Diploma in

International Financial
Reporting

MONDAY 12 JUNE 2006

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST be

answered

Section B THREE questions ONLY to be answered

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination

hall

The Association of Chartered Certified Accountants

Section A – This ONE question is compulsory and MUST be attempted

1 Alpha holds investments in two other entities, Beta and Gamma. All three entities prepare financial statements to
31 March and the balance sheets of the three entities at 31 March 2006 were as follows:
Alpha Beta Gamma
$’000 $’000 $’000

Assets
Non-current assets:
Property, plant and equipment 90,000 80,000 80,000
Available for sale investments 113,000 – –
(Notes 1+2)
–––––––– –––––––– ––––––––
203,000 80,000 80,000
–––––––– –––––––– ––––––––

Current assets:
Inventories (Note 3) 30,000 28,000 25,000
Trade receivables (Note 4) 35,000 25,000 27,000
Other current assets 4,000 3,000 3,000
Cash and cash equivalents 10,000 9,000 8,000
–––––––– –––––––– ––––––––
79,000 65,000 63,000
–––––––– –––––––– ––––––––
Total assets 282,000 145,000 143,000
–––––––– –––––––– ––––––––

Equity and Liabilities

Share capital 100,000 60,000 60,000
Retained earnings 63,000 25,000 20,000
–––––––– –––––––– ––––––––
Total equity 163,000 85,000 80,000
–––––––– –––––––– ––––––––

Non-current liabilities:
Long term borrowings 50,000 24,000 25,000
Deferred tax 36,000 13,000 14,000
–––––––– –––––––– ––––––––
Total non-current liabilities 86,000 37,000 39,000
–––––––– –––––––– ––––––––

Current liabilities:
Trade and other payables (Note 4) 18,000 13,000 14,000
Short-term borrowings 6,000 4,000 4,000
Current tax payable 9,000 6,000 6,000
–––––––– –––––––– ––––––––
Total current liabilities 33,000 23,000 24,000
–––––––– –––––––– ––––––––
Total equity and liabilities 282,000 145,000 143,000
–––––––– –––––––– ––––––––

2
Note 1 – purchase of shares in Beta
On 1 April 2004 Alpha purchased 45 million shares in Beta at an agreed price of $2·20 per share, paid in cash. This
investment is carried in the balance sheet of Alpha at cost, as permitted by IAS 27 – Consolidated and Separate
Financial Statements. At that date the balance sheet of Beta showed retained earnings of $15 million. The directors
of Alpha carried out a fair value exercise on the net assets of Beta at that date as required by IFRS 3 – Business
Combinations. The following matters arose out of the exercise:
(i) Property, plant and equipment comprised non-depreciable land with a carrying amount of $30 million and a
market value of $50 million, plus plant and equipment with a carrying amount of $30 million and a market value
of $39 million. The estimated future economic life of the plant and equipment at 1 April 2004 was three years.
None of the property, plant and equipment held by Beta at 1 April 2004 had been disposed of by 31 March
2006.
(ii) Inventories were included at cost to Beta of $20 million. The equivalent selling price of the inventories was
estimated at $25 million and a reasonable allowance for profit on the sale $4 million. Disposal costs were not
considered to be material. All the inventories as at 1 April 2004 had been sold by 31 March 2006.
(iii) At 1 April 2004 Beta was subject to legal action from a customer. The customer was claiming damages of
$3 million. The directors of Beta had made no provision for this amount because they considered the case could
be successfully defended. However at 1 April 2004 they would have been prepared to make a payment of
$600,000 to have the case dismissed. In the event the case was successfully defended and no payment was
necessary.
(iv) At 1 April 2004 Beta had a brand name that it had protected by a legal process preventing any other business
from using the name. This brand was not included in the individual balance sheet of Beta because the directors
did not consider that it met the recognition criteria in IAS 38 – Intangible Assets – for internally developed
intangible assets. The directors of Alpha considered that the brand name had a market value of $10 million at
1 April 2004 and that it would give Beta a competitive advantage for 10 years from that date.

Note 2 – purchase of shares in Gamma

On 1 June 2005 Alpha purchased 10 million shares in Gamma for $1·40 per share. This purchase was made with
a view to further purchases in future. The current shareholding has not resulted in the directors of Alpha being able
to exercise any influence over the operating and financial policies of Gamma. The fair value of a share in Gamma at
31 March 2006 was $1·60. The balance sheet of Alpha continues to carry this investment at cost.

Note 3 – inventories
The inventories of Beta at 31 March 2006 include components purchased from Alpha at a cost of $15 million. Alpha
paid $12 million to produce the components.

Note 4 – trade receivables and payables

The trade receivables of Alpha included $5 million receivables from Beta in respect of the purchase of components
(see Note 3). Beta paid this amount on 30 March 2006 but the cash was not received and recorded by Alpha until
2 April 2006. There were no other intra-group current account balances.

Note 5 – other information

(i) The share capital of all three entities comprises equity shares of $1. All equity shares carry one vote and no
special controlling powers exist other than through the ownership of equity shares.
(ii) Despite owning a reasonably substantial number of equity shares in Gamma, Alpha does not have the power to
appoint any representatives to the board of directors of Gamma.
(iii) The goodwill arising on acquisition of Beta has not suffered any impairment since 1 April 2004.
(iv) The fair value adjustments give rise to temporary differences. The rate of taxation to apply to temporary
differences is 25%

Required:
(a) Prepare the consolidated balance sheet of Alpha at 31 March 2006. Your workings should include references
to international financial reporting standards where appropriate. (21 marks)
(b) Explain the effect on your answer to (a) if the investment in Gamma gave Alpha representation on the board
of directors of Gamma and the ability to participate in its policy making process. You do NOT need to prepare
the consolidated balance sheet under this revised assumption. (4 marks)
(25 marks)
3 [P.T.O.
Section B – THREE questions ONLY to be attempted

2 Delta is an entity that prepares its financial statements to 31 March each year. The financial statements for the year
ended 31 March 2006 are being prepared and you are provided with the following trial balance at that date:
$’000 $’000
Revenue (Note 1) 215,000
Inventories at 1 April 2005 (Note 2) 30,000
Raw material purchases 90,000
Production costs (Note 3) 50,000
Distribution costs (Note 3) 15,000
Administration costs (Note 3) 30,000
Property, plant and equipment:
– at cost (Note 4) 100,000
– accumulated depreciation at 31 March 2005 (Note 4) 30,000
Suspense account (Note 5) 13,000
Construction contact (Note 6) 12,000
Interest paid on long-term borrowing 4,000
Income tax account (Note 7) 1,000
Deferred tax (Note 7) 7,000
Trade receivables 50,000
Cash and cash equivalents 48,000
Trade payables 15,000
Long-term borrowings (10% interest rate) 40,000
Equity share capital ($1 shares) 90,000
Dividend paid 31 December 2005 20,000
Retained earnings at 31 March 2005 40,000
–––––––– ––––––––
450,000 450,000
–––––––– ––––––––
Notes to the Trial Balance
Note 1 – revenue
Revenue includes a sale of goods on 1 March 2006 for $10 million. The goods cost Delta $5 million to manufacture.
The terms of the sale gave Delta an option to repurchase the goods for $11 million on 30 April 2006. The buyer had
an option to require Delta to repurchase the goods for $11 million on 30 April 2006.
Note 2 – inventories
On 31 March 2006 the inventories at Delta’s premises was counted. The appropriate value of the inventories –
measured in accordance with the principles of IAS 2 – Inventories – was $35 million.
Note 3 – production, distribution and administration costs
The amounts contained in the trial balance do not include depreciation of property, plant and equipment. Depreciation
(including any gains or losses on sale of plant and equipment and other than that of the construction contract plant
(Note 6)) should be allocated 70:10:20 between production, distribution and administration.
Note 4 – property, plant and equipment
Cost Accumulated depreciation at
31 March 2005
$’000 $’000
Property 60,000 10,000
Plant and equipment 40,000 20,000
––––––– –––––––
100,000 30,000
––––––– –––––––

(i) The depreciable element of the property has an allocated cost of $25 million and is being depreciated on a
straight-line basis over 50 years.

4
(ii) The plant and equipment is being depreciated on a straight-line basis over five years, with a full year’s
depreciation in the year of purchase and no depreciation in the year of disposal. None of the plant and equipment
held at 31 March 2005 was fully depreciated at that date.
(iii) On 30 September 2005 Delta sold plant that cost $10 million on 1 September 2001 for $1 million. The
proceeds of sale were included in a suspense account (see Note 5 below).
Note 5 – suspense account
This account consists of two amounts:
(i) The proceeds of sale of plant (see note 4 above).
(ii) The proceeds of issue on 1 April 2005 of a bond carrying a zero interest rate but redeemable at an amount of
$16,105,100 on 31 March 2010. As an alternative to redemption, the bond-holders have the option to convert
the bond into equity shares. Had the option not been available the bond-holders would have only been prepared
to invest $10 million given their requirement for a 10% return on their investment.
Note 6 – construction contract
On 1 October 2005 Delta commenced work on a construction contract that had been signed on 15 September 2005.
The contract was for a fixed price of $40 million. Delta purchased plant at a cost of $10 million for use on the
contract. This plant will have no value when the contract is completed on 30 September 2006. Other costs incurred
on the contract, together with estimated costs to complete, were as follows:

Incurred to Estimated costs

date to complete
$’000 $’000
Purchase of materials 8,000 4,000
Labour and other overheads 6,000 7,000

The costs incurred to date were all debited to the contract account. On 31 March 2006 the contract was certified as
being 40% complete and the customer made a progress payment of $12 million. This payment was credited to the
contract account. No other entries have been made in respect of this contract.
Note 7 – income tax
– On 30 September 2005 Delta made full and final payment of $8 million to discharge the income tax liability for
the year ended 31 March 2005. The amount originally provided was $7 million.
– The estimated income tax liability for the year ended 31 March 2006 is $6 million.
– A further credit of $2 million is required to the deferred tax account.

Required:
(a) Prepare the income statement for Delta for the year ended 31 March 2006. (11 marks)
(b) Prepare the statement of changes in equity for Delta for the year ended 31 March 2006. (3 marks)
(c) Prepare the balance sheet for Delta as at 31 March 2006 (11 marks)
Notes to the income statement and balance sheet are not required. However, your workings should justify your
treatment of items referred to in the trial balance and the notes with appropriate references to international
financial reporting standards.
(25 marks)

5 [P.T.O.
3 You are a qualified accountant who supervises a number of trainee accountants. Your company is a listed company
located within the European Union that raises capital on a number of capital markets. The European Union has
recently passed a regulation that requires listed companies to use international financial reporting standards (IFRSs)
when preparing consolidated financial statements for publication. The regulation applies to accounting periods
beginning on or after 1 January 2005. The financial statements for the year ended 31 March 2006 have just been
published. One of your trainees has left you a memorandum that contains four questions relating to the financial
statements.

(a) I have noticed that the 2006 financial statements have been prepared using IFRSs, whilst the 2005 statements
were based on our own domestic standards. Why has this happened? Have our domestic standards become
discredited? Why have the 2006 financial statements included reconciliations of the 2005 numbers between
those originally presented and the equivalent numbers under IFRSs? Were the reconciliations optional or are they
required in the financial statements of first time adopters of IFRSs? (8 marks)
(b) You will be aware that we acquired a new subsidiary during the previous accounting period. Following this
acquisition the intangible assets that are shown in the consolidated balance sheet contain a number of items
relating to this subsidiary:
(i) The value of customer lists.
(ii) The value of trademarks.
(iii) The value of an internet domain name.
These assets do not appear in the individual balance sheet of the subsidiary to which they relate so why are they
in the consolidated balance sheet? (5 marks)
(c) The financial statements disclose that in the previous year a number of subsidiaries made errors in counting their
inventories. These errors affected last year’s closing inventories and their effect has been reported in the
statement of changes in equity. The financial statements also disclose that in the current year a number of
subsidiaries revised the estimated useful economic lives of their plant. The effect of the revision has all been
included in the consolidated income statement. In order to be consistent with the treatment of the inventories
error shouldn’t the prior period effect of the change in estimate be shown in the statement of changes in equity?
(5 marks)
(d) I remember that on 1 April 2005 the company issued options that allowed employees to purchase shares for
$10 per share on 31 December 2005 provided they satisfied certain performance conditions in the nine-month
period between 1 April 2005 and 31 December 2005. The market value of the shares on 1 April 2005 was only
$10, although by 31 December 2005 the market value had risen to $12 and 200,000 options were exercised,
generating $2 million. I do not understand why the 2006 financial statements, prepared in accordance with
IFRSs, include a charge in the income statement income of $360,000 relating to these share options. This
represents a charge of $1·80 per share but since our company hasn’t paid anything why should there be a charge
in the income statement at all? (7 marks)

Required:
Draft a reply that responds to the questions raised by your trainee. Where relevant, you should refer to appropriate
international financial reporting standards.
The mark allocation is shown against each of the four questions above.
(25 marks)

6
 This is a blank page.
Question 4 begins on page 8.

7 [P.T.O.
4 (a) Omega is an entity that requires a consistently high level of investment in property, plant and equipment.
Historically the investment has always been financed either using equity or by arranging appropriate borrowings.
More recently a greater proportion of the finance has been provided in the form of borrowing because conditions
for a share issue have been unfavourable. This has led to Omega’s borrowings increasing to such a level that the
directors would be uncomfortable about the impact of further significant borrowings on the balance sheet.
However, conditions for a share issue remain unfavourable, but the demand for additional investment in property,
plant and equipment continues.
Your assistant has approached you with the suggestion that a future solution to this dilemma might be to lease
property, plant and equipment rather than purchase it. This strategy, according to your assistant, would enable
Omega to procure the additional property, plant and equipment it needs without additional borrowings that would
have an unfavourable impact on the balance sheet.

Required:
Draft a reply that responds to the suggestion made by your assistant. Where relevant, you should refer to
appropriate international financial reporting standards. Your answer should explain the way in which the
characteristics of a lease determine its accounting treatment. (7 marks)

(b) Your requirements for capital investment in the next accounting period are set out below. In each case your
assistant has identified an alternative leasing option for your consideration:

New fleet of vehicles

Omega needs a new fleet of vehicles for its sales staff. The new fleet would cost $800,000 to purchase outright
and would have an expected useful economic life of four years from the date of purchase. As an alternative to
outright purchase, Omega could lease the vehicles on a two-year lease for annual rentals of $180,000, payable
monthly in arrears. At the end of two years the lease could be re-negotiated or the vehicles returned to the lessor.
The lessor provides a full repair and maintenance service for the fleet of vehicles that is free of charge throughout
the two-year lease period.

New production plant

Omega needs to re-fit one of its production plants with new machinery. The machinery would cost $2·4 million
to buy and would have an expected useful economic life of six years. As an alternative to outright purchase the
machines could be leased on a four-year lease with payments of $760,000 annually in arrears. At the end of
the four-year period Omega has the option to continue to lease the machinery for a further two years for an annual
rental of $1, payable in arrears. Omega is responsible for the repair and maintenance of the machinery
throughout the primary and secondary rental period. At the end of six years the machinery is likely to have a
negligible residual value.

Required:
Assuming the leasing option is taken up in both cases, compute all relevant amounts (excluding cash) that would
appear in the income statement and the balance sheet for the first year of the lease. Assume in both cases that
the leases commenced on the first day of the accounting period and that all payments in arrears have been made
by the balance sheet date. Where relevant, you should refer to appropriate international financial reporting
standards. Assume, where necessary, an annual finance cost of 10%. (12 marks)

8
(c) Omega is likely to need to acquire at least one new property in the near future. A potential property has been
identified which would cost $10 million to purchase outright. The purchase price of $10 million could be
reasonably apportioned 50:50 between the land and the buildings. The buildings are estimated to have a useful
economic life of 25 years. As an alternative to outright purchase, two leasing options exist:
(i) To lease the property on a 25-year lease. At the end of the lease term the title to the property would pass to
Omega
(ii) To lease the property on a 25-year lease but at a lower rental than in (i) above). At the end of the 25-year
period the title to the property would remain with the lessor and Omega would have to vacate it.
Required:
Assuming Omega wants to lease the property rather than purchase it outright, EXPLAIN (without performing any
detailed calculations) how the lease would be treated in the financial statements of Omega under both options.
Where relevant, you should refer to appropriate international financial reporting standards. (6 marks)

(25 marks)

9 [P.T.O.
5 Epsilon prepares consolidated financial statements under international financial reporting standards. Your assistant
has prepared the first draft of the financial statements for the year ended 31 March 2006 but there are a number of
transactions about which she is unsure. These are listed below:
(a) Transaction 1
(i) On 1 April 2005 Epsilon acquired a new subsidiary, Kappa, purchasing all 100 million shares of Kappa.
The terms of the sale agreement included the exchange of three shares in Epsilon for every two shares
acquired in Kappa. On 1 April 2005 the market value of a share in Epsilon was $10 and the market value
of a share in Kappa $13·50.
(ii) The terms of the share purchase included the payment of an additional $1·21 per share acquired provided
the profits of Kappa for the two years ending 31 March 2007 exceeded a target figure. Current estimates
are that it is 75% probable that the management of Kappa will achieve this target.
(iii) Legal and professional fees associated with the acquisition of Kappa shares were $1,200,000, including
$200,000 relating to the cost of issuing shares. The senior management of Epsilon estimate that the cost
of their time that can be fairly allocated to the acquisition is $100,000. This figure of $100,000 is not
included in the legal and professional fees of $1,200,000 mentioned above.
(iv) The individual balance sheet of Kappa at 1 April 2005 comprised net assets that had a fair value at that
date of $1,200 million. Additionally Epsilon considered Kappa possessed certain intangible assets that were
not recognised in its individual balance sheet:
– Customer relationships had a reliable estimate of value of $100 million. This value has been derived
from the sale of customer databases in the past.
– Employee expertise had a reliable estimate of value of $80 million.
(v) The directors of Epsilon were unsure how long the goodwill on acquisition of Kappa would last but they
thought that 10 years might be a prudent estimate of its useful economic life. However, they considered that
the goodwill had not suffered any impairment up to 31 March 2006.
(vi) The annual discount rate to use in any relevant calculations is 10%.
Required:
Compute the goodwill on consolidation of Kappa that will appear in the consolidated balance sheet of Epsilon
at 31 March 2006. You should make appropriate references to international financial reporting standards.
(9 marks)
(b) Transaction 2
On 1 April 2005 Epsilon issued convertible loan notes for total proceeds of $500 million. The notes were
repayable at $500 million on 31 March 2009 or convertible into equity shares on that date. Interest of
$40 million was payable annually in arrears. The finance cost of a non-convertible loan at 1 April 2005 would
have been 10% per annum.
Required:
Show how the convertible loan note would be presented in the balance sheet of Epsilon at 31 March 2006.
You should make appropriate references to international financial reporting standards. (8 marks)

10
(c) Transaction 3
Epsilon is planning a major equity investment in Europe towards the end of 2006. Latest indications are that this
investment will cost 100 million euros and that the funds will be required on 30 November 2006. However, at
the balance sheet date Epsilon had not entered into a contractual commitment to purchase the shares.
Epsilon wanted to provide a measure of certainty regarding the cost of the investment in $s. Therefore, on
31 January 2006 the entity entered into a contract to purchase 100 million euros for $140 million, with a
delivery date of 30 November 2006. On 31 March 2006, the rate of exchange was such that this contract was
a favourable one for Epsilon and had a fair value of $1,500,000.
Required:
Show how the equity investment and currency contract will affect the consolidated balance sheet of Epsilon
as at 31 March 2006. Indicate how any changes in carrying value will be reported in the statement of
changes in equity and/or income statement for the year ended 31 March 2006. You should make appropriate
references to international financial reporting standards. (8 marks)
(25 marks)

End of Question Paper

11