Course Notes 2015 September 2015 – June 2016 exams

ACCA
Paper F7

Financial Reporting

Tutor details

J15
ii Introduction AC C A F7

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AC C A F 7 Introduction iii

Contents
Page

Introduction i

Contents iii
1 An introduction to paper F7 Financial Reporting vi
2 Exam format vi
3 Study planner vii

1: An introduction to Group Accounts 1

1 Definition of a group 1
2 Group financial statements 2
Chapter 1: Home study 11
3 Recording the investment in the subsidiary 11
4 Gain on a bargain purchase 11

2: More Group Accounts 15

1 Fair values 15
2 Intra group trading 16
3 Non-controlling interest and goodwill at full or fair value 18
4 A more detailed look at Goodwill 26
5 Mid-year acquisitions 27

3: Consolidated statement of profit or loss and other comprehensive income 29

1 Introduction 29
2 Mid-year acquisitions 32
3 Uneven accrual of profit 33

4: Accounting for associates 35

1 Definition of associate 35
2 Accounting treatment 35
3 Additional PUP adjustments for practice 40

5: Interpreting financial statements 41

1 Introduction 41
2 Question scenarios 42
3 Other aspects of interpretation 43
4 The key ratios 43
5 Specialised, not-for-profit and public sector entities 48

6: Statement of cash flows 49

1 Introduction 49
2 Definitions 50
3 Pro forma statement of cash flows – indirect method 50
4 Preparing a statement of cash flows – indirect method 51
5 Direct method 59
iv Introduction AC C A F7

7: The conceptual and regulatory framework for financial reporting 61

1 Introduction 61
2 The IASB’s Conceptual Framework 62
3 Specialised, not-for-profit and public sector entities 65
4 Regulatory framework 66
5 IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors 66

8: The preparation of financial statements 69

1 IAS 1: Presentation of Financial Statements 69

2 Components of financial statements 69
3 Proforma financial statements 70
4 Additional notes 72

9: Tangible non-current assets 77

1 Recognition and classification 77

2 IAS 16: Property, Plant and Equipment 77
3 IAS 40 Investment Property 81
4 IAS 23 Borrowing Costs 81
5 IAS 20: Accounting for Government Grants and Disclosure of Government Assistance 82
6 IAS 36: Impairment of Assets 83
7 IFRS 5: Non-current Assets Held for Sale and Discontinued Operations 85

10: Intangible assets 87

1 IAS 38: Intangible Assets 87

11: Preparation of single company accounts 89

1 Approach to questions 89

12: Leases IAS 17 95

1 Finance lease 95
2 Operating leases 98
3 Sale and leaseback 100

13: Revenue and Inventory 103

1 Revenue 103
2 Specific applications of IFRS 15 110
3 Inventories: IAS 2 112

14: Financial instruments 115

1 IAS 32: Financial Instruments - Presentation 115

2 IFRS 9: Financial Instruments - Recognition and Measurement 116
3 Compound instruments 118
4 Transfer of a financial asset – factoring of receivables 120

15: Provisions and contingencies 123

1 Provisions 123
2 Contingent liabilities 126
3 Contingent assets 127
AC C A F 7 Introduction v

16: Taxation 129

1 Current tax 129

2 IAS 12: Deferred Tax 130
3 Tax losses 133

17: IAS 33: Earnings per share 135

1 Earnings per Share: IAS 33 135

Solutions to Class lecture examples 141

Chapter 1 141
Chapter 2 145
Chapter 3 147
Chapter 4 148
Chapter 5: No lecture examples 153
Chapter 6 153
Chapters 7 to 8: No lecture examples 155
Chapter 9 155
Chapter 10: No lecture examples 157
Chapter 11 157
Chapter 12 160
Chapter 13 161
Chapter 14 163
Chapter 15: No lecture examples 164
Chapter 16 164
Chapter 17 164
vi Introduction AC C A F7

1 An introduction to paper F7 Financial Reporting

This paper follows on from the basic accounting techniques covered in Knowledge Module F3 Financial
Accounting. It also introduces techniques that will be required in Professional Essentials module P2
Corporate Reporting.
According to the ACCA Syllabus, the aim of the paper is to “develop knowledge and skills in
understanding and applying accounting standards and the theoretical framework in the preparation of
financial statements of entities, including groups and how to analyse and interpret those financial
statements.”
On successful completion of this paper, candidates should be able to:
(a) Discuss and apply conceptual and regulatory frameworks for financial reporting
(b) Accounting for transactions in accordance with International accounting standards
(c) Analyse and interpret financial statements
(d) Prepare and present financial statements for single entities and business combinations in
accordance with International Accounting Standards

2 Exam format
As with all other ACCA exams, F7 is a three-hour exam with an additional 15 minutes’ reading and
planning time. Note that the format of the exam has changed from the December 2014 sitting
onwards.
All questions are compulsory and may contain computational and discursive elements. Some
questions will adopt a scenario/case study approach.
 Section A: 20 multiple choice questions of 2 marks each.
 Section B: 2 × 15 mark questions and one 30 mark question.
 The 30-mark question will examine the preparation of financial statements for either a single
entity or a group.
 The Section A and B questions can cover any areas of the syllabus.
AC C A F 7 Introduction vii

3 Study planner
PER ref Time Question from
Chap Subject Comments (hours) question bank 

1-4 Group Accounts This is a very important topic – it PO10 12 OT’s 1.1 – 1.15
may be tested in a 30 mark hours Q2 Paradigm
question. You need to work Q4 Prodigal
through these chapters very
Q7 Pedantic
carefully
Q10 Pumice
5 Reports and ratio Another core area - very PO11 4 hours OT’s 2.1, 2.8, 2.9
analysis important to learn the ratios and Q13 Quartile
practise writing reports

6 Statements of cash You should leave this chapter to PO10 4 hours OT’s 2.2 - 2.6
flows complete after Chapter 17 as it Q12 Monty
draws on knowledge of other Q16 Coaltown
chapters covered later in the
notes. You could be asked to
prepare and/or analyse a
statement of cash flows.
7 Conceptual and Not a major part of the syllabus, PO10 2 hours OT’s 3.1 – 3.15
Regulatory but contains some important Q19 Laidlaw
Framework for principles. Likely to be tested in
Financial Reporting section A.
8 Preparation of This is mostly a chapter of PO10 1 hour OT’s 5.8, 5.13,
Financial Statements proformas ─ you need to make 5.30-31, 5.44-45,
sure you learn them. 5.47-48, 5.50
9 Tangible non- An area which is examined PO10 2 hours OT’s 5.1, 5.9,
current assets regularly 5.16, 5.18-22,
5.24-29
Q41 Dearing
10 Intangible assets This is a relatively minor chapter PO10 0.5 OT’s 5.2, 5.12,
hours 5.15
11 Preparation of single This is a major chapter – there PO10 3 hours Q24 Moby
company accounts may be a 30 mark question on this Q31 Sandown
area. Before attempting questions Q32 Candel
in the Question Bank, you may
Q33 Dexon
wish to do Chapter 12 leases and
Chapter 16 Taxation first.
12 Leases Make sure you know the PO10 1.5 OT’s 5.3, 5.4,
difference between the hours 5.40, 5.52
accounting for finance leases and
operating leases
13 Revenue and A core area which takes practice PO10 1.5 OT’s 5.6, 5.7,
inventory hours 5.17, 5.23, 5.32,
5.43, 5.54-57,
5.59-65
Q22 Tunshill
14 Financial This is a difficult technical subject PO10 1.5 OT’s 5.33 – 5.36,
instruments which takes question practice to hours 5.58
master
viii Introduction AC C A F7

PER ref Time Question from

Chap Subject Comments (hours) question bank 

15 Provisions and Not a difficult topic conceptually. PO10 1 hour OT’s 5.10, 5.37 –
contingencies Likely to be tested in section A. 5.39, 5.41-42
16 Taxation Questions regularly ask you to PO10 1 hour OT 5.11, 5.14
work out the liability and expense
in the statement of profit or loss.
17 Earnings per share A very common calculation in the PO10, 1 hour OT’s 5.5, 5.46,
exam. Could be examined at the PO11 5.53
end of a section B question.

The chapter number refers to the chapter of the Course Notes. The time is a guide as to how long you
should spend per topic, to cover the chapter and related questions. Tick each session off when you
have completed it.
If you complete all the sessions before you have received the mock exam please email your tutor to
request it or check www.firstintuition.net to download it.

3.1 Practical Experience Requirements (PER) and Performance Objectives

ACCA requires students to have 36 months’ practical experience in order to become members. Part of
the practical experience requirements is achieving performance objectives that demonstrate that you
can apply what you’ve learnt when studying to real-life, work activities.
ACCA has set out 20 performance objectives in 9 areas. You are required to achieve 13 performance
objectives – all 9 Essentials performance objectives and any 4 Options performance objectives. ACCA
has provided guidance on which objectives are strongly linked to which exam. The relevant objectives
for F7 comprise Essentials objectives and Options objectives:
Manage self (relevant for all exams) (Essentials)
(5) Communicate effectively (relevant for all exams) (Essentials)
(6) Use information and communications technology (relevant for all exams) (Essentials)
(10) Prepare financial statements for external purposes (relevant for F7 and P2)
(11) Interpret financial transactions and financial statements (relevant for F7 and P2)
You can find further guidance on Practical Experience Requirements and performance objectives at:
http://www.accaglobal.com/uk/en/student/practical-experience.html
 1

An introduction to Group
Accounts

1 Definition of a group
A subsidiary company is any company which is controlled by another company.
Per IFRS 10, Consolidated Financial Statements, an investor controls an investee if and only if the
investor has all of the following elements:
 Power over the investee, i.e. the investor has the ability to direct the relevant activities
 Exposure, or rights, to variable returns from its involvement with the investee
 The ability to use its power over the investee to affect the amount of the investor's returns
“Power” comes from “rights”, normally voting rights. Therefore, in most instances in the exam,
“control” will come via owning the majority of the shares in that company.
Be careful in Objective Test Questions. Strictly, the standard doesn’t mention “shareholdings” and so
any potential answer which mentions shareholdings is likely to be incorrect.
 2 1: An introduction to Group Accounts AC C A F7

Group structure
A plc

100% 75%

B Ltd C Ltd
In the above scenario, A plc (“A”) owns 100% of the shares in B Ltd (“B”) and 75% of the shares in C Ltd
(“C”). As such, A “controls” both B and C. Where such a relationship exists, we can refer to A as the
“parent” or “holding” company and B and C as A’s “subsidiary” companies.
In A’s accounts the investments in B and C will initially be shown at cost (credit cash, debit
investments). Subsequently, A can continue to carry the investments at cost. This means that over
time it is impossible for shareholders of the parent to see the performance of the subsidiaries.
Therefore, when one company controls another, it is required to produce an additional set of accounts
─ the group (or consolidated) accounts. The aim of these accounts is to present the results of the
group of companies as a single business entity.
This additional set of accounts is issued to the shareholders of the parent company.

2 Group financial statements

Group accounts are likely to be a key part of the F7 exam. It is essential, therefore, to have a firm
grasp of this topic.

In order to prepare group accounts, we need to add together the Statements of Financial Position of
the parent and subsidiaries and put through some additional workings.
There are a number of rules that you need to learn:
 The investment in the subsidiary never appears in the consolidated set of accounts. It is
replaced by the net assets of the subsidiary and goodwill (see later).
 The share capital of the consolidated accounts is that of the parent company only.
 The assets and liabilities are simply added together (there will be some adjustments dealt with
in Chapter 2).
 Goodwill needs to be calculated and shown as an intangible asset.
 Retained earnings need to be calculated.
AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 3

ILLUSTRATION 1.1

A acquires 100% of the share capital of B on 1 January 2014 for $1,000.

Prepare the consolidated statement of financial position at that date.
Statement of financial position as at 1 January 2014
A plc B Ltd
$ $
ASSETS
Non-current assets
Property, plant and equipment 10,000 700
Investment in B Ltd 1,000*
Current assets
Inventories 4,000 300
Trade receivables 1,500 350
Cash 700 200
17,200 1,550

EQUITY AND LIABILITIES

Equity
Share capital 14,000 800
Retained earnings 3,000 100
Current liabilities 200 650
17,200 1,550

* Note how the investment in B Ltd is recorded at cost in A’s accounts. The Examiner may expect you
to know this.
The above sets of accounts are the individual accounts of A and B. They show the respective positions
of both companies.
Consolidated Statement of Financial Position of A Group as at 1 January 2014
A Group

$
ASSETS
Non-current assets
Property, plant and equipment (10,000 + 700) 10,700
Goodwill (W1)
Current assets
Inventories (4,000 + 300) 4,300
Trade receivables (1,500 + 350) 1,850
Cash (700 + 200) 900

EQUITY AND LIABILITIES

Equity
Share capital (parent company only) 14,000
Retained earnings (W2)
Current liabilities (200 + 650) 850
4 1: An introduction to Group Accounts AC C A F7

2.1 Goodwill: IFRS 3

In group accounting, Goodwill can be seen as the difference between the price paid to acquire a
business and the fair value of the net assets of that business.
Goodwill is considered to be an asset of the group and is capitalised as an intangible non-current asset
on the group statement of financial position. Unlike other intangible assets, it is not amortised but
instead reviewed annually for impairment. Any impairment loss should be recognised against
goodwill and recorded as an expense in the statement of profit or loss.
In the exam, put these workings on a separate page in your answer – you will earn valuable marks for
clear, relevant workings.
The steps to help you are shown below.

STEPS
Step 1: You need the cost of the investment. This can be given to you in the first few lines of
the question or you may have to calculate it.
Step 2: You need the net assets of the subsidiary at the acquisition date.
Step 3: You need the % of ownership. (This can be given or you may need to work it out as a %
of subsidiary’s share capital.) This will help you calculate goodwill and non-controlling interest.
(W1) Goodwill (at 1 January 2014)
$ $
Cost of combination 1,000
Less: B’s net assets at acq’n date:
Share capital 800
Retained earnings 100
900
Group share (100%) (900)
Goodwill 100

2.2 Group retained earnings

This is the parent company’s retained earnings plus the group company’s share of the subsidiary’s post
acquisition reserves. (This means group share of subsidiaries profit after the acquisition date.)
In the current example (but not ever again in your studies!) the SFP date is the same as the date of
acquisition. Therefore, there are no “post-acquisition” retained earnings.
(W2) Retained earnings
A B
$ $
Retained earnings at SFP date per question 3,000 100
Retained earnings at acquisition (100)
Therefore, B’s post-acq’n retained earnings Nil
Group share of B’s post-acq’n retained earnings
(100% × nil) Nil
3,000
Less: goodwill impairment losses to date (nil)
3,000

When you put the goodwill $100 and retained earnings $3,000 into the SFP you will see that the Assets
and Equity/Liabilities section of the SFP agree at $17,850.
AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 5

LECTURE EXAMPLE 1.1

Here are the statements of financial position of A and B two years later, on 31 December 2015.
A plc B Ltd
$ $
ASSETS
Non-current assets
Property, plant and equipment 20,000 1,200
Investment in B Ltd 1,000*
Current assets
Inventories 6,000 500
Trade receivables 1,900 650
Cash 1,000 600
29,900 2,950

EQUITY AND LIABILITIES

Equity
Share capital 14,000 800
Retained earnings 15,000 1,600
Current liabilities 900 550
29,900 2,950

* note how the investment in B Ltd is still recorded at cost in A’s accounts.
Additional information:
 An impairment review was carried out on the goodwill of B as at 31 December 2015.
An impairment of $30 was calculated.
Required:
Prepare the group statement of financial position as at 31 December 2015.
6 1: An introduction to Group Accounts AC C A F7

Consolidated statement of financial position of A plc group as at 31 December 2015

A Group
$
ASSETS
Non-current assets
Property, plant and equipment
Goodwill (W1)

Current assets
Inventories
Trade receivables
Cash

EQUITY AND LIABILITIES

Equity
Share capital
Retained earnings (W2)

Current liabilities

Take the easy marks first by completing the proforma and adding together the assets and liabilities.
Then, calculate goodwill and finally retained earnings. As goodwill is similar to what we have seen
before, we have completed this for you below.
(W1) Goodwill
The original
$ $ goodwill
Cost of combination 1,000 calculation used
in Illustration 1.1
Less: % of B’s net assets at acq’n:
will still be
Share capital 800
relevant. We also
Retained earnings 100
need to
900 acknowledge
Group share (100%) (900) any impairments
Goodwill at acquisition date 100 since the date of
Cumulative impairments since acq’n (30) acquisition.
Carrying amount of goodwill 70

This figure (after impairments) goes onto the Group SFP.

AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 7

(W2) Group retained earnings

A B
$ $
Retained earnings at SFP date per question
Retained earnings at acquisition
Therefore, B’s post-acq’n ret. earnings
Group share of B’s post-acquisition ret. earnings
(100% × )
Less: goodwill impairment losses to date
Retained earnings

2.3 Non-controlling interest (NCI)

A parent company does not have to own 100% of the share capital of another company in order to
control it.
For example, if A Ltd owns 75% of C Ltd, then 25% of the shares will be owned by a non-group
company, but A still controls C.
We refer to this 25% shareholding as “non-controlling interest” in the group statement of financial
position.
The non-controlling interest essentially is owed its share of the net assets at the SFP year-end date and
this is shown in the group SFP under Equity. It needs another working:
NCI % at acquisition (from goodwill working) X
Plus: NCI% of subsidiary’s post-acq’n retained earnings (from retained earnings working) X
Less: NCI% of goodwill impairment (if using “full” method of goodwill) (X)
Total NCI (in Group SFP) X

For the assets and liabilities section of the group statement of financial position, we still add together
100% of the parent and 100% of the subsidiary’s figures (be careful!), representing the fact that the
parent controls the assets and liabilities of the subsidiary.
The non-controlling interest line therefore acts a bit like a balancing figure on the statement of
financial position, showing the users of the accounts that the parent company does not own all of the
shares in the subsidiary.
Note: IFRS 3 gives companies a choice of goodwill and NCI calculation. The Examiner will show the way
he wishes you to calculate this with his choice of wording.
 The proportionate / partial method (below)
 The full or fair value method (see in Chapter 2)
 8 1: An introduction to Group Accounts AC C A F7

LECTURE EXAMPLE 1.2

Eric Ltd acquired 80% of the shares of Ernie Ltd on 1 January 2010 when Ernie’s retained earnings were
$3,000. Their respective statements of financial position as at 31 December 2012 (i.e. three years
later) were:
Eric Ltd Ernie Ltd
$ $
ASSETS
Non-current assets
Property, plant and equipment 15,000 3,000
Investment in Ernie Ltd 10,000
Current assets
Inventories 4,000 2,000
Trade Receivables 1,500 3,500
Cash 400 1,500
5,900 7,000
30,900 10,000

EQUITY AND LIABILITIES

Equity
Share capital 14,000 3,500
Retained earnings 13,500 4,500
27,500 8,000
Current liabilities 3,400 2,000
30,900 10,000

Remember: the investment in Subsidiary figure tells us the original cost of investment is $10,000.
The group policy is to value the NCI on a proportionate / partial basis.
Impairment losses on recognised goodwill to date have amounted to $400.
Required:
Prepare the consolidated statement of financial position of Eric and its subsidiary as at 31 December
2012.
AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 9

Consolidated statement of financial position of Eric Ltd Group as at 31 December 2012

Eric Group
$
ASSETS
Non-current assets
Property, plant and equipment
Goodwill (W1)

Current assets
Inventories
Trade receivables
Cash

EQUITY AND LIABILITIES

Equity
Share capital
Retained earnings (W2)
Non-controlling interest (W3)

Current liabilities

(W1) Goodwill

$ $
Cost of combination
Non-controlling interest
Less: Ernie’s net assets at acq’n:
Share capital
Retained earnings

Goodwill at acquisition date

Cumulative impairments since acq’n
Carrying amount of goodwill

EXAM SMART
Tutor’s hints:
Note that by adding back 20% of the net assets of the subsidiary and then deducting 100%,
you are effectively deducting 80% of the net assets.
Unless you are told otherwise, assume that the subsidiary’s share capital at acquisition is the
same as its current share capital.
10 1: An introduction to Group Accounts AC C A F7

(W2) Group retained earnings

Eric Ernie
$ $
Retained earnings at SFP date per question
Retained earnings at acquisition
Therefore, Ernie’s post-acq’n ret. earnings
Group share of Ernie’s post-acq’n ret. earnings
(80% × )
Less: goodwill impairment losses to date
Retained earnings

(W3) Non-controlling interest

NCI% × Ernie’s Net assets at acq’n (from Goodwill working)
+ NCI% Ernie’s Retained earnings (W2)

2.4 “Other” reserves

If the subsidiary has reserves other than retained earnings, we will treat this reserve in exactly the
same way as the retained earnings reserves earlier; i.e. if the reserve existed at the date of acquisition,
we will include it in the goodwill calculation.
A common examinable example of this is the revaluation reserve.
If the reserve moves after the acquisition date, then we will need to do an additional reserves working,
which will look very similar to the retained earnings working earlier.
The group is only entitled to its share of the post-acquisition change in reserves.
The key difference is that the impairment of goodwill is only shown in the retained earnings working.

2.5 Recap of group rules so far

The fundamental principles of group accounting are that:
 You only ever include the share capital of the parent company in the group accounts.
 Goodwill is the difference between the price paid and the net assets acquired at the acquisition
date.
 The retained earnings for the group are the parent company’s retained earnings plus their share
of post-acquisition profits in the subsidiary.
 Non-controlling Interest (NCI) needs to be calculated
It is essential that the above workings are learnt thoroughly as they are examined every time!
AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 11

Chapter 1: Home study

3 Recording the investment in the subsidiary

According to IAS 27 Separate Financial Statements, the parent company can record its investment in a
subsidiary in its own individual company accounts at either:
 Cost or
 At cost initially and then “revalued” each year end to fair value.
Unless the question specifically states otherwise, we will work on the assumption that the parent
records its investment at initial cost only.

3.1 Definition of a subsidiary

According to IFRS 10 Consolidated Financial Statements, a subsidiary is an entity that is controlled by
another entity. There are three elements in the definition of control:
 Power over the investee (whether or not that power is used)
 Exposure or rights to variable returns from the investee
 The ability to use power over the investee to affect the reporting entity’s returns from the other
company.
Using the concept of substance over form, it is possible to consolidate a company for which less than
50% of the shares are held, particularly if the other shares are held by a large number of non-
controlling (minority) shareholders. New disclosure requirements mean that even if it determined that
an entity does not control another entity, management should disclose the information that is
considered in reaching that decision, so its judgement becomes more transparent.

3.2 Exemption from preparing group accounts

Not all groups have to prepare group accounts. A parent need not prepare group accounts if:
 It is itself a wholly-owned subsidiary, or partially-owned with the consent of the non-controlling
interest and
 Its debt or equity instruments are not publicly traded and
 The ultimate or any intermediate parent produces group accounts that comply with IFRS.

3.3 Exclusion of a subsidiary from the group accounts

Directors may want to exclude a subsidiary from the group accounts, particularly if its results would
worsen the financial position of the group. IFRS 10 does not allow any subsidiary to be excluded from
the group accounts.

4 Gain on a bargain purchase

It is possible, on the acquisition of a subsidiary, to pay less for the company than the net assets of the
company the company is worth. For example:
A business buys 100% of the share capital of another for $1,000. The net assets of the business
acquired are $1,200. There is therefore a gain on a bargain purchase (“negative goodwill”) of $200.
Where this is the case, IFRS 3 states that you should reassess and if you are certain that the figures are
appropriate, credit the statement of profit or loss with the $200 gain (i.e., recognise a gain of $200 in
profit or loss).
12 1: An introduction to Group Accounts AC C A F7

LECTURE EXAMPLE 1.3: HOMEWORK

Bono Ltd acquired 75% of the shares of Edge Ltd on 1 January 2005 when Edge’s retained earnings
were $2,500 and its revaluation surplus was $300.
Their respective Statements of financial position as at 31 December 2007 were:
Bono Ltd Edge Ltd
$ $
ASSETS
Non-current assets
Property, plant and equipment 11,000 2,000
Investment in Edge Ltd 5,000
Current assets
Inventories 27,000 2,000
Trade receivables 1,800 3,500
Cash 200 4,500
45,000 12,000

EQUITY AND LIABILITIES

Equity:
Share capital 10,000 2,000
Revaluation surplus 1,000 2,100
Retained earnings 14,700 3,000
25,700 7,100
Current liabilities 19,300 4,900
45,000 12,000

Required:
Prepare the consolidated statement of financial position of Bono and its subsidiary as at 31 December
2007.
The group policy is to value the NCI at its proportionate value.
Impairment losses on recognised goodwill to date have amounted to $900.
AC C A F 7 1 : A n i n t r o d u c t i o n t o G r o u p Ac c o u n t s 13

Bono
Group
$
ASSETS
Non-current assets
Property, plant and equipment
Goodwill (W1)

Current assets
Inventories
Trade receivables
Cash

TOTAL ASSETS
EQUITY AND LIABILITIES
Equity
Share capital
Revaluation surplus (W4)
Retained earnings (W2)
Non-controlling interest (W3)

Current liabilities
Trade payables

Workings
14 1: An introduction to Group Accounts AC C A F7
 15

More Group Accounts

1 Fair values
A company’s value per the statement of financial position doesn’t necessarily give a fair representation
of what that company is actually worth. When preparing single company accounts, a company can
largely choose to ignore the market value or fair value of its assets and liabilities.
However, when preparing group accounts, the assets and liabilities of the subsidiary (but not the
parent) must be stated at their “fair value”, where "fair value" is the amount for which an asset could
be exchanged in an arm’s length transaction by knowledgeable and willing parties.
IFRS 13 Fair Value Measurement defines fair value as “the price that would be received to sell an asset
(or paid to transfer a liability) in an orderly transaction between market participants at the
measurement date. It is essentially the “market value”.

Approach:

STEPS
Step 1: For each asset that you are given that has a different book value to fair value at the
acquisition date, put the difference in the “at acquisition” column.
Step 2: For any change after the acquisition date, put that amount in the “change” column.
(e.g. depreciation of plant, disposal of land, inventory sold).
Step 3: Subtract the “change” from the “at acquisition” column to give the balance at the SFP
date.
16 2: More Group Accounts AC C A F7

ILLUSTRATION 2.1

P group has a year end of 31 December 2011. It acquired S Co on 1 January 2011. At that date, the
carrying values in S Co were different to fair values as shown below.
Carrying
amount Fair value
$000 $000
Inventory (sold 1 Nov 2011) 15 29
Land 17 20
Plant (remaining life of 5 years) 20 25
Key working needed in group accounts
At At SFP
acquisition Change date
$000 $000 $000
Inventory (sold by year end) 14 (14) nil
Land 3 – 3
Plant 5 (1) 4
22 (15) 7

The numbers go to these workings Goodwill(W) Ret Earn(W) SFP

Note that the inventory has been sold and so is not on the SFP at the year end and the plant with a life
of five years has been depreciated for one year.
Also, the figures in this table show the difference between the fair value of the assets and their
carrying amount  the table does NOT show what the fair value of the assets are.

2 Intra group trading

The purpose of consolidation is to present the parent and its subsidiaries as if they are trading as a
single entity. Therefore, any sales between group members and any amounts still outstanding
between these members at the year end should be eliminated.

2.1 Intra group balances

If group companies buy or sell goods to each other on credit, there will be an intercompany
receivable/payable at the end of each accounting period. These amounts payable are often referred to
as “current accounts”. The current accounts should be cancelled on consolidation as intra group
receivables and payables should not be shown on the group statement of financial position – “you
can’t owe money to yourself”.

Reconciliation of intra group balances

Where current accounts do not agree at the year end, this will be due to in transit items such as
inventories and cash.
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 17

Prior to consolidation, adjustments will need to be made for these in transit items. This is usually done
by pushing the transaction to its final destination – an adjustment we will make on the face of the
question paper, using the following journals:
 Cash in transit
Dr Cash (Add to cash)
Cr Receivables (Deduct from receivables)
 Goods in transit
Dr Inventories (Add to inventories)
Cr Payables (Add to payables)
 Eliminate intra group receivables and payables
Dr Intra group payable (Deduct from payables)
Cr Intra group receivable (Deduct from receivables)

2.2 Inventories sold at a profit to other group companies

EXAM SMART
This is one of the most commonly examined adjustments in the exam and ensures that
inventories are valued at the lower of cost and NRV to the group.

When inventories are sold at a profit by one group member to another then, on consolidation, the
buying company’s inventories will be overstated to the extent of the profit still included in its year end
statement of financial position. To eliminate this “unrealised profit” from the value of inventories, we
post an adjustment to the consolidated inventory figure. We call this the “provision for unrealised
profit”, or “PUP” adjustment:
Sale by Parent (P) to Subsidiary (S)
Adjust in P's books
Dr Retained earnings of P (i.e. the seller)
Cr Consolidated inventories
Sale by Subsidiary to Parent
Adjust in S's books
Dr Retained earnings of S (i.e. the seller)
Cr Consolidated inventories
Note: if some or all of the goods transferred between the two group companies have subsequently
been sold on to third parties at the year end, then the adjustment above should only reflect the
proportion of the “unrealised profit” still left in inventories at the year end.

Important proforma:
PUP = profit on intercompany sale × % of goods still in inventories at the year end.
18 2: More Group Accounts AC C A F7

2.3 Transfer of property, plant and equipment between group companies

Carrying amount and depreciation
The transfer of PPE at a profit within the group gives rise to similar issues to the transfer of inventories
outlined above i.e. PPE should be stated at cost to the group as the profit on the sale is unrealised.
Therefore, an adjustment to reduce the value of PPE is needed.
An additional problem is that the items of PPE will subsequently be depreciated based on the new,
higher carrying amount. Effectively, the group is “over-depreciating” the asset and so an adjustment is
needed to inflate the value of the asset.
These adjustments are netted off into a single journal:
Dr Expense/Retained earnings (of the selling company) X
Cr Property, plant and equipment X
Where X is the net unrealised profit, calculated as:
Original PUP on transfer Z
Less: depreciated by the year end (Y)
X

ILLUSTRATION 2.2

On 1 July 2011 P sold an item of plant to S at its agreed fair value of $12m. The plant had a book value
at that date of $7m. The estimated remaining useful life at the date of sale was five years (straight line
depreciation). Year end is 31 December 2011.
PUP = $12m – $7m = $ 5.0m
Less depreciation $5m/5 × 6/12 $(0.5)m
Net PUP $ 4.5m

3 Non-controlling interest and goodwill at full or fair value

IFRS 3 gives the parent the choice of either measuring NCI as a proportionate share of the net assets
at the year end date (the “partial method” used in Chapter 1), or at full or fair value (the “full method”
used in this chapter onwards).
The exam is likely to ask you to calculate goodwill using the full method.

ILLUSTRATION 2.3

Let’s revisit Lecture example 1.2 from Chapter 1 but without the goodwill impairment.
Eric Ltd acquired 80% of the shares of Ernie Ltd on 1 January 2009 for $10,000 when Ernie’s retained
earnings were $3,000.
Their respective equity as at 31 December 2011 (i.e. three years later) was:
Eric Ltd Ernie Ltd
$ $
Share capital 14,000 3,500
Retained earnings 13,500 4,500
27,500 8,000
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 19

We previously calculated goodwill (before any impairment) to be as follows:

(W1) Goodwill
$ $
Cost of combination 80% 10,000

Non-controlling interest (20% x 6,500) 20% 1,300

Less: Ernie’s net assets at acq’n:
Share capital 3,500
Retained earnings 3,000
(6,500)
Goodwill at acquisition date 4,800

The problem with the partial method and the resulting $4,800 figure is that it only represents 80% of
the subsidiary’s goodwill.
Under the full method we effectively “gross up” the goodwill figure in the group statement of financial
position so that it represents 100% of the subsidiary’s goodwill (i.e.$4,800 × 100/80 = $6,000).
In the exam, however, we won’t gross the figures up in this way, we will use the following proforma:
$
Fair value of parent’s consideration: as above 80% 10,000
Fair value of NCI’s consideration: (20/80 × 10,000) 20% 2,500
= Fair value of the business 12,500
Fair value of Ernie’s net assets (100%) (6,500)
Goodwill at acquisition 6,000

In reality (and probably in the exam too), the NCI is not going to be worth as much as the controlling
interest (CI). Normally a premium is paid to have the CI.
In the above example, the Examiner may say that the fair value of the NCI’s consideration is only
$2,000, meaning that the goodwill working would look like this:
$
Fair value of parent’s consideration 80% 10,000
Fair value of NCI’s consideration (given) 20% 2,000
= Fair value of the business 12,000
Fair value of Ernie’s net assets (6,500)
Goodwill at acquisition 5,500

Make sure you learn and practise the proforma above  it WILL appear as part of your exam.
Valuing non-controlling interest at fair value at the date of acquisition
When the Examiner wants you to use the full method of goodwill, he will use the following wording.
Keep an eye open for it in your group questions:
“The parent company’s policy is to value the non-controlling interest at fair value at the date of
acquisition”
He will then either tell you what the fair value of the NCI is at the date of acquisition (e.g. the $2,000
given above) or he may ask you to calculate it.
For example, using the data from Eric and Ernie above, we know that Eric owns 80% of Ernie.
The Examiner may state that the share price of Ernie at the date of acquisition was $3 per share.
Given that Eric owns 80% of Ernie’s 3,500 shares (= 2,800 shares), this means that the NCI owns 20% (= 700
shares) worth 700 × $3 = $2,100. You would then put the $2,100 in the NCI line in the proforma above.
20 2: More Group Accounts AC C A F7

EXAM SMART
Examiner trap – beware!
In the examples we have seen so far, we have used the cost of investment figure as the first
line in the goodwill calculation. This has meant that there is no “investment in subsidiary”
figure in the final group statement of final position.
However, as well as buying shares in subsidiaries, a parent may also own shares in other
companies which they don’t control. The investments in these companies should be included
in the final group statement of financial position as an investment.

ILLUSTRATION 2.4

Ben Ltd acquired 80% of the shares of Ellie Ltd on 1 January 2009 for $5,000 when Ellie’s retained
earnings were $2,500.
Their respective statements of financial position as at 31 December 2011 were:
Ben Ltd Ellie Ltd
$ $
Non-current assets
Property, plant and equipment 9,000 3,000
Investments  be careful here 6,000
Current assets
Inventories 5,800 3,500
Cash 1,200 500
22,000 7,000

Equity and liabilities

Share capital 8,000 2,000
Retained earnings 12,700 3,000
Trade payables 1,300 2,000
22,000 7,000

It is the group policy to value the non-controlling interest at acquisition at fair value. The fair value of
the NCI at the date of acquisition was $1,500.
An impairment review was conducted at the year end and it was decided that the goodwill on the
acquisition of Ellie was impaired by 10%.
Required:
Prepare the consolidated statement of financial position of Ben and its subsidiary as at 31 December
2011.
Tutor note: An important feature of the full method of goodwill is that the impairment of goodwill is
split between the retained earnings and NCI workings  see over the page.
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 21

SOLUTION
Ben
Group
ASSETS $
Non-current assets
Property, plant and equipment (9,000 + 3,000) 12,000
Investments in non-group companies (6,000 – 5,000 inv’t in Ellie) 1,000
Goodwill (W1) 1,800
Current assets
Inventories 9,300
Cash 1,700
TOTAL ASSETS 25,800

EQUITY AND LIABILITIES

Share capital 8,000
Retained earnings (W2) 12,940
Non-controlling interest (W3) 1,560
Trade payables 3,300
25,800

(W1) Goodwill
$
Fair value of parent’s consideration : 80% 5,000
Fair value of NCI’s consideration per question 20% 1,500
6,500
Fair value of the net assets acquired
Share capital 2,000
Retained earnings 2,500
(4,500)
Goodwill at acquisition 2,000
Impairment (200)
1,800

(W2) Group retained earnings

Ben Ellie
$ $
Retained earnings at y/e per question 12,700 3,000
Retained earnings at acquisition (2,500)
Therefore, Ellie’s post-acq’n ret. earnings 500
Group share of Ellie’s post-acquisition RE: (80% × 500) 400
Less : group share of impairment (80% × 200) (160)
12,940

(W3) Non-controlling interest

NCI @ acquisition (per question) 1,500
Plus : NCI share of post-acq’n retained earnings: (20% × 500) 100
Less : NCI share of goodwill impairment (20% × 200) (40)
Therefore, NCI = $1,560
22 2: More Group Accounts AC C A F7

LECTURE EXAMPLE 2.1: COMPREHENSIVE EXAMPLE USING THE TECHNIQUES FROM THIS CHAPTER

On 1 January 2011, Posh Ltd acquired 75% of the shares of Becks Ltd. This was by way of an immediate
share exchange of 2 shares in Posh for every three shares in Becks. The market price of Posh’s shares
on 1 January 2011 was $5.
The transaction has yet to be recorded in the books of Posh. Becks’ retained earnings at the date of
acquisition were $800,000.
Their respective statements of financial position as at 31 December 2012 were:
Posh Ltd Becks Ltd
$000 $000
ASSETS
Non-current assets
Property, plant and equipment 13,000 2,000
Investments 7,000
Current assets
Inventories 3,000 1,000
Trade receivables 1,200 2,000
Cash 1,500 200
25,700 5,200

EQUITY AND LIABILITIES

Equity
Share capital $1 shares 10,000 3,000
Retained earnings 12,500 2,000
Current liabilities 3,200 200
25,700 5,200

Additional information:
(a) At acquisition, the fair value of some of Becks’ assets were greater than their book value as
follows:
$000
Inventories (sold 1 November 2012) 50
Plant (4-year life) 20
70

(b) During 2012 Becks sold goods to Posh at a selling price of $4 million. These goods had cost
Becks $2.4 million. Posh had $2.5 million (at cost to Posh) of these goods still in inventory at
31 December 2012.
(c) On the 29 December 2012 Posh sent Becks a cheque for $100,000. This had not reached Becks
by the year end. Following the adjustment for this the intercompany accounts were agreed at
$300,000.
(d) Cumulative impairment losses on recognised goodwill to date have amounted to $100,000.
(e) It is the group’s policy to value the non-controlling interest at its full or fair value at the date of
acquisition. For this purpose, the directors value this at $2.50 per share.
Required:
Prepare the consolidated Statement of Financial Position of Posh Ltd and its subsidiary as at
31 December 2012.
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 23

STEPS
Step 1: Read the requirements and then layout a proforma/blank SFP, using the one given in
the question as a guide, with additional lines for i) goodwill and ii) non-controlling interest.
Step 2: Start at the top of the question and do something with each bit of information. Put it in
a working or as an adjustment on the face of the question paper or add it to the group structure
working. This is so you do not lose or forget a vital piece of the puzzle.
Step 3: When you have reached the end of the information return to the SFP given in the
question and now add the assets and liabilities that you can and insert them into your
proforma. Also insert the share capital of the holding company.
Step 4: This should leave you with i) goodwill, ii) retained earnings and iii) non-controlling
interest. Tackle them in this order.
Consolidated statement of financial position of Posh Ltd Group at 31 December 2012

Posh Ltd
Group
$000
ASSETS
Non-current assets
Property, plant and equipment
Goodwill (W4)
Investments
Current assets
Inventories
Trade receivables
Cash

EQUITY AND LIABILITIES

Equity
Share capital
Share premium (W1)
Retained earnings (W5)
Non-controlling interest (W6)
Current liabilities
24 2: More Group Accounts AC C A F7

(W1) Group structure

SFP date 31/12/12- 2 years after aq’n

Posh

1/1/11 75%

Becks Retained earnings at aq’n $800,000

Note that in this question, Posh has not yet recorded the investment in Becks.
Posh has issued 2/3 × 3,000 × 75% = 1,500 shares, each with a nominal value of $1 and a market value
of $5 :
In Posh, double entry would be
Dr Investments $ 7,500  this becomes the cost of inv’t in the goodwill
working
Cr Share capital (NV: 1,500 shares × $1 nominal value $ 1,500
Cr Share premium (1,500 shares at a premium of $4) $ 6,000
For the consolidation we need the adjustment to share capital and the $7,500 to our goodwill working
for cost of combination.
(W2) Fair value adjustment
At At SFP
acquisition Change date
$000 $000 $000
Inventories
Property, plant and equipment

Goodwill (W) Ret Earn (W) SFP (W)

(W3) PUP adjustment to goods held in inventory
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 25

(W4) Goodwill

$000 $000
Cost of combination (at fair value) – W1
Plus : NCI
Less: Beck’s net assets at acq’n (at fair value)
Share capital
Retained earnings
Fair value adjustment (W2)

Less: impairments to date

Goodwill

(W5) Group retained earnings

Posh Becks
$000 $000
Retained earnings at SFP date per question
Retained earnings at acquisition
Fair value adjustment (W2)
PUP
Group share
Less: goodwill impairment losses to date

Retained earnings

(W6) Non-controlling interest

NCI @ acquisition (from goodwill working)
Plus: NCI share of post-acq’n retained earnings:
Less: NCI share of goodwill impairment
Therefore, NCI =
26 2: More Group Accounts AC C A F7

4 A more detailed look at Goodwill

4.1 Cost of a business combination
The cost of the business combination is measured as the fair values at the date of exchange.
Some additional matters to consider:
 Deferred consideration – refers to any amounts payable in the future. The fair value used in the
goodwill calculation is the present value of the future amount payable, using the purchaser’s
cost of capital to discount.
 Contingent consideration – is usually payable to the former owners and is dependent on some
future event. The future amount payable should be measured at fair value at the acquisition
date. Estimates of the amounts payable and the likelihood of it being issued are both taken into
account in estimating the fair value. If the estimate is subsequently revised, the movement
should NOT be put through the goodwill working, but rather should be put through profit or
loss.
 Share-for-share exchanges – sometimes company A acquires the shares in company B by issuing
some of its own shares. These should be valued at their market value at the date of acquisition.
 Quoted shares – published price at the date of the exchange transaction.
 Directly attributable costs such as legal fees must be expensed and not added to the cost of
investment.

4.2 Fair value of the identifiable assets and liabilities and contingent
liabilities acquired
The subsidiary’s identifiable assets, liabilities and contingent liabilities are recognised when they meet
the following criteria:
(a) In the case of an asset other than an intangible asset, it is probable that associated future
economic benefits will flow to the parent, and its fair value can be measured reliably;
(b) In the case of a liability other than a contingent liability it is probable than an outflow of
resources will be required to settle the obligation, and its fair value can be measured reliably;
(c) In the case or an intangible asset or a contingent liability, its fair value can be measured reliably.
The fair value concept would also mean that certain assets that were not included on the subsidiary’s
own individual company statement of financial position could nonetheless be included in the group
statement of financial position if their fair value could be established.
For example, under IAS 38 Intangible Assets, a subsidiary may have a brand or patent which is not
recognised in its own individual accounts, following international accounting standards. However,
under group fair value rules, this brand may be included in the goodwill calculation as an asset of the
subsidiary and in the year end group statement of financial position, if:
 It meets the definition of an intangible asset
 its fair value can be measured reliably
This might be relevant where a parent buys a subsidiary to acquire a brand, which the group wants to
put onto its group statement of financial position.
In addition, if the acquired subsidiary has a contingent liability disclosed in its own statement of
financial position, the parent should include this as an actual provision in the statement of financial
position of the subsidiary. This would reduce the net assets of the acquired subsidiary and therefore
increase goodwill.
AC C A F 7 2 : M o r e G r o u p Ac c o u n t s 27

EXAM SMART
There are many examples of exam questions where the Examiner tries to “catch you out” on
this topic. Just because an item isn’t allowed to appear in an individual company’s accounts
doesn’t prevent it from being allowed in a set of group accounts.

ILLUSTRATION 2.5: LUND AND MEYER ─ ILLUSTRATION OF SOME OF THESE POINTS

Lund buys 80% of Meyer on 1 January 2011 via a 1 for 2 share for share exchange. At that date, Meyer
had share capital of 1 million $1 shares, which each had a market value of $1.50 at that date. On that
date, Lund’s shares had a market value of $2.
In addition, Lund has agreed to pay a further $1.2m cash, payable on 1 January 2012. Lund’s cost of
capital is 10%.
The fair value of Meyer’s identifiable net assets at 1 January 2011 was $700,000. However, Meyer
trades under a brand name, which it believes is worth $500,000. This is (correctly) not included in the
SFP of Meyer, but the directors of Lund agree with the valuation and have taken this into account in
their purchase price.
Finally, Meyer is being sued by a customer for $200,000 but doesn’t think the customer will win the
case and so has (correctly) disclosed the matter in its accounts as a contingent liability, but has not
included it as a provision on its statement of financial position.
Lund uses the full method of goodwill and the NCI at the date of acquisition was $0.8m.
Goodwill:
$000 $000
Cost of combination
Shares issued : 400,000 shares issued at $2 800
Deferred consideration : $1.2m/1.1 1,091
Plus: NCI 800
2,691
Less: Meyer’s net assets at acq’n (at fair value)
Per above 700
Brand 500
Contingent Liability (200)
(1,000)
Goodwill at date of acquisition 1,691

Note: the brand and contingent liability will also appear in the final group SFP.

5 Mid-year acquisitions
In the real world, acquisitions occur every day of the year. The key consideration here is that the
acquisition almost certainly will not occur at a company’s year end. If an acquisition occurs midway
through a year, we will need to construct the acquired company’s statement of financial position at
that date.
In exam questions, unless told otherwise, assume that profits accrue evenly over the year.
28 2: More Group Accounts AC C A F7

LECTURE EXAMPLE 2.2

Murray acquired 75% of the issued share capital of Henman on 30 September 2011.
Murray uses the full method of goodwill and has valued NCI at the date of acquisition at $900.
At the year end 31 December 2011, the two companies have the following statements of financial
position:
Murray Henman
$ $ $ $
Investment in Henman 3,000 –
Other assets 11,500 6,000
14,500 6,000

Share capital 6,000 1,500

Share premium – 50
Retained earnings
1 Jan 2011 4,500 1,500
Profit for 2011 1,500 1,000
6,000 2,500
12,000 4,050
Liabilities 2,500 1,950
14,500 6,000

Required:
Calculate the goodwill at the date of acquisition.
SOLUTION
Working 1 Goodwill

$ $
Cost of combination
Plus : NCI
Less: Henman’s net assets at acq’n:
Share capital
Share premium
Retained earnings

Goodwill at acquisition date

 29

Consolidated statement of profit

or loss and other comprehensive
income

1 Introduction
The purpose of the consolidated statement of profit or loss and other comprehensive income is to
show the performance of the group for an accounting period as if all of the companies in the group
were a single entity.
Just as the initial phase of the preparation of the consolidated statement of financial position is based
on adding the statements of financial position of the individual company’s accounts, the same applies
to the preparation of the statement of profit or loss and other comprehensive income.
30 3: Consolidated statement of profit or loss and other comprehensiv e income AC C A F7

Therefore, in its simplest form, the consolidated statement of profit or loss can be prepared as follows:
Statements of profit or loss for the year ending 31 December 2012
South
(an 80% Consolidated
subsidiary of Stmt of
North North) profit or loss
$000 $000 $000

Revenue 100 50 150

Cost of sales (75) (30) (105)
Gross profit 25 20 45
Distribution costs (12) (5) (17)
Administrative expenses (8) (3) (11)
Other income – dividends receivable from South 40 – Nil
Profit before tax 45 12 17
Income tax expense (2) (2) (4)
Profit for the period 43 10 13
Attributable to :
Parent bal 11
Non-controlling interest (20% × 10) 2
13

Note that intercompany dividends do not appear in the final consolidated statement of profit or loss
– you can’t “earn income from yourself”.
It’s also worth noting that, with the statement of profit or loss, the figures of the subsidiary should
only be included from the date of acquisition. This means that you may have to time-apportion the
figures of the subsidiary in the group statement of profit or loss.
So, if South had been purchased exactly half-way through its financial year, then we would only
include 6/12 of its revenue, cost of sales etc.

1.1 Non-controlling interest

In the example above, we simply added the statements of profit or loss of the group companies
together to form the group accounts. We would do this, no matter what percentage the parent held
in the subsidiary company. Therefore, to acknowledge the fact that the parent may not own all of the
subsidiary company, we need to split the group’s profit into that which is attributable to the parent
company and that which is attributable to the non-controlling interest.

Statement of profit or loss NCI = NCI % × S’s profit for the year

1.2 Dividends
There is a simple way to deal with dividends in the Statement of profit or loss – ignore any dividends
receivable from subsidiaries regardless of whether they have been paid or not.
For dividends paid, as required by IAS 1, we will recognise the dividend paid by the parent company in
the consolidated statement of changes in equity (i.e. through reserves).
AC C A F 7 3: Consolidated statement of profit or loss and other comprehensive income 31

1.3 Intra group trading

When one group company trades with another, there are two potential adjustments that need to be
considered:
(1) For any sale between parent and subsidiary, regardless of who sells to whom:
Dr Group Revenue X
Cr Group Cost of Sales X
where X represents the total value of the sales between the companies. Note that this
adjustment is needed regardless of whether any profit was made on the sale and regardless of
whether any of the goods sold are still in inventory at the year end.
(2)
Dr Cost of Sales Y
Cr Cr Inventories (SFP) Y
where Y represents the Provision for Unrealised Profit (PUP). As for the statement of financial
position, this adjustment is made in the books of the company making the sale and is only
needed if any of the goods sold are still in inventory at the year end.

LECTURE EXAMPLE 3.1

Bermuda acquired 80% of the issued share capital of Bahama on 1 January 2010. Bahama had sold
goods to Bermuda during the year for $5,000,000 which included $2,000,000 profit. One quarter of
these goods were still in inventories at the year end.
Statements of profit or loss for the year ended 31 December 2011
Bermuda Bahama
$000 $000
Revenue 20,000 15,000
Cost of sales 13,200 7,800
Gross profit 6,800 7,200
Distribution costs 1,200 1,650
Administrative expenses 1,700 2,200
Profit before tax 3,900 3,350
Income tax expense 1,300 1,000
Profit for the period 2,600 2,350

Required:
Prepare the consolidated statement of profit or loss for the year ended 31 December 2011.
32 3: Consolidated statement of profit or loss and other comprehensiv e income AC C A F7

Bermuda Group consolidated statement of profit or loss for the year ended 31 December 2011

$000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit before tax
Income tax expense
Profit for the period
Attributable to:
Owners of the parent
Non-controlling interest

Workings

2 Mid-year acquisitions
The results for any subsidiary are only included from the date of acquisition. Therefore, when
preparing the Statement of profit or loss, care needs to be taken to only include those revenues and
expenses achieved since the date of acquisition. The simplest way of doing this is to time-apportion all
of the subsidiary’s figures for the year.

LECTURE EXAMPLE 3.2

Iceland acquired 90% of the issued share capital of Sweden on 30 September 2011. The statements of
profit or loss for the year ended 31 December 2011 are:
Iceland Sweden
$ $
Revenue 10,000 1,000
Cost of sales and expenses (4,000) (700)
Profit before tax 6,000 300
Income tax expense (1,400) (90)
Profit for the period 4,600 210

Notes
 On 1 November 2011, Iceland sold inventories to Sweden at a price of $300, which included a
profit on transfer of $40. Half of these inventories had been sold by Sweden by the year end.
AC C A F 7 3: Consolidated statement of profit or loss and other comprehensive income 33

 An impairment test carried out at the year end revealed impairment losses of $30 relating to
recognised goodwill.
 Additional depreciation on fair value adjustments amounted to $14 in the post-acquisition
period.
Required:
Prepare the consolidated Statement of profit or loss for Iceland and its subsidiary for the year ended
31 December 2011, assuming that Iceland uses the full method of goodwill.
Iceland Group Consolidated Statement of profit or loss for the year ended 31 December 2011

$
Revenue
Cost of sales and expenses
Profit before tax
Income tax expense
Profit for the period
Attributable to:
Owners of the parent
Non-controlling interest

(W1) Intercompany sale

(1) Sale itself

(2) PUP
PUP = profit on intercompany sale × % of goods still in inventories at the year end

3 Uneven accrual of profit

Occasionally you are told in questions that profits do not accrue evenly on a time basis but rather
fluctuate with factors such as seasonal trade or expenses occurring at identifiable points in time. If this
is the case just follow the information given and only include post-acquisition events.
34 3: Consolidated statement of profit or loss and other comprehensiv e income AC C A F7
 35

Accounting for associates

1 Definition of associate
According to IAS 28, an associate is “an entity over which the investor has significant influence”.

KEY TERM
Significant influence. Significant influence is the power to participate in the financial and
operating policy decisions of the associate but is not control or joint control over those
policies. For examination purposes, we will assume that one company has significant
influence over another if it holds between 20% and 50% of that company’s shares.

IAS 28 states significant influence can be shown by:

 Representation on the board of directors
 Participation in policy making processes
 Material transactions between the investor and investee

2 Accounting treatment
2.1 The investor’s separate financial statements
We treat the investment in the associate in the parent company’s accounts in exactly the same way as
we treated the investment in the subsidiary (i.e. at cost).

2.2 Consolidated financial statements

An investment in an associate should be accounted for in consolidated financial statements using the
equity method (IAS 28). The equity method is the cost of the associate plus or minus any post-
acquisition profits or losses less any impairment.
36 4: Accounting for associates AC C A F7

Statement of financial position

The investment in the associate is shown under non-current assets and is calculated as:
Cost of associate X
Share of post-acquisition retained earnings X/(X)
Less: impairment losses on associate to date (X)
Less : share of dividend received (X)
“Investment in Associate” X

Statement of profit or loss

Group % of Associate’s Profit After Tax for the year X
shown before group profit before tax.
An associate is not a group company, therefore there will be no cancellation of intra-group
transactions, but dividends from the associate are ignored.
However, IAS 28 states that unrealised profits and losses on transactions between investor and
associate should be eliminated in the same way as for group accounts. The calculation for the
Provision for Unrealised Profit (PUP) is identical to that of a subsidiary, with the final PUP being
multiplied by the group share of the associate:
If Parent sells to Associate:
Dr P’s COS (SofPorL) and P’s retained earnings (SFP): A% × PUP
Cr Invt in Associate A% × PUP (if the associate holds the inventory)
If Associate sells to Parent:
Dr “Share of A’s profit” (SofPorL) & P’s retained earnings (SFP): A% ×
PUP
Cr Group Inventories A% × PUP (if the parent holds the inventory)
Remember:
 Fair values should be used when calculating net asset values.
 Uniform accounting policies should be used, or adjustments must be made.
 After application of the equity method, any impairment losses are considered re the investor's
net investment in the associate as a whole.
 There is no goodwill and no non-controlling interest calculation needed for an associate.

LECTURE EXAMPLE 4.1: STATEMENT OF FINANCIAL POSITION

Pink purchased 80% of Spears on 1 January 2000 for $7m when the retained earnings of Spears were
$4m and a 40% holding in Aguilera on 1 July 2001 for $2.5m when its retained earnings were $3m.
AC C A F 7 4 : Ac c o u n t i n g f o r a s s o c i a t e s 37

At 31 December 2011 the statements of financial position of the three companies were:
Pink Spears Aguilera
$000 $000 $000
Property, plant and equipment 15,000 7,000 3,000
Investment in Spears and Aguilera (at cost) 9,500 – –
Current assets 8,100 4,200 2,500
32,600 11,200 5,500

Share capital 4,000 3,000 1,000

Retained earnings 24,600 6,200 3,500
Liabilities 4,000 2,000 1,000
32,600 11,200 5,500

An impairment test conducted at the year end revealed cumulative impairment losses of $0.9m in
respect of the investment in Aguilera. The loss is not reflected in Pink’s own financial statements as
the investment is not impaired below its original cost. No impairment was found in Spears.
During the year, Aguilera sold goods to Pink for $6m at a profit margin of 25%. $2m of these goods
remained in Pink’s inventories at the year end.
Pink’s policy is to value the non-controlling interest of its subsidiaries at the date of acquisition at its
fair value. For this purpose, the directors considered a share price of $2.50 to be appropriate.
Required:
Prepare the consolidated statement of financial position of the Pink group as at 31 December 2011.
Pink Group – Consolidated statement of financial position as at 31 December 2011

$000
Property, plant and equipment
Goodwill (W1)
Investment in associate (W4)
Current assets

Share capital
Retained earnings (W3)
Non-controlling interest (W5)
Liabilities
38 4: Accounting for associates AC C A F7

(W1) Goodwill in Spears

$000 $000
Cost of combination
Plus : NCI
Less: Spear’s net assets at acq’n:
Share capital
Retained earnings

Goodwill at acquisition date

Less: impairment losses to date
Goodwill @ Year end
(W2) PUP
PUP = profit on intercompany sale × % of goods still in inventories at the year end

(W3) Group retained earnings

Pink Spears Aguilera

$000 $000 $000
Retained earnings at SFP date per question 24,600 6,200 3,500
Less: PUP (W2)
Retained earnings at acquisition
Post-acquisition retained earnings
Group share of Spears’ post-acq’n RE (80%)
Group share of Aguilera’s post-acq’n RE (40%)
Less: impairment losses to date

(W4) Investment in associate

$000
Cost of associate
Share of post-acquisition retained earnings
Less: impairment losses on associate to date
Investment in associate
(W5) Non-controlling interest (in subsidiary only)

$000
NCI at acq’n (from goodwill working)
+NCI% Spears’ post-acq’n retained earnings (W2): (20% × )
AC C A F 7 4 : Ac c o u n t i n g f o r a s s o c i a t e s 39

LECTURE EXAMPLE 4.2: STATEMENT OF PROFIT OR LOSS

Continuing from Lecture example 4.1, the statements of profit or loss of the three companies for the
year ended 31 December 2011 are as follows:
Pink Spears Aguilera
$000 $000 $000
Revenue 30,000 15,000 4,000
Cost of sales (16,000) (6,000) (1,500)
Gross profit 14,000 9,000 2,500
Expenses (3,500) (3,000) (500)
Finance income 100 – 100
Finance costs (1,000) (500) (90)
Profit before tax 9,600 5,500 2,010
Income tax expense (1,600) (1,300) (170)
Profit for the year 8,000 4,200 1,840
Aguilera suffered an impairment loss of $0.3m during the year.
Required:
Prepare the consolidated statement of profit or loss for the Pink group for the year ended
31 December 2011.
Pink Group Consolidated Statement of profit or loss for year ended 31 December 2011

$000
Revenue
Cost of sales
Gross profit
Expenses
Finance income
Finance costs
Share of profit of associate
Profit before tax
Income tax expense
Profit for the year

Attributable to:
Owners of the parent
Non-controlling interest
40 4: Accounting for associates AC C A F7

3 Additional PUP adjustments for practice

The idea here is for you to practise calculating PUP adjustments and to explain what the adjustments
required would be to items in the statement of profit or loss or to the statement of financial position,
including NCI and retained earnings. (These can be expressed as debits or credits or, if you prefer,
increase or decrease.)
Unless stated you may assume that acquisitions occurred some years ago. The year-end date is
31 December 2009.
Treat each numbered question separately.
P= Parent, S= Subsidiary (80%), A= Associate (30%)
(1) During the year S sold goods to P totalling $ 15,000 making a profit of 25% on the cost of these
sales. At the year end P had 20% of these goods left in inventory.
(2) During the year P sold goods S totalling $ 24,000 making a margin of 30% on these sales. At the
year end S had 30% of these goods left in inventory.
(3) During the year S sold goods P totalling $ 18,000 making a profit on these sales of $3000. At the
year end P had $6,000 of these goods left in inventory.
(4) During the year P sold goods to A totalling $ 30,000 making a profit of 20% on the cost of these
sales. At the year end A had half of these goods left in inventory.
(5) During the year A sold goods to P totalling $ 16,000 making a profit of 25% on the cost of these
sales. At the year end P had a quarter of these goods left in inventory.
(6) On the 1 January 2008 P sold an item of plant to S at its agreed fair value of $6m. The plant had
a book value at that date of $4m. The estimated remaining useful life at the date of sale was
five years (straight-line depreciation).
 41

Interpreting financial
statements

1 Introduction
The interpretation of a set of financial statements is a key skill in this exam.
The use of ratio analysis may highlight unusual results or clarify trends, enabling various users of
accounts to make informed decisions relating to the company.
For ratios to be useful, comparisons must be made – either to another company, against budget or
year-on-year or industry standards.

1.1 Users of financial statements

There are a number of users of a company’s financial statements, each with different needs:
(a) Shareholders and potential investors – use ratios to help them determine whether they should
buy or sell shares
(b) Suppliers and lenders – will determine whether the debts are recoverable
(c) Employees – will determine their job security
(d) Management – will focus on areas of the business which need attention and the level and trend
of profits
A typical performance appraisal question can take many forms, discussed below.

1.2 Vertical or trend analysis (i.e. this year vs last year)

A company's performance may be compared to its previous period's performance. Past results may be
adjusted for the effects of price changes. A weakness of this type of comparison is that there are no
independent benchmarks to determine whether the chosen company's current year results are good
42 5: Interpreting financial statements AC C A F7

or bad. Just because a company's results are better than its results in the previous financial period it
does not mean the results are good. It may be that its results in the prior year were particularly poor.

1.3 Horizontal analysis (i.e. Co. A versus Co. B)

To try to overcome the problem of vertical analysis, it is common to compare a company's
performance for a particular period with the performance of an equivalent company for the same
period. This introduces an independent yardstick to the comparison. However, it is important to pick a
similar sized company that operates in the same industry. Again, this type of analysis is not without
criticism ─ it may be that the company selected as a comparator may have performed particularly well
or particularly poorly.

1.4 Industry average comparison (e.g. Co. A versus industry average)

This type of analysis compares a company's results (ratios) to a compilation of the average of many
other similar types of company.
The context of the analysis needs to be kept in mind. You may be asked to compare two companies as
a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a
shareholder may be asking for advice on how their investment in a company has performed. A bank
may be considering offering a loan to a company and requires advice.

2 Question scenarios
Most questions on this topic will have information in the scenario that requires particular
consideration. A common complaint from markers is that candidates often make no reference to such
circumstances. In effect, the same answer would be given regardless of what the question said. It is
worth noting that there are many 'clues' in the question ─ ignore them at your peril.
By far the most common complaint by markers is that candidates' comments explaining the movement
or differences in reported ratios lack any depth or commercial understanding. A typical comment may
be that “receivables collection has improved from 60 days to 40 days”. Such a comment does not
constitute interpretation ─ it is a statement of fact. To say a ratio has gone up or down is not helpful or
meaningful.
What is required in a good answer are the possible reasons as to why the ratio has changed. There
may be many reasons why a ratio has changed and no-one can be certain as to exactly what has
caused the change. All that is required are plausible explanations for the changes. Even if they are not
the actual cause, marks will be awarded.
We encourage you to use words such as “this may be due to …” in your answer.
Questions often ask for answers in a report format. Your solution should therefore follow the format :
To :
From :
Date :
Subject :
Then, use a brief introduction, followed by headings such as “profitability” and “liquidity” to cover the
main movements in the scenario.
A conclusion/summary is often useful too.
AC C A F 7 5: Interpreting financial statements 43

3 Other aspects of interpretation

Ratio analysis on its own is not sufficient for interpreting a set of company accounts. There are other
pieces of information which should be looked at, for example:
 Absolute figures, e.g. this year’s turnover or profits compared to last year’s.
 The content of any accompanying commentary on the accounts and other statements.
 The background of the company or industry information.
 Current and future developments in the company's markets, at home and abroad, recent
acquisitions or disposals of a subsidiary by the company;
 Events after the statement of financial position date.
 The accounting policies used.
 A modified auditor's report.
 Inflation.
 Seasonality or year-end figures may not be representative e.g. major non-current assets
purchased just prior to the year end will not necessarily have incurred a full year’s depreciation
charge yet.
 Related party transactions which are not at an arm’s length.
 Past performance is not necessarily a good indicator of future performance.
 “Window dressing” – some companies manipulate their figures in the short term. For example,
raising invoices pre year end and reversing them post year end.
 Non-financial information such as the company’s commitment to the environment or its
charitable donations is becoming more and more relevant.

4 The key ratios

Three major categories:
Profitability
 Gross profit How profitable is a company?
 Net profit How well is a company run?
 Return on capital employed What return can shareholders expect?
 Asset turnover
Liquidity
 Current ratio How easily can a company meet its debts
 Quick ratio (acid test) and obligations?
 Receivables collection period How effectively does a company manage
 Payables payment period its working capital?
 Inventory turnover
Gearing and funding
 Assets funded by debt How much borrowing does a company
 Interest cover have? Can it meet its’ interest and
 Dividend cover dividend payments?

Ratios are calculated using figures in the company’s statement of profit or loss and statement of
financial position.
44 5: Interpreting financial statements AC C A F7

The term working capital means a company’s net current assets, i.e. inventories, receivables less
payables. Generally a business is said to “manage” its working capital if it maximises cash generation
from these items, i.e. with shorter payment periods for receivables, and quick turnaround of
inventory.
We will illustrate each of these ratios using example financial statements.
ABC Ltd Statement of profit or loss for the year ended 31 December 2008
2008 2007
$ $
Revenue 10,000 7,700
Cost of sales (4,500) (4,000)
Gross profit 5,500 3,700
Other income 300 250
Distribution costs (1,000) (900)
Administrative expenses (400) (390)
Other expenses (150) (160)
Finance cost (80) (20)
Profit before tax 4,170 2,480
Income tax expense (1,500) (1,000)
Net profit for the period 2,670 1,480

ABC Ltd Statement of financial position at 31 December 2008

2008 2007
ASSETS $ $
Non-current assets
Land and buildings 6,000 3,600
Property, plant and equipment 500 550
Goodwill 350 350
6,850 4,500
Current assets
Inventories 600 500
Trade and other receivables 400 320
Other current assets 100 80
Cash and cash equivalents 200 240
1,300 1,140
Total assets 8,150 5,640

EQUITY and LIABILITIES

Capital and reserves
Share capital 1,000 700
Share premium 200 0
General reserve 300 300
Retained profits 3,000 2,430
4,500 3,430
Non-current liabilities
Loans 500 125
Current liabilities
Trade and other payables 700 715
Accruals 50 70
Income tax payables 300 300
Dividend payable 2,100 1,000
3,150 2,085
Total equity and liabilities 8,150 5,640
AC C A F 7 5: Interpreting financial statements 45

4.1 Profitability ratios

Gross profit margin = Gross profit
Revenue

2008 2007
5,500 = 55% 3,700 = 48%
10,000 7,700
 Used to make pricing decisions – increased selling price relative to direct costs will result in
increased gross profit margin.
 This ratio won’t generally change dramatically from one period to the next, as a company will
normally decide at what profit margin it wishes/is able to sell its products. Gross profit margins
may fall if a company lowers selling prices in an attempt to sell more goods. Note that the
volume of goods sold won’t affect this ratio.
 Falling margin may be due to increase costs or reduced prices to buy market share.
 Check that policies are consistent.
 Improved / reduced purchasing power.

Operating profit margin = Profit before interest and tax

Revenue

2008 2007
4,170 + 80 = 42% 2,480 + 20 =32%
10,000 7,700
 Can reflect how efficiently a business is being run, i.e. through controlled overheads or
economies of scale.
 Note: you need to be careful when calculating PBIT. Most statements of profit or loss only give
PBT so you will need to add back the interest charge to arrive at PBIT.

Net asset turnover = Revenue

TALCL (SF + NC liabilities)

2008 2007
10,000 = 2.0 7,700 = 2.17
(8,150–3,150) (5,640–2,085)
 Measures how much turnover is generated for every $ of assets employed
 When were new assets acquired?
 What are new assets used for?
 Are they working efficiently and or have they improved performance?

Return on capital employed (ROCE) = Profit before interest and tax

TALCL (= SF + NC liabilities)

2008 2007
4,250 = 0.85 2,500 = 0.7
(8,150 – 3,150) (5,640–2,085)
 Measures how much profit is generated for every $ of assets employed.
 Indicates how efficiently the company uses its assets.
 Different industries will have different benchmark rates as some businesses will be more capital
intensive than others, say service businesses.
46 5: Interpreting financial statements AC C A F7

ROCE is the only ratio which compared profits to the overall size of the business and is sometimes
called the primary ratio in ratio analysis.

ROCE = Operating Profit margin × Net Asset turnover

4.2 Liquidity ratios

The term liquid means “readily convertible into cash”. Certain assets are more readily convertible into
cash, e.g.
Cash and bank deposits – is already cash!
Reducing
liquidity

Receivables – require a customer to pay to turn into cash

Inventory – must sell goods and then receive cash from the customer

Working capital is defined as current assets – current liabilities

Current ratio = Current assets

Current liabilities

2008 2007
1,300 = 0.41 1,140 = 0.55
3,150 2,085
 Measures how easily a company can meet its current obligations.
 Less than 1 means CL > CA and could be a cause for concern, e.g. how will company pay tax and
dividend?
 “Correct” level depends on the industry:
– Too high indicates too much cash tied up in working capital
– Too low and we cannot meet obligations as they fall due

Quick ratio = Current assets – Inventory

Current liabilities

2008 2007
700 = 0.22 640 = 0.31
3,150 2,085
 In times of crisis, businesses struggle to sell inventory quickly.
 Quick ratio (or acid test) sometimes seen as better test of liquidity.

Receivables collection period = Trade receivables × 365

Credit sales

2008 2007
400 × 365 = 14.6 days 320 × 365 = 15.2 days
10,000 7,700
 Shows how quickly customers settle their debts
 Depends on credit policy
 Competitors/ Industry average?
 Quality of management or credit control team
AC C A F 7 5: Interpreting financial statements 47

Payables payment period = Trade payables × 365 Credit

Purchases (or COS)

2008 2007
700 × 365 = 56.8 days 715 × 365 = 65.2 days
4,500 4,000
 Shows how quickly a business pays its suppliers
 Is business struggling to pay suppliers?
 Will this affect supply and therefore ability to fulfil orders?
 Preferable to use “credit purchases” as the denominator but ok to use “COS” if this isn’t
available

Inventory days = Inventory × 365

COS

2008 2007
600 × 365 = 48.7 days 500 × 365 = 45.6 days
4,500 4,000
 Shows how long a business takes to sell its inventory.
 Ideal inventory holding depends on nature of inventory (e.g. perishable foods v stationery).
 No business wants too much inventory.
 Risk of obsolete inventory.
 There is a cost to holding inventory.
You may be asked for the rate of inventory turnover, which is:
COS
Inventory
In the above example this would be 4,500/600 = 7.5 times, i.e. the company would turnover its
inventory 7.5 times in 2008.
The operating, or cash, cycle
This is the total time taken from purchase of raw materials to collection of cash. It can be measured as:
Inventory days x
Plus Receivables days x
Less Payables days (x)
Operating cycle days x

The lower the cycle the better. Companies like Dell and Tesco have low debtors and hold on to the
customers’ cash before paying suppliers and with JIT processes they may have a negative operating
cycle.

4.3 Investor ratios

Div idendper share
 Dividend yield = %
Marketshareprice

EPS Earnings(Profit after tax )

 Dividend cover = or
Div idendper share Div idendspaid
48 5: Interpreting financial statements AC C A F7

4.4 Gearing
Companies may be financed by equity or borrowings, or a mixture of both.
High gearing means there is a high proportion of borrowing (loans)
Low gearing means there is a high proportion of equity (shares)
Generally, the higher the level of gearing the more risky a company is (because loans attract a fixed
rate of return and may have specified repayment dates).

Gearing ratio = Interest bearing debt (excl. overdraft, incl Pref shares)
TALCL (SF + NC Liabilities)

2008 2007
500 = 10% 125 = 3.5%
4,500 + 500 3,430 + 125
 Low levels signifies low risk.
 No ideal: depends on industry standards and economic situation in particular countries.
 Higher the gearing the more difficult it maybe to borrow in the future especially in a credit
crunch.

Interest cover = PBIT

Interest payable expense

This ratio shows how many times the interest expense can be covered by profits. In simple terms, the
higher this figure is, the easier the company will find it to pay its interest expense.
Advantages of gearing Disadvantages of gearing
Debt cheaper than equity Harder to raise extra finance
 Interest is fixed while profits grow in times  Lenders unlikely to advance more funds if loans
of inflation or economic growth already exist
 Interest is tax deductible  Shareholders may not wish to buy shares as more
risky (dividends paid after interest)

5 Specialised, not-for-profit and public sector entities

Whereas the objective of private companies is, in general, to maximise the wealth of their
shareholders, the objective of not-for-profit or public sector organisations will depend on the nature of
the business that they are in. For example, the objective of a health service will be reduced waiting
lists and increased life expectancy, whereas Oxfam’s objectives will revolve around helping to reduce
poverty around the world.
It is worth acknowledging that even though such organisations don’t exist to increase the wealth of
shareholders, that doesn’t mean that they should act inefficiently. Cost control, inventory
management and providing “value for money” are core features of almost all organisations and so
some of the ratios outlined earlier in this chapter will still be relevant.
Most issued IFRSs are relevant for both profit-making and not-for-profit organisations. However,
standards such as Earnings per Share are not as relevant for not-for-profit organisations as
“performance” is not a key indicator for such entities.
 49

Statement of cash flows

1 Introduction
Businesses should measure cash flows in addition to profits. Profits may differ from cash flows because
certain items are charged against profit even if there is no cash effect, e.g. depreciation, sales on
credit. Cash flows are not affected by an entity’s choice of accounting policies, or by accounting
estimates.
One way to value a business is by considering its ability to generate cash.
Statements of cash flows:
 Link statement of profit or loss and opening and closing statement of financial positions, i.e.
explains changes in financial position during a period
 Easier to understand than statements of profit or loss
 Less easy to manipulate than statement of profit or loss
 Enhance comparability of financial statements
50 6: Statement of cash flows AC C A F7

2 Definitions
KEY TERMS
 Cash. Cash on hand and demand deposits.
 Cash equivalents. Short term, highly liquid investments, readily convertible to cash.
 Operating activities. Principal revenue-producing activities.
 Investing activities. Acquisition and disposal of non-current assets and other
investments not included in cash equivalents.
 Financing activities. Result in changes in the size and composition of the equity capital
and borrowings of the entity

2.1 Indirect v Direct method

 Indirect method most commonly used as is easier to prepare. Net profit or loss is adjusted for
changes in working capital and non-cash items included in the statement of profit or loss.
 Direct method shows total gross cash receipts and payments and is therefore more useful to
the user, but is more time consuming to prepare and is rarely used. IAS 7 permits either
method.

3 Pro forma statement of cash flows – indirect method

EXAM SMART
LEARN THIS PROFORMA!
AC C A F 7 6 : St a t e m e n t o f c a s h f l o w s 51

FiT Limited – Statement of cash flows (indirect method) for year ended 2011
$m $m
Cash flows from operating activities
Profit before taxation 3,390
Adjustments for:
Depreciation 450
Loss on disposal of property, plant and equipment 100
Investment income (500)
Interest expense 300
3,740
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,380
Cash flows from investing activities
Purchase of property, plant and equipment (900)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid* (1,200)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 110
Cash and cash equivalents at beginning of period (Note) 120
Cash and cash equivalents at end of period (Note) 230

* This could also be shown as an operating cash flow

Notes to the statement of cash flows
Note: Cash and cash equivalents (a useful working to use not examined specifically).
2011 2010
$m $m
Cash on hand and balances with banks 40 25
Bank overdraft (-) (-)
Short-term investments 190 95
Cash and cash equivalents 230 120

4 Preparing a statement of cash flows – indirect method

4.1 Cash flows from operating activities
A $ of profit is not a $ of cash. We have to adjust the profit figure for:
 Non-cash items, e.g. depreciation, profit/loss on disposal of non-current asset
 Items appearing elsewhere in the cash flow statement, e.g. interest
52 6: Statement of cash flows AC C A F7

(a) Working capital changes

If we make a sale on credit and a customer has not yet paid, we have less cash than sales would
indicate. Similarly, if we don’t pay a creditor, we have more cash than purchases would indicate.
The same applies to inventory. If inventory increases, profit is unaffected, as closing inventory is
deducted from COS. Cash decreases however as we have used it to buy the extra inventory.
In the exam, you may be asked to calculate the movement in trade receivables, trade payables
and inventories.

ILLUSTRATION 6.1: WORKING CAPITAL CHANGES

Extract from a company’s SFP:

2011 2010
$ $
Trade receivables 100 136
Inventories 40 70
Trade payables 35 48
Resulting extract from the company’s statement of cash flow:
Cash flows from operating activities
$
Decrease in trade receivables 36
Decrease in inventories 30
Decrease in trade payables (13)
The important thing to note here is whether the figures go in brackets (indicating a cash outflow) or no
brackets (indicating a cash inflow).

In the illustration above, you should be able to see the logic in the fact that if trade receivables
have gone down, then that means that, net, our customers have paid us  cash inflow.
Likewise, if inventories have decreased, that means we’ve sold them  cash inflow.
And finally, if trade payables have decreased then, net, we’ve paid our suppliers  cash outflow.
Obviously, the opposite would apply if the figures had increased.
(b) Income taxes paid
You may be given a statement of profit or loss and this and last year’s statement of financial
position.
Income tax paid will be the figure in the statement of profit or loss adjusted for opening and
closing income tax payables.

ILLUSTRATION 6.2: INCOME TAXES PAID

2012 2011
$ $
Deferred tax provision 100 45
Income tax payable 70 60
You are also told that the income tax expense for 2012 is $100.
AC C A F 7 6 : St a t e m e n t o f c a s h f l o w s 53

$
Bal b/f (IT of 60 + DT 45) 105
Stmt of P or L 100
Therefore, tax paid bal (35)
Bal c/f (IT of 70 + DT of 100) 170

This technique works for interest paid and dividends paid too.

(c) Cash flows from investing activities

Here we have cash flows for acquisition and disposal of non-current assets and investments and
the returns received from investments.
You may have 4 pieces of information about non-current assets in a cash flow statement (more if
assets are revalued).

These are adjusting items in arriving at “operating

 Depreciation
profit before working capital changes”
 Profit/loss on sale

 Cost of new assets These are included in “cash flows from

 Proceeds from sale of asset investing activities”

Note. If the Examiner gives information about cost and accumulated depreciation, you may
need two separate non-current asset and accumulated depreciation accounts.
If you are given information in net carrying amount terms, you will only need one “non-current
asset at NCA” account.

ILLUSTRATION 6.3: CASH FLOWS FROM INVESTING ACTIVITIES

The following balances were extracted from the books of Fixed Ltd:
2011 2010
$ $
Plant and equipment at cost 10,000 8,000
Accumulated depreciation (2,500) (1,500)
NBV 7,500 6,500

During the year an item of plant was sold for $1,000. This had originally cost $2,500 and had a net
book value of $1,400 at the date of sale.
Required:
Show the relevant extracts from the statement of cash flows.

STEPS
Step 1: Consider the checklist. Have we been given the following?
 Depreciation expense? X
 Profit or loss on sale? X
 Additions? X
 Sale proceeds? √
54 6: Statement of cash flows AC C A F7

Step 2: Set up workings for asset at cost, accumulated depreciation and disposals to find the
three missing figures.
(W1) Plant: cost
$
b/f 8,000
Disposal at cost (2,500)
Additions (bal) 4,500
c/f 10,000

(W2) Plant: accumulated depreciation

$
b/f 1,500
Disposal : accum dep’n (1,100)
Dep’n charge (bal) 2,100
c/f 2,500

Profit or loss on disposal

$
Proceeds 1,000
Less : NCA (1,400)
= Profit / (loss) on disposal (400) loss

Step 3: Show the relevant entries in the cash flow statement.

Fixed Ltd Statement of cash flows for the year ended 31 December 2011
$
Cash flow from operating activities
Net profit before taxation XXXX
Depreciation 2,100
Loss on sale 400
Operating profit before working capital changes YYYY
Increase in inventory etc (ZZZ)
Cash flow from investing activities
Purchase of plant (4,500)
Proceeds from sale of plant 1,000
Note how a loss on disposal is ADDED BACK (since it is a non-cash expense in the statement of profit or
loss).
Similarly, a profit on disposal would be DEDUCTED.

4.2 Cash flows from financing activities

Examples:
 Proceeds from share and loan issues
 Repayment of borrowings/shares
 Dividends paid
AC C A F 7 6 : St a t e m e n t o f c a s h f l o w s 55

ILLUSTRATION 6.4: CARTER LTD

The following balances were extracted from the books of Carter Ltd:
2008 2007
$ $
Share capital ($1 NV) 1,450 1,000
Share premium 600 0
During the year there was a 1:5 bonus issue followed by an issue at full price. The bonus issue was
funded out of retained earnings.
Required:
Calculate the cash raised from share issues during the year.

STEPS
Step 1: Bonus issue
Dr Retained earnings (1/5 × $1,000) $200
Cr Share capital $200
Step 2: Cash received
Simply take the opening balances away from the closing balances so:
$1,450 – $1000+$600 – $0= $,1050
Now because the bonus issue is from retained earnings and there is no cash deduct this too. So cash
received = $ 1050 – $ 200= 850

EXAM SMART
In the exam, use the following table to get to the right numbers quickly.

Share Share
capital premium
$ $
Bal b/f 1,000 Nil
Bonus issue 200 Nil
Therefore, “another share issue” – assume for cash Balance 250 600
Bal c/f 1,450 600

Therefore, cash received = 850

56 6: Statement of cash flows AC C A F7

LECTURE EXAMPLE 6.1: FULL STATEMENT OF CASH FLOWS

Below are the statements of financial position for Patchin Ltd at 31 December 2010 and 31 December
2011 and the statement of profit or loss for the year ended 31 December 2011.
Patchin Ltd Statement of profit or loss for the year ended 31 December 2011
$000
Revenue 800
Cost of sales and expenses (711)
Profit before tax 89
Income tax expense (110)
Loss for the year (21)
Other comprehensive income:
Gain on property revaluation 60
39

Patchin Ltd Statement of financial position as at 31 December 2011

2011 2010
ASSETS $000 $000
Non-current assets
Property, plant and equipment 512 397
Development costs 80 13
Current assets
Inventories 420 370
Trade receivables 250 189
Investments 30 –
Cash 25 8
TOTAL ASSETS 1,317 977

EQUITY AND LIABILITIES

Equity
$1 ordinary shares 200 165
Share premium 211 100
Revaluation surplus 60 –
Retained earnings 246 278
Non-current liabilities
Debentures 140 –
Deferred tax 30 17
Finance lease liabilities 20 10
Current liabilities
Trade payables 170 210
Finance lease liabilities 90 55
Income tax payable 90 100
Provision for warranties 50 35
Bank overdraft 10 7
TOTAL EQUITY AND LIABILITIES 1,317 977

Notes:
(1) Deferred development expenditure amortised during 2011 was $15,000.
(2) Additions to property, plant and equipment totalling $160,000 were made. Also, Patchin
purchased $61,000 of property, plant and equipment via a finance lease.
AC C A F 7 6 : St a t e m e n t o f c a s h f l o w s 57

(3) Proceeds from the sale of equipment were $60,000, giving rise to a profit of $9,000. No other
items of property, plant and equipment were disposed of during the year.
(4) Expenses include interest paid on the new 5% debentures issued on 1 January 2011.
(5) Current asset investments are deemed to be “cash equivalents”.
(6) A bonus issue of 1 for 15 ordinary shares was made on 1 January 2011 from retained earnings,
the remaining share issue during the year was made for cash.
Required:
Prepare a statement of cash flows for Patchin Ltd for the year ended 31 December 2011, in accordance
with IAS 7.
Patchin Ltd Statement of cash flows for the year ended 31 December 2011

Cash flows from operating activities $000 $000

Profit before taxation
Adjustments for:
Depreciation
Amortisation
Interest expense
Profit on disposal of equipment

Increase in trade receivables

Increase in inventories
Decrease in trade payables
Increase in provisions
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
Cash flows from investing activities
Development expenditure
Purchase of property, plant and equipment
Proceeds from sale of equipment
Net cash used in investing activities

Cash flows from financing activities

Proceeds from issue of shares
Proceeds from issue of debentures
Payment of finance leases
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at the beginning of period 1
Cash and cash equivalents at end of period
58 6: Statement of cash flows AC C A F7

Workings
(W1) – PPE

$000
b/f

(W2) – Intangible assets

$000
b/f

(W3) – Share issue

Share capital Share premium

$000 $000
Bal b/f
Bonus issue : 1 for 15
Therefore, “another share issue” – assume
for cash Balance
Bal c/f
Therefore, cash received =

(W4) – Retained earnings

$000
b/f 278
AC C A F 7 6 : St a t e m e n t o f c a s h f l o w s 59

(W5) – Tax paid

$000
b/f

(W6) – Finance lease liability

$000
b/f

5 Direct method
The operating activities element of the statement of cash flows should be shown as follows:
$000 $000
Cash flows from operating activities
Cash receipts from customers X
Cash paid to suppliers and employees (X)
Cash generated from operations X
Interest paid (X)
Income taxes paid (X)
Net cash from operating activities X
Cash receipts from customers
This represents cash flows received during the accounting period in respect of sales and can usually be
derived from a simple trade receivables T account.
Cash paid to suppliers and employees
This represents cash flows made during the accounting period in respect of goods and services and
amounts paid to employees including the associated tax. It will, therefore comprise gross salaries and
any other benefits.
60 6: Statement of cash flows AC C A F7

ILLUSTRATION 6.5: DIRECT METHOD

Using the figures from Lecture example 1, show how the cash generated from operations would be
presented in Patchin’s statement of cash flows under the direct method.
SOLUTION
Direct method
$000
Cash flows from operating activities
Cash receipts from customers (W1) 739
Cash paid to suppliers and employees (W4) (658)
Cash generated from operations 81

Workings
(W1): Trade receivables
$000
b/f 189
Revenue 800
Cash received (bal) (739)
c/f 250

(W2): Purchases
$000
Opening inventory 370
+ “Purchases + expenses” (bal) 761
– Closing inventory (420)
= Cost of sales + expenses 711

(W3): Adjust purchases for non-cash items

$000
Purchases + expenses (from above) 761
Depreciation (115)
Amortisation (15)
Profit on disposal 9
Increase in provision (15)
Interest expense (7)
618

(W4): Trade payables

$000
b/f 210
Purchases 618
Cash paid (bal) (658)
c/f 170
 61

The conceptual and regulatory

framework for financial reporting

1 Introduction
The IASB’s Conceptual Framework for Financial Reporting is a set of generally accepted accounting
principles, which form the basis of all International Accounting Standards. The objective of such a
framework is to enable standard-setters to achieve a consistent and coherent set of fundamental
principles which will help users of financial statements to form more complete assessments of
companies’ performance.
The IASB Conceptual Framework assists

 Preparers of financial statements in applying international standards and in dealing with topics
that have yet to form the subject of an International Financial Reporting Standard
 Auditors in forming an opinion as to whether financial statements conform with IFRS
 Users of financial statements in interpreting the information contained in financial statements
prepared in conformity with IFRS
 Those who are interested in the work of IASB, providing them with information about its
approach to the formulation of accounting standards.
Whilst not a standard, the IASB’s Conceptual Framework serves as a guide to resolving accounting
issues that are not addressed directly in a standard. It assists accountants to assess the appropriate
treatment of an item. It is NOT intended that its principles should override a specific IFRS where the
two conflict.
62 7: The conceptual and regulatory framework for financial reporting AC C A F7

1.1 Distinguish between a principles-based and a rules-based framework

A rules-based accounting system is likely to be very prescriptive and is generally considered to be a
system which relies on a series of detailed rules that prescribe how financial statements should be
prepared.
Such a system is considered less flexible, but often more comparable and consistent than a principles-
based system.
Some would argue that rules-based systems can lead to looking for ‘loopholes’.
Also, it is not possible for rules to cover all possible accounting transactions.
By contrast, a principles-based system relies on generally accepted accounting principles that are
conceptually based and are normally underpinned by a set of key objectives.
They are more flexible than a rules-based system, but they do require judgement and interpretation
which could lead to inconsistencies between reporting entities and can sometimes lead to the
manipulation of financial statements.
Because IFRSs are based on The Conceptual Framework for Financial Reporting, they are often
regarded as being a principles-based system. Of course IFRSs do contain many rules and requirements
(often lengthy and complex), but their critical feature is that IFRS ‘rules’ are based on underlying
concepts.
In reality most accounting systems have an element of both rules and principles and their designation
as rules-based or principles-based depends on the relative importance and robustness of the principles
compared to the volume and manner in which the rules are derived.

2 The IASB’s Conceptual Framework

The Conceptual Framework helps companies to resolve any issue for which there is no specified
treatment, whilst staying within the parameters which are deemed acceptable to the accountancy
world.
The key elements of the Conceptual Framework are as follows.

2.1 The objective of general purpose financial reporting

The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity.
Many existing and potential investors, lenders and other creditors cannot require reporting entities to
provide information directly to them and must rely on general purpose financial statements for much
of the financial information they need. Consequently, they are the primary users to whom general
purpose financial reports are directed.
However, general purpose financial reports do not and cannot provide all of the information that
existing and potential investors, lenders and other creditors need. Those users need to consider
pertinent information from other sources, e.g. general economic conditions and expectations, political
events and political climate, and industry and company outlooks.

2.2 Qualitative characteristics of useful financial information

The qualitative characteristics of useful financial information identify the types of information that are
likely to be most useful to existing and potential investors, lenders and other creditors for making
decisions about the reporting entity on the basis of information in its financial report (financial
information).
AC C A F 7 7: The conceptual and regulatory framework for financial reporting 63

They are categorised into two categories:

 Fundamental qualitative characteristics
 Enhancing qualitative characteristics.

Fundamental qualitative characteristics

These are the characteristics needed to ensure that the financial statements are “true and fair”.
 Relevance - Information in financial statements is relevant when it is capable of making a
difference in the economic decisions of users. Relevant information has predictive and/or
confirmatory value i.e. it helps users to assess past, present or future events (predictive value)
and helps users to confirm past assessments (confirmatory value).
Materiality is a threshold quality of information. Items need to be material if they are to be of
any importance to users. Information is material if omitting it or misstating it could influence
the decisions that users might make based on the financial statements of a specific reporting
entity.
 Faithful representation – Faithful representation replaces the previously used term “reliability”.
Information which faithfully represents economic phenomena generally has three key
characteristics :
 It is complete
 It is neutral
 It is free from error
Faithful representation implies that financial information should reflect the economic substance
of an entity’s transactions, even where this is different from their legal form.

Enhancing qualitative characteristics

There are four characteristics which enhance the usefulness of information:
 Comparability –Comparability should enable users to identify similarities and differences
between items, both between different periods for the same entity and between different
entities. Comparability is facilitated by the existence and disclosure of accounting policies.
 Verifiability – Verifiable information which enables users to determine whether a particular
accounting treatment is a faithful representation. . Some figures in a set of financial statements
can be directly verified e.g. by counting cash.
 Timeliness – To be useful, information must be provided to users within a reasonable time.
 Understandability – information should be presented in such a way that it is understandable by
users with reasonable business knowledge. This can present management with a problem
because clearly not all users have the same (financial) abilities and knowledge. However, useful
information should not be omitted from the financial statements simply because it may be too
complex for some users to understand.
There is also the fundamental underlying assumption that the company preparing the financial
statements is a going concern i.e. the financial statements are being prepared on the assumption that
an entity is a going concern and will continue in operation for the foreseeable future.

2.3 The elements of financial statements

Financial statements portray the financial effects of transactions by grouping them into broad classes
according to their economic characteristics.
 Assets - 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.
64 7: The conceptual and regulatory framework for financial reporting AC C A F7

 Liabilities - a present obligation of the entity arising from past events, the settlement of which is
expected to result in an economic outflow from the entity of resources embodying economic
benefits.
 Equity - The residual interest in the assets of an entity after deducting all its liabilities, so
EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES
 Income - Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
 Expenses - Decreases in economic benefits during the accounting period in the form of outflows
or depletions of assets or increases of liabilities that result in decreases in equity, other than
those relating to distributions to equity participants.

2.4 Recognition of the elements of financial statements

Recognition means inclusion in the financial statements. The recognition criteria are:
 An item meets the definition of an element; and
 It is probable that any future economic benefit associated with the item will flow to or from the
entity; and
 The item's cost or value can be measured with reliability.
One of the more important aspects of recognition is when to recognise sales revenue (see Chapter
13).

2.5 Measurement of the elements of financial statements

Once an element is recognised in the financial statements, we need to ensure that it is recorded at the
correct monetary amount:

2.5.1 Historical cost

Most elements in the statement of financial position are measured at historical cost i.e. the amount of
cash that was paid to acquire them (or the cash that will be paid to settle them).
Advantages
 Easy to calculate and prove
 Concept is familiar to users
Disadvantages
 Out of date assets lead to information which isn’t “relevant”
 These “out-of-date” assets lead to “out-of-date” costs being recorded (e.g. depreciation)

2.5.2 Net Realisable value

Values items at the amount of cash that is expected to be received/paid upon selling/settling that
item.

2.5.3 Current cost

The amount of cash that would need to be paid today in order to acquire an equivalent asset. This
method of measurement is used in times of very high inflation.
AC C A F 7 7: The conceptual and regulatory framework for financial reporting 65

2.5.4 Present value of future cash flows

The present discounted values of future net cash flows that an asset is expected to generate or that
are expected to be paid in order to settle a liability.

2.5.5 Fair value

The price that would be received to sell an asset or price paid to transfer a liability (exit
price) in an orderly transaction between market participants at measurement date.

IFRS 13 Fair Value Measurement emphasises that fair value is a market based measurement based on
current market conditions rather than the intentions of an entity. It is assumed that an asset will be
sold in its principal or most advantageous market. The condition and location of the asset should be
taken into account, together with any restrictions on sale or use. The fair value of a non-financial asset
should take into account its highest and best use.
An entity should use the valuation technique that is appropriate for it given its circumstances. To help
this decision, the standard provides a fair value hierarchy detailing the inputs which companies should
use to help determine the fair value of an item:
 A level 1 input will be a quoted price from an active market for an identical asset e.g. the share
price of a publicly traded equity investment.
 A level 2 input is one which is observable directly or indirectly for the asset. E.g. the quoted
price of a similar asset in an active market.
 A level 3 input is an unobservable input, based on the best information available e.g. the
estimated present value of the future cash flows relating to an item.

2.6 Concepts of capital and capital maintenance

It is possible to think of an entity’s profit as the difference between its capital at the beginning and end
of a period.
“Capital” could be defined in terms of:
 Financial capital – shareholders’ funds, represented by the share capital and reserves of a
statement of financial position – an entity only makes a profit if its shareholders’ funds increase
after taking inflation into account.
 Physical/Operating capital – the physical assets and liabilities needed to keep the company
running – in times of rising prices, an entity can only earn a profit if its physical productive
capacity increases during the year.
Capital maintenance is a concept that is intended to ensure that excessive dividends are not paid in
times of rising prices, (i.e., that an entity’s capital is maintained).

3 Specialised, not-for-profit and public sector entities

The primary aims of public sector and not-for-profit entities such as charities are likely to differ from
“normal” profit-making entities in that their goals will revolve around a strategy other than the
maximisation of revenue and the minimisation of costs. For example:
 A local council will focus on providing value for money for the local community in the provision
of libraries, schools and hospitals.
 A charity will have a non-financial target such as the protection of wildlife or the promotion of
healthy eating.
 A hospital will aim to treat as many patients as possible with the available resources.
66 7: The conceptual and regulatory framework for financial reporting AC C A F7

There is no requirement for public sector entities to use IFRSs although there are moves to promote
their use to aid the comparability of accounts across the globe.

4 Regulatory framework
4.1 Advantages of IFRS over a national framework
 Since IFRSs have been produced in co-operation with other internationally renowned standard
setters, a company using IFRS may enhance its status and reputation (for example, an improved
credit rating).
 Its own financial statements would be comparable with other companies that use IFRS. This
would help the company to better assess and rank prospective investments.
 The use of IFRSs may make the audit fee less expensive.
 If a company needs to raise finance in the future, it will find it easier to get a listing on any
security exchange.

4.2 The standard setting process

There are four basic steps in the process leading to the publication or revision of an International
Financial Reporting Standard (IFRS):

STEPS
Step 1: Identify a subject and e stablish an advisory committee
Step 2: Issue a discussion paper setting out the possible options for a new standard, with public
comment invited (this may be issued after the exposure draft).
Step 3: Issue of Exposure Draft (again with public comment invited), being a draft of the final
standard. Any feedback on this draft or the discussion paper would be analysed.
Step 4: Issue of final IFRS

4.3 Scope
Not all businesses have to prepare financial statements. The following list summarises the requirement:
 Sole traders and partnerships – No requirement.
 Private limited companies – UK standards, but may apply IFRS
 Small limited companies – Exempt
 Listed public limited companies – IFRS

5 IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors

5.1 Accounting policies
Accounting policies are the significant principles, bases, conventions, rules and practices applied by an
entity in preparing and presenting the financial statements.
AC C A F 7 7: The conceptual and regulatory framework for financial reporting 67

5.2 Changes in accounting policy

Generally, an entity should use the same accounting policies from one period to the next
(consistency). However, an entity should only change an accounting policy if:
 There is a new statutory requirement or accounting standard
 The new policy presents more relevant information about the financial statements
A change in accounting policy occurs if there is a change in:
 recognition e.g. recognising an item as an asset rather than an expense,
 presentation e.g. Co A is an accountancy training college which has previously presented
tutor salaries as “administrative” expenses. It has now decided that “cost of sales” is a more
suitable category of expense, or
 measurement basis of an item e.g. using replacement cost instead of historical cost

Accounting treatment
If a change in accounting policy takes place, the entity should not only adjust this year’s figures, but
should also, as far as practicable, adjust the comparative amounts for the prior period. This has the
effect of preparing the financial statements as if the new policy had always been in place
(“retrospective application”).
In the exam this may mean adjusting the current year figures and adjusting the retained earnings
brought forward in the statement of changes in equity (see Chapter 8).
This will be the case UNLESS the change in accounting policy is due to a change in the IFRS and the IFRS
states that you shouldn’t apply the change retrospectively. Therefore, a company that changes from a
cost model to a revaluation model for PPE would experience a change in accounting policy, but this
would be treated prospectively, not retrospectively; i.e. we would NOT restate last year’s figures to a
revalued amount.
Examples of change in accounting policy include:
 Changing from FIFO to weighted average on inventory valuation.
 Measuring assets at fair value having previously measured them at historic cost.
Key disclosures
 The nature of the change in accounting policy,
 The reasons why the change provides more relevant and reliable information,
 The amount of the adjustment for the current and each prior period presented,
 The amount of the adjustment to periods before those presented.

5.3 Changes in accounting estimates

A change in accounting estimate is an adjustment to the estimation technique that helps to calculate
the carrying value of an asset.
Changes in accounting estimates result from new information or new developments. Examples of
estimates that may change include:
 Warranty provisions changing from 5% of sales to 10%
 Inventory obsolescence
 Depreciation method changing from straight-line to reducing-balance
 A change in the residual value of an item of PPE
 Changing the useful lives of depreciable assets
Changes in accounting estimates are simply adjusted in the financial statements of the period in which
they arise.
68 7: The conceptual and regulatory framework for financial reporting AC C A F7

5.4 Prior period errors

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:
(a) Was available when the financial statements for those periods were authorised for issue; and
(b) Could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Prior period errors are treated in the same way as changes in accounting policies i.e. the entity should
not only adjust this year’s figures, but should also, as far as practicable, adjust the comparative
amounts for the prior period.
 69

The preparation of financial

statements

1 IAS 1: Presentation of Financial Statements

There are five fundamental accounting concepts which should be applied in all accounting
transactions:
 Accruals Already seen in the
 Going concern Framework in Chapter 7

 Consistency – of presentation and classification from one period to the next

 Offsetting – elements should not be offset unless required or permitted by the relevant
standard
 Materiality and aggregation – each material class of similar items should be presented
separately in the financial statements.

2 Components of financial statements

A complete set of financial statements should include:
 Statement of financial position (SFP) (previously the balance sheet)
 Statement of profit or loss and other comprehensive income (previously the income
statement)
 Statement of changes in equity (SOCIE) showing either:
– all changes in equity, or
– changes in equity other than those arising from transactions with equity holders acting in
their capacity as equity holders
70 8: The preparation of financial statements AC C A F7

 Statement of cash flows, and

 Notes, comprising a summary of accounting policies and other explanatory notes.
Certain items, such as the write-down of inventories or PPE must be disclosed separately in the
statement of profit or loss and OCI if material. These items are sometimes referred to as “exceptional
items”.
Section B in the exam is likely to contain a 15- or 30-mark question on the reporting of non-group
financial statements. This may be from information in a trial balance or by restating draft financial
statements. It is therefore essential that you learn the proformas for each of the above statements.
There are also techniques from the F3 syllabus that are assumed knowledge.
If you are at all unsure of double entry or any basic accounting techniques talk to your tutor now!

3 Proforma financial statements

FiT Ltd – Statement of financial position at 31 December 2014
2014 2013
$000 $000
ASSETS
Non-current assets
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
X X
Current assets
Inventories X X
Trade receivables X X
Other current assets X X
Cash and cash equivalents X X
X X
Total assets X X
EQUITY AND LIABILITIES
Equity
Share capital 70 50
Share premium 15 10
Revaluation surplus 65 20
Retained earnings 170 100
Total equity 320 180
Non-current liabilities
Long-term borrowings X X
Deferred tax X X
Long-term provisions X X
Total non-current liabilities X X

Current liabilities
Trade and other payables X X
Short-term borrowings X X
Current tax payable X X
Short-term provisions X X
Total current liabilities X X
Total liabilities X X
Total equity and liabilities X X
AC C A F 7 8: The preparation of financial statements 71

FiT Ltd – Statement of profit or loss and other comprehensive income for the year ended
31 December 2014
2014 2013
$000 $000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Profit before tax X X
Income tax expense (X) (X)
Profit for the year 200 X

Other comprehensive income:

Gain on revaluation of properties 45 (X)
Total comprehensive income for the year 245 X

FiT Ltd – Statement of changes in equity for the year ended 31 December 2014
Share Share Reval’n Retained Total
capital premium surplus earnings
$000 $000 $000 $000 $000
Balance at
31 December 2013 50 10 20 100 180
Changes in accounting – – –
policies (5) (5)
Restated balance 50 10 20 95 175
Total comprehensive
income 45 200 245
Dividends paid (125) (125)
Issue of share capital 20 5 25
Balance at
31 December 2014 70 15 65 170 320
72 8: The preparation of financial statements AC C A F7

4 Additional notes
4.1 Taxation
One of the most common mistakes made in the exam relates to the taxation figure in the statement of
profit or loss and the statement of financial position (SFP).
Every year end, a company will estimate its tax bill for the year (of, say, $1,000) and will post the
following journal:
(1)
Dr P&L: tax expense $1,000
Cr SFP: tax liability $1,000
Often, this estimate will be revised by the tax inspector, with the actual bill being paid a few
months after the year end. For example, the actual bill might be $1,200 not $1,000 in the above
example. In this case, the following journal would be needed:
(2)
Dr SFP: tax liability $1,200
Cr Cash $1,200
Therefore, there will now be a debit balance of $200 for the tax liability in the SFP even though
the tax liability has been settled.
This $200 represents the under-provision made in last year’s financial statements. Before we
post this year’s tax charge estimate, we need to eliminate this balance with the following
journal:
(3)
Dr P&L: tax expense $200
Cr SFP: tax liability $200
This has the effect of eliminating the statement of financial position figure. We can now post
this year’s estimate of the tax bill.
In the exam, you will often be told that there is an under-provision (DEBIT) or overprovision (CREDIT)
brought forward from the previous year which needs to be eliminated before this year’s tax estimate
is put through.

4.2 Notes to the accounts

A question may ask you to prepare some additional notes to the accounts. These “flesh out” the detail
needed to support the figures in the statement of financial position and statement of profit or loss.
The most likely notes to appear in the exam are:
(a) Income tax expense
Current tax X
Under/overstatement of prior periods X/(X)
Deferred tax (See Chapter 16) X
X
AC C A F 7 8: The preparation of financial statements 73

(b) Property, plant and equipment

Only the total net carrying amount (NCA) of PPE is shown in the SFP. The following note is
essential in any set of financial statements.
Land and Machinery Office Total
buildings equipment
Cost/ Valuation $ $ $ $
Cost/valuation at 1 January 2011 X X X X
Additions X X X X
Revaluation in the year X - - X
Disposals (X) (X) (X) (X)
Cost/valuation at
31 December 2011 X X X X
Depreciation
Accumulated depreciation at
1 January 2011 X X X X
Charge for the year X X X X
Released on disposal (X) (X) (X) (X)
Accumulated depreciation at
31 December 2011 X X X X
Net carrying amount
@ 31 December 2011 X X X X
Net carrying amount
@ 31 December 2010 X X X X

Included within the net carrying amount of plant and machinery is $X in respect of assets held
under finance leases (IAS 17).

4.3 IAS 10: Adjusting and Non-adjusting events

IAS 10 relates to events taking place between the last day of the reporting period (the year end date)
and the date on which the financial statements are approved and signed by the directors.
This period is usually several months.

4.3.1 Adjusting events

Adjusting events are events taking place after the reporting period which provide further evidence of
conditions existing at the end of the reporting period or which call into question the going concern
status of the entity.
For this reason, adjusting events require adjustment to be made to the financial statements. If going
concern is no longer applicable, the financial statements must be prepared on a break-up basis.

Examples
 Settlement of a court case after the reporting date that confirms a present obligation at the
reporting date (if the claim was made before the year end).
 Evidence received after the reporting date indicating that an asset was impaired at the
reporting date, e.g. bankruptcy of a customer or sale of inventory for less than cost (sale or
purchase made before reporting date), or determination of sale proceeds for an asset sold prior
to the year end.
 Discovery of theft, fraud or accounting errors that show that the financial statements are
incorrect (fraud or error made prior to reporting date).
74 8: The preparation of financial statements AC C A F7

4.3.2 Non-adjusting events

Non-adjusting events provide evidence of conditions arising after the end of the reporting period. If
material, these should be disclosed by note, but they do not require that the financial statements be
adjusted.
However, if the event is so significant that it affects the going concern of the company concerned, then
it may be treated as an adjusting event.

Examples
 Decline in market value of an investment between the reporting date and the date when the
financial statements are authorised for issue (change in market conditions after the reporting
date).
 Destruction of an asset, e.g. by fire, after the reporting date (fire occurred after reporting date).
 Announcement of plan to close a manufacturing plant made after the reporting date
(announcement made after reporting date).
 Change in the tax rate announced after the reporting date, but affecting the current tax liability.

ILLUSTRATION 8.2: ADJUSTING EVENT

Company X has a 31 December year end. Just after the year end, in January, company X received
notification of the bankruptcy of a customer. The balance of the trade receivable due from the
customer at the year was $23,000 and at the date of the notification it was $25,000. No payment is
expected from the bankruptcy proceedings.
SOLUTION
This is an adjusting event after the reporting period within the terms of IAS 10. $23,000 should be
written off to irrecoverable debts at the year end and the trade receivables balance correspondingly
reduced.

ILLUSTRATION 8.3: NON-ADJUSTING EVENT

On 12 January after the year end, a fire completely destroyed the company's largest warehouse and
the inventory it contained. The carrying amounts of the warehouse and the inventory were $10 million
and $6 million respectively.
It appears that the company has not updated the value of its insurance cover and only expects to be
able to recover a maximum of $9 million from its insurers. The company's trading operations have
been severely disrupted since the fire and it expects large trading losses for some time to come.
SOLUTION
This is a non-adjusting event as it does not affect the valuation of property or inventory at the year
end.
However, it would be treated as adjusting if the scale of losses were judged to threaten the going
concern status of the company. It will certainly need to be disclosed in the notes to the financial
statements, disclosing separately the $16m loss and the expected insurance recovery of $9m.
AC C A F 7 8: The preparation of financial statements 75

4.4 Biological assets

IAS 41 Agriculture is a relatively small standard that relates to entities that grow or rear biological
assets such as cows and plants.
Taking the simple example of a farm, the activities that the farm performs on a daily basis are referred
to as “agricultural activity”. This would include the growing of plants / trees or the rearing of livestock.
This agricultural activity will give rise to “biological assets” such as the cow or tree and the harvested
produce (“agricultural produce”) such as milk or grapes.
The main focus of the standard for exam purposes is the valuation of the assets and produce.
The standard requires biological assets to be measured on initial recognition and at each year end at
their fair value less costs to sell. Fair value is essentially the price that that asset could be sold for in an
active market. The movement in fair value is shown in the statement of profit or loss.
The agricultural produce is measured, at the point of harvest, at fair value less estimated costs to sell.
It then becomes “inventory” and is subsequently valued in accordance with IAS 2 Inventories, at the
lower of cost / initial fair value less costs to sell and net realisable value.
The sale of agricultural produce such as milk would be dealt with as revenue per IFRS 15 Revenue from
Contracts with Customers.
76 8: The preparation of financial statements AC C A F7
 77

Tangible non-current assets

1 Recognition and classification

From the Conceptual Framework, the definition of an asset is 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”.
To acknowledge the “non-current” aspect of these assets, this definition can be amended to include
the fact that non-current assets are expected to be recovered more than 12 months after the
statement of financial position date.
There are two types of non-current asset:
 Tangible – those with physical substance (section 2 below)
 Intangible – those with no physical substance (see Chapter 10)
To be included in the accounts the recognition criteria must be met (see Chapter 6).

2 IAS 16: Property, Plant and Equipment

2.1 Definition
Property, plant and equipment (PPE) are tangible items that:
 Are held by an entity for use in the production or supply of goods or services, for rental to
others, or for administrative purposes; and
 Are expected to be used during more than one period.
78 9: Tangible non-current assets AC C A F7

2.2 Measurement at acquisition

All items of property, plant and equipment are initially recognised at cost.
Cost includes:
 Purchase price, including import duties, after deducting trade discounts and rebates (but
excluding VAT)
 Directly attributable costs of bringing the asset to the location and condition necessary for it to
be capable of operating in the manner intended by management, e.g.
(i) Employee benefit costs
(ii) Cost of site preparation
(iii) Initial delivery and handling costs
(iv) Installation and assembly costs
(v) Costs of testing whether the asset is functioning properly
(vi) Professional fees.
 Capitalised costs would not include :
(i) Staff training costs for new machinery
(ii) Repairs and maintenance costs
 Estimated cost of dismantling and removing the item and restoring the site on which it is
located due to obligation (IAS 37) incurred when the item is acquired or through use (other than
to produce inventories).
 Finance costs: the capitalisation of qualifying finance costs is required providing they meet the
conditions of IAS 23 Borrowing Costs (see section 4 below).

2.3 Subsequent expenditure

Parts of some items of property, plant and equipment may require replacement at regular intervals.
For example, a furnace may require relining after a specified number of hours use or the roof of a
building may require replacement after so many years.
Subsequent costs are capitalised when the cost of replacement is incurred, providing the recognition
criteria are met. They should then be treated separately for the purpose of calculating depreciation.
Day to day servicing costs, for example repairs and maintenance, are not capitalised. These costs are
recognised as expenses when incurred and are referred to as “revenue expenses”.

2.4 Measurement after acquisition

After the initial recognition, an entity must choose either the cost or the revaluation models as its
accounting policy:
Cost model: Property, plant and equipment is carried at cost less accumulated depreciation and
impairment losses.
Revaluation model: Property, plant and equipment is carried at a revalued amount. This revalued
amount is the fair value at date of revaluation less subsequent accumulated depreciation and
impairment losses.
(a) Cost model (depreciation)
All non-current assets (apart from land and investment properties) should be depreciated over
their useful lives down to their residual value. There are two depreciation methods:
(i) Straight line Cost – residual value
Estimated useful life
AC C A F 7 9: Tangible non-current assets 79

(ii) Reducing balance % depreciation rate × NCA

Exam questions may change the useful life of the asset or may include an increase or decrease
in the asset’s value. There is a simple way of ensuring that the correct depreciation charge is
always applied in the statement of profit or loss:
Depreciation charge = Remaining carrying amount – residual value
Remaining useful life
Other points to note:
The useful life of property, plant and equipment should be reviewed at least at each financial
year end, and if expectations differ from previous estimates, the depreciation charge for current
and future periods should be adjusted.
The depreciation method should also be reviewed at least at each financial year end.
“Complex assets” are those that contain two or more significant parts e.g. an aircraft with
engines or a furnace with a lining. For such assets, the depreciation charge for each distinct part
should be calculated separately.

LECTURE EXAMPLE 9.1: DEPRECIATION

A non-current asset is purchased for $120,000 on 1 January 2013. It has a useful life of eight years and
no residual value. On 1 January 2015, it is decided that the asset only has a remaining life of two years.
Required:
What will be the depreciation charge and carrying amount for the years ending 31 December 2013 to
2016?

Y/e Depreciation charge Carrying Amount at year end

$000 $000
2013
2014
2015
2016

(b) Revaluation model

An entity may choose to carry its non-current assets at fair value (in practice usually market
value and normally determined by professional valuation)
Where an item of property, plant and equipment is revalued, all other assets in the same class
should also be revalued.
Revaluations should be made with “sufficient regularity” to ensure that the carrying amount
does not differ materially from its fair value.
Any surplus arising on revaluation should be credited to a revaluation reserve (in the SFP).
Depreciation should then be charged on the revalued amount, with the expense still being
recorded in the statement of profit or loss in the usual way.
Any excess depreciation (i.e. the difference between the old depreciation charge and the new
charge based on the revalued amount) can be transferred from the revaluation reserve to
retained earnings each year.
On disposal of the asset, any remaining balance in the revaluation surplus should be transferred
to retained earnings.
80 9: Tangible non-current assets AC C A F7

LECTURE EXAMPLE 9.2: REVALUATION

An asset cost $100,000 on 1 January 2001 and had a useful life of 10 years. On 1 January 2003, the
asset was revalued to $120,000. The asset was disposed of for $190,000 on 31 December 2005.
Required:
What are the accounting entries for each of the years 2001 to 2005?
Cost/ Dep’n Acc Carrying Revaluation
Year valuation charge dep’n Amount surplus
$000 $000 $000 $000 $’000
2001 100
2002
On 1 January 2003, the asset is revalued to $120,000, thereby creating a revaluation surplus of $
Dr Cost
Dr Accumulated depreciation (to clear out all depreciation to date)
Cr Revaluation surplus
The new depreciation charge based on the revalued amount =
As this new charge is higher than the “old” charge, the company can transfer the “excess depreciation”
from the revaluation surplus to retained earnings. The company has chosen to do this. This should be
done every year for an amount of $
Cost/ Dep’n Acc Carrying Revaluation
Year valuation charge dep’n Amount surplus
$000 $000 $000 $000 $000
2003
2004
2005
The disposal takes place on 31 December 2005, leading to a profit on disposal of:
AC C A F 7 9: Tangible non-current assets 81

3 IAS 40 Investment Property

Many companies own more than one property. It might occupy one for its day-to-day activities and
another which it could rent out for its rental income and capital appreciation – an investment
property.
Initially, an investment property should be measured at cost. At each subsequent year end, a business
can either:
(a) Value the property as a normal non-current asset at depreciated cost or
(b) It can choose the fair value model, whereby the property is revalued each year end, with any
gain or loss recognised in the statement of profit or loss. Under this model, depreciation is not
charged on the revalued asset.
Whichever policy it chooses should be applied to all of its investment properties.
If a company changes the use of an investment property to a conventional property (perhaps because
it reoccupies the property itself), then the deemed new cost of the property is taken to be its fair value
at the date of the change in use. This is the new “cost” that is depreciated.

4 IAS 23 Borrowing Costs

Where assets are self-constructed, a business may have to borrow funds. Borrowing costs comprise
interest and other costs incurred by a business in connection with the borrowing of funds.
IAS 23 requires these costs to be capitalised as a part of the cost of a “qualifying asset”, providing they
meet the conditions in the standard below.
A qualifying asset is an asset that necessarily takes a substantial period of time to be ready for its
intended use or sale. The amount of costs capitalised depends upon whether the borrowings were
specific to the asset or part of general borrowings:
 Funds borrowed specifically for a qualifying asset – capitalise actual interest incurred during the
period of construction less investment income on temporary investment of the funds.
 Funds borrowed generally – weighted average of interest outstanding during the period.
Capitalisation commences when:
 Expenditures for the asset are being incurred;
 Borrowing costs are being incurred; and
 Activities that are necessary to prepare the asset for its intended use or sale are in progress (e.g.
when construction begins).
Capitalisation should be suspended during extended periods when development is interrupted (e.g.
strikes, bad weather).
Capitalisation should cease when substantially all the activities necessary to prepare the qualifying
asset for its intended use or sale are complete. Subsequent borrowing costs should be expensed
through the SPorL.
Any interest earned during the temporary investment of specific loans should be deducted from the
amount of finance costs that can be capitalised. However, this can only be done during those periods
where the interest costs are being capitalised. If interest is not being capitalised, perhaps because
building work hasn’t started yet, the interest earned must be recorded as interest income in the
statement of profit or loss.
82 9: Tangible non-current assets AC C A F7

4.1 Disclosure
The disclosures are:
 The amount of borrowing costs capitalised during period
 The capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.

LECTURE EXAMPLE 9.3: BORROWING COSTS

Dennis Ltd’s accounting policy is to capitalise borrowing costs on the construction of non-current
assets. On 1 March 2005 Dennis borrowed $8m at an interest rate of 4% to finance the construction of
a building.
Construction began on 1 March 2005 and the building was ready for occupation on 1 October 2005.
No construction took place from 1 May 2005 to 30 June 2005 due to bad weather. Dennis invested the
funds received on 1 March 2005, earning interest of $50,000 from 1 March until 30 April 2005.
Required:
What is the level of borrowing costs that can be capitalised on the cost of the building?
SOLUTION

5 IAS 20: Accounting for Government Grants and Disclosure of

Government Assistance
Initially, a company should only recognise a grant when there is reasonable assurance that it will
comply with the conditions attaching to the grant and that the grants will be received.
There are two types of grant:
(1) Those relating to income (e.g. a grant towards training costs). The grant should be recognised as
“other income” in the same periods as the related costs, so as to match them. Alternatively, the
grant can be deducted from the related expense.
(2) Those relating to assets (e.g. a grant towards the purchase of a non-current asset). At the
discretion of the company these grants should either be presented as:
(i) “Deferred income” on the SFP and then amortised over the asset’s life, or
(ii) By deducting the grant from the cost of the asset acquired and reporting the net amount
in the SFP, thus leading to a lower annual depreciation charge.
AC C A F 7 9: Tangible non-current assets 83

5.1 Repayment of grants

Any government grant that becomes repayable should be accounted for as a revision to an accounting
estimate as per IAS 8.
Repayment of grants relating to income should be recognised as an expense.
Repayments of grants relating to assets should be recorded by increasing the carrying amount of the
asset or reducing the deferred income balance, whichever is more appropriate.

6 IAS 36: Impairment of Assets

A business must assess at the end of each reporting period whether there is any indication that an asset
may be impaired. If an indication of impairment does exist, then the recoverable amount of the asset
must be determined. If an impairment does occur, the entity must account for it (see section 6.3).
An asset is impaired if its carrying amount is greater than its recoverable amount, where recoverable
amount is the higher of:
 Fair value less costs of disposal (net proceeds from the sale of the asset at arm’s length)
 Value in use (the present value of the future cash flows that the asset is expected to generate)
One of the problems in applying this definition is that assets rarely generate cash flows in isolation;
most assets generate cash flows in combination with other assets.
IAS 36 introduces the concept of a cash generating unit – see section 6.2 below – which would help
with the calculation of the value in use.
(Note : For goodwill and intangible assets with an indefinite life, the recoverable amount should be
determined on at least an annual basis, regardless of whether any impairment indicators exist.)

LECTURE EXAMPLE 9.4: IMPAIRMENT

The following measures relate to a non-current asset:

Carrying Amount $51,000
Net Realisable Value $36,000
Value in Use $44,000
Required:
What is the recoverable amount of the asset and is there an impairment?
SOLUTION

6.1 Causes of impairment

Typical causes of impairment can be:
External sources
 Significant fall in the market value of the asset
 An adverse effect on the business in the technological, market, economic or legal environment
in which the entity operates (e.g. a recession)
 Increased market interest rates that reduce the value in use
84 9: Tangible non-current assets AC C A F7

Internal sources
 Evidence of obsolescence or physical damage.
 The asset is not used as much in the business as it once was
 Internal evidence that the asset’s performance will be worse than expected.

6.2 Cash-generating units (CGUs)

It is often not possible to estimate the recoverable amount of an individual asset. In such
circumstances, a business should determine the recoverable amount of the group of assets (CGU) to
which it belongs.

6.3 Recognition of impairment losses

Impairment losses are treated as follows:
(a) Assets carried at historical cost (i.e. those that have never been revalued in the past)
Dr SPorL (depreciation)
Cr SFP (non-current asset)

OR for a CGU
Dr SPorL
Cr 1) Goodwill
Cr 2) Other assets on a pro-rata basis (ensuring no asset is written
down to an amount lower than its recoverable amount or zero)

(b) Revalued assets

Dr SFP (revaluation reserve re the asset ─ down to nil)
Dr SPorL (depreciation)
Cr SFP (non-current asset)

LECTURE EXAMPLE 9.5: IMPAIRMENT AND DEPRECIATION

Co A purchases a non-current asset for $15,000 on 1 January 2002. It has an estimated useful life of
five years and no residual value.
An impairment test carried out at the year end date of 31 December 2003 revealed the net selling
price to be $6,000 and the value in use $5,000.
Required:
What will be the depreciation charge each year of the asset's life?
SOLUTION

Y/e Depreciation charge Carrying amount at y/e

$000 $000
31 December 2002
31 December 2003
31 December 2004
31 December 2005
31 December 2006
AC C A F 7 9: Tangible non-current assets 85

7 IFRS 5: Non-current Assets Held for Sale and Discontinued Operations

IFRS 5 requires entities to disclose information about:
(a) Non-current assets that are held for sale and
(b) Discontinued operations.

7.1 Non-current assets held for sale

An asset is “held for sale” if the entity plans to recover its value by selling it, rather than using it in the
business.
To be classified as 'held for sale', the following criteria must be met:
 Seeking the entity must be actively seeking a buyer.
 Available the asset must be available for immediate sale in its present condition.
 Likely the sale must be highly probable.
 Expected the sale is expected to be completed within 1 year.
Once classified as “held for sale”, an asset should be re-categorised:
 From a “non-current” asset to a “current asset”
 Valued at the lower of carrying amount and fair value less costs to sell - – this means that you
effectively perform an impairment review when you classify the asset as “held for sale”.
 Depreciation should be ceased on the asset
Note: If the asset had previously been revalued, then the asset should be revalued before it is
classified as “held for sale”.

7.2 Disposal groups

An entity may decide to dispose of a group of assets instead of a single asset. For example, a company
might decide to sell all of the assets relating to a sales office which is being closed down.
The accounting treatment for a disposal group is identical to that for a single asset, except that the
entity must show separately the assets held for sale and the liabilities held for sale (i.e. they must not
be offset).

7.3 Discontinued operations

A discontinued operation is a component of an entity that, at the year end, either has been disposed
of or is classified as held for sale and:
(a) Represents a separate major line of business or geographical area of operations, or
(b) Is part of a single coordinated plan to dispose of a separate major line of business or
geographical area of operations, or
(c) Is a subsidiary acquired exclusively with a view to resale.
A component of an entity is one that has operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
Therefore, when a business has a disposal group (which is reflected in the SFP), it may also have
discontinued operations (which are shown in the SPorL).
Essentially, the results of the entity need to be split between those that relate to the continuing
activities of the business and those that are now discontinued.
86 9: Tangible non-current assets AC C A F7

7.4 Disclosure
Discontinued operations
On the face of the SPorL - 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 the remeasurement to fair value less costs to sell or on
the disposal of assets/disposal groups comprising the discontinued operation.
On the face of the SPorL or in the notes
 The revenue, expenses, and pre-tax profit or loss of discontinued operations, and the related
income tax expense;
 The gain or loss recognised on the measurement to fair value less costs to sell or on the disposal
of assets/disposal groups comprising the discontinued operation and related income tax
expense;
 The net cash flows attributable to the operating, investing, and financing activities of
discontinued operations.

Non-current assets/disposal groups held for sale or sold

In the notes
 A description of the non-current asset (or disposal group);
 A description of the facts and circumstances of the sale, or leading to the expected disposal, and
the expected manner and timing of the disposal;
 The gain or loss recognised on assets classified as held for sale, and (if not separately disclosed
on the face on the statement of profit or loss) the caption which includes it.
 87

10

Intangible assets

1 IAS 38: Intangible Assets

An intangible asset is an identifiable non-current asset without physical substance.
An intangible asset may be recognised in the financial statements if:
 It is probable that the entity will receive future economic benefits from the asset
and
 The cost of the asset can be measured reliably.

1.1 Recognition and measurement

 Intangible assets purchased separately (e.g. purchased licence to operate a radio station) should
be recognised at cost including any directly attributable costs of preparing the asset for its
intended use.
 Intangible assets purchased as part of a business combination should be recorded at fair value.
 Internally generated goodwill (e.g. reputation) is not recognised (because it cannot be
measured reliably).

1.2 Measurement after recognition

Two alternative policies:
(1) Cost model - cost less accumulated amortisation and impairment losses
(2) Revaluation model - revalued amount less accumulated amortisation and impairment losses.
88 10: Intangible assets AC C A F7

Amortisation
Amortisation is the term we use for the depreciation of an intangible asset. The rules are identical to
those for a tangible asset. The following points are also relevant:
 The residual value is normally assumed to be zero.
 Amortisation begins when the asset is available for use.
 Some intangibles are considered to have an indefinite useful life. These assets are not
amortised, but have annual impairment tests.

Revaluation
If the revaluation model is followed, the revaluation must be fair value at date of revaluation by
reference to an active market.
All other assets in the same class should be revalued, unless there is no active market for them in
which case the cost model should be used for those assets.
Revaluations must be made with such regularity that the carrying amount does not differ materially
from its fair value at the end of the reporting period.

1.3 Research and development costs

Research costs: Costs that are incurred to “gain new scientific or technical knowledge and
understanding”. These costs are NOT recognised as an intangible asset, but are always expensed in the
Statement of profit or loss.
Development costs: Costs which are incurred in the “application of research findings to a plan/design
for the production of new or substantially improved materials, products or processes prior to
commercial production or use.
These costs must be recognised if all of the following criteria are met:
 P robable future economic benefits will be generated by the asset
 I ntention to complete and use/sell asset
 R esources adequate and available to complete and use/sell asset
 A bility to use/sell the asset
 T echnical feasibility of completing asset for use/sale
 E xpenditure can be measured reliably.
Costs can only commence capitalisation once all of these criteria are met. Amortisation of these costs
will commence when the asset is ready for use, even if it not actually being used at that date.

1.4 IFRS 3 Goodwill

We have already seen above that internally generated goodwill is not capitalised. There is another
form of goodwill – “purchased goodwill” – which arises when a business acquires the shares or assets
of another business.
Goodwill = Cost of business as a whole – fair value of its separable net assets
Purchased goodwill should be capitalised on a group statement of financial position and represents
the difference between what is paid for an entity and the fair value of that entity.
Purchased goodwill is not amortised, but instead is tested for impairment annually.
Goodwill is dealt with more fully in Chapters 1 to 4.
 89

11

Preparation of
single company accounts

1 Approach to questions
There is no absolute right or wrong way to approach these styles of questions. You need to practise
them to find what technique works best for you, given your own particular strengths.
However, the following technique provides a useful guide:

STEPS
Step 1: Set up the necessary proformas:
- Statement of financial position
- Statement of profit or loss
- SOCIE
- Workings
Step 2: Mark up the relevant items in the trial balance that are going to change.
Step 3: Start at the beginning of the trial balance putting each number either in a working or in
the proforma (if you know it is going to be adjusted by additional information).
Step 4: Work your way through the additional information given, starting with those parts you
find easiest.
Step 5: Complete remaining workings and proformas.
Remember: There are no “bonus marks” for a balancing statement of financial position so don’t
worry if yours doesn’t balance.
90 11: Preparation of single company accounts AC C A F7

You must be familiar with the various accounting adjustments that were covered in F3, in particular:
 Cost of sales calculations
 Inventory valuation
 Depreciation calculations
 Accounting for share issues

LECTURE EXAMPLE 11.1: PREPARATION OF SINGLE COMPANY ACCOUNTS

FiT Co is an entity which owns a number of factories and specialises in producing lighting equipment
and selling it to large retailers. It also owns a small chain of lighting shops.
The company's list of balances as at 30 September 2012 is as follows:
$000 $000
Revenue 10,000
Cost of sales 3,330
Inventories (At 30 September 2012) 630
Goodwill ( related to lighting shops) 200
Lighting shops at cost 4150
Lighting shops depreciation 1250
Distribution costs 700
Administration costs 600
Loan interest 30
Dividend 600
Premises cost 9,000
Premises depreciation at 1 October 2011 900
Plant and equipment 1,800
Plant and equipment depreciation at 1 October 2011 600
Trade receivables 590
Trade payables 630
Bank 40
Loan Note (10%) Repayable 2016 400
Ordinary Shares (50 cents each) 1,000
Suspense account 980
Retained profits 5,910
21,670 21,670

Additional information:
(1) The lighting shops were valued at $3,000,000 by an external valuer on 1 July 2012. Shortly after
a buyer expressed an interest at that price. The sale is expected to be complete by 1 January
2013 at the valuation price. The cost of selling the shops is estimated to be $300,000.
The lighting shops are regarded as a cash generating unit.
The revenue and expenses of the lighting shops for the year ended 30 September 2012 all
included in the trial balance were as follows:
$000
Revenue 470
Cost of sales 280
Administration expenses 85
Distribution costs 120
AC C A F 7 11: Preparation of single company accounts 91

(2) Depreciation (which is charged to cost of sales) has still to be charged for the year on the
following bases:
Premises 2% of cost
Plant and equipment 20% of net book value
On the 30 September 2012, after the correct depreciation charge for the year has been applied,
the premises were valued at $9.5 million.
(3) The tax charge for the year has been estimated at $1,550,000.
(4) The dividend was paid on 1 July 2012.
(5) During the year a 1 for 2 rights issue took place at $1 per share. The only entry made with
respect to this issue was to debit cash with the proceeds of $1,000,000 net of issue expenses of
$20,000 (i.e. a net $980,000) and to credit the $980,000 to the suspense account.
(6) On the 1 April 2012 an employee was dismissed following the discovery of a fraud that resulted
in receivables being overstated. The auditors assessed that $25,000 was taken in the current
year and $45,000 from the previous year.
(7) FiT Co wishes to show the minimum information in relation to the discontinued operation.
Required:
Prepare a statement of profit or loss and other comprehensive income and statement of changes in
equity for FiT Co for the year ended 30 September 2012 and a statement of financial position at that
date. Notes to the financial statements are not required.
SOLUTION
FiT Co – Statement of profit or loss and other comprehensive income for the year ended
30 September 2012

$000
Revenue
Cost of sales (W1)
Gross profit
Distribution costs (W1)
Administrative expenses (W1)
Finance cost
Profit before tax
Income tax expense
Profit for the year from continuing operations
Profit / (loss) for the year from discontinued operations
Profit for the year ( To the SOCIE)
Other comprehensive income
Gains on revaluation
Total comprehensive income
92 11: Preparation of single company accounts AC C A F7

FiT Co – Statement of financial position at 30 September 2012

Assets $000
Non-current assets
Property, plant and equipment (W3)
Current assets
Asset held for sale (W2)
Inventories
Receivables
Cash and cash equivalents

TOTAL ASSETS
EQUITY AND LIABILITIES
Equity
Share capital
Share premium
Revaluation surplus
Retained earnings
Total equity
Non-current liabilities
Current liabilities
Trade payables
Income tax payable
Interest accrual

Total liabilities
TOTAL EQUITY AND LIABILITIES

Statement of changes in equity for the year ended 30 September 2012

Share Share Revaluation Retained Total

capital premium surplus earnings
$000 $000 $000 $000 $000
Opening balance
AC C A F 7 11: Preparation of single company accounts 93

Workings
(W1) Expense categories

Dist’n Admin
Cost of Sales costs expenses

(W2) Discontinued operation

(W3) Property, plant and equipment

Premises Plant & Equip Total

$000 $000 $000
Cost b/f
Accumulated dep’n b/f
Carrying amount b/f
Depreciation charge for year (W4)
Additions/Disposals
Revaluation
Carrying amount c/f
94 11: Preparation of single company accounts AC C A F7

(W4) Depreciation charge

(W5) Share capital

 95

12

Leases IAS 17

There are essentially two types of lease:

(1) Finance lease
(2) Operating lease

1 Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards relating to ownership of
an asset (to the lessee). Title may or may not be eventually transferred.
IAS 17 identifies five situations which would normally lead to a lease being classified as a finance lease:
(a) The lease transfers ownership of the asset to the lessee at the end of the lease term;
(b) The lessee has the option to purchase the asset at a price sufficiently below fair value at
exercise date, and that it is reasonably certain the option will be exercised;
(c) The lease term is for a major part of the asset’s economic life even if title is not transferred;
(d) Present value of minimum lease payments (PVMLP) amounts to substantially all of the asset’s
fair value at inception;
(e) The leased asset is so specialised that it could only be used by the lessee without major
modifications being made.

1.1 Definitions

KEY TERMS
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.
96 12: Leases IAS 17 AC C A F7

Minimum lease payments - the payments over the lease term that the lessee is, or can be
required to make, together with any amounts guaranteed by the lessee or related party.
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.
Interest rate implicit in the lease - the discount rate that, at the inception of a lease, causes
the present value of the minimum lease payments to be equal to the fair value of the leased
asset.

1.2 Accounting treatment of finance leases by the lessee

At inception of lease
Dr Property, plant and equipment (PPE)
Cr Finance lease liability
With the lower of:
 The fair value of the leased asset
 The present value of the minimum lease payments
In the exam it will be very clear what the value of the asset is.
The finance lease liability is effectively a “loan”, reflecting the substance of the transaction i.e. you
have borrowed in order to fund the purchase of a non-current asset. In the SFP the liability will be split
between current (repayable < one year) and non-current (repayable > one year).

1.3 Depreciation
The item of PPE will be depreciated, in the normal way, over the shorter of the lease term and its
useful economic life.
If there is a reasonable certainty that the lessee will obtain ownership by the end of the lease term
(e.g. a hire purchase contract) then the asset should be depreciated over its useful life (this would
have to be indicated in the exam question).

EXAM SMART
In questions, remember to add the net carrying amount of the leased asset to PPE or if you
have a working for PPE add cost of the asset and then depreciate it in the working.
Remember also to expense the depreciation. These are easy marks.

1.4 Disclosures
The following amounts will be included in the financial statements relating to finance leases:
Non-current assets (PPE): Net carrying amount of the leased asset added to other PPE
Non-current liabilities: Finance lease liability due after more than one year
Current liabilities: Finance lease liability due within one year
Statement of profit or loss: Depreciation of leased PPE and finance costs
In the exam depreciation is often charged to cost of sales and the interest will of course go to finance
costs. Also remember to accrue any finance cost not yet paid.
In addition, the standard requires the following disclosure in the notes in relation to the outstanding
capital element of the lease. It has never been examined.
AC C A F 7 12: Leases IAS 17 97

$
Within one year X
Later than one year and not later than five years X
Later than five years X
X

1.5 Lease payments

As the company makes its regular lease payments, the amount of the payment will pay off an element
of capital and an element of interest.
The technique that the Examiner uses to split the payment is the actuarial method. This technique
involves using the “interest rate implicit in the lease” defined above. This interest rate, which will be
given to you, is effectively the interest rate on the “loan” that you have used to fund the non-current
asset purchase.
In order to calculate the interest charge for a period, apply the interest rate implicit in the lease to the
amount of capital outstanding at the beginning of the period.
Deduct repayments made from the interest first and any balance is then used to reduce capital.

LECTURE EXAMPLE 12.1

Henleaze Ltd makes up its accounts to 31 December each year. It enters into a finance lease (as
lessee) to lease an item of equipment with the following terms:
Inception of lease: 1 January 2014
Term: 5 years at $4,000 per annum payable in arrears
PVMLP: $16,000
Useful life: 8 years
Interest rate implicit in the lease: 12%
Required:
Prepare the relevant extracts in respect of the above lease for the year ended 31 December 2014.

$
Statement of profit or loss (extract)
Depreciation (W2)
Finance costs (W1)

Statement of financial position (extract)

Non-current assets
Property, plant & equipment (W2)
Non-current liabilities
Finance lease liability (W1)
Current liabilities
Finance lease liability (W1)
98 12: Leases IAS 17 AC C A F7

(W1) Finance lease liability

FL Liability
1.1.2014 Asset/FL Liability
1.1.14 to 31.12.14 Interest = 12% x
31.12.2014 Instalment 1
31.12.2014 Y/e liability
1.1.15 to 31.12.15 Interest = 12% x
31.12.2015 Instalment 2

(W2) Asset and depreciation

LECTURE EXAMPLE 12.2

Using the same information, what difference does it make if the payments are in advance paid on
1 January 2014?
FL Liability
1.1.2014 Asset
1.1.2014 Instalment 1

2 Operating leases
An operating lease is defined as “a lease other than a finance lease” (!)
From this, we can deduce that an operating lease is one which does not transfer substantially all the
risks and rewards relating to ownership of an asset (to the lessee).

2.1 Accounting treatment

First, since the company leasing the asset does not enjoy the risks and rewards of the asset, it does
NOT include the asset on it its statement of financial position (SFP).
AC C A F 7 12: Leases IAS 17 99

Neither does it have a liability on its SFP.

Lease payments should be recognised as an expense in the statement of profit or loss on a straight-line
basis over the lease term (unless some other systematic basis is representative of the time pattern of
the user’s benefit).

ILLUSTRATION 12.1: OPERATING LEASE 1

Twyford Ltd enters into a non-cancellable four-year operating lease costing $6,000 per annum. The
machine has a useful life of ten years.
The annual cost will be spread on a straight line basis over four years:
Dr SPorL: operating lease rentals $6,000
Cr Cash $6,000
for each of the four years of the lease term.

ILLUSTRATION 12.2: OPERATING LEASE 2

Twyford Ltd enters into a non-cancellable four-year operating lease, paying a $4,000 deposit followed
by an annual charge of $3,000 for four years. The machine has a useful life of ten years.
The total cost of the lease is spread over the four years i.e. $4,000 deposit + (4 × $3,000) = $16,000
over four years = $4,000 per annum:
Year 1:
Dr SPorL: Operating lease rental $4,000
Dr SFP: Prepayments $3,000
Cr Cash $7,000
Years 2, 3 & 4:
Dr SPorL: Operating lease rental $4,000
Cr Cash $3,000
Cr Prepayments $1,000
100 12: Leases IAS 17 AC C A F7

LECTURE EXAMPLE 12.3

Twyford Ltd enters into a non-cancellable five-year operating lease, paying an annual charge of $3,000
for five years. As an incentive to enter the lease, Twyford was given a cash back incentive of $2,000 at
the start of the lease. The machine has a useful life of ten years.
Required:
How should the above transaction be recorded each year?
SOLUTION

3 Sale and leaseback

Sometimes, a cash-poor company may need to raise finance quickly, but will not want to give up the
use of its major non-current assets. One solution here is to sell an asset and lease it back.
The first thing to do in a sale and leaseback is to determine whether the lease is an operating lease or
a finance lease. This can be determined by observing who bears the risks and rewards of the asset (as
for a normal lease scenario).

Sale and Finance Leaseback

If the lease is a finance leaseback then, in substance, no sale has taken place and so the double entry
to account for the receipt of cash is:
Dr Cash
Cr Finance lease liability
The calculations for the finance lease are then as per usual.
Note: Since there is no “disposal” as such, then the only entries needed in respect of the PPE is that
the excess of sales proceeds over the carrying amount of the asset would be added to the carrying
value of the asset and a “deferred income” balance created and released to the statement of profit or
loss over the lease term.
AC C A F 7 12: Leases IAS 17 101

Sale and Operating Leaseback

Things are a bit more interesting here. Once you have determined that the leaseback is an operating
leaseback, you will need to determine three figures (which may be given to you or you may have to
calculate them):
 CA = Carrying amount
 SP = Sale Proceeds
 FV = Fair Value
Note : in ALL situations, if FV < CA, then this is an impairment which should be recorded in the
statement of profit or loss immediately.
As the lease is an operating lease, you will lose the non-current asset from your statement of financial
position and therefore a disposal will have taken place on which a profit or loss will have been made.
We need to determine how to treat this profit or loss.
There are three likely scenarios:
(1) SP = FV.
This is the most likely scenario in the real world – you sold the asset for what is was worth.
Here, you should simply recognise any profit or loss in the statement of profit or loss for the
year.
(2) SP < FV.
Why have you decided to sell the asset for less than it was worth? Here, you should recognise
any profit or loss immediately unless the reason for the apparent loss made is the fact that you
will be paying future rentals at below market price. In this case, the “loss” is in fact an
“asset/prepayment” and should be placed on the statement of financial position and amortised.

ILLUSTRATION: SP < FV

Capello enters into a three-year sale and leaseback transaction:

Carrying amount = $20,000
Sale proceeds = $14,000
Fair Value = $16,000
Firstly, the asset is impaired since its FV < CA. So the CA needs to be written down immediately to
$16,000:
Dr P or L $4,000
Cr Non-current assets (carrying amount) $4,000
This makes the carrying amount $16,000. Then the apparent loss of $2,000 ($14,000 - $16,000) should
be recognised immediately in the statement of profit or loss unless compensated by future rentals at
below market price. If this is the case, the “loss” of $6,000 should be accounted for as:
Dr Cash $14,000
Cr Non-current assets (carrying amount) $16,000
Dr Prepayments (not statement of profit or loss) $2,000
This prepayment will be reversed out for each of the three years of the lease:
Dr Statement of profit or loss ($2,000 / 3years) $667  this has the effect of increasing the “low”
rental expense
Cr Prepayments $667
102 12: Leases IAS 17 AC C A F7

(3) SP > FV.

How have you managed to sell something for more than it was worth? The substance of the
transaction is that you have effectively (i.e. in substance) sold the asset for its fair value and also
that the other party has loaned you some money. The “excess profit” should be deferred and
amortised over the lease life.

ILLUSTRATION: SP > FV

Capello enters into a three-year sale and leaseback transaction:

Carrying amount = $20,000
Sale proceeds = $24,000
Fair Value = $21,000
Dr Cash $24,000
Cr Non-current assets (carrying amount) $20,000
Cr Statement of profit or loss: profit on disposal (FV – CA) $1,000
Cr SFP: Deferred income (SP – FV) $3,000
This deferred income balance can then be amortised over the lease term of 3 years:
Dr SFP : Deferred income $1,000
Cr Statement of profit or loss $1,000
 103

13

Revenue and Inventory

1 Revenue
1.1 Introduction
IFRS 15 Revenue from Contracts with Customers establishes a comprehensive framework for
determining when to recognise revenue and how much revenue to recognise.
The core principle in this framework is that a company should recognise revenue to depict the transfer
of promised goods or services to the customer in an amount that reflects the consideration to which
the company expects to be entitled in exchange for goods and services.

1.2 The “Five Step” Model

Revenue from contracts with customers is recognised based on the application of a principle based
“five step” model:

Step 1: Identify the contract(s) with the customer

A contract is an agreement between two or more parties that creates enforceable rights and
obligations. Contracts can be written, verbal or implied by an entity’s customary business practices.
IFRS 15 requires all contracts to have the following attributes:
 The contract has been approved
 The rights and payment terms regarding goods and services to be transferred can be identified
 The contract has commercial substance
 It is probable that the consideration will be received, considering the customer’s ability and
intention to pay
104 13: Revenue and Inventory AC C A F7

Step 2: Identify the performance obligations in the contract

Performance obligations are the promises in the contract to transfer to a customer goods or services
that are distinct. Goods and services are distinct (and revenue from selling them is accounted for
separately) if:
 The customer can “benefit” from the good or service on its own through use, consumption, sale
or the generation of economic benefit
 The promise to transfer a good or service is separable from other promises in the contract.

Step 3: Determine the transaction price

The transaction price is the amount of consideration an entity expects to be entitled to in exchange for
transferring the promised goods and services.
Usually the transaction price is a fixed amount of customer consideration. However it may be affected
by:
 Significant financing components. This occurs if the timing of the payments specified in the
contract provides either the customer or the entity with a significant benefit of financing the
transfer of goods and services. The transaction price should be adjusted to reflect the cash
selling price at the point in time control of the goods or services is transferred.
 Variable components e.g. contingent payments. The variable consideration should be included
in the transaction price only to the extent that it is highly probable that a significant reversal in
the amount of cumulative revenue recognised will not occur when the uncertainty associated
with the variable consideration is no longer present.
 Consideration payable to a customer e.g. refunds and rebates. This should be treated as a
reduction in the transaction price.
 Non-cash consideration. This should be measured at fair value.

Step 4: Allocate the transaction price to each performance obligation

This allocation should be based on the stand alone selling price of each distinct good or service. If a
standalone selling price is not observable then it should be estimated.

ILLUSTRATION 13.1: SALE OF A PRODUCT INCLUDING SERVICING

On 1 January 2014, Bobby Jean sold a product for $5m and is committed to the ongoing service of the
product for three years after the sale. The value of this service has been included in the total selling
price of $5m for the year ending 31 December 2014.
When this type of servicing is supplied separately, the normal selling price is $480,000 per annum.
The normal selling price of the product (when supplied separately) is $4,560,000.
Required:
Explain how this transaction should be treated in the financial statements for the year ending
31 December 2014.
SOLUTION
The sale agreement contains two separate performance obligations (the product and the servicing), so
the total price of $5 million must be apportioned between the two parts on the basis of their normal
stand-alone prices. The total standalone price of the product plus the servicing would be $4,560 +
($480 × 3) = $6,000.
AC C A F 7 13: Revenue and Inventory 105

$000
Product (5,000 × 4,560/6,000) 3,800
Servicing (5,000 × (480 × 3)/6,000) 1,200
Total transaction price 5,000

Sales made which include revenue for ongoing servicing work must have part of the revenue deferred.
At 31 December 2014, there are two more years of servicing work, thus $0.8 million ($1.2 million ×
2/3) must be treated as deferred revenue, split equally between current and non-current liabilities.
The final revenue figure recorded for the year ending 31 December 2014 is therefore $5m ─ $0.8m =
$4.2m.

Step 5: Recognise revenue as each performance obligation is satisfied

A performance obligation is satisfied at the point when a promised good or service is transferred to a
customer i.e. when a customer obtains control over that good or service. Control of an asset refers to
the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset
through use, consumption or sale.
A performance obligation may be satisfied at a point in time (typically goods) or over time (typically
services).
Revenue may be recognised over time if any of the following criteria are met:
 Customer simultaneously receives and consumes all of the benefits e.g. a cleaning contract
 The entity’s work creates or enhances an asset (e.g. work in progress) controlled by the customer
 The entity’s performance does not create an asset with an alternative use to the entity, and the
entity has an enforceable right to payment for performance completed to date.
Revenue that is recognised over time is recognised in a way that depicts the entity’s performance in
transferring control of goods or services to customers. Methods include:
 Output methods e.g. surveys of performance completed to date, appraisals of results achieved,
milestones reached, units produced or delivered
 Input methods e.g. resources consumed, labour hours, costs incurred, time lapsed, machine
hours, excluding costs that do not represent the seller’s performance.

ILLUSTRATION 13.1: REVENUE RECOGNISED OVER A PERIOD OF TIME

Aussie entered into a two year contract with a customer on 1 January 2015. The total contract price is
$100m. Performance obligations are satisfied over a period of time and progress towards completion
is measured by comparing costs incurred to total expected costs.
At 31 December 2015, the costs incurred are $56m and the total expected costs are $80m.
In the year ended 31 December 2015 Aussie will recognise revenue of $56m/$80m × $100m = $70m

Revenue is recognised at a point in time if the criteria for recognising revenue over time are not met.

1.3 Recognition of contract costs

IFRS 15 also includes requirements for accounting for some costs that are related to a contract with a
customer.
106 13: Revenue and Inventory AC C A F7

1.3.1 Costs of obtaining a contract

A company should recognise an asset for the incremental costs of obtaining a contract if those costs
are expected to be recovered e.g. professional fees. Incremental costs are costs that the entity would
not have incurred if the contract had not been obtained.

1.3.2 Costs to fulfil a contract

For costs that are not within the scope of another Standard, a company should recognise an asset for
these costs if the following criteria are met:
 The costs are specifically identifiable and relate directly to a contract e.g. direct labour,
materials, overhead allocations
 The costs generate or enhance resources of the company that will be used in satisfying
performance obligations in the future; and
 The costs are expected to be recovered
Contract assets should be amortised on a systematic basis consistent with the pattern of transfer of
goods or services to which the asset relates.
Costs that are recognised as an expense as incurred are:
 General and administrative expenses
 Wastage, scrap and other unanticipated costs not incorporated into pricing the contract
 Cost related to or that cannot be distinguished from past performance obligations

1.4 Financial statement extracts for contracts where performance

obligations are satisfied over time
Statement of profit or loss
Contract A Contract B Total
$ $ $
Revenue (x% × total contract revenue) X X X
Expenses (x% × total contract costs) (X) (X) (X)
Recognised profit X X X
Statement of financial position
$
Current assets
Contract asset (W) X
Trade receivables (W) X
Current liabilities
Contract liability (W) X
Working
Contract A Contract B
$ $
Total contract costs incurred to date X X
Total profit recognised to date X X
Less: total invoiced to date (X) (X)
Contract asset / liability X (X)
Amounts invoiced to date X X
Less: cash received (X) (X)
Trade receivables X X
AC C A F 7 13: Revenue and Inventory 107

LECTURE EXAMPLE 13.1

Builder had the following contracts with customers ongoing at its year end of 31 December 2009.
Performance obligations are satisfied over time for each of these contracts.
Progress towards completion on each contract is determined by comparing cost to date with
estimated total cost.
A B
$000 $000
Contract price 200 300
Cost incurred to date 120 150
Estimated cost to completion 40 100
Amounts invoiced 140 200
Cash received 115 185
Required:
Prepare the extracts for the statement of profit or loss and statement of financial position relating to
the above contracts at 31 December 2009.
Statement of profit or loss

A B Total
$000 $000 $000
Revenue
Expenses
Recognised profit
Statement of financial position

Current assets
Contract asset (W)
Trade receivables (W)
Current liabilities
Contract liability (W)
Workings
START HERE  (W1)
A B
$000 $000
Costs to date
Costs to complete

% Complete
108 13: Revenue and Inventory AC C A F7

(W2) Contract asset / liability

A B
$000 $000
Total contract costs incurred to date
Add: profit recognised
Less: total amounts invoiced to date
Contract asset / liability

(W3) Trade receivables

Amounts invoiced to date

Less: cash received
Trade receivables

1.5 Impairment of the contract asset

Contract costs should only be recognised as an asset to the extent that they are expected to be
recovered. Impairment exists when the carrying amount of a contract asset is greater than the
remaining consideration receivable, less directly related costs incurred.
Loss making contracts are accounted for as onerous contracts under IAS 37 (see Chapter 15 for
details).

1.6 Progress of the contract cannot be reasonably measured

Sometimes, in the early stages of a contract’s life (say <20% complete), the progress of the contract
cannot yet be reasonably measured. If this is the case:
 Revenue should be recognised only to the extent that it is probable that contract costs incurred
will be recovered.
 Contract costs should be recognised as an expense in the period incurred.

1.7 Recognition of revenue after the first accounting period

After the first accounting period, care is needed to make sure that the correct numbers are included in
the accounts. Having already included part of the revenue and costs, these cannot be accounted for
again, so in subsequent years the previous year’s revenue and costs need to be excluded.
AC C A F 7 13: Revenue and Inventory 109

LECTURE EXAMPLE 13.2

On the 1 October 2013 Thomas entered into a four-year contract with a customer. The fixed value of
the contract is $250m. Performance obligations under this contract are satisfied over time.
Year to Year to
30 Sept 2015 30 Sept 2014
Costs incurred during the year $ 100 m $80 m
At the year-end estimated total cost to complete the project $ 20 m $ 120 m
Amounts invoiced and cash received in the year $ 90 m $ 100 m
Amounts recognised in the statement of profit or loss:
Revenue ? $100 m
Cost of sales ? $80 m
Thomas measures progress towards completion by comparing costs to date with total estimated costs.
During the year ended 30 September 2015 a mistake was made and an additional amount of $5m was
spent correcting the error. These additional costs are not included in the costs shown in the table
above and are not recoverable from the customer.
Required:
Calculate the amounts to be recorded for the above contract in Thomas’s statement of profit or loss
for the year ended 30 September 2015 and in the statement of financial position at that date. (Work to
the nearest $ million.)
Working - % complete
Costs to date
Total costs
Statement of profit or loss for the year ended 30 September 2015
Total to Total to
last y/e date
30/9/14 30/9/15 This year
40%
$m $m $m
Revenue 100
Cost of sales (80)
Mistake -

Recognised profit 20
Statement of financial position at 30 September 2015

$m
Total costs incurred to date
Total profit recognised to date
Less: amounts invoiced to date

Contract asset / liability

110 13: Revenue and Inventory AC C A F7

2 Specific applications of IFRS 15

2.1.1 Principal versus agent
When a party other than the seller is involved in providing goods or services to a customer, the seller
needs to determine whether the nature of its promise is a performance obligation to provide the
specified goods or services itself (i.e. the entity is a principal) or to arrange for the other party to
provide those goods or services (i.e. the entity is an agent). For example, a travel agent arranges for a
third party to provide goods and services to customers.
Principal Agent
The entity’s performance obligation is to provide The entity’s performance obligation is to arrange for
the specified good or service itself the provision of goods or services by another party
The entity controls a promised good or service The entity does not control promised good or service
before it transfers it to a customer e.g. before it transfers it to a customer
establishes the price, bears inventory and credit
risk
The entity recognises revenue in the gross The entity recognises revenue in the amount of any
amount of consideration to which it expects to be fee or commission to which it expects to be entitled
entitled in exchange for those goods or services in exchange for arranging for the other party to
transferred provide its goods or services.

ILLUSTRATION 13.2: PRINCIPAL VERSUS AGENT

Portsmouth’s revenue includes $12 million for goods it sold acting as an agent for Southampton.
Portsmouth earned a commission of 20% on these sales and remitted the difference of $9.6 million
(included in cost of sales) to Southampton.
Required:
Discuss whether the current accounting treatment is correct.
SOLUTION:
Portsmouth is acting as an agent (not the principal) for the sales on behalf of Southampton. Therefore
the statement of profit or loss should only include $2.4 million commission revenue (20% of the sales
of $12 million). Therefore, $9.6 million ($12m – $2.4m) should be deducted from revenue and cost of
sales.

2.1.2 Repurchase agreements

A repurchase agreement is a contract in which an entity sells an asset and also promises or has the
option to repurchase it in the future.
If an entity has an obligation or a right to repurchase the asset, a customer does not obtain control of
it as they are limited in their ability to direct the use of, and obtain substantially all of the remaining
benefits from the asset even though they may have physical possession of the asset.
Therefore the seller must continue to recognise the asset and also recognise a financial liability for any
consideration received from the customer. The difference between the amount of consideration
received from the customer and the amount of consideration to be paid to the customer should be
treated as interest. The time value of money should also be considered if material.
AC C A F 7 13: Revenue and Inventory 111

ILLUSTRATION 13.3: REPURCHASE ARRANGEMENTS

Chateau Ltd is a wine producer. It normally holds inventories for three years before selling them.
A large quantity of one-year old wine has been sold to a finance company at its cost of $5 million. The
sales proceeds have been credited to revenue and the wine has been removed from inventory.
Chateau Ltd has an option to buy back the wine in two years' time at its original selling price of $5
million plus accrued interest of 10% per annum from the date of the sale. The market value of the
wine in 2 years’ time is expected to be $8 million.
Required:
Discuss whether the current accounting treatment is correct.
SOLUTION:
According to IFRS 15, this type of transaction should be treated as a financing arrangement. In effect,
Chateau Ltd has a loan from the finance company, secured on the wine. It is virtually certain that
Chateau Ltd will repurchase the wine in two years’ time as the repurchase price is below market value.
Chateau should remove the revenue of $5 million from the statement of profit or loss and continue to
recognise the wine in its statement of financial position at cost. It should also recognise a non-current
liability of $5m. The interest of 10% per annum should be included in the statement of profit or loss as
a finance cost and accrued in each of the two years.

2.1.3 Bill and hold arrangements

A bill-and-hold arrangement is a contract under which a seller bills a customer for a product but
retains physical possession. This may arise if a customer has a lack of available storage space for the
item.
Revenue should be recognised when the customer obtains control of the product. This may be when
the product is delivered to the customer’s site. However, it is possible for a customer to obtain control
of a product even though it remains in the seller’s physical possession. This situation will arise if the
customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from
the product. Consequently, the seller does not control the product but is merely providing custodial
services.
Revenue is recognised by the seller if all of the following criteria are met:
 the reason for the bill-and-hold arrangement must be substantive (for example, the customer
has requested the arrangement);
 the product must be identified separately as belonging to the customer;
 the product must be ready for physical transfer to the customer; and
 the entity cannot use the product or to direct it to another customer.
If a seller recognises revenue for the sale of a product on a bill-and-hold basis, they must also consider
whether they have any remaining performance obligations (for example, for custodial services). If this
is the case then the seller should allocate a portion of the transaction price to these obligations.

2.1.4 Consignments
These arise when a seller delivers a product to another party (such as a dealer or a distributor) for sale
to end customers, but retains control of that product. Consignment inventories are common in the
motor trade and book industries. The seller should not recognise revenue upon delivery of a product
to another party if the delivered product is held on consignment.
112 13: Revenue and Inventory AC C A F7

Indicators that an arrangement is a consignment arrangement include:

 the product is controlled by the seller until a specified event occurs, such as the sale of the
product to a customer of the dealer or until a specified period expires;
 the seller is able to require the return of the product or transfer the product to a third party
(such as another dealer); and
 the dealer does not have an unconditional obligation to pay for the product (although it might
be required to pay a deposit).

3 Inventories: IAS 2
Inventories should be measured at the lower of:
(a) Cost
(b) Net realisable value – taking each item of inventory separately i.e. a loss-making item of
inventory cannot be “offset” against a profit-making item.

3.1 Cost
Per IAS 2, the cost of inventories shall comprise “all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition”.
“Costs of purchase” comprise purchase price, import duties and other taxes and transport, handling
and other costs directly attributable to the acquisition of finished goods, materials and services, less
trade discounts, rebates and other similar items.
“Costs of conversion” include:
 Costs which are directly related to units of production, e.g. direct labour, direct expenses and
sub-contracted work
 Systematic allocation of fixed and variable production overheads incurred in converting
materials into finished goods. The allocation of fixed production overheads to units of
production is based on normal capacity. In periods of abnormally high production fixed
overhead unit allocations are reduced to avoid valuing inventories above cost.
“Other costs” can be included in the cost of inventories to the extent incurred in bringing the
inventories to their present location and condition e.g. non-production overheads of designing a
product for a specific customer.

3.2 Determining cost

Estimation techniques may be used for convenience if the results approximate to actual costs.
Examples of potential estimation methods include:
 Standard cost: based on normal levels of materials and supplies, labour efficiency and capacity
utilisation.
 Retail method: cost is determined by reducing sales price of the inventory by an appropriate
percentage gross margin. This method is often used in the retail industry for measuring
inventories of rapidly-changing items that have similar margins.
If various batches of inventories have been purchased at different times during the year and at
different prices, it may be impossible to determine precisely which items are still held at the year end
and therefore what the actual purchase cost of the goods was. For example, imagine trying to
accurately cost a bucket of golf balls.
AC C A F 7 13: Revenue and Inventory 113

In such circumstances, the following estimation methods are allowed under IAS 2:
 FIFO (first in, first out)
The cost of inventories is calculated on the basis that the quantities in hand represent the most
recent purchases or production.
OR
 Weighted average cost
The cost of inventories is calculated by using a weighted average price computed by dividing the
total cost of items by the total number of such items. The price is recalculated on a periodic
basis with the items taken out of inventory being removed at the prevailing weighted average
cost.
An entity must use the same cost formula for all inventories having a similar nature and use to the
entity. Note that LIFO (Last In First Out) is not permitted, per IAS 2.

3.3 Net realisable value (NRV)

NRV is the estimated selling price in the ordinary course of business less:
 Estimated costs of completion
 Estimated costs necessary to make the sale (e.g. marketing, selling and distribution costs)
Remember these items are deducted from selling price, not added.

NRV < cost

Inventory may be sold for less than cost in a wide variety of circumstances e.g.
(a) Where there has been an increase in costs or a fall in selling price
(b) Where the inventories have deteriorated or become obsolete
(c) Where a decision has been made as part of the company’s marketing strategy to sell products at
a loss
(d) Where errors in production or purchasing have occurred.
You may be given information in a question telling you that inventory has been sold after the year end
for an amount less than cost. You must adjust the inventory value in the SFP (and hence cost of sales in
the SPorL) to the lower amount.
114 13: Revenue and Inventory AC C A F7
 115

14

Financial instruments

1 IAS 32: Financial Instruments - Presentation

A financial instrument is defined as 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 fall into three categories:
(1) Financial assets: e.g.
 Cash;
 An equity instrument of another entity (e.g. purchase a shareholding in another
company);
 A contractual right to receive cash from another entity, e.g. trade receivables;
 A derivative standing at a gain.
(2) Financial liability: e.g.
 A contractual obligation to deliver cash to another entity; e.g. trade payables, debenture
loans, redeemable preference shares.
 A derivative standing at a loss.
(3) Equity instrument. A contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities; e.g. a company’s own ordinary shares, share options, non-
redeemable preference shares.
A potential problem arises in the presentation of preference shares. Preference shares are shares in a
company which give their holders an entitlement to a fixed dividend but which do not usually carry
voting rights.
Because of this entitlement, it could be argued that the issuing company has an obligation to pay this
dividend, and that the instrument, in substance, has similar characteristics to debt. This is particularly
the case if the preference shares are redeemable i.e. they have to be repurchased by the issuing
company at some future date.
116 14: Financial instruments AC C A F7

Therefore, redeemable preference shares are very often categorised as “liabilities” and not “equity”
(or shares).
A further complication can be added if the preference shares are “cumulative” meaning that any
dividends not paid in any year must be paid in future years. This feature means that cumulative
preference shares (both redeemable and non-redeemable) are very likely to be categorised as a
liability.

2 IFRS 9: Financial Instruments - Recognition and Measurement

2.1 Initial measurement – financial assets and financial liabilities
Most financial instruments are initially measured at fair value +/- any transaction costs (add to assets
and deduct from liabilities).
The exceptions are assets or liabilities held at fair value through the profit or loss account. These are
recorded at fair value excluding transaction costs. Movement in fair values for these items passes
through the statement of profit or loss, as do transaction costs.

2.2 Subsequent measurement – financial assets

Financial assets are classified into one of three categories:

Amortised cost
Amortised cost with the effective interest method is used where:
 The business intends to hold the assets in order to collect contractual cash flows as opposed to
selling the asset (“the business model test”). For exam purposes, this often means that the asset
the company is holding is not equity shares; and
 The contractual terms of the financial asset give rise, on specified dates, to cash flows that are
solely payments of principal and interest (“the contractual cash flow characteristics test”).

Fair value through profit or loss

Financial assets that do not meet the amortised cost criteria, including most equity investments and all
derivatives, must be measured at fair value with the movements in fair value going through the
statement of profit or loss.

Fair value through other comprehensive income

Financial assets are measured at fair value with movements in fair value going through other
comprehensive income where:
 The business intends to hold the assets in order to collect contractual cash flows and to sell
them; and
 The contractual terms of the financial asset give rise, on specified dates, to cash flows that are
solely payments of principal and interest (meaning that the asset is a debt instrument not
equity shares).
Additionally, if equities are held not for trading (i.e. long-term investments), there is an option to take
the gains and losses through “other comprehensive income”/reserves. This decision, once taken, is
irrevocable/irreversible.
AC C A F 7 14: Financial instruments 117

ILLUSTRATION 14.1: AMORTISED COST

Gav Co purchased 5% debentures in Zurich Co on 1 January 2009 (their issue date) for $500,000 as an
investment. Gav intends to hold them for six years, at which point Zurich will have to repay Gav
$560,000. Transaction costs of $5,000 were incurred on purchase. The effective rate of interest
applicable to the bond is 6.5%.
Initial measurement :
Dr Financial asset $505,000 (including the transaction costs of $5,000)
Cr Cash $505,000
Subsequent measurement:
As the financial asset passes the “business model” and “contractual cash flow” tests, it will be
measured at amortised cost :
Year end Effective interest @ Interest received
31 December Asset b/f 6.5% (@5% coupon) Asset c/f
$000 $000 $000 $000
2009 505 32.8 (25) 512.8
2010 512.8 33.3 (25) 521.1
2011 521.1 33.9 (25) 530.0
2012 530.0 34.5 (25) 539.5
2013 539.5 35.1 (25) 549.6
2014 549.6 35.7 (25) 560

Dr Fin asset Dr Cash The year end

Cr PorL : finance income Cr Fin asset balance is
the “amortised
cost”

ILLUSTRATION 14.2: FAIR VALUE

Gav Co purchased 30,000 shares in Jersey Co on 1 November 2010 for $2.00 each as a short-term
investment. Transaction costs on purchase or sale are 1% purchase/sale price. The share price at the
year end, 31 December 2010, was $2.20.
Initial recording :
Dr Financial asset $60,000 (excluding. transaction cost)
Cr Cash $60,000
At the year end
The financial asset will be held at fair value ($2.20), (but potential transaction costs are ignored):
30,000 × $2.20 = $66,000
Therefore, Dr Financial asset $6,000
Cr S of P or L $6,000
118 14: Financial instruments AC C A F7

2.3 Subsequent measurement - financial liabilities

Financial liabilities are normally measured at amortised cost using the effective interest method.
However, financial liabilities held for short-term profit making and/or derivatives are measured at fair
value, with any gains/losses going through the statement of profit or loss:

ILLUSTRATION 14.3: FINANCIAL LIABILITY

Gav Co issued a bond of $200,000 on 1.1.03 for proceeds of $157,763. Interest of 4% is payable
annually on 31 December. The bond will be redeemed on 31.12.2007 for $200,000. (i.e. at par).
The effective rate of interest applicable to the bond is 9.5%.
Initial measurement :
Dr cash $157,763
Cr Financial liability $157,763
Like most financial liabilities, it will be held at amortised cost:
Interest paid
Year Liability b/f Effective interest @ 9.5% (@4% coupon) Liability c/f
$000 $000 $000 $000
2003 157.8 15.0 (8) 164.8
2004 164.8 15.7 (8) 172.5
2005 172.5 16.4 (8) 180.9
2006 180.9 17.2 (8) 190.1
2007 190.1 18.0 (8) 200

Dr SofPorL :Finance costs Dr Fin liability The year end

Cr Fin liability Cr cash balance is
the “amortised
cost”

3 Compound instruments
Compound instruments are those which show characteristics of both equity and financial liabilities.
If this is the case, then we “split” the components on the statement of financial position.
The most common example of a compound instrument is convertible debt – debt that the holder has
the option of converting into shares at some point in the future.
The accounting treatment of convertible debt follows the principle of substance over form; that is, we
pretend that the debt is a combination of debt and equity and “split” the instrument into its two
component parts.
The liability part of the instrument is valued using current market interest rates, with the equity part
being left as a residual (balance).
AC C A F 7 14: Financial instruments 119

LECTURE EXAMPLE 14.1

On 1 January 2011, a company issued a $400,000 5% convertible loan note at par, with interest
payable annually in arrears.
The loan is convertible in four years’ time into equity shares on the basis of $100 of loan note for
10 equity shares or it may be redeemed at par in cash at the option of the loan note holder.
A similar loan note, without the conversion option, would have required the company to pay an
interest rate of 8%.
The present value of $1 receivable at the end of the year, based on discount rates of 5% and 8%, can
be taken as:
5% 8%
End of year 1 0.95 0.93
2 0.91 0.86
3 0.86 0.79
4 0.82 0.74

EXAM SMART
In the exam, and above, you will often be given the annuity factors at the coupon rate too
(here 5%)  Ignore them - they are always a trap.

Required:
Show the initial accounting treatment of the loan note at 1 January 2011 and the balances to be
shown in the financial statements for the year ended 31 December 2011.
(W1) Initial recording on 1 January 2011:
Dr Cash $400,000
Cr Financial liability
Cr Equity (balance)
120 14: Financial instruments AC C A F7

(W2) Fair value of equivalent non-convertible loan note

Year ended
31 December Cash flow Discount rate Discounted cash flow
$000 $000 $000
5% × $400,000 =
2011 $20,000 interest 0.93 18,600
2012
2013
2014
Value of debt component
Value of equity option component ( = balance)
400,000
At 31 December 2011: year end
The financial liability element of the loan note will be measured at amortised cost from 1 January 2011
onwards. Therefore, at 31 December, the amortised cost could be calculated:
Year ended Effective Interest paid
31 December Liability b/f interest @ 8% (@5% coupon) Liability c/f
$000 $000 $000 $000

2011
2012
And so on...
Therefore, for the year ending 31 December 2011, the finance / interest cost in the statement of profit
or loss would be ……………………………………and the financial liability balance on the statement of financial
position would be ……………………………………

4 Transfer of a financial asset – factoring of receivables

IFRS 9 also provides guidance on accounting for the transfer of financial assets and when they should
be derecognised. An example of this is the factoring of receivables.
When a company makes a sale on credit, it faces credit risk i.e. the risk that the customer pays late or
not at all. To reduce this risk, some companies “sell” their debt to a debt factor, who buys the debts
from the seller, normally charging a fee for the immediate payment of the debt.
In order to determine whether the receivable balance should be derecognised, an entity should
consider whether the risks and rewards of ownership have been transferred, for example whether
they are still exposed to credit risk in relation to the balance.

ILLUSTRATION 14.4: FACTORING RECEIVABLES

On 31st March 2015 Apple sold trade receivables with a book value of $15m to Factor. Apple received
an immediate payment of $12m. The terms of the arrangement are as follows:
 Factor Co administers the sales ledger of Apple Co.
 Interest is charged at 2% per month on uncollected debts.
 Any debts not recovered after 90 days are transferred back to Apple Co for immediate cash payment.
Apple has derecognised the receivables and charged $3m to administrative expenses.
Required:
Discuss whether the current accounting treatment is correct.
AC C A F 7 14: Financial instruments 121

SOLUTION:
Apple still bears the risk of the non-payment of the receivables so the substance of this transaction is a
loan. Therefore Apple must continue to recognise the asset on its statement of financial position and
the proceeds of the ‘sale’ treated as a current liability.
The difference between the factored receivables and the loan received of $3m should be removed
from administrative expenses.
The double entry is:
$000 $000
Dr Trade receivables 15,000
Cr Administrative expenses 3,000
Cr Current liabilities 12,000
122 14: Financial instruments AC C A F7

.
 123

15

Provisions and contingencies

1 Provisions
A provision is a liability of uncertain timing or amount. IAS 37 covers those provisions which an entity
may need to meet future payments that it is obliged to pay to third parties.
The standard does NOT apply to allowance for doubtful debts or allowances for depreciation.

1.1 Recognition
The recognition criteria are the same as those in the framework for all liabilities.
 When an entity has a present obligation (legal or constructive) as a result of a past event;
 It is probable (> 50% chance) that an outflow of economic resources will be required to settle
the obligation, and
 A reliable estimate can be made of the amount of the obligation.
All 3 criteria need to be met before a provision can be recognised.
The provision should be calculated each year end, with the movement being taken to the Statement of
profit or loss.
Where the effect of the time value of money is material, the provision must be discounted to the
present value of the future expenditure.

1.2 Present obligations and obligating events

A past event which leads to a present obligation is called an obligating event. For an event to be an
obligating event, it is necessary that the entity has “no realistic alternative to settling that obligation”
created by the event.
124 15: Provisions and contingencies AC C A F7

Legal vs constructive obligations

A legal obligation is one that derives from a contract, legislation or any other operation of law.
A constructive obligation is an obligation that derives from an entity’s actions where:
 From an established pattern of past practice, published policies or a specific 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 in other parties that it will discharge those
responsibilities.

1.3 Application of the recognition and measurement rules

(a) Future operating losses
Provisions should not be recognised for future operating losses as future operating losses do
not meet the definition of a liability or the Conceptual Framework recognition criteria.
(b) Restructuring
A provision for restructuring costs is recognised only when the entity has a constructive
obligation to restructure. Such an obligation only arises where an entity:
 Has a detailed formal plan for the restructuring, and
 Has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement the plan or announcing its main features to those affected by it.

ILLUSTRATION 15.1: CONSTRUCTIVE OBLIGATIONS

On 19 December 2013, the board of an entity decided to close down a division.
Requirement 1:
Assuming that no steps were taken to implement the decision and the decision was not communicated
to any of those affected by the Statement of Financial Position date of 31 December 2013, explain the
appropriate accounting treatment.
There is no “constructive obligation” as the decision has not been communicated to any outside party.
Therefore, no provision is allowed at the year end.
Requirement 2:
Assuming that a detailed plan had been agreed by the board on 19 December 2013, letters sent to
notify customers and the staff of the division have received redundancy notices, explain the
appropriate accounting treatment.
The communication of the plan to customers and staff gives rise to a constructive obligation because
it creates a valid expectation that the division will be closed.
Provision can be made for restructuring costs, e.g. redundancy payments, closure costs, including lease
payments on property, but not for any cost towards the ongoing business such as retraining,
relocation, new computer systems.

(c) Warranty provisions

An entity that sells goods “under warranty” will have a legal obligation to repair those goods
should any faults occur. The entity should make a provision based on its best estimate of the
repair costs.
AC C A F 7 15: Provisions and contingencies 125

ILLUSTRATION 15.2: WARRANTY PROVISION

Sonny sells goods with a one year warranty. If all of the goods sold required minor repairs, the total
cost would be $1.2m. If all of the goods sold required major repairs, the total cost would be $8m.
Sonny expects that 80% of the goods will have no faults, 15% will have minor faults and 5% will have
major faults.
Required:
What provision should Sonny include in its financial statements?
SOLUTION
The expected value of the repair costs is calculated as follows:
Provision
$
No repairs needed 80% × nil cost Nil
Minor repairs needed 15% × $1.2m $180,000
Major repairs needed 5% × $8m $400,000
$580,000

Therefore, Sonny should include a provision of $580,000 in its financial statements.

(d) Decommissioning costs/future repairs

In many industries, where raw materials are extracted, a business may only be granted a licence
if it repairs any damage made during the extraction process.
If there is an obligation to make these repairs, the business should make a provision for them. If
the costs relate to a non-current asset, they can be included as part of the cost of that asset,
and then depreciated as normal.

ILLUSTRATION 15.3: DECOMMISSIONING COSTS

On 31 December 2006, Messy Co constructed an oil rig in the North Sea. The UK Government included
a clause in the licence that Messy had to return the sea bed to its previous state at the end of the
extraction process.
The clean-up costs are estimated to be $26,532,977 in 20 years’ time. The interest rate Messy uses for
its cost of capital is 5%.
Required:
What amounts should be included in Messy’s financial statements in the years ended 31 December
2006 and 2007?
31 December 2006 Present value of $26,532,977 = 26,532,977 = $10,000,000
1.0520
Dr Non-current assets $10m
Cr Provision $10m
31 December 2007 Present value of $26,532,977 = 26,532,977 = $10,500,000
1.0519
Dr Finance cost (SPorL) $0.5m
Cr Provision $0.5m
126 15: Provisions and contingencies AC C A F7

Notice that in the years after initial recognition the difference in value created by the passage of time,
is expensed to the statement of profit or loss as a finance cost. This is sometimes referred to by the
Examiner as “unwinding of the discount”.
The $10m non-current asset needs to be depreciated over 20 years and expensed to the SOCI in the
usual way.

(e) Onerous contracts

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 a vacant leasehold property.

2 Contingent liabilities
A contingent liability is either:
(a) A possible obligation (< 50% chance) whose existence will be confirmed only by the occurrence
of one or more uncertain future events not wholly within the control of the entity; or
(b) An existing obligation that arises from past events but is not recognised because:
 it is not probable that an outflow of economic benefit will be required to settle the
obligation; or
 because the amount of the obligation cannot be measured with sufficient reliability.
Contingent liabilities are not recognised in an entity’s statement of financial position ─ they are merely
disclosed in the notes.

ILLUSTRATION 15.4: CONTINGENT LIABILITIES

Pell Co sells wedding cakes. After a wedding in Bristol, eight people suffered from food poisoning
which has been directly linked to the wedding cake. The married couple are now suing Pell Co. Pell
Co’s solicitor advises them that there is a 40% chance that they will lose the case. If the case is lost,
damages of $200,000 will be payable.
Requirement 1:
How should this matter be dealt with in the financial statements?
Since this is a single event, the most likely outcome will dictate whether a provision is needed. Since
there is a 40% chance of losing the case, Pell Co should NOT provide for the possible damages, but may
disclose the matter as a contingent liability in the notes to its financial statements.
Requirement 2:
After the year end there have been developments in the case which suggest that there is now a 70%
chance that Pell Co will lose the case. How would this information change the financial statements?
As long as the financial statements have not been issued, this development would be sufficient to
change the contingent liability into a provision for potential damages of $200,000, i.e. this is an
adjusting event after the statement of financial position date.
AC C A F 7 15: Provisions and contingencies 127

3 Contingent assets
A contingent asset is a possible asset arising from past events whose existence will only be confirmed
by the occurrence of one or more uncertain future events not wholly within the control of the entity.
An entity should only recognise an asset on its Statement of Financial Position when the realisation of
the profit is virtually certain.
If the realisation is merely probable (> 50% chance), then we can refer to that asset as a contingent
asset and disclose it in the notes to the financial statements. A brief description of the nature of the
contingent asset and, where practicable, an estimate of the financial effect should be disclosed.
If the realisation is possible (i.e. < 50% chance), then no disclosure is required.
128 15: Provisions and contingencies AC C A F7
 129

16

Taxation

1 Current tax
KEY TERM
Current tax. Current tax is the amount of income taxes payable (or recoverable) by a
company in respect of its taxable profit or loss for a period. Current tax is therefore a direct
tax.

A company will estimate how much tax is due on its profits for the year and will record this estimate
with the following journal:
Dr SPorL: Income tax expense
Cr SFP: Income tax liability
Often, the actual amount of tax paid will differ from this estimate. Any such “over-provision” or
“under-provision” is adjusted in the next financial statements.

ILLUSTRATION 16.1: ACCOUNTING FOR CURRENT TAX

Kavanagh estimated that the income tax payable for the year ended 31 December 2011 was $75,000.
It settled the actual tax liability in 2012, paying $79,000.
The tax estimate for the year ended 31 December 2012 is $51,000.
The tax entries for the year ending 31 December 2011 are:
Dr SPorL: Income tax expense $75,000
Cr SFP: Income tax liability $75,000
130 16: Taxation AC C A F7

For the year ending 31 December 2012, we need to acknowledge that the 2011 tax liability estimate
was too low – there was an underprovision of $4,000. This will adjusted through the 2012 accounts:
Dr SPorL: Income tax expense $4,000
Dr SFP: Income tax liability $79,000
Cr Cash $79,000
Cr SFP: Income tax liability $4,000
And then for the 2012 estimate:
Dr SPorL: Income tax expense $51,000
Cr SFP: Income tax liability $51,000
The tax note for the statement of profit or loss for the year ended 31 December 2012 will be drawn
up:
$
Current tax 51,000
Under-provision in 2011 4,000
55,000

2 IAS 12: Deferred Tax

Deferred tax is not a “real” tax, but is simply an accounting adjustment which acknowledges that it is
prudent to provide for any tax due in the future as a result of past events (just like the provision rule).
Deferred tax arises because of temporary differences between the accounting treatment and the tax
treatment of certain items. If you have done F6 you will know, for example, that when calculating the
tax charge we add back depreciation amongst other things and deduct capital allowances (the tax
man’s depreciation).
The temporary difference between the tax treatment and the accounting treatment gives rise to a
deferred tax adjustment.

2.1 Accelerated capital allowances

ILLUSTRATION 16.2: DEFERRED TAX

A business purchases a non-current asset for $100, with a 10-year useful economic life. Capital
allowances (tax depreciation) are available from the local tax authority of 100%. To calculate the
company’s taxable profit, a simple adjustment is needed to its accounting profit before tax:
$
Accounting profit (say) 100
Add: depreciation charge (non-allowable) 10
Less: tax depreciation (allowable) (100)
Taxable profit 10

Therefore, if the tax rate is 30%, the company will pay tax of $3 (30% × taxable profit of $10) and
should therefore have a provision for current tax of $3 in its accounts.
AC C A F 7 16: Taxation 131

However, if we imagine the same computation next year:

$
Accounting profit (say) nil
Add: depreciation charge (non-allowable) 10
Less: tax depreciation (already received full allowance) (nil)
Taxable profit 10

Therefore, next year (and indeed, every year for the next nine years of the asset’s life), the company
will have to pay tax of $3, even if they don’t make an accounting profit. As this tax is unavoidable, they
should provide for it now (it meets the criteria for recognition as a liability).
Since this tax relates to the future taxable profits of the business, we simply refer to it as “deferred
tax” instead of “current tax”, but the journal is identical:
Dr SPorL: Income tax expense (9 years of $3) $27
Cr SFP: Deferred tax liability $27

EXAM SMART
In questions we will calculate the provision by working out the “temporary difference”
between the asset’s carrying value in the accounts and its “tax base” or “tax written down
value” (WDV).

This is easiest done in table format:

NBV Tax WDV Difference Deferred tax
$ $ $ $
End of Year 1 90 0 90 27
End of Year 2 80 0 80 24
End of Year 3 70 0 70 21
The decrease in the deferred tax provision is taken to the SporL as a tax credit.
It should be remembered that for an increase in ANY provision, the double entry is:
Dr SPorL: Tax expense $X
Cr SFP: Provision $X
And for a decrease in a provision (as we have above)
Dr SFP: Provision $X
Cr SPorL: Tax expense $X
where X is the overall movement in the provision.

LECTURE EXAMPLE 16.1

Fit Co acquired non-current assets on 1 April 2010 costing $500,000. The assets qualified for
accelerated first year tax allowance at the rate of 50% for the first year. The second and subsequent
years were at a tax depreciation rate of 25% per year on the reducing balance method.
AB depreciates all non-current assets at 20% a year on the straight line basis.
The rate of corporate tax applying to Fit Co for 2010/11 and 2011/12 was 25%. Assume Fit Co has no
other qualifying non-current assets.
132 16: Taxation AC C A F7

Required:
Apply IAS 12 Income Taxes and calculate:
(a) The deferred tax balance required at 31 March 2011
(b) The deferred tax balance required at 31 March 2012
(c) The charge to the statement of profit or loss for the year ended 31 March 2012

CA Tax WDV Difference Deferred tax

$ $ $ $
1.4.2010
31.3.2011
31.3.2012

2.2 Items credited or charged directly to equity

As we have seen above, the normal double entry for a deferred tax provision is:
Dr S of P or L: Tax expense
Cr SFP: Deferred tax provision
However, gains on certain items are not recorded in the statement of profit or loss, but rather go
straight to reserves. It follows that the “debit” created for deferred tax purposes should also be
recorded in reserves.

ILLUSTRATION 16.3: DEFERRED TAX ON ITEMS CREDITED OR CHARGED DIRECTLY TO EQUITY

Morse revalues an asset with an original cost of $100m and a carrying amount of $80m up to a value
of $150m. The gain of $70m is recorded in the revaluation reserve. This gain will be taxable on the
sale of the asset. Cumulative tax depreciation to date amounts to $30m.
IAS 12 requires a deferred tax liability to be recorded even if the management does not intend to sell
the asset.
Since the revaluation is credited to the revaluation surplus, the movement in deferred tax is also
charged to the revaluation surplus:
The provision is based on the difference between :
Revalued carrying amount ($150m) and the tax value (cost $100m less tax depreciation of $30m =
$70m) i.e. a difference of $80m.
$80m × 30% tax rate = $24m deferred tax provision at the year end.
This compares to a deferred tax provision PRIOR to the revaluation of $3m, calculated as:
Accounting value of $80m ─ tax value of $70m ($100m cost ─ $70m tax depreciation) = $10m × 30% =
$3m.
Therefore, adjustment needed =
Dr SFP: Revaluation reserve $21m
Cr SFP: Deferred tax liability $21m

This means that the final revaluation reserve at the end of the year is $70m - $21m = $49m
AC C A F 7 16: Taxation 133

3 Tax losses
If a company makes tax losses, it will generally be allowed to carry forward those losses against any
future profits, thus reducing the tax payable in the future.
For example, if Co X has tax losses of $1,000,000 brought forward at 1 January 2014, then made a
taxable profit of $1,500,000 during 2014, it would only pay tax of $150,000
[($1,500,000 – $1,000,000) × 30%] and not $1,500,000 × 30% = $450,000.
This is a saving of $300,000. As long as Co X can foresee using these tax losses against future profits,
it would be able to include a deferred tax asset of $300,000 in the financial statements for year ended
31 December 2013.
Dr Deferred Tax asset $300,000
Cr PorL Tax expense $300,000
In addition to the tax note, the company should also disclose the difference between accounting and
taxable profits.
134 16: Taxation AC C A F7
 135

17

IAS 33: Earnings per Share

1 Earnings per Share: IAS 33

IAS 33 applies to all companies with shares which are publicly traded. EPS figures need to be disclosed
on the face of the statement of profit or loss.
There are two types:
 Basic earnings per share
 Diluted earnings per share

1.1 Basic earnings per share

Definitions
 Earnings: Profit or loss for the period attributable to ordinary equity holders of the parent i.e.
consolidated profit after tax, non-controlling interests (see Chapter 3) and preference dividends
 No. of shares: The weighted average number of equity shares in issue. There are three types of
share issue that you need to be familiar with:
(i) Issue at full market price
(ii) Bonus issue
(iii) Rights issue
 Theoretical ex-rights price (TERP): This is the theoretical share price that would arise after a
rights issue if there were no additional information available in the market.
You must learn the formula for EPS:
Earnings
EPS (in cents) = × 100
Weightedave No. of shares
136 17: IAS 33: Earnings per share AC C A F7

1.2 Calculation of weighted average number of shares

(1) Issue at full market price (FMP)
Where an issue of shares is made at FMP, the number of shares for the year will need to be
time-apportioned.

ILLUSTRATION 17.1: CALCULATION OF WEIGHTED AVERAGE NUMBER OF SHARES

A company has earnings of $200,000 and a year end of 31 December. On 1 October 2013 the company
issued 200,000 $1 ordinary shares at full market price. The issued share capital before the share issue
was 800,000 shares.
Weighted average number of shares
Weighted average
Date Narrative No. of shares Time no of shares
1.01.13 Opening bal 800,000 × 9/12 600,000
1.10.13 Issue @ FMP 200,000
1,000,000 × 3/12 250,000
31.12.13 850,000

$200,000
EPS = × 100 = 23.5 cents per share (cps)
850,000

(2) Bonus issue

Bonus shares are issued for no consideration. Therefore, the same level of profits will now be
applied to a higher number of shares. From a comparative perspective this can lead to a
distortion (see below).

ILLUSTRATION 17.2: BONUS ISSUES

A company with a 31 December year end and issued share capital of 100 $1 shares makes a 2 for 1
bonus issue on 1 July 2014 (i.e. two new shares are given away to each holder of one share).
The company’s summary results are:
2014 2013
Earnings (say) $20 $20
No of shares 300 100
EPS 6.6cps 20cps
If we only look at the EPS year on year, we might assume that the company’s performance has
deteriorated, whereas all that has happened is that the number of shares has trebled.
To make EPS comparable, we need to calculate the weighted average number of shares and restate
the 2013 figure as if it had the same share capital as 2014. To do this, we apply a “bonus fraction” to
all shareholdings prior to the bonus issue.

Bonus fraction = New number of shares

Old number of shares

In the above illustration 300/100 = 3.

AC C A F 7 17: IAS 33: Earnings per share 137

Weighted
No. of average no
Date Narrative shares Time Bonus fraction of shares
1.01.14 Opening bal 100 × 6/12 300/100 150
1.07.14 Bonus issue 200
300 × 6/12 150
31.12.14 300

2014 Earnings per share = $20 × 100 = 6.67cps

300
This compares with 20 cps in 2013. Now to comply with the standard we need to restate the
comparative. We do this by multiplying by the inverse of the fraction.
2013 Earnings per share = 20 cps × 1/3 = 6.67cps

(3) Rights issue

A rights issue gives current shareholders the right but not the obligation to buy new shares in a
company. In calculating the weighted average number of shares a rights issue also requires a
bonus fraction to be applied to all shareholdings prior to the rights issue in the same way as the
bonus issue. However, the bonus fraction is calculated as:

Bonus fraction = Fair value per share immediately before exercise of rights
Theoretical ex rights price (TERP)

An easier way to remember this formula is old share price

new share price
Calculation of “TERP” (or new share price)

ILLUSTRATION 17.3: RIGHTS ISSUE

A company makes a rights issue on a 1 for 3 basis. The share price immediately before the rights issue
was $8 and the rights price was $6.
$
3 shares × $8 = 24.00
1 share × $6 = 6.00
4 shares 30.00

TERP = $30 / 4 shares = $7.50 (i.e. in theory, the new share price should fall to $7.50).
Bonus fraction = 8 / 7.50
This is then applied to the shares in issue before the issue date, as in the previous illustration.
The comparative EPS figure would be restated multiplied by the inverse fraction, i.e. 7.50 / 8.

LECTURE EXAMPLE 17.1

On 1 January 2013, Gardiner Co had 2,000,000 ordinary shares in issue. On 30 June 2013 the company
made a rights issue of 1 for 5 @ $2.00. The fair value of the shares on the last day before the issue of
shares from the rights issue was $3.00.
Finally, on 31 October 2013 the company made a 1 for 10 bonus issue.
Profit for the year was $500,000. The reported EPS for year ended 31 December 2012 was 15.2c.
138 17: IAS 33: Earnings per share AC C A F7

Required:
Calculate the EPS for year ended 31 December 2013 and the restated EPS for year ended 31 December
2012.
Weighted
No. of Bonus average no
Date Narrative shares Time Fraction of shares

TERP =

Bonus fraction =

1.3 Diluted EPS

Diluted EPS acts as a “warning sign” for investors in that it shows what the EPS could become if all
“potential shares” were actually in issue.
Common scenarios include:
 Convertible loan stock
 A company that has issued share options to directors or employees
The issue of shares attached to these instruments would adversely affect EPS. Imagine investing in a
company with what appears to be a high EPS and then three months later the directors cash in their
share options and suddenly the EPS is half what you expected.
To protect shareholders and investors, companies must disclose diluted EPS figures.
AC C A F 7 17: IAS 33: Earnings per share 139

Convertible loan stock

With convertible loans the principle is to “pretend” that the loan stock does not exist and that the
shares have been issued instead. To do this the interest expense (net of tax) from the loan stock needs
to be added back to profits and the shares that would be issued added to those already issued.

LECTURE EXAMPLE 17.2

Tower Co had the same 10 million ordinary shares in issue on both 1 January 2013 and 31 December
2013. On 1 January 2013, the company issued 1,400,000 $1 units of 5% convertible loan stock. Each
unit of stock is convertible into 6 ordinary shares on 1 April 2016 at the option of the holder. The
following is an extract from Tower Co's statement of profit or loss for the year ended 31 December
2013:
$000
Profit from operations 620
Interest payable on 5% convertible loan stock (70)
Profit before tax 550
Income tax at 30% (165)
Profit for the year 385

Required:
Calculate the basic and diluted earnings per share figures for the year ended 31 December 2013.
Basic EPS =

Diluted EPS =

Working

Earnings: $
Net basic earnings
Add back: loan stock interest net of income tax (or preference dividends) “saved”

No. of
No of shares: shares
Basic weighted average
Add: additional shares on conversion
Diluted number of shares
140 17: IAS 33: Earnings per share AC C A F7

(a) Share options or warrants

With share options, the principle is to “pretend” that the shares have already been issued,
however as the options are normally issued at a discount to the market price, effectively the
option holder gets some free shares. It is the free shares we are interested in.

LECTURE EXAMPLE 17.3

Happy Co has a profit of $4m for the year ended 31 October 2014 and 1.8m ordinary shares in issue.
Happy Co also had outstanding 150,000 options for the whole year with an exercise price of $10.
The average market price of one ordinary share during the period was $15.
Required:
Calculate the basic and diluted EPS.
Basic EPS =

Diluted EPS =

The technique used for share options is quite different to that for convertible debt:

STEPS
Step 1: Calculate the cash receivable on the exercise of the options  Here, 150,000 × $10 =
$1,500,000.
Step 2: Calculate the number of shares that would have been issued if the cash received had
been used to buy shares at average market price for the period.
Step 3: Deduct the figure in (2) above from the actual number of shares issued – this gives you
the number of shares that have effectively been “given away”.
Step 4: Add these “free” shares to the average number of shares for the period to derive the
diluted EPS.
 141

Solutions to
Class lecture examples

Chapter 1
Lecture example 1.1
A Group
$
ASSETS
Non-current assets
Property, plant and equipment 21,200
Goodwill (W1) 70

Current assets
Inventories 6,500
Trade receivables 2,550
Cash 1,600
31,920
EQUITY AND LIABILITIES
Equity
Share capital 14,000
Retained earnings (W2) 16,470

Current liabilities 1,450

31,920
142 Solutions to Class lecture examples AC C A F7

(W2) Group retained earnings

A B
$ $
Retained earnings at reporting date per question 15,000 1,600
Retained earnings at acquisition (100)
Therefore, B’s post-acq’n ret. earnings 1,500
Group share of B’s post-acquisition ret. Earnings
(100% × 1,500) 1,500
16,500
Less: goodwill impairment losses to date (30)
16,470

Lecture example 1.2

Eric
Group
$
ASSETS
Non-current assets
Property, plant and equipment (15,000 + (100% × 3,000)) 18,000
Goodwill (W1) 4,400
Current assets
Inventories (4,000 + 2,000) 6,000
Trade receivables 5,000
Cash 1,900
TOTAL ASSETS 35,300

EQUITY AND LIABILITIES

Equity
Share capital 14,000
Retained earnings (W2) 14,300
Non-controlling interest (W3) 1,600
Current liabilities 5,400
35,300

(W1) Goodwill
$ $
Cost of combination 10,000
Plus : NCI (20% × 6,500) 1,300
Less : % of Ernie’s net assets at acq’n :
Share capital 3,500
Retained earnings 3,000
(6,500)
Goodwill at acquisition date 4,800
Cumulative impairments since acq’n (400)
Carrying amount of goodwill 4,400
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 143

(W2) Group retained earnings

Eric Ernie
$ $
Retained earnings at reporting date per question 13,500 4,500
Retained earnings at acquisition (3,000)
Therefore, Ernie’s post-acq’n ret. earnings 1,500
Group share of Ernie’s post-acquisition ret. earnings (80% × 1,500) 1,200
Less: goodwill impairment losses to date (400)
14,300
(W3) Non-controlling interest
NCI% × Ernie’s net assets at acquisition (from goodwill working) 1,300
+ NCI % × Ernie’s post-acq’n retained earnings (20% × 1,500) 300
$1,600

Note: We split the subsidiary’s post-acquisition reserves of 1,500 into “our share” (80%) and “the NCI
share” (20%)  you do this in EVERY group question.

Lecture example 1.3

Bono
Group
$
ASSETS
Non-current assets
Property, plant and equipment 13,000
Goodwill (W1) 500
Current assets
Inventories 29,000
Trade receivables 5,300
Cash 4,700
TOTAL ASSETS 52,500

EQUITY AND LIABILITIES

Equity
Share capital 10,000
Revaluation Surplus (W4) 2,350
Retained earnings (W2) 14,175
Non-controlling interest (W3) 1,775
Trade payables 24,200
52,500
144 Solutions to Class lecture examples AC C A F7

(W1) Goodwill
$ $
Cost of combination 5,000
Plus: NCI at acquisition (25% × 4,800) 1,200
Less: % of B’s Net Assets at acq’n :
Share capital 2,000
Revaluation surplus 300
Retained earnings 2,500
(4,800)
Goodwill at acquisition date 1,400
Cumulative impairments since acq’n (900)
Carrying amount of goodwill 500

(W2) Group retained earnings

Bono Edge
$ $
Retained earnings at reporting date per question 14,700 3,000
Retained earnings at acquisition (2,500)
Therefore, Edge’s post-acq’n ret. earnings 500
Group share of Edge’s post-acquisition ret. earnings (75% × 500) 375
Less: goodwill impairment losses to date (900)
14,175

(W3) Group revaluation surplus

Bono Edge
$ $
Revaluation Surplus at reporting date per question 1,000 2,100
Revaluation Surplus at acquisition (300)
Therefore, Edge’s post-acq’n rev’n surplus 1,800
Group share of Edge’s post-acquisition rev’n surplus (75% × 1,800) 1,350

2,350

(W4) Non-controlling interest

NCI% × Net assets at acq’n (from goodwill) 1,200
+ NCI% × sub’s post acq retained earnings (25% × 500 (W2)) 125
+ NCI% sub’s post acq revaluation reserve (25% × 1,800 (W3)) 450
$1,775
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 145

Chapter 2
Lecture example 2.1
Posh Group - Consolidated statement of financial position of Posh Ltd group as at 31 December 2012
Posh
Group
$000
Non-current assets
Property, plant & equipment (13,000 + 2,000+ 10 FV (W2)) 15,010
Goodwill (W4) 5,405
Investments (i.e. investments other than that in Becks) 7,000
Current assets
Inventories (3000+1000-1000 PUP (W3)) 3,000
Trade receivables (1,200+2,000-100 cash-in-t -300 i/co) 2,800
Cash (1,500+200+100 cash in transit) 1,800
35,015

Equity
Share capital (10,000+1500 (W1)) 11,500
Share premium (W1) 6,000
Retained earnings (W5) 12,530
Non-controlling interest (W6) 1,885
Current liabilities
Trade payables (3,200 + 200 – 300i/co) 3,100
35,015

(W2) Fair value adjustment

At
At reporting
acquisition Change date
$000 $000 $000
Inventories (now sold) 50 (50) Nil
Property, plant and equipment 20 (10) 10
70 (60) 10

(W3) PUP adjustment to goods held in inventory.

PUP = profit on intercompany sale × % of goods still in stock at the year end
= $1,600 × 2.5/4
= $1,000
Dr Retained earnings $1,000
Cr Inventories $1,000
In Beck’s (seller’s) accounts
146 Solutions to Class lecture examples AC C A F7

(W4) Goodwill
$000 $000
Cost of combination (W1) 7,500
Non-controlling interest (25% × 3,000 shares = 750 shares @ $2.50 each) 1,875
Less: % of B’s net assets at acq’n (at fair value):
Share capital 3,000
Retained earnings 800
Fair value adjustment (from W2) 70
(3,870)
Goodwill at date of acquisition 5,505
Less: impairments to date : (100)
Final goodwill on consol SFP 5,405
(W5) Group retained earnings
Posh Becks
$000 $000
Per question 12,500 2,000
At acq’n date (800)
Fair value adj’t (W2) ( 60)
PUP adjt (W3) (1,000)
140
Group share (75% × 140) 105
Less : impairment in goodwill (100 × 75%)) (75)
Group Retained Earnings 12,530

(W6) Non-controlling interest

NCI @ acquisition (from goodwill working) 1,875
Plus : NCI share of post-acq’n retained earnings: (25% × 140) 35
Less : NCI share of goodwill impairment (25% × 100) (25)
Therefore, NCI = $1,885

Lecture example 2.2

(W1) Goodwill
$ $
Cost of combination 3,000
Plus: NCI 900
Less: % of Henman net assets at acq’n :
Share capital 1,500
Share premium 50
Retained earnings (W2) 2,250
(3,800)
Goodwill at acquisition date 100

(W2) Retained earnings of Henman at 30 September 2011

$
Retained Earnings @ 1 January 2011: 1,500
Plus : profit for the 9 months to 30 September (9/12 × 1,000) 750
Retained earnings at 30 September 2011 2,250
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 147

Chapter 3
Lecture example 3.1
$
Revenue (20,000 + 15,000 – 5,000 w1) 30,000
Cost of sales (13,200 + 7,800 – 5,000 + 500 w2) (16,500)
Gross profit 13,500
Distribution costs (1,200 + 1,650) (2,850)
Administrative expenses (1,700 + 2,200) (3,900)
Profit before tax 6,750
Income tax expense (1,300 + 1,000) (2,300)
Profit for the period 4,450

Attributable to:
Owners of the parent (balancing figure) 4,080
Non-controlling interest (20% ×(2,350 – 500 (W2)) 370
4,450

Workings
Intercompany sale
(W1) Sale itself
Dr Group revenue $5,000,000
Cr Group COS $5,000,000
(W2) PUP
Dr COS ($2m × ¼) $500,000
Cr Inventories $500,000
In the books of the company making the sale – here, the subsidiary Bahama. This will affect the non-
controlling interest.

Lecture example 3.2

Iceland Group – Consolidated Statement of profit or loss for the year ended 31 December 2011
$
Revenue (10,000 + (1,000 × 3/12) – 300 (W1)) 9,950
Cost of sales and expenses (4,000 + (700 × 3/12) – 300 + 20 (W2)) + 30 imp. +14 FV) (3,939)
Profit before tax 6,011
Income tax expense ( 1,400 + (90 × 3/12) (1,423)
Profit for the period 4,588

Attributable to:
Owners of the parent 4,587
Non-controlling interest (10% × ((3/12 × 210) - 14 FV dep’n – 30 impairment)) 1
4,588

Intercompany sale
(W1) Sale itself
Dr Group revenue $300
Cr Group COS $300
148 Solutions to Class lecture examples AC C A F7

(W2) PUP
Dr COS ($40 × ½ ) $20
Cr Inventories (SFP) $20

Chapter 4
Lecture example 4.1
Pink Group – Consolidated statement of financial position as at 31 December 2011
$000
Property, plant and equipment 22,000
Goodwill (W1) 1,500
Investment in associate (W4) 1,800
Current assets (8,100 + 4,200 – 200 (W2)) 12,100
37,400

Share capital 4,000

Retained earnings (W5) 25,460
Non-controlling interest (W4) 1,940
Liabilities 6,000
37,400

Workings
(W1) Goodwill in Spears
$000 $000
Cost of combination: controlling interest 7,000
Non-controlling interest (20% × 3,000 SC = 600 shares @$2.50 per share) 1,500
Less: S’s net assets at acq’n:
Share capital 3,000
Retained earnings 4,000
(7,000)
Goodwill at acquisition date 1,500
Less: impairment losses to date (nil)
1,500

(W2) PUP
PUP = profit on intercompany sale × % of goods still in stock at the year end
(25% profit margin × $6m × 2/6)
= $500,000
BUT: the sale involved an associate so we also need to take the Associate’s share of this PUP
= 40% × $500,000 = $200,000
Therefore,
Dr Group retained earnings $200,000
Cr Group inventories (as the inventories are held by Pink) $200,000
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 149

(W3) Group retained earnings

Pink Spears Aguilera
$000 $000 $000
Per question 24,600 6,200 3,500
Less: PUP (W2) (200)
Retained earnings at acquisition (4,000) (3,000)
Therefore, post-acq’n ret. earnings 2,200 500
Group share of Spear’s post-acq’n ret. earnings (80%) 1,760
Group share of Aguilera’s post-acq’n ret. earnings (40% × 500) 200
Less: impairment losses to date (900)
25,460

(W4) Investment in associate

$000
Cost of associate 2,500
Plus: post-acq’n retained reserves (40% × 500) 200
Less: impairment losses on associate to date (900)
1,800

(W5) Non-controlling interest (in subsidiary only)

$000
NCI% × Spears NA @ acq’n (see goodwill working) 1,500
NCI% × Spears retained earnings (20% × 2,200) 440
1,940

Lecture example 4.2

Pink Group – Consolidated Statement of profit or loss for year ended 31 December 2011
$000
Revenue (30,000 + 15,000) 45,000
Cost of sales (16,000 + 6,000) (22,000)
Gross profit 23,000
Expenses (3,500 + 3,000) (6,500)
Finance income 100
Finance costs (1,000 + 500) (1,500)
Share of profit of associate (40% × 1,840)– 300 impairment – 200 PUP) 236
Profit before tax 15,336
Income tax expense (1,600 + 1,300) (2,900)
Profit for the year 12,436

Attributable to:
Owners of the parent 11,596
Non-controlling interest (20% × 4,200) 840
12,436
150 Solutions to Class lecture examples AC C A F7

Solutions to additional PUP questions

Don’t forget that a PUP = profit made on the intercompany sale x percentage of goods left in inventory
at the year end.
(1) S sells to P, so the profit is in S.
$ %  note that this is markup of 25%
Sales 15,000 125
COS (12,000) 100
Profit 3,000 25
The profit made on the sale = 15,000 × 25/125 = 3,000.
As only 20% is still in inventory:
PUP adj = profit made on the i/co sale × percentage of goods left in inventory at the year end.
= 3,000 × 20%
= 600
Adjustments to statement of profit or loss
For the original sale:
Dr Revenue 15,000 (decrease)
Cr Cost of sales 15,000 (decrease)
For the PUP:
Dr Cost of sales (P/L) & retained earnings 600 (increases COS and decreases RE)
Cr Inventories 600 (decrease)
This PUP adjustment is made in the seller’s books  here, S, the subsidiary.
At the bottom of group statement of profit or loss when apportioning profit between parent
and NCI, reduce the subsidiary’s profit by 600.
(2) P sells to S so the profit is in P.
$ %  note that this is margin of 30%
Sales 24,000 100
COS (16,800) 70
Profit 7,200 30
The profit made on the sale = 24,000 × 30/100 = 7,200
As only 30% is still in inventory:
PUP adj = profit made on the i/co sale × percentage of goods left in inventory at the year end.
= 7,200 × 30%
= 2,160
Adjustments to statement of profit or loss
For the original sale:
Dr Revenue 24,000 (decrease)
Cr Cost of sales 24,000 (decrease)
For the PUP:
Dr Cost of sales (P/L) & retained earnings 2,160 (increases COS and decreases RE)
Cr Inventories 2,160 (decrease)
This PUP adjustment is made in the seller’s books  here, P, the parent.
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 151

(3) S sells to P so the profit is in S.

$
Sales 18,000
COS (balance) (15,000)
Profit 3,000
As only 6.000/18,000 = 33.33% is still in inventory:
PUP adj = profit made on the i/co sale × percentage of goods left in inventory at the year end.
= 3,000 × 33.33%
= 1,000
Adjustments to statement of profit or loss
For the original sale:
Dr Revenue 18,000 (decrease)
Cr Cost of sales 18,000 (decrease)
For the PUP :
Dr Cost of sales (P/L) & retained earnings 1,000 (increases COS and decreases RE)
Cr Inventories 1,000 (decrease)
This PUP adjustment is made in the seller’s books  here, S, the subsidiary.
At the bottom of group statement of profit or loss when apportioning profit between parent
and NCI, reduce the subsidiary’s profit by 1,000
(4) P sells to A so the profit is in P.
However, when dealing with an associate it is easier to consider who has the inventory.
In this case it will be A.
$ %  note that this is markup of 20%
Sales 30,000 120
COS (25,000) 100
Profit 5,000 20
The profit made on the sale = 30,000 × 20/120 = 5,000
As only 50% is still in inventory:
PUP adj = profit made on the i/co sale × percentage of goods left in inventory at the year end.
= 5,000 × 50%
= 2,500
AND , as the sale involves an associate, we also need to multiply the PUP of 2,500 by the share
of the associate of 30% = 750
Adjustments to statement of profit or loss
For the original sale:
No adjustments needed for sales to/from an associate
For the PUP:
Dr P’s Retained Earnings 750 decreases RE)
Cr Invt in Associate 750 (decrease)
152 Solutions to Class lecture examples AC C A F7

(5) A sells to P so the profit is in P.

However when dealing with an associate it is easier to consider who has the inventory.
In this case it will be P.
$ %  note that this is markup of 25%
Sales 16,000 125
COS (12,800) 100
Profit 3,200 25
The profit made on the sale = 16,000 × 25/125 =3,200
As only 25% is still in inventory:
PUP adj = profit made on the i/co sale x percentage of goods left in inventory at the year end.
= 3,200 × 25%
= 800
AND, as the sale involves an associate, we also need to multiply the PUP of 800 by the share of
the associate of 30% = 240
Adjustments to statement of profit or loss
For the original sale:
No adjustments needed for sales to/from an associate
For the PUP:
Dr P’s Retained Earnings 240 decreases RE)
Cr Inventories 240 (decrease)
(6) P sells to S so the profit is in P.
This is an asset sold in excess of book value so the profit is unrealised.
Sales value 6,000,000
Book value (4,000,000)
Profit 2,000,000
This is depreciated over the useful life left at date of sale in this case 5 yrs = 400,000 per year.
The transaction occurred at the start of the previous year so two years’ depreciation is to be
deducted.
Total adj = 2,000,000-800,000= 1,200,000
Adjustments to statement of profit or loss
The extra depreciation will have been charged to the statement of profit or loss in S so there is
no statement of profit or loss adjustment to make.
No adjustment to NCI as profit is in P
Adjustments to SFP
Dr P’s (seller’s) retained earnings 1,200,000 (decrease)
Cr Property plant and equipment 1,200,000 (decrease)
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 153

Chapter 5: No lecture examples

Chapter 6
Lecture example 6.1
Patchin Ltd – Statement of cash flows for the year ended 31 December 2011
Cash flows from operating activities $000 $000
Profit before taxation 89
Adjustments for:
Depreciation (W1) 115
Amortisation (W2) 15
interest expense (5% × 140) 7
profit on disposal of equipment (9)
217
increase in trade receivables (250 – 189) (61)
increase in inventories (420 – 370) (50)
decrease in trade payables (170 – 210) (40)
increase in provisions (50 – 35) 15
Cash generated from operations 81
interest paid (7)
income taxes paid (W3) (107)

Net cash from operating activities (33)

Cash flows from investing activities

Development expenditure (W2) (82)
Purchase of property, plant and equipment (160)
Proceeds from sale of equipment 60
Net cash used in investing activities (182)
Cash flows from financing activities
Proceeds from issue of shares (W5) 135
Proceeds from issue of debentures 140
Payment of finance lease liabilities (W4) (16)

Net cash from financing activities 259

Net increase in cash and cash equivalents 44
Cash and cash equivalents at the beginning of period 1
Cash and cash equivalents at end of period 45

Note: Cash and cash equivalents

Cash and cash equivalents included in the statement of cash flow comprise the following statement of
financial position amounts:
2011 2010
$000 $000
Cash on hand 25 8
Overdraft (10) (7)
Short-term investments 30 –
Cash and cash equivalents 45 1
154 Solutions to Class lecture examples AC C A F7

Workings
(W1) – PPE: net carrying amount
$000
b/f 397
Additions 160
New finance lease 61
Revaluation 60
Disposals (NCA) (51)
Depreciation charge (bal) (115)
C/f 512
Profit on disposal
$000
Proceeds 60
Less : NCA of assets sold Bal (51)
Profit on disposal 9
(W2) – Intangible assets : dev’t costs
$000
b/f 13
Additions (bal) 82
Amortisation charge (15)
C/f 80

(W3) Share issue

Share Share
capital premium
$000 $000
Bal b/f 165 100
Bonus issue: 1 for 15 11 Nil
Therefore, “another share issue” – assume for cash Balance 24 111
Bal c/f 200 211
Therefore, cash received = 135
(W4) – Retained Earnings
$000
b/f 278
Loss per stmt of P or L (21)
Bonus issue (11)
Dividend paid (bal) (nil)
C/f 246

(W5) – Tax paid

$000
b/f (IT of 100 + DT of 17 117
Tax charge per stmt of P or L 110
Tax paid (bal) (107)
C/f (IT of 90 + DT of 30) 120
(W6) – finance lease liability
$000
b/f (<1yr of 55 + > 1 yr of 10) 65
New finance lease 61
Finance lease paid (bal) (16)
C/f (< 1 yr of 90 + > 1 yr of 20) 110
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 155

Chapters 7 to 8: No lecture examples

Chapter 9
Lecture example 9.1
Y/e Depreciation charge NCA at year end
$000 $000
2013 120/8 = 15 120 – 15 = 105
2014 15 90
2015 45 45
2016 45 Nil

On 1 January 2015, its remaining life is revised down to two years. Therefore, the depreciation
charge = Remaining net carrying amount – residual value
Remaining useful life
= 90,000 = $45,000 per annum
2 years

Lecture example 9.2

Y/e Depreciation charge NCA at year end Revaluation reserve
$000 $000 $000
2001 $100/10 years = 10 100–10 = 90 Nil
2002 10 80 Nil
At 1 January 2003: revalue from NCA of $80,000 to $120,000, thereby creating a revaluation surplus of
$40,000:
Dr Cost (120,000 – 100,000) 20,000
Dr Accumulated depreciation (clear out all depreciation to date) 20,000
Cr Revaluation surplus $40,000
New depreciation based on the revalued amount: $120,000 = $15,000
8 years
This compares to an “original” annual depreciation charge of $10,000 per annum, an “excess” of
$5,000. The company should transfer an element of this amount from the revaluation surplus to
retained earnings for each remaining year of the asset’s life.
Y/e Depreciation charge NCA at year end Revaluation reserve
$000 $000 $000
2003 15 120–15 = 105 40 – 5 = 35
2004 15 90 30
2005 15 75 25

The disposal takes place on 31 December 2005:

$000
Proceeds 190
Less : NCA at date of disposal (75)
Profit on disposal 115
156 Solutions to Class lecture examples AC C A F7

Dr Cash 190
Dr Non-current assets (Accumulated depreciation) 45
Cr Non-current asset (Cost/value) 120
Cr SPorL: profit on disposal 115
As the asset is no longer on the statement of financial position, the revaluation surplus must be
eliminated. This is done by transferring any balance on that account to the retained earnings reserve:
Dr Revaluation surplus 25
Cr Retained earnings 25

Lecture example 9.3

Capitalisation of borrowing costs should commence when construction starts (1 March 2005) and
cease when the warehouse is ready for use (1 October 2005).
During May and June 2005, whilst construction was interrupted, borrowing costs may not be
capitalised.
Any interest received when the funds were invested should be deducted from the borrowing costs
capitalised. Note that had the interest been earned in a period where the interest costs were not being
capitalised, then the $50,000 would have been recognised in profit or loss as interest income.
$
$8,000,000 × 4% × 5/12 (Mar, Apr, Jul, Aug, Sept) 133,333
Less: interest received (50,000)
83,333

Lecture example 9.4

Recoverable amount = higher of:
 fair value less costs of disposal = Net Realisable Value = $36,000
 Value in Use = $44,000
Therefore, there is an impairment of $7,000

Lecture example 9.5

Y/e Depreciation charge NCA at year end
$000 $000
2002 15/5 = 3 15 – 3 = 12
2003 3 9
The impairment test at 31 December 2003 reveals a recoverable amount of $6,000. The impairment is
therefore $3,000:
Dr SPorL $3,000
Cr Non-current asset $3,000

Y/e Depreciation charge NCA at year end

$000 $000
2004 6/3 = 2 6–2=4
2005 2 2
2006 2 Nil
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 157

Chapter 10: No lecture examples

Chapter 11
Lecture example 11.1
FiT Co –Statement of profit or loss and other comprehensive income for the year ended
30 September 2012
$000
Revenue ( 10,000 – 470) 9,530
Cost of sales (W1) (3,470)
Gross profit 6,060
Distribution costs (W1) (580)
Administrative expenses (W1) (540)
Finance cost (30 TB + 10 accrued) (40)
Profit before tax 4,900
Income tax expense (W4) (1,550)
Profit for the year from continuing operations 3,350
Loss for the year from discontinued operations (415)
Profit for the year 2,935
Other comprehensive income:
Gains on revaluation 1,580
Total comprehensive income 4,515
158 Solutions to Class lecture examples AC C A F7

FiT Co - Statement of financial position as at 30 September 2012

Assets $000
Non-current assets
Property, plant and equipment (W3) 10,460
Current assets
Asset held for sale (W2) 2,700
Inventories 630
Receivables (590-70) 520
Cash and cash equivalents 40
TOTAL ASSETS 14,350

EQUITY AND LIABILITIES

Equity
Share capital (1,000 TB + rights issue of 500) 1,500
Share premium (net of share issue expense) 480
Revaluation surplus 1,580
Retained earnings 8,200
Total equity 11,760
Non-current liabilities: Loan Note 400
Current liabilities
Trade payables 630
Interest accrual 10
Income tax payable 1,550
2,190
Total liabilities 2,590
TOTAL EQUITY AND LIABILITIES 14,350

Statement of changes in equity for the year ended 30 September 2012

Share Share Revaluation Retained
capital premium surplus earnings Total
$000 $000 $000 $000 $000
1 Oct 2011 1,000 – 5,910 6,910
Fraud prior year (45) (45)
Dividend (600) (600)
Property reval. 1,580 1,580
Share issue 500 500 1,000
Share issue expenses (20) (20)
Profit for the year 2,935 2,935
Total 1,500 480 1,580 8,200 11,760

Workings
(W1) Expense categories
Admin
Cost of sales Dist’n costs expenses
$000 $000 $000
Per TB 3,330 700 600
Discontinued operations (280) (120) (85)
Fraud 25
Depreciation charge (W4): 420
3,470 580 540
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 159

(W2) Discontinued operation (working in 000s)

Carrying amount: Fair value less costs to sell = 3,000–300 = 2,700 (As less than NCA see below to SFP)
Net carrying amount = Goodwill 200
Lighting shops 4,150
Depreciation (1,250)
Total 3,100
Therefore, impairment of 3,100 – 2,700=400 (To discontinued operation expenses below).
Discontinued operation result
$000
Revenue 470
Cost of Sales (280)
Admin Expenses (85)
Distribution costs (120)
Impairment (above) (400)
Loss on discontinued operation (415)

(W3) Property, plant and equipment

Plant and
Premises equipment Total
$000 $000 $000
Cost b/f 9,000 1,800 10,800
Accum dep’n b/f (900) (600) (1,500)
Carrying amount b/f 8,100 1,200 9,300
Additions/Disposals – – -
Depreciation charge (W4) (180) (240) (420)
Revaluation (9,500 – (8,100 – 180) 1,580 – 1,580
c/f 9,500 960 10,460

(W4) Depreciation charge

$000
Premises : 2% × 9,000 180
Plant and equipment : 20% × (1,800 – 600)) 240
(W5) Share capital
1,000,000
Shares in issue prior to rights issue = = 2,000,000 shares.
0.50 𝑐𝑒𝑛𝑡𝑠

1 for 2 rights issue therefore led to an issue of 1,000,000 new shares.

Nominal value of new shares = 1,000,000 × 50 cents= 500,000
Actual entry made was:
Dr Cash 980
Cr Suspense 980
Should have been:
Dr Cash 980
Cr SC 500
Cr SP 480
Note: Share issue expenses can be offset against the share premium account.
160 Solutions to Class lecture examples AC C A F7

Chapter 12
Lecture example 12.1
$
Statement of profit or loss (extract)
Depreciation (W2) 3,200
Finance costs (W1) 1,920
Statement of financial position (extract)
Non-current assets
Property, plant and equipment (W2) 12,800
Non-current liabilities
Finance lease liability (W1) 11,590
Current liabilities
Finance lease liability (W1) 2,330

Working 1

FL Liability
1.1.2014 Asset 16,000
1.1.14 to 31.12.14 Interest = 16,000 × 12% 1,920
31.12.2014 Instalment 1 (4,000)
31.12.2014 Y/e liability 13,920
1.1.15 to 31.12.15 Interest = 13,920 × 12% 1,670
31.12.2015 Instalment 2 (4,000)
11,590

Working 2
Depreciation based on shorter of lease term and useful life = 5 years
Therefore, depreciation charge = $16,000 / 5 years = $3,200
Therefore, carrying amount = £16,000 - $3,200 = $12,800

Lecture example 12.2

FL Liability
1.1.2014 Asset 16,000
1.1.2014 Instalment 1 (4,000)
12,000
1.1.14 to 31.12.14 Interest = 12,000 × 12% 1,440
Year end 31.12.14 Liability 13,440
1.1.15 Instalment 2 (4,000)
9,440
So the differences are the: Finance costs are now 1,440
Non-current liabilities 9,440 (bal)
Current liabilities 4,000
Interest accrual 1,440
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 161

Lecture example 12.3

The total cost of the lease is spread over the 5 years i.e. 5 × $3,000 = $15,000 less cashback incentive
of $2,000 = $13,000 spread over 5 years = $2,600 per annum:
Yr 1 :
Dr Profit or loss: OL rental $2,600
Cr Cash (net) $1,000
Cr Accruals and deferred income $1,600
Yrs 2,3,4,5:
Dr Profit or loss: OL rental $2,600
Dr Deferred income $400
Cr Cash $3,000

Chapter 13
Lecture example 13.1
(W1) % complete
A B
$000 $000
Costs to date 120 150
Costs to complete 160 250

75% 60%

Statement of profit or loss A B Total

$000 $000 $000
Revenue 150 180 330
Expenses (120) (150) (270)

Profit 30 30 60
Statement of financial position
Current assets
Contract asset (W2) 10
Trade receivables (W3) 40
Current liabilities
Contract liability (W2) 20
(W2) Contract asset/liability
A B
$000 $000
Total contract costs incurred 120 150
Add: profit recognised 30 30
Less: total invoiced to date (140) (200)
Contract asset / liability 10 (20)

This is effectively how much “behind” we are in our invoicing to our customers and is shown as an
asset.
If it is a negative figure (as it is in contract B), it is effectively showing how much we’ve “over-invoiced”
our customers and is therefore a liability.
162 Solutions to Class lecture examples AC C A F7

(W3) Trade receivables

$000 $000
Progress billings to date 140 200
Less: cash received (115) (185)
Trade receivables 25 15

Lecture example 13 2
Working - % complete
September 2014: 80/80 + 120 = 40% complete
September 2015: 80 + 100/80 + 100 + 20 = 90% complete

Statement of profit or loss for the year ended 30 September 2015

For this column, take
the difference between
the first 2 columns

Last year Total to Total

(40%) date (90%) $m
Revenue 100 225 50% × 250 125
Expenses (80) (180) 50% x 200 (100)
Mistake (5) (5)
Recognised profit/(loss) 20 40 20

Statement of financial position at 30 September 2015

$m
Total costs incurred to date (80 +100) 180
Total profit recognised to date (40 + 5) 45
Less progress billings to date (100 + 90) (190)
Contract asset 35

Note that the cost of the mistake of $5m is ignored in the statement of financial position as it is not
recoverable from the customer.
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 163

Chapter 14
(W1) Initial recording on 1 January 2011:
Dr Cash $400,000
Cr Financial liability (W2) $362,400  this will be measured at amortised cost from now on
Cr Equity (balance) $37,600  this remains fixed
(W2) Fair value of equivalent non-convertible loan note
Year ended 31 Discounted
December Cash flow Discount rate cash flow
$000 $000 $000
2011 5% × $400,000 = $20,000 interest 0.93 18,600
2012 $20,000 0.86 17,200
2013 $20,000 0.79 15,800
2014 $420,000 0.74 310,800
Value of debt component 362,400
Value of equity option component ( = balance) 37,600
400,000

At 31 December 2011: year end

The financial liability element of the loan note will be measured at amortised cost from 1 January 2011
onwards. Therefore, at 31 December, the amortised cost could be calculated:
Year ended Effective interest Interest paid
31 December Liability b/f @ 8% (@5% coupon) Liability c/f
$000 $000 $000 $000
2011 362.4 29.0 (20) 371.4
2012 371.4 29.7 (20) 381.1
And so on...
Therefore, for the year ending 31 December 2011, the finance / interest cost in the statement of profit
or loss would be 29.0 and the financial liability balance on the statement of financial position would be
371.4.
164 Solutions to Class lecture examples AC C A F7

Chapter 15: No lecture examples

Chapter 16
Lecture example 16.1
CA Tax WDV Difference Deferred tax
$ $ $ $
1.4.2010 cost 500,000 500,000
Depreciation (100,000) (250,000)
31.3.2011 400,000 250,000 150,000 37,500
Depreciation (100,000) (62,500)
31.3.2012 300,000 187,500 112,500 28,125

(a) Deferred tax provision at 31 March 2011 = $150,000 × 25% = 37,500

(b) Deferred tax provision at 31 March 2012 = $112,500 × 25% = 28,125
(c) Charge to the statement of profit or loss for the year ended 31 March 2012 = $37,500 – $28,125
= $9,375 credit

Chapter 17
Lecture example 17.1
EPS for y/e 31.12.2013= $500,000 = 20.1c
2,486,078 (W)
Restated EPS for y/e 31.12.2012 = 15.2 c × 10/11 × 2.83/3 = 13.0c
(W1) Weighted average no of shares:
Weighted
No of average no
Date Narrative shares Time Bonus fraction of shares
1.1.13 Bal b/f 2,000,000 × 6/12 × 3/2.83 (W1) × 11/10 = 1,166,078
30.06.13 Rights Issue + 400,000
2,400,000 × 4/12 × 11/10 = 880,000
31.10.13 Bonus Issue +240,000
2,640,000 × 2/12 = 440,000
2,486,078
(W2) Rights issue:
Fair value per share immediately before exercise of rights
Bonus fraction =
Theoretical ex-rights price (TERP)

“TERP”:
$
5 shares @ $3 = 15
1 share @ $2 2
6 shares 17

$17 3
 TERP = = $2.83 Bonus fraction =
6 2.83
AC C A F 7 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 165

Lecture example 17.2

Basic EPS = $385,000 = 3.9c
10,000,000
Diluted EPS:
Earnings: $
Net basic earnings 385,000
Add back: loan stock interest net of IT 'saved' (1,400,000 × 5% × 0.7) 49,000
434,000

No of shares: No. of shares

Basic weighted average 10,000,000
Add: additional shares on conversion (6 × 1,400,000) 8,400,000
Diluted number of shares 18,400,000

Diluted EPS = $434,000 = 2.4c

18,400,000

Example 17.3
Basic EPS = $4,000,000 = $2.22
1,800,000
Diluted EPS:
(1) Cash receivable on the exercise the options = 150,000 × $10 = $1,500,000
(2) Number of shares at market price = $1,500,000/15 = 100,000 shares
(3) Actual number of shares issued = 150,000 shares
(4) we’ve effectively “given away” 50,000 shares
 Diluted EPS = $4,000,000 = $2.16
1,800,000 + 50,000
166 Solutions to Class lecture examples AC C A F7