. However, where a company becomes a subsidiary, the assets are under indirect control of the parent via its control of the subsidiary. Control can be achieved in a number of ways, the most obvious being a holding of over 50% of the ordinary, i.e. vote-carrying, shares.
(iii) Equity Equity is defined in BFRS Framework (Elements) as the residual amount found by deducting all of the entity's liabilities from its assets. In an individual company those net assets are owned by one ownership interest – the company's shareholders. However, in consolidated accounts the consolidated net assets will include 100% of the subsidiary even though some of those net assets are not owned by the group. Therefore, the equity interest is split between (c)
The parent company's shareholders The minority shareholders in the subsidiary
Consolidated balance sheet as at 30 June 20X0 CU
382
ASSETS Non-current assets Property, plant and machinery (27,000 + 12,500) Current assets (25,000 + 12,000) Total assets
39,500 37,000 76,500
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings (9,000 + (2/3 × 14,000)) Attributable to equity holders of Crawford Ltd Minority interest (1/3 × 17,000) Equity Non-current liabilities Current liabilities (7,000 + 7,500) Total equity and liabilities
20,000 6,000 18,333 44,333 5,667 50,000 12,000 14,500 76,500
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Consolidated income statement for the year ended 30 June 20X0 CU 54,000 (20,000) 34,000 (3,600) (4,200) 26,200 (1,200) 25,000 (8,000) 17,000
Revenue (24,000 + 30,000) Cost of sales (9,000 + 11,000) Gross profit Distribution costs (2,300 + 1,300) Administrative expenses (1,500 + 2,700) Profit from operations Finance cost Profit before tax Income tax (3,000 + 5,000) Profit after tax Attributable to Equity holders of Crawford Ltd (ß) Minority interest (1/3 × 10,000)
13,667 3,333 17,000
Consolidated statement of changes in equity for the year ended 30 June 20X0 (extract)
Net profit for the period Balance b/f (2,000 + (2/3 × 4,000)) (1/3 × 4,000) Balance carried forward
Attributable to the equity holders of Crawford Ltd CU 13,667 4,667 18,334
Minority interest CU 3,333 1,333 4,666
Total CU 17,000 6,000 23,000
Point to note No goodwill arises on the acquisition of Dietrich Ltd as the shares were acquired at net asset value, i.e. their nominal value when retained earnings were CUnil.
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Answers to Interactive questions
Answer to Interactive question 1 Austin Ltd: Consolidated balance sheet as at 31 December 20X7 CU Non-current assets Property, plant and equipment (80,000 + 8,000) Current assets (58,000 + 13,000) Total assets
88,000 71,000 159,000
Capital and reserves Called up share capital (Austin Ltd only) Retained earnings (Austin Ltd only) Attributable to equity holders of Austin Ltd Minority interest (20% × Reed Ltd's 15,000) Equity Liabilities (20,000 + 6,000) Total equity and liabilities
100,000 30,000 130,000 3,000 133,000 26,000 159,000
(Retained earnings are Austin Ltd's only, because Reed Ltd has, as yet, earned nothing under Austin Ltd's control.)
Answer to Interactive question 2 Austin Ltd Consolidated income statement for the year ended 31 December 20X8 Revenue (20,000 + 5,000) Costs (15,000 + 3,000) Profit Attributable to: Equity holders of Austin Ltd (ß) Minority interest (20% × 2,000)
CU 25,000 (18,000) 7,000 6,600 400 7,000
Consolidated balance sheet as at 31 December 20X8 CU Non-current assets Property, plant and equipment (82,000 + 9,000) Current assets (81,000 + 20,000) Total assets Capital and reserves Called up share capital (Austin Ltd only) Retained earnings (35,000 + (80% × (7,000 – 5,000)) (i.e. Austin Ltd + its share of Reed Ltd post-acquisition) Attributable to equity holders of Austin Ltd Minority interest (20% × Reed Ltd's 17,000) Equity Liabilities (40,000 + 12,000) Total equity and liabilities
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91,000 101,000 192,000 100,000 36,600 136,600 3,400 140,000 52,000 192,000
chapter 11
Group accounts: consolidated balance sheet Contents Introduction Examination context Topic List 1
Context
2
Goodwill
3
Consolidated balance sheet workings
4
Mid-year acquisitions
5
Intra-group balances
6
Unrealised intra-group profit
7
Fair value adjustments
8
Other consolidation adjustments
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Identify the financial effects of group accounting in the context of BFRS Framework
Explain and demonstrate the concepts and principles surrounding the consolidation of financial statements including: – – –
Tick off
The single entity concept Substance over form The distinction between control and ownership
Calculate the amounts to be included in an entity’s consolidated balance sheet in respect of its new and continuing interests in subsidiaries in accordance with the international financial reporting framework
Prepare and present a consolidated balance sheet (or extracts therefrom) including adjustments for intra-group transactions and balances, goodwill, minority interests and fair values
Specific syllabus references for this chapter are: 1d,g, 3d,e.
Practical significance The consolidated balance sheet provides the owners of the group with important information over and above that which is available in the parent’s own balance sheet. The cost of the investment made in the subsidiary is replaced with the net assets controlled by the parent company. This application of substance over form provides a more realistic representation of what their investment is really worth as the balance sheets of the parent and subsidiary are produced as if they were a single entity. The single entity concept has more detailed implications for the preparation of the balance sheet which we will look at in this chapter.
Stop and think Why is information about the assets and liabilities of the subsidiary of more use to the shareholders than the cost of their investment?
Working context The preparation of the consolidated balance sheet involves the combination of the individual balance sheets of the group members. As we said in Chapter 10, this process is often computerised. However, detailed work will be needed on the consolidation adjustments. This might include for example, establishing fair values at the date of acquisition so that goodwill can be correctly calculated and the identification and elimination of intra-group balances. In this chapter, we will look at consolidation adjustments from the perspective of the consolidated balance sheet. Chapter 12 considers the same consolidation adjustments from the perspective of the consolidated income statement.
Syllabus links This chapter looks in detail at the preparation of the consolidated balance sheet and is fundamental to the Financial Accounting syllabus. It builds on the principles introduced in Chapter 10 and applies them to more complex situations. A detailed knowledge and understanding of this topic will also be assumed in Financial & Corporate Reporting at the Advanced Stage.
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Examination context
Exam requirements Each Financial Accounting paper is likely to feature either a written test question on the consolidated balance sheet or the consolidated income statement (or, more rarely, the consolidated cash flow statement). In a consolidated balance sheet question the majority of marks are likely to be awarded for the preparation of the balance sheet or extracts therefrom including a number of consolidation adjustments. Typically, the group structure will include more than one subsidiary or a subsidiary and an associate (associates are covered in Chapter 13). However, you may also be required to explain the consolidation process in relation to the principles of substance over form and/or the single entity concept. Short-form questions on this area, including goodwill calculations, fair value adjustments and the elimination of intra-group transactions and balances are also likely to appear regularly in the exam. In the examination, candidates may be required to:
Prepare a consolidated balance sheet (or extracts therefrom) including the results of the parent entity and one or more subsidiaries including adjustments for the following: – – – – – –
Acquisition of a subsidiary, including mid-year acquisitions Goodwill Intra-group items Unrealised profits Fair values Other consolidation adjustments
Explain the process of consolidating the balance sheet in the context of the single entity concept, substance over form and the distinction between control and ownership.
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Financial accounting
1 Context Section overview
1.1
This chapter considers the preparation of the consolidated balance sheet in more detail.
Consolidated balance sheet This chapter builds on the basic principles of group accounts (dealt with in Chapter 10) by applying them in more detail to the preparation of the consolidated balance sheet. In particular it covers the following issues:
Goodwill Intra-group balances Unrealised intra-group profit Standardised workings Fair value adjustments
All of the above relate to the application of the single entity concept and reflect the distinction between control and ownership.
2 Goodwill Section overview
2.1
Goodwill on acquisition is recognised in the consolidated balance sheet as an intangible non-current asset.
An annual impairment review is performed.
Any discount on acquisition is recognised in profit or loss in the period in which the acquisition is made.
Calculation In the previous chapter we said that the investment in the parent’s balance sheet is cancelled against the net assets of the subsidiary at acquisition.
Worked example: Cancellation Using the facts from Interactive question 1 in Chapter 10, we had the following information: Cost of 80% investment in Reed Ltd (in Austin Ltd’s balance sheet) Net assets of Reed Ltd at acquisition
CU 12,000 15,000
If you compare the cost of the investment (CU12,000) with the net assets acquired (80% CU15,000 = CU12,000) you can see that this cancels exactly. Austin Ltd has paid an amount which is equal to its share of the assets and liabilities of Reed Ltd at acquisition.
In practice this is not likely to be the case. The parent company will often pay more for the subsidiary than the net assets would suggest, in recognition that the subsidiary has attributes that are not reflected in its balance sheet. The extra amount paid by the parent is goodwill. (We looked at some of the factors which create goodwill in Chapter 6.)
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Interactive question 1: Goodwill
11
[Difficulty level: Easy]
P Ltd pays CU10,000 to buy 75% of the share capital of S Ltd. The balance sheet of S Ltd shows the following. CU 16,000
Assets Share capital Retained earnings Equity Liabilities
1,000 11,000 12,000 4,000 16,000
Requirement Calculate the goodwill arising on P Ltd's acquisition of S Ltd. Fill in the proforma below. CU Consideration Less: Share of net assets acquired Goodwill Point to note For the purposes of calculating goodwill net assets at acquisition are normally calculated as equity plus retained earnings (and other reserves, if any) at the acquisition date. See Answer at the end of this chapter.
2.2
Accounting treatment Goodwill arising on consolidation is recognised in the consolidated balance sheet as an intangible non-current asset. Goodwill is not amortised through the income statement in annual instalments. Instead an annual impairment review will be performed to ascertain whether part of its value has been lost as a result of factors external or internal to the business. (Impairment losses under BAS 36 Impairment of Assets were covered in Chapter 5.) If goodwill has suffered an impairment the loss will be recognised in the consolidated income statement. Retained earnings in the consolidated balance sheet will also be reduced. Point to note Retained earnings will be reduced by the impairment recognised to date, not just the fall in value which relates to the current year. This is because goodwill is a consolidation adjustment, i.e. it only affects the group accounts. The single entity accounts which are used as the basis of the consolidated balance sheet will not reflect any previous impairments in goodwill.
2.3
Acquisition at a discount In certain circumstances the parent entity may pay less to acquire a subsidiary than represented by its share of the subsidiary’s net assets. These circumstances might include the following:
The subsidiary has a poor reputation It suffers from inherent weaknesses not reflected in its assets and liabilities The parent company has negotiated a good deal
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Financial accounting This negative balance or ‘discount on acquisition’ is recognised in profit or loss in the period in which the acquisition is made.
3 Consolidated balance sheet workings Section overview
3.1
A number of standard workings should be used when answering consolidation questions.
Question technique As questions increase in complexity a formal pattern of workings is needed. Review the standard workings below, then attempt Interactive question 2 which puts these into practice. (1) Establish group structure P Ltd 80%
S Ltd (2) Set out net assets of S Ltd
Share capital Retained earnings
At BS date CU X X X
At acquisition CU X X X
Post acquisition CU X X
(3) Calculate goodwill Cost Less: Share of net assets at acquisition (see W2) Impairment to date Balance c/f
CU X (X) X (X) X
(4) Calculate minority interest (MI) Share of net assets at BS date (W2)
CU X
(5) Calculate retained earnings P Ltd (100%) S Ltd (share of post-acquisition retained earnings (see W2)) Goodwill impairment to date (see W3)
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CU X X (X) X
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Interactive question 2: Consolidated balance sheet workings [Difficulty level: Easy] The following are the summarised balance sheets of a group of companies as at 31 December 20X1. Non-current assets Property, plant and equipment Investments Shares in Viv Ltd (75%) Shares in Neil Ltd (2/3) Current assets Capital and reserves Called up share capital (CU1 ordinary) Retained earnings Equity Liabilities
Rik Ltd CU 100,000
Viv Ltd CU 40,000
Neil Ltd CU 10,000
25,000 10,000 45,000 180,000
40,000 80,000
25,000 35,000
50,000
20,000
10,000
100,000 150,000 30,000 180,000
40,000 60,000 20,000 80,000
15,000 25,000 10,000 35,000
Rik Ltd acquired its shares in Viv Ltd and Neil Ltd during the year, when their retained earnings were CU4,000 and CU1,000 respectively. At the end of 20X1 the goodwill impairment review revealed a loss of CU3,000 in relation to the acquisition of Viv Ltd. Requirement Prepare the consolidated balance sheet of Rik Ltd at 31 December 20X1. Fill in the proforma below. Rik Ltd: Consolidated balance sheet as at 31 December 20X1 CU Non-current assets Property, plant and equipment Intangibles (W3) Current assets Capital and reserves Called up share capital Retained earnings (W5) Attributable to equity holders of Rik Ltd Minority interest (W4) Equity Liabilities WORKINGS (1) Group structure Rik Ltd 75%
2/3
Viv Ltd
Neil Ltd
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Financial accounting (2) Net assets Balance sheet date CU
Acquisition CU
Post-acquisition CU
Balance sheet date CU
Acquisition CU
Post-acquisition CU
Viv Ltd Share capital Retained earnings
Neil Ltd Share capital Retained earnings (3) Goodwill Viv Ltd CU
Neil Ltd CU
Total CU
Cost of investment Less: Share of net assets acquired Viv Ltd Neil Ltd Goodwill Impairment to date Balance c/f (4) Minority interest Viv Ltd – Share of net assets at BS date Neil Ltd – Share of net assets at BS date
CU
(5) Retained earnings Rik Ltd Viv Ltd – Share of post-acquisition retained earnings Neil Ltd – Share of post-acquisition retained earnings Goodwill impairment to date (W3)
CU
See Answer at the end of this chapter.
4 Mid-year acquisitions Section overview
4.1
If a subsidiary is acquired mid-year, net assets at acquisition will need to be calculated. Unless told otherwise assume profits of the subsidiary accrue evenly over time.
Calculation A parent entity might not acquire a subsidiary at the start or end of a year. If the subsidiary is acquired midyear, it is necessary to calculate reserves, including retained earnings, at the date of acquisition.
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11
This is necessary in order to:
Calculate net assets at acquisition (which is required as part of the goodwill calculation) Calculate consolidated reserves, e.g. retained earnings
Points to note 1
It is usually assumed that a subsidiary’s profits accrue evenly over time.
2
However, unless otherwise stated, it should be assumed that any dividends paid by the subsidiary are out of post acquisition profits.
Interactive question 3: Mid-year acquisition
[Difficulty level: Easy]
P Ltd acquired 80% of S Ltd on 31 May 20X2 for CU20,000. S Ltd's retained earnings had stood at CU15,000 on 1 January 20X2. S Ltd's net assets at 31 December 20X2 were as follows. CU 1,000 15,600 16,600
Share capital Retained earnings Equity Requirements (a)
Produce the standard working for S Ltd's net assets (W2).
(b) Produce the standard working for goodwill on consolidation (W3). (c)
Calculate S Ltd's retained earnings which will be included in the consolidated retained earnings.
(d) Calculate S Ltd's (i) pre-acquisition and (ii) post acquisition earnings assuming that S Ltd has paid a dividend of CU2,000 on 30 June 20X2. Fill in the proforma below.
Solution (a)
Net assets (W2) Balance sheet date CU
Share capital Retained earnings
Acquisition CU
Post acquisition CU
(b) Goodwill (W3) CU Cost of investment Less: Share of net assets acquired (c)
Profit from S Ltd included in consolidated retained earnings CU Share of post-acquisition retained earnings of S Ltd
(d) (i)
Pre-acquisition earnings CU Retained earnings per balance sheet Add back: Dividend paid Total earnings before dividend Pre-acquisition earnings
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Financial accounting (ii)
Post-acquisition earnings CU
Total earnings before dividend = × 7/12 = Less: Dividend paid See Answer at the end of the chapter.
5 Intra-group balances Section overview
5.1
Group accounts reflect transactions with third parties only. The effect of transactions between group members are cancelled on consolidation. This is an application of the single entity concept.
The single entity concept The objective of group accounts is to present the group as a single entity. Hence the effects of transactions between group members need to be eliminated, as the group has not transacted with any third party. P Eliminate effect of transactions between group members Single entity concept S Reflecting the group as a single entity means that items which are assets in one group company and liabilities in another need to be cancelled out, otherwise group assets and liabilities will be overstated. Intra-group balances result from, for example,
5.2
One group company's loans, debentures or redeemable preference shares held by another group company
Intra-group trading
Dividends from a subsidiary to a parent
Loans, debentures and redeemable preference shares Cancel the credit balance in one company against the debit balance in the other before adding assets and liabilities line-by-line.
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5.3
11
Intra-group trading Outstanding amounts in respect of intra-group trading are usually recorded in the balance sheet in current accounts (= receivable or payable account for a fellow group company).
Step 1 Check that current accounts agree before cancelling. They may not agree if goods or cash are in-transit at year end.
Step 2 Make balances agree by adjusting for in-transit items in the receiving company’s books.
Step 3 Cancel intra-group balances.
Worked example: Intra-group trading Extracts from the balance sheets of Impala Ltd and its subsidiary Springbok Ltd at 31 March 20X4 are as follows. Impala Ltd CU 25,000 –
Receivable from Springbok Ltd Payable to Impala Ltd
Springbok Ltd CU – (20,000)
Springbok Ltd sent a cheque for CU5,000 to Impala Ltd on 28 March 20X4, which Impala Ltd did not receive until 2 April 20X4.
Solution Steps 1 and 2 Assume that Impala Ltd had received the cash from Springbok Ltd.
Receivable from Springbok Ltd (25-5) Cash and cash equivalents Payable to Impala Ltd
Impala Ltd CU 20,000 5,000 –
Springbok Ltd CU – – (20,000)
Step 3 Cancel inter-company balances on consolidation, leaving in the consolidated balance sheet Cash and cash equivalents
5.4
CU 5,000
Dividends As with intra-group balances such as loans, these must be cancelled out. The parent’s dividend receivable from the subsidiary needs to be cancelled against the subsidiary's declared dividend payable, leaving in the consolidated balance sheet that part of the subsidiary’s dividend payable to the minority. This will be in addition to the parent's own dividend payable.
Step 1 Check that all companies have recorded all declared dividends (you may be given draft balance sheets before such closing adjustments). Read the question carefully to establish this.
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Step 2 If declared dividends payable have not been recorded DR CR
Retained earnings (via retained earnings working for P, net assets working for S) Payables – declared dividends
CU X
CU X
with declared dividend payable
Step 3 If S has declared a dividend which has not yet been paid, P must record its share. If this has not been done, record P’s dividend receivable from S. DR CR
CU X
Receivables – dividends receivable P's retained earnings (via retained earnings working)
CU X
with share of dividend receivable from S
Step 4 Cancel the dividends receivable and dividends payable intra-group balances. This will leave that part of S’s dividend payable to the minority in addition to P’s own dividend payable.
Interactive question 4: Dividends
[Difficulty level: Intermediate]
Impala Ltd acquired 75% of Springbok Ltd when the retained earnings of Springbok Ltd stood at CU20,000. Balance sheets as at 31 March 20X4 are as follows.
Assets (including receivables) Share capital Retained earnings Equity Liabilities (including payables)
Impala Ltd CU 130,000
Springbok Ltd CU 90,000
40,000 60,000 100,000 30,000 130,000
25,000 45,000 70,000 20,000 90,000
At 31 March 20X4 the two companies have declared dividends, which have not been accounted for, as follows. CU 10,000 5,000
Impala Ltd Springbok Ltd Requirement
Show the adjustments necessary to record the above information and how it will be presented in the consolidated balance sheet and consolidation workings at 31 March 20X4. Fill in the proforma below. (a)
396
Recording of dividends in individual companies' books Impala Ltd's dividend Impala Ltd's books DR CR
CU
CU
Springbok Ltd's dividend Springbok Ltd's books DR CR
CU
CU
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(b) In consolidation workings (1) Group structure Impala Ltd 75%
Springbok Ltd (2) Net assets of Springbok Ltd Balance sheet date CU
CU
Acquisition CU
Postacquisition CU
Share capital Retained earnings Per question Dividends (4) Minority interest CU (5) Retained earnings CU Impala Ltd per question Dividends proposed Dividends from Springbok Ltd Share of Springbok Ltd post-acquisition (c)
In consolidated balance sheet CU Payables: Declared dividends payable Parent company Minority interest
Point to note There is no standard working 3 as goodwill is not required in this instance. See Answer at the end of this chapter.
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6 Unrealised intra-group profit Section overview
6.1
The consolidated balance sheet must show assets at their cost to the group.
Any profit arising on intra-group transactions must be eliminated from the group accounts until it is realised by a sale outside the group.
Introduction One of the implications of the application of the single entity concept is that group accounts should only reflect profits generated from transactions which have been undertaken with third parties, i.e. entities outside the group. Where intra-group activities give rise to profits these are unrealised as far as the group as a whole is concerned. These profits can result from:
Intra-group trading Intra-group transfers of non-current assets
Unrealised profits must be eliminated from the balance sheet on consolidation to prevent the overstatement of group profits.
6.2
Inventories As we have seen in section 5.3 any receivable/payable balances outstanding between group companies, resulting from trading transactions, are cancelled on consolidation. If these transactions have been undertaken at cost no further problem arises. However, each company in a group is a separate trading entity and may sell goods to another group member at a profit. If these goods remain in inventories at the year end this profit is unrealised from the group’s point of view. In the consolidated balance sheet, applying the single entity concept, inventories must be valued at the lower of cost and net realisable value to the group. Where goods transferred at a profit are still held at the year end the unrealised profit must be eliminated on consolidation. This is achieved by creating a provision for unrealised profit (PURP). The way in which this adjustment is made depends on whether the company making the sale is the parent or the subsidiary.
6.2.1
Parent sells goods to subsidiary The issues are best illustrated by an example.
Worked example: Intra-group profit (PS) Ant Ltd, a parent company, sells goods which cost CU1,600 to Bee Ltd for CU2,000. Ant Ltd owns 75% of the shares in Bee Ltd. Bee Ltd still hold the goods in inventories at the year end. In the single entity accounts of Ant Ltd the profit of CU400 will be recognised. In the single entity accounts of Bee Ltd the inventory will be valued at CU2,000. If we simply add together the figures for retained reserves and inventory as recorded in the individual balance sheets of Ant Ltd and Bee Ltd the resulting figures for consolidated reserves and consolidated inventory will each be overstated by CU400. A consolidation adjustment is therefore necessary as follows:
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DR Seller's (Ant Ltd's) retained earnings (i.e. adjust in retained earnings working) CR Inventories in consolidated balance sheet
CU 400
11
CU 400
Point to note In this example, as the parent was the seller the unrealised profit is all 'owned' by the shareholders of Ant Ltd. None is attributable to the minority interest.
6.2.2
Subsidiary sells goods to parent Where the subsidiary is the selling company the profit on the transfer will have been recorded in the subsidiary’s books.
Worked example: Intra-group profit (SP) Using the worked example above, if we now assume that Bee Ltd sold the goods to Ant Ltd the adjustment would be as follows: DR Seller's (Bee Ltd's) retained earnings (i.e. adjust in net assets working) CR Inventories in consolidated balance sheet
CU 400
CU 400
Points to note 1
2
The net assets of the subsidiary at the balance sheet date will be reduced by the amount of the unrealised profit. Any subsequent calculations based on this net assets figure will therefore be affected as follows:
The group share of the post-acquisition retained earnings of the subsidiary will be reduced, i.e. the group will bear its share of the adjustment.
The minority interest will be based on these revised net assets i.e. the minority interest will bear its share of the adjustment.
Inventories in the consolidated balance sheet are reduced by the full amount of the unrealised profit irrespective of whether the parent or the subsidiary is the selling company.
Interactive question 5: Unrealised profits
[Difficulty level: Intermediate]
P Ltd owns 80% of S Ltd, which it acquired when the retained earnings of S Ltd were CU20,000. No goodwill was acquired. Balance sheets at the end of the current accounting period are as follows.
Assets Share capital Retained earnings Equity Liabilities
P Ltd CU 170,000
S Ltd CU 115,000
30,000 100,000 130,000 40,000 170,000
10,000 65,000 75,000 40,000 115,000
During the current accounting period S Ltd sold goods to P Ltd for CU18,000, which gave S Ltd a profit of CU6,000. At the balance sheet date half of these goods were included in P Ltd's inventories.
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Financial accounting Requirement Show how the adjustment to eliminate unrealised profits will appear in the consolidation workings for P Ltd. Fill in the pro forma below. CU
CU
Acquisition
Postacquisition CU
DR CR WORKINGS (1) Group structure P Ltd 80%
S Ltd (2) S Ltd net assets Balance sheet date CU
CU
CU
Share capital Retained earnings Per question Less: PURP
(4) Minority interest CU Share of net assets (5) Retained earnings P Ltd Share of S Ltd
CU
See Answer at the end of this chapter.
6.3
Non-current asset transfers As well as trading with each other, group companies may wish to transfer non-current assets (NCA). If the asset is transferred at a profit two issues arise:
The selling company will have recorded a profit or loss on sale
The purchasing company will have recorded the asset at the amount paid to acquire it, and will use that amount as the basis for calculating depreciation.
On consolidation, the single entity concept applies. The consolidated balance sheet must show assets at their cost to the group, and any depreciation charged must be based on that cost. In other words, the group accounts should reflect the non-current asset as if the transfer had not been made.
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The adjustment in the consolidated balance sheet is calculated as follows: CU X (X) X
NBV of NCA at year end Less: NBV of NCA at year end if transfer had not been made Unrealised profit The adjustment is then made as: DR Selling company retained earnings CR NCA NBV in consolidated balance sheet
CU X
CU X
This treatment is consistent with that of inventories.
6.3.1
Parent sells non-current asset to subsidiary As with inventories the impact of the adjustment will depend on whether the parent company or the subsidiary makes the sale.
Interactive question 6: Non-current asset transfers
[Difficulty level: Easy]
P Ltd owns 80% of S Ltd. P Ltd transferred to S Ltd a non-current asset at a value of CU15,000 on 1 January 20X7. The original cost to P Ltd was CU20,000 and the accumulated depreciation at the date of transfer was CU8,000. Both companies depreciated such assets at 20% per year on cost to the company. Requirement Calculate the consolidated balance sheet adjustment at 31 December 20X7. Fill in the proforma below.
Solution Following the transfer the asset will be included at CU
Cost Less: Depreciation Had the transfer not been made, the asset would stand in the books at
CU
Cost Less: Accumulated depreciation at date of transfer Provision for current year Overall adjustment in CBS CU DR CR
CU
Seller's (P Ltd's) retained earnings (i.e. adjust in retained earnings working) Non-current assets
Point to note In this question, as the parent is the selling company, none of the adjustment is attributed to the minority interest. See Answer at the end of this chapter.
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6.3.2
Subsidiary sells non-current asset to parent Again a consolidation adjustment is made to reflect the situation that would have existed if the transfer had not been made. The amount of the adjustment is calculated as before (see section 6.3 above). The adjustment is then made as follows: DR Seller's (S Ltd) retained earnings (i.e. adjust in net assets working) CR NCA NBV in consolidated balance sheet
CU X
CU X
Points to note 1
As the subsidiary is the seller the adjustment to retained earnings will be made in the net assets working.
2
Any subsequent calculations based on this net assets figure will therefore be affected as follows:
The group share of the post-acquisition retained earnings of the subsidiary will be reduced i.e.. as for sale of inventories
The minority interest will be based on these revised net assets, i.e. as for sale of inventories.
7 Fair value adjustments Section overview
7.1
In calculating the goodwill acquired, the net assets of the subsidiary should be measured at their fair value.
A consolidation adjustment will be required for the difference between the book value and fair value of the net assets.
Calculation of goodwill In section 2 of this chapter we said that goodwill is calculated by comparing the cost of the investment in the subsidiary with the net assets acquired. Strictly speaking the net assets brought into this calculation should be at fair value, which may be different to book value. This raises two issues:
How do we measure the fair value of the subsidiary’s net assets? How are fair values reflected in the consolidation?
How we measure the fair value of a subsidiary’s net assets will be dealt with in detail in Chapter 15. This section looks at the way that the fair values are incorporated into the consolidated balance sheet.
7.2
Reflecting fair values The identifiable assets, liabilities and contingent liabilities of a subsidiary are brought into the consolidated financial statements at their fair value. Normally these fair values are not reflected in the single entity financial statements. Therefore the difference between fair values and book values is treated as a consolidation adjustment made only for the purposes of the consolidated financial statements. The increase (or decrease) in value is treated as a revaluation at acquisition and also applies in subsequent years if the asset is still held.
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Revaluation upwards
Create a revaluation reserve in the net assets working at acquisition and at the balance sheet date.
Revaluation downwards
Create a provision against retained earnings in the net assets working at acquisition and at the balance sheet date.
11
Points to note 1
Post-acquisition depreciation may need to be adjusted so that it is based on the revalued amount.
2
Goodwill in the subsidiary’s individual balance sheet is not part of the identifiable assets and liabilities acquired. If the subsidiary’s own balance sheet at acquisition includes goodwill, this must not be consolidated. In the net asset working retained earnings at acquisition and at the balance sheet date should be reduced by the amount of the goodwill.
Interactive question 7: Fair value adjustments
[Difficulty level: Easy]
P Ltd acquires 60% of S Ltd on 31 December 20X4 for CU80,000. The balance sheet of S Ltd at this date is as follows. Freehold land (fair value CU30,000) Goodwill arising on the acquisition of a sole trader Sundry assets (book value = fair value) Share capital Retained earnings Equity Liabilities
CU 20,000 5,000 130,000 155,000 20,000 85,000 105,000 50,000 155,000
Requirement Calculate the goodwill arising on the acquisition of S Ltd. Fill in the proforma below. (1) Group structure P Ltd 60%
S Ltd (2) Net assets of S Ltd BS date = Acquisition date CU CU Share capital Revaluation Retained earnings Per question Less: Goodwill
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Financial accounting (3) Goodwill Cost of investment Less: Share of FV of net assets acquired
CU
Point to note In the asset section of the balance sheet the freehold land will be consolidated at CU30,000. The goodwill in the subsidiary's balance sheet of CU5,000 will not be recognised as an intangible asset in the consolidated balance sheet. See Answer at the end of this chapter.
8 Other consolidation adjustments Section overview
8.1
If a subsidiary has reserves other than retained earnings, the group share of post-acquisition reserves should be consolidated.
The balances of the subsidiary should be adjusted to reflect the accounting policies of the parent company prior to consolidation.
Other reserves in a subsidiary As we have already mentioned, a subsidiary may have other reserves apart from retained earnings in its balance sheet, e.g. a revaluation reserve. If this is the case, such reserves should be treated in exactly the same way as retained earnings.
Other reserves at acquisition form part of the net assets at acquisition, i.e. they should be recorded in the net assets working at acquisition.
The group share of any post acquisition movement in other reserves should be recognised in the consolidated balance sheet.
Points to note
8.2
1
A separate working should be used for each reserve; do not mix retained earnings with other reserves as the other reserves may include amounts which are not distributable by way of dividend.
2
If a subsidiary is loss-making or has any other negative reserves the group will consolidate its share of the post-acquisition losses/negative reserves.
Accounting policy alignments On consolidation uniform accounting policies must be applied for all amounts. This is another consequence of the single entity concept. If the parent company and subsidiary have different accounting policies the balances in the subsidiary’s financial statements must be adjusted to reflect the accounting policies of the parent company. Point to note These adjustments are made in the net assets working.
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Interactive question 8: Accounting policy alignments
11
[Difficulty level: Easy]
William Ltd has been 85% owned by Mary Ltd for some years. On 1 January 20X4 William Ltd acquired an item of plant for CU40,000. William Ltd depreciates this item of plant at 15% on a reducing balance basis, while Mary Ltd's policy for this class of plant is 10% per annum on a straight-line basis. Requirement Set out the adjustment required in the preparation of the consolidated balance sheet at 31 December 20X5. Fill in the pro forma below. Following the transfer the asset will be included at: CU Carrying amount of plant in CBS Carrying amount in William Ltd's BS Increase in carrying amount CU DR CR CR
CU
Non-current assets Consolidated retained earnings Minority interest
See Answer at the end of this chapter.
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Summary and Self-test
Summary
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Self-test 1
The summarised balance sheets of Peep Ltd and Pitti Ltd at 31 December 20X6 are as follows.
Net assets Share capital (CU1 shares) Retained earnings
Peep Ltd CU 300,000
Pitti Ltd CU 160,000
100,000 200,000 300,000
100,000 60,000 160,000
On 31 December 20X6 Yum Ltd purchased for cash 90% of Peep Ltd’s shares for CU360,000 and 75% of Pitti Ltd’s shares for CU100,000. The carrying amounts of the assets in both companies are considered to be fair values. In the consolidated balance sheet at 31 December 20X6, goodwill and discount on acquisition will be shown as Goodwill A B C D 2
CUnil CU60,000 CU90,000 CU90,000
Discount on acquisition CUnil CU60,000 Nil CU20,000
The summarised balance sheets of Black Ltd and Red Ltd at 31 December 20X6 were as follows. Black Ltd Red Ltd CU'000 CU'000 Total assets 60,000 29,000 Share capital Retained earnings Equity Current liabilities Total equity and liabilities
20,000 24,000 44,000 16,000 60,000
10,000 4,000 14,000 15,000 29,000
On 1 January 20X7 Black Ltd bought all the share capital of Red Ltd for CU17,000,000 in cash. The carrying amount of Red Ltd’s assets are considered to be fair values. The amount of retained earnings to be included in the consolidated balance sheet as at 1 January 20X7 are A B C D 3
CU21,000,000 CU24,000,000 CU25,000,000 CU28,000,000
Milton Ltd owns all the share capital of Keynes Ltd. The following information is extracted from the individual company balance sheets as on 31 December 20X1. Milton Ltd Keynes Ltd CU CU Current assets 500,000 200,000 Current liabilities 220,000 90,000 Included in Milton Ltd’s purchase ledger is a balance in respect of Keynes Ltd of CU20,000. The balance on Milton Ltd’s account in the sales ledger of Keynes Ltd is CU22,000. The difference between those figures is accounted for by cash in transit. If there are no other intra-group balances, what is the amount of current assets less current liabilities in the consolidated balance sheet of Milton Ltd and its subsidiary? A B C D
CU368,000 CU370,000 CU388,000 CU390,000
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Financial accounting 4
Laker Ltd owns 80% of the ordinary shares of Hammond Ltd. The following amounts have been extracted from their draft financial statements at 31 December 20X0.
Current liabilities Trade payables Amount owed to subsidiary Income tax Amounts owed to trade investments Other payables
Laker Ltd CU
Hammond Ltd CU
5,200 500 100 150 50 6,000
7,100 – 150 200 70 7,520
Hammond Ltd shows an amount receivable from Laker Ltd of CU620 and the difference is due to cash in transit. What is the total carrying amount of current liabilities in the consolidated balance sheet of Laker Ltd? A B C D 5
CU11,900 CU12,400 CU13,020 CU13,170
Austen Ltd has owned 100% of Kipling Ltd and 60% of Dickens Ltd for many years. At 31 December 20X5 the trade receivables and trade payables shown in the individual company balance sheets were as follows.
Trade receivables Trade payables
Austen Ltd CU'000 50 30
Trade payables are made up as follows. Amounts owing to Austen Kipling Dickens Other suppliers
– 2 3 25 30
Kipling Ltd CU'000 30 15
Dickens Ltd CU'000 40 20
– – – 15 15
– 4 – 16 20
The intra-group accounts agreed after taking into account the following. (1) An invoice for CU3,000 posted by Kipling Ltd on 31 December 20X5 was not received by Austen Ltd until 2 January 20X6 (2) A cheque for CU2,000 posted by Austen Ltd on 30 December 20X5 was not received by Dickens Ltd until 4 January 20X6. What amount should be shown as trade receivables in the consolidated balance sheet of Austen Ltd? A B C D
408
CU56,000 CU106,000 CU109,000 CU111,000
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6
11
The following is the draft balance sheet information of Ho Ltd and Su Ltd, as on 30 September 20X2.
Ordinary CU1 shares Retained earnings Trade payables Other payables Total assets
Ho Ltd CU'000 2,600 750 350 – 3,700
Su Ltd CU'000 1,000 700 900 100 2,700
3,700
2,700
Ho Ltd acquired 60% of the share capital of Su Ltd several years ago when Su Ltd’s retained earnings were CU300,000. Su Ltd has not yet accounted for the estimated audit fee for the year ended 30 September 20X2 of CU40,000. The consolidated retained earnings on 30 September 20X2 are A CU950,000 B CU966,000 C CU990,000 D CU1,450,000 7
Tottenham Ltd owns 95% of Chelsea Ltd and 97.5% of Leyton Ltd. Dividends for the year ended 31 December 20X8 are as follows. Interim paid CU 10,000 – –
Tottenham Ltd Chelsea Ltd Leyton Ltd
Final proposed CU 40,000 (declared 15 December 20X8) 10,000 (declared 15 December 20X8) 18,000 (declared 14 February 20X9)
What is the total amount shown for dividends payable appearing in the consolidated balance sheet as at 31 December 20X8? A B C D 8
CU40,500 CU41,150 CU68,000 CU50,950
Bass Ltd acquired its 70% holding in Miller Ltd many years ago. At 31 December 20X7 Miller Ltd had inventory with a carrying amount of CU15,000 purchased from Bass Ltd at cost plus 25%. The effect on consolidated retained earnings and minority interests as stated in the consolidated balance sheet is A B C D
9
No effect on minority interest No effect on minority interest Reduce minority interest by CU250 Reduce minority interest by CU750
Reduce group retained earnings by CU1,000 Reduce group retained earnings by CU3,000 Reduce group retained earnings by CU750 Reduce group retained earnings by CU2,250
Oxford Ltd owns 100% of the issued share capital of Cambridge Ltd, and sells goods to its subsidiary at a profit margin of 20%. At the year end their balance sheets showed inventories of Oxford Ltd Cambridge Ltd
CU290,000 CU160,000
The inventory of Cambridge Ltd included CU40,000 of goods supplied by Oxford Ltd and there was inventory in transit from Oxford to Cambridge amounting to a further CU20,000. At what amount should inventory be carried in the consolidated balance sheet? A B C D
CU438,000 CU442,000 CU458,000 CU462,000
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Rugby Ltd has a 75% subsidiary, Stafford Ltd, and is preparing its consolidated balance sheet as on 31 December 20X6. The carrying amount of property, plant and equipment in the two companies at that date is as follows. Rugby Ltd Stafford Ltd
CU260,000 CU80,000
On 1 January 20X6 Stafford Ltd had transferred some equipment to Rugby Ltd for CU40,000. At the date of transfer the equipment, which had cost CU42,000, had a carrying amount of CU30,000 and a remaining useful life of five years. The group accounting policy is to depreciate equipment on a straight-line basis down to a nil residual value. It is also group policy not to revalue equipment. What is the figure that will be disclosed as the carrying amount of property, plant and equipment in the consolidated balance sheet of Rugby Ltd as on 31 December 20X6? A B C D 11
CU340,000 CU332,000 CU330,000 CU312,000
Makepeace Ltd owns 70% of Dempsey Ltd. Draft balance sheets of the two companies at 31 December 20X7 show the following.
Property, plant and equipment at cost Accumulated depreciation Carrying amount
Makepeace Ltd CU 101,000 (25,000) 76,000
Dempsey Ltd CU 75,000 (30,000) 45,000
On 1 January 20X7 Makepeace Ltd sold to Dempsey Ltd a machine which had originally cost CU24,000 and was 75% depreciated. The profit on sale was CU4,000. Both companies depreciate at 25% per annum on cost. What is the carrying amount of property, plant and equipment for inclusion in the consolidated balance sheet at 31 December 20X7? A B C D 12
CU117,000 CU123,500 CU111,000 CU113,500
Lynton Ltd acquired 75% of the 200,000 CU1 ordinary shares and 50% of the 100,000 CU1 redeemable preference shares of Pinner Ltd when its retained earnings were CU24,000. The retained earnings of Lynton Ltd and Pinner Ltd are now CU500,000 and CU60,000 respectively. What are the figures for minority interest and consolidated retained earnings in the consolidated balance sheet? A B C D
13
Minority interest CU65,000 CU65,000 CU115,000 CU115,000
Consolidated retained earnings CU527,000 CU545,000 CU527,000 CU545,000
Wolf Ltd acquired 80,000 CU1 ordinary shares in Fox Ltd on 1 April 20X5 at a cost of CU77,000. Fox Ltd’s retained earnings at that date were CU50,000 and its issued ordinary share capital was CU100,000. What is the amount of the discount on acquisition arising on the acquisition? A B C D
410
CU35,000 CU43,000 CU63,000 CU73,000
© The Institute of Chartered Accountants in England and Wales, March 2009
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11
Sansom Ltd has two subsidiaries, Mabbutt Ltd and Waddle Ltd. It purchased 10,000 CU1 shares in Mabbutt Ltd on 1 January 20X1 for CU35,000 when the retained earnings of Mabbutt Ltd stood at CU21,000. It purchased 15,000 CU1 shares in Waddle Ltd for CU20,000 on 31 December 20X1 when the retained earnings of Waddle Ltd stood at CU16,000. The issued share capital of the two subsidiaries is as follows. Mabbutt Ltd Waddle Ltd
CU15,000 CU20,000
By the end of 20X4 goodwill impairment losses totalled CU4,400. What is the carrying amount of goodwill in the consolidated balance sheet at 31 December 20X4? A B C D 15
CU11,000 CU10,800 CU6,600 CUnil
Tring Ltd acquired 60% of the share capital of Hessle Ltd on 31 March 20X6. The share capital and retained earnings of Hessle Ltd as on 31 December 20X6 were as follows. CU 400,000 120,000 60,000 580,000
Ordinary 25p shares Retained earnings at 1 January 20X6 Net profit for 20X6 The profits of Hessle Ltd have accrued evenly throughout 20X6. The discount arising on acquisition was CU3,000.
What is the cost of the investment in Hessle Ltd in the balance sheet of Tring Ltd as on 31 December 20X6? A B C D 16
CU318,000 CU324,000 CU336,000 CU342,000
Hill Ltd owns 60% of the ordinary share capital of Down Ltd and all of its 10% borrowings. The following transactions have been recorded by Down Ltd as at 31 December 20X3. Half year’s interest due Interim dividend paid
CU15,000 CU50,000
Hill Ltd has not yet accounted for the interest receivable from Down Ltd. In preparing the consolidated balance sheet for Hill Ltd and its subsidiary at 31 December 20X3, which of the following adjustments is required in respect of intra-group dividends and debenture interest? Debit Current liabilities CU45,000
Credit Current assets CU15,000 Retained earnings CU30,000
B
Current liabilities CU45,000
Current assets CU30,000 Retained earnings CU15,000
C
Current liabilities CU15,000
Retained earnings CU15,000
A
D
Current liabilities CU30,000
Current assets CU30,000
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 17
Heron Ltd owns 80% of Sparrow Ltd and 75% of Swift Ltd. Sparrow Ltd has made a non-current loan of CU500,000 to Swift Ltd. In the financial statements of Heron Ltd group, the loan will appear
18
A
As a non-current asset in the balance sheet of the parent company and nowhere in the consolidated balance sheet
B
As a non-current asset in the balance sheet of the parent company and as a non-current asset in the consolidated balance sheet
C
Nowhere in the balance sheet of the parent company but as a non-current asset in the consolidated balance sheet
D
Nowhere in the balance sheet of the parent company and nowhere in the consolidated balance sheet
Nasty Ltd is a wholly-owned subsidiary of Ugly Ltd. Inventory in their individual balance sheets at the year end is shown as follows. Ugly Ltd Nasty Ltd
CU40,000 CU20,000
Sales by Ugly Ltd to Nasty Ltd during the year were invoiced at CU15,000, which included a profit to Ugly Ltd of 25% on cost. Two thirds of these goods were in inventory at the year end. At what amount should inventory appear in the consolidated balance sheet? A B C D 19
CU50,000 CU57,000 CU57,500 CU58,000
On 31 December 20X3 Easby Ltd purchased 80% of the share capital of Haddon Ltd for CU226,000 when the retained earnings of the latter stood at CU60,000. The fair value of Haddon Ltd’s property was CU70,000 more than the carrying amount, but this revaluation had not been incorporated in Haddon Ltd’s books. The goodwill arising on consolidation was CU42,000. What is the carrying amount for minority interest in the consolidated balance sheet of Easby Ltd as at 31 December 20X3? A B C D
20
CU36,800 CU46,000 CU63,500 CU67,000
Fallin Ltd acquired 100% of the share capital of Gaydon Ltd for CU150,000 on 1 May 20X6. Equity at 30 April was as follows.
Ordinary share capital Revaluation reserve Retained earnings
Fallin Ltd 20X7 CU'000 100 – 340 440
Gaydon Ltd 20X7 20X6 CU'000 CU'000 50 50 25 15 135 25 210 90
An impairment review at 30 April 20X7 revealed that goodwill arising on the acquisition of Gaydon Ltd had become impaired by CU6,000 in the year. What were the consolidated capital and reserves of the Fallin Ltd group on 30 April 20X7? A B C D
412
CU500,000 CU548,000 CU554,000 CU560,000
© The Institute of Chartered Accountants in England and Wales, March 2009
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11
Wilsons Ltd purchased 70% of Watneys Ltd for CU20,000 on 30 June 20X2. The balance sheets of Watneys Ltd are as follows. 30 September 20X2 20X1 CU CU 1,000 1,000 2,000 2,000 21,000 12,000 24,000 15,000
Ordinary share capital Share premium Retained earnings You ascertain that there have been no issues of shares since the above purchase. What is the goodwill acquired in the business combination? A B C D
CU4,775 CU3,200 CU9,500 CU4,600
Data for questions 22 to 26 With reference to the information below, answer questions 22 to 26 with respect to the consolidated financial statements of VW Ltd. Summarised balance sheets as at 30 September 20X7 ASSETS Property, plant and equipment Investments 100,000 shares in Polo Ltd 40,000 shares in Golf Ltd Current assets Inventories Trade receivables Cash EQUITY AND LIABILITIES Capital reserves Ordinary shares of CU1 each Retained earnings Equity Current liabilities
VW Ltd CU'000 200
Polo Ltd CU'000 40
Golf Ltd CU'000 30
150 70
– –
– –
150 250 50 870
90 40 20 190
80 20 10 140
500 90 590 280 870
100 40 140 50 190
50 70 120 20 140
Notes (1) VW Ltd acquired its shares in Polo Ltd on 1 October 20X5 when Polo Ltd’s retained earnings were CU30,000. (2) VW Ltd acquired its shares in Golf Ltd on 30 September 20X6. Golf Ltd’s net profit for the year ended 30 September 20X7 was CU30,000. (3) Included in Polo Ltd’s inventory at 30 September 20X7 was CU15,000 of goods purchased from VW Ltd during the year. VW Ltd invoiced Polo Ltd at cost plus 50%. (4) During the year ended 30 September 20X7 Polo Ltd sold goods costing CU50,000 to Golf Ltd for CU70,000. Golf Ltd still had half of these goods in inventory at 30 September 20X7. (5) The following intra-group balances are reflected in the above balance sheet of VW Ltd at 30 September 20X7. CU20,000 receivable from Polo Ltd CU10,000 payable to Golf Ltd
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 22
Minority interest will be carried at A B C D
23
Inventories will be carried at A B C D
24
CU22,000 CU20,000 CU18,000 CUnil
The consolidated retained earnings will be presented at A B C D
27
CU295,000 CU290,000 CU285,000 CU280,000
What is the amount of goodwill to be included under intangible assets? A B C D
26
CU320,000 CU305,000 CU302,500 CU295,000
Trade receivables will be carried at A B C D
25
CU52,000 CU24,000 CU18,000 CU10,000
CU114,000 CU113,000 CU111,000 CU109,000
CRAWFORD LTD PART II Following on from the facts in Chapter 10 Self-test question 4 (Crawford Ltd part 1), assume that Crawford Ltd paid CU2,500 (not CU2,000) for the 2,000 shares in Dietrich Ltd and that Crawford Ltd’s property, plant and equipment were CU26,500 (not CU27,000), all other information remaining the same. An impairment review at 30 June 20X0 revealed that goodwill in respect of Dietrich Ltd had fallen in value over the year by CU40. By 1 July 20W9 goodwill had already been written down by CU210. Requirement Prepare the consolidated balance sheet of Crawford Ltd as at 30 June 20X0.
28
(7 marks)
DUBLIN LTD The following are the summarised balance sheets of a group of companies as at 31 December 20X9. Dublin Ltd CU ASSETS Non-current assets Property, plant and equipment Investments: 40,000 CU1 shares in Shannon 30,000 CU1 shares in Belfast Current assets Total assets
414
90,000 50,000 45,000 185,000 215,000 400,000
© The Institute of Chartered Accountants in England and Wales, March 2009
Shannon Ltd CU
60,000 – – 60,000 50,000 110,000
Belfast Ltd CU
50,000 – – 50,000 30,000 80,000
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Revaluation reserve Retained earnings Equity Current liabilities Total equity and liabilities
190,000 – 60,000 250,000 150,000 400,000
50,000 10,000 30,000 90,000 20,000 110,000
11
40,000 – 16,000 56,000 24,000 80,000
Dublin Ltd purchased its shares in Shannon Ltd five years ago when there were retained earnings of CU20,000 and a balance on its revaluation reserve of CU10,000. Belfast Ltd had retained earnings of CU16,000 when Dublin Ltd acquired its shares on 1 January 20X9. At the end of 20X9 the goodwill impairment review revealed a loss of CU300 in relation to the goodwill acquired in the business combination with Belfast Ltd. Requirement Prepare the consolidated balance sheet as at 31 December 20X9 of Dublin Ltd and its subsidiaries. (12 marks) 29
EDINBURGH LTD The following are the draft balance sheets of Edinburgh Ltd and its subsidiary Glasgow Ltd as at 31 December 20X5. Edinburgh Ltd Glasgow Ltd CU CU CU CU ASSETS Non-current assets Property, plant and equipment 147,000 82,000 Investments 80,000 – 227,000 82,000 Current assets Inventories 73,200 35,200 Trade and other receivables 82,100 46,900 Glasgow Ltd current account 14,700 – Cash and cash equivalents 8,000 25,150 178,000 107,250 Total assets 405,000 189,250 EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (CU1 shares) Share premium account Revaluation reserve Retained earnings Equity Non-current liabilities Borrowings Current liabilities Trade and other payables Edinburgh Ltd current account Total equity and liabilities
250,000 – – 32,000 282,000
50,000 6,250 15,000 40,000 111,250 20,000
123,000 –
50,000 8,000 123,000 405,000
58,000 189,250
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting Points to note 1
Edinburgh Ltd acquired 40,000 shares in Glasgow Ltd on 1 January 20X5 for a cost of CU63,000 when the balance on Glasgow Ltd’s reserves were as follows. CU 6,250 – 10,000
Share premium account Revaluation reserve Retained earnings
Edinburgh Ltd also acquired CU12,000 of Glasgow Ltd’s non-current borrowings at par on the same date. 2
The current account difference is due to cash in transit.
3
At the end of 20X5 the goodwill impairment review revealed a loss of CU1,250 in relation to the goodwill acquired in the business combination with Glasgow Ltd. Requirement Prepare the consolidated balance sheet of Edinburgh Ltd at 31 December 20X5.
30
(15 marks)
CLOSE LTD The summarised balance sheets of Close Ltd and Steele Ltd as at 31 December 20X9 were as follows. Close Ltd CU CU ASSETS Non-current assets Property, plant and equipment Investments Current assets Inventories Trade and other receivables Investments Cash and cash equivalents Current account – Close Ltd
80,000 84,000 164,000 18,000 62,700 – 10,000 –
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (CU1 shares) Share premium account Revaluation reserve Retained earnings Equity Current liabilities Trade and other payables Current account – Steel Ltd
Steele Ltd CU
58,200 – 58,200 12,000 21,100 2,500 3,000 3,200
90,700 254,700
41,800 100,000
120,000 18,000 23,000 56,000 217,000
60,000 – 16,000 13,000 89,000
35,000 2,700
Total equity and liabilities
CU
11,000 – 37,700 254,700
11,000 100,000
The following information is relevant. (1) On 1 January 20X7 Close Ltd acquired 48,000 shares in Steele Ltd for CU84,000 cash when the retained earnings of Steele Ltd were CU8,000 and the balance on the revaluation reserve was CU16,000. (2) The inventories of Close Ltd include CU4,000 of goods from Steele Ltd invoiced to Close Ltd at cost plus 25%. (3) A cheque for CU500 from Close Ltd to Steele Ltd, sent before 31 December 20X9, was not received by the latter company until January 20Y0.
416
© The Institute of Chartered Accountants in England and Wales, March 2009
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11
(4) An impairment review at 31 December 20X9 revealed that goodwill in respect of Steele Ltd had fallen in value over the year by CU500. By 1 January 20X9 this goodwill had already suffered impairments totalling CU1,700. Requirements (a)
Prepare the consolidated balance sheet of Close Ltd and its subsidiary Steele Ltd as at 31 December 20X9. (12 marks)
(b) Explain the adjustments necessary in respect of intra-group sales when preparing the consolidated balance sheet of the Close Ltd group. (6 marks) (18 marks) Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting
Technical reference For a comprehensive Technical reference section, covering all aspects of group accounts (except group cash flow statements) see Chapter 15.
418
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11
Answers to Self-test 1
C Yum Ltd 90% Peep Ltd
75% Pitti Ltd CU 360,000 (270,000) 90,000
Shares in Peep Ltd Net assets acquired (90% 300,000) Goodwill Shares in Pitti Ltd Net assets acquired (75% 160,000) Discount on acquisition
100,000 120,000 (20,000)*
* Credited to the consolidated income statement in the period in which the acquisition is made (i.e. on 31 December 20X6). 2
B CU'000 24,000
Black Ltd only No post-acquisition profits have yet arisen in Red Ltd. 3
D Milton CU'000 500 (220) 280
Current assets Current liabilities 4
Keynes CU'000 200 (90) 110
Adjustment CU'000 –22 + 2 +20
C CU 6,000 7,520 (500) 13,020
Laker Hammond Less: Intra-group indebtedness 5
Consolidated CU'000 680 (290) 390
B CU'000
Austen Ltd Kipling Ltd Dickens Ltd Less: Cash in transit
CU'000 50 30
40 (2)
Less: Intra-group receivables Owed to Kipling Ltd (2 + 3 + 4) Owed to Dickens
38 118 9 3 (12) 106
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 6
B CU 750 216 966
Ho Ltd Su Ltd – Ho Ltd’s share of post-acquisition retained earnings (60% ((700 – 40) – 300)) 7
A CU 40,000 500 40,500
Tottenham Ltd Chelsea Ltd (10,000 5%)
Dividends declared after the year end will be recognised in the following year’s financial statements. Only the MI’s percentage of dividends payable will appear in consolidated current liabilities. 8
B CU 15,000 (3,000) 12,000
Carrying amount Profit element (25/125) Cost
Bass Ltd (the parent company) is the seller of the inventory. Therefore the adjustment does not affect the minority interest. 9
C CU'000 290 160 20 (12) 458
Oxford Ltd Cambridge Ltd In transit to Cambridge Ltd Less: PURP ((40 + 20) 20%) 10
B
Cost Accumulated depreciation NBV
Is CU 40,000 (8,000) 32,000
Should be CU 42,000 (18,000) 24,000
Adjustment required Dr Stafford Ltd retained earnings CU8,000, Cr Property, plant and equipment NBV CU8,000. Property, plant and equipment in consolidated balance sheet = 260,000 + 80,000 – 8,000 = CU332,000 (B) 11
D CU 6,000 4,000 10,000
Carrying amount at 1 January 20X7 (1/4 24,000) Add: Profit on disposal Sale price
Cost Accumulated depreciation Carrying amount
420
© The Institute of Chartered Accountants in England and Wales, March 2009
Is CU 10,000 (2,500) 7,500
Should be CU 24,000 (24,000) –
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
11
CU Consolidated property, plant and equipment Makepeace Ltd Dempsey Ltd Less: Intra-group profit 12
76,000 45,000 (7,500) 113,500
A CU
Minority interest Ordinary shares (25% (200,000 + 60,000))
65,000
Consolidated retained earnings Lynton Ltd Pinner Ltd (75% (60,000 – 24,000))
500,000 27,000 527,000
Point to note Redeemable preference shares are classified as liabilities. 13
B CU 77,000 (120,000) (43,000)
Cost Net assets acquired (80% 150,000) Discount on acquisition 14
C CU Mabbutt Ltd Cost of investment Less: Share of net assets acquired Share capital Retained earnings
35,000 15,000 21,000 36,000 × 2/3
Goodwill Impairment to date Balance c/f Waddle Ltd Cost of investment Less: Share of net assets acquired Share capital Retained earnings
CU
CU 20,000 16,000 36,000 × 75%
(24,000) 11,000 (4,400) 6,600 CU 20,000
(27,000) (7,000) *
* Recognised in the consolidated income statement in the year in which the acquisition was made. 15
A Share of net assets acquired (60% (400 + 120 + (3/12 60))) Less: Discount arising on acquisition Cost of investment
CU'000 321 (3) 318
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 16
C (1)
DR Current assets in H with interest receivable CR Retained earnings of H
CU'000 15
CU'000 15
To account for the interest receivable by Hill Ltd (2)
DR Current liabilities in D CR Current assets in H
CU'000 15
CU'000 15
To cancel intra-group balances for interest – there will be no o/s balances for the dividends as they have been paid Summary DR Current liabilities CR Retained earnings of H 17
CU'000 15
CU'000 15
D The loan is not in Heron’s accounts. On consolidation Sparrow’s asset will cancel with Swift’s liability.
18
D CU 40,000 (2,000) 20,000 58,000
Ugly Ltd Less: PURP (2/3 15,000 25/125 ) Net assets acquired 19
B CU 226,000 (42,000) 184,000 × 100/80 230,000 46,000
Cost of investment Less: Goodwill Nasty Ltd Fair value of net assets Minority interest (20% 230,000) 20
C Consolidated capital and reserves Ordinary share capital Revaluation reserve (25 – 15) Retained earnings Fallin Ltd Gaydon Ltd (135 – 25) Goodwill impairment to date
CU'000
CU'000 100 10
340 110 (6) 444 554
422
© The Institute of Chartered Accountants in England and Wales, March 2009
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21
11
A Cost of investment Less: Share of net assets acquired Share capital Share premium Retained earnings 1 October 20X1 Nine months ( 9/12 9,000)
CU
CU 20,000
1,000 2,000 12,000 6,750 21,750× 70% (15,225) 4,775
Goodwill Questions 22 to 26 VW Ltd 100% Polo Ltd 22
80% Golf Ltd
B Minority interest = 20% (50,000 + 70,000) = CU24,000
23
B CU'000 150 90 80 320
VW Ltd Polo Ltd Golf Ltd Less: PURP Note (3) (15,000 50/150 in VW Ltd's retained earnings) Note (4) (1/2 70,000 - 50,000 in Polo Ltd's retained earnings) 24
(5) (10) 305
D VW Ltd Less: Intra-group receivable Polo Ltd Golf Ltd Less: Intra-group receivable
CU'000 250 (20) 40 20 (10) 280
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 25
B CU Shares in Polo Ltd Net assets acquired Share capital Retained earnings
100,000 30,000
Goodwill Shares in Golf Ltd Net assets acquired Share capital Retained earnings (70 – 30) Group share ( 80%) Discount on acquisition – Credited to CIS in period of acquisition 26
(130,000) 20,000 70,000
50,000 40,000 90,000 (72,000) (2,000)
C VW Ltd Less: PURP Polo Ltd ((40,000 – 10,000 PURP) – 30,000) Golf Ltd (80% 30,000) Discount on acquisition of Golf Ltd
27
CU 150,000
CU 90,000 (5,000) 85,000 – 24,000 2,000 111,000
CRAWFORD LTD PART II Consolidated balance sheet as at 30 June 20X0 ASSETS Non-current assets Property, plant and equipment (26,500 + 12,500) Intangibles (W1)
CU
Current assets (25,000 + 12,000) Total assets
39,000 250 39,250 37,000 76,250
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings (W3) Attributable to equity holders of Crawford Ltd Minority interest (W2) Equity Non-current liabilities Current liabilities (7,000 + 7,500) Total equity and liabilities
20,000 6,000 18,083 44,083 5,667 49,750 12,000 14,500 76,250
WORKINGS (1) Goodwill Cost of shares Net assets acquired (2/3 3,000) Impairment to date (210 + 40) Balance c/f
424
© The Institute of Chartered Accountants in England and Wales, March 2009
CU 2,500 (2,000) 500 (250) 250
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
11
(2) Minority interest CU 5,667
1/3 × 17,000 (3)
Retained earnings CU 9,000 9,333 (250) 18,083
Crawford Ltd Dietrich Ltd (2/3 14,000) Less: Goodwill impairment to date (W1) 28
DUBLIN LTD Consolidated balance sheet as at 31 December 20X9 CU ASSETS Non-current assets Property, plant and equipment (90,000 + 60,000 + 50,000) Intangibles (W3) Current assets (215,000 + 50,000 + 30,000) Total assets
200,000 2,700 202,700 295,000 497,700
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Retained earnings (W5) Attributable to equity holders of Dublin Ltd Minority interest (W4) Equity Current liabilities (150,000 + 20,000 + 24,000) Total equity and liabilities
190,000 81,700 271,700 32,000 303,700 194,000 497,700
WORKINGS (1) Group structure Dublin Ltd 80% Shannon Ltd
75% Belfast Ltd
(2) Net assets
Shannon Ltd Share capital Revaluation reserve Retained earnings Belfast Ltd Share capital Retained earnings
Balance sheet date CU 50,000 10,000 30,000 90,000
Acquisition date CU 50,000 10,000 20,000 80,000
40,000 16,000 56,000
40,000 16,000 56,000
Postacquisition CU – – 10,000
© The Institute of Chartered Accountants in England and Wales, March 2009
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425
Financial accounting (3) Goodwill
Cost of shares Net assets acquired Shannon Ltd (80% 80,000) (W2) Belfast Ltd (75% 56,000) (W2) (Discount on acquisition)/goodwill Credited/(impairment) to date Balance c/f
Shannon Ltd CU 50,000
Belfast Ltd CU 45,000
(64,000) (14,000) 14,000 –
(42,000) 3,000 (300) 2,700
(4) Minority interest CU 18,000 14,000 32,000
Shannon Ltd (20% 90,000 (W2)) Belfast Ltd (25% 56,000 (W2)) (5) Retained earnings
CU 60,000 8,000 – (300) 14,000 81,700
Dublin Ltd Shannon Ltd (80% 10,000 (W2)) Belfast Ltd (75% nil (W2)) Less: Goodwill impairment to date (W3) Add: Discount on acquisition (W3) 29
EDINBURGH LTD Consolidated balance sheet as at 31 December 20X5 ASSETS Non-current assets Property, plant and equipment (147,000 + 82,000) Intangibles (W3) Investments (80,000 – 63,000 – 12,000) Current assets Inventories (73,200 + 35,200) Trade and other receivables (82,100 + 46,900) Cash and cash equivalents (8,000 + 25,150 + 6,700) Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Revaluation reserve (W6) Retained earnings (W5) Attributable to equity holders of Edinburgh Ltd Minority interest (W4) Equity Non-current liabilities Borrowings (20,000 – 12,000) Current liabilities Trade and other payables (123,000 + 50,000) Total equity and liabilities
426
© The Institute of Chartered Accountants in England and Wales, March 2009
CU
CU 229,000 8,750 5,000 242,750
108,400 129,000 39,850
277,250 520,000
250,000 12,000 54,750 316,750 22,250 339,000 8,000 173,000 520,000
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
11
WORKINGS (1) Group structure Edinburgh Ltd 80% Glasgow Ltd (2) Net assets of Glasgow Ltd Balance sheet date CU 50,000 6,250 15,000 40,000 111,250
Share capital Share premium Revaluation reserve Revaluation earnings
Acquisition date CU 50,000 6,250 – 10,000 66,250
Postacquisition CU – – 15,000 30,000
(3) Goodwill CU 63,000 (53,000) 10,000 (1,250) 8,750
Cost of shares Net assets acquired (80% 66,250) (W2) Impairment to date Balance c/f (4) Minority interest
CU 22,250
20% × 111,250 (W2) (5) Retained earnings
CU 32,000 24,000 (1,250) 54,750
Edinburgh Ltd Glasgow Ltd (80% 30,000 (W2)) Less: Goodwill impairment to date (W3) (6) Revaluation reserve
CU 12,000
Glasgow Ltd (80% 15,000 (W2)) 30
CLOSE LTD (a)
Consolidated balance sheet as at 31 December 20X9 ASSETS Non-current assets Property, plant and equipment (80,000 + 58,200)) Intangibles (W3) Current assets Inventories (18,000 + 12,000 – 800)) Trade and other receivables (62,700 + 21,100) Investments Cash and cash equivalents (10,000 + 3,000 + 500) Total assets
CU
CU 138,200 14,600 152,800
29,200 83,800 2,500 13,500 129,000 281,800
© The Institute of Chartered Accountants in England and Wales, March 2009
427
Financial accounting EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Revaluation reserve Retained earnings (W5) Attributable to equity holders of Close Ltd Minority interest (W4) Equity Current liabilities Trade and other payables (35,000 + 11,000)) Total equity and liabilities
120,000 18,000 23,000 57,160 218,160 17,640 235,800 46,000 281,800
(b) Adjustments When group companies have been trading with each other two separate adjustments may be required in the consolidated balance sheet. (i)
Elimination of unrealised profits If one company holds inventories at the year end which have been acquired from another group company, this will include a profit element that is unrealised from a group perspective. Here Steele Ltd has sold goods to Close Ltd at cost plus 25%. The mark-up of 25% will only become realised when the goods are sold to a third party. Therefore if any intra-group inventory is still held at the year end, it must be eliminated from the consolidated accounts. This will require an adjustment of CU800 (4,000 25/125) which is always made against the selling company’s retained earnings, i.e.
Steele Ltd’s retained earnings (W2) Consolidated inventory
DR CU 800
CR CU 800
As well as eliminating the unrealised profit, this reduces inventory back to its original cost to the group. (ii)
Contra out intra-group balances As group companies are effectively treated as one entity, any intra-group balances must be eliminated on consolidation. Here, intra-group current accounts have arisen as a result of the intra-group trading and these must be contra’d out. Before this can be done the current accounts must be brought into agreement by adjusting the accounts of the 'receiving' company (here Steele Ltd) for the cheque in-transit, i.e.
Cash Current account
DR CU 500
CR CU 500
This will reduce the current account receivable to CU2,700, which means that it now agrees with the payable balance shown in the accounts of Close Ltd. The balance can then be contra’d out, i.e.
Current account in Close Ltd Current account in Steele Ltd
428
© The Institute of Chartered Accountants in England and Wales, March 2009
DR CU 2,700
CR CU 2,700
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
11
WORKINGS (1) Group structure Close Ltd
80%
Steele Ltd (2) Net assets of Steele Ltd
Share capital Revaluation reserve Retained earnings Per question Less: PURP (4,000 × 25/125)
Balance sheet date CU CU 60,000 16,000
Acquisition date CU 60,000 16,000
Postacquisition CU – –
13,000 (800) 12,200 88,200
8,000 84,000
4,200
(3) Goodwill Cost of shares Less: Net assets acquired (80% × 84,000 (W2)) Impairment to date (500 + 1,700) Balance c/f
CU 84,000 (67,200) 16,800 (2,200) 14,600
(4) Minority interest Share of net assets (20% × 88,200 (W2))
CU 17,640
(5) Retained earnings Close Ltd Steele Ltd (80% 4,200 (W2)) Less Goodwill impairment to date (W3)
CU 56,000 3,360 (2,200) 57,160
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting
Answers to Interactive questions
Answer to Interactive question 1 P Ltd has paid CU10,000 to buy 75% of S Ltd's net assets of (16,000 – 4,000) = CU12,000 CU 10,000 (9,000) 1,000
Consideration Less: Share of net assets acquired (75% × 12,000) Goodwill
Answer to Interactive question 2 Rik Ltd: Consolidated balance sheet as at 31 December 20X1 CU Non-current assets Property, plant and equipment (100,000 + 40,000 + 10,000) Intangibles (W3)
150,000 6,667 156,667 110,000 266,667
Current assets (45,000 + 40,000 + 25,000) Capital and reserves Called up share capital Retained earnings (W5) Attributable to equity holders of Rik Ltd Minority interest (W4) Equity Liabilities (30,000 + 20,000 + 10,000)
50,000 133,334 183,334 23,333 206,667 60,000 266,667
WORKINGS (1)
Group structure Rik Ltd
75%
Viv Ltd
2/3
Neil Ltd
(2) Net assets
Viv Ltd Share capital Retained earnings Neil Ltd Share capital Retained earnings
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Balance sheet date CU
Acquisition CU
Postacquisition CU
20,000 40,000 60,000
20,000 4,000 24,000
– 36,000
10,000 15,000 25,000
10,000 1,000 11,000
– 14,000
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
11
(3) Goodwill
Cost of investment Less: Share of net assets acquired Viv Ltd (75% × 24,000 (W2)) Neil Ltd (2/3 × 11,000 (W2)) Goodwill Impairment to date Balance c/f
Viv Ltd CU 25,000
Neil Ltd CU 10,000
Total CU
(18,000) 7,000 (3,000) 4,000
(7,333) 2,667 – 2,667
9,667 (3,000) 6,667
(4) Minority interest CU 15,000 8,333 23,333
Viv Ltd – Share of net assets at BS date (25% × 60,000 (W2)) Neil Ltd – Share of net assets at BS date (1/3 × 25,000 (W2)) (5) Retained earnings
CU 100,000 27,000 9,334 (3,000) 133,334
Rik Ltd Viv Ltd – Share of post-acquisition retained earnings (75% × 36,000 (W2)) Neil Ltd – Share of post-acquisition retained earnings (2/3 × 14,000 (W2)) Goodwill impairment to date (W3)
Answer to Interactive question 3 (a)
Net assets (W2)
Share capital Retained earnings (15,000 + (5/12 × (15,600 – 15,000)))
Balance sheet date CU 1,000 15,600 16,600
Acquisition CU 1,000 15,250 16,250
Postacquisition CU – 350
(b) Goodwill (W3) Cost of investment Less: Share of net assets acquired (80% × 16,250 (W2)) (c)
CU 20,000 (13,000) 7,000
Profit from S Ltd included in consolidated retained earnings Share of post-acquisition retained earnings of S Ltd (80% × 350 (W2))
(d) (i)
Pre-acquisition earnings Retained earnings per balance sheet Add back: Dividend paid Total earnings before dividend Pre-acquisition earnings (5/12 × 17,600)
(ii)
CU 280 CU 15,600 2,000 17,600 7,333
Post-acquisition earnings Total earnings before dividend = × 7/12 = Less: Dividend paid
17,600 10,267 (2,000) 8,267
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Financial accounting
Answer to Interactive question 4 (a)
Recording of dividends in individual companies' books Impala Ltd's dividend Impala Ltd's books DR Retained earnings CR Payables
CU
CU
10,000 1 10,000
Springbok Ltd's dividend Springbok Ltd's books DR Retained earnings CR Payables (Due to minority interest CU1,250)
5,000 2
Impala Ltd's books DR Receivables (75% × 5,000) CR Retained earnings
3,750
5,000
3,7501
Notes 1
Include in retained earnings working (W5).
2
Include in net assets working (W2).
(b) In consolidation workings (1) Group structure Impala Ltd 75%
Springbok Ltd (2) Net assets of Springbok Ltd Balance sheet date CU Share capital Retained earnings Per question Dividends
Acquisition
CU 25,000
CU 25,000
40,000 65,000
20,000 45,000
Postacquisition CU –
45,000 (5,000) 20,000
(4) Minority interest 25% × 65,000 (W2)
CU 16,250
(5) Retained earnings Impala Ltd per question Dividends declared Dividends from Springbok Ltd Share of Springbok Ltd post-acquisition (75% × 20,000) (W2)
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CU 60,000 (10,000) 3,750 15,000 68,750
GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET
(c)
11
In consolidated balance sheet CU
Payables: Declared dividends payable Parent company Minority interest
10,000 1,250
Answer to Interactive question 5 CU 3,000
DR Seller's (S Ltd's) retained earnings (adjust in net assets working) CR Inventories in CBS (1/2 × 6,000)
CU 3,000
WORKINGS (1) Group structure P Ltd 80%
S Ltd (2) S Ltd net assets Balance sheet date CU
Share capital Retained earnings Per question Less: PURP
Acquistion
CU 10,000
CU 10,000
62,000 72,000
20,000 30,000
Postacquisition CU
65,000 (3,000)
(4) Minority interest Share of net assets (20% × 72,000) (5) Retained earnings P Ltd Share of S Ltd (80% × 42,000)
42,000 CU 14,400 CU 100,000 33,600 133,600
Answer to Interactive question 6 Following the transfer the asset will be included at CU 15,000 (3,000) 12,000
Cost Less: Depreciation – 20% Had the transfer not been made, the asset would stand in the books at Cost Less: Accumulated depreciation at date of 'transfer' Provision for current year (CU20,000 × 20%)
CU 20,000 (8,000) (4,000) 8,000
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Financial accounting Overall adjustment in CBS DR Seller's (P Ltd's) retained earnings CR Non-current assets
CU 4,000
CU 4,000
Answer to Interactive question 7 (1) Group structure P Ltd 60% S Ltd (2) Net assets of S Ltd
Share capital Revaluation (30,000 – 20,000) Retained earnings Per question Less: Goodwill
BS date = Acquisition date CU CU 20,000 10,000 85,000 (5,000)
80,000 110,000
(3) Goodwill CU 80,000 (66,000) 14,000
Cost of investment Less: Share of FV of net assets acquired (60% × 110,000 (W2))
Answer to Interactive question 8 Following the transfer the asset will be included at CU 32,000 28,900 3,100
Carrying amount of plant in CBS (40,000 80%) Carrying amount in William Ltd's BS (40,000 85% 85%) Increase in carrying amount
DR CR CR
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Non-current assets Consolidated retained earnings (85%) Minority interest (15%)
© The Institute of Chartered Accountants in England and Wales, March 2009
CU 3,100
CU 2,635 465
chapter 12
Group accounts: consolidated statements of financial performance Contents Introduction Examination context Topic List 1
Consolidated income statement
2
Intra-group transactions and unrealised profit
3
Consolidated income statement workings
4
Mid-year acquisitions
5
Dividends
6
Other adjustments
7
Consolidated statement of changes in equity
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Identify the financial effects of group accounting in the context of BFRS Framework
Explain and demonstrate the concepts and principles surrounding the consolidation of financial statements including: –
The single entity concept
–
Substance over form
–
The distinction between control and ownership
Calculate the amounts to be included in an entity’s consolidated statements of financial performance in respect of its new and continuing interests in subsidiaries in accordance with the international financial reporting framework
Prepare and present a consolidated income statement (or extracts therefrom) including adjustments for intra-group transactions and balances, goodwill, minority interests and fair values
Prepare and present a consolidated statement of changes in equity (or extracts therefrom) in accordance with Bangladesh financial reporting framework
Tick off
Specific syllabus references for this chapter are: 1d,g, 3d,e.
Practical significance The consolidated income statement provides the owners of the group with important information over and above that which is available in the parent’s own income statement. The investment income receivable from the subsidiary is replaced with the profits controlled by the parent company. This application of substance over form provides a more realistic representation of the performance of the group as the combined income statements of the parent and subsidiary are produced as if they were a single entity. The single entity concept has more detailed implications for the preparation of the consolidated income statement which we will look at in this chapter. The consolidated statement of changes in equity provides a ‘bridge’ between the consolidated balance sheet and consolidated income statement. It achieves this by reconciling the group’s opening equity (capital, reserves and minority interest) to the closing position.
Stop and think Why is information about the profits of the subsidiary of more use to the shareholders than information about the investment income received?
Working context In very simple terms, the preparation of the consolidated income statement and consolidated statement of changes in equity involves the combination of the individual statements of the group members. As we said in Chapter 10, this process is often computerised. However, detailed work will be needed on the consolidation adjustments, particularly in respect of the consolidated income statement. This might include the identification and elimination of intra-group transactions and the elimination of unrealised profit. We will look at a number of consolidation adjustments in this chapter.
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Syllabus links This chapter looks in detail at the preparation of the consolidated income statement and is fundamental to the Financial Accounting syllabus. It builds on the principles introduced in Chapter 10 and applies them to more complex situations. A detailed knowledge and understanding of this topic and of the consolidated statement of changes in equity will also be assumed in Financial & Corporate Reporting at the Advanced Stage.
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Financial accounting
Examination context
Exam requirements Preparation of a consolidated income statement could be examined in either the short-form questions or written test section of the paper. In either case the focus of the questions will normally be on consolidation adjustments including intra-group trading, unrealised profits and irredeemable preference shares. In written test questions a mid-year acquisition is likely to be incorporated, so any dates given should be read carefully. The consolidated statement of changes in equity could be examined in conjunction with the consolidated income statement. Alternatively, it could appear as part of a mixed question or as a short-form question. In the examination, candidates may be required to:
Prepare a consolidated income statement (or extracts therefrom) including the results of the parent entity and one or more subsidiaries including adjustments for the following: – – – –
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Acquisition of a subsidiary, including a mid-year acquisition Intra-group transactions Unrealised profits Interest and management charges
Explain the process of consolidating the income statement in the context of the single entity concept, substance over form and the distinction between control and ownership.
Prepare a consolidated statement of changes in equity (or extracts therefrom) including the effects of new and continuing interests in subsidiaries.
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1 Consolidated income statement Section overview
1.1
The preparation of the consolidated income statement is consistent with the consolidated balance sheet.
Basic principles In Chapter 10 we introduced the basic principles and mechanics involved in the consolidation of the income statement as follows: Consolidated income statement CU X
Revenue (P + S (100%) – intra-group items) Profit after tax (PAT) (CONTROL)
X
(OWNERSHIP) Attributable to: Equity holders of P (ß) Minority interest (MI% × S's PAT)
X X X
The consolidated income statement is prepared on a basis consistent with the consolidated balance sheet. Therefore: The consolidated income statement shows income generated from the net assets under the parent company’s control
In the consolidated income statement dividend income from the subsidiary is replaced with the subsidiary’s income and expenses on a line-by-line basis as far as profit after tax (PAT)
The single entity concept is applied
The effects of transactions between group members are eliminated on consolidation
The ownership of profits is shared between the owners of the parent and any minority interest
Profit after tax is split between the profit attributable to the parent’s shareholders (balancing figure) and the profit attributable to the minority interest (calculated as the MI’s share of S’s PAT)
In sections 2-6 of this chapter we will consider a number of consolidation adjustments. We have already seen many of the issues raised in the context of the consolidated balance sheet. In this chapter we will look at how the adjustment is made from the point of view of the consolidated income statement.
2 Intra-group transactions and unrealised profit Section overview
The value of intra-group sales is deducted as a consolidation adjustment from consolidated revenue and cost of sales.
A provision for unrealised profit is set against the selling company’s profit.
Profits or losses on non-current asset transfers should be eliminated against the selling company’s profit.
A depreciation adjustment may be required so that depreciation is based on the cost of the asset to the group.
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Financial accounting
2.1
Intra-group trading When one company in a group sells goods to another group member an identical amount is added to the sales revenue of the first company and to the cost of sales of the second. Yet as far as the entity’s dealings with third parties are concerned no sale has taken place. The consolidated figures for sales revenue and cost of sales should represent sales to, and purchases from third parties. An adjustment is therefore necessary to reduce the sales revenue and cost of sales figures by the value of intra-group sales made during the year. This adjustment is made as follows:
Step 1 Add across P and S revenue and P and S cost of sales.
Step 2 Deduct value of intra-group sales from revenue and cost of sales. Point to note This adjustment has no effect on profit and hence will have no effect on the minority interest share of profit.
2.2
Unrealised profits on trading If any items sold by one group company to another are included in inventories (i.e. have not been sold on outside the group by the year end), their value must be adjusted to the lower of cost and NRV to the group (as for CBS), again applying the single entity concept. Steps to set up the provision for unrealised profit (PURP) are the same as for the consolidated balance sheet (covered in Chapter 11):
Step 1 Calculate the amount of inventories remaining at the year end.
Step 2 Calculate the intra-group profit included in it.
Step 3 Make a provision against the inventories to reduce them to cost to the group (or NRV if lower). Points to note 1
In practical terms the provision is set up by increasing cost of sales by the amount of the unrealised profit. (If closing inventory is reduced, cost of sales is increased).
2
This provision must always be set against the selling company’s profit. As a result, where the seller is a subsidiary that is not wholly owned, it reduces the profit for the year for MI calculations.
3
Where P has sold on some of the goods purchased from S to a third party, any profit earned by S (as well as that earned by P) on those goods will have been realised as far as the group is concerned, so no adjustment is necessary.
Interactive question 1: Unrealised profits
[Difficulty level: Exam standard]
Whales Ltd owns 75% of Porpoise Ltd. The gross profit for each company for the year ended 31 March 20X7 is calculated as follows:
Revenue Cost of sales Gross profit
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© The Institute of Chartered Accountants in England and Wales, March 2009
Whales Ltd CU 120,000 (80,000) 40,000
Porpoise Ltd CU 70,000 (50,000) 20,000
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During the year Porpoise Ltd made sales to Whales Ltd amounting to CU30,000. CU15,000 of these sales were in inventories at the year end. Profit made on the year end inventories items amounted to CU2,000. Requirement Calculate group revenue, cost of sales and gross profit. Fill in the proforma below. Whales Ltd CU
Porpoise Ltd CU
Adj CU
Consol CU
Revenue C of S – per Q – PURP GP See Answer at the end of this chapter.
2.3
Non-current asset transfers The consolidated income statement should include depreciation of non-current assets based on cost to the group, and should exclude any profit or loss on non-current asset transfers between group members. This is consistent with the treatment in the consolidated balance sheet. The adjustment is made as follows:
Eliminate the profit or loss on transfer and adjust depreciation in full (control)
The profit or loss is eliminated against the seller. This automatically affects the minority interest where S was the seller who recorded the original profit or loss (ownership)
Depreciation is adjusted against the seller even though it is the purchaser who recorded it. This is because the depreciation adjustment reflects the realisation of the profit over time, i.e. over the asset’s life (ownership)
Worked example: Non-current asset transfers (Based on Interactive question 6 in Chapter 11) P Ltd owns 80% of S Ltd. P Ltd transferred to S Ltd a non-current asset (NCA) at a value of CU15,000 on 1 January 20X7. The original cost to P Ltd was CU20,000 and the accumulated depreciation at the date of transfer was CU8,000. Both companies depreciate such assets at 20% per year on cost to the company. At 31 December 20X7 the adjustment in the consolidated balance sheet (CBS) was calculated by comparing CU 12,000
Carrying amount of NCA with transfer (15,000 × 80%) Carrying amount of NCA without transfer ((20,000 – 8,000) – (20,000 × 20%))
(8,000) 4,000
Adjustment made in CBS was: DR Selling company retained earnings CR Non-current assets at carrying amount in CBS
CU 4,000
CU 4,000
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Financial accounting In the consolidated income statement (IS) for the year: (a)
Eliminate the profit (or loss) on transfer at 1 January 20X7 since it is unrealised DR Selling company IS for year (heading where profit credited) (15,000 – 12,000) CR NCA carrying amount in CBS
CU 3,000
CU 3,000
Point to note For the non-current asset note to the consolidated balance sheet, the credit to non-current asset carrying amounts will be split into a debit of CU5,000 to the non-current asset cost account and a credit of CU8,000 to the non-current asset accumulated depreciation account. (b) Increase/(decrease) the depreciation charge, so that it is calculated on the asset's cost to the group. In this case, increase the charge by CU 4,000 (3,000) 1,000
Depreciation without transfer (20,000 × 20%) Depreciation with transfer (15,000 × 20%)
DR Selling company IS for year (heading where depreciation charged) CR NCA carrying amount in CBS
CU 1,000
CU 1,000
Point to note The non-current asset note to the consolidated balance sheet will include this credit in accumulated depreciation. The overall effect is an adjustment of CU4,000 in both the consolidated income statement and consolidated balance sheet.
Interactive question 2: Non-current asset transfers [Difficulty level: Exam standard] P Ltd owns 80% of S Ltd. P Ltd transferred a non-current asset to S Ltd on 1 January 20X7 at a value of CU15,000. The asset originally cost P Ltd CU12,000 and depreciation to the date of transfer was CU4,800. The profit on transfer has been credited to depreciation expense. Both companies depreciate their assets at 20% per annum on cost. Total depreciation for 20X7 was CU35,000 for P Ltd and CU25,000 for S Ltd. Requirement Show the adjustments required for the above transaction in the consolidated income statement. Fill in the proforma below.
Solution P Ltd CU Depreciation – per Q NCA PURP Depreciation adjustment See Answer at the end of this chapter.
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S Ltd CU
Adj CU
Consol CU
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3 Consolidated income statement workings Section overview
3.1
The key working for the preparation of the consolidated income statement is the consolidation schedule.
Pro forma workings As questions increase in complexity a formal pattern of workings is needed. (1) Establish group structure
P 80%
S (2) Prepare consolidation schedule
Revenue C of S – Per Q – PURP (seller's books) Exps – Per Q – GW impairment (if any) Tax – Per Q
P CU X (X) (X) (X) (X) (X)
Profit
S CU X (X) or (X) (X)
Adj CU (X) X
(X)
Consol CU X
} }
(X) (X) (X)
X
May need workings for (e.g.) – PURPs – GW impairment (3) Calculate minority interest (MI) S PAT × MI%
MI% ×
Interactive question 3: Income statement workings
X
=
CU X
[Difficulty level: Easy]
Pathfinder Ltd owns 75% of Sultan Ltd. Income statements for the two companies for the year ending 30 September 20X7 are as follows.
Revenue Cost of sales Gross profit Expenses Investment income from Sultan Ltd Profit before tax Income tax expense Profit after tax
Pathfinder Ltd CU 100,000 (60,000) 40,000 (20,000) 1,500 21,500 (6,000) 15,500
Sultan Ltd CU 50,000 (30,000) 20,000 (10,000) – 10,000 (3,000) 7,000
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Financial accounting During the year one group company sold goods to the other for CU20,000 at a gross profit margin of 40%. Half of the goods remained in inventories at the year end. Requirements (a)
Prepare extracts from the consolidated income statement for the year ended 30 September 20X7 showing revenue, cost of sales, gross profit and minority interest, assuming that the intra-group sales have been made by Pathfinder Ltd to Sultan Ltd.
(b) Prepare the consolidated income statement of Pathfinder Ltd for the year ended 30 September 20X7, assuming that the intra-group sales have been made by Sultan Ltd to Pathfinder Ltd. Fill in the proforma below. 295
Solution (a)
Consolidated income statement (extracts) for the year ended 30 September 20X7 CU Revenue Cost of sales Gross profit Minority interest (W3)
WORKINGS (a)
(1) Group structure
P 75%
S (2) Consolidation schedule Pathfinder Ltd CU
Sultan Ltd
Adj
Consol
CU
CU
CU
Revenue C of S – per Q – PURP (W4) Expenses Income tax Profit (3) Minority interest CU Sultan Ltd (4) PURP Selling price Cost Gross profit
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%
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CU
CU
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(b) Consolidated income statement for the year ended 30 September 20X7 CU
Revenue Cost of sales Gross profit Expenses Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of Pathfinder Ltd () Minority interest (W3) WORKINGS (b) (1) Group structure As part (a) (2) Consolidation schedule Pathfinder Ltd CU
Revenue C of S – per Q – PURP (W4)
Sultan Ltd
Adj
Consol
CU
CU
CU
Income tax Profit (3) Minority interest CU Sultan Ltd (4) PURP As part (a) See Answer at the end of this chapter.
4 Mid-year acquisitions Section overview
4.1
The results of the subsidiary are consolidated from the date of acquisition.
The income statement amounts of the subsidiary are time apportioned.
Method of apportionment When we looked at the balance sheet we saw that consolidated retained earnings included only the postacquisition profits of the subsidiary. This principle also applies to the consolidated income statement. If the subsidiary is acquired during the accounting period, the entire income statement of the subsidiary is split between pre-acquisition and post-acquisition proportions. Only the post-acquisition figures are included in the consolidated income statement.
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Financial accounting Points to note 1
Assume revenue and expenses accrue evenly over the year unless the contrary is indicated – therefore time-apportion results of the subsidiary from the date of acquisition.
2
Time-apportion totals for revenue, cost of sales, expenses and tax first, then deduct post-acquisition intra-group items.
3
Recognise as an expense any goodwill impairment losses arising on the acquisition (calculation of goodwill was dealt with in Chapter 11).
Interactive question 4: Mid-year acquisitions
[Difficulty level: Easy]
P Ltd acquired 75% of S Ltd on 1 April 20X7. Extracts from the companies’ income statements for the year ended 31 December 20X7 are as follows. P Ltd CU 100,000 (70,000) 30,000
Revenue Cost of sales Gross profit
S Ltd CU 75,000 (60,000) 15,000
Since acquisition P Ltd has made sales to S Ltd of CU15,000. None of these goods remain in inventories at the year end. Requirement Calculate revenue, cost of sales and gross profit for the group for the year ending 31 December 20X7.
Solution P Ltd Consolidated income statement for the year ended 31 December 20X7
Revenue Cost of sales Gross profit
P Ltd CU
S Ltd CU
Adj CU
Consol CU
See Answer at the end of this chapter.
5 Dividends Section overview
5.1
Intra-group dividends should be cancelled on consolidation.
The uncancelled amount should be disclosed in the consolidated statement of changes in equity.
Treatment Dealing with intra-group dividends is made a bit more complicated by the fact that:
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Dividends received and receivable are shown as income in the income statement; but Dividends paid and payable are shown in the statement of changes in equity.
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Nevertheless the single entity concept must be applied to dividends paid/payable by the subsidiary, by:
Cancelling P’s dividend income from S in P’s income statement against S’s dividends in S’s statement of changes in equity
Leaving the uncancelled amount of S’s dividends to be shown as the dividends to the minority interest in the consolidated statement of changes in equity (see section 8 below).
If P has not yet accounted for its dividends from S, then P’s income will need to be recorded before this cancellation takes place.
6 Other adjustments Section overview
6.1
The effect of all other intra-group transactions is cancelled on consolidation.
Redeemable preference shares Redeemable preference shares are treated as a financial liability (under BAS 32 Financial Instruments: Presentation) rather than as part of equity. Consequently, distributions to shareholders are classed as finance costs rather than as dividends. On consolidation finance income received/receivable in the parent’s books is cancelled against the amount paid/payable in the subsidiary’s books, leaving only the portion paid/payable to third parties as a finance cost.
6.2
Interest and management charges Interest or management charges paid/payable in the income statement of the subsidiary (expense) should be cancelled against the interest or management charges received/receivable in the income statement of the parent company (income).
7 Consolidated statement of changes in equity Section overview
7.1
The consolidated statement of changes in equity (CSCE) shows the change in group equity reconciling the position at the start of the year with the position at the end of the year.
There are separate analysis columns for each type of share capital and reserves in respect of the parent's equity holders.
Changes in the minority interest in share capital and reserves are presented in a single column.
Structure of CSCE The CSCE is the link between the consolidated income statement and the figures for equity shown in the consolidated balance sheet, in that it shows the movement between the retained earnings brought forward at the start of the year and those carried forward at the end of the year. As can be seen in the proforma layout included in section 6 of Chapter 2, the CSCE also shows movements on other reserves and on share capital. Listed below are the main points.
Equity holders of the parent: there are separate analysis columns for each type of share capital and reserves, together with a total column. –
There will nearly always be entries for net profit/(loss) for the period and dividends paid/payable.
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Financial accounting
–
There will sometimes be entries for issues of share capital and revaluations of non-current assets (dealt with in Chapter 5).
–
Where there are such revaluations or have been in the past, there will usually be a transfer between reserves for the additional depreciation charge on the increase in value. As this is merely a transfer between reserves, they contra out against each other and no value appears in the total column.
Minority interest in subsidiaries: there is only a single column, which is the equivalent of the total column for the equity holders of the parent. –
There will nearly always be entries for the MI’s share of S’s net profit/(loss) for the period and dividends paid/payable.
–
There will sometimes be entries for S’s revaluations of non-current assets (dealt with in Chapter 5).
–
In practice there will sometimes be entries for issues of share capital by S, but these fall outside the Financial Accounting syllabus.
–
There will never be a value for transfers between reserves in S, because they contra out against each other.
–
If a non wholly-owned subsidiary is acquired during the year there will be an entry for MI added on the acquisition of a subsidiary (see section 7.4).
Worked example: CSCE The following are extracts from the financial statements for the year ended 30 June 20X8 of William Ltd and Rufus Ltd.
Profit from operations Dividends from Rufus Ltd Profit before tax Income tax expense Profit after tax Dividends declared Share capital of CU1
William Ltd CU 196,000 24,000 220,000 (70,000) 150,000
Rufus Ltd CU 95,000 – 95,000 (30,000) 65,000
20,000
30,000
200,000
50,000
William Ltd purchased 40,000 shares in Rufus Ltd some years ago. Prepare the consolidated income statement and the consolidated statement of changes in equity for William Ltd for the year ended 30 June 20X8, as far as the information permits.
Solution Consolidated income statement for the year ended 30 June 20X8 Profit from operations (196 + 95) Income tax expense (70 + 30) Profit after tax Attributable to: Equity holders of William Ltd ( Minority interest (20% × 65)
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CU 291,000 (100,000) 191,000 178,000 13,000 191,000
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Point to note The amount attributable to the equity holders of William Ltd can be separately calculated, omitting the intra-group dividend (as William Ltd’s shareholders are given their share of Rufus Ltd’s profits, they cannot also be given their share of a dividend paid out of those profits): 100% of (150,000 – 24,000) + 80% of CU65,000 = CU178,000. Consolidated statement of changes in equity for the year ended 30 June 20X8 Attributable to equity holders of William Ltd Share Retained capital earnings Total CU CU CU – 178,000 178,000 – (20,000) (20,000) – 158,000 158,000 200,000 – 200,000 200,000 158,000 358,000
Net profit for the year Dividends declared (W) Brought forward (W) Carried forward
Minority interest CU 13,000 (6,000) 7,000 10,000 17,000
Total CU 191,000 (26,000) 165,000 210,000 375,000
WORKING MI share of Rufus Ltd’s:
7.2
dividend
20% × 30,000 = CU6,000
share capital
20% × 50,000 = CU10,000
Transfers to reserves Some companies transfer amounts from retained earnings to named reserves. Such transfers are made in the analysis columns in the CSCE and are therefore shown net of MI. In the analysis columns in the CSCE: Group transfers between reserves
=
P's transfers between reserves
+
P% of S's transfers between reserves
This matches with the treatment of reserves attributable to the equity holders of P in the consolidated balance sheet, i.e. they include P’s reserves and P’s share of S’s post-acquisition reserves. 6
7.3
Retained earnings brought forward To calculate each of the group reserves brought forward, simply do a working, as you would for the consolidated balance sheet, but at the start of the year. Therefore each group opening reserve will be:
Group reserve b/f
=
P’s reserve b/f
+
P% of S’s postacquisition reserve b/f
Goodwill impairment (to start of year) and any other adjustments to opening position
Point to note The MI amount brought forward will be the MI share of S's equity (i.e. MI’s share of S’s capital and reserves) brought forward.
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Financial accounting
Interactive question 5: Retained earnings brought forward [Difficulty level: Exam standard] Continuing the facts from worked example: CSCE, the following further information is now available in relation to the financial statements for the year ended 30 June 20X8 of William Ltd and Rufus Ltd. William Ltd CU 270,000
Retained earnings brought forward
Rufus Ltd CU 120,000
When William Ltd purchased its 40,000 shares in Rufus Ltd, Rufus Ltd's retained earnings stood at CU70,000. Three years ago a goodwill impairment loss of CU10,000 was recognised in William Ltd's consolidated financial statements. Requirement Adjust the previously drafted consolidated statement of changes in equity for William Ltd for the year ended 30 June 20X8 to take account of the additional information. Fill in the pro forma below.
Solution Consolidated statement of changes in equity for the year ended 30 June 20X8 Attributable to equity holders of William Ltd Share Retained capital earnings Total CU CU CU
Minority interest CU
Total CU
Net profit for the year Dividends declared Brought forward (W) Carried forward WORKING CU Group reserves b/f William Ltd Rufus Ltd Goodwill impairment to date CU MI b/f Share capital Retained earnings See Answer at the end of this chapter.
450
© The Institute of Chartered Accountants in England and Wales, March 2009
GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE
7.4
12
Acquisition during the year Section 4 explained that the results for the new subsidiary are only brought into the consolidated income statement from the date of acquisition. Any minority interest in the results of the newly-acquired subsidiary will similarly be calculated from that date and the amount included as profit for the year in the minority interest column in the CSCE in the normal way. But in the year end consolidated balance sheet, the minority interest in the new subsidiary will be calculated as their share of the year end equity in the new subsidiary. This will include not only the profit for the post-acquisition period but also their share of the newly-acquired subsidiary’s:
Share capital; plus Retained earnings brought forward at the start of the current year; plus Current year profits to the date of acquisition.
Their share of the total of these amounts will have to be brought into the CSCE, as a single line described as ‘Added on acquisition of subsidiary’.
Interactive question 6: Acquisition during the year [Difficulty level: Exam standard] Joseph Ltd acquired an 80% interest in Mary Ltd on 1 October 20X8. The following figures relate to the year ended 31 March 20X9.
Income statement Revenue Costs Profit before tax Income tax expense Profit after tax Statements of changes in equity Profit for the year Brought forward Carried forward
Joseph Ltd CU'000
Mary Ltd CU'000
800 (400) 400 (140) 260
550 (350) 200 (50) 150
Retained earnings CU'000 CU'000 260 150 400 300 660 450
Additional information Share capital
CU'000 500
CU'000 100
Requirement Prepare the consolidated income statement and the consolidated statement of changes in equity for the Joseph Ltd group for the year ended 31 March 20X9. Fill in the pro forma below.
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Financial accounting
Solution Consolidated income statement for the year ended 31 March 20X9 CU'000
Revenue Costs Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of Joseph Ltd Minority interest (W1) Consolidated statement of changes in equity for the year ended 31 March 20X9
Net profit for the year Added on acquisition of subsidiary (W2)
Attributable to equity holders of Joseph Ltd Share Retained capital earnings Total CU CU CU
Minority interest CU
Total CU
Brought forward Carried forward WORKINGS (1) Minority interest in profit for the year CU'000 (2) Minority interest added on acquisition CU'000 Share capital Retained earnings b/f Profit for first half of current year 20% of See Answer at the end of this chapter.
452
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000
GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE
12
Summary and Self-test Summary
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Financial accounting
Self-test 1
Barley Ltd has owned 100% of the issued share capital of Oats Ltd for many years. Barley Ltd sells goods to Oats Ltd at cost plus 20%. The following information is available for the year. Revenue CU 460,000 120,000
Barley Ltd Oats Ltd
During the year Barley Ltd sold goods to Oats Ltd for CU60,000, of which CU18,000 were still held in inventory by Oats Ltd at the year end. At what amount should total revenue appear in the consolidated income statement? A B C D 2
CU520,000 CU530,000 CU538,000 CU562,000
Ufton Ltd is the sole subsidiary of Walcot Ltd. The cost of sales figures for 20X1 for Walcot Ltd and Ufton Ltd were CU11 million and CU10 million respectively. During 20X1 Walcot Ltd sold goods which had cost CU2 million to Ufton Ltd for CU3 million. Ufton Ltd has not yet sold any of these goods. What is the consolidated cost of sales figure for 20X1? A B C D
CU16 million CU18 million CU19 million CU20 million
Using the following information answer questions 3 and 4 Patience Ltd has a wholly owned subsidiary, Bunthorne Ltd. During 20X1 Bunthorne Ltd sold goods to Patience Ltd for CU40,000 which was cost plus 25%. At 31 December 20X1 CU20,000 of these goods remained unsold. 3
In the consolidated income statement for the year ended 31 December 20X1 the revenue will be reduced by A B C D
4
CU20,000 CU30,000 CU32,000 CU40,000
In the consolidated income statement for the year ended 31 December 20X1 the profit will be reduced by A B C D
CU4,000 CU6,000 CU8,000 CU10,000
Using the following trading accounts and related notes answer questions 5 and 6 for the year ended 30 April 20X6 For the year ended 30 April 20X6 Hop Ltd and its 90% subsidiary Skip Ltd had the following trading accounts.
Revenue Cost of sales Gross profit
454
© The Institute of Chartered Accountants in England and Wales, March 2009
Hop Ltd CU 100,000 (70,000) 30,000
Skip Ltd CU 46,000 (34,500) 11,500
GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE
12
Notes (1) In each company all sales were made at the same percentage mark-up. (2) Goods purchased by Skip Ltd at a cost of CU9,000 were sold to Hop Ltd. This transaction is reflected in the above trading accounts. (3) Hop Ltd had sold two-thirds of these purchases at the year end. (4) There had been no trading between Skip Ltd and Hop Ltd in previous years. 5
The consolidated revenue for the year was A B C D
6
The consolidated gross profit for the year was A B C D
7
CU146,000 CU143,000 CU137,000 CU134,000 CU40,500 CU40,350 CU39,450 CU38,500
Fosters Ltd in 20X7 invoiced CU120,000 of goods to its 75% subsidiary, Stella Ltd, at cost plus 30%. Stella Ltd had 25% of these in inventory at the year end. At the start of the year Stella Ltd had CU15,000 worth of inventory invoiced from Fosters Ltd on the same pricing basis, all of which was sold in 20X7. The consolidation adjustment to group gross profit in respect of inventory is debit A B C D
8
CU3,461 CU4,500 CU6,923 CU9,000
Shaw Ltd owns 75% of the ordinary share capital and 40% of the CU125,000 of 8% debt of Wilde Ltd. The following details are extracted from the books of Wilde Ltd. Income tax expense Profit after tax
CU24,000 CU70,000
Shaw Ltd has profit before tax of CU80,000 in its own accounts and has no paid or proposed dividends. Neither company has yet accounted for interest payable or receivable. What is the total consolidated profit before tax for the year? A B C D
CU148,000 CU150,000 CU164,000 CU168,000
Using the following information answer questions 9 to 11 The statement of changes in equity of Suton Ltd shows the following in respect of retained earnings Profit for the period Interim dividend paid Balance brought forward Balance carried forward
CU'000 10 (7) 3 21 24
80% of the share capital of Suton Ltd was acquired by Teigh Ltd when Suton Ltd’s retained earnings amounted to CU5,000.
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Financial accounting 9
How much of Suton Ltd’s retained earnings will be included in closing consolidated retained earnings? A B C D
10
CU20,800 CU19,200 CU19,000 CU15,200
How much of Suton Ltd’s profit for the period is included in the consolidated profit for the financial year attributable to the equity holders of Teigh Ltd? A CU10,000 B CU8,000 C CU5,600 D CU2,400
11
If the minority shareholders’ interest in Suton Ltd amounted to CU5,200 at the start of the year, how much will it be at the end of the year? A B C D
12
CU7,200 CU6,600 CU5,800 CU4,600
On 1 May 20X2 Small Ltd acquired its sole subsidiary, Tiny Ltd, when the net assets of the latter were CU250,000. In the consolidated financial statements of Small Ltd for the year ended 30 April 20X3 the minority’s share of profit for the year was CU10,000 and the minority interest in the consolidated balance sheet was CU56,000. During the year the minority interest received a dividend of CU4,000. What is the minority interest in Tiny Ltd to the nearest whole percentage point? A B C D
13
25% 24% 20% 18%
Cherry Ltd own 75% of Plum Ltd. For the year ended 31 December 20X1 Plum Ltd reported a net profit of CU118,000. During 20X1 Plum Ltd sold goods to Cherry Ltd for CU36,000 at cost plus 50%. At the year end these goods are still held by Cherry Ltd. In the consolidated income statement for the year ended 31 December 20X1 the minority interest is A B C D
456
CU25,000 CU26,500 CU27,250 CU29,500
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14
12
The following figures related to Sanderstead Ltd and its subsidiary Croydon Ltd for the year ended 31 December 20X9. Sanderstead Ltd CU 600,000 (400,000) 200,000
Revenue Cost of sales Gross profit
Croydon Ltd CU 300,000 (200,000) 100,000
During the year Sanderstead Ltd sold goods to Croydon Ltd for CU20,000, making a profit of CU5,000. These goods were all sold by Croydon Ltd before the year end. What are the amounts for total revenue and gross profit in the consolidated income statement of Sanderstead Ltd for the year ended 31 December 20X9? A B C D 15
Revenue
Gross profit
CU900,000 CU900,000 CU880,000 CU880,000
CU300,000 CU295,000 CU300,000 CU295,000
Chicken Ltd owns 80% of Egg Ltd. Egg Ltd sells goods to Chicken Ltd at cost plus 50%. The total invoiced sales to Chicken Ltd by Egg Ltd in the year ended 31 December 20X1 were CU900,000 and, of these sales, goods which had been invoiced at CU60,000 were held in inventory by Chicken Ltd at 31 December 20X1. What is the reduction in aggregate group gross profit? A B C D
16
CU16,000 CU20,000 CU24,000 CU30,000
Marlowe Ltd owns 60% of the ordinary share capital and 25% of the CU200,000 5% loan stock of Southey Ltd. Neither company has yet accounted for interest payable or receivable. The following details are extracted from the books of Southey Ltd. Profit Dividend (declared prior to the year-end)
CU100,000 CU40,000
What amount should be shown as the minority interest in the consolidated income statement of Marlowe Ltd? A B C D 17
CU20,000 CU36,000 CU37,600 CU54,000
Several years ago Horace Ltd acquired 75% of the ordinary share capital of Sylvia Ltd. The income statement of Sylvia Ltd for the year ended 28 February 20X7 showed profit after tax of CU4,000. During the year Horace Ltd sold goods to Sylvia at a mark up on cost of 50%. 75% of these goods had been sold to third parties by the year end. What is the minority interest in the consolidated income statement of Horace Ltd for the year ended 28 February 20X7? A B C D
CU625 CU750 CU938 CU1,000
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Financial accounting 18
Set out below are the summarised income statements of Dennis Ltd and its 80% subsidiary Terry Ltd.
Profit from operations Dividend from Terry Ltd Profit before tax Income tax expense Profit after tax
Dennis Ltd CU 89,000 16,000 105,000 (42,000) 63,000
Terry Ltd CU 45,000 – 45,000 (15,000) 30,000
What is the profit for the financial year attributable to the equity holders of Dennis Ltd to be disclosed in the consolidated income statement? A B C D 19
CU63,000 CU71,000 CU77,000 CU87,000
HUMPHREY LTD The following are the draft income statements for the year ended 30 September 20X5 of Humphrey Ltd and its subsidiary Stanley Ltd.
Revenue Cost of sales Gross profit Distribution costs Administrative costs Profit from operations Investment income Finance cost Profit before tax Income tax expense Profit after tax
Humphrey Ltd CU'000 1,100 (600) 500 (60) (65) 375 20 (25) 370 (160) 210
Stanley Ltd CU'000 400 (240) 160 (50) (55) 55 5 (6) 54 (24) 30
The following information is relevant (1) Humphrey Ltd acquired 80% of Stanley Ltd many years ago, when the retained earnings of that company were CU5,000. Both companies have only ordinary shares in issue. (2) Total intra-group sales in the year amounted to CU100,000, Humphrey Ltd selling to Stanley Ltd. (3) At the year end the balance sheet of Stanley Ltd included inventory purchased from Humphrey Ltd. Humphrey Ltd had recognised a profit of CU2,000 on this inventory. (4) The retained earnings of Humphrey Ltd and Stanley Ltd as at 30 September 20X4 were CU90,000 and CU40,000 respectively. Stanley Ltd’s share capital is comprised of CU50,000 CU1 ordinary shares. (5) Humphrey Ltd paid an interim dividend of CU100,000 in the year. Stanley Ltd paid an equivalent dividend of CU20,000. Requirement Prepare a consolidated income statement and extracts from the consolidated statement of changes in equity for the year ended 30 September 20X5. (10 marks)
458
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20
12
HIGH LTD High Ltd acquired its 80% interest in the ordinary shares and 25% interest in the redeemable preference shares of Tension Ltd for CU9,000 and CU1,000 respectively on 1 April 20X3 when Tension Ltd’s retained earnings were CU4,000. There were no other reserves at that date. The preference shares carry no votes. The following are the draft income statements of High Ltd and Tension Ltd for the year ended 31 March 20X9. CU
High Ltd
Revenue Dividends from Tension Ltd Ordinary Preference Bank deposit interest Less
CU 274,500
CU
Tension Ltd CU 181,250
4,800 150 250 279,700
Cost of sales Distribution costs Administrative costs Preference dividend paid
Income tax expense Profit after tax
126,480 67,315 25,555 –
(219,350) 60,350 (29,000) 31,350
– – 100 181,350 86,520 42,885 17,295 600
(147,300) 34,050 (15,100) 18,950
The following information is also available. (1) The inventory of High Ltd at 31 March 20X9 includes goods purchased from Tension Ltd at a profit to that company of CU700. Total intra-group sales for the year amounted to CU37,500. (2) On 1 April 20X8 High Ltd sold plant costing CU7,000 to Tension Ltd for CU10,000. The profit on sale has been taken to cost of sales. Depreciation has been provided by Tension Ltd at 10% per annum on the cost of CU10,000. (3) Included in Tension Ltd’s administrative costs is an amount for CU3,500 in respect of management charges invoiced and included in revenue by High Ltd. (4) Tension Ltd’s issued share capital comprises 10,000 50p ordinary shares and 4,000 CU1 15% redeemable preference shares. (5) Four years ago a goodwill impairment loss was recognised in High Ltd’s consolidated financial statements leaving goodwill in the consolidated balance sheet at CU1,200. A further CU180 impairment loss needs to be recognised in the current year. (6) Retained earnings at 1 April 20X8 were CU576,000 for High Ltd and CU72,600 for Tension Ltd. Requirements (a)
Prepare the consolidated income statement for the year ended 31 March 20X9 and calculate the retained earnings brought forward attributable to the equity holders of High Ltd and to the minority interest. (10 marks)
(b) For each adjustment you have made in the consolidation schedule explain why you have made it (include in your answer the journal adjustment and the impact on consolidated profit). (10 marks) (20 marks)
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting 21
ETHOS LTD The following draft income statements and statements of changes in equity were prepared for the year ended 31 March 20X9. Income statements
Ethos Ltd CU 303,600 (143,800) 159,800 (71,200) 88,600 2,800 91,400 (46,200) 45,200
Revenue Cost of sales Gross profit Operating costs Profit from operations Investment income Profit before tax Income tax expense Profit after tax
Pathos Ltd CU 217,700 (102,200) 115,500 (51,300) 64,200 1,200 65,400 (32,600) 32,800
Statements of changes in equity (extracts)
Net profit for the year Transfer between reserves Interim dividends on ordinary shares Balance brought forward Balance carried forward
Ethos Ltd General Retained reserve earnings CU CU – 45,200 15,000 (15,000) – (30,000) 15,000 200 – 79,300 15,000 79,500
Pathos Ltd General Retained reserve earnings CU CU – 32,800 5,000 (5,000) – – 5,000 27,800 – 38,650 5,000 66,450
On 30 November 20X8 Ethos Ltd acquired 75% of the issued ordinary capital of Pathos Ltd for CU130,000. Pathos Ltd has in issue 100,000 CU1 ordinary shares. Ethos Ltd has 500,000 CU1 ordinary shares in issue. Profits of both companies accrue evenly over the year. Requirements (a)
Prepare the consolidated income statement and consolidated statement of changes in equity for the year ended 31 March 20X9. (10 marks)
(b) Explain why only four months of Pathos Ltd’s income statement is included in the consolidated income statement. (3 marks) (13 marks) 22
HIGG LTD The following summarised income statements have been prepared for the year ended 30 June 20X5 by Higg Ltd and its subsidiary undertaking Topp Ltd. Higg Ltd Topp Ltd CU CU CU Revenue 647,200 296,800 Cost of sales (427,700) (194,100) Gross profit 219,500 102,700 Operating costs (106,300) (42,300) Profits from operations 113,200 60,400 Investment income Dividends from Topp Ltd 7,000 – Dividends from quoted investments 3,000 2,000 Interest from Topp Ltd 1,600 – 11,600 Finance cost – (8,000) Profit before tax 124,800 54,400 Income tax expense (58,300) (27,300) Profit after tax 66,500 27,100
460
© The Institute of Chartered Accountants in England and Wales, March 2009
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12
The following information is relevant. (1) Higg Ltd acquired 70% of the CU100,000 issued ordinary shares of Topp Ltd for CU95,000 on 1 July 20X1 when retained earnings of Topp Ltd were CU13,200. On the same date Higg Ltd acquired 20% of the 8% loan stock of Topp Ltd. The total loan stock issued at par is CU100,000. (2) The revenue of Higg Ltd includes sales to Topp Ltd of CU36,000, all invoiced at cost plus 25%. On 30 June 20X5 the inventory of Topp Ltd included CU9,000 in respect of such goods. (3) Three years ago a goodwill impairment loss of CU5,910 was recognised in Higg Ltd’s consolidated financial statements. A further loss of CU1,970 needs to be reflected in the current year consolidated financial statements. (4) Higg Ltd paid an interim ordinary dividend of CU20,000 and total dividends to irredeemable preference shareholders of CU8,000. Topp Ltd paid an interim ordinary dividend of CU10,000. (5) The retained earnings of Higg Ltd and Topp Ltd as at 1 July 20X4 were CU72,400 and CU29,600 respectively. The share capital of Higg Ltd comprises 500,000 CU1 ordinary shares and 100,000 CU1 irredeemable preference shares. Requirement Prepare the consolidated income statement and consolidated statement of changes in equity for the year ended 30 June 20X5. (10 marks) Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
© The Institute of Chartered Accountants in England and Wales, March 2009
461
Financial accounting
Technical reference For a comprehensive Technical reference section, covering all aspects of group accounts (except group cash flow statements) see Chapter 15.
462
© The Institute of Chartered Accountants in England and Wales, March 2009
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12
Answers to Self-test 1
A
Revenue = 460,000 + 120,000 – 60,000 = CU520,000
2
C Walcot Ltd CUm (11)
Cost of sales PURP
Ufton Ltd CUm (10)
Reduce revenue by intra-group sales of CU40,000.
4
A
Reduce consolidated profit by provision for unrealised profit.
D CU'000 100 46
Less: Intra-group sales (9 ×
46 ) 34.5
(12) 134
A CU'000 30.0 11.5
Hop Ltd Skip Ltd Less: PURP ((12 – 9 ×
7
CUm
25 = CU4,000 125
Hop Ltd Skip Ltd
6
Consol
(19)
D
5
CUm 3
(1)
3
20,000 ×
Adj
1 ) 3
(1.0) 40.5
A CU
30 Closing PURP (120,000 × 25% × 130 )
6,923
30 Opening PURP (15,000 × 130 ) Increase required 8
(3,462) 3,461
D
Interest receivable (40% × 10,000) Interest payable PBT
Shaw Ltd CU 4,000 80,000
Wilde Ltd CU (10,000) 94,000
Adj CU (4,000) 4,000
Cons CU – (6,000) 174,000 168,000
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Financial accounting 9
D
Share of Suton's post-acquisition retained earnings
= 24,000 – 5,000 = 19,000 × 80% = CU15,200
10
B
Profit after tax
= 10,000 × 80% = CU8,000
11
12
C B/f Share of IS (10 × 20%) Less Share of dividends (7 × 20%) C/f
CU'000 5.2 2.0 (1.4) 5.8
C/f Dividend Profit At acquisition
CU 56,000 4,000 (10,000) 50,000
C
Minority interest at acquisition =
50,000 250,000
= 20% 13
B CU 29,500 (3,000) 26,500
Share of consolidated profit (25% ×118,000) Less Share of PURP (25% × 36,000 × 50/150) 14
C
Revenue Cost of sales Gross profit 15
Sanderstead Ltd CU 600,000 (400,000)
Adj
Consol
CU (20,000) 20,000
CU 880,000 (580,000) 300,000
% 150 (100) 50
CU 60,000 (40,000) 20,000
B SP Cost Gross profit
16
Croydon Ltd CU 300,000 (200,000)
B Profit prior to finance cost Finance cost (200,000 × 5%) × 40%
464
© The Institute of Chartered Accountants in England and Wales, March 2009
CU 100,000 (10,000) 90,000 36,000
GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE
17
12
D CU 1,000
Share of profit after tax (25% × 4,000) Point to note
As the inventory was sold by Horace Ltd, the PURP adjustment would be to Horace Ltd's profits and would have no impact on the MI. 18
B CU 89,000 (42,000) 47,000 24,000 71,000
Profit from operations – Dennis Ltd Less income tax expense Group share of Terry Ltd (80% × 30,000) 19
HUMPHREY LTD Consolidated income statement for the year ended 30 September 20X5 CU'000 1,400 (742) 658 (110) (120) 428 (31) 9 406 (184) 222
Revenue (W2) Cost of sales (W2) Gross profit Distribution costs (W2) Administration expenses (W2) Profit from operations Finance cost (W2) Investment income (W2) Profit before tax Income tax expense (W2) Profit after tax Attributable to Equity holders of Humphrey Ltd ( Minority interest (W3)
216 6 222
Consolidated statement of changes in equity for the year ended 30 September 20X5 (extracts)
Net profit for the period Interim dividend on ordinary shares (W5) Balance brought forward (W4 and W6) Balance carried forward
Retained earnings attributable to equity holders of Humphrey Ltd CU'000 216 (100) 116 118 234
Minority interest CU'000 6 (4) 2 18 20
Total CU'000 222 (104) 118 136 254
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Financial accounting WORKINGS (1) Group structure Humphrey Ltd 80% Stanley Ltd (2) Consolidation schedule
Revenue C of S Per Q PURP Distribution Administrative Finance cost Inv income (20 – 16) Income tax PAT
Humphrey Ltd CU'000 1,100 (600) (2) (60) (65) (25) 4 (160)
Stanley Ltd CU'000 400 (240) – (50) (55) (6) 5 (24) 30
Adj
Consol
CU'000 (100)
CU'000 1,400
100 –
(742) (110) (120) (31) 9 (184)
(3) Minority interest 20% × 30,000 (W2) or as per PAT in question
CU'000 6
(4) Retained earnings b/f Group Humphrey Ltd Stanley Ltd (80% × (40 – 5))
CU'000 90 28 118
(5) Intra-group dividend Check consistency between companies. Received by Humphrey Ltd (80% × 20) Received by M1 (20% × 20) Paid by Stanley Ltd
CU'000 16 4 20
(6) Minority interest b/f Share capital Retained earnings × 20%
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© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 50 40 90 18
GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE
20
12
HIGH LTD (a)
Consolidated income statement for the year ended 31 March 20X9 CU 414,750 (178,900) 235,850 (110,200) (39,530) 86,120 (450) 350 86,020 (44,100) 41,920
Revenue (W2) Cost of sales (W2) Gross profit Distribution costs (W2) Administration expenses (W2) Profit from operations Finance cost (W2) Investment income (W2) Profit before tax Income tax expense (W2) Profit after tax Attributable to Equity holders of High Ltd ( Minority interest (W3)
38,270 3,650 41,920
Retained earnings brought forward Attributable to equity holders of High Ltd (W5) Minority interest (W5)
CU 630,280 14,520
(b) Adjustments in consolidation schedule (i)
Intra-group sales of inventory As the consolidated accounts treat High Ltd and Tension Ltd as one entity, the total intragroup trading needs to be eliminated on consolidation. The total of CU37,500 will be in both Tension Ltd’s revenue and High Ltd’s cost of sales. The adjustment required is DR CU 37,500
Revenue Cost of sales
CR CU 37,500
This has no impact on net consolidated profit. For the same reason, it is also necessary to eliminate the unrealised profit on the inventory held by High Ltd at the year end. This adjustment will also reduce inventory to original cost to the group. The adjustment is
Cost of sales of Tension Ltd Inventory in the consolidated balance sheet
DR CU 700
CR CU 700
This will reduce consolidated profit. (ii)
Intra-group sale of plant For the same reasons as given for inventory above, it is necessary to eliminate the unrealised profit and reduce the plant to its original cost. The adjustment is
Cost of sales of High Ltd Cost of plant in the consolidated balance sheet
DR CU 3,000
CR CU 3,000
This will have a one-off impact on consolidated profit this year.
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting In current and future years (until the plant has been fully depreciated by Tension Ltd) it will also be necessary to adjust the depreciation charge by 10% of the PURP, to reflect the gradual realisation of the above profit through the annual depreciation charge. This will require the following.
Accumulated depreciation in the consolidated balance sheet Cost of sales of High Ltd
DR CU 300
CR CU 300
Therefore the net impact is to reduce current year consolidated profit by CU2,700. (iii) Management charges As with intra-group trading, this charge must be contra’d out on consolidation to reflect the single entity concept. The adjustment required is
Revenue of High Ltd Administrative costs of Tension Ltd
DR CU 3,500
CR CU 3,500
This has no impact on consolidated profit. (iv) Impairment of goodwill Goodwill only exists in the consolidated accounts and therefore the individual income statements include no impairment of goodwill. The impairment charge for the year is dealt with as follows.
Administration costs Goodwill in the consolidated balance sheet
DR CU 180
CR CU 180
This will reduce consolidated profit. (v)
Redeemable preference shares These are in substance liabilities and the net 'dividend' payable outside the group should be included as part of the consolidated finance cost. Effectively the 'dividends' paid by Tension Ltd are contra’d against the dividends received by High Ltd and the adjustment required is
Dividends received Dividends paid (25% × CU600) This leaves CU450 payable to third parties. WORKINGS (1) Group structure High Ltd 80% ords (25% prefs) Tension Ltd
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© The Institute of Chartered Accountants in England and Wales, March 2009
DR CU 150
CR CU 150
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(2) Consolidation schedule High Ltd CU 274,500
Revenue C of S Per Q Inventory PURP NCA PURP Depreciation (10% 3,000) Distrib Admin Per Q Impairment of GW Preference dividends received Preference dividends paid Inv income – interest Income tax PAT
(126,480) (3,000) 300 (67,315) (25,555) (180) 150 250 (29,000)
Tension Ltd CU 181,250 (86,520) (700)
Adj CU (37,500) (3,500)
(600) 100 (15,100) 18,250
CU 414,750
37,500 (178,900) (110,200)
(42,885) (17,295)
Consol
3,500 (150) 150
(39,530) (450) 350 (44,100)
(3) Minority interest 20% CU18,250 = CU3,650 (4) Goodwill Cost Less Share of net assets at acquisition Ordinary shares (80% 5,000) Retained earnings (80% 4,000) On acquisition NBV at last impairment Impairment loss previously recognised
CU 9,000 (4,000) (3,200) 1,800 (1,200) 600
(5) Retained earnings b/f High Ltd Tension Ltd ((72,600 – 4,000) × 80%) Less: Impairment loss to date (W4) Minority interest (72,600 × 20%)
CU 576,000 54,880 (600) 630,280 14,520
Point to note Alternative calculation for PAT of Tension Ltd (W2) PAT per question Less Inventory PURP
CU 18,950 (700) 18,250
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Financial accounting 21
ETHOS LTD (a)
Consolidated income statement for the year ended 31 March 20X9 CU 376,167 (177,867) 198,300 (88,300) 110,000 3,200 113,200 (57,067) 56,133
Revenue (W2) Cost of sales (W2) Gross profit Operating costs (W2) Profit from operations Investment income (W2) Profit before tax Income tax expense (W2) Profit after tax Attributable to Equity holders of Ethos Ltd ( Minority interest (W3)
53,400 2,733 56,133
Consolidated statement of changes in equity for the year ended 31 March 20X9 Attributable to equity holders of Ethos Ltd Ordinary share General Retained capital reserve earnings Total CU CU CU CU Net profit for the period Transfer between reserves (W4) Added on acquisition of subsidiary (W5) Interim dividend on ordinary shares Balance brought forward Balance carried forward
Minority interest CU
Total CU
–
–
53,400
53,400
2,733
56,133
–
16,250
(16,250)
–
–
–
–
–
–
–
40,129
40,129
– –
– 16,250
(30,000) 7,150
(30,000) 23,400
– 42,862
(30,000) 66,262
500,000
–
79,300
579,300
–
579,300
500,000
16,250
86,450
602,700
42,862
645,562
(b) Time apportionment The results of a subsidiary are included in the consolidated accounts only from the date control is achieved. Ethos Ltd acquired 75% of the issued ordinary capital of Pathos Ltd on 30 November 20X8. This is the date on which control passed and hence the date from which the results of Pathos Ltd should be reflected in the consolidated income statement. Therefore only profits earned by Pathos Ltd in the four months since that date are post-acquisition profits. The remaining previous eight months profit from 1 April 20X8 to 30 November 20X8 are all preacquisition profits and will be included in the calculation of goodwill on consolidation.
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WORKINGS (1) Group structure Ethos Ltd 75% (acq 30 November 20X8 4/12 in) Pathos Ltd (2) Consolidation schedule Ethos Ltd CU 303,600 (143,800) (71,200) 2,800 (46,200)
Revenue C of S Op costs Inv income Income tax PAT
Pathos Ltd CU 72,567 (34,067) ((17,100) 400 (10,867) 10,933
Adj CU – –
Consol CU 376,167 (177,867) (88,300) 3,200 (57,067)
(3) Minority interest in profit for the year CU 2,733
25% x 10,933 (W2) (4) Transfer to general reserve Ethos Ltd Pathos Ltd (75% × 5,000 × 4/12)
CU 15,000 1,250 16,250
(5) Minority interest added on acquisition Share capital Retained earnings At 1 April 20X8 In current year (32,800 x 8/12) × 25%
CU 100,000 38,650 21,867 160,517 40,129
Point to note Alternative calculation for PAT of Pathos Ltd (W2) PAT per question 32,800 × 4/12
CU 10,933
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Financial accounting 22
HIGG LTD Consolidated income statement for the year ended 30 June 20X5 CU 908,000 (587,600) 320,400 (150,570) 169,830 (6,400) 5,000 168,430 (85,600) 82,830
Revenue Cost of sales Gross profit Operating costs Profit from operations Finance cost Investment income Profit before tax Income tax expense Profit after tax Attributable to Equity holders of Higg Ltd ( Minority interest (W3)
74,700 8,130 82,830
Consolidated statement of changes in equity for the year ended 30 June 20X5
Net profit for the period Interim dividend on ordinary shares (W5) Total dividends on preference shares (irredeemable) Balance brought forward (W4, W6) Balance carried forward
Attributable to equity holders of Higg Ltd Ordinary Preference share share capital Retained capital (irredeemable) earnings Total CU CU CU CU –
74,700
–
–
(20,000)
(20,000)
(3,000)
(23,000)
– –
– –
(8,000) 46,700
(8,000) 46,700
– 5,130
(8,000) 51,830
500,000
100,000
77,970
677,970
38,880
716,850
500,000
100,000
124,670
724,670
44,010
768,680
(1) Group structure Higg Ltd 70% Topp Ltd
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8,130
Total CU
–
WORKINGS
74,700
Minority interest CU
82,830
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(2) Consolidation schedule
Revenue C of S Per Q PURP (25/125 9,000) Op costs Per Q Impairment of GW Inv income Dividends from quoted investments Interest received Finance cost Income tax PAT
Higg Ltd CU 647,200
Topp Ltd CU 296,800
Adj CU (36,000)
(427,700) (1,800)
(194,100)
36,000
(106,300) (1,970)
(42,300)
3,000 1,600 (58,300)
Consol CU 908,000 (587,600) (150,570)
2,000 (8,000) (27,300) 27,100
(1,600) 1,600
5,000 – (6,400) (85,600)
(3) Minority interest CU 8,130
30% × 27,100 (4) Retained earnings b/f
CU Group Higg Ltd Topp Ltd (70% (29,600 – 13,200)) Less: Goodwill impaired to 1 July 20X4
72,400 11,480 (5,910) 77,970
(5) Intra-group dividends and interest Paid by Topp Ltd Dividends Interest Received by Higg Ltd Dividends (70% × 10,000) Interest (20% × 8,000) Dividends received by MI (30% 10,000)
CU 10,000 8,000 7,000 1,600 3,000
(6) Minority interest b/f Share capital Retained earnings × 30%
CU 100,000 29,600 129,600 38,880
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Answer to Interactive questions
Answer to Interactive question 1 Whales Ltd CU 120,000 (80,000)
Revenue C of S – per Q – PURP GP
40,000
Porpoise Ltd CU 70,000 (50,000) (2,000) 18,000
Adj CU (30,000) 30,000 –
Consol CU 160,000 (102,000) 58,000
Points to note 1
The intra-group sale is eliminated in the adjustments column. It has no effect on the overall profit.
2
The unrealised profit is eliminated by increasing the cost of sales of the selling company. Where the selling company is the subsidiary this will reduce the profit figure on which the calculation of minority interest is subsequently based.
Answer to Interactive question 2 Depreciation – per Q NCA PURP (15,000 – (12,000 – 4,800)) Depreciation adjustment ((15,000 – 12,000) 20%)
P Ltd CU (35,000) (7,800) 600
S Ltd CU (25,000)
Adj CU
Consol CU (67,200)
Answer to Interactive question 3 (a)
Consolidated income statement (extracts) for the year ended 30 September 20X7 Revenue Cost of sales Gross profit Minority interest (W3) WORKINGS (1)
Group structure P 75% S
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CU 130,000 (74,000) 56,000 (1,750)
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(2) Consolidation schedule
Revenue C of S – per Q – PURP (W4) Expenses Income tax Profit
Pathfinder Ltd CU 100,000 (60,000) (4,000)
Sultan Ltd CU 50,000 (30,000)
Adj CU (20,000) 20,000
Consol CU 130,000 (74,000)
(10,000) (3,000) 7,000
(3) Minority interest Sultan Ltd
25%
7,000
% 100 (60) 40
CU 20,000 (12,000) 8,000
(W2)
CU 1,750
(4) PURP Selling price Cost Gross profit (b)
CU 1/2 =
4,000
Consolidated income statement for the year ended 30 September 20X7 CU 130,000 (74,000) 56,000 (30,000) 26,000 (9,000) 17,000
Revenue Cost of sales Gross profit Expenses Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of Pathfinder Ltd () Minority interest (W3)
16,250 750 17,000
WORKINGS (1) Group structure As part (a) (2) Consolidation schedule
Revenue C of S – per Q – PURP (W4) Expenses Income tax Profit
Pathfinder Ltd CU 100,000 (60,000) (20,000) (6,000)
Sultan Ltd CU 50,000 (30,000) (4,000) (10,000) (3,000) 3,000
Adj CU (20,000) 20,000
Consol CU 130,000 (74,000) (30,000) (9,000)
(3) Minority interest Sultan Ltd
25%
3,000
(W2)
CU 750
(4) PURP As part (a)
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Answer to Interactive question 4 P Ltd Consolidated income statement for the year ended 31 December 20X7 9
Revenue C of S Gross profit
P Ltd CU 100,000 (70,000) 30,000
/12 S Ltd CU 56,250 (45,000) 11,250
Adj CU (15,000) 15,000 –
Consol CU 141,250 (100,000) 41,250
Answer to Interactive question 5 Consolidated statement of changes in equity for the year ended 30 June 20X8
Net profit for the year Dividends declared Brought forward (W) Carried forward
Attributable to equity holders of William Ltd Share Retained capital earnings Total CU CU CU – 178,000 178,000 – (20,000) (20,000) – 158,000 158,000 200,000 300,000 500,000 200,000 458,000 658,000
Minority interest CU 13,000 (6,000) 7,000 34,000 41,000
Total CU 191,000 (26,000) 165,000 534,000 699,000
WORKING Group reserves b/f William Ltd Rufus Ltd (80% (120,000 – 70,000)) Goodwill impairment to date
CU 270,000 40,000 (10,000) 300,000 CU
MI b/f Share capital (20% 50,000) Retained earnings (20% 120,000)
10,000 24,000 34,000
Answer to Interactive question 6 Consolidated income statement for the year ended 31 March 20X9 Revenue (Joseph + half Mary) Costs (Joseph + half Mary) Profit before tax Income tax (Joseph + half Mary) Profit after tax Attributable to: Equity holders of Joseph Ltd () Minority interest (W1)
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CU000 1,075 (575) 500 (165) 335 320 15 335
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Consolidated statement of changes in equity for the year ended 31 March 20X9
Net profit for the year Added on acquisition of subsidiary (W2) Brought forward Carried forward
Attributable to equity holders of Joseph Ltd Share Retained capital earnings Total CU'000 CU'000 CU'000 – 320 320 – – – 500 400 900 500 720 1,220
Minority interest CU'000 15 95 – 110
Total CU'000 335 95 900 1,330
WORKINGS (1) Minority interest in profit for the year CU000 15
20% of (150,000 50%) (2) Minority interest added on acquisition Share capital Retained earnings b/f Profit for first half of current year (150,000 50%) 20% of
CU000 100 300 75 475
CU000
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chapter 13
Group accounts: associates
Contents Introduction Examination context Topic List 1
Investment in an associate
2
Equity method: consolidated balance sheet
3
Equity method: consolidated income statement
4
Associate's losses
5
Transactions between a group and its associate
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Introduction
Learning objectives
Explain the relationship between a group and its associate
Explain the principles behind the treatment of the associate
Reflect an associate in group accounts by means of equity accounting
Deal with transactions between a group and its associate
Tick off
Specific syllabus references for this chapter are: 1g, 3c,d,e.
Practical significance In Chapters 10-12 we have seen that companies may acquire other entities as a means of achieving growth and meeting corporate objectives. We have been looking at situations where an investor obtains control of an investee through the ownership of a majority of the ordinary share capital. However, there are other ways in which an investment may be made. A minority stake could be obtained such that the investor can influence, rather than control, the key decisions made by the entity. This is normally achieved through the acquisition of 20% or more of the voting rights (normally attached to ordinary shares). This type of investment is referred to as an associate. But why would an entity wish to obtain a minority stake only? In many cases the acquisition of a minority stake is part of a wider plan. The investor is able to be involved in the strategy of the target company, through representation on the board whilst at the same time limiting its financial commitment. It is able to evaluate whether the target company would fit in with its existing activities and, if appropriate, to make initial plans for a merger. The target company may also benefit from this process as the investing entity can often provide expertise such as management and logistics services. This approach is common in high technology and developing industries. Typically these involve small, newly-established entities which require capital funding. If the readers of financial information are to understand the level of influence an entity can exercise it is essential that the method of reporting reflects this adequately. BAS 28 Investments in Associates aims to ensure that this is the case.
Stop and think? How do you think a simple trade investment differs from an investment in an associate?
Working context If you have worked on a client which involves a group of companies the investments made by the parent company may have included an associate. As we saw in Chapter 10 the subsidiaries in a group are normally consolidated by preparing a consolidation package. Typically the same type of procedure is used in respect of the associate. The key issues which would need to be addressed specifically include the correct identification of the investment as an associate and the appropriate accounting treatment in the financial statements.
Syllabus links More complex aspects of group financial statements will be examined in the Financial Reporting paper and at the Advanced stage. It is therefore important that you have a sound understanding of the accounting treatment of associates to carry forward to these other papers.
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Examination context
Examination commentary Associates could be examined in both the short-form question and written test sections of the paper. In the written test section it is likely that the associate will be examined in the context of the preparation of a consolidated balance sheet or income statement, within a group structure which includes at least one subsidiary. A written element of such a question could focus on an explanation of equity accounting by reference to the underlying principles or a comparison of the treatment of associates under BFRS. In the examination candidates could be required to:
Incorporate the results of an associate in the consolidated financial statements using the equity method
Explain the equity method and the principles behind it
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1 Investment in an associate Section overview
1.1
An associate is an entity over which the parent exercises significant influence.
Significant influence is presumed where the parent holds 20% or more of the voting rights.
An associate is not part of the group.
An investment in an associate should be accounted for in the consolidated financial statements using the equity method of accounting.
Introduction In the previous chapters we have seen that where a parent entity controls another entity (normally by holding over 50% of the ordinary share capital) it is said to have a subsidiary. The results of the parent and subsidiary are consolidated in group accounts as if they were a single entity. However, investments can take a number of different forms. An investing entity may obtain sufficient shares such that the investment is of significant importance to it, without achieving control. This type of investment is referred to as an associate and is dealt with by BAS 28 Investments in Associates. In this chapter we will look at how to account for an associate. (The detailed provisions of BAS 28 are dealt with in Chapter 15.)
1.2
Associate Definition Associate: An entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.
When deciding whether an investment should be treated as an associate the critical feature is whether the investing entity has significant influence over the investee.
Definition Significant influence: The power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies.
Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity. BAS 28 states that:
482
If an investor holds 20% or more of the voting power of the investee (directly or indirectly) it is presumed that the investor has significant influence; therefore associate status will be presumed unless it can be demonstrated otherwise.
If an investor holds less than 20% of the voting power of the investee (directly or indirectly) it is presumed that the investor does not have significant influence; therefore there is no associate status unless demonstrated otherwise.
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BAS 28 also states that significant influence can be shown by one or more of the following:
Representation on the board of directors Participation in policy making decisions Material transactions between the investor and investee Interchange of managerial personnel Provision of essential technical information
Point to note For examination purposes you should assume that a holding of 20% or more of the ordinary share capital constitutes significant influence.
1.3
Relationship with the group An associate is not part of the group as a group comprises the parent and its subsidiaries only. In terms of the Financial Accounting syllabus, the group investment in the associate is always held by the parent company, not a subsidiary. So:
P Group 80% S
1.4
40% A
Treatment in investing company's own accounts The balance sheet of the investing company shows the investment in the associate in non-current asset investments, usually at cost. The investing company's income statement shows dividend income received and receivable from the associate as 'income from associates'. The question is whether this provides the shareholders of the parent company with sufficient information. It could be argued that to reflect fairly the nature of the investor's interest where it is in a position to exercise significant influence the group's interest in the net assets and results of the associate should be reflected. This is achieved by the use of the equity method of accounting.
1.5
Treatment in consolidated financial statements: accounting principles An investment in an associate should be accounted for in the consolidated financial statements using the equity method of accounting. This method reflects the substance of the relationship between the entities rather than their legal form. The group's share of the associate's profits, assets and liabilities are included in the consolidated financial statements rather than the cost of the investment and dividend income received. (Exceptions to the general requirement to apply the equity method of accounting are described in Chapter 15.) Point to note The equity method is only used in the group accounts i.e. the parent company holds investments in subsidiaries as well as associates. If the investor does not issue consolidated financial statements the investment will be shown in the investor's individual financial statements as described in section 1.4 above.
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2 Equity method: consolidated balance sheet Section overview
2.1
The investment in the associate is shown as a single line entry in the consolidated balance sheet.
If the carrying amount of the investment has suffered an impairment it should be written down to its recoverable amount.
Basic principle An associate is accounted for as follows:
The interest in the associate is presented as a single line under non-current assets described as 'Investments in Associates'.
It is initially recognised at cost and is subsequently adjusted in each period for changes in the parent's share of the net assets.
In group reserves the parent's share of the associate's post-acquisition reserves are included (as for a subsidiary).
Point to note The assets and liabilities of the associate are not included on a line-by-line basis.
2.2
Calculation of balance sheet carrying amount The investment in the associate is calculated as follows: Original cost (in P's books) Share of post acquisition change in net assets Less: Impairment losses to date
CU X X X (X) X
Point to note If the parent company has made any long term loans to the associate which are not expected to be repaid in the foreseeable future these should be included as part of the investment in the associate.
2.3
Impairment losses At the date of acquisition the investment in the associate is recognised at cost (see section 2.1). This represents the parent's share of the fair value of the net assets acquired plus goodwill arising on acquisition. This goodwill is not separately calculated or disclosed (as with a subsidiary) but instead is included as part of the carrying amount of the investment. This presentation aims to avoid giving the misleading impression that the investor has acquired a goodwill asset through control over its share of the associate’s individual assets, liabilities and contingent liabilities. It has only gained significant influence over the affairs of the associate so no goodwill is calculated at the date the investment is made. As a result impairment tests are performed in relation to the investment as a whole. If the investment has suffered an impairment it is written down to its recoverable amount (see section 2.2). Point to note If there is a discount on the purchase of the investment (i.e. the cost is less than the fair value of the net assets acquired) it must be recognised in profit or loss for the period in which the investment is made. In practice this is unlikely to occur.
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2.4
Application of the equity method in the consolidated balance sheet Remember that the equity method is only used in group accounts. This means that the parent has subsidiaries as well as an associate. In an examination question the practical implication of this is that you will need to produce the consolidation workings for the subsidiaries (See Chapter 11). These workings are adapted for the inclusion of the associate as follows: Working1: Group structure
Include the associate in the group structure diagram
Working 2: Net assets
Produce a net assets working for the associate (as for a subsidiary) This should include any fair value or accounting policy adjustments to the associate's net assets The post acquisition change in net assets will form part of the 'Investments in Associates' balance
Working 5: Consolidated retained earnings (reserves)
Include the parent's share of the associate's post acquisition retained earnings
The calculation of the carrying amount of the investment in the associate will usually be Working 6.
Interactive question 1: Equity method (CBS)
[Difficulty level: Easy]
P Ltd owns 80% of S Ltd and 40% of A Ltd. Balance sheets of the three companies at 31 December 20X8 are as follows.
Investment: shares in S Investment: shares in A Sundry assets Share capital – CU1 ordinary shares Retained earnings Equity Liabilities
P CU 800 600 6,600 8,000
S CU
A CU
1,000 4,000 5,000 3,000 8,000
400 3,400 3,800 2,000 5,800
800 3,600 4,400 1,000 5,400
– – 5,800 5,800
– – 5,400 5,400
P acquired its shares in S when S's retained earnings were CU520, and P acquired its shares in A when A's retained earnings were CU400. In 20X7 an impairment loss of CU20 was recognised in relation to the investment in A. Requirement Prepare the consolidated balance sheet at 31 December 20X8. Fill in the proforma below.
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Solution P Ltd: Consolidated balance sheet as at 31 December 20X8 CU
Intangibles (W3) Investments in associates (W6) Sundry assets Share capital Retained earnings (W5) Attributable to equity holders of P Ltd Minority interest (W4) Equity Liabilities WORKINGS (1) Group structure
(2) Net assets Balance sheet date CU
Acquisition CU
Post acquisition CU
S Ltd Share capital Retained earnings A Ltd Share capital Retained earnings (3) Goodwill S Ltd Cost of investment Net assets acquired Balance c/f
CU
(4) Minority interest CU S Ltd (5) Retained earnings CU P Ltd S Ltd A Ltd Impairment to date
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(6) Investments in associates Original cost Share of post-acquisition change in net assets (W2)
CU
Impairment losses to date See Answer at the end of this chapter.
3 Equity method: consolidated income statement Section overview
3.1
Share of profit of associates is recognised as a single line entry in the consolidated income statement.
Basic principle The associate is accounted for as follows:
The group's share of the associate's profit after tax is recognised in the consolidated income statement as a single line entry.
This is disclosed immediately before the group profit before tax as 'Share of profit of associates'.
If the associate is acquired mid-year its results should be time-apportioned.
Points to note (1) It may seem odd to include an after tax balance in arriving at the profit before tax, but this is in line with the Guidance on Implementing BAS 1 Presentation of Financial Statements. (2) The revenues and expenses of the associate are not consolidated on a line-by-line basis.
3.2
Impairment review Where an impairment review in the current period has revealed an impairment loss to be charged to the income statement, the loss is deducted from the parent's share of the profit after tax of the associate (or added to the parent's share of a post-tax loss.)
3.3
Application of the equity method in the consolidated income statement An additional working will be required to calculate the parent's share of the associate's profit after tax. Point to note The consolidation schedule (Working 2) will only include the parent and any subsidiaries as the associate is not consolidated.
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Interactive question 2: Equity method (CIS)
[Difficulty level: Easy]
P Ltd has owned 80% of S Ltd and 40% of A Ltd for several years. Income statements for the year ended 31 December 20X8 are as follows. P Ltd CU 14,000 (9,000) 5,000 (2,000) 3,000 1,000 4,000 (1,000) 3,000
Revenue Cost of sales Gross profit Administrative expenses Profit from operations Investment income Profit before tax Income tax expense Profit after tax
S Ltd CU 12,000 (4,000) 8,000 (6,000) 2,000 – 2,000 (1,200) 800
A Ltd CU 10,000 (3,000) 7,000 (3,000) 4,000 400 4,400 (2,000) 2,400
An impairment loss of CU120 is to be recognised in 20X8 in relation to the investment in A Ltd. Requirement Prepare the consolidated income statement for the year ended 31 December 20X8. Fill in the proforma below.
Solution P Ltd: Consolidated income statement for the year ending 31 December 20X8 CU
Revenue Cost of sales Gross profit Administrative expenses Profit from operations Investment income Share of profit of associates (W4) Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of P Ltd () Minority interest (W3) WORKINGS (1) Group structure
P Group 80%
40%
S
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GROUP ACCOUNTS: ASSOCIATES 13
(2) Consolidation schedule P Ltd CU
S Ltd CU
Adj CU
Consol CU
Revenue Cost of sales Admin expense Inv. income Tax (3) Minority interest CU S Ltd (4) Share of profit of associates CU A Ltd See Answer at the end of this chapter.
4 Associate's losses Section overview
4.1
Losses recognised in respect of the associate are limited to the carrying amount of the associate.
Accounting treatment Where an associate makes a loss the following treatment should be adopted: Consolidated balance sheet
The group's share of the loss should be recognised as a reduction in the carrying amount of the associate. The group share of the post-tax loss should be recognised.
Consolidated income statement Point to note
Once the carrying amount of the investment in the associate has been reduced to zero, no further losses are recognised by the group. The parent is only required to make a provision for any additional losses incurred by the associate to the extent that the parent has a legal or constructive obligation to make good these amounts.
Worked example: Associate's losses At 31 December 20X6, the carrying amount of P Ltd's 40% interest in A Ltd is CU600,000. In the year ended 31 December 20X7 A Ltd makes a post-tax loss of CU2,000,000. The associate will be recognised in the consolidated financial statements at 31 December 20X7 as follows:
40% x CU2,000,000 = CU800,000
Consolidated income statement CU (600,000)
Consolidated balance sheet CU Nil
The loss recognised is limited to the carrying amount of the investment i.e. CU600,000.
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5 Transactions between a group and its associate Section overview
5.1
Transactions between the group and its associates are not cancelled on consolidation.
An adjustment is required for any unrealised profit.
Basic principle As we said in section 1 the associate is not part of the group. This means that whilst the single entity concept applies to the parent and subsidiaries it does not apply to any associates. One of the consequences of this is that transactions between a group member and an associate are not cancelled on consolidation.
5.2
Trading transactions Trading transactions are not cancelled on consolidation. Consolidated income statement
Consolidated balance sheet
No adjustment is made to revenue or cost of sales for transactions between the group and the associate. Receivables and payables balances due from/to the associate in the individual balance sheet of the parent or its subsidiaries are carried across into the consolidated balance sheet.
Point to note In the consolidated balance sheet balances relating to loans and trading balances between the group and the associate should be shown separately.
5.3
Dividends Balances in respect of dividends from the associate are not cancelled on consolidation. However it would still be necessary to ensure that all dividends payable/receivable have been fully accounted for in the books of the individual companies (as for a subsidiary.) Consolidated income statement
Consolidated balance sheet
Dividend income from the associate is not recorded in the consolidated income statement. This is because under the equity method the group's share of the associate's profit before dividends has been recognised. If the dividend income was also recognised the same profits would be recognised twice. A receivable will be recognised in the consolidated balance sheet for dividends declared by the associate due to the group.
Interactive question 3: Dividends
[Difficulty level: Easy]
P Ltd (which also has a subsidiary) has a 40% associate A Ltd. A Ltd has declared a dividend of CU100. Requirement Show the entries to record this dividend in the books of A Ltd and P Ltd and set out its impact on the consolidated balance sheet and workings. Fill in the proforma below.
490
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Solution 1
2
Account for the dividend in the books of the individual companies A's books DR CR
CU
CU
P's books DR CR
CU
CU
Impact on CBS and workings (1) (2) (3) (4)
See Answer at the end of the chapter.
5.4
Unrealised profits Whilst transactions between the group and the associate are not cancelled on consolidation any unrealised profit on these transactions should be eliminated. In this respect the principle applied is similar to that applied to a subsidiary (see Chapters 11 and 12).
Worked example: Unrealised profits A sale is made by A Ltd to P Ltd. P Ltd has a 25% holding in A Ltd. All of the goods remain in inventory at the year-end. 75% of the profit made from the sale relates to interests held by other investors therefore only 25% of the profit (that part which belongs to the group) should be eliminated.
The adjustment is made in the books of the seller. The way that the adjustment is made depends on whether the selling company is the parent or the associate. Points to note
5.4.1
1
Unrealised profit will only arise if the goods transferred are still held by the parent or associate. If the goods have been sold to a third party there is no unrealised profit.
2
Unrealised profit adjustments apply to the transfer of non-current assets as well as the transfer of goods.
Parent sells goods to the associate Consolidated balance sheet:
Reduce P's retained earnings by its share of the unrealised profit. Reduce the carrying amount of the investment in A by P's share of the unrealised profit.
Point to note The carrying amount of the associate is adjusted rather than inventory as the inventory of the associate is not consolidated.
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Financial accounting Consolidated income statement:
Reduce P's revenue by its share of the sale on which profit is unrealised Reduce P's cost of sales by its share of the cost of goods transferred on which profit is unrealised.
Point to note The net effect of these two adjustments reduces group profit by its share of the unrealised profit.
Interactive question 4: Unrealised profits (P A) [Difficulty level: Exam standard] P Ltd owns 35% of A Ltd. During the current financial year P Ltd sold goods to A Ltd for CU300,000 on which its gross margin was 40%. A Ltd held CU50,000 of these goods in its inventories at the year end. Requirement Show the journal entries necessary to adjust for the PURP in P Ltd's consolidated balance sheet and set out the adjustments necessary to P Ltd's consolidated income statement. Fill in the proforma below.
Solution Consolidated balance sheet journal CU
DR CR
CU
Consolidated income statement
See Answer at the end of this chapter.
5.4.2
Associate sells goods to the parent Consolidated balance sheet
Reduce P's share of A's retained earnings by its share of the unrealised profit. Reduce P's inventory on consolidation by its share of the unrealised profit.
Point to note The effect on retained earnings is normally dealt with by adjusting the associate's net assets at the balance sheet date in the net assets working (working 2) by 100% of the unrealised profit. The group share of post-acquisition retained earnings will then be based on this revised figure. Consolidated income statement
Reduce P's share of A's profits after tax by its share of the unrealised profit.
Point to note This is normally achieved by reducing the associate’s profit after tax by 100% of the unrealised profit. The group share is then taken of the revised balance.
492
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Interactive question 5: Unrealised profits (A P) [Difficulty level: Exam standard] Assume the same facts as in Interactive Question 4 except that A Ltd is the seller and P Ltd holds the CU50,000 goods in inventory. Requirements (a)
Show the journal entries to adjust for the PURP in P Ltd's consolidated balance sheet.
(b) If A Ltd has profit after tax of CU75,000 calculate the share of profit of associates figure which would appear in the consolidated income statement. Fill in the proforma below.
Solution (a)
Consolidated balance sheet journal CU
CU
DR CR (b)
Share of profit of associates for consolidated income statement CU
Associate’s PAT Less: Unrealised profit group share See Answer at the end of this chapter.
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Financial accounting
Summary and Self-test
Summary
494
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Self-test Answer the following questions. 1
Durie Ltd has many subsidiary companies. On 1 January 20X6 Durie Ltd bought 30% of the share capital of Edberg Ltd for CU6,660. The retained earnings of Edberg Ltd at that date were CU13,000 and the fair value of its assets less liabilities was CU20,000. The excess of fair value over carrying amount related to a plot of land which was still owned at 31 December 20X9. The fair value was not reflected in the books of Edberg Ltd. The summarised draft balance sheet of Edberg Ltd on 31 December 20X9 includes the following. CU 5,000 17,000 22,000
Share capital – CU1 ordinary shares Retained earnings Total equity By the end of 20X9 the investment in Edberg Ltd had been impaired by CU264. At what amount should the investment in Edberg Ltd be shown using the equity method on 31 December 20X9? A B C D 2
CU6,996 CU7,596 CU7,656 CU8,256
Extracts from the income statements of Pik Ltd and its subsidiaries and Wik Ltd, its associate, for the year ended 31 March 20X6 are as follows.
Gross profit Administrative expenses Distribution costs Dividends from Wik Ltd Profit before tax Income tax expense Profit after tax
Pik Ltd (inc subsidiaries) CU'000 2,900 (750) (140) 20 2,030 (810) 1,220
Wik Ltd CU'000 1,600 (170) (190) – 1,240 (440) 800
Pik Ltd acquired 25% of the ordinary shares in Wik Ltd on 1 April 20X3 when the retained earnings of Wik Ltd were CU80,000. At what amount should the profit before tax be shown in the consolidated income statement of Pik Ltd for the year ended 31 March 20X6? A B C D 3
CU2,010,000 CU2,210,000 CU2,340,000 CU3,270,000
Albert Ltd owns many subsidiaries and 25% of Victoria Ltd. In the year ended 31 December 20X5 Albert Ltd sold goods to Victoria for CU400,000, earning a gross profit of 20%. Victoria Ltd held CU120,000 of them in its inventories at the year end. By what amount should Albert Ltd's revenue be reduced when preparing its consolidated income statement? A B C D
CU400,000 CU120,000 CU100,000 CU30,000
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Financial accounting 4
Austen Ltd has owned 100% of Kipling Ltd and 30% of Dickens Ltd, an associate, for many years. At 31 December 20X5 the trade receivables and trade payables shown in the individual company balance sheets were as follows.
Trade receivables Trade payables Trade payables included amounts owing to Austen Ltd Kipling Ltd Dickens Ltd Other suppliers
Austen Ltd CU'000 50 30
Kipling Ltd CU'000 30 15
Dickens Ltd CU'000 40 20
– 2 7 21 30
– – – 15 15
– 4 – 16 20
The inter-company accounts agreed after taking into account the following. (1) An invoice for CU3,000 posted by Kipling Ltd on 31 December 20X5 was not received by Austen Ltd until 2 January 20X6. (2) A cheque for CU6,000 posted by Austen Ltd on 30 December 20X5 was not received by Dickens Ltd until 4 January 20X6. What amount should be shown as trade receivables in the consolidated balance sheet of Austen Ltd? A B C D 5
CU75,000 CU79,000 CU87,000 CU115,000
At 31 December 20X8, Beed Ltd, Transformer Ltd and Berlin Ltd each have share capital of CU10,000, retained earnings of CU20,000 and net assets at fair value of CU30,000. Beed Ltd subscribed at par value for 60% of Transformer Ltd on its incorporation seven years ago and has acquired 40% of Berlin Ltd for CU32,000 on 31 December 20X8. What amounts will be identical in the consolidated balance sheet at 31 December 20X8? A B C D
6
Minority interest and investments in associates, but not consolidated retained earnings Minority interest and consolidated retained earnings, but not investments in associates Consolidated retained earnings and investments in associates, but not minority interest Minority interest, consolidated retained earnings and investments in associates
H Ltd and its subsidiaries (S1 and S2) and associate (A) have the following inter-company balances at the year end.
H with A S2 with A S1 with A
H CU'000 50 CR
S1 CU'000
S2 CU'000 75 DR
80 CR
A CU'000 50 DR 80 DR
All the differences related to cash in transit and where this is the case adjustments are to be made in the books of the receiving company. After making the necessary adjustments to reflect the above, the consolidated financial statements of H Ltd will include A B C D
496
No balances due to or from associates An amount due from associates of CU75,000 An amount due to associates of CU55,000 An amount due to associates of CU130,000
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7
Hot Ltd owns 80% of the issued share capital of Warm Ltd and 40% of the issued share capital of Cold Ltd. In the individual accounts the income tax expenses for the year are as follows. Hot Ltd Warm Ltd Cold Ltd
CU40,000 CU36,000 CU20,000
At what amount should the income tax expense appear in the consolidated income statement? A B C D 8
CU68,800 CU76,000 CU84,000 CU96,000
House Ltd owns 80% of the issued share capital of Window Ltd and 25% of the issued share capital of Door Ltd. The revenues for the year are as follows. House Ltd Window Ltd Door Ltd
CU750,000 CU500,000 CU80,000
What amount for revenue should appear in the consolidated income statement for the year? A B C D 9
CU1,150,000 CU1,250,000 CU1,270,000 CU1,330,000
Helen Ltd acquired 35% of Troy Ltd on 1 January 20X6 for CU90,000. At that date Troy Ltd had share capital of CU70,000 and retained earnings of CU96,000. It also owned a plot of land which had a fair value of CU60,000 compared to a carrying amount of CU42,000; this fair value has not been incorporated into the books of Troy Ltd and this land is still held at the current year end 31 December 20X9. Since acquisition, Troy Ltd has made total profits after tax of CU118,000 including CU110,000 made in the current year. The investment in Troy Ltd has become impaired by CU2,560 during the current year. What is the net amount to be included in the consolidated income statement in respect of Troy Ltd? A B C D
10
CU35,310 CU35,940 CU38,500 CU41,300
Grape Ltd holds 80% of the ordinary shares of Pear Ltd and 40% of those of Plum Ltd. The three companies' profits after tax for the current year, before accounting for dividends receivable, and their total dividends payable for the year are as follows.
Grape Ltd Pear Ltd Plum Ltd
Profit after tax CU 100,000 100,000 100,000
Dividends payable CU 50,000 50,000 50,000
In Grape Ltd's consolidated income statement, what amount will be disclosed as the profit/(loss) for the period? A B C D 11
CU220,000 CU240,000 CU280,000 CU300,000
On 1 January 20X0 Adam Ltd purchased 30% of Eve Ltd for CU55,000. At this date the retained earnings of Eve Ltd stood at CU60,000 and the fair value of net assets, which was subsequently reflected
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Financial accounting in the books, was CU170,000. The excess of fair value over carrying amount related to a plot of land which was still owned at 31 December 20X4. The balance sheet of Eve Ltd on 31 December 20X4 showed the following. Share capital Revaluation reserve Retained earnings Total equity
CU 100,000 10,000 200,000 310,000
At what amount should Adam Ltd's investment in Eve Ltd be stated in its consolidated balance sheet at 31 December 20X4? A B C D 12
CU93,000 CU96,000 CU97,000 CU100,000
On 31 December 20X3 Salisbury Ltd owned 30% of Balfour Ltd, 90% of Gladstone Ltd and 80% of Peel Ltd. During the year Gladstone Ltd sold goods to Peel Ltd for CU4,000,000 making a profit of CU1,000,000. 25% of these goods remained in Peel Ltd's inventory as at the year end. Total equity of each company at 31 December 20X3 was as follows. Balfour Ltd Gladstone Ltd Peel Ltd
CUm 1 12 24
What amount should be shown as minority interest in the consolidated balance sheet of Salisbury Ltd at 31 December 20X3? A B C D 13
CU5.960m CU5.975m CU6.660m CU6.675m
At 30 June 20X6, the carrying amount of Penguin Ltd's 30% investment in Antelope Ltd was CU750,000. In the year ended 30 June 20X7 Antelope made a post-tax loss of CU3,000,000. What amount will be recognised in the consolidated income statement for the year ended 30 June 20X7 as share of associate’s losses? A B C D
498
Nil (CU900,000) (CU750,000) (CU3,000,000)
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14
HALEY LTD The draft balance sheets of three companies as at 31 December 20X9 are set out below.
Property, plant and equipment Investments at cost 18,000 shares in Socrates Ltd 18,000 shares in Aristotle Ltd Current assets Ordinary shares of CU1 each Retained earnings Equity Current liabilities
Haley Ltd CU 300,000
Socrates Ltd CU 100,000
Aristotle Ltd CU 160,000
75,000 30,000 345,000 750,000
– – 160,000 260,000
– – 80,000 240,000
250,000 400,000 650,000 100,000 750,000
30,000 180,000 210,000 50,000 260,000
60,000 100,000 160,000 80,000 240,000
The retained earnings of Socrates Ltd and Aristotle Ltd when the investments were acquired eight years ago were CU70,000 and CU30,000 respectively. Impairment reviews to date have resulted in the need for the following amounts to be written off Haley Ltd's investments. CU 12,000 2,400
Socrates Ltd Aristotle Ltd Requirement Prepare the consolidated balance sheet as at 31 December 20X9. 15
(10 marks)
CORFU LTD Corfu Ltd holds 80% of the ordinary share capital of Zante Ltd (acquired on 1 February 20X9) and 30% of the ordinary share capital of Paxos Ltd (acquired on 1 July 20X8). The draft income statements for the year ended 30 June 20X9, are set out below.
Revenue Cost of sales and expenses Trading profit Dividends receivable from Zante Ltd Profit before tax Income tax expense Profit after tax
Corfu Ltd CU'000 12,614 (11,318) 1,296 171 1,467 (621) 846
Zante Ltd CU'000 6,160 (5,524) 636 – 636 (275) 361
Paxos Ltd CU'000 8,640 (7,614) 1,026 – 1,026 (432) 594
Included in the inventory of Paxos Ltd at 30 June 20X9 was CU150,000 for goods purchased from Corfu Ltd in May 20X9, which the latter company had invoiced at cost plus 25%. These were the only goods Corfu Ltd sold to Paxos Ltd but it did make sales of CU50,000 to Zante Ltd during the year. None of these goods remained in Zante Ltd's inventory at the year end. Requirement Prepare a consolidated income statement for Corfu Ltd for the year ended 30 June 20X9. (10 marks)
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Financial accounting 16
KING LTD King Ltd acquired shares in two other companies as follows.
Company Prawn Ltd Madras Ltd
Acquisition date 1 October 20X7 31 December 20X5
Shares acquired % 80 25
Goodwill on acquisition CU 90,000
Retained earnings at acquisition CU 260,000 340,000
The results and changes in equity of the three companies for the year ended 30 September 20X9 are as follows.
Revenue Cost of sales and expenses Profit before tax Income tax expense Profit after tax
Net profit for the period Final dividends declared Balance brought forward Balance carried forward
King Ltd CU'000 800 (550) 250 (80) 170 King Ltd CU'000 170 (70) 100 600 700
Prawn Ltd CU'000 430 (255) 175 (45) 130
Madras Ltd CU'000 600 (440) 160 (60) 100
Retained earnings Prawn Madras Ltd Ltd CU'000 CU'000 130 100 (50) (40) 80 60 320 540 400 600
You are also given the following information. (1) King Ltd has yet to account for dividends receivable. (2) During the year King Ltd made sales of CU80,000 to Prawn Ltd at a gross profit of 25%. At the year end Prawn Ltd still held CU36,000 of these goods in inventory. Madras Ltd made sales of CU150,000 to Prawn Ltd; all of those goods had been sold to third parties by the year end. (4) Impairment reviews at the following dates revealed the following amounts to be written off in respect of King Ltd's investment in Prawn Ltd and Madras Ltd.
Review at 30 September 20X8 30 September 20X9
Prawn Ltd CU'000 9 9
Madras Ltd CU'000 17 6
Requirements Prepare the consolidated income statement and the retained earnings column in the consolidated statement of changes in equity of the King Ltd group for the year ended 30 September 20X9. Work to the nearest CU000. (15 marks)
500
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17
WATER LTD The draft balance sheets of three companies as at 30 September 20X5 are as follows.
Non-current assets Property, plant and equipment Investments 160,000 shares in Hydrogen Ltd 80,000 shares in Oxygen Ltd Current assets Inventories Trade receivables Cash Total assets Capital and reserves Ordinary share capital Retained earnings Equity Non-current liabilities Current liabilities Trade payables Total equity and liabilities
Water Ltd CU
Hydrogen Ltd CU
Oxygen Ltd CU
697,210
648,010
349,400
562,000 184,000 1,443,210
– – 648,010
– – 349,400
495,165 415,717 101,274 2,455,366
388,619 320,540 95,010 1,452,179
286,925 251,065 80,331 967,721
600,000 1,015,000 1,615,000 400,000
200,000 820,000 1,020,000 150,000
200,000 463,000 663,000 100,000
440,366 2,455,366
282,179 1,452,179
204,721 967,721
You are given the following additional information. (1) Water Ltd purchased the shares in Hydrogen Ltd on 1 October 20X0 when the retained earnings of Hydrogen Ltd were CU500,000. (2) The shares in Oxygen Ltd were acquired on 1 October 20X2 when the retained earnings were CU242,000. (3) Included in the inventory figure for Water Ltd is inventory valued at CU20,000 which had been purchased from Hydrogen Ltd at cost plus 25%. (4) Included in the trade payables figure of Water Ltd is CU18,000 payable to Oxygen Ltd, the amount receivable being recorded in the trade receivables figure of Oxygen Ltd. (5) Impairment reviews to date have revealed a total of CU1,000 to be written off goodwill in respect of Hydrogen Ltd and CU2,000 off in respect of Water Ltd's investment in Oxygen Ltd. Requirements (a)
Prepare the consolidated balance sheet for Water Ltd as at 30 September 20X5.
(15 marks)
(b) Identify the required accounting treatment for different levels of investment in undertakings for consolidated accounts purposes, explaining why these are appropriate. (5 marks) (c)
Set out a brief explanation in note form of how subsidiaries and associates are accounted for in the consolidated balance sheet. (5 marks) (25 marks)
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Financial accounting 18
NOTLEY LTD The board of directors of Notley Ltd have asked you, as financial controller, to prepare some information in relation to the company’s draft financial statements for the year ended 30 June 20X6. Details are as follows. (1) Notley Ltd acquired 30% of the ordinary share capital of Blackmore Ltd on 1 February 20X6 for CU285,000. Blackmore Ltd had retained earnings of CU328,000 at the date of acquisition and CU415,750 at 30 June 20X6. Blackmore Ltd had share capital of CU500,000 at the date of acquisition and this has remained unchanged. The recoverable amount of the investment in the associate has been assessed at 30 June 20X6 as CU300,000. (2) Notley Ltd has recognised a number of provisions in its financial statements. Details are as follows:
Notley Ltd had a problem with faulty goods being delivered to a number of its customers during the period. The fault was identified after the first customer complaint. Goods potentially affected were only those produced in March 20X6. Sales during this period totalled CU75,000 and the company estimated that approximately 70% of these would have been affected by the fault. Notley Ltd is likely to have to pay compensation of around CU3 per CU1 of revenue affected. It is hoped that all claims will be settled in the next three years.
Warranty agreements are sold with a number of Notley Ltd’s products. At the beginning of the year the provision was CU125,000. Of this amount CU60,000 was utilised during the period. A weighted average method is used to calculate the required warranty provision based on past claims history and future expectations. There is a 55% chance that goods will not develop a defect, a 35% chance that goods will develop minor defects costing a total of CU300,000 and a 10% chance that a major fault will arise estimated at costing a total of CU450,000. Warranties are provided to customers for periods of between two and five years.
The board publicly announced during the period that as part of the company’s reorganisation programme, it would close one of its loss making divisions. The details of the closure have been fully communicated to employees. The directors started to run down the operations of the division during the period but full closure is likely to take another 12 to 18 months. Future costs associated with the closure are estimated at: CU 2,500,000 800,000 250,000 175,000
Employee redundancies Lease termination costs Staff relocation costs Retraining costs
(3) Notley Ltd had 100,000 CU1 ordinary shares in issue at the beginning of the year. The shares had been issued at their nominal value. Additional financing was raised in October through a further share issue. 20,000 CU1 ordinary shares were issued at CU1.50 each. The group’s other reserves, before adjusting for the issues in (1) and (2) above and dividends, shown in its draft balance sheet at the beginning and end of the year were:
Retained earnings Revaluation reserve The following dividends were declared by Notley Ltd 3 August 20X5 8 August 20X6
502
25p per share 32p per share.
© The Institute of Chartered Accountants in England and Wales, March 2009
At 1 July 20X5 CU 780,000 275,000
At 30 June 20X6 CU 3,484,000 450,000
GROUP ACCOUNTS: ASSOCIATES 13
Requirements (a)
Calculate the amounts that will be shown for the investment in Blackmore Ltd in the income statement for the year ended 30 June 20X6 and in the balance sheet as at that date. (3 marks)
(b) Prepare the provisions note for the financial statements for the year ended 30 June 20X6, including narrative commentary. Note: Ignore discounting. (9 marks) (c)
Prepare the consolidated statement of changes in equity for Notley Ltd for the year ended 30 June 20X6. (6 marks) (18 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Financial accounting
Technical reference For a comprehensive Technical reference section, covering all aspects of group accounts (except group cash flow statements) see Chapter 15.
504
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Answers to Self-test 1
B CU 6,660
Cost of investment in Edberg Ltd Share of post acquisition change in net assets (calculated as 30% change in retained earnings (17,000 – 13,000))
1,200 7,860 (264) 7,596
Impairment losses to date Tutorial note: if (a)
The amount of the fair value adjustment is the same at the balance sheet date and the date the investment is made; and
(b) It has not been reflected in the associate's books then it can be omitted from the calculation of the post-acquisition change in the associate's net assets. 2
B CU'000 Pik Ltd (incl subsidiaries) Gross profit Less Administrative expenses Distribution costs Share of profit of associates (25% 800)
3
D
4
A
2,900 (750) (140) 200 2,210
Albert Ltd's share of the revenue it recognised in respect of the goods held in inventories must be eliminated, so 25% CU120,000 = CU30,000.
Austen Ltd Kipling Ltd Less Intra group (2 + 3)
CU'000
CU'000 50
30 (5)
25 75
Do not cancel balances with Dickens Ltd as Dickens Ltd is an associate. 5
C Minority interest (40% 30,000) Investments in associates Consolidated retained earnings Beed Ltd Transformer Ltd (60% 20,000) Berlin Ltd (no post-acquisition profits)
CU'000 12,000 32,000 20,000 12,000 – 32,000
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Financial accounting 6
D
All balances with associates are retained on consolidation. CU 50 CR 80 CR 130 CR
H S1 The CU75,000 DR in S2 disappears once adjustment has been made for cash in transit. 7
B Hot Ltd Warm Ltd
8
B House Ltd Window Ltd
9
38,500 (2,560) 35,940
B Grape Ltd Pear Ltd Plum Ltd (40% 100,000)
11
CU 750,000 500,000 1,250,000
B Share of PAT (110,000 35%) Less Impairment
10
CU 40,000 36,000 76,000
CU 100,000 100,000 40,000 240,000
C Cost of investment in Eve Ltd Share of post acquisition change in net assets (30% (310,000 - 170,000))
CU 55,000 42,000 97,000
As the excess of fair value over carrying amount at the date the investment was made was subsequently reflected in Eve Ltd's books, no fair value adjustment needs to be made at 31 December 20X4. 12
B Minority interest Peel (20% 24) Gladstone (10% (12 – 0.25))
13
CUm
C Under BFRS the amount of the loss is restricted to the carrying amount of the investment.
506
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4.800 1.175 5.975
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14
HALEY LTD Consolidated balance sheet as at 31 December 20X9 CU ASSETS Non-current assets Property, plant and equipment (30,000 + 100,000) Intangibles (W3) Investments in associates (W6) Current assets (345,000 + 160,000) Total assets
400,000 3,000 48,600 451,600 505,000 956,600
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Retained earnings (W5) Attributable to equity holders of Haley Ltd Minority interest (W4) Equity Current liabilities (100,000 + 50,000) Total equity and liabilities
250,000 472,600 722,600 84,000 806,600 150,000 956,600
WORKINGS (1) Group structure (2) Net assets Socrates Ltd Haley Ltd 60% Share capital Retained earnings
Aristotle Ltd Ltd Socrates
Share capital Retained earnings
30%
Aristotle Ltd
Balance sheet date CU 30,000 180,000 210,000
Acquisition CU 30,000 70,000 100,000
Balance sheet date CU 60,000 100,000 160,000
Acquisition CU 60,000 30,000 90,000
Post acquisition CU – 110,000
Post acquisition CU – 70,000
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Financial accounting (3) Goodwill
Cost of investment Share of net assets acquired (60% 100,000 (W2)) Impairment to date Balance c/f
Socrates Ltd CU 75,000 (60,000) 15,000 (12,000) 3,000
(4) Minority interest Socrates Ltd (40% 210)
CU'000 84
(5) Retained earnings Haley Ltd Socrates Ltd (60% 110,000 (W2)) Aristotle Ltd (30% 70,000 (W2)) Less Impairment to date (12,000 + 2,400)
CU 400,000 66,000 21,000 (14,400) 472,600
(6) Investment in associates Cost of investment in Aristotle Ltd Share of post acquisition change in net assets (30% 70,000 (W2)) Impairment to date 15
CU 30,000 21,000 51,000 (2,400) 48,600
CORFU LTD Consolidated income statement for the year ended 30 June 20X9 Revenue (W2) Cost of sales and expenses (W2) Share of profit of associates (W4) Profit before tax Income tax expense (W2) Profit after tax Attributable to Equity holders of Corfu Ltd () Minority interest (W3)
508
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 15,086 (13,534) 1,552 178 1,730 (736) 994 964 30 994
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WORKINGS (1) Group structure
Corfu Ltd
80%
30%
Zante Ltd
Paxos Ltd
(2) Consolidation schedule Corfu Ltd CU'000 Revenue 12,614 Re Paxos (30% 150,000) C of S Per Q (11,318) Re Paxos (30% (150,000 100/125)) Income tax (621)
Zante Ltd 5/12 CU'000 2,567 (2,302)
Adj CU'000 (50) (45) 50 36
(115) 150
Consol CU'000 15,086 (13,534) (736)
(3) Minority interest Zante Ltd (20% 150,000 (W2))
CU'000 30
(4) Share of profit of associates CU'000 178
Paxos Ltd (30% 594) 16
KING LTD (a)
Consolidated income statement for the year ended 30 September 20X9 Revenue (W2) Cost of sales and expenses (W2) Share of profit of associates (W5) Profit before tax Income tax expense (W2) Profit after tax Attributable to Equity holders of King Ltd () Minority interest (W3)
CU'000 1,150 (743) 407 19 426 (125) 301 275 26 301
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Financial accounting Consolidated statement of changes in equity for the year ended 30 September 20X9 (extract) Retained earnings CU'000 275 (70) 205 672 877
Net profit for the period Final dividends on ordinary shares Balance brought forward (W4) Balance carried forward
WORKINGS (1) Group structure
King Ltd
80%
25%
Prawn Ltd
Madras Ltd
(2) Consolidation schedule
Revenue C of S and expenses Per Q PURP (36 25%) Impairment of goodwill re Prawn Ltd Income tax PAT
King Ltd CU'000 800 (550) (9) (9) (80)
Prawn Ltd CU'000 430 (255) (45) 130
Adj CU'000 (80)
Consol CU'000 1,150
80 (743) (125)
(3) Minority interest Prawn Ltd (130,000 20%) (4) Retained earnings brought forward King Ltd Prawn Ltd (80% (320 – 260)) Madras Ltd (25% (540 – 340)) Less Impairment to date (9 + 17)
CU'000 26 CU’000 600 48 50 (26) 672
(5) Share of profit of associates Madras Ltd ((25% 100) – 6)
CU000 19
Tutorial note The trading between Madras Ltd and Prawn Ltd is not cancelled as Madras Ltd is not part of the 'single entity'.
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17
WATER LTD (a)
Consolidated balance sheet as at 30 September 20X5 CU ASSETS Non-current assets Property, plant and equipment (697,210 + 648,010) Intangibles (W3) Investments in associates (W7) Current assets Inventories (495,165 + 388,619 – 4,000 (W6)) Trade and other receivables (415,717 + 320,540) Cash and cash equivalents (101,274 + 95,010)
CU 1,345,220 1,000 270,400 1,616,620
879,784 736,257 196,284
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Retained earnings (W5) Attributable to equity holders of Water Ltd Minority interest (W4) Equity Non-current liabilities Borrowings (400,000 + 150,000) Current liabilities Trade and other payables (440,366 + 282,179) Total equity and liabilities
1,812,325 3,428,945
600,000 1,353,200 1,953,200 203,200 2,156,400 550,000 722,545 3,428,945
(b) Required accounting treatment for different levels of investment (i)
Control The investment will be treated as a subsidiary and consolidated in accordance with BAS 27 Consolidated and Separate Financial Statements. The ability to direct the decision making of the undertaking means that full consolidation is appropriate. The assets/liabilities and income/expenses under group control are shown as one. The minority share is shown in order to indicate the proportion not owned by the group.
(ii)
Significant influence Many investments involve the influencing of decisions rather than outright control. Such investments are treated as associates and equity accounted on consolidation in accordance with BAS 28 Investments in Associates. This level of involvement is reflected by showing the underlying value of the investment in the balance sheet and the share of profit in the income statement.
(iii) Simple investment Here the investor has no significant involvement in the investee undertaking. Consequently only amounts paid/payable or received/receivable are reflected in the group accounts. The cost of such investments is shown in the balance sheet, whilst dividend income is reflected in the income statement.
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Financial accounting (c)
Explanation of accounting methods used (i)
Subsidiary – Impact on balance sheet
100% of the net assets of a subsidiary will be included on a line-by-line basis.
Intra-group balances will be contra'd out.
Unrealised profits on intra-group sales of inventory and property, plant and equipment will be removed.
Goodwill is recognised if the cost of the acquisition exceeds the share of the fair value of the net assets acquired.
Consolidated retained earnings will include – –
(ii)
Parent company's percentage of subsidiary's post-acquisition profits Cumulative goodwill impairments to date.
The minority interest will show the value of the net assets included in the consolidated balance sheet but owned by 'outside' interests.
Associate – Impact on balance sheet
The cost of the investment is increased by the share of the post acquisition increase in the associate's net assets and decreased by any impairment losses.
Consolidated retained earnings will include – –
The parent company's percentage of the associate's post-acquisition profits Cumulative investment impairments to date.
WORKINGS (1) Group structure
Water Ltd
80%
40%
Hydrogen Ltd
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Oxygen Ltd
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(2) Net assets Hydrogen Ltd
Share capital Retained earnings Per question Less: PURP (W6)
Balance sheet date CU CU 200,000
Acquisition CU 200,000
Postacquisition CU –
820,000 (4,000) 816,000 1,016,000
500,000 700,000
Balance sheet date CU 200,000 463,000 663,000
Acquisition CU 200,000 242,000 442,000
316,000
Oxygen Ltd
Share capital Retained earnings
Post acquisition CU – 221,000
(3) Goodwill Hydrogen Ltd CU 562,000 (560,000) 2,000 (1,000) 1,000
Cost of shares Share of net assets acquired (80% 700,000 (W2)) Impairment to date Balance c/f (4) Minority interest
CU 203,200
Share of net assets (20% 1,016,000 (W2)) (5) Retained earnings
CU 1,015,000 252,800 88,400 (3,000) 1,353,200
Water Ltd Hydrogen Ltd (80% 316,000 (W2)) Oxygen Ltd (40% 221,000 (W2)) Less Impairment to date (1,000 + 2,000) (6) PURP % 125 (100) 25
SP Cost GP
CU 20,000 (16,000) 4,000
(7) Investments in associates Cost of investment in Oxygen Ltd Share of post acquisition change in net assets (40% 221,000 (W2)) Impairment to date
CU 184,000 88,400 272,400 (2,000) 270,400
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Financial accounting 18
NOTLEY LTD (a)
Investment in Blackmore Ltd Income statement for the year ended 30 June 20X6 – Share of profit of associates Group share of profit 1 Feb X6-30 June X6 ((CU415,750 - CU328,000) x 30%) Less: Impairment (W1)
CU 26,325 (11,325) 15,000
Balance sheet as at 30 June 20X6 – Investment in associates CU 285,000 26,325 311,325 (11,325) 300,000
Original cost Share of post acquisition change in net assets (87,750 (W2) x 30%) Less: Impairment losses to date (W1) Recoverable amount Tutorial note
The recoverable amount of the associate is assessed at CU300,000 and therefore an impairment of CU11,325 should be recognised against the associate investment in the balance sheet and recognised as an expense in the income statement. (b) Provisions for liabilities and charges
At 1 July 20X5 Utilised in the year Income statement charge (β) At 30 June 20X6 (W3)
Warranty provision CU 125,000 (60,000) 85,000 150,000
Provision for closure of division CU 3,300,000 3,300,000
Other provisions CU 157,500 157,500
Total CU 125,000 (60,000) 3,542,500 3,607,500
The warranty provision is in respect of warranties provided to customers, for periods between two and five years. The provision is based on a weighted average calculation taking into account past claims history and future expectations. Notley Ltd announced during the period that it would be closing a loss making division. Details of the closure have been fully communicated to those affected. The provision should be utilised in the next twelve to eighteen months. Other provisions consist of compensation claims made by customers. This amount is an estimate based on claims made to date. The provision should be utilised in the next three years. (c)
Consolidated statement of changes in equity
Balance at 30 June 20X5 Gain on revaluation (450 – 275) Net loss for the period (W4) Total recognised income and expense for the period Dividends Share issue Balance at 30 June 20X6
514
Share capital CU 100,000 -
Share premium CU -
Revaluation reserve CU 275,000 175,000
Retained earnings CU 780,000 -
Total CU 1,155,000 175,000
100,000
-
450,000
(823,500) (43,500)
(823,500) 506,500
20,000 120,000
10,000 10,000
450,000
(25,000) (68,500)
(25,000) 30,000 511,500
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WORKINGS (1) Impairment Cost plus share of post-acquisition change in net assets (CU285,000 + CU26,325) Recoverable amount (per Q) Impairment
CU 311,325 (300,000) 11,325
(2) Net assets Balance sheet date CU 500,000 415,750 915,750
Share capital Retained earnings
Acquisition CU 500,000 328,000 828,000
Post acquisition CU – 87,750 87,750
(3) Warranty provision (55% x nil) + (35% x CU300,000) + (10% x CU450,000) = CU150,000 Division closure: Employee redundancies Lease termination costs Total provision Other provision
CU 2,500,000 800,000 3,300,000 CU75,000 x 70% x CU3 = CU157,500
(4) Net profit for period Per question (3,484,000 – 780,000) Adjustment (1) – associate Adjustment (2) – provisions Loss for period
CU 2,704,000 15,000 (3,542,500) (823,500)
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Financial accounting
Answers to Interactive questions
Answer to Interactive question 1 P Ltd: Consolidated balance sheet as at 31 December 20X8 CU Intangibles (W3) Investments in associates (W6) Sundry assets (6,600 + 5,800)
64 1,860 12,400 14,324
Share capital Retained earnings (W5) Attributable to equity holders of P Ltd Minority interest (W4) Equity Liabilities (3,000 + 2,000)
1,000 7,564 8,564 760 9,324 5,000 14,324
WORKINGS (1) Group structure
P Group 80%
40%
S
A
(2) Net assets
S Ltd Share capital Retained earnings A Ltd Share capital Retained earnings
Balance sheet date CU
Acquisition CU
400 3,400 3,800
400 520 920
800 3,600 4,400
800 400 1,200
Postacquisition CU – 2,880
3,200
(3) Goodwill S Ltd Cost of investment Net assets acquired (80% 920 (W2)) Balance c/f
CU 800 (736) 64
(4) Minority interest S Ltd (20% 3,800)
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CU 760
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(5) Retained earnings CU 4,000 2,304 1,280 (20) 7,564
P Ltd S Ltd (80% 2,880 (W2)) A Ltd (40% 3,200 (W2)) Impairment to date (6) Investments in associates
CU 600 1,280 1,880 (20) 1,860
Original cost Share of post acquisition change in net assets (40% 3,200 (W2)) Impairment losses to date
Answer to Interactive question 2 P Ltd: Consolidated income statement for the year ending 31 December 20X8 CU 26,000 (13,000) 13,000 (8,000) 5,000 1,000 840 6,840 (2,200) 4,640
Revenue (W2) Cost of sales (W2) Gross profit Administrative expenses (W2) Profit from operations Investment income (W2) Share of profit of associates (W4) Profit before tax Income tax expense (W2) Profit after tax Attributable to: Equity holders of P Ltd () Minority interest (W3)
4,480 160 4,640
WORKINGS (1) Group structure
P Group 80%
40%
S
A
(2) Consolidation schedule
Revenue Cost of sales Admin expenses Inv. income Tax
P Ltd CU 14,000 (9,000) (2,000) 1,000 (1,000)
S Ltd CU 12,000 (4,000) (6,000) – (1,200) 800
Adj CU
Consol CU 26,000 (13,000) (8,000) 1,000 (2,200)
(3) Minority interest S Ltd (20% 800 (W2))
CU 160
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Financial accounting (4) Share of profit of associates CU 840
A Ltd ((40% 2,400) – 120)
Answer to Interactive question 3 1
Account for the dividend in the books of the individual companies A's books DR Retained earnings (1) CR Payables (2)
CU 100
100 CU
P's books DR Receivables (40% 100) (3) CR Income statement (4) 2
CU
CU
40 40
Impact on CBS and workings (1) = Adjust in A's net assets working (i.e. W2). (2) = Can effectively ignore as net assets part of A's balance sheet is not used in the workings. (3) = Include in receivables in consolidated balance sheet. (4) = Include in retained earnings schedule (i.e. W5).
Answer to Interactive question 4 Consolidated balance sheet journal DR P's retained earnings (35% (50,000 40%)) CR Investment in A
CU 7,000
CU 7,000
Consolidated income statement In the consolidation schedule (W2) reduce P's revenue by CU17,500 (35% 50,000) and its cost of sales by CU10,500 (17,500 (100 – 40)%). The effect is to reduce P's profit by CU7,000.
Answer to Interactive question 5 (a)
Consolidated balance sheet journal
DR P's share of A's post acquisition retained earnings (35% (50,000 40%)) CR P's inventories
CU 7,000
CU 7,000
The effect on retained earnings can best be dealt with by adjusting A's net assets in the net assets working (W2) by 100% of the PURP (so CU20,000 (50,000 40%)) before calculating P's 35% share of A's post acquisition retained earnings. (b)
Share of profit of associates for consolidated income statement CU
Associate’s PAT Less: Unrealised profit Group share 35%
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75,000 (20,000) 55,000 19,250
chapter 14
Group accounts: disposals
Contents Introduction Examination context Topic List 1
Introduction
2
Treatment of disposal in parent company's own financial statements
3
Full disposal of a subsidiary
4
Partial disposal of a subsidiary: retention of control
5
Partial disposal of a subsidiary: retention of significant influence
6
Partial disposal of a subsidiary: retention of no influence
7
Disposal of an associate
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Account for the complete and partial disposal of a subsidiary in the parent's books and in the group accounts
Account for the complete and partial disposal of an associate in the parent's books and in the group accounts
Explain how the underlying principles of group accounts are applied in accounting for disposals
Tick off
Specific syllabus references for this chapter are: 1g, 3d,e.
Practical significance So far, we have been looking at the circumstances in which one entity acquires an investment in another entity. However, the decision to dispose of an investment is an equally important decision. A company may decide to dispose of an investment for a number of reasons, including:
The need to generate cash The fact that the investment does not fit in with future strategic plans Underperformance of the investment
This chapter considers the accounting treatment of the disposal of a subsidiary or associate.
Stop and think What kinds of strategic decisions might lead to the disposal of an investment?
Working context Where a subsidiary has been disposed of there are a number of key issues which the accountant will need to consider. The most important of these considerations will include establishing the date of disposal and the net assets of the subsidiary at the disposal date. The disposal must be appropriately accounted for and disclosed.
Syllabus links This topic is introduced in Financial Accounting and is also relevant to the Financial & Corporate Reporting paper. More complex aspects are covered at the Advanced Stage.
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Examination context
Examination commentary Preparation of consolidated financial statements represents 35% of the syllabus and disposals of subsidiaries and associates forms part of this. This topic could be examined in either the written test or the short-form question section of the paper. Short-form questions are likely to focus on the calculation of the group profit or loss on disposal. Written test questions are more likely to focus on the impact of the disposal on the consolidated financial statements as a whole. In the examination candidates may be required to:
Prepare consolidated financial statements including the effects of the disposal of a subsidiary or an associate
Prepare extracts to the consolidated financial statements including the calculation of the group profit or loss on disposal of a subsidiary or an associate
Explain the principles behind the treatment of the disposal of a subsidiary or an associate.
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Financial accounting
1 Introduction Section overview
1.1
An entity may dispose of all or some of its shares in a subsidiary.
Disposal possibilities When a group disposes of all or part of its interest in a subsidiary this needs to be reflected in the parent's individual financial statements and in the group financial statements. The disposal may be:
A full disposal i.e. the entire shareholding is sold A partial disposal i.e. some interest is retained in the entity
Partial disposals could include the following situations:
Retention of control i.e. the entity remains a subsidiary Retention of significant influence i.e. the entity becomes an associate Retention of no influence i.e. the entity becomes a trade investment
Similarly a group may dispose of an associate. It may dispose of all of its interest or retain a small trade investment. Both full disposal and partial disposals of subsidiaries and associates are examinable in the Financial Accounting syllabus.
2 Treatment of disposal in parent company's own financial statements Section overview
2.1
A profit or loss will be calculated by comparing the sale proceeds with the carrying amount of the proportion of the investment disposed of.
Recording the disposal In the individual financial statements of the parent company the investment in the subsidiary or associate will have been recorded as follows: Balance sheet
Non-current asset investment (normally at cost)
Income statement
Dividend income receivable from the subsidiary or associate
When all or part of the investment is sold this will be treated as a non-current asset disposal. This will usually give rise to a profit or loss on disposal in the parent's individual financial statements. The disposal will be recorded as follows: DR Cash/receivables (proceeds) CR Investment in S or A (Carrying amount – usually cost) DR or CR Income statement loss/profit on disposal
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CU X X
CU or
X X
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3 Full disposal of a subsidiary Section overview
The subsidiary disposed of will not be included in the consolidated balance sheet.
In the consolidated income statement. – – –
3.1
The results of the subsidiary should be time-apportioned and consolidated up to the date of disposal The minority interest will be based on the subsidiary’s results up to the date of disposal The group profit or loss on disposal should be recognised
In the consolidated statement of changes in equity the balances relating to the minority interest in the subsidiary sold will be removed.
Consolidated balance sheet The consolidated balance sheet (like any other balance sheet) shows the financial position at a particular point in time (i.e. the balance sheet date.) As a result, if a subsidiary has been disposed of during the year, that subsidiary will not be reflected in the consolidated balance sheet. A consolidated balance sheet will only need to be prepared if the parent has other subsidiaries and will be prepared as though the subsidiary disposed of had never existed.
3.2
Consolidated income statement When a subsidiary is disposed of, its resources cease to be controlled by the group at the date of disposal. Prior to that point, they are under the group's control and therefore the results of the subsidiary up to the disposal date must be included in the consolidated income statement. So there will always be a consolidated income statement in the year of disposal, even if the parent has no other subsidiaries. The consolidated income statement will include:
3.3
S's results up to the date of disposal
If there is a minority interest in the subsidiary, their share of S's results up to the date of disposal
The profit or loss arising on the disposal
Group profit/loss on disposal The profit or loss on disposal is the difference between the sales proceeds and the parent's total investment in the subsidiary, i.e. the values in respect of the subsidiary which would appear in a consolidated balance sheet prepared immediately before the disposal. These values are the sum of:
P's share of S's net assets at the date of disposal. These net assets will be the net assets at the start of the year in which the disposal takes place, plus/minus the net asset increase/decrease arising through S's profit/loss in the period up to the disposal and minus any dividends paid by S in that period; and
The goodwill acquired in the business combination with S, to the extent that it has not already been recognised as an expense as a result of impairment reviews.
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Financial accounting So the calculation is as follows: Proceeds Less: Share of net assets at disposal Net assets brought forward Profit/(loss) to date of disposal Dividends paid (see points to note 1)
CU
X X/(X) (X) X
P's share Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition Goodwill at acquisition Impairment to date Profit/(loss) on disposal
CU X
(X) X X (X) X (X) (X) X/(X)
Points to note 1
The retained reserves/net assets at the date of disposal of the subsidiary should be calculated deducting only those dividends to which the parent is entitled i.e. dividends paid up to the date of disposal (and dividends declared if the shares are sold ex-dividend).
2
In examination questions you should assume that a subsidiary which is fully disposed of is a separately reportable business segment and meets the BFRS 5 Non-current Assets Held for Sale and Discontinued Operations definition of a discontinued activity (the presentation of discontinued operations was discussed in Chapter 4). As such the disposal should be disclosed in accordance with BFRS 5.
These learning materials adopt the approach illustrated in BFRS 5 1G example 11. This includes a one line entry in the income statement which incorporates both the subsidiary's results up to the date of disposal and the group profit or loss arising on disposal. You should adopt this approach in the examination.
Interactive question 1: Profit/loss on disposal
[Difficulty level: Exam standard]
Champion Ltd has held a 70% investment in Hercules Ltd for many years. On 31 December it disposed of all of this investment. Further details are as follows: Cost of investment Hercules Ltd's net assets at the date of acquisition Sale proceeds Hercules Ltd's net assets at the date of disposal Requirement Calculate the profit/loss on disposal: (a)
In Champion Ltd's individual accounts
(b) In the consolidated accounts assuming that in respect of goodwill (i) (ii)
There has been no impairment There has been an impairment loss of CU470
Fill in the proforma below.
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CU 2,000 1,900 2,100 2,400
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Solution (a)
Champion Ltd's separate financial statements CU
Proceeds Cost Profit on disposal (b) Consolidated financial statements No impairment CU CU
Impairment of CU470 CU CU
Proceeds Less: Share of net assets at date of disposal Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition Goodwill at acquisition Impairment to date Profit/(loss) on disposal See Answer at the end of this chapter.
3.4
Consolidated statement of changes in equity There will almost always be a need for a consolidated statement of changes in equity (CSCE) in the year of disposal (the only exception would be if the parent had no other subsidiaries and there had been no minority interest in the subsidiary now disposed of). In relation to the subsidiary disposed of, the CSCE will contain the following in the minority interest column:
S's current period profit (to the date of disposal) attributable to the minority interest. This reflects the minority interest amount shown in the consolidated income statement
The minority interest in S's share capital and retained earnings brought forward, i.e. the minority interest as shown in the previous period's consolidated balance sheet
A deduction for the total of the above amounts. This deduction must be made because at the end of the current period there will be no minority interest in relation to S, which has now been disposed of
Point to note There is no need to make a similar deduction in the CSCE for P's share of S's post-acquisition retained earnings brought forward plus P's share of S's current period profits. That deduction has in effect already been made by the profit or loss on disposal calculation.
Worked example: Full disposal Ben Ltd bought 80% of the share capital of Bill Ltd for CU950,000 on 1 October 20X1. At that date Bill Ltd's retained earnings stood at CU510,000. Ben Ltd has several other subsidiaries, which are wholly owned.
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Financial accounting The balance sheets at 30 September 20X8 and the summarised income statements to that date are given below: Balance sheets
Property, plant and equipment Investment in Bill Ltd Current assets Share capital (CU1 ordinary shares) Retained earnings Current liabilities Income statements Profit before interest and tax Income tax expense Profit for the period
Ben Ltd Group CU'000 2,050 950 2,700 5,700
Bill Ltd CU'000 600 – 1,300 1,900
2,000 2,500 4,500 1,200 5,700
300 1,100 1,400 500 1,900
CU'000 1,400 (400) 1,000
CU'000 180 (50) 130
CU'000 1,000 1,500 2,500
CU'000 130 970 1,100
Statement of changes in equity (extract) Profit for the period Retained earnings at 30 September 20X7 Retained earnings at 30 September 20X8 No entries have been made in the accounts for any of the following transactions. Assume that profits accrue evenly throughout the year. To date no impairment losses on goodwill have been recognised. The Box Ltd group figures exclude any amounts for Bill Ltd. Requirement Prepare the consolidated balance sheet, income statement and statement of changes in equity extract at 30 September 20X8 on the basis that Ben Ltd sells its entire holding in Bill Ltd for CU2,100,000 on 30 September 20X8. You should assume that the disposal is a discontinued operation in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
Solution Ben and Bill Consolidated balance sheet as at 30 September 20X8 Property, plant and equipment Current assets (2,700 + 2,100) Share capital Retained earnings (W4) Current liabilities
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CU'000 2,050 4,800 6,850 2,000 3,650 5,650 1,200 6,850
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Consolidated income statement for the year ended 30 September 20X8 CU'000
Continuing operations Profit before tax Income tax expense Profit for the period from continuing operations Discontinued operations Profit for the period from discontinued operations (678 + 130) (W1 + W2) Profit for the period
1,400 (400) 1,000 808 1,808
Attributable to: Equity holders of Ben Ltd (β) Minority interest (20% 130)
1,782 26 1,808
Consolidated statement of changes in equity (extract)
Profit for the year Eliminated on disposal of subsidiary (26 + 254 (W5)) Balance at 30 September 20X7 (W3 + W5) Balance at 30 September 20X8 (W4)
Ben Ltd Retained earnings CU'000 1,782 – 1,782 1,868 3,650
Minority interest (Bill Ltd) CU'000 26 (280) (254) 254 –
WORKINGS (1) Profit of Bill Ltd for year to disposal CU'000 130 130
PAT 12/12 (2) Profit on disposal of Bill Ltd CU'000 Sale proceeds Less: Share of net assets at disposal (1,400 80%)
CU'000 2,100 (1,120) 980
Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition (80% (300 + 510))
950 (648) (302) 678
(3) Retained earnings brought forward Ben Ltd Bill Ltd (80% x (970 – 510))
CU'000 1,500 368 1,868
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Financial accounting (4) Retained earnings carried forward CU'000 2,500 1,150 3,650
Ben Ltd Profit on disposal (2,100 – 950) (5) MI b/f
CU'000 300 970 1,270 254
Share capital Retained earnings b/f 20% Point to note
The profit on disposal figure in the retained earnings carried forward balance is the profit which would appear in Ben Ltd's own income statement. This adjustment is required as Ben Ltd's own financial statements do not reflect the disposal. (We are told that no entries have been made in respect of this transaction.)
Interactive question 2: Full disposal
[Difficulty level: Exam standard]
Daring Ltd has a number of subsidiaries, one of which, Glory Ltd, was sold in the current year. The draft accounts for the Daring Group (being Daring Ltd and the subsidiaries it still has) and Glory Ltd at 31 March 20X1 are as follows: Balance sheets
Intangibles – goodwill Investment in Glory Ltd at cost Sundry assets Share capital (CU1 ordinary shares) Retained earnings Attributable to equity holders of Daring Ltd Minority interest Equity Liabilities Sales proceeds account
Daring Group CUm 4,000 3,440 42,450 49,890
Glory Ltd CUm – – 9,500 9,500
8,000 11,000 19,000 12,000 31,000 10,000 8,890 49,890
3,000 3,500 6,500 – 6,500 3,000 – 9,500
Daring Group CUm 12,950 (5,400) 7,550
Glory Ltd CUm 3,800 (2,150) 1,650
Income statements
Profit before tax Income tax expense Profit after tax Attributable to: Equity holders of Daring Ltd Minority interest
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5,050 2,500 7,550
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Statements of changes in equity
Profit for the year Balance b/f Balance c/f
Daring Group Attributable to equity holders of Daring Ltd Share Retained capital earnings Total CUm CUm CUm – 5,050 5,050 8,000 5,950 13,950 8,000 11,000 19,000
Glory Ltd
Minority interest CUm 2,500 9,500 12,000
Total CUm 7,550 23,450 31,000
CUm 1,650 4,850 6,500
Daring Ltd acquired 90% of Glory Ltd when the retained earnings of Glory Ltd were CU700m. In an earlier accounting period an impairment loss of CU20m was recognised in relation to the goodwill arising on the acquisition of Glory Ltd. On 31 December 20X0 Daring Ltd sold all its shares in Glory Ltd for CU8,890m. Daring Ltd has debited cash and credited a sales proceeds account in the balance sheet with this amount, as it is unsure what entries are needed. Requirement Prepare the Daring Group consolidated balance sheet, consolidated income statement and consolidated statement of changes in equity for the year ended 31 March 20X1. You should assume that the disposal of Glory Ltd constitutes a discontinued operation in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
Solution Daring Group Consolidated balance sheet at 31 March 20X1 CUm Intangibles – goodwill Sundry assets Share capital (CU1 ordinary shares) Retained earnings Attributable to equity holders of Daring Ltd Minority interest Equity Liabilities Consolidated income statement for the year ended 31 March 20X1 CUm Continuing operations Profit before tax (W2) Income tax expense (W2) Profit for the period from continuing operations Discontinued operations Profit for the period from discontinued operations (W4 and W5) Profit for the period Attributable to: Equity holders of Daring Ltd () Minority interest
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Financial accounting Consolidated statement of changes in equity for the year ended 31 March 20X1 Attributable to equity holders of Daring Ltd Share Retained capital earnings Total CUm CUm CUm
Minority interest CUm
Total CUm
Daring Group CUm
Consol CUm
Profit for the year Eliminated on disposal of subsidiary (W9) Balance b/f (W7 and W8) Balance c/f WORKINGS (1) Group structure
(2) Consolidation schedule for CIS
Profit before tax Tax (3) Minority interests in Glory Ltd for CIS CUm (4)
Profit of Glory Ltd for year to disposal CUm
(5) Profit on disposal of Glory Ltd for CIS CUm
CUm
Sale proceeds Less: Share of net assets at disposal Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition Goodwill at acquisition Impairment to date
(6) Net assets at disposal Share capital Retained earnings b/f Profit for year to disposal (W4)
530
© The Institute of Chartered Accountants in England and Wales, March 2009
CUm
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(7) Group retained earnings b/f for CSCE CUm
Daring Group Glory Ltd Goodwill impairment to date (8) Minority interest b/f for CSCE
CUm (9) Minority interest eliminated on disposal CUm See Answer at the end of this chapter.
4 Partial disposal of a subsidiary: retention of control Section overview
In the consolidated balance sheet the subsidiary should be consolidated based on the year-end holding.
In the consolidated income statement: – –
4.1
The minority interest should be time apportioned reflecting the pre and post disposal stake. The group profit or loss on disposal should be recognised and separately presented
In the CSCE an amount will be added representing the increase in the minority interest in the net assets at the date of disposal.
Subsidiary to subsidiary A parent entity may sell some of its shares in a subsidiary but still retain control. For example, a 90% stake could be reduced to a 60% stake. Point to note For disclosure purposes you should assume that this does not constitute a discontinued operation.
4.2
Accounting treatment The accounting treatment would be as follows:
Consolidated balance sheet –
As the parent company still holds a subsidiary at the balance sheet date the assets and liabilities of the subsidiary should be consolidated as normal.
–
The minority interest should be calculated based on the year-end holding.
Consolidated income statement –
As the parent has held a subsidiary throughout the period the revenues and expenses should be consolidated as normal (i.e. 100% for the whole year).
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Financial accounting –
The change in % holding is reflected in the minority interest calculation. This should be calculated to reflect the pre and post disposal situation.
–
The group profit or loss should be calculated and recognised.
Worked example: Minority interest At the start of its year, on 1 January 20X7, Pine Ltd owned 90% of Sycamore Ltd. On 30 June 20X7 Pine Ltd disposed of 1/3 of its shares in Sycamore Ltd. Sycamore Ltd has a profit after tax for the year ended 31 December 20X7 of CU600,000. In the consolidated income statement the minority interest will be calculated as follows: Minority interest CU 30,000 120,000 150,000
CU600,000 x 10% x 6/12 = CU600,000 x 40% x 6/12 =
Point to note In the above worked example Pine Ltd disposed of 1/3 of its 90% shareholding i.e. 30% of the company. Pine Ltd's holding was therefore reduced from 90% to 60% increasing the minority interest from 10% to 40%.
4.3
Group profit or loss The group profit or loss is calculated in essentially the same way as for the full disposal (see section 3.3 above). Care must be taken, however, to ensure that the correct proportions of net assets and goodwill are brought in to the calculation.
Worked example: Partial disposal: profit/loss on disposal Leeds Ltd has held a 90% investment in York Ltd for many years. On 31 December it disposed of 1/3 of its investment. Further details are as follows: CU’000
CU’000 2,500 1,900 900 2,400
CU’000
CU’000 900 (720) 180
Cost of investment York Ltd net assets at acquisition Sale proceeds York Ltd net assets at disposal There has been no impairment of goodwill. The profit or loss in the group accounts would be calculated as follows: Proceeds Less: Share of net assets at disposal disposed of (30% x 2,400) Less: Carrying amount of goodwill at disposal relating to disposal Cost of investment Share of net assets at acquisition (90% x 1,900) Goodwill at acquisition Relating to disposal (790 x 1/3) Loss on disposal
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2,500 (1,710) 790 (263) (83)
GROUP ACCOUNTS: DISPOSALS
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30% of the net assets at disposal are brought in to the above calculation as the net assets relate to the company as a whole. 1/3 of the goodwill is brought in to the above calculation as the goodwill only relates to the 90% share in York Ltd originally held by Leeds Ltd. In other words, Leeds Ltd has disposed of 30% of York Ltd but 1/3 of its investment.
Point to note The profit or loss on disposal will normally be presented separately on the face of the consolidated income statement. Consolidated income statement (extract) Profit from operations Loss on sale of interest in subsidiary Profit before tax Income tax expense Profit for period
4.4
CU'000 X (83) X (X) X
Consolidated statement of changes in equity In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minority interest column:
S's current period profit attributable to the minority interest.
The minority interest in S's share capital and retained earnings brought forward i.e. the minority interest as shown in the previous period's consolidated balance sheet.
An adjustment representing the increase in the minority interest (due to the part disposal) in the net assets at the date of the change in stake. This must be added because the minority interest at the end of the current period will be based on the year-end position.
Worked example: Adjustment representing increase in the minority interest Apple Ltd owned 80% of Orange Ltd on 1 January 20X7 when the net assets of Orange Ltd were CU675,000. Apple Ltd disposes of one quarter of its shares in Orange Ltd on 31 December 20X7 when the net assets of Orange Ltd are CU750,000. The net profit of Orange Ltd for the year is CU75,000. The minority interest, which increases from 20% to 40% during the year as Apple Ltd’s shareholding decreases from 80% to 60%, would be reflected in the consolidated statement of changes in equity as follows: Consolidated statement of changes in equity (extract)
Profit for year (75,000 x 20% x 12/12) Partial disposal of subsidiary (20% x 750,000) Balance at 31 December 20X6 (675,000 x 20%) Balance at 31 December 20X7 (750,000 x 40%)
Minority interest CU'000 15,000 150,000 165,000 135,000 300,000
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Financial accounting
5 Partial disposal of a subsidiary: retention of significant influence Section overview
In the consolidated balance sheet the investment is accounted for as an associate based on the yearend holding.
In the consolidated income statement: – – –
5.1
The results are consolidated up to the date of disposal The equity method is used for the post-disposal period The group profit or loss on disposal should be recognised and separately presented
In the CSCE the balances relating to the minority interest in the subsidiary sold will be removed.
Subsidiary to associate A parent entity may sell some of its shares in a subsidiary but still retain significant influence. For example, an 80% stake could be reduced to a 40% stake. Point to note For disclosure purposes you should assume that this does not constitute a discontinued operation.
5.2
Accounting treatment The accounting treatment would be as follows:
Consolidated balance sheet –
Consolidated income statement –
–
The investment is accounted for using the equity method based on the year-end holding. This reflects the pre and post disposal situation therefore the subsidiary's results are time apportioned and:
Consolidated up to the date of disposal
Equity accounted for in the post-disposal period.
The group profit or loss on disposal should be calculated and recognised and is normally separately presented on the face of the income statement (see section 4.3 above).
Consolidated statement of changes in equity
In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minority interest column:
534
–
S's current period profit (to the date of disposal) attributable to the minority interest. This reflects the minority interest shown in the consolidated income statement.
–
The minority interest in S's share capital and retained earnings brought forward i.e. the minority interest shown in the previous period's consolidated balance sheet.
–
A deduction for the total of the above amounts. This deduction must be made because at the end of the current period there will be no minority interest in relation to the subsidiary as it is now an associate.
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6 Partial disposal of a subsidiary: retention of no influence Section overview
In the consolidated balance sheet the investment is frozen at its level under the equity method.
In the consolidated income statement – –
6.1
The results are consolidated up to the date of disposal The group profit or loss on disposal should be recognised and separately presented
In the CSCE the balances relating to the minority interest in the subsidiary sold will be removed.
Subsidiary to trade investment A parent entity may sell a majority of its shares in a subsidiary such that it holds a small investment, without retaining control or significant influence. For example, a 90% stake could be reduced to a 10% stake. Point to note For disclosure purposes you should assume that this does constitute a discontinued operation in accordance with BFRS 5.
6.2
Accounting treatment The accounting treatment would be as follows:
Consolidated balance sheet –
The investment is recorded in the consolidated balance sheet at its value under the equity method, i.e. the group share of net assets and goodwill retained by the group at the date of disposal.
–
The investment remains in the consolidated balance sheet at this value unless impaired i.e. the value is not updated at each subsequent year-end.
Consolidated income statement –
The results of the subsidiary are time apportioned and consolidated up to the date of disposal.
–
After disposal only dividend income is recognised.
–
The group profit or loss on disposal is included in the presentation of the profit or loss from discontinued operations as required by BFRS 5.
Consolidated statement of changes in equity In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minority interest column: –
S's current period profit (to the date of disposal) attributable to the minority interest. This reflects the minority interest shown in the consolidated income statement.
–
The minority interest in S's share capital and retained earnings brought forward i.e. the minority interest shown in the previous period's consolidated balance sheet.
–
A deduction for the total of the above amounts. This deduction must be made because at the end of the current period there will be no minority interest in relation to the subsidiary as it is now a trade investment.
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Financial accounting Point to note This study manual makes the working assumption that the trade investment in the consolidated balance sheet should be recorded at its equity method value at the date of disposal. The recognition and measurement of equity investments which are not accounted for as subsidiaries or associates, in accordance with BAS 39 Financial Instruments: Recognition and Measurement, will be covered in more detail in the Financial Reporting syllabus.
Interactive question 3: Partial disposal: impact on financial statements [Difficulty level: Intermediate] Requirement Based on the information provided in Worked example: Full disposal (see section 3 above) prepare the consolidated balance sheet, consolidated income statement and extracts from the consolidated statement of changes in equity at 30 September 20X8 in the following circumstances: (a)
Ben Ltd sells one quarter of its holding in Bill Ltd for CU380,000 on 30 June 20X8.
(b) Ben Ltd sells one half of its holding in Bill Ltd for CU1,350,000 on 30 June 20X8, and the remaining holding is to be dealt with as an associate. (Work to the nearest CU'000.) Fill in the proforma below.
Solution (a)
Partial disposal (subsidiary to subsidiary) mid year Consolidated balance sheet as at 30 September 20X8 Property, plant and equipment Goodwill Current assets Share capital (CU1 ordinary shares) Retained earnings Minority interest Current liabilities
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CU’000
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Consolidated income statement for the year ended 30 September 20X8 CU’000
Profit from operations Profit on sale of interest in subsidiary Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of Ben Ltd Minority interest Consolidated statement of changes in equity (extract) Ben Ltd Retained earnings CU’000
Minority interest (Bill Ltd) CU’000
CU’000
CU’000
Profit for the year Partial disposal of subsidiary Balance at 30 September 20X7 Balance at 30 September 20X8 WORKINGS (1) Group structure
(2) Profit on disposal of Bill Ltd Sale proceeds Less: Share of net assets at disposal
Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition Goodwill at acquisition Re disposal
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Financial accounting (3) Minority interest in Bill Ltd for CIS CU'000
CU'000
(4) Retained earnings/MI brought forward As per worked example
1,868
254
(5) Retained earnings carried forward Ben Ltd Add: Profit on disposal
CU'000
Bill Ltd (6) MI c/f CU'000 Share capital Retained earnings
%
(b) Partial disposal (subsidiary to associate) mid year Consolidated balance sheet as at 30 September 20X8 Property, plant and equipment Investments in associates
CU'000
Current assets Share capital (CU1 ordinary shares) Retained earnings Current liabilities Consolidated income statement for the year ended 30 September 20X8 Profit from operations Profit on sale of interest in subsidiary Share of profit of associates Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of Ben Ltd Minority interest
538
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000
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Consolidated statement of changes in equity (extract)
Profit for the year Eliminated on disposal of subsidiary
Ben Ltd Retained earnings CU'000
Minority interest (Bill Ltd) CU'000
Balance at 30 September 20X7 Balance at 30 September 20X8 WORKING (1) Group structure
(2) Investments in associates CU'000 Cost of associates Share of post acquisition retained earnings (3) Profit on disposal of Bill Ltd CU'000
CU'000
Sale proceeds Less: Share of net assets at disposal Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition Goodwill at acquisition Re disposal (4) Minority interest in Bill Ltd for CIS (5) Retained earnings/MI brought forward As per worked example
CU'000 CU'000 1,868
CU'000 254
(6) Retained earnings carried forward CU'000 Ben Ltd Add: Profit on disposal Bill Ltd See Answer at the end of this chapter.
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Financial accounting
7 Disposal of an associate Section overview
7.1
The principles involved are similar to those relating to the disposal of a subsidiary.
Full disposal The accounting treatment would be as follows: Consolidated balance sheet
–
7.2
As the parent no longer holds an investment in the associate at the year-end the associate will not be recognised in the consolidated balance sheet.
Consolidated income statement –
Up to the date of disposal the profits of the associate will be recognised in the consolidated income statement using the equity method of accounting.
–
The group profit or loss on disposal will be calculated as per the disposal of a subsidiary (see section 3.3 above) and will usually be separately presented on the face of the income statement, immediately underneath the share of the associate’s profit for the pre-disposal part of the period.
Partial disposal A parent may sell some of its shares in an associate such that it loses significant interest but still retains a small trade investment. The accounting treatment would be as follows:
Consolidated balance sheet –
At the year end the parent company simply holds a trade investment. The investment in the former associate is brought in to the consolidated balance sheet at its equity method value, i.e. the group share of net assets and goodwill retained by the group at the date of disposal.
Consolidated income statement –
Up to the date of disposal the profits of the associate will be recognised in the consolidated income statement using the equity method.
–
After the disposal the parent will record any dividends received, which are paid out of profits earned after the change of status, as investment income.
–
The group profit or loss on disposal will be calculated and recognised and will usually be separately presented on the face of the income statement, immediately underneath the share of the associate’s profit for the pre-disposal part of the period.
Worked example: Disposal of an associate An investor has had an investment of 40% in an associate for a number of years. During the year the group disposes of ¾ of its investment and no longer has significant influence. The following information is available: Cost of 40% investment Goodwill on original acquisition Proceeds received Net asset value of associate at date of sale The goodwill was capitalised on the acquisition of the associate and has not been impaired.
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CU 220,000 20,000 210,000 620,000
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In the consolidated balance sheet the former associate would be valued as follows: Remaining share of net assets (620,000 x 10%) Goodwill retained (20,000 x 1/4)
CU 62,000 5,000 67,000
In the consolidated income statement the group profit on disposal would be calculated as follows: Proceeds Less: Net assets disposed of (620,000 x 30%) Goodwill associated with disposal (20,000 x ¾)
CU 210,000 (186,000) (15,000) 9,000
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Financial accounting
Summary and Self-test
Summary
Full disposal of S
CBS
CIS
CSCE
Reflect year end position - no subsidiary
Consolidate results to date of disposal
Remove balances relating to MI in S sold
MI based on S’s results up to date of disposal Recognise group profit or loss (combine with S’s results to date of disposal)
Partial disposal of S: control retained
Consolidate based on year end position
Consolidate results for the entire period Time apportion MI Recognise group profit or loss separately
Partial disposal of S: retention of significant influence
Equity account for investment
Consolidate up to date of disposal Use equity method for post disposal period
Will include an adjustment representing the increase in the minority interest in the net assets at the date of change MI balances relating to subsidiary sold will be deducted
Recognise group profit or loss separately Partial disposal of S: trade investment held
Include investment at its value under the equity method
Consolidate up to date of disposal (then only record dividends received) Recognise group profit or loss separately
Full disposal of A
Partial disposal of A: trade investment held
Reflect year end position – no associate
Equity method up to date of disposal
Include investment at its value under the equity method
Equity method up to date of disposal (then only record dividends received)
Recognise group profit or loss separately
Recognise group profit or loss separately
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MI balances relating to subsidiary sold will be deducted
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Self-test Answer the following questions. 1
On 1 January 20X1 Rainbow Ltd acquired all of Zippy Ltd's 1,000 CU1 ordinary shares. The goodwill acquired in the business combination was CU10,000 of which 40% had been written off as impaired by the end of 20X2. On 1 January 20X3 Rainbow Ltd sold all the shares for CU140,000 when Zippy Ltd's retained earnings amounted to CU112,000. What is the profit on disposal which should be included as part of the profit for the period from discontinued operations figure in the consolidated income statement of Rainbow Ltd? A B C D
2
CU15,000 CU21,000 CU27,000 CU28,000
Yogi Ltd has held an 80% investment in Bear Ltd for many years. On 31 December 20X6 it disposed of all of its investment. Details for the acquisition and disposal are as follows. Cost of investment Fair value of Bear Ltd's net assets at acquisition (reflected in Bear Ltd's books) Sale proceeds on 31 December 20X6
CU'000 7,380 9,000 9,940
Goodwill acquired in the business combination has been fully written off as a result of impairment reviews. The summarised balance sheet of Bear Ltd on 31 December 20X6 showed the following. CU'000 3,000 7,350 10,350
Called up share capital Retained earnings Equity
What is the profit/(loss) on disposal of the shares in Bear Ltd that will be included as part of the profit for the period from discontinued operations figure in the consolidated income statement of Yogi Ltd for the year ended 31 December 20X6? A B C D 3
(CU410,000) (CU1,220,000) CU1,480,000 CU1,660,000
The Bill Group disposed of its 60% interest in Ben Ltd after owning it for five years. Original cost was CU120,000 and goodwill acquired in the business combination was CU50,000. Sales proceeds were CU250,000, and this has been posted to a suspense account in Bill Ltd's individual accounts. Ben Ltd had net assets of CU100,000 on disposal and 50% of the original amount of the goodwill had been written off as impaired. What is the profit on disposal which will be included as part of the profit for the period from discontinued operations figure within the consolidated income statement of the Bill Group? A B C D
CU100,000 CU130,000 CU165,000 CU185,000
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Financial accounting 4
On 1 September 20X1 the Villa Group acquired 70% of Charlton Ltd's 1,000 CU1 ordinary shares. The goodwill acquired in the business combination was CU1,200. On 1 September 20X5 the Villa Group sold all the shares for CU50,000 when Charlton Ltd's retained earnings were CU89,000. What is the loss on disposal which will be included as part of the profit for the period from discontinued operations figure in the consolidated income statement of the Villa group? A B C D
5
CU13,000 CU13,500 CU14,000 CU14,200
The Gill Group disposed of the following mid way through the financial year. Tracey Ltd (100% subsidiary) for Debbie Ltd (55% subsidiary) for
CU150,000 CU70,000
Goodwill acquired in the business combinations has been fully written off as a result of impairment reviews. The retained earnings of the companies are as follows. Tracey Ltd Debbie Ltd
At acquisition CU70,000 CU25,000
At disposal CU100,000 CU40,000
The consolidated retained earnings of the remaining Gill Group, including the profit made on the disposal of the investments in the year were CU230,000 at 31 December 20X6. What will be the amount for consolidated retained earnings included in the consolidated balance sheet for the Gill Group as at 31 December 20X6? A B C D 6
CU230,000 CU260,000 CU266,000 CU275,000
Tom Ltd acquired 75% of Bill Ltd on 1 January 20X4. The goodwill acquired in the business combination was CU125,000. On 1 January 20X9 Tom Ltd disposed of its entire holding in Bill Ltd for CU820,000. On this date the net assets of Bill Ltd amounted to CU790,000 and goodwill impairment write offs to date totalled to CU31,250. What is the profit/(loss) on disposal which should be included as part of the profit for the period from discontinued operations figure in the consolidated income statement of Tom Ltd? A B C D
7
CU(63,750) CU102,500 CU196,250 CU133,750
Chelsea Ltd has held an 80% investment in Hammersmith Ltd for a number of years. On 31 December 20X7 it disposed of ¼ of its investment. Details of the original acquisition and disposal are as follows: Cost of investment Fair value of Hammersmith Ltd's net assets at acquisition (reflected in Hammersmith's books) Sale proceeds on 31 December 20X7 50% of the goodwill acquired in the business combination has been written off as a result of impairment reviews.
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CU'000 8,856 10,800 11,928
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The summarised balance sheet of Hammersmith Ltd on 31 December 20X7 showed the following: CU'000 3,600 8,820 12,420
Called up share capital Retained earnings Equity
What is the profit on disposal of the shares in Hammersmith Ltd that will be included as part of the profit for the period from discontinued operations figure in the consolidated income statement of Chelsea Ltd for the year ended 31 December 20X7? A B C D 8
CU'000 8,796 9,390 9,417 9,714
Maple Ltd has had a 30% investment in an associate, Ash Ltd for a number of years. The goodwill was capitalised on acquisition of the associate and has not been impaired. During the year the group disposed of 50% of its investment and could no longer exercise significant influence. The following information is available: Cost of investment Goodwill on acquisition Proceeds received Net asset value of associate at date of sale
CU 165,000 15,000 157,500 620,000
What is the profit/(loss) on disposal of the shares in Ash Ltd that will be included in the consolidated income statement of Maple Ltd for the year ended 31 December 20X7? A B C D 9
CU57,000 CU64,500 CU75,000 CU(160,000)
The Blair Group purchased 75% of Brown Ltd a number of years ago for CU5,000,000. The goodwill arising on that business combination was CU1,250,000. On 31 December 20X7 the Blair Group disposed of 80% of its shares in Brown Ltd for CU7,500,000. On this date the net assets of Brown Ltd amounted to CU8,200,000 and the amount of goodwill impairment to date was CU375,000. In the consolidated balance sheet of the Blair Group at 31 December 20X7 at what amount will the remaining investment in Brown Ltd be stated? A B C D
CU750,000 CU1,230,000 CU1,361,000 CU1,405,000
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Financial accounting 10
The Greatheed Group purchased a 70% investment in Gaveston Ltd on 1 January 20X4 for CU8,500,000. At that date the retained earnings of Gaveston Ltd stood at CU9,800,000. On 31 December 20X7 the Greatheed Group disposed of half of its investment in Gaveston Ltd for CU5,200,000. Share capital and retained earnings of Gaveston Ltd at that date were as follows. Share capital Retained earnings
CU'000 1,000 14,500 15,500
In the consolidated balance sheet of Greatheed Ltd for the year ended 31 December 20X7 at what amount would the remaining interest in Gaveston Ltd be shown? A B C D 11
CU’000 4,250 5,190 5,895 10,145
On 1 September 20X4 the Moorefields Group acquired 40% of Davenport Ltd’s 1,000 CU1 ordinary shares. The goodwill was capitalised on acquisition of this associate and 50% has been written off as a result of impairment. During the year ended 31 December 20X7 the Moorefields Group disposed of all of its shares in Davenport Ltd. The following information is available. Cost of original investment Goodwill on acquisition Proceeds received on disposal Davenport Ltd’s net assets at date of sale
CU 198,000 18,000 189,000 744,000
What is the loss on disposal of Davenport Ltd that will be included in the consolidated income statement of the Moorefields Group for the year ended 31 December 20X7? A B C D 12
CU9,000 CU108,600 CU117,600 CU126,600
PARABLE LTD Parable Ltd is a holding company with a number of subsidiaries. The consolidation for the year ended 31 December 20X8 has been carried out to include all subsidiaries except Story Ltd. Story Ltd has been 80% owned by Parable Ltd since 20X2, at which date Story Ltd's retained earnings amounted to CU50,000, but on 30 June 20X8 Parable Ltd sold all of its shares in Story Ltd. Details are as follows. Cost of original investment (80,000 out of 100,000 CU1 ordinary shares) Goodwill acquired in the business combination fully recognised as an expense as a result of impairment reviews Sales proceeds
CU 150,000 30,000 500,000
Because Parable Ltd is unsure how to deal with its investment in Story Ltd in the 20X8 consolidation, it has not yet consolidated Story Ltd into the group financial statements.
546
© The Institute of Chartered Accountants in England and Wales, March 2009
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Income statements for the year ended 31 December 20X8 are set out below.
Profit from operations Sales proceeds on disposal of Story Ltd Profit before tax Income tax expense Profit for the year Attributable to Equity holders of Parable Ltd Minority interest
Parable Ltd group CU 875,500 500,000 1,375,500 (405,000) 970,500
Story Ltd CU 325,600 – 325,600 (102,500) 223,100
870,300 100,200 970,500
The Parable Ltd group and Story Ltd had retained earnings brought forward of CU1,926,300 and CU326,400 respectively. Other minority interests brought forward were CU507,500. Requirements (a)
Prepare the consolidated income statement and the retained earnings and minority interest columns for the statement of changes in equity for the Parable Ltd group for the year ended 31 December 20X8 in so far as the information is available. (8 marks)
(b) Redraft the above on the basis that (i)
Parable Ltd sells only a quarter of its shares in Story Ltd for CU200,000 and that the disposal does not constitute a discontinued operation in accordance with BFRS 5.(5 marks)
(ii)
Parable Ltd sells all but a 20% holding of its shares in Story Ltd, for CU400,000, retains significant influence and that the disposal does not constitute a discontinued operation in accordance with BFRS 5. (5 marks) (18 marks)
13
ARBITRARY LTD Arbitrary Ltd holds 80% of the ordinary shares of Contrary Ltd which it purchased five years ago, on 1 July 20X0, for CU175,000. On 1 July 20X5 Arbitrary Ltd sold all of these shares and used the proceeds (CU212,000) to purchase 65% of the ordinary shares of Enthusiast Ltd on the same date. Share capital of Contrary Ltd and Enthusiast Ltd has remained constant for many years at CU100,000 and CU200,000 respectively. Net assets of Contrary Ltd and Enthusiast Ltd were as follows.
Net assets
Contrary Ltd At At acquisition 1 January 20X5 CU CU 187,000 150,000
Enthusiast Ltd At 1 January 20X5 CU 280,000
Income statements and statements of changes in equity for all three companies for the year ended 31 December 20X5 were as follows.
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Financial accounting Income statements
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Interim dividend received from Contrary Ltd Profit before tax Income tax expense Profit after tax
Arbitrary Ltd CU 1,926,500 (1,207,200) 719,300 (207,500) (192,600) 8,000 327,200 (110,000) 217,200
Contrary Ltd CU 521,600 (386,200) 135,400 (79,200) (26,100) – 30,100 (9,500) 20,600
Enthusiast Ltd CU 792,400 (405,900) 386,500 (198,200) (107,100) – 81,200 (27,500) 53,700
Statements of changes in equity
Net profit for the period Interim dividends on ordinary shares (paid 1 May 20X5) Final dividends on ordinary shares (declared 1 December 20X5) Balance brought forward Balance carried forward
Arbitrary Ltd CU 217,200 (50,000) – 167,200 671,300 838,500
Retained earnings Contrary Enthusiast Ltd Ltd CU CU 20,600 53,700 (10,000) – (5,000) 5,600 50,000 55,600
– 53,700 80,000 133,700
No entries have been made in Arbitrary Ltd's income statement relating to the sale of Contrary Ltd. In an earlier accounting period an impairment loss of CU12,700 was recognised in relation to the goodwill arising on the acquisition of Contrary Ltd. Requirements (a)
Prepare the consolidated income statement and the retained earnings and minority interest columns for the statement of changes in equity for Arbitrary Ltd for the year ended 31 December 20X5 in so far as the information is available. (15 marks) Note. You should assume that the disposal of Contrary Ltd constitutes a discontinued operation in accordance with BFRS 5 Non-current assets held for sale and discontinued operations.
(b) Calculate the profit on disposal that would be shown in the individual accounts of Arbitrary Ltd and explain how and why this differs from group profit on disposal. (4 marks) (c)
Briefly discuss the concepts of control and ownership in the context of this disposal. (4 marks) (23 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
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Technical reference For a comprehensive Technical reference section, covering all aspects of group accounts (except group cash flow statements) see Chapter 15.
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Financial accounting
Answers to Self-test 1
B Sale proceeds Less: Share of net assets at disposal (1,000 + 112,000) Carrying amount of goodwill (10,000 60%)
2
CU 140,000 (113,000) (6,000) 21,000
D Sale proceeds Less: Share of net assets at disposal (80% 10,350)
CU'000 9,940 (8,280) 1,660
If any initial goodwill has been fully written off, net assets at disposal date can be used in this calculation. 3
4
C Sale proceeds Less: Share of net assets at disposal (100,000 60%) Carrying amount of goodwill (50,000 50%)
CU 250,000 (60,000) (25,000) 165,000
Sale proceeds Less: Share of net assets at disposal (70% (1,000 + 89,000)) Carrying amount of goodwill
CU 50,000 (63,000) (1,200) (14,200)
D
5
A
6
D
As the profit on disposal has been included within the remaining Gill Group retained earnings, no further adjustment is necessary.
Sale proceeds Less: Share of net assets at disposal (790,000 75%) Carrying amount of goodwill (125,000 – 31,250) 7
C Sale proceeds Less: 20% x 12,420 25% x 108 (see below)
Goodwill Cost of investment Share of NA at acquisition (80% x 10,800) Impaired (50%)
550
CU 820,000 (592,500) (93,750) 133,750
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CU'000 11,928 (2,484) (27) 9,417 CU'000 8,856 (8,640) 216 (108) 108
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9
10
11
12
14
A Proceeds NA disposed of (15% x 620,000) Goodwill (15,000 x 50%)
CU 157,500 (93,000) (7,500) 57,000
Share of net assets at disposal (15% x CU8.2m) Goodwill re remaining shares (15/75 x (1,250 – 375))
CU’000 1,230 175 1,405
Cost of investment (50% x 8,500) Increase in retained earnings (14,500 – 9,800) x 35%
CU’000 4,250 1,645 5,895
Proceeds Less: Net assets disposed of (744,000 x 40%) Goodwill not yet written off (18,000 x 50%)
CU 189,000 (297,600) (9,000) (117,600)
D
C
C
PARABLE LTD (a)
Consolidated income statement for the year ended 31 December 20X8 CU
Continuing operations Profit before tax Income tax expense Profit for the period from continuing operations
875,500 (405,000) 470,500
Discontinued operations Profit for the period from discontinued operations (111,550 + 69,640) (W2, W3) Profit for the period Attributable to Equity holders of Parable Ltd () Minority interest (W4)
181,190 651,690
529,180 122,510 651,690
Consolidated statement of changes in equity for the year ended 31 December 20X8 (extracts)
Net profit for the period Eliminated on disposal of subsidiary (85,280 (W6) + 22,310 (W4)) Balance brought forward (W5 and W6) Balance carried forward
Equity holders of Parable Ltd Retained earnings CU 529,180 – 529,180 2,117,420 2,646,600
Minority interest CU 122,510 (107,590) 14,920 592,780 607,700
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Financial accounting (b) (i)
Consolidated income statement for the year ended 31 December 20X8 CU 1,201,100 92,410 1,293,510 (507,500) 786,010
Operating profit (875,500 + 325,600) Profit on sale of interest in subsidiary (W3) Profit before tax Income tax expense (405,000 + 102,500) Profit for the period Attributable to: Equity holders of Parable Ltd () Minority interest (W4)
618,880 167,130 786,010
Consolidated statement of changes in equity for the year ended 31 December 20X8 (extracts)
Net profit for the period Partial disposal of subsidiary (W7) Balance brought forward (W5, W6) Balance carried forward (ii)
Equity holders of Parable Ltd Retained earnings CU 618,880 – 2,117,420 2,736,300
Minority interest CU 167,130 107,590 592,780 867,500
Consolidated income statement for the year ended 31 December 20X8 CU 1,038,300 77,230 22,310 1,137,840 (456,250) 681,590
Operating profit (875,500 + (325,600 6/12)) Profit on sale of interest in subsidiary (W3) Share of profit of associate (223,100 6/12 20%) Profit before tax Income tax expense (405,000 (102,500 6/12)) Profit for the period Attributable to: Equity holders of Parable Ltd () Minority interest (W4)
559,080 122,510 681,590
Consolidated statement of changes in equity for the year ended 31 December 20X8 (extracts)
Net profit for the period Eliminated on disposal of subsidiary (as (a)) Balance brought forward (W5 and W6) Balance carried forward
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Equity holders of Parable Ltd Retained earnings CU 559,080 – 559,080 2,117,420 2,676,500
Minority interest CU 122,510 (107,590) 14,920 592,780 607,700
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WORKINGS (1) Group structure
Parable Ltd group
Parable Ltd group
Parable Ltd group
(2) Profit for year to disposal PAT of S Ltd
CU 223,100
6/12 =
111,550
(3) Profit on disposal of operations
Sale proceeds Less: Share of net assets at disposal Net assets at 1 January 20X8 Profit to 30 June 20X8 (W2)
Complete disposal (a) CU CU 500,000 426,400 111,550 537,950 80%
(430,360) 69,640
Partial disposal (subsidiary retained) (b)(i) CU CU 200,000
Partial disposal (associate retained) (b)(ii) CU CU 400,000
537,950 20% (107,590) 92,410
537,950 60% (322,770) 77,230
(4) Minority interest for year No subsidiary retained (a) and (b)(ii) CU Story Ltd (223,100 6/12 20%) ((223,100 6/12 20%) + (223,100 6/12 40%)) Other
22,310 100,200 122,510
Subsidiary retained (b)(i) CU 66,930 100,200 167,130
(5) Retained earnings b/f Parable Ltd group Add Story Ltd (80% (326,400 – 50,000)) Less Goodwill impairment to date
CU 1,926,300 221,120 (30,000) 2,117,420
(6) Minority interest b/f Story Ltd ((100,000 + 326,400) 20%) Other
CU 85,280 507,500 592,780
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Financial accounting (7) Partial disposal of subsidiary CU 537,950 107,590
Net assets at date of disposal (100,000 + 326,400 + (6/12 223,100)) 20% 13
ARBITRARY LTD (a)
Consolidated income statement for the year ended 31 December 20X5 CU Continuing operations Revenue (W2) Cost of sales (W2) Gross profit Distribution costs (W2) Administrative expenses (W2) Profit before tax Income tax expense (W2) Profit for the period from continuing operations
2,322,700 (1,410,150) 912,550 (306,600) (246,150) 359,800 (123,750) 236,050
Discontinued operations Profit for the period from discontinued operations (10,300 + 79,060) (W3 + W4) Profit for the period Attributable to Equity holders of Arbitrary Ltd () Minority interest (W5)
89,360 325,410 313,952 11,458 325,410
Consolidated statement of changes in equity for the year ended 31 December 20X5 (extracts)
Net profit for the period Added on acquisition of subsidiary (W8) Eliminated on disposal of subsidiary (W9) Interim dividend on ordinary shares Balance brought forward (W6) + (W7) Balance carried forward
Equity holders of Arbitrary Ltd Retained earnings CU 313,952 – – (50,000) 263,952 629,000 892,952
Minority interest CU 11,458 107,397 (32,060) – 86,795 30,000 116,795
(b) Calculation of profit in individual accounts of Arbitrary Ltd Sale proceeds Less Cost Profit
CU 212,000 (175,000) 37,000
The different calculations of profit on disposal reflect the different way in which the subsidiary (Contrary Ltd) is accounted for in the individual and consolidated accounts. In the individual balance sheet of Arbitrary Ltd Contrary Ltd is carried at cost of CU175,000. The profit on disposal is therefore the sale proceeds less this cost. In the consolidated financial statements the cost of Contrary Ltd is replaced with its underlying net assets and with goodwill acquired in the business combination. The profit on disposal is therefore based on sale proceeds less the percentage of net assets being sold (here 80%) less the unimpaired goodwill which is being sold in full (as it only ever related to the 80% share of net assets acquired).
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(c)
14
Application of control and ownership ideas Control Up to 1 July 20X5 Arbitrary Ltd owns 80% of Contrary Ltd and therefore controls it. So the consolidated income statement should include 100% of Contrary Ltd's profits up to that date. After 1 July 20X5 Arbitrary Ltd no longer controls Contrary Ltd. Its results should be excluded from the consolidated income statement for the last six months of the year and also from the consolidated balance sheet. This treatment reflects the fact that once Contrary Ltd has been sold its resources are no longer under group control. Ownership For the first six months of the year 100% of Contrary Ltd's profits are included in the consolidated income statement. However, 20% of its profits are owned by the minority interest and this has to be deducted in arriving at the group's share of profit (CU20,600 x 6/12 x 20%). When the disposal occurs the group is selling its ownership interest in the net assets and its goodwill. Therefore the group profit on disposal is calculated from the point of view of ownership.
WORKINGS (1) Group structure Arbitrary Ltd 80% (sold 1 July 20X5 6/12 in)
65% (acq 1 July 20X5 6/12 in)
Contrary Ltd
Enthusiast Ltd
(2) Consolidation schedule Arbitrary Ltd CU 1,926,500 (1,207,200) (207,500) (192,600) (110,000)
Revenue C of S Distrib cost Admin exp Tax PAT
Enthusiast Ltd 6/12 CU 396,200 (202,950) (99,100) (53,550) (13,750) 26,850
Consol CU 2,322,700 (1,410,150) (306,600) (246,150) (123,750)
(3) Profit for year to disposal PAT of C Ltd 6/12
CU 20,600 10,300
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Financial accounting (4) Profit on disposal of Contrary Ltd operations Sale proceeds Less: Share of net assets at disposal Net assets at 1 January 20X5 Profit to 1 July 20X5 (W3) Dividends paid
Less: Carrying amount of goodwill Cost of investment Share of net assets at acquisition (80% 187,000) Impairment to date
CU 150,000 10,300 (10,000) 150,300 80% 175,000 (149,600) 25,400 (12,700)
CU 212,000
(120,240) 91,760
(12,700) 79,060
(5) Minority interest in year Contrary Ltd (20% x 10,300 (W3)) Enthusiast Ltd (35% x 26,850 (W2))
CU 2,060 9,398 11,458
(6) Retained earnings b/f Arbitrary Ltd Contrary Ltd (80% x (50,000 – (187,000 – 100,000)) Goodwill impairment to 31 December 20X4
CU 671,300 (29,600) (12,700) 629,000
(7) Minority interest b/f Contrary Ltd (150,000 20%)
CU 30,000
(8) Minority interest added on acquisition of subsidiary Enthusiast Ltd ((200,000 + 80,000 + 26,850 (W2)) 35%)
CU 107,397
(9) Minority interest eliminated on disposal of subsidiary CU Contrary Ltd B/f (W7) Current year (W5)
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30,000 2,060 32,060
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Answers to Interactive questions
Answer to Interactive question 1 (a)
Champion Ltd's individual accounts CU 2,100 (2,000) 100
Proceeds Cost Profit on disposal (b) Consolidated accounts No impairment CU CU Proceeds 2,100 (1,680) Less: Share of net assets at date of disposal (70% 2,400) 420 Less:Carrying amount of goodwill at date of disposal Cost of investment 2,000 Share of net assets at acquisition (1,330) (70% 1,900) Goodwill at acquisition 670 Impairment to date – (670) Profit/(loss) on disposal (250)
Impairment of CU470 CU CU 2,100 (1,680) 420 2,000 (1,330) 670 (470) (200) 220
Answer to Interactive question 2 Daring Group Consolidated balance sheet at 31 March 20X1 CUm 4,000 42,450 46,450
Intangibles – goodwill Sundry assets Share capital (CU1 ordinary shares) Retained earnings (from CSCE) Attributable to equity holders of Daring Ltd Minority interest Equity Liabilities
8,000 16,450 24,450 12,000 36,450 10,000 46,450
Consolidated income statement for the year ended 31 March 20X1 Continuing operations Profit before tax (W2) Income tax expense (W2) Profit for the period from continuing operations Discontinued operations Profit for the period from discontinued operations (1,238 + 3,321) (W4 and W5) Profit for the period Attributable to: Equity holders of Daring Ltd () Minority interest (2,500 + 124 (W3))
CUm 12,950 (5,400) 7,550 4,559 12,109 9,485 2,624 12,109
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Financial accounting Consolidated statement of changes in equity for the year ended 31 March 20X1
Profit for the year Eliminated on disposal of subsidiary (W9) Balance b/f (W7 and W8) Balance c/f
Attributable to equity holders of Daring Ltd Share Retained capital earnings Total CUm CUm CUm – 9,485 9,485 – – 8,000 8,000
– 9,485 6,965 16,450
– 9,485 14,965 24,450
Minority interest CUm 2,624
Total CUm 12,109
(609) 2,015 9,985 12,000
(609) 11,500 24,950 36,450
WORKINGS (1) Group structure
Daring
90% for 9/12 of year
Glory (2) Consolidation schedule for CIS
Profit before tax Tax
Daring Group CUm 12,950 (5,400)
Consol CUm 12,950 (5,400)
Tutorial note. In this case the consolidation schedule only includes the results of the parent group as those of Glory Ltd are to be treated as discontinued. (See working 4.) In an examination question it is likely that you will have to deal with another subsidiary still retained at the year end as well as the company disposed of so this working will be required. (3) Minority interests in Glory Ltd for CIS CUm 124
1,238 (W4) 10% (4) Profit of Glory Ltd for year to disposal
CUm 1,650 1,238
PAT 9/12 (5) Profit on disposal of Glory Ltd for CIS CUm Sale proceeds Less: Share of net assets at disposal (90% 6,088 (W6)) Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition (90% (3,000 + 700)) Goodwill at acquisition Impairment to date Profit on disposal
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CUm 8,890 (5,479) 3,411
3,440 (3,330) 110 (20) (90) 3,321
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(6) Net assets at disposal Share capital Retained earnings b/f (4,850 – 3,000) Profit for year to disposal (W4)
CUm 3,000 1,850 1,238 6,088
(7) Group retained earnings b/f for CSCE Daring Group Glory Ltd (90% (1,850 – 700)) Goodwill impairment to date
CUm 5,950 1,035 (20) 6,965
(8) Minority interest b/f for CSCE Glory Ltd (4,850 10%) = 485 + other subsidiaries 9,500
CUm 9,985
(9) Minority interest eliminated on disposal B/f amount 485 (W8) + current year 124 (W3)
CUm 609
Answer to Interactive question 3 (a)
Partial disposal (subsidiary to subsidiary) mid year Consolidated balance sheet as at 30 September 20X8 Property, plant and equipment Goodwill (302-75) Current assets (2,700 + 1,300 + 380) Share capital (CU1 ordinary shares) Retained earnings (W5) Minority interest (W6) Current liabilities (1,200 + 500)
CU'000 2,650 227 2,877 4,380 7,257 2,000 2,997 4,997 560 5,557 1,700 7,257
Consolidated income statement for the year ended 30 September 20X8 Profit from operations Profit on sale of interest in subsidiary (W2) Profit before tax Income tax expense (400 + 50) Profit for the period Attributable to: Equity holders of Ben Ltd (β) Minority interest (W3)
CU'000 1,580 31 1,611 (450) 1,161
1,128 33 1,161
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Financial accounting Consolidated statement of changes in equity (extract)
Profit for the year Partial disposal of subsidiary Balance at 30 September 20X7 (W4) Balance at 30 September 20X8 (W5 + W6)
Ben Ltd Retained earnings CU'000 1,129 – 1,129 1,868 2,997
Minority interest (Bill Ltd) CU'000 33 273 306 254 560
CU'000
CU'000 380 (274) 106
WORKINGS (1) Group structure
Ben plc
80% x 9/12 60% x 3/12 Bill Ltd (2) Profit on disposal of Bill Ltd Sale proceeds Less: Share of net assets at disposal ((300 + 970 + 9/12 130) 20%) Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition (80% (300 + 510)) Goodwill at acquisition Re disposal (1/4)
950 (648) 302
(75) 31
(3) Minority interest in Bill Ltd for CIS 20% 130 9/12 = 40% 130 3/12 =
CU'000 20 13
CU'000 33
(4) Retained earnings/MI brought forward As per Worked example
CU000 1,868
CU000 254
(5) Retained earnings carried forward Ben Ltd Add: Profit on disposal (380 – (950 25%)) Bill Ltd (60% (1,100 – 510))
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CU'000 2,500 143 2,643 354 2,997
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(6) MI c/f CU'000 300 1,100 1,400 560
Share capital Retained earnings 40% (b) Partial disposal (subsidiary to associate) mid year Consolidated balance sheet as at 30 September 20X8
CU'000 2,050 711 2,761 4,050 6,811
Property, plant and equipment Investments in associates (W2) Current assets (2,700 + 1,350) Share capital (CU1 ordinary shares) Retained earnings (W6)
2,000 3,611 5,611 1,200 6,811
Current liabilities Consolidated income statement for the year ended 30 September 20X8
CU'000 1,535 652 13 2,200 (438) 1,762
Profit from operations (1,400 + (9/12 180)) Profit on sale of interest in subsidiary (W3) Share of profit of associates (130 3/12 40%) Profit before tax Income tax expense (400 + (9/12 50)) Profit for the period Attributable to: Equity holders of Ben Ltd (β) Minority interest (W4)
1,743 19 1,762
Consolidated statement of changes in equity (extract)
Profit for the year Eliminated on disposal of subsidiary (19 + 254)
Ben Ltd Retained earnings CU'000 1,743 1,743
Balance at 30 September 20X7 (W5) Balance at 30 September 20X8 (W6)
1,868 3,611
Minority interest (Bill Ltd) CU'000 19 (273) (254) 254 –
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Financial accounting WORKINGS (1) Group structure Ben Ltd
80% x 9/12 Bill Ltd
40% x 3/12 Bill Ltd
(2) Investments in associates CU'000 475 236 711
Cost of associate (950 ½) Share of post acquisition retained earnings (40% (1,100 – 510)) (3) Profit on disposal of Bill Ltd CU'000 Sale proceeds Less: Share of net assets at disposal (300 + 970 + (9/12 130)) 40% Less: Carrying amount of goodwill at date of disposal Cost of investment Share of net assets at acquisition (80% (300+510)) Goodwill at acquisition Re disposal (1/2)
950 (648) 302
CU'000 1,350 (547) 803
(151) 652
(4) Minority interest in Bill Ltd for CIS CU'000 19
20% 130 9/12 (5) Retained earnings/MI brought forward As per worked example
CU'000 1,868
CU'000 254
(6) Retained earnings carried forward Ben Ltd Add: Profit on disposal (1,350 – (950 50%)) Bill Ltd (40% (1,100 – 510))
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CU'000 2,500 875 3,375 236 3,611
chapter 15
Business combinations, consolidated financial statements and associates Contents Introduction Examination context Topic List 1
Sources of requirements
2
BFRS 3 Business Combinations
3
Identifying the acquirer
4
Measuring the cost of a business combination
5
Allocating the cost of the business combination
6
Goodwill
7
Practical issues
8
Disclosures
9
BAS 27 Consolidated and Separate Financial Statements
10
BAS 28 Investments in Associates
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Financial accounting
Introduction
Learning objectives
Identify and explain the relationship between companies as parent, subsidiary or associate
Determine whether group accounts are required
Calculate goodwill including the measurement of identifiable assets, liabilities and contingent liabilities in relation to the acquisition of a subsidiary
Explain the accounting treatment of goodwill in the consolidated balance sheet and consolidated income statement
Explain the accounting treatment in consolidated financial statements of: –
Subsidiaries
–
Associates
Tick off
Specific syllabus references for this chapter are: 1g, 3a,b,c,d,e.
Practical significance One of the key topics covered in this chapter is goodwill, particularly the way in which fair values affect the calculation of goodwill on acquisition of a subsidiary. Goodwill arising in these circumstances can be a significant asset, particularly for acquisitive groups. For example, the UK Vodafone Group plc recognised CU69,118 million of goodwill in its 2006 financial statements. This represented over three quarters of shareholders’ equity. Accounting standards emphasise the need to recognise identifiable intangible assets rather than subsuming them within goodwill. This has become an increasingly important issue as the nature of business has changed. At acquisition a subsidiary may have intangible assets such as brands as key business assets as well as the more traditional tangible assets of property, plant and equipment.
Stop and think What would be the potential benefits of subsuming identifiable intangible assets within goodwill?
Working context Goodwill and fair values are key factors affecting consolidated accounts. Although accounting standards provide guidance, the assessment of fair values still involves judgement. As a result, this aspect of the consolidation process is likely to be carried out by more senior members of staff.
Syllabus links This chapter puts the treatment of a subsidiary and an associate covered in Chapters 10 to 14 into the context of the relevant accounting standards. It is important that you are familiar with the principles which underpin the purchase method and equity method described in this chapter as well as being able to produce the consolidated financial statements. More complex aspects of group accounts are dealt with in Financial & Corporate Reporting at the Advanced Stage.
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Examination context
Exam commentary Accounting and reporting concepts constitute 10% of the syllabus, and an ability to explain and demonstrate the concepts and principles surrounding the consolidated financial statements would be included here. This is likely to be tested in the written test section of the paper. Typically a question would require preparation of some consolidated information followed by an explanation of the principles behind the method. Alternatively you could be asked to justify your treatment of an investment as a subsidiary or an associate. Goodwill and fair values are also popular exam topics and would be tested within the 35% groups part of the paper. This area could be examined in the written test section but is also likely to be examined in shortanswer questions. In the exam candidates may be required to:
Explain the following concepts: – – – –
Control Substance over form Single entity concept Significant influence
Distinguish between a subsidiary, an associate and a trade investment and explain the accounting treatment of each of these
Calculate goodwill incorporating fair values of: – –
Consideration Assets, liabilities and contingent liabilities acquired
Demonstrate the subsequent accounting treatment of goodwill
Prepare simple extracts from financial statements in accordance with Companies Act and BFRS
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1 Sources of requirements Section overview
1.1
This chapter considers group accounts in the context of BFRS Framework and the relevant Bangladesh Financial Reporting Standards.
Context Previous chapters have dealt with the mechanics of preparing consolidated financial statements. This chapter covers the International Financial Reporting Standards relating to business combinations (the acquisition of one business by another), subsidiaries and associates which form the basis of the consolidation process dealt with earlier. The standards covered in this chapter are as follows:
1.2
BFRS 3 Business Combinations (sections 2-8) BAS 27 Consolidated and Separate Financial Statements (section 9) BAS 28 Investments in Associates (section 10)
Underlying principles The key elements in financial statements, identified in BFRS Framework, which are relevant to business combinations, subsidiaries and associates are:
Assets: resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity
Liabilities: present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic resources.
Also relevant are the definitions of:
Gains, which are a part of income: increases in economic benefits through enhancements of assets or decreases in liabilities other than contributions from equity
Losses, which are included in expenses: decreases in economic benefits through depletions of assets or additional liabilities other than distributions to equity
The recognition criteria: –
It is probable that any future economic benefit associated with the item will flow to or from the entity; and
–
The item has a cost or value that can be measured with reliability
and the need to account for matters in accordance with their substance and economic reality, not merely their legal form.
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2 BFRS 3 Business Combinations Section overview
2.1
All business combinations should be accounted for using the purchase method.
Objective The objective of BFRS 3 is to set out the accounting and disclosure requirements for a business combination. In practice business combinations can be structured in all sorts of different ways, usually for reasons which are peculiar to the parties to the combination and/or to suit the legal and tax environments in which they operate. In an area of such potential complexity BFRS 3 looks beyond the legal form of the transaction to the underlying substance, in line with BFRS Framework. This can be seen in the definitions below.
Definitions Business combination. The bringing together of separate entities or businesses into one reporting entity. Business. An integrated set of activities and assets conducted and managed for the purpose of providing: (a)
A return to investors; or
(b) Lower costs or other economic benefits directly and proportionately to policyholders or participants. A business generally consists of inputs, processes applied to those inputs, and resulting outputs that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set is presumed to be a business.
Nearly all business combinations result in one entity, the acquirer, obtaining control of one or more other businesses. We will look at the issue of control in section 3. The type of business combination with which you need to be familiar is the acquisition of one company by another resulting in a parent-subsidiary relationship. (We have looked at the practical application of this relationship in Chapters 10-12.) Point to note If assets alone are purchased, such as a fleet of motor vehicles these will be accounted for under BAS 16 Property, Plant and Equipment not BFRS 3.
Definitions Parent. An entity that has one or more subsidiaries. Subsidiary. An entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).
2.2
Scope BFRS 3 applies to all business combinations except those for which there are or will be separate BFRSs. None of these excluded combinations fall within the Financial Accounting syllabus.
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2.3
Purchase method of accounting All business combinations must be accounted for by applying the purchase method. This involves three key steps:
Identifying an acquirer
Measuring the cost of the business combination; and
Allocating the cost of the business combination to the identifiable assets and liabilities (including contingent liabilities) acquired.
We will look at these three steps in more detail in the following sections 3-5 of this chapter.
3 Identifying the acquirer Section overview
The acquirer should be identified for all business combinations.
The acquirer is the entity which obtains control of the other entity.
There are a number of ways in which control can be achieved.
Control is normally assumed where the acquirer obtains more than 50% of the voting rights in the acquiree.
BFRS 3 states that the acquirer should be identified for all business combinations.
Definitions Acquirer. The combining entity that obtains control of the other combining entities or businesses. Control. The power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities.
In practical terms the simplest way in which control can be achieved is where the acquirer (P) gains more than half of the voting rights in the acquiree (S) i.e. rights relating to votes of the shareholders in general meeting. These rights are normally attached to the ordinary shares BFRS 3 states that in this case control should be assumed unless it can be demonstrated otherwise. Control also exists, however, where P has power:
Over a majority of the voting rights, through an agreement with others
To govern the financial and operating policies of S under statute or agreement (this is similar to the definition of control above)
To appoint or remove the majority of the members of the board of directors (or equivalent top management) of S, or
To cast the majority of votes at S's board meetings.
In most business combinations it should be relatively straightforward to identify the acquirer. Where this is not the case BFRS 3 provides a number of additional indicators as follows:
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If the fair value of one of the entities is significantly greater than the other entity, the entity with the larger fair value is likely to be the acquirer
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Where the business combination is effected through an issue of shares for cash or other assets, the entity giving up the cash or other assets is likely to be the acquirer
Where one of the entities is able to select the management team of the combined entity, that party is likely to be the acquirer.
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4 Measuring the cost of a business combination Section overview
4.1
The cost of a business combination includes the fair values at the date of exchange of assets given, liabilities incurred or assumed and equity instruments issued by the acquirer.
Quoted equity investments should be valued at their published price.
Deferred consideration should be discounted.
Costs directly attributable to the combination should be recognised as part of the cost of the combination.
General rule The cost of the business combination is
4.2
The total of the fair values of the consideration given; and Any costs directly attributable to the business combination.
Fair value of consideration BFRS 3 requires that consideration given should be measured at fair value at the date of exchange.
Definition Fair value. The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
The Financial Accounting syllabus includes only combinations achieved through a single exchange transaction (not a gradual build up of control through successive transactions to acquire shares in the acquiree) so for our purposes the date of exchange is the acquisition date.
Definition Acquisition date. The date on which the acquirer effectively obtains control of the acquiree.
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Financial accounting This is the same date as that which would be used to split pre and post-acquisition profits. Points to note
4.3
1
Consideration given may be in the form of cash or other assets, liabilities assumed or incurred and equity instruments (e.g. shares) issued by the acquirer.
2
The fair value of any quoted equity investments (marketable securities) forming part of the purchase consideration would be the published price at the date of exchange, except in rare circumstances.
3
Future losses or other costs expected to be incurred as a result of the combination are not included as part of the cost of the combination.
Deferred consideration Where settlement of the consideration is deferred to a later date, it is valued at its discounted present value at the time of acquisition. For marketable securities this is their market value at the acquisition date (market value being the best estimate of the present value of all future benefits accruing on the securities).
4.4
Contingent consideration Part of the consideration for the acquisition may be contingent on the acquired business meeting certain targets in the future, or may be dependent on other uncertain future events. The normal principles of BAS 37 Provisions, Contingent Liabilities and Contingent Assets (dealt with in Chapter 9) are applied. Therefore, the additional cost of investment is recognised if it is probable (more likely than not) that the additional consideration will be paid and if its amount can be estimated reliably. If this is not the case, a contingent liability for the additional consideration will be disclosed. The assessment of whether contingent consideration is likely to be paid is an accounting estimate, not an accounting policy. Hence, if the assessment needs to be revised in the light of subsequent experience (because, for example, the acquired business beats or falls short of its targets) and the revision arises after the completion of the initial accounting (see section 6.4 below), the consequential effect on goodwill is accounted for in the period of the revision, not retrospectively. Point to note There is no time limit within which such adjustments to goodwill must be made.
4.5
Directly attributable costs Costs directly attributable to the acquisition can be included in the cost of the combination. These will include professional and other fees relating specifically to the individual transaction e.g. accountants’ fees and legal costs. It will not include general administrative costs and internal costs e.g. staff costs relating to employees in the acquisitions department. These costs relate to all transactions, therefore they are not directly attributable to an individual acquisition. The costs of arranging financial liabilities (e.g. loans) and issuing equity are deducted from the liability/equity, rather than being added to the cost of the business combination.
Worked example: Issue costs Fir Ltd acquired 100% of Pine Ltd by issuing 200,000 new CU1 ordinary shares at a fair value of CU2 per share. The issue costs associated with these shares were CU20,000. Professional fees were also incurred in respect of the acquisition amounting to CU25,000.
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The cost of the business combination would be as follows: Fair value of shares issued (200,000 × CU2) Professional fees
CU 400,000 25,000 425,000
The issue costs do not form part of the cost of the combination but are deducted from the share premium arising on the issue of the new share capital as follows: CU 200,000 (20,000) 180,000
Share premium (200,000 × CU1) Less: Issue costs
5 Allocating the cost of the business combination Section overview
5.1
The acquiree's identifiable assets, liabilities and contingent liabilities should be recognised at fair value at the date of acquisition.
Where certain criteria are met the acquiree's assets, liabilities and contingent assets should be recognised separately.
Provisions for future reorganisation plans and future losses should not be recognised as liabilities at the acquisition date.
Contingent liabilities which can be measured reliably should be recognised as liabilities at the acquisition date.
An intangible asset may only be recognised if it is separable or arises from contractual or other legal rights and can be measured reliably.
BFRS 3 provides guidance on the measurement at fair value of specific assets, liabilities and contingent liabilities.
Basic principle BFRS 3 requires that the acquiree's identifiable assets, liabilities and contingent liabilities should be recognised at fair value at the date of acquisition. The exception to this is non-current assets that are classified as held for sale in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations. These are recognised at fair value less costs to sell. Point to note What constitutes the acquiree's identifiable assets, liabilities and contingent liabilities is important as the difference between the cost of the business combination and the acquirer's share of these represents goodwill. (The mechanics of this calculation were covered in Chapters 10-12.) The higher the total value of net assets acquired, the lower the total value of goodwill and vice versa.
5.2
Identification of net assets acquired Separate recognition of the acquiree's assets, liabilities and contingent liabilities is required where they meet specific criteria at the acquisition date. The criteria are based on BFRS Framework definitions of an asset and a liability, covered in Chapter 1. These are as follows:
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Financial accounting Assets other than intangible assets
Where it is probable that any associated future economic benefits will flow to the acquirer, and their fair value can be measured reliably.
Liabilities other than contingent liabilities
Where it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and its fair value can be measured reliably.
(see section 5.3 below)
Intangible assets
5.3
(see section 5.4 below)
Where they meet the definition of an intangible asset in accordance with BAS 38 Intangible assets and their fair value can be measured reliably.
Contingent liabilities
Where their fair value can be measured reliably.
Recognition of liabilities An acquirer may only recognise an acquiree's liabilities if they exist at the acquisition date. This application of the normal BFRS Framework definition of a liability prohibits any account being taken at that time of two factors which will have depressed the price the acquirer is prepared to pay for the acquiree: Reorganisation plans devised by the acquirer which will only be put into effect once control over the acquiree is gained.
Acquirers often plan to create value by changing the cost structure of the acquiree so that the post-acquisition cost base is less than the sum of the acquirer's and acquiree's existing cost bases. The acquirer will evaluate the oneoff costs of making these changes when deciding what lower price to offer for the acquiree, but as these costs are neither a liability nor a contingent liability of the acquiree prior to the date control is gained, they cannot be set up as provisions at the time of acquisition.
Future losses to be incurred as a result of the business combination (this covers future losses to be incurred by the acquirer as well as by the acquiree).
An acquirer will often target a loss-making business, in the expectation that after reorganisation and with new management it will become profitable. But it often takes some time for the benefits of such changes to emerge, during which time further trading losses will be incurred. The reorganisation process may also cause short-term losses within the acquirer. The total of such losses will depress the price to be offered by the acquirer. But no account can be taken of them, because future losses relate to future, not past, events.
Point to note Contrast the first of these situations with contractual obligations put in place by the acquiree (not the acquirer) prior to the acquisition date and conditional on being taken over. (Such contractual obligations are sometimes put together on a large scale by the acquiree's management, precisely to deter acquirers. In these cases they are often described as 'poison pill' defences.) Prior to the acquisition date these are present obligations arising from past events but outflows of resources are not probable. So they will be dealt with as contingent liabilities by the acquiree up to the moment when a business combination becomes probable. At that point they meet the recognition criteria for a liability and must be recognised as one of the acquiree's liabilities in allocating the cost of the combination.
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5.4
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Recognition of intangible assets As already noted in section 5.2 above, intangible assets must be recognised when they can be reliably measured. But even before that test, they must meet the definition of an intangible asset under BAS 38 Intangible Assets. This BAS was dealt with in detail in Chapter 6, but the following points are relevant here:
An intangible asset is a non-monetary asset without physical substance. It must be separable or arise from contractual or other legal rights. 'Separable' means that the asset can be sold separately from the entity owning the asset, while 'contractual or other legal rights' provides evidence of the existence of the asset. Contrast an intangible defined in this way with goodwill arising on an acquisition, which is not separable and does not arise from contractual or other legal rights
The illustrative examples which accompany BFRS 3 (but which are not an integral part of it) list the following examples of intangible assets which could be recognised on a business combination: –
Separable assets:
Customer lists Non-contractual customer relationships Databases
Customer lists are often leased (i.e. used for a period without ownership being gained) for mailing purposes by entities wanting to try to acquire new customers. Customer relationships are details of customers together with their past buying profiles which can be sold, on the basis that even though these customers have no outstanding commitments to make purchases, the probability is that a number of them will place future orders. A value can then be put on this probability. –
Assets arising from contractual or other legal rights:
5.5
Trademarks Internet domain names Newspaper mastheads Non-competition agreements Unfulfilled contracts with customers Copyrights over plays Books, music, videos, etc Leases Licences to broadcast television and/or radio programmes Licences to fish in certain waters Licences to provide taxi services Patented technology Computer software
The definition also covers research and development projects which are in process at the acquisition date. These will often not be recognised in the acquiree's balance sheet as we saw in Chapter 6.
Measurement of net assets acquired Where the BFRS 3 recognition criteria are met the assets, liabilities and contingent liabilities acquired should be measured at fair value as follows: Asset, liability or contingent liability
Fair value
Financial instruments traded in an active market
Current market values
Financial instruments not traded on an active market
Estimated values based on comparable instruments of entities with similar characteristics
Receivables
Present value of amounts to be received.
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Financial accounting Asset, liability or contingent liability
Fair value (Discounting is not required for short-term receivables where the effect is likely to be immaterial.)
Inventories of finished goods
Selling price less: The costs of disposal and A reasonable profit allowance for the selling effort of the acquirer.
Inventories of work-in-progress
Selling price of finished goods less: Costs to complete Costs of disposal and A reasonable profit allowance for the completing and selling effort.
Inventories of raw materials
Current replacement costs
Land and buildings
Market values
Plant and equipment
Market values Depreciated replacement cost should be used where the asset is of a specialised nature and there is no market-based evidence of fair value (see worked example below).
Intangible assets
Market value by reference to an active market. If no active market exists the amounts the acquirer would have paid in an arm's length transaction between knowledgeable willing parties, based on the best information available.
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Accounts and notes payable, long-term debt, liabilities and accruals
Present values of amounts to be paid.
Onerous contracts (see Chapter 9)
Present values of amounts to be paid.
Contingent liabilities (see section 5.6 below)
The amounts that a third party would charge to assume those contingent liabilities.
(Discounting is not required for short-term payables where the effect is likely to be immaterial.)
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Worked example: Depreciated replacement cost Gareth Ltd is being acquired by Roz Ltd. Gareth Ltd owns specialised plant for which no market value is available. This plant originally cost CU3m, is one-third of the way through its useful life and has no residual value. So it stands in its books at cost CU3m less accumulated depreciation CU1m, i.e. CU2m. New plant with a similar capacity would cost CU3.6m. 'Depreciated' replacement cost means that the same proportionate amount of accumulated depreciation is applied to the replacement cost. The replacement plant would cost CU3.6m, accumulated depreciation of one-third would be CU1.2m, so the depreciated replacement cost is CU2.4m.
5.6
Contingent liabilities BFRS 3 requires an acquirer to recognise an acquiree's contingent liabilities where their amount can be measured reliably. This is in spite of the fact that they will not have been recognised in the balance sheet of the acquiree (under BAS 37 ). Once recognised, contingent liabilities must be carried at the higher of the amount under BAS 37 (which will be nil until they become liabilities) and their value at the acquisition date, less any subsequent amortisation. Points to note
5.7
1
If these cannot be measured reliably, their value, whatever it is, will be subsumed within goodwill or discount on acquisition. But full disclosure must still be made.
2
Even if recognised, the normal BAS 37 disclosures re contingent liabilities must be made.
Consequences of recognition at fair value The consequences of the recognition of the acquiree's assets, liabilities and contingent liabilities at the acquisition date are that:
5.8
The acquirer's consolidated income statement must include the acquiree's profits and losses from the same date
The fair values of the acquiree's net assets form the basis of all the subsequent accounting in the consolidated financial statements even where fair values are not incorporated into the acquiree's single entity financial statements. For example, depreciation will be based on the fair values of property, plant and equipment which may not be the same as the carrying amount in the acquiree's balance sheet
Any minority interest in the acquiree is based on the minority interest share of the net assets at their fair values
Summary The allocation of the cost of a business combination is made as follows: Fair value of assets given, liabilities assumed and equity instruments issued Less: Fair value of tangible assets acquired Fair value of intangible assets acquired Fair value of assets acquired Fair value of liabilities acquired Fair value of contingent liabilities acquired Fair value of net assets acquired Share of net assets acquired at fair value Goodwill/(discount on acquisition)
CU X X X (X) (X) X
CU X
(X) X/(X)
We will look at goodwill in more detail in section 6 below.
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Interactive question 1: Measuring fair value
[Difficulty level: Exam standard]
Kelly Ltd acquired 75% of Eclipse Ltd on 1 July 20X7. The consideration comprised:
5 million 25p ordinary shares of Kelly Ltd (market value 60p) to be issued on 1 July 20X7 (issue costs of CU10,000 were paid to a merchant bank)
CU1 million cash payable on 1 July 20X7
A further 1 million 25p ordinary shares of Kelly Ltd to be issued on 1 July 20X8, provided that Eclipse Ltd achieves a profit for the year ended 31 March 20X8 of CU10 million.
Professional fees to bankers and advisers relating to the acquisition totalled CU20,000 (excluding the issue costs stated above). The directors of Kelly Ltd estimate that the value of their time spent working on the acquisition was CU25,000. The fair value of the identifiable assets and liabilities recognised by Eclipse Ltd at 1 July 20X7 is CU3,628,000. The financial statements of Eclipse Ltd have for some years disclosed a contingent liability with a potential amount of CU2 million. The fair value of this contingent liability at 1 July 20X7 has been estimated at CU200,000. Current forecasts indicate that Eclipse Ltd will probably make profits of at least CU12 million for the year to 31 March 20X8. Requirement Show the entries in Kelly Ltd's books to record the investment in Eclipse Ltd, and calculate goodwill acquired in the business combination. Fill in the proforma below.
Solution CU'000
CU'000
CU'000
CU'000
Recording investment in Eclipse Ltd Shares to be issued 1 July 20X7 DR CR CR CR Cash DR CR Professional fees DR CR Shares to be issued 1 July 20X8 DR CR Goodwill on consolidation of Eclipse Ltd Cost of investment Shares Cash Fees Shares to be issued Identifiable assets and liabilities acquired Per books of Eclipse Ltd Contingent liability Group share (75%) See Answer at the end of this chapter.
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6 Goodwill Section overview
6.1
Goodwill is calculated as the excess of the fair value of the acquisition cost over the acquirer's interest in the fair value of the net assets acquired.
Goodwill arising on a business combination is recognised as an intangible asset in the consolidated balance sheet.
Goodwill should be tested for impairment at least annually.
If a discount arises the measurement of the fair value of net assets acquired should be checked.
If the discount remains it should be recognised in profit or loss in the accounting period in which the acquisition is made.
Goodwill at acquisition In accordance with BFRS 3 any excess of the acquisition cost over the acquirer's interest in the fair value of the net assets acquired should be:
Described as goodwill; and Recognised as an asset (as it meets the recognition criteria)
Definition Goodwill. Future economic benefits arising from assets that are not capable of being individually identified and separately recognised.
Point to note Any goodwill carried in the acquiree's balance sheet becomes subsumed in the goodwill arising on acquisition, because:
6.2
It is excluded from identifiable assets (see section 5.4 above) This reduces the net assets acquired; and Must therefore increase the goodwill arising on consolidation.
Goodwill subsequent to acquisition After initial recognition, goodwill should be:
6.3
Carried in the balance sheet at cost less accumulated impairment losses; Tested for impairment at least annually in accordance with BAS 36 Impairment of Assets.
Discount on acquisition A discount on acquisition arises if the acquirer’s share of the fair value of the net assets acquired exceeds the cost of the acquisition, i.e. there is 'negative goodwill'. BFRS 3 is based on the assumption that this usually arises because of errors in the measurement of the acquiree's net assets (i.e. assets, liabilities and contingent liabilities) and/or of the cost of the combination. So the first action is always to reassess the identification and measurement of the net assets and the measurement of the cost of the combination, checking in particular whether the fair values of the net assets acquired correctly reflect future costs arising in respect of the acquiree. If the discount still remains once these reassessments have been made, then it is attributable to a bargain purchase, i.e. the acquirer has managed to get away with paying less than the full value for the acquiree. This discount does not meet BFRS Framework's definition of a liability, so it must be part of equity. It must therefore be recognised in profit or loss in the same accounting period as the acquisition is made.
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6.4
Initial accounting Initial accounting is the process of identifying and determining the fair values of:
The acquiree's identifiable assets, liabilities and contingent liabilities; and The cost of the combination, i.e. of the assets given, liabilities assumed and equity instruments issued.
Whilst every effort should be made to complete this process by the end of the accounting period in which the combination is effected, it may be that in some cases only provisional values can be established by that time. This is often true of the valuation of non-current assets, including intangibles. In such cases:
Provisional values should initially be used
Adjustments to the values of the net assets and/or the cost of the combination made within one year of the acquisition date should be backdated to the acquisition date. Changes in both these sets of values may therefore lead to a restatement of the provisional values for goodwill or the discount on acquisition
Comparative figures for the previous period (the one in which the combination was effected) must be restated as if these adjustments had been made as part of the initial accounting. So depreciation charges in the previous period in respect of PPE may have to be restated.
Point to note This one year period can only be used to reassess fair values. It cannot be used to backdate the recognition of acquired assets and liabilities which did not meet the recognition criteria at the acquisition date but do so during this period, because this would involve taking account of events after the acquisition date. As an example, major pollution damage resulting from an accident taking place within the one year period may result in new types of liabilities being identified, types which were unknown at the acquisition date. No such liabilities can be recognised at the acquisition date as they were not known at that time.
6.5
Subsequent adjustments The need for further adjustments may emerge later but to allow them to be backdated to the acquisition date might result in continual changes to previously published data, in a way which is not helpful to users of financial statements. For example, a large group might make several acquisitions every year; adjustments to fair values at the date of each acquisition might result in annual adjustments to comparative figures and not just for acquisitions in the immediate prior period. So fair value adjustments made after the end of the one year period are to be treated as follows:
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In limited circumstances, they are backdated to the acquisition date with restatement of goodwill or discount on acquisition and all comparative figures. These circumstances are if they arise as a result of an error, as defined by BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (dealt with in Chapter 4). But such errors will be very rare
If they are adjustments to the fair value of the cost of the combination (see section 4 above), then goodwill or discounts on acquisition are adjusted, but in the current period only. There is no backdating to the acquisition date and no restatement of the comparative figures
In all other circumstances, such adjustments are to be treated as changes in accounting estimates, as defined in BAS 8. There is no backdating to the acquisition date and no restatement of comparative figures. These adjustments are recognised as income or expenses in the accounting period in which they arise. So if a debt which had a fair value of nil at the acquisition date (i.e. it had been recognised as an expense in profit or loss) is recovered in full two years afterwards, it is treated as income, not as a reduction in goodwill.
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7 Practical issues Section overview
7.1
Where a subsidiary has not reflected fair values in its single entity financial statements, adjustments will need to be made as part of the consolidation process.
Fair value adjustments The way fair value adjustments are taken up in the initial calculation of goodwill is dealt with in Chapter 11. But such adjustments may also have to be taken up subsequently, because there is no requirement that the acquiree should recognise in its own accounting records the fair values attributed to its assets and liabilities at the acquisition date. If these fair values have been recognised by the acquiree, then its financial statements are suitable for the consolidation process. But if they have not, it will be necessary to make adjustments for fair values as part of the consolidation process:
In the consolidated balance sheet changes will often be necessary to the acquiree's carrying amounts for non-current assets and the accumulated depreciation/amortisation
In the consolidated income statement such changes will affect the current period's depreciation/amortisation charges.
Other adjustments may have to be made, depending on the circumstances. An adjustment will always be necessary for any contingent liabilities recognised at the acquisition date, to the extent they are only disclosed in the acquiree's financial statements.
Interactive question 2: Fair value adjustments
[Difficulty level: Exam standard]
Chris Ltd acquired 60% of Andy Ltd for CU8m on 1 July 20X2 when Andy Ltd's balance sheet showed net assets of CU5m. The fair value of Andy Ltd's property, plant and equipment was CU1m higher than carrying amount, but this was not reflected in Andy Ltd's books. At 30 June 20X5 Andy Ltd's balance sheet shows net assets of CU10m. Chris Ltd's policy is to depreciate property, plant and equipment over 10 years. Andy Ltd's financial statements still disclose a contingent liability for a claim for damages against it. At the acquisition date its fair value was estimated at CU100,000, which was its carrying amount until 30 June 20X5 when it was re-estimated at CU80,000. Requirement Calculate as at 30 June 20X5 Chris Ltd's share of Andy Ltd's post-acquisition reserves and the goodwill arising on consolidation and the adjustment to be made to Andy Ltd's depreciation charge for the consolidated income statement for the year ended 30 June 20X5. Fill in the proforma below.
Solution Chris Ltd's share of Andy Ltd's post-acquisition reserves (W1)
CU'000
Goodwill arising on consolidation (W2) Adjustments to Andy Ltd's depreciation charge (W3)
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Financial accounting WORKINGS (1) Net assets and post-acquisition reserves Balance sheet date CU'000
At acquisition CU'000
Postacquisition CU'000
Andy Ltd Net assets PPE fair value uplift Depreciation thereon Contingent liability Chris Ltd's share (2) Goodwill Cost of shares Share of net assets
CU'000
(3) Depreciation charge CU'000 Additional charge See Answer at the end of this chapter.
8 Disclosures Section overview
BFRS 3 requires a number of disclosures.
As business combinations may result in very significant changes to the nature of a group of companies, substantial disclosures are required under three headings, to enable users to evaluate the nature and effects of: 1
Business combinations effected in the accounting period or after its finish but before the financial statements are authorised for issue (in the latter case, there will just be disclosures by way of note, with no amounts actually being recognised in the financial statements)
2
Gains, losses, errors and other adjustments which relate to combinations effected in the current or previous periods
3
Changes in the carrying amount of goodwill during the period.
In respect of new business combinations there must be disclosure of:
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The names and descriptions of the combining entities
The acquisition date
The percentage of the voting shares acquired
The cost of the combination, together with a description of the components of that cost
Details of any operations which have been or will be disposed of
The amounts recognised at the acquisition date for each class of assets, liabilities and contingent liabilities
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Any discount on acquisition, together with the line item in the income statement within which it has been recognised
Descriptions of the factors which led to the recognition of goodwill or discount on acquisition
The post-acquisition profit or loss included in the consolidated income statement
For combinations during the period, estimates of the consolidated revenue and profit or loss which would have been recognised if the acquisition date for all combinations had been the first day of the accounting period.
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In respect of gains, losses etc re combinations effected in the current or previous periods, there must be disclosure of:
Gains or losses on acquired net assets
Adjustments to provisional values in the initial accounting for combinations effected in the immediately preceding period
Errors corrected under BAS 8.
In respect of goodwill there must be a reconciliation of the opening carrying amount (gross amount less accumulated impairment losses) with the closing amount, in terms of
Additions Amounts recognised as an expense as a result of disposals Any impairment losses incurred Any other adjustments.
9 BAS 27 Consolidated and Separate Financial Statements Section overview
9.1
With limited exceptions, all parents must present consolidated financial statements.
Consolidated financial statements must include the parent and all the entities under its control.
BAS 27 sets down key consolidation procedures (which we have demonstrated in Chapters 10-14).
The investment in the subsidiary is carried at cost in the parent's balance sheet.
Scope definitions BAS 27 is to be applied in the preparation of the consolidated financial statements (CFS) of the group. It is also to be applied in accounting for subsidiaries (and associates – see section 10.1 below) in the parent company's individual financial statements. The definitions used in BAS 27 are the same as those discussed in relation to BFRS 3. The following additional definitions should be noted:
Definitions A group. A parent and all its subsidiaries. Consolidated financial statements. The financial statements of a group presented as those of a single economic entity. Minority interest. That portion of the profit or loss and net assets of a subsidiary attributable to the equity interests that are not owned, directly or indirectly through subsidiaries, by the parent.
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9.2
Control The factors identified by BAS 27 which would indicate that one entity controls another are very similar to those identified by BFRS 3. However, BAS 27 also requires an assessment of whether any potential voting rights that are currently exercisable or convertible contribute to control. Potential voting rights are considered not currently exercisable or convertible when they cannot be exercised or converted until:
A future date or The occurrence of a future event.
For example, an entity may own share warrants or debt or equity instruments that are convertible into ordinary shares that if exercised or converted would give the entity additional voting power. In making this assessment the entity should examine all the facts and circumstances that affect the potential voting rights (e.g. terms of exercise, contractual arrangements). However, the intention of management and the financial ability to exercise or convert should not have an effect on the assessment.
9.3
Presentation of CFS With one exception, a parent must present CFS. A parent need not prepare CFS if:
9.4
Either it is a wholly-owned subsidiary or the owners of the minority interest have all been informed of the proposal that CFS are not prepared and none have objected (note that it is not necessary for them all to vote positively in favour – non-objection is sufficient); and
Its securities are neither publicly traded nor in the process of being issued to the public; and
CFS are prepared by the immediate or ultimate parent company.
Scope of CFS The CFS must include the parent and all the companies under its actual control, i.e. its subsidiaries. The guidance as to what constitutes control is the same as in BFRS 3 (see section 3 above). Exclusion from the CFS is not permitted on the grounds that a subsidiary's business is dissimilar from those of the other companies in the group. There is only one circumstance in which an entity falling within the definition of a subsidiary is not consolidated in the normal way. This is when a new subsidiary is acquired but the 'held for sale' criteria of BFRS 5 are met, e.g. it is expected to be sold within 12 months of acquisition (BFRS 5 as it applies to individual assets held for sale is covered in Chapter 5). Accounting for this situation is outside the scope of the Financial Accounting syllabus. Point to note In some other circumstances it may look as though a 'subsidiary' has not been consolidated, for example where it comes under the control of a government or goes into administration as part of a financial restructuring. But BAS 27 takes the position that because such an entity is no longer controlled, it is no longer a subsidiary. It is not a question of omitting such an entity from the CFS; the absence of control means that it is not eligible for inclusion.
9.5
Consolidation procedures BAS 27 makes specific reference to those consolidation procedures necessary to present the group as a single economic entity. These were explained in earlier chapters, i.e.:
582
Eliminating the carrying amount of the parent's investment against its share of the equity in its subsidiaries, with goodwill being the resultant figure
Eliminating intra-group balances, transactions, profits and losses in full (i.e. not just the parent's share)
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Calculating the minority interest and presenting it as a separate figure: – –
In the balance sheet, within total equity but separately from the parent shareholders' equity In the income statement.
Point to note The balance sheet amount for the minority interest cannot go below nil (any excess being charged against the parent shareholders' equity) unless there is a binding obligation on the minority interest to make additional investments in the subsidiary to cover the losses. If there is a minority interest in cumulative preference shares which are classified as equity, the minority interest must be allocated their share of the relevant dividends even if they have not been declared. There are additional requirements that:
Where the parent and subsidiary have different reporting dates, that difference must be not more than three months (remember that, because it has control, the parent can dictate a reporting date to the subsidiary) and adjustments must be made for major transactions between the two dates. An example of such an adjustment would be if the subsidiary with cash appearing in its balance sheet at the earlier date lent it to the parent so that the same cash was in the parent's balance sheet at the later date. An adjustment must be made to eliminate this double-counting.
Uniform accounting policies must be applied to all companies in preparing the CFS. If they are not adopted in the subsidiaries' own financial statements, then adjustments must be made as part of the consolidation. It might be the case that certain group companies take advantage of the alternative accounting treatments allowed in some areas by BFRSs, but these must be made uniform on consolidation.
Changes in the composition of the group are accounted for as follows:
9.6
Acquisitions are accounted for under BFRS 3, by bringing into the consolidated income statement the new subsidiary's income and expenses from the date of acquisition
In the case of disposals, the income and expenses to the date of disposal (i.e. the date control is lost) are included in the CFS, as is the difference between the proceeds of sale and the carrying amount in the consolidated balance sheet at that date (which will be the parent's share of the subsidiary's net assets at the date of disposal plus any remaining goodwill relating to that subsidiary).
Parent's separate financial statements The investment in a subsidiary is carried at cost in the parent's balance sheet, cost being the fair value of the consideration given as computed under BFRS 3. Note that the same treatment is used for associates (dealt with in section 10 below). The knock-on effect is that the only income included in the parent's income statement are the distributions received of profits earned after the date of acquisition; distributions out of earlier profits are accounted for as return of the investment made and are deducted from cost.
9.7
Disclosures in CFS Disclosure must be made of:
The nature of the relationship between parent and subsidiary when the parent does not own, directly or indirectly, more than half of the voting power in the subsidiary
Reasons why a parent does not have control over an investee, even though it holds more than half of the voting power in it
A subsidiary's reporting date if different from that of the parent, together with the reason for using a different date
The nature of any restrictions on a subsidiary's ability to transfer funds to the parent
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10 BAS 28 Investments in Associates Section overview
10.1
An associate is an entity over which the investor has significant influence.
A holding of 20% or more of the voting power in an investee is presumed to provide the investor with significant influence.
Associates must be accounted for in the consolidated financial statements using the equity method.
Scope and definitions BAS 27 is to be applied in accounting for investments in associates in the investor's own financial statements as an individual company. So BAS 28 is to be applied in the CFS only. The requirements of BAS 28 are very similar to those of BAS 27, adjusted for the fact that the investor company has significant influence over the associate, rather than the control it has over a subsidiary. The definition of an associate is as follows:
Definition Associate. An entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture. Significant influence. The power to participate in financial and operating policy decisions of the investee, but is not control or joint control over those policies.
Points to note
584
1
A holding of 20% or more of the voting power in an investee (but less than the 50.1% which would create a parent/subsidiary relationship) is presumed to provide the investor with that significant influence, while a holding of less than that is presumed not to do so. Both of these presumptions are rebuttable on the facts of the case.
2
It is the mere holding of 20% which is sufficient.
3
It is possible for an investee to be the associate of one investor and the subsidiary of another, because the former investor can still have significant influence when the latter has control. A holder of more than 75% can do most things in a company, such as passing a special resolution, without paying much attention to the other shareholders, so someone else holding 20% is unlikely to have significant influence. But it is always necessary to have regard to the facts of the case.
4
Significant influence is evidenced in a number of ways, such as representation on the board of directors, participation in the policy-making process and material transactions with the investee. (See Chapter 9.)
5
Significant influence may be lost in the same circumstances as a parent may lose control over what was a subsidiary.
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10.2
15
Equity method The equity method must be carried out in relation to associates, the rationale being that it reflects the significant influence the investor holds by making the investor answerable for the associate's overall performance, not just for the distributions received. So the investor's share of the associate must be included in the investor's financial statements. Under the equity method, the investment in the associate is initially recognised at cost, but the carrying amount is then increased or decreased by the investor's share in the post-acquisition change in the associate's net assets. Shares of post-acquisition profits/losses will be recognised in the investor's consolidated income statement, but shares of revaluations of non-current assets will be recognised directly in the consolidated statement of changes in equity. When an investment in an associate meets the 'held for sale' criteria of BFRS 5, e.g. it is expected to be sold within 12 months of acquisition, it is still classified as an associate, but it is not subject to equity accounting; BFRS 5 is applied instead. Once significant influence is lost, the investee is no longer an associate, so the investor's income statements subsequently include only distributions received. The procedures used in consolidation are applied wherever possible to accounting for associates. So:
Profits and losses on transactions between the investor and the associate are eliminated to the extent of the investor's share
There are provisions as to reporting dates, adjustments for material transactions when they do not coincide and uniform accounting policies which are very similar to those for subsidiaries
Recognition of a share of an associate's losses can only result in the investor's interest being written down below nil (so as to become a liability) if the investor has incurred obligations on behalf of the associate.
The differences are that:
10.3
There is no cancellation of the investment against the share of the associate's net assets. This is because there is no line-by-line addition to balance sheet items of the investor's share of the associate's assets and liabilities. Such addition is appropriate under conditions of control, but not under those of significant influence
There is no goodwill calculation at the date the investment is made
Instead, the investor's interest in the associate is shown in the balance sheet, as a single line under non-current assets
The whole of that interest is subjected to an impairment review if there is an indicator of impairment
That interest includes items which are in substance a part of the investment, such as long-term loans to the associate. But short-term receivables which will be settled in the ordinary course of business remain in current assets
The investor's interest in the associate's post-tax profits less any impairment loss is recognised in its consolidated income statement.
Investor's separate financial statements Under BAS 27, the investment in the associate is carried at cost in the investor's balance sheet. The knock-on effect is that the only income included in the investor's income statement are the distributions received out of profits earned after the date of acquisition.
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10.4
Disclosures The minimum disclosures are:
The fair value for an investment in any associate for which there are published price quotations (i.e. the associate's securities are dealt in on a public market)
Summarised financial statements of the associate
Reasons why the investor thinks the 20% presumptions are overcome, if that is the case
The associate's reporting date, if different from that of the investor
Restrictions on funds transfers from the associate
Losses in the associate, both current period and cumulative, which have not been recognised in the investor's financial statements (because the investment has already been written down to nil)
The investment to be shown as a non-current asset in the balance sheet
The investor's share of the associate's: – – – –
586
After-tax profits, to be shown in the investor's income statement Discontinued operations Changes in equity recognised directly in equity, to be shown in the investor's statement of changes in equity Contingent liabilities.
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Summary and Self-test
Summary
Allocation of cost: -
Identifiable assets Identifiable liabilities Contingent liabilities
-
Goodwill: capitalise and review for impairment
-
Discount: recognise in income statement immediately
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Financial accounting
Self-test Answer the following questions. 1
2
In relation to accounting for goodwill, BFRS 3 Business Combinations permits a company to A
Amortise goodwill over its useful life
B
Write off immediately and amortise goodwill relating to different acquisitions
C
Revalue goodwill upwards
D
Restate goodwill at acquisition as a result of adjustments to values within one year of the acquisition date
With regard to goodwill, in accordance with BFRS 3 Business Combinations, which of the following statements is true? A B C D
3
Goodwill should be amortised over its useful life Goodwill will normally have a low positive residual value Goodwill should be tested for impairment at least annually Goodwill should be carried in the balance sheet at cost indefinitely
With regard to goodwill, in accordance with BFRS 3 Business Combinations, which of the following statements is true? A Negative goodwill should be recognized in the balance sheet on the balance sheet date B Negative goodwill should be recognized in profit or loss on acquisition date C Negative goodwill should be adjusted with the existing goodwill D Negative goodwill should be amortised over its useful life
4
Ovett Ltd acquires the following during the year ended 30 June 20X6. 1 2
The separable net assets of Elliott, a sole trader. 100% of the share capital of Moorcroft Ltd.
In accordance with BFRS 3 Business Combinations goodwill may arise in Ovett Ltd's own financial statements in respect of A B C D 5
Elliott and Moorcroft Ltd Elliott only Moorcroft Ltd only Neither Elliott nor Moorcroft Ltd
Linford Ltd purchased the net assets of the business of Merrow Ltd on 30 June 20X0 for CU750,000. The balance sheet of Merrow Ltd on 30 June 20X0 disclosed the following. Goodwill Development costs Property, plant and equipment Net current assets
CU 50,000 65,000 340,000 200,000 655,000
The fair value of the property, plant and equipment of Merrow Ltd amounted to CU355,000 on the acquisition date; all the other items are stated at their fair values. The notes to the financial statements of Merrow Ltd disclosed a contingent liability of CU100,000. The fair value of this at 30 June 20X0 was CU10,000. In accordance with BFRS 3 Business Combinations, the amount of goodwill arising on the purchase of the business of Merrow Ltd is A B C
588
CU80,000 CU105,000 CU140,000
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D 6
15
CU195,000
Ling Ltd purchased 80% of the ordinary shares of Moy Ltd on 1 June 20X0 for CU5,400,000. The summarised balance sheet of Moy Ltd on this date showed the following. CU'000 1,000 500 400 2,700 4,600
Ordinary share capital Share premium account Revaluation reserve Retained earnings
The fair value of the identifiable net assets of Moy Ltd exceeded their carrying amount by CU150,000. The balance sheet of Moy Ltd included goodwill of CU500,000. In accordance with BFRS 3 Business Combinations the amount of goodwill acquired in the business combination is A B C D 7
8
CU650,000 CU1,150,000 CU1,600,000 CU2,000,000
Tony Ltd purchased 80% of Simon Ltd during the year. Which of the following would not normally be included as part of the fair value of the consideration in accordance with BFRS 3 Business Combinations? A
Further shares in Tony Ltd to be issued in one year's time
B
Additional cash to be paid in two years' time if certain targets are met by Simon Ltd. It is considered more likely than not that those targets will be met
C
Professional fees paid for obtaining legal advice re the acquisition
D
A proportion of the salary cost of staff working full time in the general acquisitions department
Tom Ltd has purchased all the share capital of Jerry Ltd during the year. Which of the following items should Tom Ltd take into account when calculating the fair value of the net assets acquired in accordance with BFRS 3 Business Combinations?
9
1
A possible loss dependent on the outcome of a legal case which has not been provided for in Jerry Ltd's books. The fair value of the loss can be estimated reliably.
2
A provision required to cover the costs of reorganising Jerry Ltd's departments to fit in with Tom Ltd's structure.
3
A warranty provision in Jerry Ltd's books to cover the costs of commitments made to customers.
A B C D
3 only 2 and 3 only 1 and 3 only 1 only
Which of the following is/are acceptable when assessing fair values on acquisition in accordance with BFRS 3 Business Combinations? 1
Valuation of non-current assets at market value where this is different from their carrying amount.
2
Discounting a trade receivable to present value where the debt is not due to be recovered for two years.
3
Valuation of specialised plant and machinery at depreciated replacement cost.
A B C
1 only 2 only 1 and 2
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Financial accounting D 10
1, 2 and 3
Leeds Ltd acquired the whole of the issued share capital of Cardiff Ltd for CU12 million in cash. In arriving at the purchase price Leeds Ltd had taken into account future costs for reorganising Cardiff Ltd of CU1 million and Cardiff Ltd's anticipated future trading losses of CU2 million. The fair value of the net assets of Cardiff Ltd before taking into account these matters was CU7 million. In accordance with BFRS 3 Business Combinations, what is the amount of goodwill acquired in the business combination? A B C D
11
CU8 million CU7 million CU6 million CU5 million
Castor Ltd acquires 75% of the share capital of Pollux Ltd on 1 December 20X1. The consideration given is CU1 million in cash and 300,000 CU1 ordinary shares of Castor Ltd. The market value of each of Castor Ltd's shares on 1 December is 300 pence. On 1 December the fair value of Pollux Ltd's net assets is CU1 million. In accordance with BFRS 3 Business Combinations what is the amount of goodwill acquired in the business combination to be dealt with in Castor Ltd's consolidated accounts? A B C D
12
CU300,000 CU550,000 CU900,000 CU1,150,000
In accordance with BFRS 3 Business Combinations the timetable for the acquisition of a subsidiary will usually include the following four dates. 1
The date on which consideration passes.
2
The date on which an offer becomes or is declared unconditional.
3
The date from which the acquiring company has the right to share in the profits of the acquired business under the agreement.
4
The date on which control passes.
The effective date for accounting for the business combination should be A B C D 13
The earlier of 1 and 2 The earlier of 1 and 4 3 only 4 only
On 31 July 20X6 Yonder Ltd announced an all-cash takeover bid for Fidge Ltd. Subsequently the following events occurred. 7 August 20X6. The board of Fidge Ltd unanimously recommended the offer and announced that all directors would be accepting in respect of their own holdings. 14 August 20X6. Yonder Ltd announced that it had received acceptances amounting to more than 50% of the shares in Fidge Ltd. 21 August 20X6. Yonder Ltd declared that the offer had become unconditional. 28 August 20X6. Control of Fidge Ltd passed to Yonder Ltd. In accordance with BFRS 3 Business Combinations Yonder Ltd should account for the acquisition of Fidge Ltd from A B C D
590
7 August 20X6 14 August 20X6 21 August 20X6 28 August 20X6
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15
Sam Ltd has a share capital of CU10,000 split into 2,000 A ordinary shares of CU1 each and 8,000 B ordinary shares of CU1 each. Each A ordinary share has ten votes and each B ordinary share has one vote. Both classes of shares have the same rights to dividends and on liquidation. Tom Ltd owns 1,500 A ordinary shares in Sam Ltd. Dick Ltd owns 5,000 B ordinary shares in Sam Ltd. All three companies conduct similar activities and there is no special relationship between the companies other than that already stated. The shareholdings in Sam Ltd are held as long-term investments and are the only shareholdings of Tom Ltd and Dick Ltd. In accordance with BFRS 3 Business Combinations consolidated financial statements must be prepared by A B C D
15
16
Neither Tom Ltd nor Dick Ltd Tom Ltd only Dick Ltd only Both Tom Ltd and Dick Ltd
According to BAS 28 Investments in Associates under the equity method of accounting the balance sheet of an investing group will include in respect of its associate A
Long-term receivables due from associate, but not its share of net assets of the associate
B
Cost of investment plus share of post-acquisition change in associate's net assets plus long-term receivables due from associate
C
Share of net assets of the associate and long-term receivables due from associate
D
Cost of investment plus share of post-acquisition change in associate's net assets but not receivables due from associate
Inveresk Ltd has equity shareholdings in three other companies. Raby Ltd Seal Ltd
Inveresk Ltd 40% 25%
Toft Ltd
30%
Notes No other holdings larger than 10% Another company holds 75% of Seal Ltd's equity and dominates the board of directors This investment has been classified as held for sale under BFRS 5 Non-current assets held for sale and discontinued operations
According to BAS 28 Investments in Associates the associates of Inveresk Ltd are most likely to be A B C D 17
Raby Ltd only Raby Ltd and Seal Ltd Raby Ltd and Toft Ltd Raby Ltd, Seal Ltd and Toft Ltd
Which of the following statements is/are true when equity accounting for an associate in accordance with BAS 28 Investments in Associates? 1
Any impairment losses in respect of the investment in the associate will not affect group profit before tax in the consolidated income statement.
2
Balances owing to associates should not appear in the consolidated balance sheet.
A B C D
1 only 2 only Both 1 and 2 Neither 1 nor 2
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19
20
Which of the following statements is/are true when accounting for a subsidiary? 1
Provisions for unrealised profits should always be deducted from the parent company's retained earnings.
2
When a subsidiary prepares its own financial statements, it may adopt the parent company's accounting policies.
3
When a parent and subsidiary have different reporting dates, that difference must be no more than three months.
4
A parent may omit a company from the consolidated financial statements where the company is held for sale in accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
A B C D
1, 2, 3 and 4 1, 2 and 4 only 1 and 2 only 2 and 3 only
According to BAS 28 Investments in Associates which of the following statements about equity accounting for an associate is/are true? 1
The consolidated income statement should show separately the group's share of the associate's tax charge.
2
Dividends received from an associate should not be included in the consolidated income statement.
3
Any impairment loss relating to the investment in the associate will reduce the minority interest's share of profit.
4
Balances payable/receivable between an associate and subsidiary should appear on the consolidated balance sheet.
A B C D
1, 2 and 4 only 2, 3 and 4 only 1 and 3 only 2 and 4 only
Apple Ltd acquired 90% of Banana Ltd on 1 January 20X7 for CU800,000. At the date of acquisition Banana Ltd had the following assets and liabilities: Property, plant and equipment Contingent liability Patent allowing sole use of technology for a fixed period of time
CU 750,000 (50,000) 25,000
The above values represent fair values all of which can be measured reliably. The useful life of goodwill is estimated to be 10 years. Goodwill has suffered no impairment to date. At 31 December 20X7 goodwill in the consolidated balance sheet of Apple Ltd would be: A B C D
592
CU100,000 CU125,000 CU170,000 CU147,500
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PAYNE LTD The draft balance sheets at 31 March 20X5 of Payne Ltd and its 80% subsidiary Glass Ltd, acquired on 30 September 20X4, are as follows. Payne Ltd CU'000 CU'000
Glass Ltd CU'000 CU'000
3,138 –
552 475
90 3,228
– 1,027
ASSETS Non-current assets Property, plant and equipment Intangibles (including goodwill of CU275,000) Investments: Shares in Glass Ltd Current assets Inventories Trade and other receivables Suspense account Cash and cash equivalents
927 975 128 836
403 423 – 132
Total assets
2,866 6,094
958 1,985
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (50p shares) Revaluation reserve Retained earnings Equity Current liabilities (trade payables) Total equity and liabilities
2,000 475 1,905 4,380 1,714 6,094
700 – 765 1,465 520 1,985
The following points are relevant. 1
At the acquisition date the balance sheet of Glass Ltd showed net assets with a carrying amount of CU1,265,000. Included in this total were freehold land with a carrying amount of CU250,000 (market value CU683,000), goodwill (arising on the acquisition of an unincorporated business some years ago) with a carrying amount of CU300,000 and patent rights acquired giving Glass Ltd sole use of certain technology for five years which have a carrying amount of CU100,000. The fair values of all other assets and liabilities are approximately equal to their carrying amounts. A contingent liability at this date (which was not provided for in the financial statements) was disclosed as a potential CU300,000. However, its fair value was assessed at CU58,000. A final decision on this matter is expected to be reached by the end of 20X5.
2
At the acquisition date the directors of Payne Ltd intended to restructure and reorganise Glass Ltd and wished to provide for restructuring costs which are forecast as CU78,000.
3
At the acquisition date an investment in plant and machinery was required to bring the remaining production line of Glass Ltd up to date. This will amount to CU290,000 in the next 12 months.
4
The consideration for the acquisition comprised cash of CU90,000 and 800,000 shares with a nominal value of 50p and fair value of 130p each. The issue of shares has not yet been reflected in the books of Payne Ltd.
5
Professional fees to bankers and solicitors in respect of the acquisition amounted to CU75,000. In addition the directors of Payne Ltd estimate that the value of their time spent working on the acquisition amounted to CU53,000. At the moment these expenses have been posted to a suspense account.
6
Glass Ltd sells part of its output to Payne Ltd. Included in the inventories of Payne Ltd are goods valued at CU150,000 purchased from Glass Ltd since acquisition at cost plus 25%.
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Financial accounting Requirements (a)
Calculate the value of the goodwill arising on the acquisition of Glass Ltd in accordance with BFRS 3 Business Combinations. (5 marks)
(b) Prepare the consolidated balance sheet for Payne Ltd as at 31 March 20X5.
(13 marks) (18 marks)
22
PRIMAX LTD Primax Ltd holds the following investments. 1
4,000 of the 10,000 CU1 ordinary shares in Alders Ltd, an engineering company with seven directors on the board, five of whom are appointed by Primax Ltd. Of the remaining shares 2,000 are held by Yeti Ltd. Primax Ltd is a major supplier to Yeti Ltd and the board of Yeti Ltd have agreed to vote with Primax Ltd on all matters concerning Alders Ltd.
2
CU3,000 nominal value of the 5,000 CU2 ordinary shares in Bulls Ltd, and 80% of its CU1 irredeemable preference shares. The remaining shares are held by other companies in sizeable blocks, but none hold more than Primax Ltd. Each member of Bulls Ltd appoints one person to the board of directors. The irredeemable preference shares carry no voting rights.
3
3,000 of the 10,000 CU1 ordinary shares in Clyde Ltd. These were recently acquired, as the directors of Primax Ltd believe that Clyde Ltd has excellent growth potential in the future. However, the market in which Clyde Ltd operates is very specialised and Primax Ltd has decided to take no part in the running of Clyde Ltd. Primax Ltd intends to hold its shares for several years, but not to influence the board in any way.
4
2,500 of the 12,000 equity shares in Suffolk Ltd. Suffolk Ltd was established ten years ago and made considerable profits in the first eight years of its existence. During this time Primax Ltd appointed two members to the board of directors and was actively involved in developing operating and financial policies. Last year one of the directors on the board of Primax Ltd resigned through ill health and the other directors decided to give Primax Ltd the right to appoint four out of the six directors of Suffolk Ltd and to remove any director if a dispute is not resolved within one month. Since then Primax Ltd has taken a more active role in managing the business.
Requirement Discuss the nature of each holding, and state the method of accounting in the group accounts under BAS 27 Consolidated and Separate Financial Statements and BAS 28 Investments in Associates. (16 marks)
594
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15
HEREFIELD LTD (Sample Paper) Herefield Ltd prepares its consolidated financial statements in accordance with BFRS. Herefield Ltd has investments in two companies, Wormford Ltd and Stringer Ltd. The draft summarised balance sheets of the three companies at 30 June 20X6 are shown below.
ASSETS Non-current assets Property, plant and equipment Investments Current assets Inventories Trade and other receivables Cash and cash equivalents Total assets EQUITY AND LIABILITIES Capital and reserves Issued capital - CU1 ordinary shares Retained earnings Equity Non-current liabilities Provisions Loans Current liabilities Trade and other payables Bank overdraft Taxation Total equity and liabilities
Herefield Ltd CU
Wormford Ltd CU
Stringer Ltd CU
1,280,000 10,950,000 12,230,000
1,800,000 – 1,800,000
5,995,000 – 5,995,000
785,000 240,000 57,600 1,082,600 13,312,600
290,000 440,000 – 730,000 2,530,000
90,000 394,000 300,000 784,000 6,779,000
9,000,000 2,734,600 11,734,600
2,000,000 (367,000) 1,633,000
4,000,000 2,396,000 6,396,000
300,000 620,000 920,000
– 550,000 550,000
187,000 – 187,000
378,000 – 280,000 658,000 13,312,600
255,000 47,000 45,000 347,000 2,530,000
72,000 – 124,000 196,000 6,779,000
Additional information: (1) On 1 July 20X2, Herefield Ltd acquired 1.7 million CU1 ordinary shares in Wormford Ltd for CU1.50 cash per share. The retained earnings of Wormford Ltd at that date were CU0.25 million. (2) Herefield Ltd acquired 2.8 million CU1 ordinary shares in Stringer Ltd on 31 March 20X6 for CU3 cash per share. The retained earnings of Stringer Ltd at 31 March 20X6 were CU2.0 million. The fair value of land held by Stringer Ltd at the date of acquisition was CU2.5 million in excess of its carrying amount. (3) At the date of acquisition Stringer Ltd had disclosed in the notes to its financial statements a contingent liability in relation to a customer claim for CU100,000. Herefield Ltd’s legal advisers estimated the fair value of the claim at CU150,000. The claim was settled on 10 June 20X6 for a final figure of CU160,000 and is payable on 10 September 20X6. Stringer Ltd recognised a provision for the final claim in its draft balance sheet at 30 June 20X6. (4) Wormford Ltd has been developing a new product based on revolutionary technology. No other similar products currently exist in the market. At 1 September 20X5 Wormford Ltd determined that the product development was at a stage where the criteria for capitalisation in accordance with BAS 38 Intangible Assets had been met. During the year Wormford Ltd incurred CU720,000 of development costs, accrued evenly through the year. These costs have been included in the income statement as operating expenses. The product is still under development at 30 June 20X6. An independent valuer has estimated the recoverable amount of the technology at CU1 million at 30 June 20X6.
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Financial accounting (5) Wormford Ltd sold goods to Herefield Ltd for CU170,000 during the year. At the year end half of these goods remained in inventory. Wormford Ltd sold the goods based on a transfer price of cost plus 25%. Wormford Ltd’s receivables included an amount for the goods at the year end, however, Herefield Ltd sent a cash payment for CU170,000 to Wormford Ltd on 25 June 20X6. Wormford Ltd received the payment on 2 July 20X6. (6) Herefield Ltd has undertaken annual impairment reviews of goodwill. At 30 June 20X6 an impairment loss of CU300,000 in respect of Wormford Ltd needs to be recognised. Requirement Prepare the consolidated balance sheet of Herefield Ltd as at 30 June 20X6. (21 marks) Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.
596
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Technical reference Point to note. The following sets out the examinability of the standards covered in this chapter. BFRS 3
All paragraphs but excluding paragraphs 10-13, 20-23, 58-60 and 65. Appendix B1-B3, B5, B7-B15 and the illustrative examples are also excluded.
BAS 27
All paragraphs but excluding all references to BAS 31, BAS 39 for investments excluded from consolidation and references to the separate financial statements of the investor.
BAS 28
All paragraphs but excluding all references to BAS 31, BAS 39 for investments excluded from consolidation and references to the separate financial statements of the investor.
The paragraphs listed below are the key references you should be familiar with. 1 BFRS 3 BUSINESS COMBINATIONS Basics
Definitions: control, parent, subsidiary, acquisition date, goodwill.
Purchase method: acquirer, cost of combination, allocation over identifiable assets, liabilities and contingent liabilities.
BFRS 3 (16)
Control through:
BFRS 3 (19)
–
P holds more than half of the voting rights in S
–
P holds a majority of voting rights in S, through an agreement with others
–
P has power to govern the financial and operating policies of S under statute or agreement
–
P has power to appoint or remove the majority of S's top management.
BFRS 3 (App A)
Cost of combination
Cost: –
BFRS 3 (24)
Fair value of assets given, liabilities assumed and equity instruments issued
–
Costs directly attributable to the acquisition, e.g. professional fees, but not internal overheads. Subsequent adjustment to cost:
–
Account on acquisition for probable outcomes of future events
–
Subsequent adjustments affect goodwill
–
If after initial accounting complete, then in current period.
BFRS 3 (32) BFRS 3 (33 – 34)
Allocation of cost
Identifiable assets – exist at acquisition date and: –
Tangible – meet normal recognition criteria
BFRS 3 (36 – 37)
–
Intangible – reliably measurable and either separable or arising from contractual/other legal rights
BFRS 3 (45 – 46)
–
May or may not have been recognised in the acquiree's own financial statements
BFRS 3 (36 – 37)
–
Detailed rules for measurement at fair value.
BFRS 3 (B 16)
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Identifiable liabilities – exist at acquisition date and: –
Meet the normal recognition criteria
BFRS 3 (41)
–
Specific exclusion for acquirer's reorganisation plans and acquirer's or acquiree's future operating losses - recognition criteria not met
BFRS 3 (41)
–
Detailed rules for measurement at fair value.
Identifiable contingent liabilities – exist at acquisition date and:
BFRS 3 (36 – 37)
–
Reliably measurable
–
Normal BAS 37 disclosures
BFRS 3 (47)
–
Subsequently carried at higher of BAS 37 value and value at acquisition date.
BFRS 3 (48)
Goodwill
Non-current asset at cost.
BFRS 3 (51)
No amortisation but subject to annual impairment reviews.
BFRS 3 (54)
Discount on acquisition
Reassess identification and measurement of the net assets acquired and measurement of cost of combination.
Any remaining amount recognised in profit or loss in period the acquisition is made.
BFRS 3 (56)
Initial accounting
At acquisition date or within 12 months thereof.
Subsequently: errors accounted for retrospectively, everything else prospectively.
BFRS 3 (62) BFRS 3 (63 – 64)
Disclosures
Business combinations effected in the accounting period or after its finish but before financial statements authorised for issue (in the latter case, by way of note).
BFRS 3 (66)
Gains, losses, errors and other adjustments which relate to combinations effected in the current or previous periods.
BFRS 3 (72)
Changes in the carrying amount of goodwill during the period.
BFRS 3 (74)
2 BAS 27 CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS Basic rule
Parent must prepare CFS to include all subsidiaries as if single economic entity.
No control if 'subsidiary' under the control of a government or regulator, etc.
BAS 27 (9) BAS 27 (21)
Exception
598
No need for CFS if wholly owned or all minority shareholders have been informed of and none have objected to the plan that CFS need not be prepared.
BAS 27 (10)
If new subsidiary meets held for sale criteria at acquisition date, account for it under BFRS 5.
BAS 27 (12)
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Procedures
As dealt with in earlier sessions.
Minority interest shown as a separate figure: –
In the balance sheet, within total equity but separately from the parent shareholders' equity
–
In the income statement, the share of the profit after tax.
BAS 27 (12 and 33)
Accounting dates of group companies to be no more than 3 months apart.
BAS 27 (26 – 27)
Uniform accounting policies across group or adjustments to underlying values.
BAS 27 (28 – 29)
Bring in share of new subsidiary's income and expenses: –
From date of acquisition, on acquisition
–
To date of disposal, on disposal.
BAS 27 (30)
Parent's separate financial statements
Account for subsidiary on basis of cost and distributions declared.
BAS 27 (37)
Disclosures
Details where own more than 50% but do not consolidate, and vice-versa.
BAS 27 (40)
3 BAS 28 INVESTMENTS IN ASSOCIATES Definitions
The investor has significant influence, but not control.
Significant influence is the power to participate in financial and operating policy decisions of the investee, but is not control over those policies (if the investor had control, then under BAS 27 the investee would be its subsidiary).
Presumptions re less than 20% and 20% or more.
Can be an associate, even if the subsidiary of another investor.
No significant influence if 'associate' under the control of a government or regulator, etc.
BAS 28 (2)
BAS 28 (6)
BAS 28 (10)
Equity method
In balance sheet: non-current asset = cost plus share of post-acquisition share in A's net assets.
In income statement: share of A's post-tax profits less any impairment loss.
BAS 28 (38)
In statement of changes in equity: share of A's changes.
BAS 28 (39)
Use cost method of accounting in investor's separate financial statements.
BAS 28 (35)
BAS 28 (38 and 39)
Disclosures
Fair value of associate where there are published price quotations.
Summarised financial statements of the associate.
Reasons why 20% presumptions overcome, if that be the case.
The investment to be shown as a non-current asset in the balance sheet, at cost plus/minus share of post acquisition change in associate's net assets plus longterm financing less impairment losses.
BAS 28 (37)
BAS 28 (38)
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The investor's share of the associate's: –
After-tax profits
–
Discontinued operations
–
Changes in equity recognised directly in equity
BAS 28 (39)
–
Contingent liabilities.
BAS 28 (40)
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Answers to Self-test 1
D
BFRS 3 paragraph 62.
2
C
The correct answer is C (BFRS 3 paragraph 55). Goodwill cannot have a residual value as it cannot be sold separately.
3
B
BFRS 3, paragraph 34 specifies charging to profit or loss. .
4
B
The goodwill arising from the purchase of shares in Moorcroft Ltd will arise on consolidation, not in the individual accounts of Ovett Ltd.
5
C CU Fair value of consideration Less: Fair value of identifiable assets and liabilities acquired (65,000 + 355,000 + 200,000) Fair value of contingent liabilities acquired
6
620,000 (10,000)
CU 750,000
(610,000) 140,000
D Fair value of consideration Less Share of fair value of net assets acquired ((4,600 + 150 – 500) 80%) Goodwill
CU000 5,400 (3,400) 2,000
7
D
BFRS 3 paragraph 29.
8
C
Contingent liabilities must be recognised even though not provided for in the acquiree's books and the warranty provision must be recognised as it arises from past events. Reorganisation plans are only put into effect once control is gained. No liability or contingent liability therefore exists at the time of acquisition.
9
D
10
D
All are required or permitted by BFRS 3 Appendix B B16.
Fair value of consideration Less: Share of fair value of net assets acquired
CUm 12 (7) 5
Acquirer's reorganisation plans and acquiree's or acquirer's future operating losses do not meet the recognition criteria for liabilities as the related liabilities did not exist at the acquisition date. 11
D CU000 Fair value of consideration Cash Shares at fair value (300 3) Less Share of fair value of net assets acquired (75% 1,000)
12
D
1,000 900 (750) 1,150
A business combination is accounted for from the acquisition date, which is the date on which control passes (BFRS 3 paragraph 36 and Appendix A).
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D
A business combination is accounted for from the acquisition date, which is the date on which control passes (BFRS 3 paragraph 36 and Appendix A).
14
B
Total number of votes: Votes 20,000 8,000 28,000
A shares 2,000 10 = B shares 8,000 1 =
Tom Ltd controls
15,000 = 54% of the votes 28,000
15
B
Both the cost of investment plus the share of post-acquisition change in associate's net assets and long-term receivables due from the associate are included. There is no cancellation of intercompany receivables as with a subsidiary.
16
C
Raby Ltd – over 20%, significant influence demonstrated. Seal Ltd – over 20%, but unlikely to have significant influence because of the other company's level of control. Toft Ltd – over 20%, significant influence demonstrated, even though classified as held for sale.
17
18
19
D
D
D
1
False – impairment write offs in respect of an associate are reflected in share of profits of associates, just above the profit before tax sub-total.0
2
False – balances with associates are not contra'd out.
1
False – PURPs should be eliminated against the selling company's profits.
2
True – uniform accounting policies only have to be adopted in the consolidated financial statements. They may be adopted in the subsidiary's own financial statements.
3
True – the difference must be no more than three months.
4
False – must be included, even though accounted for under BFRS 5
1 2 3 4
False – the consolidated income statement just shows share of A's profit after tax. True – dividends are not included as this would double count profit. False – the MI is based on S's profit not A's. True – balances between A and the rest of the group are not contra'd out.
20 As per BFRS CU Cost of investment Fair value of net assets PPE Contingent liability Patent x 90%
602
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750,000 (50,000) 25,000 725,000
CU 800,000
(652,500) 147,500
BUSINESS COMBINATIONS, CONSOLIDATED FINANCIAL STATEMENTS AND ASSOCIATES
21
15
PAYNE LTD (a)
Goodwill arising on the acquisition of Glass Ltd Calculation Fair value of consideration Cash Shares (800,000 CU1.30) Professional fees Less:Share of identifiable assets and liabilities acquired Carrying amount Add: Revaluation of non-current assets to fair value Freehold land (683,000 – 250,000) Less: Goodwill in subsidiary's own books Contingent liability
CU 90,000 1,040,000 75,000
CU
1,205,000
1,265,000 433,000 (300,000) (58,000) 1,340,000 80%
(1,072,000) 133,000
(b) Payne Ltd – consolidated balance sheet as at 31 March 20X5 ASSETS Non-current assets Property, plant and equipment (3,138 + 552 + 433) Intangibles (475 – 275 + 133(a)) Current assets Inventories (927 + 403 – 30) Trade and other receivables (975 + 423) Cash and cash equivalents (836 + 132)
CU000
CU000 4,123 333 4,456
1,300 1,398 968 3,666 8,122
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (2,000 + 400) Share premium account (800 80p) Revaluation reserve Retained earnings (W4) Attributable to the equity holders of Payne Ltd Minority interest (W3) Equity Current liabilities Trade and other payables (1,714 + 520) Acquired contingent liabilities Total equity and liabilities
2,400 640 475 2,008 5,523 307 5,830 2,234 58
2,292 8,122
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Financial accounting (2) Net assets
Share capital Retained earnings Per Q (1,265 – 700) Less: PURP (W7) Goodwill w/o
Balance sheet date CU'000 CU'000 700 765 (30) (275)
FV adj to land Contingent liability
Acquisition CU'000 CU'000 700
Post acquisition CU'000 –
565 – (300) 460 433 (58) 1,535
265 433 (58) 1,340
195
(3) Minority interest CU'000 307
20% 1,535,000 (W2) (4) Retained earnings c/f
CU'000 1,905 (53) 156 2,008
Payne Ltd Less Acquisition expenses re directors Glass Ltd (80% 195 (W2)) (5) Issue of shares DR Cost of investment (800,000 130p) CR Share capital (800,000 50p) CR Share premium (800,000 80p)
CU 1,040,000
CU 400,000 640,000
(6) Acquisition expenses DR Administrative expenses DR Cost of investment CR Suspense account
CU 53,000 75,000
CU 128,000
(7) PURP % 125 (100) 25
SP Cost GP
CU 150,000 (120,000) 30,000
Point to note The calculation in (a) was performed on the following basis, in accordance with BFRS 3. (i)
(ii)
Fair value of consideration
Cash. Fair value will be the amount actually paid.
Shares. These should be included at their fair value on the date of acquisition (CU1.30 per share).
Professional fees. These costs have only been incurred as a result of the acquisition and can therefore be included as part of the cost of acquisition.
Value of directors' time. BFRS 3 does not permit the inclusion of allocated costs which would still have been incurred had the acquisition not been entered into.
Fair value of identifiable assets and liabilities acquired
604
Freehold land. This should be valued at its market value.
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Contingent liability. Should be recognised at its fair value, which is the amount a third party would charge to assume such a liability at the date of acquisition.
Goodwill in subsidiary's own accounts – BFRS 3 only allows identifiable assets to be included (i.e. assets that are capable of being disposed of without disposing of the business of the entity). This goodwill does not meet this definition and must therefore be written off.
Reorganisation provision. This does not meet the definition of a liability at the acquisition date (as the reorganisation can only take place once control has been gained) and therefore should not be recognised.
Future investment in plant and machinery. This cannot be recognised as the cost will only be incurred after acquisition.
15
PRIMAX LTD 1
Alders Ltd Primax Ltd holds 40% of the equity shares in Alders Ltd which carry significant influence, suggesting that Alders Ltd is an associate (although this presumption can be rebutted if there is evidence to the contrary). However, the following indicate that Alders Ltd is in fact a subsidiary of Primax Ltd.
Primax Ltd controls the board of Alders Ltd, appointing five of the seven directors, and thus can control and direct the operating and financial decision making within the company.
Furthermore, Yeti Ltd, another member of Alders Ltd, has agreed to vote its 20% alongside Primax Ltd, thus giving Primax Ltd effective control of the voting shares.
In the absence of any evidence to the contrary, Alders Ltd should be accounted for as a subsidiary and consolidated using the purchase method of accounting. 2
Bulls Ltd Primax Ltd holds 1,500 of the 5,000 ordinary shares in Bulls Ltd giving Primax Ltd a 30% holding, which carries significant influence and therefore suggests that it is an associate. The 80% holding of irredeemable preference shares does not affect this decision, as the irredeemable preference shares do not carry any voting rights. Of the other shareholders none has a greater influence than Primax Ltd; however, all are sizeable. This suggests that whilst Primax Ltd's influence is significant, it is not dominant. Similarly each member appoints one person to the board of directors, giving each member some influence in the operational and financial decision making, but not control. Having shown significant influence, without actual control, Bulls Ltd would best be classified as an associate and should be accounted for on consolidation using the equity method of accounting.
3
Clyde Ltd Primax Ltd holds 30% of the ordinary shares in Clyde Ltd. Under BAS 28 Investments in Associates significant influence is presumed when a holding reaches 20%; however, this can be rebutted in the light of further evidence. Primax Ltd plays no part in the decision making of Clyde Ltd. The holding is purely held for its investment potential and the substance of the holding is better reflected as a trade investment. On consolidation Primax Ltd's investment would be shown at cost as a non-current asset investment.
4
Suffolk Ltd Primax Ltd holds 20.8% of the equity shares in Suffolk Ltd, indicating significant influence. However, the key issue is whether Primax Ltd now exercises control. As it
Can appoint a majority of the board of directors
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Can remove directors if there is a dispute
Primax Ltd now controls Suffolk Ltd which should be treated as a subsidiary and consolidated using the purchase method of accounting.
23
HEREFIELD LTD Consolidated balance sheet as at 30 June 20X6 CU ASSETS Non-current assets Property, plant & equipment (1,280,000 + 1,800,000 + 5,995,000 + 2,500,000) Goodwill (2,555,000 + 337,500 (W3)) Intangible assets (W7)
11,575,000 2,892,500 600,000 15,067,500
Current assets Inventories (785,000 + 290,000 + 90,000 – 17,000 (W6)) Trade and other receivables (240,000 + 440,000 + 394,000 – 170,000) Cash and cash equivalents (57,600 + 300,000 + 170,000)
1,148,000 904,000 527,600
Total assets EQUITY AND LIABILITIES Capital and reserves Issued capital Retained earnings (W5)
2,579,600 17,647,100
9,000,000 2,787,900 11,787,900 3,001,200 14,789,100
Minority interest (W4) Equity Non-current liabilities Provisions (300,000 + 187,000) Loans (620,000 + 550,000)
487,000 1,170,000 1,657,000
Current liabilities Trade and other payables (378,000 + 255,000 + 72,000) Bank overdraft (47,000) Taxation (280,000 + 45,000 + 124,000)
705,000 47,000 449,000 1,201,000 17,647,100
Total equity and liabilities WORKINGS (1) Group Structure Herefield 85% (1.7m/2.0m) Wormford
606
CU
70% (2.8m/4.0m) Stringer
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(2)
15
Net assets Stringer Ltd
Share capital Retained earnings Fair value – land Contingent liability
Balance sheet date CU 4,000,000 2,396,000 2,500,000 – 8,896,000
Acquisition CU 4,000,000 2,000,000 2,500,000 (150,000) 8,350,000
Post acquisition CU – 396,000 – 150,000 546,000
Balance sheet date CU 2,000,000 (367,000) (17,000) 600,000 2,216,000
Acquisition CU 2,000,000 250,000 – – 2,250,000
Post acquisition CU – (617,000) (17,000) 600,000 (34,000)
Wormford Ltd
Share capital Retained earnings Unrealised profit (W6) Intangible asset (W7) (3) Goodwill Stringer Ltd Cost of acquisition (2,800,000 x CU3) Share of net assets (70% x 8,350,000 (W2))
CU 8,400,000 (5,845,000) 2,555,000
Wormford Ltd Cost of acquisition (1,700,000 x CU1.50) Share of net assets (85% x 2,250,000 (W2)) Impairment loss
CU 2,550,000 (1,912,500) 637,500 (300,000) 337,500
(4) Minority interest Share of net assets (30% x 8,896,000 (W2)) Stringer Share of net assets (15% x 2,216,000 (W2)) Wormford
CU 2,668,800 332,400 3,001,200
(5) Retained earnings Herefield Ltd – per question Stringer Ltd (70% x 546,000 (W2)) Wormford Ltd (85% x 34,000 loss (W2)) Impairment (6) Unrealised profit CU170,000 (CU136,000) CU34,000
CU 2,734,600 382,200 (28,900) (300,000) 2,787,900 125% 100% 25%
CU34,000 x ½ = CU17,000 (7) Intangible asset Development expenditure of CU720,000. Capitalisation from 1 Sept 20X5. CU720,000 x (10/12 months) = CU600,000
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Answers to Interactive questions
Answer to Interactive question 1 Recording investment in Eclipse Ltd Shares to be issued 1 July 20X7 DR Investment in Eclipse Ltd (5m 60p) CR Cash (issue costs) CR Share capital (5m 25p) CR Share premium (3,000 – 1,250 – 10) Cash DR CR
Investment in Eclipse Ltd Cash
Professional fees DR Investment in Eclipse Ltd (fees) CR Cash Shares to be issued 1 July 20X8 DR Investment in Eclipse Ltd (1m 60p) CR Shares not issued (heading in capital and reserves)
CU'000
CU'000
3,000 10 1,250 1,740 1,000 1,000 20
20
600 600
Point to note The directors' time is not a direct cost of the acquisition and hence cannot be included in the cost of investment. Goodwill on consolidation of Eclipse Ltd Cost of investment Shares Cash Fees Shares to be issued Identifiable assets and liabilities acquired Per books of Eclipse Ltd Contingent liability Group share (75%)
CU'000
CU'000
3,000 1,000 20 600 4,620 3,628 (200) 3,428 (2,571) 2,049
Answer to Interactive question 2 Chris Ltd's share of Andy Ltd's post-acquisition reserves (W1) Goodwill arising on consolidation (W2) Adjustments to Andy Ltd's depreciation charge (W3)
608
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WORKINGS (1) Net assets and post-acquisition reserves
Andy Ltd Net assets PPE fair value uplift Depreciation thereon - 3 years = 30% Contingent liability Chris Ltd's share - 60%
Balance sheet date CU'000
At acquisition CU'000
Post acquisition CU'000
10,000 1,000 (300) (80) 10,620
5,000 1,000 0 (100) 5,900
5,000 0 (300) 20 4,720 2,832
(2) Goodwill Cost of shares Share of net assets (60% 5,900(W1))
CU'000 8,000 (3,540) 4,460
(3) Depreciation charge Additional charge (10% 1,000)
CU'000 100
Point to note If future events resulted in the contingent liability ceasing to exist (e.g. because it related to a legal claim being defended and the court judgement was in favour of the defendant), it would be re-measured at CUnil and the whole of the CU100,000 would be recognised in current period profit or loss. If future events resulted in the contingent liability crystallising into a liability (e.g. because the court judgement was in favour of the plaintiff), it would be re-measured at CUnil but the carrying amount of the net assets would be after deducting the liability.
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chapter 16
Group cash flow statements
Contents Introduction Examination context Topic List 1
Individual company cash flow statements
2
Group cash flow statements
Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions
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Introduction
Learning objectives
Prepare a cash flow statement for an individual entity including the effects of payments of instalments under finance leases
Prepare a consolidated cash flow statement including the effects of –
Dividends paid to the minority interest
–
Dividends received from associates
–
Acquisitions/disposals of subsidiaries/associates
Tick off
Specific syllabus references for this chapter are: 2c, 3e.
Practical significance As we saw in Chapter 3, a company’s performance and prospects often depend not so much on the profits earned in a period, but on liquidity and cash flows. This same principle is also true of a group of companies.
Stop and think What do you think are the benefits of a consolidated cash flow statement to the shareholders of the parent company?
Working context As we saw in Chapter 3, the cash flow statement forms an important part of the financial statements which will need to be prepared and audited. The work performed in preparing a consolidated cash flow statement will be very similar to that performed in preparing an individual cash flow statement. However, the impact of a number of additional issues will need to be considered. These include the impact of minority interests, the treatment of associates and the treatment of acquisitions and disposals of associates or subsidiaries.
Syllabus links This chapter develops many of the ideas which were introduced in Chapter 3. As you will see, the process involved in preparing a consolidated cash flow statement is very similar to that used in the preparation of a cash flow statement for an individual entity. The preparation of individual and consolidated cash flow statements is also highly relevant in the Financial & Corporate Reporting paper at the Advanced Stage, where the emphasis will change to the analysis and interpretation of these statements.
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Examination context
Exam requirements Group accounts represent 35% of the syllabus and it is likely that the consolidated cash flow statement will be examined regularly either in the written test section of the paper or in the short-form questions section. In an examination you could either be asked to prepare a full consolidated cash flow statement (from consolidated income statement, consolidated balance sheet and notes) or to prepare consolidated cash flow extracts and/or answer a number of short-form questions. In the examination candidates may be required to:
Prepare and present a consolidated cash flow statement for a group of companies including subsidiaries and associates
Prepare extracts from a consolidated cash flow statement
Prepare simple cash flow statement extracts in accordance with BFRS
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1 Individual company cash flow statements Section overview
1.1
The cash flow statement of an individual entity was covered in Chapter 3.
An instalment paid under a finance lease must be split between interest and capital repaid and the two elements presented separately in the cash flow statement.
Revision As we saw in Chapter 3 the objective of a cash flow statement is to provide information about the historical changes in cash and cash equivalents during the accounting period. In accordance with BAS 7 Cash Flow Statements cash flows are classified under the following headings:
Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities
Cash generated from operations is shown as part of cash flows from operating activities. A note to the cash flow statement is then presented showing how the cash generated from operations has been calculated using:
The direct method; or The indirect method.
Refer back to Chapter 3 if you need a reminder of the proforma for a cash flow statement and its supporting note.
1.2
Finance leases The payment of an instalment under a finance lease represents a cash outflow which must be reflected in the cash flow statement. As we saw in Chapter 8, however, an individual instalment may represent the repayment of interest accrued to date and a repayment of a proportion of the capital outstanding. For the purposes of preparing the cash flow statement these two elements must be presented separately as follows:
The repayment of interest is presented within interest paid as part of cash flows from operating activities
The repayment of capital is presented as a separate item under cash flows from financing activities.
Points to note 1 The acquisition of assets under a finance lease requires separate disclosure as a non-cash transaction (see Chapter 3 section 6). 2 For the purposes of the cash flow statement additions to PPE should exclude the effects of any new assets acquired under finance leases as these have not been purchased for cash.
Interactive question 1: Finance lease
[Difficulty level: Easy]
Camel Ltd enters into a finance lease on 1 January 20X7. Lease payments comprise three annual payments of CU10,000 commencing on 31 December 20X7. The asset would have cost CU24,869 to buy outright. The implicit interest rate is 10%.
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Requirement Show the effect of the finance lease on the cash flow statement on the basis that Camel Ltd uses the actuarial method to allocate interest to the periods of borrowing. Complete the proforma below.
Solution Cash flow (extract) statement for the year ended 31 December 20X7
CU
Cash flows from operating activities Interest paid Cash flows from financing activities Payment of finance lease liabilities WORKING Bal b/f 1.1.X7 CU
Year ended 31 December 20X7
Interest accrued at 10% CU
Payment 31 December 20X7 CU
Bal c/f 31.12.X7 CU
See Answer at the end of this chapter.
2 Group cash flow statements Section overview
2.1
The consolidated cash flow statement shows the cash flows of the group (i.e. parent and subsidiaries) with third parties.
The basis of preparation is essentially the same as for the individual cash flow statement.
Dividends to the minority interest are disclosed separately, classified as cash flows from financing activities.
Dividends received from associates are disclosed separately classified as cash flows from investing activities.
The net cash effect of the acquisition/disposal of a subsidiary should be disclosed separately and classified as cash flows from investing activities.
Cash receipts/payments to acquire/dispose of associates should be classified as cash flows from investing activities.
Basic principle In principle the preparation of the group cash flow statement is the same as that for the individual entity in that balance sheet and income statement information is converted into cash flow information, the difference being that this source information is consolidated. The aim of the consolidated cash flow statement is to show the cash flows of the group with third parties. (This is consistent with the preparation of the consolidated balance sheet and consolidated income statement.) This is achieved ‘automatically’ as the information forming the basis of the preparation
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Financial accounting of the consolidated cash flow statement (i.e. the consolidated income statement and consolidated balance sheet) has already been adjusted for intra-group transactions. A number of additional issues do need to be considered however:
Cash flows to the minority interest Cash received from associates Acquisitions/disposals of subsidiaries Acquisitions/disposals of associates
We will consider each of these in the remainder of this chapter.
2.2
Cash flows to the minority interest The minority interest represents a third party so dividends paid to the minority interest should be reflected as a cash outflow. This payment should be presented separately and classified as ‘Cash flows from financing activities’. As we saw in Chapter 3 many of the cash flows were calculated by using a T account working. This technique also applies to the consolidated cash flow statement. Dividends paid to the minority interest may be calculated using a T account as follows: MINORITY INTEREST CU MI dividend paid (balancing figure) c/f MI (CBS)
X X X
CU X X
b/f MI (CBS) MI (CIS)
Interactive question 2: Minority interest
X [Difficulty level: Exam standard]
Consolidated income statement (extract) for the year ended 31 December 20X7 CU'000 60 (20) 40
Group profit before tax Income tax expense Profit for the period Attributable to: Equity holders of the parent Minority interest
30 10 40
Consolidated balance sheet (extract) as at 31 December
Minority interest Requirement Calculate the dividend paid to the minority interest during 20X7. Complete the T account below.
616
© The Institute of Chartered Accountants in England and Wales, March 2009
20X7 CU'000 204
20X6 CU'000 200
GROUP CASH FLOW STATEMENT
16
MINORITY INTEREST CU'000
CU'000
See Answer at the end of this chapter.
2.3
Associates There are two issues to consider with regard to the associate: 1
The aim of the cash flow statement is to show the cash flows of the parent and any subsidiaries with third parties, therefore any cash flows between the associate and third parties are irrelevant. As a result, the group share of profit of the associate must be deducted as an adjustment in the reconciliation of profit before tax to cash generated from operations. This is because group profit before tax includes the results of the associate.
Worked example: Cash flows from operating activities Consolidated income statement (extract) for the year ended 31 December 20X7 CU'000 273 60 333 (63) 270
Group profit from operations Share of profit of associates Profit before tax Income tax expense Profit for the period Consolidated balance sheet (extracts) as at 31 December 20X7 CU’000 867 1,329
Inventories Receivables
20X6 CU’000 694 1,218
Cash generated from operations would be calculated and shown as follows: CU'000 333
Profit before tax Adjustments for: Share of profit of associates Increase in trade receivables (1,329 – 1,218) Increase in inventories (867 – 694) Cash absorbed by operations
(60) 273 (111) (173) (11)
© The Institute of Chartered Accountants in England and Wales, March 2009
617
Financial accounting 2
Dividends received from the associate must be disclosed as a separate cash flow classified as ‘Cash flows from investing activities’. The cash receipt can be calculated as follows: INVESTMENTS IN ASSOCIATES CU X X
b/f Inv in A (CBS) Share of profit of A (CIS)
CU Dividend received (balancing figure) c/f Inv in A (CBS)
X X X
X
Interactive question 3: Dividends received from associates [Difficulty level: Exam standard] Consolidated income statement (extract) for the year ended 31 December 20X7 CU'000 100 20 120 (50) 70
Group profit from operations Share of profit of associates Profit before tax Income tax expense Profit for the period Consolidated balance sheet (extract) as at 31 December 20X7 CU’000 184
Investments in associates
20X6 CU’000 176
Requirement Calculate the dividend received from associates during 20X7. Complete the T account below. INVESTMENTS IN ASSOCIATES CU'000
CU'000
See Answer at the end of this chapter.
2.4
Acquisitions and disposals of subsidiaries If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the purchase or sale transaction should be shown separately under ‘Cash flows from investing activities’. The net cash effect will be the cash purchase price/cash disposal proceeds net of any cash or cash equivalents acquired or disposed of.
618
© The Institute of Chartered Accountants in England and Wales, March 2009
GROUP CASH FLOW STATEMENT
16
Worked example: Acquisition of a subsidiary Warwick Ltd acquired 75% of Leamington Ltd by issuing 250,000 CU1 shares at an agreed value of CU2.50 and CU200,000 in cash. At the date of acquisition the cash and cash equivalents in Leamington Ltd’s balance sheet amounted to CU30,000. In the cash flow statement this would be shown as follows: CU'000 Cash flows from investing activities Acquisition of subsidiary Leamington Ltd, net of cash acquired (200 – 30)
(170)
Disclosure is required in the notes to the cash flow statement of the following in aggregate in respect of both acquisitions and disposals of subsidiaries during the period:
Total purchase price/disposal consideration
Portion of purchase price/disposal consideration discharged by means of cash and cash equivalents
Amount of cash and cash equivalents in the subsidiary acquired or disposed of
Amount of assets and liabilities other than cash and cash equivalents in the subsidiary acquired or disposed of, summarised by major category.
Examples of these disclosures can be found in BAS 7 Appendix A.
Point to note As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item as we saw above, care must be taken not to double count the effects of the acquisition/disposal when looking at the movements in individual asset balances. Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period must be excluded when comparing group balance sheets for cash flow calculations as follows: Subsidiary acquired in the period
Subtract PPE, inventories, payables, receivables etc at the date of acquisition from the movement on these items.
Subsidiary disposed of in the period
Add PPE, inventories, payables, receivables etc at the date of disposal to the movements on these items.
This would also affect the calculation of the dividend paid to the minority interest. The T account working introduced in section 2.2 above would be modified as follows: MINORITY INTEREST
MI in S at disposal MI dividend paid (balancing figure) c/f MI (CBS)
CU X X X X
b/f MI (CBS) MI in S at acquisition MI (CIS)
CU X X X X
© The Institute of Chartered Accountants in England and Wales, March 2009
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Financial accounting
Worked example: Calculating cash flows Continuing from the worked example above (Acquisition of a subsidiary) you have the following additional information. Consolidated balance sheet (extract) of Warwick Ltd at 31 December 20X7 CU000 500
Property, plant and equipment
20X6 CU000 400
At the date of acquisition Leamington Ltd’s balance sheet included property, plant and equipment at a cost of CU75,000. There were no disposals of property, plant and equipment in the period. Calculate the amount to be disclosed as ‘Purchase of property, plant and equipment’ under ‘Cash flows from investing activities’.
Solution Normally, when preparing the cash flow statement, a comparison of the opening and closing assets would be made to determine the cost of additions. In this case if we make the comparison there are CU100,000 of additional assets (500 – 400). However, CU75,000 of these additional assets are as a result of the acquisition of the subsidiary. The cash outflow due to the purchase of the subsidiary as a whole is dealt with separately as we described above, therefore we are only concerned with any other assets purchased. Therefore the information would be presented as follows: CU
Cash flows from investing activities Acquisition of subsidiary Leamington Ltd, net of cash acquired Purchase of property, plant and equipment (500 – 400 – 75)
(170) (25)
Alternatively the adjustment could be made in a T account working as follows: PROPERTY, PLANT AND EQUIPMENT – COST ACCOUNT
b/f On acquisition Additions (balancing figure)
CU'000 400 75 25 500
CU'000 c/f
Interactive question 4: Acquisition of a subsidiary
500 500
[Difficulty level: Exam standard]
On 1 October 20X8 P Ltd acquired 90% of S Ltd by issuing 100,000 shares at an agreed value of CU2 per share and paying CU100,000 in cash. At that time the net assets of S Ltd were as follows: Property, plant and equipment Inventories Trade receivables Cash and cash equivalents Trade payables
620
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 190 70 30 10 (40) 260
GROUP CASH FLOW STATEMENT
The consolidated balance sheets of P Ltd as at 31 December were as follows: Non-current assets Property, plant and equipment Goodwill Current assets Inventories Trade receivables Cash and cash equivalents
Capital and reserves Ordinary share capital (CU1 shares) Share premium account Retained earnings Attributable to equity holders of P Ltd Minority interest Equity Current liabilities Trade payables Income tax payable
20X8 CU'000
20X7 CU'000
2,500 66 2,566
2,300 – 2,300
1,450 1,370 76 2,896 5,462
1,200 1,100 50 2,350 4,650
1,150 650 1,791 3,591 31 3,622
1,000 500 1,530 3,030 – 3,030
1,690 150 1,840 5,462
1,520 100 1,620 4,650
The consolidated income statement for the year ended 31 December 20X8 was as follows: Revenue Cost of sales Gross profit Administrative expenses Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of P Ltd Minority interest
16
CU'000 10,000 (7,500) 2,500 (2,080) 420 (150) 270 261 9 270
The statement of changes in equity for the year ended 31 December 20X8 (extract) was as follows: Retained earnings CU'000 Balance at 31 December 20X7 1,530 Profit for the period 261 Balance at 31 December 20X8 1,791 You are also given the following information: 1 2 3
All other subsidiaries are wholly owned. Depreciation charged to the consolidated income statement amounted to CU210,000. There were no disposals of property, plant and equipment during the year
Requirement Prepare a consolidated cash flow statement for P Ltd for the year ended 31 December 20X8 under the indirect method in accordance with BAS 7 Cash Flow Statements. The only notes required are those reconciling profit before tax to cash generated from operations and a note showing the effect of the subsidiary acquired in the period. Complete the proforma below. © The Institute of Chartered Accountants in England and Wales, March 2009
621
Financial accounting
Solution Consolidated cash flow statement for the year ended 31 December 20X8 Cash flows from operating activities Cash generated from operations (Note 2) Income taxes paid Net cash from operating activities
CU'000
CU'000
Cash flows from investing activities Acquisition of subsidiary S Ltd, net of cash acquired (Note 2) Purchase of property, plant & equipment Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Dividend paid to minority interest Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of period Cash and cash equivalents at the end of period Notes to the cash flow statement (1) Reconciliation of profit before tax to cash generated from operations CU'000 Profit before taxation Adjustments for: Depreciation Increase in trade and other receivables Increase in inventories Increase in trade payables Cash generated from operations (2) Acquisition of subsidiary During the period the group acquired subsidiary S Ltd. The fair value of assets acquired and liabilities assumed were as follows: Cash and cash equivalents Inventories Receivables Property, plant and equipment Trade payables Minority interest Goodwill Total purchase price Less: Cash of S Ltd Less: Non-cash consideration Cash flow on acquisition net of cash acquired
622
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000
GROUP CASH FLOW STATEMENT
16
WORKINGS (1) PROPERTY, PLANT AND EQUIPMENT CU'000
CU'000
(2) GOODWILL CU'000
CU'000
(3) MINORITY INTEREST CU'000
CU'000
(4) INCOME TAX PAYABLE CU'000
CU'000
See Answer at the end of this chapter.
© The Institute of Chartered Accountants in England and Wales, March 2009
623
Financial accounting
Interactive question 5: Disposal
[Difficulty level: Exam standard]
Below is the consolidated balance sheet of the Othello Group as at 30 June 20X8 and the consolidated income statement for the year ended on that date: Consolidated balance sheet as at 30 June
Non-current assets Property, plant and equipment Current assets Inventories Receivables Cash and cash equivalents
Capital and reserves Share capital Retained earnings Attributable to equity holders of Othello Ltd Minority interest Equity Current liabilities Trade payables Income tax payable
20X8 CU’000
20X7 CU’000
4,067
3,950
736 605 294 1,635 5,702
535 417 238 1,190 5,140
1,000 3,637
1,000 3,118
4,637 482 5,119
4,118 512 4,630
380 203 583 5,702
408 102 510 5,140
Consolidated income statement for the year ended 30 June 20X8 (summarised) Continuing operations Profit before tax Income tax expense Profit for the period from continuing operations Discontinued operations Profit for the period from discontinued operations Profit for the period Attributable to: Equity holders of Othello Ltd Minority interest
CU’000 862 (((290) 572 50 622 519 103 622
You are given the following information: 1
Othello Ltd sold its entire interest in Desdemona Ltd on 31 March 20X8 for cash of CU400,000. Othello Ltd had acquired an 80% interest in Desdemona Ltd on incorporation several years ago. The net assets at the date of disposal were: Property, plant and equipment Inventories Receivables Cash and cash equivalents Trade payables
624
© The Institute of Chartered Accountants in England and Wales, March 2009
CU’000 390 50 39 20 (42) 457
GROUP CASH FLOW STATEMENT
2
The profit for the period from discontinued operations figure is made up as follows: CU’000 20 (4) 34 50
Profit before tax Income tax expense Profit on disposal 3
16
The depreciation charge for the year was CU800,000. There were no disposals of non-current assets other than on the disposal of the subsidiary.
Requirements With regard to the consolidated cash flow statement for the year ended 30 June 20X8: (a) Show how the disposal will be reflected in the cash flow statement (b) Calculate additions to property, plant and equipment as they will be reflected in the cash flow statement. (c) Calculate dividends paid to the minority interest. (d) Prepare the note to the cash flow statement required for the disposal of the subsidiary. (e) Prepare the reconciliation of profit before tax to cash generated from operations. Work to the nearest CU000 Complete the proforma below.
Solution (a)
Cash flows from investing activities CU'000
(b) Cash flows from investing activities (W1) CU'000 (c)
Cash flows from financing activities (W2) CU'000
(d) Notes to the cash flow statement During the period the group disposed of its subsidiary Desdemona Ltd. The book value of assets and liabilities disposed of were as follows: Cash and cash equivalents Inventories Receivables Property, plant and equipment Payables Minority interest (W2)
CU'000
Profit on disposal Total sale proceeds Less: Cash of Desdemona Ltd disposed of Cash flow on disposal net of cash disposed of
© The Institute of Chartered Accountants in England and Wales, March 2009
625
Financial accounting (e)
Reconciliation of profit before tax to cash generated from operations CU'000 Profit before tax Adjustments for: Depreciation Increase in receivables Increase in inventories Increase in payables Cash generated from operations
WORKINGS (1)
PROPERTY, PLANT AND EQUIPMENT – NBV CU'000
(2)
CU'000
MINORITY INTEREST CU'000
CU'000
See Answer at the end of this chapter.
2.5
Acquisitions and disposals of associates Receipts and payments of cash to acquire/dispose of associates should be classified as ‘Cash flows from investing activities.’
626
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GROUP CASH FLOW STATEMENT
16
Summary and Self-test
Summary
© The Institute of Chartered Accountants in England and Wales, March 2009
627
Financial accounting
Self-test Answer the following questions. 1
In accordance with BAS 7 Cash Flow Statements what is the net cash flow from financing activities given the information below? Receipts Share issue
CU 5,000
Loan
9,000
A B C D 2
Payments Loan repayments (including CU300 interest) Expense of share issue
CU 2,200 500
CU7,100 CU11,300 CU11,600 CU12,100
Sun Ltd provides the following information: Consolidated balance sheet as at 31 December
Inventories Trade receivables Trade payables
20X8 CU 550,000 943,000 620,000
20X7 CU 475,000 800,000 530,000
Consolidated income statement for the year ended 31 December 20X8 CU 775,000
Profit before tax
During the year Sun Ltd acquired an 80% interest in the equity share capital of Shine Ltd. Extracts from Shine Ltd’s balance sheet at acquisition were as follows: CU 80,000 110,000 70,000
Inventories Trade receivables Trade payables
In accordance with BAS 7 Cash Flow Statements what is the cash generated from operations in the consolidated cash flow statement of Sun Ltd for the year ended 31 December 20X8? A B C D 3
CU647,000 CU743,000 CU757,000 CU767,000
Spades Ltd acquired an 80% interest in the share capital of Clubs Ltd on 1 May 20X4, when the net assets of Clubs Ltd were CU600,000. Extracts from the consolidated balance sheet of Spades Ltd as at 30 September 20X6 are as follows:
Minority interest
20X6 CU 750,000
20X5 CU 720,000
Minority interest in the profit for the year was CU100,000. What is the amount to be included in the consolidated cash flow statement for the dividends paid to the minority according to BAS 7 Cash Flow Statements? A B C D
628
CU90,000 CU70,000 CU190,000 CU250,000
© The Institute of Chartered Accountants in England and Wales, March 2009
GROUP CASH FLOW STATEMENT
4
16
The following are extracts from the balance sheet of Scratch Ltd as at 31 December:
Property, plant and equipment (Note 1) Obligations under finance leases (Note 2) Within one year After more than one year
20X4 CUm 192
20X3 CUm 175
20 51
10 45
Notes 1
During 20X4, Scratch Ltd disposed of property, plant and equipment with a net book value of CU10 million and charged depreciation of CU42 million.
2
Rentals paid under finance leases during 20X4 amounted to CU18 million. Interest charged to the income statement amounted to CU6 million.
What amount should be included in purchase of property, plant and equipment in the cash flow statement for the year ended 31 December 20X4 in accordance with BAS 7 Cash Flow Statements? A B C D 5
6
CU35 million CU41 million CU51 million CU69 million
How should an acquisition or disposal of a subsidiary be disclosed in a consolidated cash flow statement prepared in accordance with BAS 7 Cash Flow Statements? A
On the face of the cash flow statement, giving an analysis of all the cash flows relating to the subsidiary
B
As a note to the cash flow statement, showing a summary of the effects of acquisitions and disposals of subsidiaries, including how much of the consideration comprised cash
C
It need not be disclosed at all
D
As a note to the cash flow statement, showing a breakdown of all cash flows relating to the subsidiary
The following extracts relate to Rain Ltd: Consolidated income statement for the year ended 31 December 20X5 CU 500,000 (150,000) 350,000
Group profit before tax Income tax expense Profit for the period Attributable to: Equity holders of Rain Ltd Minority interest
295,000 55,000 350,000
Consolidated balance sheet as at 31 December
Minority interest
20X5 CU 550,000
20X4 CU 525,000
During the year ended 31 December 20X5 Rain Ltd acquired a 75% interest in the equity shares of Puddle Ltd when the net assets of Puddle Ltd were CU400,000. In accordance with BAS 7 Cash Flow Statements what was the amount of dividend paid to the minority interest in the year ended 31 December 20X5? A B C D
CU20,000 CU130,000 CU180,000 CU330,000
© The Institute of Chartered Accountants in England and Wales, March 2009
629
Financial accounting 7
Brink Ltd acquired a 75% interest in the share capital of Edge Ltd on 1 January 20X6. The balance on Edge Ltd's property, plant and equipment at that date was CU500,000. Extracts from the consolidated balance sheet of Brink Ltd as at 31 December 20X6 are as follows:
Property, plant and equipment
20X6 CU 4,100,000
20X5 CU 3,700,000
Depreciation charged for the year ended 31 December 20X6 was CU970,000. What is the amount to be included in the consolidated cash flow statement for purchase of property, plant and equipment in accordance with BAS 7 Cash Flow Statements? A B C D 8
CU70,000 CU870,000 CU995,000 CU1,370,000
The consolidated financial statements of Brad Ltd show the following information: Consolidated income statement (extract) for the year ended 31 December 20X7 CU'000 220 44 264 (110) 154
Group profit from operations Share of profit of associates Income tax expense Profit for period Consolidated balance sheet (extract) as at 31 December 20X7
Investments in associates
20X7 CU'000 405
20X6 CU'000 387
In accordance with BAS 7 Cash Flow Statements what is the dividend receivable from associates? A B C D 9
CU'000 18 26 44 62
Romeo Ltd had acquired 75% of Juliet Ltd for CU750,000 a number of years ago. During the year ended 31 December 20X7 Romeo Ltd disposed of its entire interest in Juliet Ltd for CU1,020,000 in cash. The net assets of Juliet Ltd at the date of disposal were: Property, plant and equipment Inventories and receivables Cash and cash equivalents Trade payables
CU'000 700 150 75 (47) 878
In accordance with BAS 7 Cash Flow Statements what amount would be disclosed as ‘Disposal of subsidiary’ under cash flows from investing activities? A B C D
630
CU'000 361 750 945 1,020
© The Institute of Chartered Accountants in England and Wales, March 2009
GROUP CASH FLOW STATEMENT
10
16
TASTYDESSERTS LTD The following are extracts from the consolidated financial statements of Tastydesserts Ltd and one of its wholly owned subsidiaries, Custardpowders Ltd, the shares in which were acquired on 31 October 20X8. Balance sheets as at
ASSETS Non-current assets Property, plant and equipment Goodwill Investments in associates
Tastydesserts Ltd Group 31 December 31 December 20X8 20X7 CU'000 CU'000
Custardpowders Ltd 31 October 20X8 CU'000
4,764 42 2,195
3,685 – 2,175
694 – –
1,735 2,658 43 11,437
1,388 2,436 77 9,761
306 185 7 1,192
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Retained earnings
4,896 216 2,458
4,776 – 2,000
400 – 644
Non-current liabilities Loans
1,348
653
–
1,915 176 346 82 11,437
1,546 343 380 63 9,761
148 – – – 1,192
Current assets Inventories Receivables Bank balances and cash Total assets
Current liabilities Payables Bank overdrafts Taxation Dividends payable Total equity and liabilities
Consolidated income statement for the year ended 31 December 20X8 Profit before interest and tax Share of profit of associates Profit before tax Income tax expense Profit for the period Attributable to: Equity holders of Tastydesserts Ltd Minority interest
CU'000 546 120 666 126 540 540 – 540
The following information is also given: (1) The consolidated figures at 31 December 20X8 include Custardpowders Ltd. (2) Depreciation charged on property, plant and equipment during the year was CU78,000. Additions to property, plant and equipment, excluding property, plant and equipment acquired on the acquisition of Custardpowders Ltd, were CU463,000. There were no disposals.
© The Institute of Chartered Accountants in England and Wales, March 2009
631
Financial accounting (3) The cost on 31 October 20X8 of the shares in Custardpowders Ltd was CU1,086,000 comprising the issue of CU695,000 unsecured loan stock at par, 120,000 ordinary shares of CU1 each at a value of 280p each and CU55,000 in cash. (4) No write down of goodwill was required during the period. (5) Total dividends charged to retained earnings by Tastydesserts Ltd during the period amounted to CU82,000. Requirement Prepare a consolidated cash flow statement for Tastydesserts Ltd for the year ended 31 December 20X8 using the indirect method, a note reconciling profit before tax to cash generated from operations and a note showing the effect of the subsidiary acquired in the period. (15 marks) 11
GREENFINGERS LTD Greenfingers Ltd is a 40 year old company producing wooden furniture. 22 years ago it acquired a 100% interest in a timber import company, Arbre Ltd. In 20W9 it acquired a 40% interest in a competitor, Water Features Ltd and on 1 January 20X7 it acquired a 75% interest in Garden Furniture Designs Ltd. The draft consolidated accounts for the Greenfingers Group are as follows. Draft consolidated income statement for the year ended 31 December 20X7 Profit from operations Share of profit of associates Dividends from long-term investments Interest payable Profit before taxation Income tax expense Profit after taxation Attributable to: Equity holders of Greenfingers Ltd Minority interest
632
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 4,455 1,050 465 (450) 5,520 (1,485) 4,035 3,735 300 4,035
GROUP CASH FLOW STATEMENT
16
Draft consolidated balance sheet as at 31 December 20X7 CU'000 CU'000 ASSETS Non-current assets Property, plant and equipment Buildings at net book value Machinery: Cost Accumulated depreciation Net book value
6,225 9,000 (3,600)
5,925 5,550 13,545
Total assets EQUITY AND LIABILITIES Capital and reserves Ordinary share capital (25p shares) Share premium account Retained earnings Attributable to equity holders of Greenfingers Ltd Minority interest Equity Non-current liabilities Finance lease liabilities Loans Current liabilities Trade payables Finance lease liabilities Income tax payable Accrued interest and finance charges Total equity and liabilities
25,020 41,475
11,820 8,649 10,335 30,804 345
6,600 900 7,500 – 3,000 1,230 11,730 3,000 3,825 5,460
12,285 24,015
6,000 6,285 7,500 19,785 – 31,149
2,130 4,380
19,785 510 1,500
6,510 1,500 720 1,476 120
20X6 CU'000
4,200 (3,300) 5,400 11,625 300 3,300 1,230 16,455
Goodwill Investments in associates Long-term investments Current assets Inventories Receivables Cash and cash equivalents
CU'000
3,816 41,475
2,010 840 600 690 90
2,220 24,015
Additional information 1
There have been no acquisitions or disposals of buildings during the year. Machinery costing CU1.5 million was sold for CU1.5 million resulting in a profit of CU300,000. New machinery was acquired in 20X7, including additions of CU2.55 million acquired under finance leases.
© The Institute of Chartered Accountants in England and Wales, March 2009
633
Financial accounting 2
Information relating to the acquisition of Garden Furniture Designs Ltd is as follows: Property, plant and equipment Inventories Trade receivables Cash Trade payables Income tax Minority interest Goodwill 2,640,000 ordinary shares issued as part consideration Balance of consideration paid in cash
CU'000 495 96 84 336 (204) (51) 756 (189) 567 300 867 825 42 867
Requirement Prepare a consolidated cash flow statement for the Greenfingers Group for the year ended 31 December 20X7 using the indirect method. The only note required is that reconciling profit before tax to cash generated from operations. (20 marks)
634
© The Institute of Chartered Accountants in England and Wales, March 2009
GROUP CASH FLOW STATEMENT
16
Technical reference Point to note All of BAS 7 is examinable with the exception of paragraphs 24-28, 38 and Appendix B. The paragraphs listed below are the key references you should be familiar with. 1 Cash flow statement and finance leases
Disclose the assets acquired via finance leases as a non-cash transaction
BAS 7 (43 – 44)
2 Group cash flow statements
Example of a consolidated cash flow statement
Cash flows arising from acquisitions/disposals of subsidiaries and associates should be
–
Presented separately
–
Classified as investing activities
Additional information should be disclosed in respect of acquisitions and disposals
BAS 7 Appendix A BAS 7 (39)
BAS 7 (40)
Also see Chapter 3 Technical reference section.
© The Institute of Chartered Accountants in England and Wales, March 2009
635
Financial accounting
Answers to Self-test 1
C Inflows
Share issue Loan
Outflows Share expenses Loan repayments, less interest (2,200 – 300) 2
D
CU 775,000 5,000 (33,000) 20,000 767,000
Profit before tax Decrease in inventory (550 – 475 – 80) Increase in receivables (943 – 800 –110) Increase in payables (620 – 530 – 70) 3
CU 5,000 9,000 14,000 (500) (1,900) 11,600
C MINORITY INTEREST CU'000 750
c/f Dividend paid to minority () 4
B
190 940
b/f Minority interest in income statement Acquisition of subsidiary (600 20%)
CU'000 720 100 120 940
The additions in the cash flow statement should only be additions for cash. The inception of a finance lease is not a cash transaction and must therefore be excluded. The amount of assets acquired under finance leases is calculated by looking at the movement in the liability for finance leases. As this balance represents capital only, the payment which goes into the working must exclude the interest element. NON-CURRENT ASSETS AT NBV b/f Total additions ()
CUm 175 69 ___ 244
Depreciation Disposals c/f
CUm 42 10 192 244
OBLIGATIONS UNDER FINANCE LEASES Payment c/f
CUm 12
b/f Additions ()
71 83
Therefore additions for cash (69 – 28) = CU41m 5
636
B
BAS 7 (40)
© The Institute of Chartered Accountants in England and Wales, March 2009
CUm 55 28 __ 83
GROUP CASH FLOW STATEMENT
6
16
B MINORITY INTEREST CU
7
MI dividend paid ()
130,000
c/f (CBS)
550,000 680,000
CU 525,000 55,000 100,000
b/f (CBS) MI (CIS) MI in S acquired (400,000 25%)
680,000
B PPE CU'000 3,700 500 870 5,070
b/f Acquired with Edge Additions () 8
CU'000 Depreciation charge c/f
970 4,100 5,070
B INVESTMENTS IN ASSOCIATES CU'000 387 44
b/f (CBS) Share of profit (CIS) (tax already deducted)
___ 431 9
C
10
TASTYDESSERTS LTD
CU'000 26
Dividend received () c/f (CBS)
405 431
(1,020 - 75) = CU945,000
Cash Flow Statement for the year ended 31 December 20X8 CU'000 Cash flows from operating activities Cash generated from operations (Note 1) Income taxes paid (W1) Net cash from operating activities
767 (160)
Cash flows from investing activities Acquisition of subsidiary Custardpowders Ltd, net of cash acquired (Note 2) Purchase of property, plant and equipment Dividends received from associates (W2) Net cash used in investing activities
(48) (463) 100
Cash flows from financing activities Dividends paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period
CU'000
607
(411) (63)
(63) 133 (266) (133)
© The Institute of Chartered Accountants in England and Wales, March 2009
637
Financial accounting Notes to the cash flow statement (1) Reconciliation of profit before tax to cash generated from operations CU'000 666
Profit before taxation Adjustments for: Depreciation Share of profit of associates
78 (120) 624 (37) (41) 221 767
Increase in receivables (2,658 – 2,436 – 185) Increase in inventories (1,735 – 1,388 – 306) Increase in payables (1,915 – 1,546 – 148) Cash generated from operations (2) Acquisition of subsidiary
During the period the group acquired subsidiary Custardpowders Ltd. The fair value of the assets acquired and liabilities assumed were as follows: Bank balances and cash Inventories Receivables Property, plant and equipment Payables Goodwill Total purchase price Less: Cash of Custardpowders Ltd Less: Non-cash consideration – Loan stock issued – Shares issued Cash flow on acquisition net of cash acquired
CU'000 7 306 185 694 (148) 1,044 42 1,086 (7) (695) (336) 48
WORKINGS (1) INCOME TAX PAYABLE
Cash paid (β) c/f
CU'000 160 346 506
b/f CIS
CU'000 380 126 506
(2) INVESTMENTS IN ASSOCIATES
b/f Inv in A Share of profit
CU'000 2,175 120
CU'000 Dividends received (β) c/f Inv in A
2,295
638
© The Institute of Chartered Accountants in England and Wales, March 2009
100 2,195 2,295
GROUP CASH FLOW STATEMENT
16
(3) SHARE CAPITAL AND PREMIUM CU'000 c/f (4,896 + 216)
5,112
b/f Issued to acquire S (120,000 CU2.80)
5,112
CU'000 4,776 336 5,112
No shares have been issued for cash during the year. 11
GREENFINGERS LTD Consolidated cash flow statement for the year ended 31 December 20X7 CU'000 Cash flows from operating activities Cash generated from operations (note 1) Interest paid (W2) Income taxes paid (W3) Net cash used in operating activities Cash flows from investing activities Acquisition of subsidiary Garden Furniture Designs Ltd, net of cash acquired (W4) Purchase of property, plant and equipment (W5) Proceeds from sale of property, plant and equipment Dividends received Dividends received from associate (W6) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of ordinary share capital (W7) Proceeds from issue of loan notes (W8) Payments under finance leases (W10) Dividends paid (3,735 + 7,500 – 10,335) Dividends paid to minority interests (W9) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year
1,116 (420) (750)
CU'000
(54)
294 (3,255) 1,500 465 750 (246) 7,359 2,880 (810) (900) (144)
8,385 8,085 5,460 13,545
Notes (1) Reconciliation of profit before tax to cash generated from operations Profit before tax Adjustments for: Depreciation (W1) Profit on sale of property, plant and equipment Share of profits of associates Investment income Interest expense Increase in trade and other receivables (5,550 – 3,825 – 84) Increase in inventories (5,925 – 3,000 – 96) Increase in trade payables (1,500 – 840 – 204) Cash generated from operations
CU'000 5,520 975 (300) (1,050) (465) 450 5,130 (1,641) (2,829) 456 1,116
© The Institute of Chartered Accountants in England and Wales, March 2009
639
Financial accounting WORKINGS (1) ACCUMULATED DEPRECIATION – PLANT CU'000 b/f (Plant) Disposal
300 Depreciation charge (β)
c/f (Plant)
3,600 3,900
Total depreciation: Freehold buildings (6,600 – 6,225) Plant
CU'000 3,300 600 ____ 3,900 CU'000 375 600 975
(2) INTEREST PAYABLE CU'000 420 120 540
Cash paid (β) c/f
b/f CIS
CU'000 90 450 540
(3) TAXATION CU'000 750 1,476
Cash paid (β) c/f
b/f CIS On acquisition
2,226
CU'000 690 1,485 51 2,226
(4) Purchase of subsidiary CU'000 336 (42) 294
Cash received on acquisition Less: Cash consideration Net cash inflow (5) MACHINERY
b/f On acquisition Leased Additions (β)
CU'000 4,200 495 2,550 3,255 10,500
Disposal c/f
CU'000 1,500 9,000 10,500
(6) INVESTMENTS IN ASSOCIATES
b/f Share of profit (CIS)
CU'000 3,000 1,050
CU'000 Dividends received (β) c/f
4,050
640
© The Institute of Chartered Accountants in England and Wales, March 2009
750 3,300 4,050
GROUP CASH FLOW STATEMENT
16
(7) SHARE CAPITAL AND PREMIUM CU'000 c/f (11,820 + 8,649)
20,469 20,469
b/f (6,000 + 6,285) Non-cash consideration (660 + 165) Proceeds from issue (β)
CU'000 12,285 825 7,359 20,469
(8) LOAN NOTES CU'000 c/f
4,380 4,380
b/f Proceeds from issue (β)
CU'000 1,500 2,880 4,380
(9) MINORITY INTERESTS CU'000 144 345 489
Dividends to MI (β) c/f
b/f Share of profits (CIS) On acquisition
CU'000 – 300 189 489
(10) OBLIGATIONS UNDER FINANCE LEASES CU'000
Capital repayment (β) c/f Current Long-term
810 720 2,130 3,660
b/f Current Long-term New lease commitment
CU'000 600 510 2,550
3,660
© The Institute of Chartered Accountants in England and Wales, March 2009
641
Financial accounting
Answers to Interactive questions
Answer to Interactive question 1 Cash flow statement (extract) for the year ended 31 December 20X7 CU Cash flows from operating activities Interest paid
(2,487)
Cash flows from financing activities Payment of finance lease liabilities
(7,513)
WORKING
Year ended 31 December 20X7
Bal b/f 1.1.X7 CU 24,869
Interest accrued at 10% CU 2,487
Payment 31 December 20X7 CU (10,000)
Bal c/f 31.12.X7 CU 17,356
The payment of CU10,000 therefore represents: CU 2,487 7,513 10,000
Interest Capital (10,000 – 2,487)
Answer to Interactive question 2 MINORITY INTEREST CU'000 b/f MI (CBS) MI (CIS) MI dividend paid (balancing figure) c/f MI (CBS)
6 204 210
CU'000 200 10 210
Answer to interactive question 3 INVESTMENTS IN ASSOCIATES CU'000 b/f Inv in A Share of profit of A
176 20
CU'00 0 Dividend received (balancing figure) c/f Inv in A
196
642
© The Institute of Chartered Accountants in England and Wales, March 2009
12 184 196
GROUP CASH FLOW STATEMENT
16
Answer to Interactive question 4 Consolidated cash flow statement for the year ended 31 December 20X8 Cash flows from operating activities Cash generated from operations (Note 1) Income taxes paid (W4) Net cash from operating activities Cash flows from investing activities Acquisition of subsidiary S Ltd, net of cash acquired (Note 2) Purchase of property, plant and equipment (W1) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital (1,150 + 650 – 1,000 – 500 – (100 CU2)) Dividend paid to minority interest (W3) Net cash from financing activities
CU'000 340 (100)
(90) (220)
CU'000
240
(310)
100 (4) 96
Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of period Cash and cash equivalents at the end of period
26 50 76
Notes to the cash flow statement (1) Reconciliation of profit before tax to cash generated from operations CU'000 420
Profit before taxation Adjustments for: Depreciation Increase in trade receivables (1,370 – 1,100 – 30) Increase in inventories (1,450 – 1,200 – 70) Increase in trade payables (1,690 – 1,520 – 40) Cash generated from operations
210 630 (240) (180) 130 340
(2) Acquisition of subsidiary During the period the group acquired subsidiary S Ltd. The fair value of assets acquired and liabilities assumed were as follows: Cash and cash equivalents Inventories Receivables Property, plant and equipment Trade payables Minority interest Goodwill Total purchase price Less: Cash of S Ltd Less: Non-cash consideration Cash flow on acquisition net of cash acquired
CU'000 10 70 30 190 (40) (26) 234 66 300 (10) (200) 90
© The Institute of Chartered Accountants in England and Wales, March 2009
643
Financial accounting WORKINGS (1) PROPERTY, PLANT AND EQUIPMENT
b/f On acquisition Additions (balancing figure)
CU'000 2,300 190 220 2,710
Depreciation c/f
CU'000 210 2,500 2,710
(2) GOODWILL
b/f Additions (300 – (90% 260))
CU'000 – 66 66
CU'000 Impairment losses (balancing figure) c/f
0 66 66
(3) MINORITY INTEREST
Dividend (balancing figure) c/f
CU'000 4 31
b/f On acquisition CIS
35
CU'000 – 26 9 35
(4) INCOME TAX PAYABLE CU'000 Cash paid (balancing figure) c/f
100 150 250
b/f CIS
CU'000 100 150 250
Answer to Interactive question 5 Disposal of subsidiary (a)
Cash flows from investing activities Disposal of subsidiary Desdemona Ltd, net of cash disposed of (400 – 20)
CU'000 380
(b) Cash flows from investing activities Purchase of property, plant and equipment (W1) (c)
Cash flows from financing activities Dividend paid to minority interest (W2)
644
CU'000 (1,307)
© The Institute of Chartered Accountants in England and Wales, March 2009
CU'000 (42)
GROUP CASH FLOW STATEMENT
16
(d) Notes to the cash flow statement During the period the group disposed of subsidiary Desdemona Ltd. The book value of assets and liabilities disposed were as follows: CU’000 20 50 39 390 (42) (91) 366 34 400 (20) 380
Cash and cash equivalents Inventories Receivables Property, plant and equipment Payables Minority interest (W2) Profit on disposal Total sale proceeds Less: Cash of Desdemona Ltd disposed of Cash flow on disposal net of cash disposed of (e)
Reconciliation of profit before tax to cash generated from operations CU’000 878
Profit before tax (862 + (20 – 4)) Adjustments for: Depreciation
800 1,678 (227) (251) 14 1,214
Increase in receivables (605 – 417 + 39) Increase in inventories (736 – 535 + 50) Increase in payables (380 – 408 + 42) Cash generated from operations WORKINGS (1) PROPERTY, PLANT AND EQUIPMENT – NBV CU'000 3,950 1,307
b/f Additions (balancing figure)
5,257
c/f Disposal of sub Depreciation charge
CU'000 4,067 390 800 5,257
(2) MINORITY INTEREST
c/f Disposal of sub (457 x 20%) Dividends to MI (balancing figure)
CU'000 482 91 42 615
b/f CIS
CU'000 512 103 615
© The Institute of Chartered Accountants in England and Wales, March 2009
645
Financial accounting
646
© The Institute of Chartered Accountants in England and Wales, March 2009
Appendix
BFRS financial statements Contents Topic List 1 Income statement 2 Balance sheet 3 Cash flow statement 4 Statement of changes in equity 5 Notes to the financial statements
© The Institute of Chartered Accountants in England and Wales, March 2009
647
Financial accounting
BFRS financial statements This appendix illustrates the layout and presentation of an individual company’s financial statements in line with the Bangladesh accounting standards which fall within the Financial Accounting syllabus. It is not a full-scale disclosure checklist and comparative figures have been omitted.
1 Income statement SPECIMEN LTD Income statement for the year ended 31 March 20X6 Notes 2
3 4 5
20
648
CU’000 Continuing operations Revenue Cost of sales Gross profit Other operating income Distribution costs Administrative expenses Profit/(loss) from operations Finance costs Investment income Profit/(loss) before tax Income tax expense Profit/(loss) for the period from continuing operations Discontinued operations Profit/(loss) for the period from discontinued operations Profit/(loss) for the period
© The Institute of Chartered Accountants in England and Wales, March 2009
X (X) X X (X) (X) X/(X) (X) X X/(X) (X) X/(X) X/(X) X/(X)
APPENDIX
2 Balance sheet SPECIMEN LTD Balance sheet as at 31 March 20X6 Notes 6 7
8
20
9 9 6 10
CU’000 ASSETS Non-current assets Property, plant and equipment Intangibles Investments Current assets Inventories Trade and other receivables Investments Cash and cash equivalents Non-current assets held for sale
CU’000 X X X X
X X X X X X
Total assets
X X
EQUITY AND LIABILITIES Capital and reserves Ordinary share capital Share premium account Revaluation reserve Retained earnings Equity
X X X X X
11 12 13
Non-current liabilities Preference share capital (redeemable) Finance lease liabilities Borrowings
X X X
20 14 13 12
Current liabilities Trade and other payables Taxation Liabilities held for sale Provisions Borrowings Finance lease liabilities
X X X X X X
Total equity and liabilities
X
X X
Date authorised by the Executive Board for issue.
© The Institute of Chartered Accountants in England and Wales, March 2009
649
Financial accounting
3 Cash flow statement SPECIMEN LTD Cash flow statement for the year ended 31 March 20X6 CU’00 0
Notes 21
Cash flows from operating activities Cash generated from operations Interest paid Income taxes paid
X (X) (X)
Net cash from operating activities 23
X
Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of property, plant and equipment Interest received Dividends received
(X) X X X
Net cash used in investing activities
(X)
Cash flows from financing activities Proceeds from issue of share capital Proceeds from issue of long-term borrowings Dividends paid
22
CU’00 0
X X (X)
Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period
(X) X X X
4 Statement of changes in equity SPECIMEN LTD Statement of changes in equity for the year ended 31 March 20X6
Attributable to equity holders of Specimen Ltd Notes Balance brought forward – as reported 10 – correction of error – as restated Recognised directly in equity: Revaluation of non-current assets Transfer of excess depreciation on revaluations Total recognised directly in equity Profit for the period Total recognised income and expense for the period 15 Dividends on ordinary shares 9 Issue of share capital Balance carried forward
650
Ordinary share capital CU’000
Share premium CU’000
Revaluation reserve CU’000
Retained earnings CU’000
Total CU’000
X – X
X – X
X – X
X (X) X
X (X) X
–
–
X
–
X
– – –
– – –
(X) X –
X X X
X X
– – X X X
– – X X X
X – – X X
X (X) – X X
X (X) X X X
© The Institute of Chartered Accountants in England and Wales, March 2009
-
APPENDIX
5 Notes to the financial statements – 31 March 20X6 (1)
Accounting policies (a)
Accounting convention The financial statements are prepared in accordance with Bangladesh Financial Reporting Standards and under the historical cost convention, modified to include the revaluation of freehold and long leasehold land and buildings.
(b) Intangibles Goodwill is the difference between the fair value of the consideration paid on the acquisition of a business and the aggregate of the fair values of its identifiable assets and liabilities and contingent liabilities. It is subject to annual impairment reviews. Development expenditure is recognised as an intangible asset to the extent it is expected to generate future economic benefits. It is amortised over its useful life, typically five years. (c)
Property, plant and equipment Non-current asset properties are valued at least every three years, and in intervening years if there is an indication of a material change in value. Surpluses on valuations of freehold and long leasehold non-current asset properties are recognised directly in equity in the revaluation reserve, and any deficits below original cost are recognised in profit or loss. Plant and equipment is carried at cost. Any plant and equipment expected to be sold within 12 months of the decision to dispose of it is reclassified as assets held for sale, presented separately in the balance sheet. It is carried at the lower of its carrying amount at the date of the decision to sell and fair value less costs to sell. Any write-down is shown as an impairment loss.
(d) Depreciation Depreciation is recognised in respect of property, plant and equipment other than freehold land and assets classified as held for sale, at rates calculated to write off the cost or valuation, less estimated residual value, of each asset evenly over its expected useful life, as follows:
Freehold buildings – over 50 years Leasehold land and buildings – over the lease term Plant and equipment – over 5 to 15 years
The depreciation methods and the useful lives and residual values on which depreciation is based are reviewed annually. (e)
Leased assets Assets held under finance leases are included in property, plant and equipment at their fair value and depreciated over their useful lives. Lease payments consist of capital and interest elements and the interest is recognised in profit or loss. The annual rentals in respect of operating leases are recognised in profit or loss.
(f)
Borrowings Borrowings are recognised at the proceeds received. Preference shares which are redeemable on a specific date are classified as long-term liabilities, while the dividends relating to them are recognised in the finance cost in the income statement.
(g)
Provisions Provisions are recognised when the company has a present obligation which will result in an outflow of resources. Restructuring provisions mainly comprise lease termination penalties and employee termination payments.
© The Institute of Chartered Accountants in England and Wales, March 2009
651
Financial accounting (h) Revenue Sales are recognised on delivery of the goods to customers and on the performance of services for customers. They are shown net of VAT and discounts. (i)
Research costs Research costs are recognised in profit or loss as incurred. Some development costs are capitalised (see (b) above).
(j)
Inventories The cost of inventories comprises all costs of purchase and conversion and other costs incurred in bringing them to their present location and condition. The FIFO cost formula is applied.
(2) Revenue Sale of goods Performance of services
CU’000 X X X
(3) Profit/loss from operations Profit/loss from operations is shown after charging/crediting: Research and development costs Depreciation of property, plant and equipment Profit/loss on disposal of property, plant and equipment Impairment of assets held for sale Impairment of goodwill Amortisation of development costs Operating lease payments Employee benefits Cost of inventories sold, included in cost of sales
CU’000 X X (X) X X X X X X
(4) Finance costs Interest on borrowings Dividends on redeemable preference shares Interest on finance lease liabilities
CU’000 X X X X
The interest rate for the borrowing costs capitalised was X%. (5) Investment income Interest Dividends
652
© The Institute of Chartered Accountants in England and Wales, March 2009
CU’000 X X X
APPENDIX
(6)
Property, plant and equipment Properties Freehold CU’00 0
Long leasehold CU’000
Short leasehold CU’000
Under construction CU’000
Plant and equipment CU’000
Total CU’0 00
Cost or valuation At 1 April 20X5 Revaluation surplus Additions Acquired in business combination Transfers Classified as held for sale Disposals At 31 March 20X6
X X X –
X – X –
X – X X
X – X –
X – X –
X X X X
X – (X) X
– – (X) X
– (X) (X) X
(X) – – X
– (X) (X) X
– (X) (X) X
Depreciation At 1 April 20X5 Classified as held for sale Disposals Charge for year At 31 March 20X6
(X) – X (X) (X)
(X) – X (X) (X)
(X) X X (X) (X)
– – – – –
(X) X X (X) (X)
(X) X X (X) (X)
X X
X X
X X
X X
X X
X X
Carrying amount At 31 March 20X6 At 31 March 20X5
The carrying amounts at 31 March 20X6 on the historical cost basis were CUX for freehold properties and CUX for long leasehold properties. Non-current asset properties were revalued as follows. Freehold properties were revalued on 1 April 20X5 by Messrs Tottitup, an independent firm of Chartered Surveyors, at CUX, on the basis of existing use value. Open market value is not considered to be materially different to existing use value. Long leases were revalued in 20X4 at CUX by Messrs Tottitup, Chartered Surveyors, on the basis of open market value. In the directors’ opinion, there has been no indication of a material change in value during the year. The carrying amount of plant and equipment of CUX includes an amount of CUY in respect of assets held under finance leases. Non-current asset properties under construction include total interest capitalised to 31 March 20X6 of CUX, of which CUY was capitalised in the current year. (7)
Intangibles
Cost
At 1 April 20X5 Additions during year At 31 March 20X6 Amortisation/impairment At 1 April 20X5 Charge for the year At 31 March 20X6 Carrying amount At 31 March 20X6 At 31 March 20X5
Goodwill CU’000
Development costs CU’000
Total CU’000
X X X
X X X
X X X
X X X
X X X
X X X
X X
X X
X X
© The Institute of Chartered Accountants in England and Wales, March 2009
653
Financial accounting (8) Inventories CU’000 X X X X
Raw materials and consumables Work in progress Finished goods and goods for resale (9) Ordinary share capital Ordinary shares of 50p each 1 April 20X5 Issued during the year At 31 March 20X6
Authorised Number CU’000 X X X X X X
Issued and fully paid Number CU’000 X X X X X X
On 30 December 20X5 X ordinary shares were issued fully paid for cash at a premium of Xp per share. As described in note 19, X ordinary shares were issued at a premium of Xp per share in the acquisition of the trade and assets of A Ltd. (10) Retained earnings The restatement of the balance brought forward is to correct an error arising out of the overvaluation of inventories at 31 March 20X5. The effect on the profit for the year ended 31 March 20X5 was CUX. Comparative information has been adjusted accordingly. (11) Preference share capital The 10% preference shares of CU1 carry no voting rights and are redeemable at par on 31 March 20Z5. Dividends are paid half-yearly and on a winding up these shares rank ahead of the ordinary shares. (12) Finance lease liabilities The minimum lease payments on finance leases are as follows:
Within one year Two to five years More than five years Future finance charges Present value
Minimum lease payments CU’000 X X X X (X) X
Present value CU’000 X X X X – X
Being: Current liabilities Non-current liabilities
X X X
(13) Borrowings Borrowings comprise: Bank loans and overdrafts Debentures Being:
Current liabilities Non-current liabilities
The debentures have a coupon of 11% and are redeemable at par on 31 March 20Z5.
654
© The Institute of Chartered Accountants in England and Wales, March 2009
CU’000 X X X X X X
APPENDIX
The bank loans are secured by a fixed charge on the freehold property and are repayable on 31 March 20Y5. The interest rate is variable, currently 6%. (14) Provisions Restructuring CU’000 X X (X) X
At 1 April 20X5 Additions Amounts used during year At 31 March 20X6
Other CU’000 X X (X) X
Total CU’000 X X (X) X
Per share Xp Xp Xp
CU’000 X X X
(15) Dividends The dividends recognised in the statement of changes in equity comprise: Final dividend for 20X5 Interim dividend for 20X6
A resolution proposing a final dividend for 20X6 of Xp per share, CUX in total, will be put to the Annual General Meeting. (16) Events after the balance sheet date Following a decision of the board, a freehold property was classified as held for sale on 1 May 20X6. The sale was completed on 15 June 20X6, realising a gain of CUX after tax of CUX. The transaction will be reflected in the company’s financial statements to 31 March 20X7. (17) Contingent liabilities The company is being sued in the USA for damages of $X million (approximately CUX million) in respect of sale of faulty goods. The directors do not expect to lose the case and do not believe any provision needs to be made. (18) Commitments Capital commitments Capital expenditure on property, plant and equipment contracted for at the balance sheet date but not recognised in these financial statements amounted to CUX. Operating lease commitments At the year end the company had commitments to make payments under non-cancellable operating leases, which fall due as follows: CU’000 X X X X
Within one year Two to five years More than five years (19) Goodwill arising during the year
X 50p ordinary shares were issued on 30 December 20X5 to acquire the assets and trade of A Ltd. Details of the consideration and assets acquired were as follows: Fair value of assets acquired: Short leasehold property Inventories Goodwill Fair value of consideration
CU’000 X X X X X
© The Institute of Chartered Accountants in England and Wales, March 2009
655
Financial accounting The income statement includes revenue of CUX and profit of CUX in relation to this trade since the date of acquisition. If the acquisition had been made on 1 April 20X5, the income statement would have included revenue of CUX and profit of CUX. (20) Discontinued activities Division A is being closed down and was classified as held for sale on 1 February 20X6. Completion of the closure is expected by the end of September 20X6. The carrying amount of assets held for sale was CUX on 31 March 20X6. The results of Division A for the year ended 31 March 20X6 were: revenue CUX, expenses CUX, pre-tax loss CUX, tax in respect of the pre-tax loss CUX, loss on the remeasurement of assets at fair value less costs to sell CUX and tax in respect of that remeasurement loss CUX. (21) Reconciliation of profit/loss before tax to cash generated from operations for the year ended 31 March 20X6 Profit/(loss) before tax Finance cost Investment income Depreciation charge Amortisation charge Loss/(profit) on disposal of non-current assets (Increase)/decrease in inventories (Increase)/decrease in trade and other receivables (Increase)/decrease in prepayments Increase/(decrease) in trade and other payables Increase/(decrease) in accruals Increase/(decrease) in provisions Cash generated from operations
CU’000 X/(X) X (X) X X X/(X) (X)/X (X)/X (X)/X (X)/X (X)/X (X)/X X
(22) Cash and cash equivalents Cash and cash equivalents consist of cash on hand and balances with banks, and investments in money market instruments. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts. Cash on hand and balances with banks Short-term investments Cash and cash equivalents
CU'000 X X X
The company has undrawn borrowing facilities of CUXm of which only CUXm may be used for future expansion. (23) Property, plant and equipment During the period the company acquired property, plant and equipment with an aggregate cost of CUX of which CUX was acquired by finance lease. Cash payments of CUX were made to purchase property, plant and equipment. (24) Details of Specimen Ltd The company is incorporated in Bangladesh. In the opinion of the directors, the immediate and ultimate controlling party of the company is its parent company, XYZ Ltd, a company incorporated in Bangladesh. No transactions took place between the company and XYZ Ltd during the year and there are no outstanding balances.
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© The Institute of Chartered Accountants in England and Wales, March 2009
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