Answers

Part 2 Examination Paper 2.5 (INT) Financial Reporting (International Stream) 1 (a) Consolidated Balance Sheet of Highmoor as at 30 September 2003: $ million Assets Non-current assets Tangible (585 + 172) Intangible Consolidated negative goodwill (40 19 (w (ii))) Software (w (v)) Investments (225 160 shares 50 loan (w (iv)) + 13)

December 2003 Answers

$ million

757 1(21) 124 128 1788 127 127 180 129

Current assets Inventory (85 + 42) Accounts receivable (95 4 in transit (w (iv)) + 36) Tax asset Bank (20 + 9 in transit (w (iv))) Total assets Equity and liabilities Capital and reserves: Ordinary shares $1 each Accumulated profits (w (i))

363 1,151

400 305 705 1 1 1281 1117 1170 35 43

Non-current liabilities 12% loan notes Minority interest (w (iii)) Current liabilities Accounts payable (210 + 71) Overdraft Taxation Total equity and liabilities Workings (Note: all figures in $ million) (i) Unrealised profit (w (v)) Minority interest (20% x 115) Pre-acq profit (80% x 150) Post acq loss (80% x 35) Balance c/f

368 1,151

Accumulated profits Highmoor Slowmoor 116 123 120 (28) 305 321 115 Cost of control

B/f Post acq loss Realisation of negative goodwill (w (ii))

Highmoor 330 1(28) 119

Slowmoor 115

321 Ordinary shares (80% x 100) Pre acq profit (w (i))

115

(ii) Investments at cost (100 x 80% x $2) Negative goodwill 160

180 120

140 200 200 The contingent consideration has not been included in the above calculation. IAS 22 Business Combinations only requires contingent consideration to be included in the cost of an acquisition if it is probable that the amount will be paid and it can be measured reliably. The additional $96 million (i.e. $120 per share) is only payable if Slowmoor makes a profit within two years of acquisition. In the year since acquisition the company made a loss of $35 million, much higher than the $15 million in its acquisition plan, and the directors of Highmoor are now less confident of the future prospects of Slowmoor. This seems to indicate that it is unlikely that any further consideration will be paid and the above treatment is justified.

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The negative goodwill of $40 million will be realised as follows: Attributable to: Proportion realised year to 30 September 2003 expected losses attributable to Highmoor 12 100% non-monetary assets 28 25% (four year life) Total negative goodwill 40 (iii) Minority interest Ordinary shares (20% x 100) Accumulated profits (w (i)) Balance c/f 43 43

amount 12 17 19

20 23 43

(iv) Elimination of loan and accrued interest: The investments of Highmoor will show an unadjusted amount of $50 million as a loan to Slowmoor. The cash in transit of $9 million from Slowmoor should be applied $4 million to cancel the accrued interest receivable and the balance of $5 million to the investment (loan). When this adjustment is made the investment and the loan will cancel each other out. (v) The net book value of the software in Slowmoors books is $40 million. If the software had been depreciated on its original cost of $30 million it would have a book value of $24 million ($30 less $6 million depreciation at 20% per annum). Thus there is an unrealised profit on the transfer of the software of $16 million ($40 million $24 million).

(b)

Negative goodwill arises in bookkeeping where the consideration given for a business is less than the fair value of the net assets acquired. Intuitively it does not make sense for a vendor to sell net assets for less than they are worth. This view is reflected by the IASB as they appear rather sceptical about the existence of negative goodwill. They say where an acquisition appears to create negative goodwill, a careful check of the value of the assets acquired and whether any liabilities have been omitted is required. Negative goodwill may arise for several reasons; the most obvious is that there has been a bargain purchase. This may occur through the vendor being in a poor financial position and needing to realise assets quickly, or it may be due to good negotiating skills on the part of the acquirer, or the vendor may not realise how much the assets are really worth. A more controversial occasion where negative goodwill arises is where a company, in determining the amount of consideration it is willing to pay for a business, will take into account the cost of anticipated future losses and post acquisition reorganisation expenditure that it believes will be required. The effect of this is that it would reduce the consideration offered/paid. As these costs cannot generally be recognised as a liability at the date of purchase, this can lead to the consideration being lower than the recognisable net assets. In relation to the acquisition of Slowmoor the following are questionable issues: Highmoor may be trying to deliberately create losses at Slowmoor to avoid paying the further consideration. An example of this may be the transfer price of the software. The additional consideration of $96 million, if payable, would change the negative goodwill into positive goodwill of $56 million. The tax asset of Slowmoor may be questionable. Accounting standards are quite restrictive over the recognition of tax assets.

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(a)

The sale of the plant has been incorrectly treated on two counts. Firstly even if it were a genuine sale it should not have been included in sales and cost of sales, rather it should have been treated as the disposal of a non-current asset. Only the profit or loss on the disposal would be included in the income statement (requiring separate disclosure if material). However even this treatment would be incorrect. As Tourmalet will continue to use the plant for the remainder of its useful life, the substance of this transaction is a secured loan. Thus the receipt of $50 million for the sale of the plant should be treated as a loan. The rentals, when they are eventually paid, will be applied partly as interest (at 12% per annum) and the remainder will be a capital repayment of the loan. In the income statement an accrual for loan interest of 12% per annum on $50 million for four months ($2 million) is required. Tourmalet Income Statement Year to 30 September 2003 continuing operations $000 Sales revenues (313,000 50,000 (see above)) 247,800 Cost of sales (w (i)) (128,800) Gross profit (loss) 119,000 Distribution expenses (26,400) Administration expenses (w (iii)) (20,000) Profit (loss) on the ordinary activities before interest 72,600 Financing cost (w (iv)) Loss on investment properties ($10 million $98 million) Investment income Profit before tax Income tax (9,200 2,100) Profit for the period

(b)

discontinuing operations $000 15,200 (16,000) (800) nil (4,700) (5,500)

Total $000 263,000 (144,800) 118,200 (26,400) (24,700) 67,100 (3,800) (200) 1,200 64,300 (7,100) 57,200

Note: IAS 35 Discontinuing Operations does not require a specific presentation of the results of a discontinued operation. The above is only one of several acceptable presentations. (c) Tourmalet Statement of Changes in Equity Year to 30 September 2003 Accumulated Revaluation Profits reserve $000 $000 At 1 October 2002 47,800 18,500 Profit for period 57,200 Transfer to realised profit 500 (500) Ordinary dividends paid (2,500) At 30 September 2003 103,000 18,000

Ordinary shares $000 50,000

Total $000 116,300 57,200 (2,500) 171,000

50,000

Note: IAS 32 Financial Instruments: Disclosure and Presentation says redeemable preference shares have the substance of debt and should be treated as non-current liabilities and not as equity. This also means that preference dividends are treated as a finance cost in the income statement. Workings (i) Cost of sales: Opening inventory Purchases Transfer to plant (see (a)) Depreciation (w (ii)) Closing inventory (285 million 25 million see below) $000 26,550 158,450 (40,000) 25,800 (26,000) 144,800

The slow moving inventory should be written down to its estimated realisable value. Despite the optimism of the Directors, it would seem prudent to base the realisable value on the best offer so far received (i.e. $2 million).

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(ii)

Non-current asset depreciation: Buildings $120/40 years Plant per trial balance ((98,600 24,600) x 20%) Plant plant treated as sold (40,000/5 years)

$000 3,000 14,800 8,000 25,800

Note: investment properties do not require depreciating under the fair value model in IAS 40. Instead they are revalued each year with the surplus or deficit being taken to income. For information only: in the balance sheet cost/valuation $000 150,000 98,600 40,000 accumulated depreciation $000 12,000 39,400 8,000 net book value $000 138,000 59,200 32,000 229,200

Land and buildings Plant per trial balance Plant incorrectly treated as sold

(iii) It would seem prudent to accrue for the penalty on the lease as it is uncertain that the permission for a change of use will be granted. In these circumstances, the payment of the penalty will be the lowest liability. This gives total administration expenses of $24,700 (23,200 + 1,500), of which $4,700 (3,200 + 1,500) is classed as discontinuing. (iv) Finance costs: income statement $000 2,000 1,800 3,800

Accrued interest on in-substance loan (see (a)) Preference dividends (30,000 x 6%)

Note this balance sheet is provided for information only. It does not form part of the answer or marking scheme. Tourmalet Balance Sheet as at 30 September 2003 $000 Non-current assets (w (ii)) Investment properties $000 229,200 9,800 239,000

Current Assets Inventory (w (i)) Trade accounts receivable Bank Total assets Equity and liabilities Capital and Reserves: Ordinary shares of 20c each Accumulated profits Revaluation reserve (see (c))

26,000 31,200 3,700

60,900 299,900

50,000 103,000 18,000 121,000 171,000

Non-current liabilities 6% Redeemable preference shares $1 each In-substance loan (see (a)) Current liabilities Trade accounts payable Accrued penalty cost (w (iii)) Accrued finance costs (2,000 + 900) Taxation

30,000 50,000 35,300 1,500 2,900 9,200

80,000

Total equity and liabilities

48,900 299,900

16

(a)

IAS 37 Provisions, Contingent Liabilities and Contingent Assets only deals with those provisions that are regarded as liabilities. The term provision is also generally used to describe those amounts set aside to write down the value of assets such as depreciation charges and provisions for diminution in value (e.g. provision to write down the value of damaged or slow moving inventory). The definition of a provision in the Standard is quite simple; provisions are liabilities of uncertain timing or amount. If there is reasonable certainty over these two aspects the liability is a creditor. There is clearly an overlap between provisions and contingencies. Because of the uncertainty aspects of the definition, it can be argued that to some extent all provisions have an element of contingency. The IASB distinguishes between the two by stating that a contingency is not recognised as a liability if it is either only possible and therefore yet to be confirmed as a liability, or where there is a liability but it cannot be measured with sufficient reliability. The IASB notes the latter should be rare. The IASB intends that only those liabilities that meet the characteristics of a liability in its Framework for the Preparation and Presentation of Financial Statements should be reported in the balance sheet. IAS 37 summarises the above by requiring provisions to satisfy all of the following three recognition criteria: there is a present obligation (legal or constructive) as a result of a past event; it is probable that a transfer of economic benefits will be required to settle the obligation; the obligation can be estimated reliably.

A provision is triggered by an obligating event. This must have already occurred, future events cannot create current liabilities. The first of the criteria refers to legal or constructive obligations. A legal obligation is straightforward and uncontroversial, but constructive obligations are a relatively new concept. These arise where a company creates an expectation that it will meet certain obligations that it is not legally bound to meet. These may arise due to a published statement or even by a pattern of past practice. In reality constructive obligations are usually accepted because the alternative action is unattractive or may damage the reputation of the company. The most commonly quoted example of such is a commitment to pay for environmental damage caused by the company, even where there is no legal obligation to do so. To summarise: a company must provide for a liability where the three defining criteria of a provision are met, but conversely a company cannot provide for a liability where they are not met. The latter part of the above may seem obvious, but it is an area where there has been some past abuse of provisioning as is referred to in (b). (b) The main need for an accounting standard in this area is to clarify and regulate when provisions should and should not be made. Many controversial areas including the possible abuse of provisioning are based on contravening aspects of the above definitions. One of the most controversial examples of provisioning is in relation to future restructuring or reorganisation costs (often as part of an acquisition). This is sometimes extended to providing for future operating losses. The attraction of providing for this type of expense/loss is that once the provision has been made, the future costs are then charged to the provision such that they bypass the income statement (of the period when they occur). Such provisions can be glossed over by management as exceptional items, which analysts are expected to disregard when assessing the companys future prospects. If this type of provision were to be incorporated as a liability as part of a subsidiarys net assets at the date of acquisition, the provision itself would not be charged to the income statement. IAS 37 now prevents this practice as future costs and operating losses (unless they are for an onerous contract) do not constitute past events. Another important change initiated by IAS 37 is the way in which environmental provisions must be treated. Practice in this area has differed considerably. Some companies did not provide for such costs and those that did often accrued for them on an annual basis. If say a company expected environmental site restoration cost of $10 million in 10 years time, it might argue that this is not a liability until the restoration is needed or it may accrue $1 million per annum for 10 years (ignoring discounting). Somewhat controversially this practice is no longer possible. IAS 37 requires that if the environmental costs are a liability (legal or constructive), then the whole of the costs must be provided for immediately. That has led to large liabilities appearing in some companies balance sheets. A third example of bad practice is the use of big bath provisions and over provisioning. In its simplest form this occurs where a company makes a large provision, often for non-specific future expenses, or as part of an overall restructuring package. If the provision is deliberately overprovided, then its later release will improve future profits. Alternatively the company could charge to the provision a different cost than the one it was originally created for. IAS 37 addresses this practice in two ways: by not allowing provisions to be created if they do not meet the definition of an obligation; and specifically preventing a provision made for one expense to be used for a different expense. Under IAS 37 the original provision would have to be reversed and a new one would be created with appropriate disclosures. Whilst this treatment does not affect overall profits, it does enhance transparency. Note: other examples would be acceptable.

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(c)

Guarantees or warranties appear to have the attributes of contingent liabilities. If the goods are sold faulty or develop a fault within the guarantee period there will be a liability, if not there will be no liability. The IASB view this problem as two separate situations. Where there is a single item warranty, it is considered in isolation and often leads to a discloseable contingent liability unless the chances of a claim are thought to be negligible. Where there are a number of similar items, they should be considered as a whole. This may mean that whilst the chances of a claim arising on an individual item may be small, when taken as a whole, it should be possible to estimate the number of claims from past experience. Where this is the case, the estimated liability is not considered contingent and it must be provided for. (i) Bodylines 28-day refund policy is a constructive obligation. The company probably has notices in its shops informing customers of this policy. This would create an expectation that the company will honour its policy. The liability that this creates is rather tricky. The company will expect to give customers refunds of $175,000 ($1,750,000 x 10%). This is not the liability. 70% of these will be resold at the normal selling price, so the effect of the refund policy for these goods is that the profit on their sale must be deferred. The easiest way to account for this is to make a provision for the unrealised profit. This has to be calculated for two different profit margins: Goods manufactured by Header (at a mark up of 40% on cost): $24,500 ($175,000 x 70% x 20%) x 40/140 = $7,000 Goods from other manufacturers (at a mark up of 25% on cost) $98,000 ($175,000 x 70% x 80%) x 25/125 = $19,600 The sale of the remaining 30% at half the normal selling price will create a loss. Again this must be calculated for both group of sales: Goods manufactured by Header were originally sold for $10,500 (175,000 x 30% x 20%). These will be resold (at a loss) for half this amount i.e. $5,250. Thus a provision of $5,250 is required. Goods manufactured by other manufacturers were originally sold for $42,000 (175,000 x 30% x 80%). These will be resold (at a loss) for half this amount i.e. $21,000. Thus a provision of $21,000 is required. The total provision in respect of the 28 day return facility will be $52,850 (7,000 + 19,600 + 5,250 + 21,000). (ii) Goods likely to be returned because they are faulty require a different treatment. These are effectively sales returns. Normally the manufacturer will reimburse the cost of the faulty goods. The effect of this is that Bodyline will not have made the profit originally recorded on their sale. This applies to all goods other than those supplied by Header. Thus these sales returns would be $128,000 (160,000 x 80%) and the credit due from the manufacturer would be $102,400 (128,000 x 100/125 removal of profit margin). The overall effect is that Bodyline would have to remove profits of $25,600 from its financial statements. For those goods supplied by Header, Bodyline must suffer the whole loss as this is reflected in the negotiated discount. Thus the provision required for these goods is $32,000 (160,000 x 20%), giving a total provision of $57,600 (25,600 + 32,000).

(d)

The Directors proposed treatment is incorrect. The replacement of the engine is an example of what has been described as cyclic repairs or replacement. Whilst it may seem logical and prudent to accrue for the cost of a replacement engine as the old one is being worn out, such practice leads to double counting. Under the Directors proposals the cost of the engine is being depreciated as part of the cost of the asset, albeit over an incorrect time period. The solution to this problem lies in IAS 16 Property, Plant and Equipment. The plant constitutes a complex asset i.e. one that may be thought of as having separate components within a single asset. Thus part of the plant $165 million (total cost of $24 million less $75 assumed cost of the engine) should be depreciated at $165 million per annum over a 10-year life and the engine should be depreciated at $1,500 per hour of use (assuming machine hour depreciation is the most appropriate method). If a further provision of $1,500 per machine hour is made, there would be a double charge against profit for the cost of the engine. IAS 37 also refers to this type of provision and says that the future replacement of the engine is not a liability. The reasoning is that the replacement could be avoided if, for example, the company chose to sell the asset before replacement was due. If an item does not meet the definition of a liability it cannot be provided for.

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(a)

Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are: Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example return on capital employed is materially affected by revaluations of assets. Comparing this ratio for two companies where one has revalued its assets and the other carries them at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, inventory valuation policies etc. Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debtor factoring. If one company collects its accounts receivable in the normal way, then the calculation of the accounts receivable collection period would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its accounts receivable (i.e. sell them to a finance company) then the calculation of its collection period would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as an operating lease rather than a finance lease. Balance sheet averages: many ratios are based on comparing income statement items with balance sheet items. The ratio of accounts receivable collection period is a good example of this. For such ratios to have meaning, there is an assumption that the year-end balance sheet figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example the level of accounts receivable and inventory of a toy manufacturer could vary largely due to the nature of its seasonal trading. Inflation can distort comparisons over time. The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of extraordinary items and finance costs. The use of norms can be misleading. A desirable range for the current ratio may be say between 15 and 2 : 1, but all businesses are different. This would be a very high ratio for a supermarket (with few accounts receivable), but a low figure for a construction company (with high levels of work in progress). Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

A more controversial aspect of ratio analysis is that management have sometimes indulged in creative accounting techniques in order that the ratios calculated from published financial statements will show a more favourable picture than the true underlying position. Examples of this are sale and repurchase agreements, which manipulate liquidity figures, and off balance sheet finance which distorts return on capital employed. Inter firm comparisons: Of particular concern with this method of using ratios is: they are themselves averages and may incorporate large variations in their composition. Some inter firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this problem. it may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different. companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures. the year end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of balance sheet averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

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(b)

Calculation of specified ratios: Comparator Return on capital employed (186 +34 loan interest/635) 346% Net assets turnover (2,425/635) 38 times Gross profit margin (555/2,425 x 100) 229% Net profit (excluding exceptionals) margin (306/2,425 x 100) 126% Net profit (before tax) margin (186/2,425 x 100) 77% Current ratio (595/500) 119 : 1 Quick ratio (320/500) 064 : 1 Inventory holding period (275/1,870 x 365) 54 days Accounts receivable collection period (320/2,425 x 365) 48 days Creditor payment period (350/1,870 x 365) (based on cost of sales) 68 days Debt to equity (300/335 x 100) 90% Dividend yield (see below) 25% Dividend cover (96/90) 107 times The workings are in $000 (unless otherwise stated) and are for Comparators ratios. The dividend yield is calculated from a dividend per share figure of 15c ($90,000/150,000 x 4) and a share price of $600. Thus the yield is 25% (15c/$600 x 100%). Sector average 221% 18 times 30% not available 125% 16 : 1 09 : 1 46 days 45 days 55 days 40% 6% 3 times

(c)

Analysis of Comparators financial performance compared to sector average for the year to 30 September 2003: To: From: Date: Operating performance The return on capital employed of Comparator is impressive being more than 50% higher than the sector average. The components of the return on capital employed are the asset turnover and profit margins. In these areas Comparators asset turnover is much higher (nearly double) than the average, but the net profit margin after exceptionals is considerably below the sector average. However, if the exceptionals are treated as one off costs and excluded, Comparators margins are very similar to the sector average. This short analysis seems to imply that Comparators superior return on capital employed is due entirely to an efficient asset turnover i.e. Comparator is making its assets work twice as efficiently as its competitors. A closer inspection of the underlying figures may explain why its asset turnover is so high. It can be seen from the note to the balance sheet that Comparators non-current assets appear quite old. Their net book value is only 15% of their original cost. This has at least two implications; they will need replacing in the near future and the company is already struggling for funding; and their low net book value gives a high figure for asset turnover. Unless Comparator has underestimated the life of its assets in its depreciation calculations, its non-current assets will need replacing in the near future. When this occurs its asset turnover and return on capital employed figures will be much lower. This aspect of ratio analysis often causes problems and to counter this anomaly some companies calculate the asset turnover using the cost of non-current assets rather than their net book value as this gives a more reliable trend. It is also possible that Comparator is using assets that are not on its balance sheet. It may be leasing assets that do not meet the definition of finance leases and thus the assets and corresponding obligations are not recognised on the balance sheet. A further issue is which of the two calculated margins should be compared to the sector average (i.e. including or excluding the effects of the exceptionals). The gross profit margin of Comparator is much lower than the sector average. If the exceptional losses were taken in at trading account level, which they should be as they relate to obsolete inventory, Comparators gross margin would be even worse. As Comparators net margin is similar to the sector average, it would appear that Comparator has better control over its operating costs. This is especially true as the other element of the net profit calculation is finance costs and as Comparator has much higher gearing than the sector average, one would expect Comparators interest to be higher than the sector average. Liquidity Here Comparator shows real cause for concern. Its current and quick ratios are much worse than the sector average, and indeed far below expected norms. Current liquidity problems appear due to high levels of accounts payable and a high bank overdraft. The high levels of inventory contribute to the poor quick ratio and may be indicative of further obsolete inventory (the exceptional item is due to obsolete inventory). The accounts receivable collection figure is reasonable, but at 68 days, Comparator takes longer to pay its accounts payable than do its competitors. Whilst this is a source of free finance, it can damage relations with suppliers and may lead to a curtailment of further credit. Gearing As referred to above, gearing (as measured by debt/equity) is more than twice the level of the sector average. Whilst this may be an uncomfortable level, it is currently beneficial for shareholders. The company is making an overall return of 346%, but only paying 8% interest on its loan notes. The gearing level may become a serious issue if Comparator becomes unable to maintain the finance costs. The company already has an overdraft and the ability to make further interest payments could be in doubt.

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Investment ratios Despite reasonable profitability figures, Comparators dividend yield is poor compared to the sector average. From the extracts of the changes in equity it can be seen that total dividends are $90,000 out of available profit for the year of only $96,000 (hence the very low dividend cover). It is worthy of note that the interim dividend was $60,000 and the final dividend only $30,000. Perhaps this indicates a worsening performance during the year, as normally final dividends are higher than interim dividends. Considering these factors it is surprising the companys share price is holding up so well. Summary The company compares favourably with the sector average figures for profitability, however the companys liquidity and gearing position is quite poor and gives cause for concern. If it is to replace its old assets in the near future, it will need to raise further finance. With already high levels of borrowing and poor dividend yields, this may be a serious problem for Comparator. Yours faithfully

(a)

(i)

An explanation of the origins of why deferred tax is provided for lies in understanding that accounting profit (as reported in a companys financial statements) differs from the profit figure used by the tax authorities to calculate a companys income tax liability for a given period. If deferred tax were ignored (flow through system), then a companys tax charge for a particular period may bear very little resemblance to the reported profit. For example if a company makes a large profit in a particular period, but, perhaps because of high levels of capital expenditure, it is entitled to claim large tax allowances for that period, this would reduce the amount of tax it had to pay. The result of this would be that the company reported a large profit, but very little, if any, tax charge. This situation is usually reversed in subsequent periods such that tax charges appear to be much higher than the reported profit would suggest that they should be. Many commentators feel that such a reporting system is misleading in that the profit after tax, which is used for calculating the companys earnings per share, may bear very little resemblance to the pre tax profit. This can mean that a governments fiscal policy may distort a companys profit trends. Providing for deferred tax goes some way towards relieving this anomaly, but it can never be entirely corrected due to items that may be included in the income statement, but will never be allowed for tax purposes (referred to as permanent differences in some jurisdictions). Where tax depreciation is different from the related accounting depreciation charges this leads to the tax base of an asset being different to its carrying value on the balance sheet (these differences are called temporary differences) and a provision for deferred tax is made. This balance sheet liability approach is the general principle on which IAS 12 bases the calculation of deferred tax. The effect of this is that it usually brings the total tax charge (i.e. the provision for the current years income tax plus the deferred tax) in proportion to the profit reported to shareholders. The main area of debate when providing for deferred tax is whether the provision meets the definition of a liability. If the provision is likely to crystallise, then it is a liability, however if it will not crystallise in the foreseeable future, then arguably, it is not a liability and should not be provided for. The IASB takes a prudent approach and IAS 12 does not accept the latter argument.

(ii)

IAS 12 requires deferred tax to be calculated using the balance sheet liability method. This method requires the temporary difference to be calculated and the rate of income tax applied to this difference to give the deferred tax asset or liability. Temporary differences are the differences between the carrying amount of an asset and its tax base. Carrying value at 30 September 2003 $000 Cost of plant Accumulated depreciation at 30 September 2003 (2,000 400)/8 years for 3 years Carrying value Tax base at 30 September 2003 Initial tax base (original cost) Tax depreciation Year to 30 September 2001 (2,000 x 40%) Year to 30 September 2002 (1,200 x 20%) Year to 30 September 2003 (960 x 20%) Tax base 30 September 2003 Temporary differences at 30 September 2003 (1,400 768) Deferred tax liability at 30 September 2003 (632 x 25% tax rate) Income statement credit year to 30 September 2003 ((200 192) x 25%) $000 2,000 (600) 1,400 2,000 800 240 192

1,232 768 632 158 2

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(b) Income statement extracts year to 30 September 2003 Depreciation of leased asset (w (i)) Lease interest expense (w (ii)) Balance sheet extracts as at 30 September 2003 Leased asset at cost Accumulated depreciation (7,800 + 10,400 (w (i))) Net book value Current liabilities Accrued lease interest (w (ii)) Obligations under finance leases (w (ii)) Non-current liabilities Obligations under finance leases (w (ii))

$ 10,400 2,672 52,000 18,200 33,800 1,872 9,504 21,696

Workings (i) Depreciation for the year ended 30 September 2002 would be $7,800 ($52,000 x 20% x 9/12) Depreciation for the year ended 30 September 2003 would be $10,400 ($52,000 x 20%) (ii) The lease obligations are calculated as follows: Cash price/fair value Rental 1 January 2002 52,000 (12,000) 40,000 2,400 800 43,200 (12,000) 31,200 1,872 624 33,696

Interest to 30 September 2002 (40,000 x 8% x 9/12) Interest to 1 January 2003 (40,000 x 8% x 3/12)

Rental 1 January 2003 Capital outstanding 1 January 2003 Interest to 30 September 2003 (31,200 x 8% x 9/12) Interest to 1 January 2004 (31,200 x 8% x 3/12)

Interest expense for the year to 30 September 2003 is $2,672 (800 + 1,872 from above), of which $1,872 is a current liability. The total capital amount outstanding at 30 September 2003 is $31,200 (the same as at 1 January 2003 as no further payments have been made). This must be split between current and non-current liabilities. Next years payment will be $12,000 of which $2,496 (1,872 + 624) is interest. Therefore capital repaid in the next year will be $9,504 (12,000 2,496). This leaves capital of $21,696 (31,200 9,504) as a non-current liability. (c) (i) Most events occurring after the balance sheet date should be properly reflected in the following years financial statements. There are two circumstances where events occurring after the balance sheet date are relevant to the current years financial statements. The first category, known as adjusting events, provides additional evidence of conditions that existed at the balance sheet date. This usually means they help to determine the value of an item that may have been uncertain at the year-end. Common examples of this are post balance sheet receipts from accounts receivable and sales of inventory. These receipts help to confirm the bad debt and inventory write down provisions. The second category is non-adjusting events. As the name suggests these do not affect the amounts contained in the financial statements, but are considered of such importance that unless they are disclosed, users of financial statements would not be properly able to assess the financial position of the company. Common examples of these would be the loss of a major asset (say due to a fire) after the balance sheet date or the sale of an investment (often a subsidiary) after the balance sheet date.

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(ii)

Inventory Sales of goods after the balance sheet date are normally a reflection of circumstances that existed prior to the year end. They are usually interpreted as a confirmation of the value of inventory as it existed at the year end, and are thus adjusting events. In this case the sale of the goods after the year-end confirmed that the value of the inventory was correctly stated as it was sold at a profit. Goods remaining unsold at the date the new legislation was enacted are worthless. Whilst this may imply that they should be written off in preparing the financial statements to 30 September 2003, this is not the case. What it is important to realise is that the event that caused the inventory to become worthless did not exist at the year end and its consequent losses should be reflected in the following accounting period. Thus there should be no adjustment to the value of inventory in the draft financial statements, but given that it is material, it should be disclosed as a non-adjusting event. Construction contract On first appearance this new legislation appears similar to the previous example, but there is a major difference. Profits on an uncompleted long term construction contract are based on assessment of the overall eventual profit that the contract is expected to make. This new legislation will mean the overall profit is $500,000 less than originally thought. This information must be taken into account when calculating the profit at 30 September 2003. This is an adjusting event.

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Part 2 Examination Paper 2.5 (INT) Financial Reporting (International Stream)

December 2003 Marking Scheme

This marking scheme is given as a guide in the context of the suggested answers. Scope is given to markers to award marks for alternative approaches to a question, including relevant comment, and where well-reasoned conclusions are provided. This is particularly the case for written answers where there may be more than one definitive solution. Marks 2 2 4 2 2 1/ 2 1 1/ 2 1 1 2 1 2 1/ 2 1/ 2 1 23 20 5 25

(a)

discussion of contingent consideration tangible non-current assets negative goodwill (2 for credit to realised profit) software investments inventory accounts receivable tax asset bank balance in hand ordinary shares accumulated profits provision minority interest accounts payable overdraft tax liability available maximum

(b)

1 mark per relevant point to

maximum Maximum for question

(a)

should not be treated as sales/cost of sales normally only the profit in income (may require disclosure) the substance of the transaction is a secured loan plant should be left on balance sheet sale proceeds of $50 million shown as loan rentals are partly interest and partly capital repayments available maximum

1 1 1 1 1 1 6 5

(b)

Income statement discontinuing operations figures sales cost of sales distribution expenses administration expenses finance costs (including 1 for preference dividends) loss on investment properties investment income taxation available maximum

3 2 5 1 2 2 1 1 2 19 17

(c)

Changes in equity profit for period dividends transfer to realised profits maximum Maximum for question

1 1 1 3 25

25

(a) (b) (c)

one mark per valid point to max the need for the Standard and examples to a max of 2 each 28 day refund policy constructive obligation calculation of provision for unrealised profits where goods resold at full price calculation of provision for loss on goods sold at half normal price the product warranties are treated collectively warranty cost can be estimated reliably therefore a liability, not a contingency faulty goods other than from Header not a loss, but must remove profit made on them quantified return of faulty goods manufactured by Header creates a loss quantification of loss available maximum

Marks 6 6 1 1 1 1 1 1 1 1 1 9 8 1 1 2 1 5 25

(d)

directors treatment is incorrect this is an example of a complex asset depreciation is $165m per annum plus $1,500 per machine hour replacement does not meet the definition of a liability maximum Maximum for question

(a)

up to 1 mark for each limitation Note: a good answer must refer to inter firm comparison issues
1/ 2

maximum

(b) (c)

mark for each relevant ratio

maximum

6 1 3 4 2 3 2 1 16 12 25

format discussion discussion discussion discussion discussion discussion

of: of: of: of: of: of:

profitability liquidity (and working capital ratios) gearing investment ratios other issues summary available maximum Maximum for question

(a)

(i) (ii)

one mark per valid point to carrying value and tax base at 30 September 2003 caculation of deferred tax at 30 September 2003 deferred tax credit in income statement

maximum

5 3 2 2 7 6 1 1 1 1 1 1 6 5 4 3 2 5 25

available maximum (b) depreciation of leased asset lease interest expense net book value of leased asset current liabilities: accrued lease interest current liabilities: obligations under finance leases non-current liabilities: obligations under finance leases available maximum (c) (i) (ii) one mark per valid point to discussion of value of inventory up to discussion of effect on construction contract up to maximum Maximum for question maximum

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