Financial Accounting

and Reporting:
Student Resources

Nineteenth edition

Barry Elliott
Jamie Elliott
 Brief contents
Chapters Pages

Part 1 Introduction to accounting on a cash flow and accrual accounting

basis 4
1. Accounting and reporting on a cash flow basis 5
2. Accounting and reporting on an accrual accounting basis 10

Part 2 Preparation of internal and published financial statements 15

3. Preparation of financial statements of comprehensive income, changes
in equity and financial position 16
4. Annual report: additional financial disclosures 29
5. Statements of cash flows 38

Part 4 Income and asset value measurement systems 42

9. Income and asset value measurement: an economist’s approach 43
10. Accounting for price-level changes 47
11. Revenue recognition 57

Part 5 Statement of financial position – equity, liability and asset

measurement and disclosure 67
12. Share capital, distributable profits and reduction of capital 68
13. Liabilities 73
14. Financial instruments 77
15. Employee benefits 86
16. Taxation in company accounts 94
17. Property, plant and equipment (PPE) 96
18. Leasing 100
19. Intangible assets 105
20. Inventories 109
21. Construction contracts 117
Part 6 Consolidated accounts 125
22. Accounting for groups at the date of acquisition 126
23. Preparation of consolidated statements of financial position after
the date of acquisition 137
24. Preparation of consolidated statements of income,
changes in equity and cash flows 139
25. Accounting for associates and joint arrangements 143
26. Introduction to accounting for exchange differences 150

Part 7 Interpretation 156

27. Earnings per share 157

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 28. Review of financial ratio analysis 163
29. Analysis of published financial statements 169

Part 8 Accountability 177

32. Integrated reporting: sustainability, environmental and social 178

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 PART 1

Introduction to accounting on a cash

flow and accrual accounting basis

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 CHAPTER 1

Accounting and reporting on a cash flow

basis
Question 1 – Sasha Parker
(a) Cash budget (£000)

Jan Feb Mar Apr May June Total

Initial capital 150.00 82.50 232.50
Customers 60.00 75.00 135.00
Total receipts 150.00 82.50 60.00 75.00 367.50
Machinery 30.00 30.00
Motor vehicles 24.00 24.00
Premises 75.00 75.00
Drawings 1.20 1.20 1.20 1.20 1.20 1.20 7.20
Suppliers 30.00 48.00 60.00 60.00 60.00 258.00
Rates 1.20 1.20
Wages 2.25 2.25 2.25 2.25 2.25 2.25 13.50
General expenses 0.75 0.75 0.75 0.75 0.75 3.75
Insurance – – – – – 2.10 2.10
Total payments 132.45 35.40 52.20 64.20 64.20 66.30 414.75
Net cash flow 17.55 (35.40) (52.20) 18.30 (4.20) 8.70
Balance b/f – 17.55 (17.85) (70.05) (51.75) (55.95)
Balance c/f 17.55 (17.85) (70.05) (51.75) (55.95) (47.25) (47.25)

(b) Statement of cash flows (£000)

Realised operating cash flows for the period ended 30 June 20X1

Receipts from customers 135.00

Payments:
Suppliers 258.00
Rates 1.20
Wages 13.50
General expenses 3.75
Insurance 2.10
278.55
(143.55)

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For information only

Statement of financial position as at 30 June 20X1

£000
Capital – introduced 232.50
– withdrawn (7.20)
Net operating cash flows: Realised (143.55)
Unrealised (7.80)
73.95
Premises (NRV) 75.00
Vehicles (NRV) 19.20
Machinery (NRV) 27.00
Net cash balance ( 47.25)
73.95

(c) Further information regarding Sasha Parker

Nature of business linked to Parker’s business background, technical ability, special
skills, know-how, existing/terminated business involvement, contacts, associates and
related parties.

Type of business unit to be used, and rationale for its selection.

Sources of long- and short-term capital.

Products’ life cycle and cash flow projections over product life cycle.

Initial investment in fixed assets and their terminal value at the end of the life cycle.

Parker’s attitude to risk, and how this affects the choice of discount rate and payback
period.

Question 2 – Mr Norman
(a) Purchases budget (€000)

Jan Feb Mar Apr May June

Sales 15.00 20.00 35.00 40.00 40.00 45.00
Gross profit 3.00 4.00 7.00 8.00 8.00 9.00
Purchases 12.00 16.00 28.00 32.00 32.00 36.00
Payments 12.00 16.00 28.00 32.00 32.00

Notes:
This is a start-up situation.
Purchases equal projected sales less a gross margin on sales at 20%.
Goods are bought in the month of sale; assume stocks remain constant.

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(b) Statement of cash flows (£000)

Jan Feb Mar Apr May June Total

Initial capital 50.00 50.00
Cash sales 7.50 10.00 17.50 20.00 20.00 22.50 97.50
Credit sales – 7.50 10.00 17.50 20.00 20.00 75.00

57.50 17.50 27.50 37.50 40.00 42.50 222.50

Premises 80.00 80.00

Rent and 2.20 2.20 2.20 2.20 2.20 2.20 13.20

rates
Suppliers 12.00 16.00 28.00 32.00 32.00 120.00

Commission 0.30 0.40 0.70 0.80 0.80 3.00

Wages 0.60 0.60 0.60 0.60 0.60 0.60 3.60
Insurance 3.50 – – – – – 3.50
86.30 15.10 19.20 31.50 35.60 35.60 223.30
Net cash flow (28.80) 2.40 8.30 6.00 4.40 6.90

Balance b/f – (28.80) (26.40) (18.10) (12.10) (7.70)

Balance c/f (28.80) (26.40) (18.10) (12.10) (7.70) (0.80) (0.80)

(c) Statements of operating cash flows and financial position

Realised operating cash flows for the period ended 30 June 20X8
£000
Receipts from customers 172.50
Payments:
Suppliers 120.00
Rates 13.20
Wages 3.60
Commission 3.00
Insurance 3.50
143.30
29.20

Notes:
The cash flow statement with summary attached is effectively a six-month cash budget
showing the cash received, cash paid each month and the resulting month-end
balances.

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It is necessary to separate sales and purchase transactions into cash and on-credit, and to
identify clearly the month of receipt and payment.

Commission is paid in the month after the sale is made, and all other cash flows are
clearly indicated and allocated to specific months.

Note that the format of the cash flow statement brings out key figures – for
management decision and control. For example:
month-end balances – assist in the control of liquidity;

cash deficiencies – identify how much must be financed;

early warning – allows management to approach appropriate sources;
cash surpluses – identify amounts to be invested on the best terms.

Statement of financial position as at 30 June 20X8

£000
Capital – introduction 50.00
Net operating cash flows : Realised 29.20
: Unrealised (4.00)
75.20
Premises (NRV) 76.00
Net cash balance (0.80)
75.20

Notes:

This statement shows net assets of £75,200.

Make up: premises £76,000 less the negative cash balance £800.

The negative cash balance indicates the need for overdraft arrangements.

The statement is based on cash flow concept:

It ignores accrual-based figures (£36,900 less £25,250).

Accruals are not regarded as real assets and liabilities.

Critics of the cash flow concept would maintain that its utility has, therefore, been
seriously diminished.

(d) Letter to the bank requesting an overdraft facility

The maximum overdraft facility of £28,800:

will be required at the end of January;

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will be eliminated by July.

Overdraft will fall progressively as per the cash budget.

It might be practical to request a limit of £30,000:

for the full six-month period;

reducing it to £15,000 thereafter to allow for contingencies. The facility is only to

be called on as required.

Refer to the cash budget to support the request:

confirm that it is based on the most likely scenario;

agree to a repayment schedule.

Specify that collateral security is available in the form of premises if it should be

required.

If not an existing customer:

give outline details of business background;

explain future plans;

market.

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 CHAPTER 2

Accounting and reporting on an accrual

accounting basis
Question 1 – Sasha Parker
(a) Cash budget (€000)

Jan Feb Mar Apr May June Total

Initial capital 150.00 75.00 225.00
Customers 60.00 75.00 75.00 210.00
Total receipts 150.00 60.00 75.00 150.00 435.00
Machinery 30.00 30.00

Motor vehicles 24.00 24.00

Premises 75.00 75.00
Drawings 1.50 1.50 1.50 1.50 1.50 1.50 9.00
Suppliers 30.00 48.00 60.00 60.00 60.00 258.00
Rates
Wages 2.25 2.25 2.25 2.25 2.25 2.25 13.50
General expenses 0.75 0.75 0.75 0.75 0.75 3.75
132.75 34.50 52.50 64.50 64.50 64.50 413.25

Net cash flow 17.25 (34.50) (52.50) (4.50) 10.50 85.50

Balance b/f – 17.25 (17.25) (69.75) (74.25) (63.75)
Balance c/f 17.25 (17.25) (69.75) (74.25) (63.75) (21.75) (21.75)

All balances are overdrawn except for January 20X1

Feb Mar Apr May June
o/d 17.25 69.75 74.25 63.75 4.65

Note:

No entries will be made for the 20X0/X1 local taxes that are paid in Feb 20X2 – this
situation arose because Sasha Parker had assumed that the business would only pay the
taxes from the start of the tax year, e.g. 1.4.20X1.

However, there will be an entry in the profit and loss account and the statement of
financial position.

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(b) Sasha Parker – profit and loss account for six months ended
30 June 20X1
€000 €000
Sales [60.00 + (5 × 75.00)] 435.00
Purchases 378.00
Closing inventory (30.00)
Cost of sales 348.00
Gross profit 87.00
Wages 13.50
General expenses 4.50
Local taxes (1.1.X1–30.6.X1) 4.00
Insurance 13.20
Depreciation:
– Vehicles 2.40
– Machinery 1.50 39.10
Net profit 47.90

Budgeted statement of financial position as at 30 June 20X1

Capital 225.00
Net profit 47.90
Less: drawings ( 9.00)
263.90
Non-current assets
Premises 75.00
Vehicles 24.00
Less: depreciation 2.40 21.60
Machinery 30.00
Less: depreciation 1.50 28.50
Current assets
Inventory 30.00
Trade receivables (3 × 75.00) 225.00
Insurance 13.20 268.20
Current liabilities
Trade payables 120.00
Local taxes (1.1.X1–30.6.X1) 4.00
Bank overdraft 4.65
General expenses 0.75 (129.40)
Net current assets 138.80
263.90

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(c) Possible action to deal with exceeding agreed overdraft limit

Approach the bank to re-negotiate the overdraft or arrange a loan facility for an agreed
term.

The amount and the period for which additional facilities are required depend on
preparing a projected cash flow statement for a longer period taking into account future
plans, e.g. owner’s drawings requirement and any additional capital expenditure.

In particular, consider alternatives such as the following:

Leasing vehicles and/or machinery

Mortgaging the property

Getting debts in quicker manner

Introducing more capital

Obtaining or providing loan capital.

Question 2 – Mr Norman
(a) Purchases budget ($000)
Jan Feb Mar Apr May Jun
Sales units 1.65 2.20 3.85 4.40 4.40 4.95

– Closing inventory 0.55 0.96 1.10 1.10 1.24

+ Closing inventory 0.55 0.96 1.10 1.10 1.24 1.38

Purchases units 2.20 2.61 3.99 4.40 4.54 5.09

Purchases Sales
$000 $000
Jan (2,200 × 40) 88.00 82.50 (1,650 × 50)
Feb (2,610 × 40) 104.40 110.00 (2,200 × 50)
Mar (3,990 × 40) 159.60 192.50 (3,850 × 50)
Apr (4,400 × 40) 176.00 220.00 (4,400 × 50)
May (4,540 × 40) 181.60 220.00 (4,400 × 50)
Jun (5,090 × 40) 203.60 247.50 (4,950 × 50)
913.20 1,072.50

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(b) Cash flow forecast ($000)

Jan Feb Mar Apr May June Total

Initial capital 150.00 150.00
Cash sales 41.25 55.00 96.25 110.00 110.00 123.75 536.25
Credit sales 41.25 55.00 96.25 110.00 110.00 412.50
191.25 96.25 151.25 206.25 220.00 233.75 1,098.75
Premises 80.00 80.00
Commission 1.65 2.20 3.85 4.40 4.40 16.50
Suppliers 88.00 104.40 159.60 176.00 181.60 709.60
Administration 8.00 8.00 8.00 8.00 8.00 8.00 48.00
Wages 17.00 17.00 17.00 17.00 17.00 17.00 102.00
Insurance 0.35 0.35
Total payments 105.35 114.65 131.60 188.45 205.40 211.00 956.45

Net cash flow 85.90 (18.40) 19.65 17.80 14.60 22.75

Balance b/f – 85.90 67.50 87.15 104.95 119.55
Balance c/f 85.90 67.50 87.15 104.95 119.55 142.30

(c) Budgeted statement of income for six months ended 30 June 20X8

$000 $000
Sales 1,072.50
Purchases 913.20
Closing inventory (1,380 units × £40) (55.20)
Cost of sales 858.00
Gross profit 214.50
Wages 102.00
Administration 48.00
Commission (2% of 1,072.50) 21.45
Insurance 0.18
Amortisation of lease 8.00
179.63
Net profit 34.87

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Budgeted statement of financial position as at 30 June 20X8

$000 $000
Capital 150.00
Net profit 34.87
184.87
Non-current assets
Leasehold premises 80.00
Less amortisation (8.00)
72.00
Current assets
Inventory 55.20
Trade receivables 123.75
Pre-payments – insurance 0.17
Cash 142.30
321.42
Current liabilities
Trade payables 203.60
Commission 4.95
208.55
Net current assets 112.87
184.87

(d) Investment of surplus funds

Acid test ratio

At the end of the first six-month trading, Norman’s statement of financial position
shows that the acid test ratio is 1.28:1 (266.22/208.55) – this is higher than the basic
1:1 ratio but it should be compared with the ratio of similar businesses in the same
industry in order to establish a norm. It would appear, however, that the business has
surplus funds to invest.

Amount to invest
A projected cash flow statement is required, taking into account future plans regarding
the owner’s drawing requirements, future capital commitments and working capital
criteria, e.g. debtor collection and creditor payment terms.

Period to invest
The projected cash flow will give an indication of the period of the investment, e.g. it
could range from overnight on the money market to term investments.
The important aspect is that the owner should be aware of the projected cash flows, so
that return on surplus funds can be maximised.

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 PART 2

Preparation of internal and published

financial statements

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 CHAPTER 3

Preparation of financial statements of

comprehensive income, changes in equity and
financial position

Question 1 – Old NV
(a) Statement of income (internal) for the year ended 31 December 20X1
€000
Sales 12,050
Less: returns 350
11,700
Inventory at 1.1. 20X1 825
Purchases 6,263
Carriage on purchases 13
Less: returns ( 313)
6,788
Inventory at 31.12.20X1 1,125
5,663
Depreciation of plant 313
5,976
Gross profit 5,724
Administration:
Wages 738
Administration expenses (286 – 12) 274
Directors’ remuneration 375
Selling:
Salesmen’s salaries 800
Distribution:
Distribution expenses 290
Depreciation of vehicles 187
Carriage 125
Financial:
Goodwill impairment 177
Audit fee 38
Debenture interest 25

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Rent receivable (100)

2,929
2,795
Tax 562
Profit for year 2,233

(b) Statement of comprehensive income for publication

Statement of comprehensive income of Old NV for the year
ended 31 December 20X1
€000 €000
Sales 11,700
Cost of sales 5,976
Gross profit 5,724
Distribution costs W1 1,402
Administrative expenses W2 1,602
Other operating income (100)
2,904
Trading profit 2,820
Interest payable 25
Profit on ordinary activities before tax 2,795
Income tax 562
Profit for the period 2,233
Other comprehensive income:
Land revaluation 50
2,283
W1
Salesmen’s salaries 800
Distribution expenses 290
Depreciation of vehicles 187
Carriage 125
1,402
W2
Wages 738
Administrative expenses 274
Directors’ remuneration 375
Goodwill impairment 177
Audit fee 38
1,602

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There will be a disclosure note as follows:

Profit on ordinary activities after tax is after charging
Goodwill impairment 177
Audit fee 38
Depreciation 500
Directors’ remuneration 375

Statement of financial position of Old NV as at 31 December 20X1

€000 €000
Non-current assets
Intangible assets (1,062 – 177) 885
Property, plant and equipment Note 1 1,074
Land 150
Current assets
Inventories 1,125
Receivables 3,875
Cash at bank and in hand 1,750
Pre-payments 12
6,762
Current liabilities
Payables 738
Provision for income tax 562
Accrued charges 63
1,363
Net current assets 5,399
Total assets less current liabilities 7,508
Non-current liabilities
Debentures 250
7,258
Equity
Ordinary shares of €1 each 3,125
Preference shares of €1 each 625
Share premium 350
Retained earnings Note 2 3,158
7,258

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Disclosure notes to show make-up of statement of financial position

balances
Note 1: Property, plant and equipment

Property, plant and equipment

Motor
Plant vehicles Total
€000 €000 €000
Cost
At 1.1.20X1 1,200 1,125 2,325
Additions 362 362
Disposals
At 31.12.20X1 1,562 1,125 2,687

Accumulated depreciation
At 1.1.20X1 738 375 1,113
Charge for year 313 187 500
At 31.12.20X1 1,051 562 1,613
Net book value
At 31.12.20X1 511 563 1,074
At 31.12.20X0 462 750 1,212

Working: accrued expenses €000

Audit fee 38
Debenture interest 25

Note 2: Movements on reserves

€000
Retained earnings at 1.1.20X1 875
Amount transferred from statement of comprehensive income 2,283
Balance at 31.12.20X1 3,158

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Question 2 – Formatone plc

(i) Statement of income

Statement of income for the year ended 30 June 20X6

£000
Sales 9480.6
Cost of sales (N1) (6,625.8)
Gross profit 2,854.8
Distribution cost (529.2)
Administrative expenses (946.8)
Operating profit 1,378.8
Taxation (N2) (181.8)
Profit after taxation 1,197.0
N1 cost of sales £000
As per trial balance 5,909.4
Depreciation of buildings (1,620/30) 54.0
Depreciation of plant (1,728 – 504) @ 10% 122.4
Write-down of intangible assets 540.0
6,625.8
N2 taxation
Over-provision (14.4)
Current tax 169.2
Deferred tax 27.0
181.8

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(ii) Statement of financial position

Statement of financial position as at 30 June 20X6

£000
Non-current assets
Land at valuation 5,400.0
Buildings at valuation 1,620.0 (54.0) 1,566.0
Plant and equipment 1,728.0 (626.4) 1,101.6
Intangible assets 270.0
Current assets
Inventory 586.8
Trade receivables 585.0
Cash 41.4 1,213.2
9,550.8
£000
Equity and reserves
Ordinary shares of 50p 2,160.0
Share premium account 432.0
Revaluation reserve 4,179.6
Retained earnings 1,796.4 8,568.0
Non-current liability
Deferred tax 64.8
Current liabilities
Trade payables 532.8
Taxation 169.2
Dividend declared 216.0 918.0
9,550.8

(iii) Statement of changes in equity

Share Share Revaluation Retained

Statement of changes in equity capital premium reserve earnings Total
Balance b/f 2,085.0 387.0 – 891.0 3,363.0

New issue of shares 75.0 45.0 – – 120.0

Land and buildings – – 4,212.0 – 4,212.0
Transfer N3 – – (32.4) 32.4 –
Retained profit for the year – – – 1,197.0 1,197.0
Interim dividend paid – – – (108.0) (108.0)
Interim dividend declared – – – (216.0) (216.0)
Balance c/f 2,160.0 432.0 4,179.6 1,796.4 8,568.0

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N3 Transfer from revaluation reserve

Revaluation surplus £972,000

Transfer 1/30 £ 32,400

Question 3 – Basalt plc

(i) Statement of income for the year ended 31 December 20X0
£000
Turnover (962 – 27 returns) 935
Cost of sales Note 1 460
Gross profit 475
Distribution costs Note 2 218
Administrative expenses Note 3 118
139
Other operating income (i.e. rent receivable) 7
Profit on ordinary activities before tax 146
Tax on profit of ordinary activities 58
Profit for the year 88
Other comprehensive income:
Revaluation of land 55
143
£000
Note 1: Opening inventory 66
Purchases 500
Carriage inwards 9

Returns out (25)

Closing inventory (90)
460
Note 2: Warehouse wages 101
Salesmen’s salaries 64
Distribution expenses 6
Hire of vehicles 19
Depreciation 28 (7/11 of 20% of £220,000)
218
Note 3: Administrative wages 60
Administrative expenses 10
Directors’ remuneration 30
Auditors’ remuneration 2
Depreciation (4/11) 16
118

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(ii) Statement of financial position as at 31 December 20X0

£000
Non-current assets
Tangible assets
Plant and machinery
(cost 220 – Depreciation b/f 49 – depreciation for year 44) 127
Current assets
Inventory 90
Trade receivables 326
Cash at bank 62
478
Liabilities
Amounts falling due within one year:
Trade payables 66
Other payables (Audit 2 + corporation tax 58) 60
126
Net current assets 352
Total assets less current liabilities 479
Equity
Called-up share capital 300
Share premium a/c 20
General reserve 16
Retained earnings 143
479

(a) Directors’ report must deal with certain matters by law, e.g.:

Proposed dividends.

Likely future developments in the company’s business.

Principal activities of the company.

Political and charitable contributions.

Consistency with other statements – reviewed by auditors.

(b) Chairman’s report

May be a highly personalised review of the business, its developments and the
environment in which it operates.

Not subject to audit.

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(c) Auditors’ report expresses an opinion as to whether the financial statements

give a ‘true and fair view’.

Question 4 – HK Ltd
(a) Statement of comprehensive income for the year ended 30 June 20X1
$000 $000
Turnover 381,600
Cost of sales
Per trial balance 318,979
+ Hire 2,400 + depreciation 799*
− Insurance 150*** + inventory loss 250 3,299
322,278
Gross profit 59,322
Administration expenses
Per trial balance 9,000 + directors 562 +
Bad debt 157 + auditor remuneration 112 9,831
Distribution costs 35,100
44,931
14,391
Profit on disposal of non-current assets 536
Profit before tax and interest 14,927
Interest payable (454 + 151 tax on interest) 605
14,322
Other operating income** 17
Profit before tax 14,339

Income tax 5,348

Profit for the year 8,991

Other comprehensive income
Revaluation gain 400
Total comprehensive income for the year 9,391
Note: *Depreciation consists of Buildings 94 + Plant 619 + Fixtures 86
**Development grant 85
Transfer versus income statement
(20% of 85) (17)
To statement of financial position 68
***Insurance is treated as an adjusting event.

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Statement of financial position as at 30 June 20X1

Intangible non-current assets
Goodwill 480
Tangible non-current assets
Freehold land 2,500
Freehold buildings 4,680
Aggregate depreciation 648 4,032
Plant and machinery 3,096
Aggregate depreciation 1,857 1,239
Fixtures and fittings 864
Aggregate depreciation 259 605
8,376
8,856
Current assets
Inventory to read (11,794 − 250 obsolescence) 11,544
Receivables (7,263 + 150 insurance) 7,413
Cash and cash equivalents 11,561
30,518
Current liabilities
Payables 2,591
Dividends (Preference 162 + Ordinary 324) 486
Tax 5,348
8,425
Net current assets 22,093

Non-current liabilities
9% loan 7,200
23,749
Deferred income − government grant (see Note) 68
23,681
Equity
Ordinary shares 50c each 3,600
9% preference shares of $1 each 5,400
Revaluation reserve 400
Retained earnings (6,364 + 8,991 − 1,074 dividends) 14,281
23,681

Note: The grant could be deducted from the cost of the plant under IAS 20.

(b) The usefulness of the non-current asset schedule

(i) The column headings allow the user to see the type of non-current assets owned by
the business. This can give helpful initial indications, e.g.

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Realisability – intangible assets might be more difficult to sell than property.

Appreciation – land is more likely to appreciate than office equipment.

Depreciation – licences are subject to amortisation and possible fall in value due
to competition.

Security – land and buildings are more likely to be accepted as security for loans
and overdrafts than intangible assets.

(ii) The carrying values may be at cost or revaluation.

If at cost, it may be that the statement of financial position gives too low an
indication of current market values – this is often an important consideration if
existing shareholders are assessing a takeover offer.

(iii) The accumulated depreciation figure when related to the cost gives an indication of
the age of the assets and possible need for capital outlays to replace with cash flow
implications.

(iv) Disposals may be an indication of the occurrence of replacement, which could

indicate growth or maintenance of existing capacity. If there is no replacement,
then consider implications for future capacity or other reasons, e.g. change of
direction, and disposal of non-profit-making parts of the business.

Question 5 – Phoenix plc

(a) Statement of comprehensive income for the year ended 30 June 20X7
£000
Revenue 6,465
Cost of sales (4,165 + 196 depreciation) (4,361)
Gross profit 2,104
Distribution cost (669)
Administration expense (1,126 + 31 depreciation + 415) (1,572)
Operating loss (137)
Exceptional item:
Gain on disposal of warehouse 75
Dividend received 80
Profit before taxation 18
Taxation (96)
Loss for the year (78)
Other comprehensive income
Revaluation gain 700
Total comprehensive income for the year 622

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(b) Statement of financial position as at 30 June 20X7

Property, plant and equipment 4,243
Investment 365
Current assets
Inventory 1,468
Trade receivables 947
Cash at bank 175
Current liabilities (868)
Net current assets 1,722
6,330
Share capital and reserves
Share capital 4,500
Share premium 500
Revaluation reserve 1,270
Retained earnings 60
6,330

(c) Statement of movement of property, plant and equipment

L&B P&M F&F Total
Balance b/f 2,400 1,800 620 4,820
Disposal (150) (150)
Revaluation reserve 160 160
Balance c/f 2,250 1,960 620 4,830
Accumulated depreciation
Balance b/f 540 360 900
Revaluation reserve (540) (540)
P&L charge 196 31 227
Balance c/f 196 391 587
WDV at 30.6.20X7 2,250 1,764 229 4,243

Current assets
Trade receivables 947

Creditors

Trade payables 566

Taxation 122
Dividend proposed 180
868

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Balances in revaluation reserve and retained earnings are made up as follows:

Revaluation reserve Retained earnings

Balance b/f 600 488

Plant and machinery revaluation 700
Transfer on disposal (30) 30
Loss for year (78)
Dividends (380)
Balance c/f 1,270 60

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Annual report: additional financial disclosures

Question 4 – Filios Products plc
(a) The majority of listed and other large entities derive their revenues and profits
from a number of sources (or segments). This has implications for the investment
strategy of the entity as different segments require different amounts of
investment to support their activities. Conventionally, produced statements of
financial position and statements of comprehensive income capture financial
position and financial performance in a single column of figures.

Segment reports provide a more detailed breakdown of key numbers from the
financial statements. Such a breakdown potentially allows a user to:

appreciate the results and financial position more thoroughly by permitting a better
understanding of past performance and thus a better assessment of future prospects;

be aware of the impact that changes in significant components of a business may have
on the business as a whole; and

be more aware of the balance between the different operations and thus be able to
assess the quality of the entity’s reported earnings, the specific risks to which the
company is subject and the areas where long-term growth may be expected.

(b) Assuming the CODM receives relevant information about the three components
referred to in the question then the segment report would look like this:
Restaurants Hotels Leisure Other Total
£m £m £m £m £m
Revenue 508 152 368 – 1,028
Interest expense (10) – – (4) (14)
Profit (W1) 75 45 18 (19) 119
Reportable segment assets (W2) 1,193 431 459 89 2,172
Reportable segment liabilities (W3) (166) (40) (56) (71) (333)
Working 1 – Segment profit
Restaurants Hotels Leisure Other Total
£m £m £m £m £m
Revenue 508 152 368 – 1,028
Cost of sales (316) (81) (287) – (684)
Administration expenses (43) (14) (38) (15) (110)
Distribution costs (64) (12) (25) – (101)
Interest expense (10) – – (4) (14)
Profit 75 45 18 (19) 119

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Working 2 – Reportable segment assets

Restaurants Hotels Leisure Other Total
£m £m £m £m £m
Non-current assets 890 332 364 77 1,663
Inventories and receivables 230 84 67 – 381
Bank balances 73 15 28 12 128
Reportable segment assets 1,193 431 459 89 2,172

Working 3 – Reportable segment liabilities

Restaurants Hotels Leisure Other Total
£m £m £m £m £m
Payables 66 40 56 31 193
Long-term borrowings 100 40 140
Reportable segment liabilities 166 40 56 71 333

(c) It is clear from the ratios below that the leisure sector is underperforming
compared with the other two sectors. Hotels are performing best, when measured
by the return on net assets ratio. It is notable that the profit margins of the three
sectors differ so significantly. This additional information illustrates the value
segment reports can add compared with overall figures.
Restaurants Hotels Leisure
Operating profit (£m) 85 45 18

Revenues (£m) 508 152 368

So operating profit % 17% 30% 5%

Revenues (£m) 508 152 368

Net assets (W2/3 above – £m) 1,027 391 403
So net asset turnover equals 0.5 times 0.4 times 0.9 times

Operating profit £m) 85 45 18

Net assets (W2/3 above – £m) 1,027 391 403
So return on net assets equals 8% 12% 4%

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Question 6 – Springtime Ltd

(a) Statement of comprehensive income for the year ended 31 March 20X4

Continuing Discontinued
operations operations Total
Turnover 30,000 5,000 35,000
Cost of sales (19,000) (4,000) (23,000)
Gross profit 11,000 1,000 12,000

Distribution costs (3,065) (425) (3,490)

Administrative costs (1,225) (15) (1,240)

6,710 560 7,270
Closure costs (350) (350)
Operating profit 6,710 210 6,920
Investment income 1,200
8,120
Taxation (3,200 – 200 + 150) 3,150
Profit for the year 4,970

Note: Tax: Income tax 3,200 – overprovision 200 + transfer to deferred tax account 150
No information is provided to allocate any income tax to discontinued operations.

Workings

Continuing Discontinued Total

Distribution costs
Delivery costs 900 300 1,200
Depreciation – vans 40 40
Depreciation – stores equipment 50 50
Storeroom costs 1,000 1,000
Delivery staff 700 700
Directors 75 25 100
Storeroom staff 300 100 400
3,065 425 3,490
Administrative costs
Audit 30 30
Depreciation – cars 10 10
Office expenses 800 800
Directors 300 300
Office staff 85 15 100
1,225 15 1,240

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Note: As allowed under IFRS 5, disclosures are given on the face of the statement of
comprehensive income.

(b) IFRS 5 has required companies to disclose in detail the activities that are
discontinued. This disclosure is both numerical and narrative, and provides a full
explanation for the activities to be discontinued, the time at which the
discontinuance should occur and the financial effect of the discontinuance.

This information is useful to users in enabling them to interpret the future

performance of the enterprise and in assessing the performance of the management
over the period. When considering the future performance of an enterprise only
the continuing operations should be considered as it is only these that will
continue into future periods. The management performance can be assessed to
some extent by having knowledge of discontinuing activities because the users
will be able to judge whether the management decision to discontinue is a good
one.

Users can also get benefits from the disclosure in understanding the future strategic
direction of the business. By discontinuing activities, the management may be
refocusing the business towards more core areas and this would be seen through
the disclosures.

Question 8 – Hoodurz
(a) Statement of comprehensive income for the year ended 31 March 20x6
Continuing Discontinued Total
$000 $000 $000
Revenue 1,640 370 2,010
Cost of sales (150 + 960 – 160) (725) (225) (950)
Gross profit 915 145 1,060
Distribution costs (420 + 20) (380) (60) (440)
Administration expenses (210 + 16 + 20) (191) (55) (246)
Operating profit 344 30 374
Finance income 75 – 75
Interest paid (10) (10)
Profit before tax 409 30 439
Tax (60) (14) (74)
Profit after tax 349 16 365

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(b) Balance sheet as at 31 March 20x6

$000 $000
Non-current assets:
Property, at valuation 280
Plant and equipment, at cost (550 – 150) 400
Plant and equipment, accumulated depreciation (220 – 15) (205) 195
Investments 560
1,035
Current assets:
Inventory 160
Trade receivables (470 – 70) 400 560
Assets held for sale (150 – 15 + 70) 205
1,800

Equity:

Ordinary shares 600

Revaluation reserve 80
Retained earnings (see working) 345
1,025

Non-current liabilities:
Loans 100
Provision for warranty claims (205 + 16) 221 321
Current liabilities:

Tax (74 – 14) 60

Bank overdraft (80 – 10) 70
Trade payables (260 – 60) 200
Accrual (staff bonus) 40 370
Liabilities held for sale (60 + 14 + 10) 84
1,800

Working:

$000
Retained earnings b/f 80
Profit for year 365
Dividends paid (65 + 35) (100)
Retained earnings c/f 345

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Question 11 – Maxpool plc

Year ended 31 December 20X0

(a) Maxpool and Ching are in a related party relationship because they are part of the
same group. Bay and Ching are in a related party relationship if Ching is Bay’s
associate. A 40% holding would normally be enough to allow Bay to exert
significant influence over Ching – the key factor in determining associate status.
Given Maxpool’s capacity to control Ching, however, it is unlikely that Bay and
Ching do have an associate relationship, and so they are unlikely to be related
parties. There is no reason why Maxpool and Bay should be related parties at this
stage.

(b) Therefore, the transaction between Bay and Ching on 30 November 20X0 would
not be disclosed as a related party transaction because Bay and Ching are not
related parties. The financial statements of Ching would need to disclose the
controlling relationship with Maxpool.

Year ended 31 December 20X1

(c) The additional purchase of shares in Ching does not change the related party
relationship between Maxpool and Ching. However, the purchase of 25% of the
shares of Bay by Maxpool is likely to make Bay an associate of Maxpool, and,
therefore, its related party. Therefore, Bay is also a related party of Ching, because
Bay is an associate of Maxpool, a member of the same group as Ching. The
transaction between Bay and Ching will be disclosed as a related party transaction
in the individual financial statements of Bay and Ching (and of Maxpool, if such
individual financial statements are prepared) and in the consolidated financial
statements of the Maxpool. As in 20X0, the financial statements of Ching would
need to disclose the controlling relationship with Maxpool.

Question 13 – IAS 8
(a)

(i) Definition of an accounting policy:

Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements.

When an IAS/ IFRS (or an Interpretation) specifically applies to a transaction,

other event or condition, the accounting policy or policies applied to that item
shall be determined by applying the Standard or Interpretation and considering
any relevant Implementation guidance issued by the IASB for the Standard or
Interpretation.

An entity shall select and apply its accounting policies consistently for similar
transactions, other events and conditions, unless a Standard or an Interpretation
specifically requires or permits otherwise.

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The use of reasonable estimates is an essential part of the preparation of financial

statements and does not undermine their reliability. Examples include bad debts,
inventory obsolescence, fair values of assets, useful lives of assets and warranty
obligations. A change in accounting estimate is an adjustment of the carrying
amount of an asset or a liability, or the amount of the periodic consumption of an
asset, that results from the assessment of the present status of, and expected future
benefits and obligations associated with, assets and liabilities.

(ii)

(1) Change in accounting policy:

An entity shall change an accounting policy only if the change:

• is required by a Standard or an Interpretation; or if it

• results in the financial statements providing reliable and more relevant

information about the effects of transactions, other events or conditions on the
entity’s financial position, financial performance or cash flows.

An entity shall account for a change in accounting policy resulting from the initial
application of a Standard or an Interpretation in accordance with the specific
transitional provisions, if any, in that Standard or Interpretation. Where this does not
apply, the entity shall apply the change retrospectively. This means that the accounts
must be altered so that they contain the numbers which would have been there had the
new policy always been in force. However, this will not apply if it is impracticable to
determine either the period specific effects or the cumulative effect of the change. The
initial application of a policy to revalue assets is not dealt with in this manner.

(ii)

(2) Change in accounting estimate:

The effect of a change in an accounting estimate, shall be recognised prospectively (i.e.

from the date of the change onward) by including it in profit or loss in the period of the
change and future periods, if relevant.

(ii)

(3) Correction of 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:

• was available when financial statements for those periods were authorised for
issue; and

• could reasonably be expected to have been obtained and taken into account in
the preparation and presentation of those financial statements.

Examples of such errors include the effects of mathematical mistakes, mistakes in

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applying accounting policies, oversights or misinterpretations of facts and fraud.

Except to the extent that it is impracticable to determine either the period-specific

effects or the cumulative effect of the error, an entity shall correct material prior period
errors retrospectively in the first set of financial statements authorised for issue after
their discovery. This means that the accounts must be altered so that they contain the
numbers which would have been there had the error never occurred. The following
actions must be taken:

• Restate the comparative amounts for the prior period(s) presented in which the
error occurred.

• If the error occurred before the earliest prior period presented, restate the
opening balances of assets, liabilities and equity for the earliest prior period
presented.

• Adjust the opening balance in the statement of changes in equity.

Omissions or misstatements of items are material if they could, individually or

collectively, influence the economic decisions of users taken on the basis of the
financial statements.

(a) The effect of the fraud existed in previous periods although the directors of Sigma
plc were unaware of it.

Hence, the financial statements should be corrected retrospectively. As the current

financial statements will show one comparative year, both of these years will be
restated. Any effect predating the earliest period presented will be adjusted for through
opening equity balances. The incremental effects of the fraud will be reported through
profit or loss each year, appearing as additional expenses. The cumulative effects will
appear in the statement of financial position, through a reduction of the trade
receivables and retained earnings figures. The opening equity balances in the statement
of changes in equity should show the original balance, adjusted by the cumulative effect
of the adjustment. So users can reconcile the figures with those published in the
previous year.

Statements of profit or loss and other comprehensive income for the year ended 31
July:

2015 2014
€000 €000
Revenue 300 275
Cost of sales (225) (212)
Gross profit 75 63
Expenses (50) (42)
Profit for year 25 21

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Statements of changes in equity (retained earnings only) for the year ended 31 July:

2015 2014
€000 €000
Balance as at 1 August 258 236
Prior period adjustment (30) (14)
Adjusted opening balance 228 222
Profit for the year 25 21
Dividends declared (16) (15)
Balance as at 31 July 237 228

Statements of financial position as at 31 July:

2015 2014
€000 €000
Non-current assets 294 306
Current assets 93 72
387 378
Equity share capital 150 150
Retained earnings 237 228
387 378

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 CHAPTER 5

Statements of cash flows

Question 1 – Direct plc

Extract from statement of cash flows for the year ended 30 September
20X9

Cash flows from operating activities

€000
Cash received from customers (316,000 + 2,000 – 1,600) 316,400
Cash paid to suppliers (110,400 – 800 – 2,400) (107,200)
Cash paid for other expenses (72,000)
Cash paid for rent (14,400 + 1,200) (15,600)
Cash paid for advertising (4,800 – 400) (4,400)
Cash paid for interest (320 – 40) (280)
116,920

Question 2 – Marwell plc

(a) Statement of cash flows for the year ended 31 December 20X2
€m
Cash flows from operating activities
Profit before tax 22.14
Adjustments for:
Depreciation 22.68
Interest payable 16.20
Loss on disposal of plant 3.78
Profit on sale of buildings (6.48)
58.32
Changes in working capital:
Increase in inventory (5.94)
Increase in trade receivables (10.26)
Decrease in trade payables (4.86)
Cash generated from operating activities 37.26
Interest paid (16.20)
Tax paid (8.1 – 2.7m) (5.40)
Dividends paid (18.36)
Net cash outflow from operating activities (2.70)

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(b) The cash flow relating to non-current assets occurs at the date that they are
acquired. Depreciation is a book entry and not a source of cash. It is added back to
the operating profit as a non-cash expense to show that the cash position of a
business improves by the amount of operating profit before deducting
depreciation.
When a non-current asset is sold, the only cash effect is the amount of the disposal
proceeds. If a loss has been deducted from the operating profit, this is a non-cash
entry and needs to be added back to the operating profit and, if a profit has been
included in the operating profit, this needs to be deducted.

Question 3 – Radar plc

Using indirect method

Statement of cash flows for the year ended 30 September 20X9

$000 $000
Cash from operating activities
Profit before tax (Note 2) 241
Adjustments for
Depreciation (Note 1) 64
Investment impairment 20
Operating profit before working capital changes 325
Decrease in inventory (596 – 397) 199
Increase in trade receivables (392 – 332) (60)
Decrease in trade payables (478 – 396) (82)
Increase in accruals (72 – 64) 8
Cash generated from operations 390
Tax paid (87 + 92 – 96) (83)
Net cash used in operating activities 307
Cash flows from investing activities:
Purchase of PPE (Note 3) (232)
Disposal of PPE 54
Purchase of Investments (Note 4) (48) (226)
Cash flows from financing activities:
Share capital 150
Share premium (Note 5) 125
Debentures (300 + 75 premium) (375)
Dividends received 17
Dividends paid (25) (108)

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Net increase in cash and cash equivalents (27)

Cash and cash equivalents at beginning of year 5
Cash and cash equivalents at end of year (22)

Note 1: Gain on disposal calculated as:

$000

Cost of goods sold 72,000

Less: Cash proceeds 54,000
18,000
Gain on disposal 16,000
Accumulated depreciation 34,000

Depreciation charge for year is calculated as follows:

$
Balance at beginning of year 288,000
Less depreciation on disposal 34,000
254,000
Closing balance 318,000
Charge for the year 64,000

Note 2: Calculation of profit before tax:

$
Retained earnings at beginning of the year 137,000
Less dividend paid (25,000)
112,000
Retained earnings at end of the year 294,000
Profit after tax 182,000
Tax expense 92,000
274,000
Less dividend received 17,000
257,000
Less profit on disposal 16,000
Profit before tax 241,000

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Note 3: Purchase of PPE

$

760,000

Balance at beginning of the year

Less Cost of equipment sold 72,000
688,000
Balance at end of the year 920,000
Cash paid for new PPE 232,000

Note 4: Purchase of investments

Balance at beginning of the year 186,000

Less impairment loss 20,000
166,000
Balance at end of the year 214,000
Cash paid to acquire new investments 48,000

Note 5: Cash received as premium on the issue of shares

$
Balance at beginning of the year 75,000
Less premium on redemption of debentures 75,000
0
Closing balance = Cash received on share issue 125,000

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Income and asset value measurement

systems

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 CHAPTER 9

Income and asset value measurement: an

economist’s approach
Question 1 – Jim Bowater
(a) Refer to Question 2 (a) below for description of underlying theory.

(b) Jim Bowater ideal economic income model:

Investment of £36,000, cost of capital 20%

Jim’s economic income (£) for each of the three years:

31 December 20X5 6,828

31 December 20X6 6,695
31 December 20X7 6,833

Jim’s economic capital will be preserved at the 1 January 20X5 level of £34,144,
provided.

He reinvests excess actual income of £672 on 31 December 20X5 and £34,107 on 31

December 20X7, generating a return of 20%.

An excess of actual income of £695 at 31 December 20X6 is created, in whose effect a

cumulative injection of capital of (695 – 672) £23 is obtained.

He maintains his income of 20% p.a. that will necessitate an investment of £34,167
from the proceeds of the proposed sale.
Workings

(i) Ideal economic income (i.e. conditions of certainty)

Period C Kt Kt−1 Ye C – Ye
20X5 t0 – t1 7,500 33,472 (b) 34,144 (a) 6,828 672

20X6 t1 – t2 6,000 34,167 (c) 33,472 (b) 6,695 (695)

20X7 t2 – t3 41,000 34,167 (c) 6,833 34,167

54,500 20,356 34,144
(a) t0 – t1 7,500 6,000 41,000 = 34,144
+ +
1.2 1.22 1.23

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(b) t1 – t2 6,000 + 41,000 = 33,472

1.2 1.22
(c) t2 – t3 41,000 = 34,167
1.2

(ii) Reinvestment under certainty to maintain 20% p.a. income

Economic income from

Original investment Reinvestment total Economic income

t0 – t1 6,828 – 6,828
t1 – t2 6,695 (20% 672) 133 (approximately) 6,828
t2 – t3 6,833 (20% 23) (5) (approximately) 6,828

Question 2 – Hicks’s Concept of Income: Spock

(a) Hick’s economic model of income and capital

Hicks’s economic model of income and capital is based on his concept of ‘well-
offness’.

Well-offness is the maximum income enjoyed by the individual without depleting the
individual’s capital stock.

It is based on the precept of consumption, which embraces the opportunity for

consumption as well as the actual consumption.

As an extension of Fisher’s original model, it takes savings into account.

It is an ex ante model which usually measures expected income in advance of the

period concerned.

Measurement of capital is necessitated in order to compute the income.

Income is the difference between opening and closing valuations of capital stock.

The capital stock is computed by utilising the concept of present values.

This concept adopts the idea of compound interest in order to compensate for the time
element between cash flows.

Limitations

In the field of accountancy, there are serious practical limitations in measuring the accountant’s
version of income and capital, for example:

Subjectivity: The present value factor, often referred to as the discount cash flow element, is
subjective.

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It requires the use of an interest rate and, as such, depending upon personal inclinations, it can
utilise the opportunity cost of capital, the return on existing capital employed within a business
entity, contemporary short-term interest rates such as that charged on bank overdrafts, the
average rate pertaining to the current economic climate, or a speculative rate as assessed on the
basis of the perceived risk involved.

Unrealised and realised flows: The model uses a mix of unrealised and realised cash flows.
Thus, it is not of practical value as a measure in determining taxation liability and dividend
policy.

Financial strategy: Attainment of flows as per a financial strategy is an integral part of the
calculations. Targets are rarely achieved with precision. Variations from target destroy the
model’s accuracy. Predictions are invariably unachievable with absolute accuracy.

Windfalls: Windfall flows cannot be foreseen and consequently cannot be incorporated within
the model.

Statement of financial position values: Statement of financial position valuations of net assets
or capital employed concern aggregations of individually valued assets and itemised liabilities.

It is not easy to apply the concept of present values across a range of individual assets and
liabilities for statement of financial position discount purposes.

(b) Calculate Spock’s ideal economic income using Hicks’s theorem

Economic capital value of the business at K0

Year Cash flow DCF factor PV

1/(1 + r)n
£ £
K1 400 0.909 364
K2 500 0.826 413
K3 600 0.751 451
400 0.751 300
1,900 1,528

Economic value at K0, i.e. at the beginning of the year is £1,528 (Note: initial capital
was £1,000; therefore, subjective goodwill is £528).

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Economic capital value of the business at K1

Year Cash flow DCF factor PV

1/(1 + r)n
£ £
K1 400 1.000 400
K2 500 0.909 455
K3 600 0.826 496
400 0.826 330
1,900 1,681

Economic value at K1 = £1,681. So Y for Y1 = £1,681 – £1,528 = £153 Rate of income return =
£153/£1,528 = 10%

Economic capital value of the business at K2

Year Cash flow DCF factor PV

1/(1 + r)n
£ £
K1 400 1.100 440
K2 500 1.100 500
K3 600 0.909 546
400 0.909 363
1,900 1,849

Economic value at K2 = £1,849. So Y for Y2 = £1,849 – £1,681 = £168 Rate of income return =
£168/£1,681 = 10%

Economic capital value of the business at K3

Year Cash flow DCF factor PV
1/(1 + r)n
£ £
K1 400 1.121 484
K2 500 1.100 550
K3 600 1.000 600
400 1.000 400
1,900 2,034

Economic value at K3 = £2,034. So Y for Y3 = £2,034 – £1,849 = £185

Rate of income return = £185/£1,849 = 10%

Note that the rate of income return is constant at 10%.

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CHAPTER 10

Accounting for price-level changes

Question 1 – Raiders plc

(a) All in £000s

(i) Cost of goods sold

Note: Closing inventory purchased on average on 31 December.

Average index is index at 30 September 20X4, i.e. 150.

Alternatively, calculate the average of indices at 1 April 20X4 and 31 March 20X5
(138 + 162)
= 150.
(2)
HC × Revaluation = Current
ratio cost
Inventory 1 April 20X4 9,600 150/133 10,827
Purchases 39,200 150/150 39,200
48,800 50,027
Inventory 31 March 20X5 11,300 150/156 10,865
COGS 37,500 39,162

(ii) Inventory figure in statement of financial position

Statement of financial position value 11,300 162/156 11,735

(iii) Equipment depreciation charge

HC × Revaluation = Current cost
ratio
Purchased 1 April 20X2 16,000 180/145 19,862
1 April 20X3 20,000 180/162 22,222
1 April 20X4 21,600 180/180 21,600
63,684
63,684 × 200/180 70,760

[63,684 + 70,760] = 10,083

CC depreciation = 15% ×
[2]

Alternatively, calculate as 15% × £70,760 = 10,614

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(iv) Statement of financial position value of equipment

Purchase Current cost Gross CC Accumulated

date @ 1 April 20X4 (200/180) depreciation
1 April 20X2 19,862 22,069 (45%) 9,931

1 April 20X3 22,222 24,691 (30%) 7,407

1 April 20X4 21,600 24,000 (15%) 3,600
70,760 20,938

Net statement of financial position value = 70,760 – 20,938 = £49,822.

(b) Evaluation of incremental informational content

Discuss users and their decisions and how current cost number should improve
predictions and control. Should also refer to recent empirical evidence and discuss
ongoing controversy within (and outside) ASB.
(c) Consider power of providers, cost, economic companies, etc.

Question 3 – Parkway plc

(a) Monetary working capital

(i) Making and stating assumptions:

COSA provides for the maintenance of inventory levels in times of inflation.

There is a view that MWC is also an integral part of daily operating activities and
should be treated similarly through a provision out of revenue, from any detrimental
impact caused by rising price levels.

However, a consensus does not exist.

Some commentators maintain that MWC is not a part of the operating capital and so
should be ignored while considering the operating capital maintenance concept.

Investment in such items as debtors is not an essential ingredient of day-to-day

operations.

Even where critics accept that MWC is a part of operating activities, varying views
exist as to which of the assets and liabilities should be included in the MWC
calculation. There are some conflicting views.

MWC should embrace monetary assets only; or

all monetary assets less all monetary liabilities should be taken into account; or

only short-term monetary liabilities should be accepted into the calculation; that
long-term monetary liabilities should be part of the gearing adjustment; or

even short-term monetary liabilities should be ignored; or

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only monetary assets and liabilities that have been generated by operating activities
should be involved, and thus these should be segregated from other monetary assets
and monetary liabilities.
(ii) Usual inclusions:

In spite of the ongoing contentious debate, there is general acceptance to include the
following items as part of MWC:

trade receivables, including prepayments, trade bills receivable and VAT recoverable
on trade purchases;

trade payables, including accruals, trade bills payable and VAT payable on turnover;

any stock not subject to COSA.

(iii) Usual exclusions:

Receivables and trade payables arising from fixed assets sold, bought or under
construction are those arising out of any other non-trading activities.

Any cash or bank balances.

Certain investments such as long-term and short-term investments. The former will be
treated as fixed assets and the latter as cash and bank balances.

Some critics formulate a case for including all or a portion of liquid resources as part of
MWC:

If cash is essential to support day-to-day ordinary operations (e.g. a retail supermarket),

then such cash is part of the MWC.

Similarly, if part of a bank balance or overdraft is subject to temporary but material

changes as a reaction to fluctuations in levels of stock, trade debtors, trade purchases or
sales, then it should be treated as MWC.

Any surplus will become part of the gearing adjustment.

Taking account of the above scenarios, the following MWCA calculation involves the
assumptions stated below and corresponding reasons for making them, i.e.

MWC is part of day-to-day ordinary operating activities.

‘Trade receivables’ are substantial.

At £60,000, this is almost 50% of the capital invested in fixed assets (£126,000).

They amount to 63% of inventories (after eliminating an average profit content in debtors
of 16% of sales, i.e. £118,000/738,000 × 100, based on the year-end debtors figure of
£60,000, i.e. 84% of £60,000/£80,000 × 100) = 63%.

If COSA is considered necessary in respect of inventories of £80,000, then so is MWC

in respect of trade receivables, inclusive of profit of £60,000.

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Total inventories of £80,000 are all subject to COSA.

Trade payables, being also substantial at £90,000, are deemed essential to the entity’s
daily operating activities. Trade payables amount to an average of 37 days’ credit, i.e.
[((£80,000 + 70,000)/2)/£738,000] × 365 during 20X8.
Short-term investments are not essential to MWC, i.e. they do not constitute a
provision of finance for, say, imminent investment in trade receivables, as part of a
marketing strategy to stimulate sales by increasing terms of credit to customers.
Cash and bank balances, and any part thereof, are essential to day-to-day ordinary
activities.
The rate of credit given and taken remains unchanged over the period.
Inventories have been charged out on the basis of FIFO and the inventory price level
index is appropriate to the MWCA.
Inventory movements have been evenly spread throughout the year.
(iv) Calculation of MWCA

30 June 20X8 30 June 20X7 Change

Trade receivables 60,000 40,000
Trade payables (90,000) (60,000)
(30,000) (20,000) (10,000)

(v) Adjustment to average price levels:

30,000 × 160 – 20,000 × 160
180 140
= 26,667 – 22,857
= Volume change (3,810)
Reduction in MWC 6,190

(b) Critical evaluation of the influence of MWCA

The concept of an MWCA acknowledges the existence of the interaction of physical
assets and monetary assets by allowing for the protection of MWC against erosion by
inflation, in the same way as COSA protects capital in stocks consumed.
The provision for additional MWC supplements the provision for extra depreciation and
COSA in maintaining the capital substance of the entity.
The calculation is not over-prudent as it takes cognisance of the protection granted by
credit suppliers in their indirect funding of credit customers.
The inclusion of monetary assets and trade payables within the inflation protection
framework reduces the risk of an excess dividend being paid. This could threaten the
going concern by overlooking the impact of inflation on the monetary working funds.
The concept recognises the lag between realising a sale and realising the resultant cash.
Changes in credit periods between that granted to trade receivables and that given by
suppliers can be affected by inflation and that impact may otherwise remain hidden if
the MWCA were not applied.

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However, a point of criticism is that when trade creditors become unstable in terms of
credit given and credit received, the MWCA calculation increases in complexity and
may not be so readily understood by the users of the accounts.
A further criticism lies in the determination of any cash floats and bank balance
movements deemed to be part of MWC by some business entities. These may be very
subjective and, consequently, inaccurate or prone to abuse by the compilers.

Question 4 – Smith plc

(i) Current purchasing power (CPP) requires the restatement of the statement of
comprehensive income and statement of financial position in terms of purchasing
power of money at the end of the accounting period in units of CPP.

It is rather like translating the historic figures into another currency.

CPP accounts are derived from the historic accounts by applying the general price
index and are issued as supplementary statements aimed at the shareholders.
The intention is to ensure that shareholders capital is maintained in terms of general
purchasing power and distributions would be restrained during a period of general
inflation.

CPP accounts are objective/factual because they are based on historical cost (HC)
figures updated to year-end values:

They can be audited as such.

They show gains and losses on monetary items not incorporated into basic CCA model.

(ii) (a) Restate the statement of income in £CPP

CPP statement of comprehensive income for the year ended 31 December 20X8

HC £000 Index CPP £000

Sales 2,000 236/228 2,070

Cost of sales
Inventory 320 236/216 350
Purchases 1,680 236/228 1,739
2,000 2,089
Closing inventory 280 236/232 (285)
1,720 1,804
Gross profit 280 266
Depreciation 20 236/120 39
Administrative expenses 100 236/228 104
120 143
Net profit 160 123

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(b) Restate the closing statement of financial position in £CPP

Statement of financial position as at 31 December 20X8

HC £000 Index CPP £000
Non-current assets
Land and buildings 1,180 236/120 2,321
Net current assets
Inventory 280 236/232 284
Trade receivables 160 160
Cash/bank 120 120
560 564
Less: Trade payables (140) (140)
420 424
Net total assets 1,600 2,745
Equity 1,600 2,745

(c) Restate the opening statement of financial position in £CPP (as at 31

December 20X8 rate)

Statement of financial position as at 31 December 20X7

HC £000 Index CPP £000
Non-current assets
Land and buildings (net) 1,200 236/120 2,360
Net current assets
Inventory 320 236/216 350
Trade receivables 80 236/220 86
Cash/bank 40 236/220 43
440 479
Less: Trade payables (200) 236/220 (215)
240 264
Net total assets 1,440 2,624
Equity (balancing figure) 1,440 2,624

(d) Calculation of monetary loss as at 31 December 20X8

Equity (balance) at 31 December 20X7 in CPP £000 2,624

Equity (balance) at 31 December 20X8 in CPP £000 2,745

Increase 121
Profit per statement of comprehensive income in CPP £000 123
Monetary loss 2

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(e) Reconciliation of monetary loss as at 31 December 20X8

HC £000 Index CPP £000

Net monetary liabilities at 31 December 20X7 (80) 236/220 (86)
Increase 220 236/228 228
Net monetary assets at 31 December 20X8 140 142
Monetary loss (140 – 142) 2

Net monetary liabilities are made up as follows:

31 December 20X7 31 December 20X8

£000 £000
Trade receivables 80 160
Bank 40 120
Trade payables (200) (140)
(80) 140

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Question 5 – Shower Ltd

20X3
HC CPP/PLA RC CoCoA

£ £ £P £P £ £ £
(i) (ii) (iii) (iv)
Sales (8,000 units) 20,000 240/120 40,000 20,000 20,000
Inventory (4,000 units) 4,000 240/100 9,600 HC × 150/100 6,000
Purchase (6,000 units) 9,000 240/120 18,000 HC × 150/150 9,000
13,000 27,600 15,00
C Inventory (2,000 units) 3,000 10,000 240/120 6,000 21,600 HC × 150/150 3,000 12,000 10,000
10,000 18,400 8,000 10,000
Sundry expenses 5,000 240/120 10,000 HC × 150/150 5,000 5,000
Depreciation £6,000/5 1,200 240/100 2,880 HC × 200/100 2,400
3,800 5,520 600 5,000

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Monetary gains Realised holding Price variation

Gains Adjustments
Loan FA FA
(8,000 × 240/100) – 8,000 2,400 – 1,200 1,200 6,000 – 2,000 (4,000)
11,200 Inventory Inventory
12,000 – 10,000 2,000 3,000 – 5,100 2,100
Monetary losses Unrealised holding Capital maintenance
Gains

 240  FA
 6000 × 120  − 6,000
 
(6,000) 9,600 – 4,800 4,800 240
2,000 ×
Inventory 100
5,100 – 3,000
–2,000
2,100
(2,800)
Profit before adjustment 5,520 Profit before adjustment 5,000
PLA net income 10,720 10,700 300

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Statements of financial position as at 31 December 20X3

HC CPP/PLA RCA CoCoA

Share capital 2,000 × 240/100 4,800 2,000 2,000
Retained earnings 3,800 PLA 10,720 600 300

Realised holding 3,200

Unrealised holding 6,900
Capital maintenance
reserve 2,000 × 240 2,800

100
–2,000

Loan 8,000 8,000 8,000 8,000

£13,800 £23,520 £20,700 £13,100

Non-current
asset
6,000 240/100 14,400 200/100 12,000
Depreciation 1,200 4,800 240/100 2,880 11,520 200/100 2,400 9,600 NRV 2,000

Inventory 3,000 240/120 6,000 255/150 5,100 NRV 5,100

Cash 6,000 6,000 6,000 6,000
£13,800 £23,520 £20,700 £13,100

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 CHAPTER 11

Revenue recognition

Question 1 – Senford plc

(a) Purchase
Dr Inventory 1,440,000
Cr Bank/creditors 1,440,000

(Purchase of 3,000 telephones @ €480 each)

Phone revenue assessment:

Phone + service contract 120

Sale of service contract 90
Therefore, monthly phone 30
revenue
Total phone revenue 24 × 30 720

Entries in the financial statements for the three months in the current financial
year:

Dr Deferred debtors 2,160,000

Cr Sales – phones 2,160,000

(Sale of 3,000 phones @ €720 each on deferred terms)

Dr Cost of goods sold – phones 1,440,000

Cr Inventory 1,440,000

(Cost of Sales of phones on deferred terms)

Dr Bank 1,080,000
Cr Deferred debtors 270,000
Cr Service rental 810,000

(Receipt of three months of revenue of €120 on 3,000 phones Credit to Deferred

debtors of €30 for three months on 3,000 phones Credit to service rental of €90 for three
months on 3,000 phones)
Dr Cost of goods sold 270,000
Cr Bank/Creditors 270,000

(Costs of €30 incurred to provide the telephone calls for 3,000 phones for three months)

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(b) Disclosure in statement of financial position

Next year Year three
Forward contracts for telephone services
First quarter 810,000 810,000
Second quarter 810,000 810,000
Third quarter 810,000 810,000
Fourth quarter 810,000 0
Total 3,240,000 2,430,000

Question 2 – Strayway plc

There is a sale and financing contract combined. The implied interest component is
found by discounting the contract amount at 9% over two years giving a revenue
before interest of 8,416,800.

Year one

Dr Bills receivable 10,000,000

Cr Sales revenue 8,416,800
Cr Interest revenue(0.09 × 8,416,800) 757,512
Cr Deferred interest 825,688

(Recording sales revenue and interest revenue separately)

Year two
Dr Deferred interest 825,688
Cr Interest revenue 825,688

(Interest revenue now current)

Dr Bank 10,000,000
Cr Bills receivable 10,000,000

(Receipt of amount due on bill)

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Question 3 – Penrith European Car Sales plc

Calculate revenue applicable to the car:

Total contract 41,500

Less services
5,000 miles 800
20,000 miles 1,200 2,000
Revenue from car sale 39,500

Dr Bank 41,500

Cr Sales – vehicles 39,500

Cr Deferred service revenue 2,000
(Sale of vehicle and two free services)

Dr Cost of sales – vehicles 30,000

Cr Inventory 30,000
(Transfer of ownership of motor vehicle)

Dr Cost of servicing 400

Cr Suppliers 400
(Providing first service)

Dr Deferred service revenue 800

Cr Service revenue 800

(5,000 mile service now supplied)

Dr Cost of servicing 600

Cr Suppliers 600
(Provision of 20,000 mile service)

Dr Deferred service revenue 1,200

Cr Service revenue 1,200

(20,000 miles service now performed)

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Question 4 – Henry Falk

(a)

There are several ways of allocating the revenue

As Falk has a three-year subscription it could be allocated as follows:

Year one Year two Year three
Evenly 100 100 100
Based on incremental revenue 120 80 100

Year one – assuming evenness

Dr Debtors 300

Cr Sales revenue 100

Cr Deferred revenue 200
Dr Cost of goods sold 60
Cr Creditors 60
(Recording revenue under method one)

Dr Bank ?

Cr Debtors 300
Dr Credit card fee ?

(Recording receipt of cash less the merchant’s fees. It would be an interesting exercise to
discuss whether the revenue should be gross or net of the merchant’s fees.)

Year two

Dr Deferred revenue 100

Cr Sales revenue 100

(Subscription now earned)

Dr Cost of goods sold 62

Cr Creditors 62

(Supplying the goods)

Year three

Dr Deferred revenue 100

Cr Sales revenue 100

(Subscription now current)

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Dr Cost of goods sold 64

Cr Creditors 64

(Supply of services)

(b)

You want to show a constant magazine revenue but you also want to recognise the fact
that the subscriber is financing the business. If the annual subscription is being
discounted to reflect that then

300 = A + A/1.1 + A/1.21

A = 109.67

Year one
Dr Debtors 300.00
Cr Revenue – subscriptions 109.67
Dr Interest expense 19.03
Cr Deferred revenue 209.36
Dr Cost of goods sold 60.00
Cr Creditors 60.00

(recording contract)
Dr Bank 294.00
Cr Debtors 300.00
Dr Credit card fees 6.00
Cr Debtors 300.00
(Collection from credit card company)

Year two
Dr Deferred revenue 99.70
Dr Interest expense 9.97
Cr Revenue – subscription 109.67
Dr Cost of goods sold 62.00
Cr Creditors 62.00

(Recording revenue, implied interest cost on getting the money early, and cost of goods sold)

Year three
Dr Deferred revenue 109.66
Cr Revenue – subscription 109.66
Dr Cost of goods sold 64.00
Cr Creditors 64.00

(recording transaction for year three)

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Interest expense is explained as follows:

Initial amount paid in advance 300.00

Less first subscription 109.67
Implied financing 190.33
Interest at 10% 19.03
New balance 209.36

Less second years’ subscription taken

out of the fund 109.67

New balance 99.69
Interest at 10% 9.97
New balance 109.66
Third subscription taken 109.66
Balance nil

This calculation assumes that there are only two years of financing as subscriptions
involving single payments are normally at the start of the period. Single payments do not
involve a year of financing as they relate to issues going out throughout the year.

(c) Disclosures

First year Years two and three

Deferred revenue for a 100 100
Deferred revenue for b 109.67 109.66

(d) You could adjust for inflation so that revenue increases at the rate of inflation.

Question 5 – Henry Falk

(a) Recording transactions

If the invoiced amount including VAT is 300 then VAT at 7.5% = 300 × (7.5/107.5) =
20.93 Then the company revenue totals 279.07. Thus annual revenue is given by:

B + B/1.1 + B/1.21 = 279.07

Year one
Dr Accounts receivable 297.00
Cr Sales revenue 102.02
Cr Deferred revenue 177.05
Cr VAT payable 20.93
Dr Collection fee 3.00
Dr Interest expense 17.71
Cr Deferred revenue 17.71

(Recording Falk’s subscription)

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Dr Bank 297.00
Cr Accounts receivable 297,00

(Collection from the credit card company less their commission)

Dr Cost of goods sold 60.00

Cr Creditors 60.00

(Recording production costs)

Dr VAT payable 20.94

Cr Bank 20.94

(Payment of VAT charges to the government)

Year two
Dr Deferred revenue 102.02
Cr Sales revenue 102.02
Dr Interest expense 9.28
Cr Deferred revenue 9.28

(Revenue no longer deferred)

Dr Cost of goods sold 62.00
Cr Creditor/Bank 62.00

(Costs incurred in producing the magazine)

Year three

Dr Deferred revenue 102.02

Cr Sales revenue 102.02

(Revenue previously in advance and now current)

Dr Cost of goods sold 66.00

Cr Creditor/Bank 66.00

(Costs incurred in producing the magazine)

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(b) Disclosures
Within one year In years two and three
Revenue in advance 102.02 102.02

Question 6 – Five G Telephones

(a) Record purchase and sale of phone assuming no contract

Xyz phones

Dr Inventory Xyz phones 500

Cr Trade creditor/bank 500

(Purchase of a telephone)

Dr Bank 1,000

Cr Sale of Xyz phones 1,000

Dr Cost of goods sold Xyz 500

Cr Inventory Xyz phones 500

(Recording sale and matching cost of goods sold)

Basic Y phones

Dr Inventory Y phones 120

Cr Trade creditor/bank 120

(Purchase of phone)

Dr Bank 200

Dr Cost of goods sold Y 120

Cr Sales revenue Y 200

Cr Inventory Y 120

(Direct sale of Y Phone)

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(b) Assuming basic connection service A

Basic connection service 40 per month

Dr Debtor 40

Dr Cost of goods sold 5

Cr Sales of services 40

Cr Trade creditors/Bank 5

(Connection service for one month and variable cost of 5c per call)

(c) Assuming basic connection service B

Basic 15 plus 50 cents per call

Dr Debtor 65

Dr Cost of goods sold 5

Cr Sales of services 65

Cr Trade creditors/Bank 5

(Connection service for one month – €15 + 100 @ 50 cents and variable cost of 5c per call)

(d) Assuming supply, connection and minimum contract

Supply of Xyz phone and connection

Dr Inventory of Xyz phones 500

Cr Trade creditors/Bank 500

(Purchase of phone)

Calculate revenue from phone and connection:

As combined contract is 79 per month or 1,896 over a 24-month contract, and the
connection service is only 40, then the revenue for the sale of the phone is 79 – 40 or
39 and so for 24 months = 936.
Dr Deferred debtor 1,896
Cr Sale of Xyz phones 936
Cr Sale of Connection Service 40
Cr Deferred revenue 920

(Recording sale of phone and services)

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Alternatively, it could be argued the Xyz sells alone for 1,000 and the connection
service is 960 and so the total is normally 1,960. As it is being sold for 1,896; so
everything is being sold at 1,896/1,960 of its normal price meaning the phone is being
sold for 967.44 and the connection service is 40 × 1,896/1,960 or 38.69 per month
(total of 928.56). The second method is the method suggested by the proposed
standard.
Dr Deferred debtor 1,896 Proposed
Cr Sale of Xyz phones 936 967.44
Cr Sale of connection service 40 38.69
Cr Deferred revenue 920 889.87

(Recording sale of phone and services)

Note:

It has been assumed the phone is sold at the time it is handed over under the legal
concept and it would also satisfy the control concept when adopted.

Other possibilities include treating half the revenue as earned, or no revenue being
earned on the sale until the final payment.

It could depend on the legal terms of the contract.

An alternative of treating the Xyz phone as being sold by instalments was rejected on
the basis that property and control of the phone have presumably passed to the
customer.
Dr Cost of goods sold Xyz 500
Dr Cost of goods – services 5
Cr Inventory Xyz 500
Cr Trade creditors/bank 5

(Recording inventory movement and cost of services)

Dr Bank 79
Cr Deferred debtors 79

(First monthly payment)

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 PART 5

Statement of financial position – equity,

liability and asset measurement and
disclosure

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 CHAPTER 12

Share capital, distributable profits and reduction

of capital

Question 1 – Telin plc

(a) Ledger accounts
Cash and bank
1/10 Balance 5,450,000 28/10 Redemption of
preference shares 8,480,000
4/10 Debentures 2,340,000
12/10 Ord. shares 6,000,000
Share premium 600,000
31/10 P&L a/c 275,000 31/10 Balance c/d 6,185,000
14,665,000 14,665,000
1/11 Balance b/d 6,185,000

10% debentures
4/10 Bank 2,340,000
31/10 Balance c/d 2,400,000 Deb. discount 60,000
1/11 Balance b/d 2,400,000

Discount on debentures

4/10 Debentures 60,000 6/10 Share premium 60,000

Share premium

6/10 Debenture discount 60,000 1/10 Balance 4,000,000

29/10 Premium on

redemption 160,000 12/10 Cash 600,000

31/10 Balance c/d 4,380,000 -

4,600,000 4,600,000

1/11 Balance b/d 4,380,000

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Profit and loss

6/10 Research expenses 1,400,000 1/10 Balance 4,600,000

29/10 Dividends on
pref. shares 80,000 31/10 Cash (profit) 275,000
29/10 Premium on
redemption 240,000
29/10 Capital redemption
reserve 1,400,000
31/10 Balance c/d 1,755,000 -

4,875,000 4,875,000

Product development costs

1/10 Balance 1,400,000 6/10 P&L a/c 1,400,000

Ordinary share capital

1/10 Balance 12,000,000

12/10 Bank 6,000,000

31/10 Balance c/f 18,900,000 30/10 (Bonus issue) CRR 900,000

18,900,000 18,900,000

1/11 Balance c/d 18,900,000

12% preference share capital

29/10 Redemption of
shares 8,000,000 1/10 Balance 8,000,000

Redemption of preference shares

29/10 Cash 8,480,000 29/10 Pref. shares 8,000,000

Premium on red. 400,000

P&L a/c 80,000

8,480,000 8,480,000

Premium on redemption

29/10 Redemption a/c 400,000 29/10 Share premium 160,000

P&L a/c 240,000

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Capital redemption reserve

30/10 Ordinary share capital 29/10 P&L a/c 1,400,000
bonus issue 900,000
31/10 Balance c/d 500,000 −-
1,400,000 1,400,000
1/11 Bal. b/d 500,000

(b) Statement of financial position as at 31 October 20X5

Ordinary share capital 18,900,000 Sundry assets 32,170,000
Capital redemption Cash at bank 6,185,000
reserve 500,000
Share premium 4,380,000
Retained profits 1,755,000
10% debentures 2,400,000
Payables 10,420,000
38,355,000 38,355,000

Notes: An advantageous course of action for shareholders is not to reduce distributable profits
unless there is no other course of action. Therefore, whenever legally possible, reduction has
been made from share premium account.

Bonus issue was made from capital redemption reserve, as this is restricted to bonus issues
only, whereas share premium can be used for some other purposes also.

(c) Under the Companies Act

(i) Premium on redemption of shares can be written off against share premium –
maximum allowed being premium received on the issue of shares, which are now
being redeemed, that is 2% of £8,000,000 = £160,000 to share premium.

Balance must be written off against profits.

(ii) Transfer to capital redemption reserve is the amount by which the aggregate
receipts from specific new issue exceeds the nominal value of shares redeemed.
Nominal value of shares redeemed 8,000,000
Less: Total receipts from new issue 6,600,000
To capital redemption reserve 1,400,000
(from distributable profits)

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Question 2 – Alpha Ltd

(a) Capital reduction and reorganisation account
£000 £000
7¾ notes 50 Ordinary shares 75
Ordinary shares – reissue 15 Ordinary shares 15
Profit and loss account 177 Preference shares 250
Shares in subsidiary company 55 Freehold property 14
Plant 57
354 354

(b) Statement of financial position as on 1 July 20X8

£000 £000
Non-current assets
Tangible assets
Freehold property 55
Plant 22
77
Investment
Shares in subsidiary company 45
Loans 40
85 162

Current assets
Inventory 132
Trade receivables 106
Bank 107
345

Payables: amounts falling due within one year

Trade payables 282
Net current assets 63
225

Payables: amounts falling due after one year

7¾ notes 200
Total assets less liabilities 25
Ordinary share capital 25

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Ordinary share capital

£000 £000
Capital reduction 75 Balance b/f 75
Capital reduction 15 Bank 25
Balance c/f 25 Reissue 15
115 115
Balance 25
Bank
OSC 25 Balance b/f 58
7¾ notes 150 Shares in sub. 10
Balance c/f 107
175 175
Balance b/f 107
7¾ notes
Balance c/f 200 Bank 150
Capital reduction 50
200 200
Balance b/f 200

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 CHAPTER 13

Liabilities

Question 2 – Incident plc

IAS 37

Under IAS 37, there is a present obligation at the period end which is estimated to cost
the company £5,000 to pay out. As a result, the company should recognise a provision of
£5,000 for the claim as a liability.

The main issue, however, is whether an asset of £4,750 can be recognised to reflect the
claim from the insurance company. Assets can only be recognised when they are
‘virtually certain’, and in this case it does not appear virtually certain that a claim will
be accepted. As a result, the contingent asset may be disclosed if it is considered
possible. However, an asset would not be expected to be recognised on the statement of
financial position.

ED IAS 37

The liability exists, as the accident occurred before 31 December 20X6, and the
company has acknowledged its responsibility for the accident. The cost of the repairs
was £5,000, which would be included as a liability at the year-end.

On the insurance claim, it is expected that the insurance company would reimburse the
cost of the claim so it would be an asset at 31 December 20X6. The amount expected
to be received was £5,000 less the excess of £250, giving an asset of £4,750 at the
year-end.

The net cost of the accident will be £250 (i.e. £5,000 less £4,750) but the statement of
financial position will include a liability of £5,000 and an asset of £4,750. No
discounting would be necessary as the cost and the claim would normally be settled
within a year.

Question 5 – Easy View Ltd – FD’s comments

1. It was agreed that the closure should take place from 1st April 2010 and should be
completed by 31 May 2010.

As this is a closure, it is not possible under IFRS 5 to treat it as a discontinued

operation until the closure is complete. It can only be shown as discontinued in the
next financial period.

2. The premises were freehold except for one that was on a lease with six years to run.
It was in an inner city shopping complex, where many properties were empty and
there was little chance of subletting. The annual rent was £20,000 per annum. Early
termination of the lease could be negotiated for a figure of £100,000. An appropriate
discount rate is 8%.

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IAS 37 provides that this is an onerous contract and provision may be made. The
amount provided is the lower of the termination cost or present value of continuing
to pay rentals. The resent value at 8% is approximately £92,500. This is the amount
of the provision as it is lower than the £100,000.

3. The office equipment and vans had a book value of £125,000 and it was expected to
realise £90,000, which a figure tentatively suggested by a dealer who indicated that
he might be able to complete by the end of April.

As these are no longer being used to generate sales, they will be disclosed in the
Statement of financial position as non-current assets held for sale under IFRS 5.

4. The staff had been mainly part-time and casual employees. There were 45
managers, however, who had been with the company for a number of years. They
were happy to retrain and work with the training resources operation. The cost of
retraining to use publishing software was estimated at £225,000.

The retraining will not be treated as part of the closure as it relates to the ongoing
training resource operation.

5. Losses of £300,000 were estimated for the current year and £75,000 for the period
until the closure was complete.

These relate to future events and so cannot be treated as part of any closure
provision.

Question 7 – Kroner

Extracts from statement of comprehensive income for the year ended

20X1 20X0
$000 $000

Depreciation of leasehold improvements 195 97

Unwinding of discount on restoration liability 49 24

Extracts from statement of financial position as at 31 March

20X1 20X0
$000 $000
Leasehold improvements 3,508 3,703

Explanations to support the figures

The leasehold improvements of $3 million will be capitalised and depreciated from 1

October 20W9 over their useful economic lives of 19.5 years.

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The completion of the improvements brings with a liability to restore the property at
the end of the lease. The liability will be measured at its discounted present value of
$800,000 ($2.5 million × 0.32). This will be included in the carrying value of the
leasehold improvements.

The total amount capitalised will, therefore, be $3.8 million ($3 million + $800,000)
and the annual depreciation charge $194,872 ($3.8 million/19.5). The charge for the
year ended 31 March 20X0 will be $97,436 ($194,872 × 6/12).

As the date of payment approaches, the discount on the restoration liability unwinds.
The unwinding in the six months to 31 March 20X0 is $24,000 ($800,000 × 6% × 6/12)
and in the year to 31 March 20X1 $49,440 ($824,000 × 6%).

Question 9 – Epsilon
As far as the closure provision is concerned, the relevant financial reporting standard is
IAS 37 – provisions, contingent liabilities and contingent assets. IAS 37 requires that
provisions should be made for the unavoidable consequences of events occurring before
the reporting date.

The steps taken before the reporting have effectively committed the entity to the
closure. The basic principle laid down in IAS 37 is that provision should be made for
the direct costs associated with the closure. On this basis, the required provision would
be:
Redundancy costs [(i) in question] 30,000
Onerous contract [(iv) in question] 5,500
35,500

Epsilon is committed to paying 8,000 to its pension plan but this will not form part of
the closure provision. This is because the payment, when made, will enable the pension
plan to discharge actuarial liabilities that are measured at 7,000. This one-off additional
retirement benefit cost of 1,000 (8,000 – 7,000) will be recognised in the income
statement of Epsilon in the year to 30 September 2008 and the net retirement benefit
obligation increased accordingly.
Redeployment costs [(iii) in the question] relate to the ongoing activities of the entity
and are not recognised as part of a closure provision. They would only be recognised as
liabilities at 30 September 2008 if Epsilon had entered into enforceable obligations to
incur the costs.

The lease with 10 years left to run [(iv) in the question] is an onerous contract, given the
lack of subletting opportunities. IAS 37 requires that the provision should be the lower
of the cost of fulfilling the contract (1,000 × 6.14 = 6,140) and the cost of early
termination (5,500).

The anticipated loss on sale of plant [(v) in the question] of 9,000 (11,000 – 2,000) is not
part of the closure provision. However, under the principles of IFRS 5 – non-current
assets held for sale and discontinued operations – the plant would be measured at the
lower region of the current carrying value (11,000) and fair value less costs to sell
(2,000). The plant would be separately displayed in a new statement of financial position
caption (non-current assets held for sale).

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Future operating losses [item (vi) in the question] are not recognised as part of a
closure provision as they relate to future events.

There is no need to disclose the results of the business segment that is to be closed
separately in the current financial year. This is because the business segment does not
satisfy the definition of a discontinued operation in the current financial year. IFRS 5
states that a discontinued operation is a component of an entity that is disposed of or
classified as held for sale before the year-end. This component is being abandoned
rather than sold so it will not be classified as discontinued until the closure occurs. In
this case, this occurs on 31 December 2008 – the year ended 30 September 2009.

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 CHAPTER 14

Financial instruments

Question 1 – DDB AG
Issue of deep discount bond

Charges to profit or loss and carrying value in the statement of financial position
shown in tabular form

Cash flows Finance Liability

charge
£000 £000 £000

At 1 April 1 (2,500 – 125 – 150) 2,225 2,225.000

At 31 March 1 10% of 2,500 (250) 13.14% × 2,225 292.365 2,267.365

At 31 March 2 10% of 2,500 (250) 13.14% × 2,267.365 297.932 2,315.297

At 31 March 3 10% of 2,500 (250) 13.14% × 2,315.297 304.230 2,369.527

At 31 March 4 10% of 2,500 (250) 13.14 × 2,369.527 311.356 2,430.882

At 31 March 5 2,500 + 10% of 2,500 (2,750) 13.14% × 2,430.882 319.418 2,750.299

Net cash flow 1,525 1,525

Interpolate for finance charge %

13%

Present value of cash outflows 2,236,209 less 2,225,000 = 11,209

14%

Present value of cash outflows 2,156,691 less 2,225,000=-68,309

13% + (11,209/(11,209 + 68,309)) = 13.14%

Workings

Implicit rate has been determined by interpolation via the formula

t =n
At
 = (1 + r)
t =1
t

The initial cost of 2,275,000 is deducted to arrive at the net present value.

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Using 13%,
t =n
250 250 250 250 2,750,000
 = 1.13
t =1
1
+ + +
1.132 1.133 1.134
+
1.135
− 2,275,000

= 221,239 + 195,787 + 173,263 + 153,330 + 1,492,590 – 2,275,000 = –38,791

Then using 12%,

t =n

 = 223,214 + 199,298 + 177,945 + 158,880 + 1,560,424 − 2,275,000 = 44,761

t =1

 44,761  
Implicit rate = 12%+ 
44,761 + 38,791  × 1% = 12.536% say
  
=12.5%

Question 2 – Fairclough plc

(a) The total finance cost is the difference between the cash repayments and the net
proceeds of the loan.

Total repayments:
Principal 10,000,000
Interest
(3 years at 6% × 10,000,000) 1,800,000
(2 years at 5% × 5,000,000) 500,000
Less net proceeds (10,000,000 – 100,000) (9,900,000)
Finance costs 2,400,000

(b) The cash flows included in the loan are:

Inception Net proceeds 9,900,000

Year 1 Interest (600,000)
Year 2 Interest (600,000)
Year 3 Interest and principal (5,600,000)
Year 4 Interest (250,000)
Year 5 Interest and principal (5,250,000)

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The liability will be recognised as follows over its life in the statement of
comprehensive income and the statement of financial position:

Year B/F Interest charge Interest paid Principal paid C/F

at 6.07%
1 9,900,000 600,697 –600,000 9,900,697
2 9,900,697 600,740 –600,000 9,901,437
3 9,901,437 600,785 –600,000 –5,000,000 4,902,222
4 4,902,222 297,450 –250,000 4,949,671
5 4,949,671 300,329 –250,000 –5,000,000 0

Question 3 – Isabelle Ltd

(a) Interest charge for each year of the loan

The interest charge is based on an internal rate of return calculation based on the
cash flows on the loan. The cash flows are:
At inception (after arrangement fees) 98,000
Interest
Year 1 (5,000)
Year 2 (5,000)
Year 3 (5,000)
Year 4 (7,000)
Year 5 (7,000)
Repayment
Year 5 (100,000)

The IRR of these cash flows (discount rate at which the NPV is zero) is 6.2% (use
internal rate of return function on spreadsheet or extrapolate from two rates
selected).

Interest in the comprehensive income statement

b/f Interest charge Interest paid c/f
6.2%
Year 1 98,000 6,076 (5,000) 99,076
Year 2 99,076 6,142 (5,000) 100,218
Year 3 100,218 6,213 (5,000) 101,431
Year 4 101,431 6,288 (7,000) 100,719
Year 5 100,719 6,281* (7,000) 100,000

*Rounding adjustment in final year interest charge.

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(b) Loan repaid

If the loan was repaid at the end of year 3, the gain recognised in the income statement
would be £1,431 (£101,431 – £100,000).

Question 4 – Henry Ltd

At 1 January 2009

The proceeds of the convertible need to be split between the debt and equity elements.
The debt is discounted to present value using the rate on similar debt without the
conversion option and the equity is the balance of the proceeds.

Debt value:
Cash flow DCF PV
€m €m €m
Year 1 Interest 10 0.935 9.35
Year 2 Interest 10 0.873 8.73
Year 3 Interest 10 0.816 8.16
Year 4 Interest 10 0.763 7.63
Year 5 Interest and capital 210 0.713 149.73
Debt value 183.60
Equity value:
Proceeds less debt value (200 – 183.6) 16.40
The entry on 1 January 2009 will, therefore, be:
Dr Cash 200
Cr Debt 183.6
Cr Equity 16.4

Interest charges in the statement of comprehensive income

b/f Interest charge Interest paid c/f
7% 5%
Year 1 183.6 12.9 (10) 186.5
Year 2 186.5 13.1 (10) 189.6
Year 3 189.6 13.3 (10) 192.9
Year 4 192.9 13.5 (10) 196.4
Year 5 196.4 13.6 (10) 200.0

Question 6 – Milner Ltd

Under IAS 32, if a capital raising instrument contains an obligation to pay out cash or
other financial assets it is a financial liability. However, if the instrument has payments
that are discretionary for the issuer it is an equity instrument.

This preference share has a liability element as there is an obligation for Milner Ltd to
repay the principal sum of €1 million at the end of the life of the instrument. However,
there is no obligation on Milner Ltd to pay any dividends throughout the life of the
instrument. The directors of Milner Ltd could decide not to declare an ordinary
dividend, in which case, no preference dividend would need to be paid. As a result, the

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instrument also contains an equity element. IAS 32 considers the contractual

obligations in instruments and not what is likely to happen in practice. As such, even if
the preference shareholders expected a dividend and Milner Ltd directors expected to
pay one, it would not change the classification.

To split the initial proceeds between the debt and equity elements, the debt is values by
discounting the cash flows at a market rate on debt without the equity element; the
equity element is then the balance of the proceeds.
Initial recognition
Debt element: €1 million × 1/1.0610 558,394

Equity element: (1,000,000 – 558,394) 441,606

Subsequent recognition

Year b/f Interest charge c/f

1 558,394 33,504 591,898
2 591,898 35,514 627,411
3 627,411 37,645 665,056
4 665,056 39,903 704,960
5 704,960 42,298 747,257
6 747,257 44,835 792,093
7 792,093 47,526 839,618
8 839,618 50,377 889,995
9 889,995 53,400 943,395
10 943,395 56,604 1,000,000

Question 8 – Little Raven plc

(a) The considerations involved in deciding how to account for the issue:

• The issue is made at a substantial discount.

• The coupon rate is significantly below market rates.

• Adopting substance over form, the discount is effectively rolled-up interest

and should be accounted for over the period of the borrowing.

• The statement of financial position should report the obligation to redeem at

par and the statement of comprehensive income should report the true cost of
the borrowing.

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If the borrowing was accumulated for:

(i) As per the question:

DR Cash 4,000
CR Debt 4,000
and each year, DR Finance charge 300
CR Cash 300

neither the obligation to repay nor the true cost of the borrowing would be fairly reported.

(ii) Taking advantage of the legal point (available in some countries) that permits
discount on issue to be debited to share premium account, the debt could be
reported as follows:
DR Cash 4,000
DR Share premium a/c 1,000
CR Debt 5,000

and, each year DR Finance charge 300

CR Cash
300

in which case the amount of debt would be fairly reported but not the true cost of the debt.

(iii) Alternatively,
DR Cash 4,000
DR Unamortised discount 1,000
CR Debt 5,000
And, each year, DR Finance charge 300
CR Cash 300
DR Finance charge X
CR Unamortised discount

with amortisation of discount on an appropriate basis over the period of debenture.

At each year-end, the debt would be reported as £5,000 less unamortised discount.
Such accounting achieves the objective of reporting the actual amount repayable and
the true cost of the debt but is not the approach adopted by IAS 32.

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(iv) Under IAS 32, the approach would be:

• On issue date
DR Cash X
CR Debt X
with the net proceeds of issue.

• Determine finance costs as total amounts repayable (interest plus redemption)

less net proceeds of issue.

• Allocate finance costs to each period at a constant rate on the carrying amount
of the debt by

DR Finance charge X
CR Debt X
DR Debt X
CR Cash X

with amounts paid in each period.

(b) Carrying Finance Carrying
Period amount at cost Payments amount at
y/e beginning (11.476%) end
£000 £000 £000 £000
30.9.X2 4,000 459 (300) 4,159
30.9.X3 4,159 477 (300) 4,336
30.9.X4 4,336 498 (300) 4,534
30.9.X5 4,534 520 (300) 4,754
30.9.X6 4,754 546 (300 + 5,000) –
2,500

(300 × 5 = 1,500 + 5,000 = 6,500 – 4,000 = 2,500)

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Revised statement of comprehensive income for the year ended 30

September
20X5 20X4
(restated)
Turnover 6,700 6,300
Cost of sales (3,025) (2,900)
Gross profit 3,675 3,400
Overheads (600) (550)
Interest payable – debenture (520) (498)
– other (75) (50)
Profit for the financial year 2,480 2,302
Statement of changes in equity (extract)
Retained profit brought forward,
as previously stated 4,300 1,800
Previous year’s adjustment (336)
[159 + 177]
[159 + 177 + 208] (544)
Retained profit brought forward restated 3,756 1,464
Retained profit, carried forward 6,236 3,766

Question 9 – George plc

The position in the financial statements for the three instruments is as follows:
Joshua Ltd

To determine the accounting for the investment in Joshua Ltd, it is first necessary to
determine whether the investment is a subsidiary, associate or joint venture. If it is, it
will be governed by standards other than IFRS 9. A 15% investment would generally
not be sufficient to give control or significant influence and, therefore, the investment is
accounted for under IFRS 9 as a financial asset.

Under IFRS 9, equity investments by default are classified as fair value with gains and
losses recognised in profit and loss. However, Joshua Ltd would be able to make an
irrevocable election to measure the investment at fair value with gains and losses in
other comprehensive income.

Debenture investment

The investment in debentures is a financial asset under IFRS 9. A receivable could be

measured at amortised cost, fair value through other comprehensive income or fair
value with gains and losses in profit and loss, depending on the characteristics and
business model of Joshua.
A debenture would normally be an investment on which only interest and principal
payments are made. This means that it would not be measured at fair value with gains
and losses in profit and loss unless the fair value option was taken.

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The business model is stated as being to collect the interest and principal the
investment would be expected to be classified and measured at amortised cost. If the
business model was to collect the contractual cash flows or sell the investment, it would
be measured at fair value with gains and losses in other comprehensive income.

Interest rate swap

The interest rate swap is a derivative and they must be classified and measured at
fair value with gains and losses in profit and loss. The swap does not act as a
hedge and, therefore, hedge accounting would not be appropriate.

Question 14 – Tan plc

The accounting entries for the recognition of the expected losses differ depending
on whether the investment is classified at amortised cost or fair value through other
comprehensive income.

Loan receivable – amortised cost

Expected credit losses are £2,000 (2% × £100,000) at 1 January 2016. These
increase to £2,500 by 31 December 2016:
1 January 2016:
Dr Income statement 2,000
Cr Loan receivable 2,000
31 December 2016:

Dr Income statement 500

Cr Loan receivable 500

Loan receivable – fair value other comprehensive income (FVOCI)

For assets measured at fair value with gains and losses in other comprehensive income
(OCI), it is necessary to recognise any loss provision against OCI rather than the asset.
The expected loss is £3,000 at 1 January 2016, increasing to £3,750 by 31 December
2016
1 January 2016

Dr Income statement 3,000

Cr Other comprehensive
3,000
income
31 December 2016

Dr Income statement 750

Cr Other comprehensive 750
income

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Employee benefits

Question 1 – Donna, Inc.

(a) Accounting for employee benefits has been an accounting area that has seen
considerable evolution over the period that international accounting standards have
been issued. In the year 2011, IAS 19 was most recently revised and it is this
revision that caused the differences in pension accounting explained to the finance
director.

Prior to its revision, the recognition of actuarial gains and losses allowed two
different approaches:

(i) A 10% corridor approach. Under this approach, actuarial gains and losses
above a 10% corridor (greater of 10% of the present value of pension
obligations and 10% of the fair value of pension assets) were recognised in
the income statement over the average remaining working lives of
employees, or any systematic shorter period. It was also acceptable to
recognise actuarial gains and losses within the corridor on the same basis.

(ii) An immediate recognition approach. Under this approach, actuarial gains

and losses were recognised in full in other comprehensive income.

With its revision in 2011 the 10% corridor approach was removed. Therefore, now all
‘remeasurements’, which include actuarial gains and losses must be recognised
immediately in other comprehensive income.

(b) The impact of IAS 19 (2011) on the pension position would be as follows:

Step 1 Change in the net pension obligation

2013 2014 2015

Present value of obligation, 1 January 300 200 (100)

Net interest cost at 6%, 5%, 4% 18 10 (4)
Current service cost 150 160 170
Contributions paid (120) (120) (130)

Actuarial (gain) loss on obligation* (bal fig) (148) (350) (336)

Present value of the obligation (asset),

31 December
200 (100) (400)

* This includes the difference in the actual and expected return on pension assets also
recognised in other comprehensive income.

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Step 2 Calculate the impact on the statement of comprehensive income

2013 2014 2015

Operating costs
Current service cost 150 160 170
Net interest cost 18 10 (4)

Profit and loss charge 168 170 166

Other comprehensive income

Actuarial gains (losses) 148 350 336

Step 3 Calculate the statement of financial position

2013 2014 2015
Present value of pension obligation,
31 December 3,600 3,500 3,200
Fair value of plan assets, 31 December (3,400) (3,600) (3,600)

Liability (asset) recognised 200 (100) (400)

Question 2 – Basil plc

Step 1 Change in the net pension obligation

20X7
Present value of obligation, 1 January 20X7 600
Net interest cost at 7% 42
Current service cost 80
Past service cost 150
Contributions paid (26)
Actuarial (gain) loss on obligation* (bal fig) (40)
Present value of the obligation (asset), 31 December 20X7 806

* This includes the difference in the actual and expected return on assets

Step 2 Calculate the impact on the statement of comprehensive income

20X7
Operating costs
Current service cost 80
Past service cost 150
Net interest cost 42

Profit and loss charge 272

Other comprehensive income
Actuarial gains (losses) 40

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Step 3 Calculate the statement of financial position

20X7
Present value of pension obligation, 31 December 20X7 4,192
Fair value of plan assets, 31 December 20X7 (3,386)
Liability (asset) recognised 806

Question 3
Plan assets at 31 March 20X6
$m
Opening net liability balance 163
Interest cost 15
Current service costs 28
Past service costs 1
Contributions paid (16)
Actuarial gains (net) (21)
Liabilities at 31 March 20X6 170

(a) Net liability recognised

$m

Net liability recognised at 31 March 20X6 (170)

(b) The amounts recognised in the statement of comprehensive income

$m
Current service costs (28)
Past service costs (1)
Net Interest costs (15)
Profit and loss charge (44)

Other comprehensive income

Actuarial gains 21

(c) Scheme termination

On termination at 31 March 20X6, the net liability recognised under the scheme is $170m.
The termination payment to the insurance company discharges the liability and any gain or
loss is required to be recognised in profit and loss.

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The accounting entry for the termination is therefore:

Dr Pension liability $170m

Cr Cash $300m
Dr Income statement $130m

Question 4 – Omega
This is an equity-settled share-based payment transaction. The approach is to measure
the goods and services received and the corresponding increase in equity:

Directly at the fair value of the goods and services received, unless that fair value
cannot be estimated reliably.

Indirectly, by reference to the fair value of the equity instruments granted, if the entity
cannot estimate reliably the fair value of the goods and services received.

As it is a transaction with employees, the entity measures the fair value of services
received by reference to the fair value of the equity instruments granted as it is not
possible to estimate reliably the fair value of the services received.

In transactions with the employees, the IASB has decided that it is appropriate to value
the benefit at the fair value of the instruments granted at their grant date and after the
grant date any movements in the share price, whether upwards or downwards, do not
influence the charge to the financial statements.

The cost of the grant is taken to income over the two-year vesting period. Where the
grant is subject to future employment or performance conditions then the latest known
estimates of the extent of performance is used to determine the total cost. This means
that in this case the total charge to the income statement will be:

50 × 500 × 0.96 × 0.96 × $2 = $46,080. In the year ended 30 September 2006, half of
this amount ($23,040) is debited to income as an operating cost and credited to equity.

Question 5
The total expected charge is (80 – 16) × 1,000 × £6.5 = £416,500 and half of this will be
debited as cost of sales in the income statement with a credit to equity.

No entries are made to reflect the increase in the fair value of each option as it is fair
value at the grant date which is the relevant figure.

Changes in the share price do not affect the financial statements. There is only an effect
if the options are exercised and the company receives the £10 per share. This would
only occur if the share price at the exercise date exceeds £10.

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Question 6 – C plc
Item 1

This is an equity-settled share-based payment transaction. For these transactions, the

value of the ‘payment’ is taken at the grant date – i.e. €3 per share.

The vesting period is from the grant date to the vesting date – 1 January 20X7 to 31
December 20X9 – three years. The cost is spread over this vesting period of three
years but the ‘liability’ is calculated at each year-end. The charge is the difference in
the ‘liability’ between each year- end. The debit entry is the charge to the income
statement and the credit is to equity. The exercise date is when the employee receives
the shares, which is 31 December 20Y0.

At 31 December 20X7:

The ‘liability’ = 300,000 × €3 × 80% × 1/3

= €240,000

There is no opening ‘liability’, so:

Charge for the year = €240,000

The accounting entries are:

Dr Income statement 240,000
Cr Equity 240,000

At 31 December 20X8:

The ‘liability’ = 300,000 × €3 × 80% × 2/3

= €480,000

With an opening ‘liability’ of €240,000:

Charge for the year = €480,000 – 240,000

= €240,000

The accounting entries are:

Dr Income statement 240,000
Cr Equity 240,000

At 31 December 20X9:

The ‘liability’ = (300,000 – 30,000) × €3 × 3/3

= €810,000

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With an opening ‘liability’ of €480,000:

Charge for the year = €810,000 – 480,000

= €330,000

The accounting entries are:

Dr Income statement 330,000

Cr Equity 330,000

Item 2

This is a cash-settled share-based payment transaction. For these transactions, the value
of the payment is taken at the estimated value at the vesting date. This is estimated at
each year-end.

The vesting period is from the grant date to the vesting date – 1 January 20X7 to 31
December 20X8 – two years. The cost is spread over this vesting period of two years
but the liability is calculated at each year-end. The charge is the difference in the
liability between each year-end. The debit entry is the charge to the income statement
and the credit is to liabilities (not equity). The exercise date is when the employee
receives the payment, which is 31 December 20X8.

At 31 December 20X7:

The liability = €85,000 × 1/2

= €42,500

There is no opening liability, so:

Charge for the year = €42,500

The accounting entries are:

Dr Income statement 42,500
Cr Liabilities 42,500

At 31 December 20X8:

The liability = €5,000 × 5 × (8 – 4)

= €100,000

With an opening liability of €42,500:

Charge for the year = €100,000 − 42,500

= €57,500

The accounting entries are:

Dr Income statement 57,500

Cr Equity 57,500

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The bonus is paid on 31 December 20X8, so the accounting entries will be:

Dr liabilities 100,000
Cr Cash book 100,000

There are no transactions in the year ended 31 December 20X9.

Question 8 – Oberon

€000
1. In statement of financial position – non-current liabilities

Benefit obligation 41,500

Related asset (32,500)

9,000
2. In statement of comprehensive income – operating costs
Current service cost (4,000)

3. In statement of comprehensive income – finance costs/income

Net interest cost (6% × €35 million)
300
4. In other comprehensive income
Actuarial losses (2,900)

Workings
Step 1 Change in the net pension obligation
20X1
5,000
Present value of obligation, 1 April 20X0
Net interest cost at 6% 300
Current service cost 4,000
Contributions paid (3,200)

Actuarial (gain) loss on obligation (bal fig) 2,900

Present value of the obligation (asset), 31 March 20X1 9,000

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Question 9 – Oliver

1. Statement of financial position

As at 31 March
20X1
20X0
€000 €000
In equity 912 304

2. Statement of comprehensive income

Year ending 31 March
20X1
20X0
€000 €000
In operating expenses 608 304

3. Explanation

The total expected cost at 31 March 20X0 = €912,000 (19 × 10,000 × €4.8).

One-third is recognised in equity as this is an equity-settled share-based payment. The

total expected cost at 31 March 20X1 = €1,368,000 (19 × 15,000 × €4.8).

Two-third is recognised in equity at 31 March 20X1. Amounts can be shown as a

separate component of equity or credited to retained earnings.

The vesting condition relating to share price is ignored in the estimation of the total
expected cost as it is one of the factors that is used to compute the fair value of the
share option at the grant date – i.e. it is a market-related vesting condition.

The cost recognised in 20X0 is the cost to date as this is the first year of the vesting
period.

The cost recognised in 20X1 is the difference between cumulative costs carried and
brought forward.

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 CHAPTER 16

Taxation in company accounts

Question 2 – Adjourn plc

(a) Requirement

Cost Accounts Tax Difference

(Depreciation) (Capital allowances) (Timing)

25,000.00 25,000.00
31.3.20X3 Depreciation/allowance 2,812.50 4,687.50 1,875.00
22,187.50 20,312.50 1,875.00
31.3.20X4 Depreciation/allowance 3,750.00 5,078.13 1,328.13
18,437.50 15,234.38 3,203.13
31.3.20X5 Depreciation/allowance 3,750.00 3,808.59 58.59
14,687.50 11,425.78 3,261.72
31.3.20X6 Depreciation/allowance 3,750.00 2,856.45 (893.55)
10,937.50 8,569.34 2,368.16
31.3.20X7 Depreciation/allowance 3,750.00 2,142.33 (1,607.67)
7,187.50 6,427.00 760.50

Tax calculated by deferral method

Deferred tax Deferred

charge in year tax provision
31.3.20X3 1,875.00 20% 375.00 375.00 Balance at 31.3.20X3
31.3.20X4 1,328.13 30% 398.44 773.44 Balance at 31.3.20X4
31.3.20X5 58.59 20% 11.72 785.16 Balance at 31.3.20X5
31.3.20X6 (893.55) 19% (169.77) 615.38 Balance at 31.3.20X6
31.3.20X7 (1,607.67) 19% (305.46) 309.92 Balance at 31.3.20X7

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Tax calculated by liability method

Difference as at As at As at As at As at As at
(timing) 31.3.X3 31.3.X4 31.3.X5 31.3.X6 31.3.X7
Tax rate 20% 30% 20% 19% 19%
31.3.X3 1,875.00
31.3.X4 3203.13
31.3.X5 3261.72
31.3.X6 2368.16
31.3.X7 760.50
--------- ---------- --------- --------- ---------
375.00 960.94 652.34 449.95 144.50

Charge in year 375.00 585.94 (308.60) (202.39) (305.45)

(b) Requirement

Under the liability method, the focus is on the statement of financial position (the
objective being to compute the deferred tax liabilities), whereas the deferral method
places the focus on the profit and loss account (the objective being to show the
annual effect that has arisen in the year of account).

The deferred tax charge is the change in the liability at the year-end.

Question 3 – Unambitious plc

Year Annual Balance of Deferred Deferred
ended Depreciation Capital increase in total tax tax expense
30 June in year allowances excess excess provision for year
£ £ £ £ £ £
2010 100,000 21,000
2011 12,000 53,000 41,000 141,000 29,610 8,610
2012 14,000 49,000 35,000 176,000 36,960 7,350
2013 20,000 36,000 16,000 192,000 40,320 3,360
2014 40,000 32,000 (8,000) 184,000 38,640 (1,680)
2015 44,000 32,000 (12,000) 172,000 36,120 (2,520)
2016 46,000 36,000 (10,000) 162,000 34,020 (2,100)

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 CHAPTER 17

Property, plant and equipment (PPE)

Question 1 – Simple SA
(a) Annual depreciation charge

Year 1

Straight-line

(SF800,000 – SF104,000)/4 = SF174,000

Reducing balance

40% of SF696,000 = SF278,400

(b) Comment to include

• Directors responsible under IAS 16 for selecting an appropriate method.

• Little guidance given as to how to exercise the choice but the following
matters may be relevant:

• risk of technological change;

• incidence of repairs; and

• extent to which the asset characteristics favour a particular method, e.g. a

lease would be amortised evenly over its life.

Question 2 – Universal Entrepreneurs plc

(a) The principles outlined in IAS 16

• A non-current asset is assessed at the year-end to ensure that it has not been
impaired.

• Fair charge is made to the statement of comprehensive income each year for the
benefit of accruing to that accounting period for use of the asset concerned.

• In no way does the IAS address the notion of showing on the statement of financial
position under the heading of ‘non-current assets’ either the value of the assets to
the enterprise or the value at which they might be sold.

• It was this factor that caused property investment companies to feel that they were
disadvantaged by the requirements of IAS 16 to depreciate buildings when these
formed the major proportion of their asset structure.

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• They argued strongly that the assets were not used in the business but were
held, like any other investment, for their income-producing value and potential
capital growth.

• As a result of these representations, the IASC developed IAS 40.

(b) Advise on policy

• Depreciate on the basis of the rate of extraction of growth over the ten-year period
in reviewing annually.

• The cost of the building (£4,000,000) should be depreciated over its useful life. It is
not an investment property and the period of the lease granted is irrelevant.

• 20% per annum straight-line.

• Depreciate on the basis of actual flying hours.

• Treat as an investment property, revaluing annually but providing depreciation as it

is a base of less than 20 years.

(c)

• The revalued amount of the buildings should be depreciated over the remainder of
their useful lives, taking account of the amounts of depreciation already provided.

• Unless the value of the land is being consumed in some way (e.g. by mining) this
should not be depreciated over the remaining period of the bases, again having
account of the amounts of amortisation already provided.

• When the valuer is instructed in respect of the freehold properties, it must be made
clear that interests of land need to be distinguished from those in the buildings
thereon.

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Question 3 – Mercury
(a) Identifying the method

The method of depreciation is the diminishing balance method. The following

calculations show that the rate applied is at 20%.
20X6 charge = 20% of £80,000 = 16,000
20X7 charge = 20% of £64,000 = 12,800
Cumulative provision = 28,800

(b) How the accumulated depreciation in line (B) was calculated

B/d from (a) above:

20X6 20% of £80,000 = 16,000
20X7 20% of £64,000 = 12,800
20X8 Balance b/f £28,800
Less: first disposal
20X6: £15,000 × 20% = £3,000
20X7: £12,000 × 20% = £2,400 (£5,400)
Less: second disposal
20X6: £30,000 × 20% = £6,000
20X7: £24,000 × 20% = £4,800 (£10,800) (16,200)
12,600

20% of (£80,000 – £45,000 disposed of)

– £12,600 for accumulated depreciation 4,480
20% of £50,000 replacement for second disposal = 10,000
Depreciation on other asset 1,000
Total given in question 28,080

(c) How the figures for 20X9 are calculated

20X9 Property, plant and equipment

Acquired Acquired Acquired Total

20X6 20X7 20X8 20X9
(balancing
figure)
£ £ £ £
Cost 35,000 50,000 5,000 90,000
Depreciation to date 17,080 10,000 1,000 28,080
17,920 40,000 4,000 61,920
Charge for 20X9 3,584 8,000 800 12,384
14,336 32,000 3,200 49,536

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(d) Calculation of profit/(loss) on disposal

Plant disposal I
£
15,000
Cost
Less: Depreciation (5,400)
Cash (8,000)
Loss 1,600
Plant disposal II

Cost 30,000

Less: Depreciation (10,800)

Cash (21,000)
Profit 1,800

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 CHAPTER 18

Leasing

Question 1 – Grabbit
(a) Dr Lease asset 450,329

Cr Lease liability 450,329

(Lease signed and machine supplied)

Dr Depreciation on Lease asset 64,333

Cr Provision for depreciation on

Leased asset 64,333

(Cost of 450,329 shared equally over seven years)

Dr Interest expense 45,033

Dr Lease liability 47,467
Cr Bank 92,500

This entry is calculated by working out the interest on the lease liability of 450,329 at
ten per cent and then saying the balance of the payment is thus a reduction in the lease
liability. The new lease balance is then 402,862 (i.e. 450,329 – 47467). To answer the
next part of the question you have to determine which part of the lease liability will be
paid during the next year and which part will be paid in following years. The payment
in year two will be 92,500 of which 40,286 is interest (10 per cent interest on the
starting balance of 402, 862) leaving 52,214 to pay down the liability. So the current
liability for the lease in the balance sheet at the end of the first year is 52,214. Another
way of looking at the same thing is to say that the interest on the lease for the second
year is not a liability owing at the end of the first year because it only arises for services
rendered in form of financing in the second year. The balance of the 92,500 namely
52,214 represents the part of the lease liability which is being paid in the second year.
The non-current liability will be 402,862 – 52,214 = 350,648. The lease asset will be
385,996.

(b) To work out the implied interest rate, calculate the present value using a rate which you
think might be close to the real rate.

(i) In this case, 92,500 for eight years at 12 % is 459,507. The right interest rate is when the
present value of the lease payments equals the cost of the asset which in this example is
450,329. So the discount rate has to be higher to make the present value lower. Try 12.5%.
The present value is 451,589. It is close but still not high enough. Try 12.6% and the present
value is 450,032 so the rate is too high now so the actual rate is between 12.5 and 12.6 per
cent. Approximate the actual rate as follows:

PV at 12.5% = 451,589

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PV at 12.6% = 450,032

Difference of .1% creates a change of 1557 but the desired change is 451,589 – 450,329 =
1,260

That requires an approximate change of 0.1% x (1260/1557) = .08%.

So the approximate interest rate is 12.5 + .08 = 12.58%.

Discounting at 12.58% gives a present value of 450,342 which is close enough to 450,329.

(ii) The journal entries will be as follows:

Dr Lease asset 450,329

Cr Lease liability 450,329

To record the commencement of the lease

Dr Depreciation expense – lease 56,291

Cr Prov for depn of lease 56,291

Depreciation of lease asset over eight years

Dr Interest expense 56651

Dr lease liability 35849
Cr Bank 92500

First lease payment

Lease asset 450329 – 56291 = 394,038

Total lease liabilities = 450,329 – 35849 = 414,480

12.58% interest on 414,480 = 52142

Principal repayment: 92,500 – 52,142 = 40,358

Current lease liability = 40,358

Non-current lease liability = 414,480 – 40,358 = 374,122

(c)
The requirement was standardised so as to require almost all leases to be accounted for
by a right of use asset and a lease liability account so as to achieve comparability
between those who purchase and those who lease. The items which were excluded from
this treatment were those of a small value (base on initial cost) and those for 12 months
or less were excluded on practical implementation grounds. The importance of having
valid measures of leverage also justified the treatment of form over substance.

(d) The standard does not allow use of the short-term lease contacts exemption where there
is an option to purchase so the statement is incorrect.

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Question 2 – Commercial substance

2 (a) It is conventionally said that the legal form of a lease represents equally unperformed
contract and therefore does not give rise to a legal liability. Accountants are said to override
that when they capitalise leases to the extent to which the minimum expected payments
under the lease give rise to assets and liabilities in the accounts. This is done to achieve
similar accounting statements irrespective of whether asset purchases are financed by loans
or by way of a lease. Then there is greater comparability. (This adherence to substances
over form has a precedent in that consolidated accounts combine assets and liabilities
although the legal position is that creditors normally only have claims over the assets of the
legal entity with which they are transacting.)

2 (b) A finance lease is defined in IFRS 16 as ‘A lease that transfers substantially all the
risks and rewards incidental to ownership of an underlying asset’ (Appendix A). If
substantially all the risks and rewards incidental to ownership of an underlying asset are not
transferred, then a lease is an operating lease. The importance of the distinction comes into
play in the books of the lessor. If in effect the risks have been transferred, it is ‘as if’ the
asset has been sold and hence the ‘book value of the physical asset’ is removed from the
books of the lessor and replaced by a receivable from the lessee.

On the other hand, if the lessor retains in their books the unamortised cost of the physical
asset because it is subject to an operating lease, then they depreciate it in a systematic
manner over the period of the lease. The payments under an operating lease are recognised
as income.

2 (c) For calculation purposes, calculate the present value of lease payments for 10 periods
at an interest rate of 4% per period. The answer is 405,545.

Period Period Period Period Period Period Period Period Period Period Period

0 1 2 3 4 5 6 7 8 9 10

Payment 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

PV of prior 371767 336637 300103 262107 222591 181495 138755 943051 48077

Total 421767 386637 350103 312107 272591 231495 188755 144305 98077

PV = 421767/1.04 = 405,545

(1) Right of use asset at the start of the lease 405,545

Less depreciation for six months 40,555
Book value at 31 Mar 20X8 364,990

Note: The depreciation is over the life of the lease as the company only has the asset for
that period.

Less depreciation for 12 months 81,110

Book value at 31 Mar 20X9 283, 880

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(2) Finance Costs

Loan at the start x interest rate = 405,545 x .04 = 16,222

Lease liability at the commence of the lease 405,545
Plus interest for six months 16,222
Less lease payment (50,000)
Total lease liability at 31 March 20X8 371,767
Plus interest for the first six months at 4% 14,871
Less lease payment (50,000)
Total lease liability at 30 September 336,638
Plus interest at 4% 13,466
Less lease payment (50,000)
Total lease liability at 31 Mar 20X9 300,104

Interest cost (1 April 20X8 to 31 Mar 20X9) = 14,871 + 13,466 = 28,337

(3) Total lease liability at 31 March 20X8 is 371,767 as above and at 31 Mar 20X9 is
300,104.

The current liability at 31/3/X8 is the payment in the next period less the interest
component which is not yet incurred = 100,000 – 28,337 = 71, 663

The non-current element at 31/3/X8 is the amount payable beyond the next financial
year so is the total lease liability at 31/3/X9 or 300,104.

Total lease liability at 31 March 20X9 is 300,104

Plus interest at 4% 12,004
Less lease payment at 30 Sept 20X9 50,000
Total lease liability at 30/9/X9 262,108
Plus interest at 4% 10,484
Less lease payment 50,000
Total lease liability at 31/3/Y0 222,592

So the non-current lease liability at 31/3/X9 is 222, 592 and the current portion is 100,000 –
12,004 – 10,484 = 77,512.

Question 3 – Smarty
Discount three cash flows of 50,000 being the remaining cash flows under the previous
arrangement and four cash flows of 25,000 under the additional option, all discounted at 3%
to give a present value of 226,473.

The prior situation was a lease liability of three payments of 50,000 at 4 % so the present
value would be 138,755 which is the amount of the total lease liability at the 31 March Y1.

The difference of 87,718 is the amount of the adjustment to the lease liability and would be
entered as follows:

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Dr Lease asset 87,718

Cr lease liability 87,718

The lease asset with three periods to run under the previous arrangement would have a net
value of 3 x 40,555 that is equal to three lots of depreciation. This comes to 121,665. The
new amount of the lease asset would, after adjustment, be 121,665 + 87,718 = 209,383.
Depreciation over the remaining seven periods would be 209,383/7 = 29,912 per six month
period or 59,824 per year which is an expense in the profit and loss statement.

Total Lease liability at 1/4/Y1 226,473

Plus interest at 3% 6,794
Less payment 50,000
Balance at 30 Sept Y1 183,267
Plus interest at 3% 5,498
Less payment 50,000
Balance at 31/3/Y2 138,765
Interest at 3% 4,163
Less payment 50,000
Balance 30 Sept Y2 92,928
Interest at 3% 2,788
Less payment 25,000
Balance 31 Mar Y3 70,716

Interest expense in the Y1/2 profit and loss = 6,794 + 5,498 = 12,292.

The current lease liability in the 31 March Y2 balance sheet is ((50,000 +25,000) – (4,163 +
2788)) = 68,049.

The non-current lease liability = 70,716.

3(b) The depreciation on the original cost of the asset would be on the normal basis for
assets of that class held by the company.

The revenue would be averaged from the date of the modification which would be 1 April
Y1 if they were notified immediately. If they leave the notification to the end of the current
lease to keep their options open, then it would be from the date of the extension. Assuming
the adjustment is from 1 April Y1, then the calculation would be 3 x 50,000 + 4 x 25,000 =
250,000. So the revenue each period would be 250,000/7 = 35,714 per half year.

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Intangible assets

Question 3 – Italin NV
(a) IAS 38: Pure and applied research, always written off in period incurred;
development expenditure may be carried forward in certain circumstances.

Income statement for the year ended 30 September (extract)

20X1 20X2 20X3 20X4 20X5 20X6 20X7

Research expenditure 200

Development cost – 50 50 50 50 50 50
Depreciation 300 300 300 300 300 300 300

Statement of financial position as at 30 September (extract)

20X1 20X2 20X3 20X4 20X5 20X6 20X7
Intangible non-current assets 300 250 200 150 100 50 400
Tangible non-current assets 2,200 1,900 1,600 1,300 1,000 700 400

Projects must be reviewed each year.

Treatment of non-current assets used in R&D as for any assets.

(b) Factors to consider:

(a) Technical feasibility.

(b) Intention to complete and use or sell.

(c) Ability to use or sell.

(d) Asset will generate possible future income – demonstrate existence of a market.

Availability of technical, financial and other resources to complete the

development or to use or sell.

Disclosure

• Accounting policy.

• Consistency and application of IAS 38

• amounts written off in the period;

• pure and applied research is written off and

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• development expenditure is capitalised and written off over six years.

• Movement on development costs capitalised.

• Non-current tangible assets used are depreciated in the normal way over their
useful life of seven years.

Question 4 – Oxlag plc

(a) Research and development costs account
£000 £000
Capital costs b/f at Capitalised costs c/f
start of year (project C) 200 Project C 500
Costs incurred in the year:
Project A 25 Costs written off to
Project C 265 Income Statement
Project D 78 Project A 35
Project D 98 133
Depreciation:
Laboratory:
Project C 20
Equipment:
Project A 10
Project C 15
Project D 20
633 633

Capitalised costs b/f Project C 500

(consists of 200 b/f + 265 costs incurred + 20 laboratory depreciation and 15 equipment
depreciation).

Non-current assets: specialised laboratory account

£000 £000
Cost b/f at start of the year 500 Depreciation b/f at start of
the year 25
Depreciation c/f at end of the year 45 Depreciation charge for the year 20
Cost c/f at end of the year 500
545 545
Cost b/f at start of year 500 Depreciation b/f at start of the year 45

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Non-current assets: specialised equipment cost

£000 £000
Cost b/f at start of the year: Depreciation b/f at start of the year
Project C 75 Project C 15
Project D 50 Project D 10
Additions: Depreciation provided in the year:
Project A 50 Project A 10
Project D 50 Project C 15
Project D 20
Depreciation c/f at end of the year 70 Cost c/f at end of the year 225
295 295
Cost b/f at start of the year 225 Depreciation b/f at start of the year 70

Market research Costs account

£000 £000
Costs b/f at start of the year 250 Costs c/f at end of the year 325
Costs in the year 75
325 325
Costs b/f at start of the year 325

Assumption is that this is a contract that will continue in future years.

(b) Amount to be charged as research costs charged in the statement

of comprehensive income for the year ended 31 January 20X2
Per T a/c Project A: Costs 25
Dep’n 10 35
Project C Dep’n 15
Project D: Costs 78
Dep’n 20 98
148

(c) Basis of amortisation:

• Any reasonably systematic basis of amortisation per IAS 38.

• Amount spent and written off reconciled with opening and closing balances in the
balance sheets.

• Most likely basis here will be expected sales of the new drug with amortisation
being calculated as the proportion of total sales during each year.

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Disclosure

• Accounting policy stating basis of capitalisation and basis of write-off.

(d) Statement of financial position amounts

Non-current assets £000

Intangible assets:
Deferred development expenditure
(recovery assured by projected future sales) 500
Tangible assets:
Land and buildings: specialised laboratory 455
Plant and machinery: specialised laboratory equipment 155
Current assets
Inventories:
Long-term work-in-progress 325

(e) Disclosures about new improved drug sales

Identify as non-adjusting post balance sheet event that requires disclosure if material is
in accordance with IAS 10, having arisen between the end of year 31 January 20X2 and
the date of signing the accounts on 14.7.20X2.

This does appear to be material, therefore, the accounts will need to disclose:

• date of new drug going on sale;

• success of new drug and

• expectation that the sales of the new drug will significantly increase following year’s
profits.

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Inventories

Question 2 – Inventory valuation methods

(a)
Receipts Issues Balance
Date
Quantity Rate £ Quantity Rate £ Quantity Rate £
FIFO
1/7 100 10 1,000 100 10 1,000
10/7 80 10 800 20 10 200
12/7 100 9.8 980 100 9.8 980
14/7 20 10 200 20 9.8 196
80 9.8 784

15/7 50 9.6 480 50 9.6 480

20/7 100 9.4 940 100 9.4 940
30/7 20 9.8 196 80 9.4 752
50 9.6 480
20 9.4 188
Cost of goods sold 2,648
LIFO
1/7 100 10 1,000 100 10 1,000
10/7 80 10 800 20 10 200
12/7 100 9.8 980 100 9.8 980
14/7 100 9.8 980 20 10 200
15/7 50 9.6 480 50 9.8 480
20/7 100 9.4 940 100 9.4 940
30/7 90 9.4 846 20 10 200
50 9.6 480
10 9.4 94
Cost of goods sold 2,626

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Weighted average

1/7 100 10 1,000 100 10 1,000

10/7 80 10 800 20 10 200
12/7 100 9.8 980 100 9.8 980
14/7 100 9.83 983 120 9.83 1,180
20 9.83 196.7
15/7 50 9.6 480 50 9.6 480
20/7 100 9.4 940 100 9.4 940
30/7 90 9.5 855 170 9.5 1,615
80 9.5 760
Cost of goods sold 2,638

(b) Advantages and disadvantages

FIFO

• The movement of some inventory follows this pattern in reality, for example,
perishables.

• However, the charge to cost of sales will still represent out-of-date prices.

• This means that a distribution policy based on profits calculated using this
method will reduce the operating capital base.

• The balance sheet value will value inventory at approaching current values.

LIFO

• The movement of inventory does not follow this pattern, and detailed records
will be required to track costs.

• The charge-to-cost of sales will represent prices prevalent at date of sale.

• This means that a distribution policy based on profits calculated using this
method will tend to maintain the operating capital base.

• However, the balance sheet value will value inventory at out-of-date values.

Average cost

• This is a common compromise between the two methods.

• The advantage is that the average represents a compromise between the FIFO
and LIFO methods.

• However, there is a disadvantage that the average cost has to be recalculated

after each purchase.

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(c) Effect of a physical shortage of inventory

FIFO

Closing inventory
75 @ 9.4 705
Cost of sales increased by
5 @ 9.4 47

LIFO

Closing inventory
15 @ 10.0 150
50 @ 9.6 480
10 @ 9.4 94
724
Cost of sales increased by
5 @ 10 50

Weighted average

Closing inventory
75 @ 9.5 712.5
Cost of sales increased by
5 @ 9.5 47.5

Question 3 – Alpha Ltd

Principles

The basis on which the inventories are valued in this solution is the one that is most
commonly used by companies, i.e. the lower of the cost and net realisable value. The
term ‘cost’ includes those overheads that have been incurred in bringing the inventories
to their existing condition, namely, manufacturing overheads. Selling and distribution
expenses have been excluded from cost as it is assumed that these are not incurred until
the units are sold.

Valuation details

Raw materials: 100 tons × cost £140 per ton = £14,000

The net realisable value is assumed to be greater than this amount as the finished units
(which incorporate the steel) sell at a profit, as follows:

£
Selling price 500
Less: selling and distribution expenses 60
Net realisable value 440
Manufacturing costs (see workings below) 350
Profit per unit 90

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The current replacement price has not been taken, as it is not within the basis of the
valuation stated above. However, as the replacement price has fallen, this is a suitable
time to consider whether the client should be advised to amend the basis of inventory
valuation to ‘the lower of cost, replacement price and net realisable value’, which is
more conservative. On this basis, the inventory would be valued at £130 per ton.

Finished units: 100 × cost £350 = £35,000

The cost comprises the following:

Per unit
£

Materials 50
Labour 150
Manufacturing overheads – 100% of labour 150
£350
Net realisable value is greater than the cost:
Selling price 500
Less: Selling and distribution expenses 60
Net realisable value £440

Damaged, finished units: 10 × £240 = £2,400

These units have been valued at cost less than the amount of the loss that will be
incurred when the units have been rectified, and are presented below:

Per unit Valuation

£ £
Cost of finished units 350 350
Cost to rectify 200
Total cost 550
Less: Net realisable value 440
Loss £110 110
Amount per unit included in the balance sheet £240

Semi-finished units: 40 × cost £250 = £10,000

The cost comprises the following:

Per unit
£
Materials 50
Labour 100
Manufacturing overheads – 100% of labour 100
Total cost per unit so far 250

An estimate should be made of the cost required to finish the work. If the total

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estimated cost exceeds the net realisable value, then the excess must be provided for by
deducting it from the £250 cost; this is similar in principle to the treatment of the
damaged units. For example:

Per unit
£
Total cost per unit so far (as above) 250
Estimated costs to complete 220
Estimated total costs to completion 470
Less: Net realisable value 440
Estimated loss on completion 30
Valuation:
Total cost per unit so far 250
Less: Estimated loss on completion 30
220

Question 4 – Beta Ltd

1. As the raw materials will realise more than cost, they have obviously been
valued at the standard cost, namely, £30,000.

2. A review of the price variance account shows that, in total, the actual cost of
materials has consistently been well above the standard costs.

3. Consequently, the £30,000 standard cost of raw materials in inventory is

significantly below the actual cost; unless the inventory figure is adjusted to
the actual cost, this year’s profit will be understated. (Moreover, the
understatement of inventories this year will result in next year’s profits being
artificially inflated).

4. Therefore, the figure to be included in the balance sheet should not be the
standard cost but a figure that is reasonably close to actual cost. This could be
done in one of the following ways:

• Value each item at the actual cost paid for it, by referring to the purchase
invoices concerned. However, this may be too laborious, in which case
method (b) or (c) should be considered.

• If the company has revised the standard costs for use in the following year,
then it may be suitable to use these revised costs for valuing the
inventories in the balance sheet. (Presumably, the revised standards are
based on the cost applicable around the year-end).

• If methods (a) and (b) are impracticable, a rough and ready method may
be used, as follows:

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£
Balance on raw materials control account 30,000
This is equal to the goods purchased in October,
November and December when the price
variances totalled 2,700
Value of raw materials at year-end 32,700

Care is needed in using this method, as the price variances may have arisen over a
narrow range of materials, in which case, the calculations of the adjustment needed
should embrace only those materials.

Conclusion:

Standard costs are used mainly as a tool of management control; their use in the
valuation of inventories for accounts purposes is merely identical. Standard costs
should not be used for inventory valuation unless they are reasonably close to actual
costs.

Question 5 – Uptodate Plc

Uptodate plc’s financial year ended on 31 March 20X8. Revised inventory.
Inventory at 7 April 20X8 200,000
Less:
(i) Purchases between 1.4 and 7.4 40,000
25% received and taken into inventory (8,000) (8,000)

Add:

(ii) Inventory omitted because invoices had not been received 10,000
(iii) Purchases per 31.3 yet to be received 5,000
(iv) Goods in bonded warehouse 12,000

Revised inventory as at 31 March 20X8 219,000

Question 8 – Agriculture
(a) IAS 41 states that an entity should recognise a biological asset or agricultural
produce when:

• It controls the asset as a result of past events.

• It is probable that future economic benefits associated with the asset will
flow to the entity.

• The fair value or cost of the asset can be measured reliably.

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These criteria are consistent with the IASC Framework (para. 83), which states
that an element should be recognised if:

• It is probable that any future economic benefit associated with the element will
flow to the enterprise.

• The element has a cost or value that can be determined reliably.

IAS 41 further states that biological assets or agricultural produce should normally be
measured at fair value less estimated point of sale costs. The standard assumes that the
fair value of a biological asset or agricultural produce can be measured reliably. This
presumption can only be rebutted for a biological asset or agricultural produce for
which market determined prices or values are not available and for which alternative
measures of fair value are ‘clearly unreliable’. Even then, this rebuttal must be made on
initial recognition of the asset.

The measurement basis selected by IAS 41 is one that is envisaged in the IASC
Framework (para 100). However, the Framework (para 101) states that the most
common measurement basis used is historical cost. For this to be a basis to produce
relevant and reliable financial information, the cost of the asset needs to be
determinable. For many biological assets (e.g. newly born calves), the concept of ‘cost’
is not an easy one to apply, and so fair value seems to be more appropriate.

(b)

Extracts from the statement of comprehensive income

$000 $000
Income
Change in fair value of purchased herd (W2) (30)
Government grant (W3) 400
Change in fair value of newly born calves (W4) 125
Fair value of milk (W5) 5.5
Total income 500.5
Expense
Maintenance costs (W2) 500
Breeding fees (W2) 300
Total expense (800)
Net income (299.5)

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Extracts from the statement of financial position

Property, plant and equipment:

Land (W1) 20,000
Mature herd (W2) 970
Calves (W4) 125
21,095
Inventory
Milk (W5) 5.5

Workings

1. Land

The purchase of the land is not covered by IAS 41. The relevant standard to apply to
this transaction is IAS 16 – property, plant and equipment. Under this standard, the
land would initially be recorded at cost and depreciated over its useful economic life.
This would usually be considered to be infinite in the case of land and so no
depreciation would be appropriate. Under the benchmark treatment laid down in IAS
16, no recognition would be made of post-acquisition changes in the value of the land.
The allowed alternative treatment would permit the land to be revalued to market value,
with the surplus taken to equity.

2. Cows

Under the ‘fair value model’ laid down in IAS 41, the mature cows would be
recognised in the balance sheet at 30 September 2004 at their fair value of 10,000 × $97 =
$970,000. The difference between the fair value of the mature herd and its cost
($970,000 – $1 million – a loss of $30,000) would be charged in the income
statement, along with the maintenance costs of $500,000.

3. Grant

Grants relating to agricultural activity are not subject to the normal requirement of IAS
20 – Accounting for Government Grants and Disclosure of Government Assistance.
Under IAS 41, such grants are credited to income as soon as they are unconditionally
receivable rather than being recognised over the useful economic life of the herd.
Therefore, $400,000 would be credited to income by Sigma.

4. Calves

They are a biological asset, and the fair value model is applied. The breeding fees are
charged to income and an asset of 5,000 × $25 = $125,000 is recognised in the balance
sheet and credited to income.

5. Milk

This is agricultural produce and is initially recognised on the same basis as biological
assets. Thus, the milk would be valued at 10,000 × $0.55 = $5,500. This is regarded as
‘cost’ for the future application of IAS 2 – Inventories – to the unsold milk.

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 CHAPTER 21

Construction contracts

Question 1 – MACTAR
The solution will be calculated on two bases, the traditional method using percentage
of completion and the calculations based on control of completed sections passing to
the client.
Project M1
Testing whether the contract will be profitable:

Cost to date 2.1

Cost to complete 0.3
Forecast cost for the whole project 2.4
Contract price 3.0
Forecast profit 0.6
Reported profit

Percentage complete 2.1/2.4

87.5%
Costs 2.1
Revenue 2.625
Profit 0.525
Statement of financial position
Work in progress 2.10
Plus profit 0.525
Total 2.625
Less billings 1.75
Work in progress in the S of FPn 0.875
Debtors (Billings – Receipts) 0.25

M6 Traditional

Costs to date 0.3

Forecast cost to complete 1.1
Forecast total costs 1.4
Contract revenue 2.0
Forecast profit 0.6

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Profit Calculation

Percentage complete 0.3/1.4

21.4%
Expenses 0.3
Revenue 0.429
Profit 0.129
Work in progress

Expenses to date 0.3

Plus profit 0.129
Total 0.429
Less progress billings to date 0.1
Work in progress 0.329
Debtors 0.1

M62 Traditional

Check profitability

Costs to date 2.3

Forecast costs to complete 0.8
Forecast total costs 3.1
Contract price 2.5 × 1.1 2.75
Expected loss 0.35
Percentage completion 2.3/3.1
74.2%
Profit calculation

Revenue 0.742 × 2.75 2.04

Expenses 2.39

In the next period, the revenue would be the balance of 0.71, so the maximum expense
that can be absorbed in that period is that amount. Subtracting those from the total
expected expenses you get the expenses for the current period; alternatively, you can
recognise the expenses to date plus the amount that won’t be recoverable in the next
period.
Loss for the period 0.35
Work in progress

Costs to date 2.3

Less loss to date 0.35
Billable costs 1.95

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Less progress billing 1.00

Work in progress 0.95
Debtors 0.25

There would need to be a note to the accounts saying that due to major difficulties with
the M62 contract 0.35 was written off.

Question 2 – Lytax Ltd

If students assume the costs incurred to date indicate the percentage of completion and
the extent of control that has passed to the client then the solution is as follows.

Workings

Contract No. 1 2 3 4 5
£000 £000 £000 £000 £000

Contract price 1,100 950 1,400 1,300 1,200

Costs incurred to date 664 535 810 640 1,070
Estimated further cost
to complete 106 75 680 800 165
Estimated cost of post-
completion work 30 10 45 20 5
800 620 1,535 1,460 1,240
Estimated profit/(loss)
On contracts 300 330 (135) (160) (40)
Profit/(loss) to date
664/800 × 300 249
535/620 × 330 285
(135) (160) (40)

Notes

Losses on unprofitable contracts are recognised in full.

(a) The statement of financial position will show the following:

Work in progress and/or liabilities

1 2 3 4 5
£000 £000 £000 £000 £000
Costs incurred to date 664 535 810 640 1,070
Recognised profits less 249 285 (135) (160) (40)
foreseeable losses
Cumulative 913 820 675 480 1030
progress billings:

Received (615) (680) (615) (385) (722)

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Awaited (60) (40) (25) (200) (34)

Retained (75) (80) (60) (65) (84)
Closing balance 163 20 (25) (170) 190

The positive balances on Contracts 1, 2 and 5, totalling £373,000, will be presented as

an asset. The negative balances on Contracts 3 and 4, totalling £195,000, will be
presented as a liability. The difference between total progress billings and total receipts
will be shown as a receivable. (135, 120, 85, 265 and 118).
(b) 1 2 3 4 5
Cumulative revenue 913 820 675 480 1,030
CR 20X8 560 340 517 400 610
Revenue for year 20X9 353 480 158 80 420
Expenses 204 290 293 170 460
Profit/(loss) 149 190 (135) (90) (40)

However, if the students take the cost of goods sold as the company’s assessment of
the extent to which control has passed to the client then the estimated profits on a
cumulative basis would be:

Project 1 580/800 × 300 = 218, i.e. (cost of work available to the client/estimated cost
to complete the project) times the estimated profit on completion.

Project 2 470/620 × 330 = 250.

Project 3 There must be a cumulative loss of 135, so if costs are 646, then revenue is
135 less or 511.

Project 4 has revenue of 525 – 160 = 365.

Project 5 has revenue of 900 – 40 = 860.

Work in progress is cumulative costs less transfers to cost of goods sold, i.e. 84, 65,
164, 115 and 170, respectively. In other words, there is no profit element in the work in
progress as it represents items which the customer does not control.

1 2 3 4 5

Cumulative costs 664 535 810 640 1,070

Less COGS 580 470 646 525 900
Balance 84 65 164 115 170

The company would also disclose the amounts of future contract revenue in existing
contracts by the periods in which they are expected.

Total contract price 1,100 950 1,400 1,300 1,200

Less already invoiced 750 800 700 650 840
Future sales 350 150 700 650 360

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Only the future sales figures would need to be disclosed.

Accounts receivable would be the sum of awaiting receipts and retained by customers:
135 (i.e. 60 + 75), 120, 85, 265 and 118.

Question 3 Beavers

Work in progress under customer control

(a)
Materials 36,000 Materials in stock 3,000
Other 18,000 Not under control 19,000
Head office costs 6,000
Depreciation* 6,400 Balance c/d 135,400
--------- ------------
157,400 157,400
Balance b/d 135,400

Work in progress not under customer control

Work in progress 19,000

Stock Other
WIP 3,000

* Depreciation may be based on time as shown here or on the basis of percentage of

completion or on actual usage during the period. Also, depreciation could be spread over
14 months rather than 15 months.

Applied Billings
Debtors 180,000
Debtors
Applied billings 180,000 Bank 150,000
– Balance c/d 30,000
180,000 180,000
Balance b/d 30,000
Materials
Work in progress 3,000

Check profitability of the contract

Expenses to date 154,400 (i.e. 135,400 + 19,000)

Estimated costs to complete 30,000
Depreciation 1,600
Forecast total costs 186,000

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Contract price = 240,000 + Incentive 10,000 = 250,000, so the project is expected to be

profitable. Therefore, no adjustment for losses is necessary.

(b) and (c)

Work under the control of the customer is 180,000. The project is expected to be
profitable:

Costs to date 154,400

Estimated costs to complete
Depreciation 1,600
Wages 10,000
Materials 12,000
Other 8,000 31,600
Total expected contract cost 186,000
Contract price 240,000
Forecast contract profit 54,000

The journal entry will be:

Dr Cost of goods sold 135,400

Dr Work in progress 44,600

Cr Revenue 180,000

Being profit on the project of 44,600 for the year

(b) In the statement of financial position:

Work in progress
Costs to date 154,400
Plus profits 44,600
Billable amount 199,000
Less billings 180,000
Net Work in progress 19,000
Materials inventory 3,000
Debtors 30,000

Plant

Cost 9,000
Less Acc depn. 6,400 2,600
(c) 44,600

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Question 5 – Quickbuild Ltd

(a) and (b)

(i) Contract revenue is based on the percentage stage of completion calculated as

follows:

First calculate the estimated profit:

€
Contract price 250,000
Estimated cost to complete 150,000
Estimated total profit 100,000

Then calculate the percentage completion:

Actual cost to date 70,000

Less inventories not yet used 10,000
Cost on contract work to date 60,000
Estimated total cost 150,000
% completed 40%
Contract revenue to be recognised:
40% of €250,000 €100,000

(ii) Contract costs

Total costs incurred 70,000

Less unused inventories on hand 10,000

Contract cost recognised in the statement of comprehensive income 60,000

Dr Inventories 10,000
Cr Contract work in progress 10,000
(Stock unused at balance date)

Dr Contract work in progress 40,000

Cr Contract revenue 100,000
Dr Cost of goods sold 60,000
(Recognising costs and expenses and the estimated profit to this stage)

Dr Debtors 60,000
Cr Construction billing 60,000
(Billing as work progresses)

Dr Bank 60,000
Cr Debtors 60,000
(Receipt of money from the customer)
In the statement of financial position:

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Inventories other 195,000

Work in progress contracts 0
Cost 60,000
Less billings 60,000

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Consolidated accounts

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 CHAPTER 22

Accounting for groups at the date of acquisition

Question 1 – Parent Ltd

(a) Parent Ltd statement of financial position as at 1 January 20X7
Ordinary shares of 1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 10,800
Cash (20,000 – 10,800) 9,200
Other net assets 25,000
45,000

Note: The investment is shown as its fair value of 10,800 and the cash has been reduced by
consideration.

Consolidated statement of financial position as at January 20X7

Parent Daughter Add Eliminate S of FP

(Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500

Retained earnings 4,500 1,800 6,300 (1,800) 4,500

45,000 10,800 55,800 45,000
Investment in
Daughter Ltd 10,800 10,800 10,800
Cash 9,200 2,000 11,200 11,200
Other net assets 25,000 8,800 33,800 33,800
45,000 10,800 55,800 0 45,000

Note: Because the cash paid exactly equals the value of the net assets acquired, there was no
difference on consolidation, that is there is no positive or negative goodwill.

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(b) Parent Ltd statement of financial position as at 1 January 20X7

Ordinary shares of 1 each [40,500 + (10,800/2)] 45,900
Share premium 5,400
Retained earnings 4,500
55,800
Investment in Daughter Ltd 10,800
Cash 20,000
Other net assets 25,000
55,800

Note: The investment is shown as its fair value of 10,800 and the shares are issued at their fair
value of 5,400 par value and 5,400 premium.

Consolidated statement of financial position as at 1 January 20X7

Parent Daughter Add Eliminate S of FP
(Dr)/Cr
Ordinary shares 45,900 9,000 54,900 (9,000) 45,900
Share premium 5,400 5,400 5,400
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
55,800 10,800 66,600 55,800
Investment in
Daughter Ltd 10,800 10,800 10,800
Cash 20,000 2,000 22,000 22,000
Other net assets 25,000 8,800 33,800 33,800
55,800 10,800 66,600 0 55,800

Note: Because the value of the shares issued exactly equals the value of the net assets
acquired, there was no difference on consolidation, i.e. there is no positive or negative goodwill.

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Parent Ltd statement of financial position at 1 January 20X7

Answer (a) (b)

Business
Other net assets 25,000 25,000
Investing:
Investment in Daughter Ltd 10,800 10,800
Financing
Financing assets
Cash

9,200 20,000
–––––– ––––––
45,000 55,800
––––––– ––––––

Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 5,400
–––––– ––––––

45,000 55,800
–––––– ––––––

Consolidated statement of financial position at 1 January 20X7

Business
Other net assets 33,800 33,800
Financing
Financing assets
Cash
11,200 22,000
–––––– ––––––
45,000 55,800
–––––– ––––––

Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 5,400
–––––– ––––––

45,000 55,800
–––––– ––––––

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Question 2 – Parent Ltd

(a) Parent Ltd statement of financial position as at 1 January 20X7

Ordinary shares of 1 each 40,500

Retained earnings 4,500
45,000
Investment in Daughter Ltd 16,200
Cash (20,000 – 16,200) 3,800
Other net assets 25,000
45,000

Note: The investment is shown as its fair value of 16,200 and the cash has been reduced by
consideration.

Consolidated statement of financial position as at 1 January 20X7

Parent Daughter Add Eliminate S of FP

(Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
45,000 10,800 55,800 45,000
Investment in
Daughter Ltd 16,200 16,200 10,800 5,400
Cash 3,800 2,000 5,800 5,800
Other net assets 25,000 8,800 33,800 33,800
45,000 10,800 55,800 0 45,000

Note: Because the cash paid exceeded the value of the net assets acquired, there was a
difference on consolidation of 5,400, which appears in the consolidated statement of financial
position as an asset goodwill – this will be reviewed for possible impairment.

(b) Parent Ltd statement of financial position as at 1 January 20X7

Ordinary shares of 1 each (40,500 + (16,200/3)) 45,900

Share premium 10,800
Retained earnings 4,500
61,200
Investment in Daughter Ltd 16,200
Cash 20,000
Other net assets 25,000
61,200

Note: The investment is shown as its fair value of 16,200 and the shares are issued at their
fair value of 5,400 par value and 10,800 premium.

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Consolidated statement of financial position as at January 20X7

Parent Daughter Add Eliminate S of FP

(Dr)/Cr
Ordinary shares 45,900 9,000 54,900 (9,000) 45,900
Share premium 10,800 10,800 10,800
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
61,200 10,800 72,000 61,200
Investment in
Daughter Ltd 16,200 16,200 10,800 5,400
Cash 20,000 2,000 22,000 22,000
Other net assets 25,000 8,800 33,800 33,800
61,200 10,800 72,000 0 61,200

Note: Because the value of the shares issued exceeded the value of the net assets
acquired, there was a difference on consolidation, which is included as goodwill in the
statement of financial position.

Parent Ltd statement of financial position at 1 January 20X7

Answer (a) (b)
Business
Other net assets 25,000 25,000
Investing:
Investment in Daughter Ltd 16,200 16,200
Financing
Financing assets
Cash
3,800 20,000
–––––– ––––-––
45,000 61,200
–––––– ––––––
Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 10,800
–––––– ––––––
45,000 61,200
–––––– ––––––

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Consolidated statement of financial position at 1 January 20X7

Business
Other net assets 33,800 33,800
Goodwill 5,400 5,400
Financing
Financing assets
Cash

5,800 22,000
–––––– ––––––
45,000 61,200
–––––– ––––––

Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 10,800
–––––– ––––––

45,000 61,200
–––––– ––––––

Question 3 – Parent Ltd

(a) Parent Ltd statement of financial position as at 1 January 20X7

Ordinary shares of £1 each 40,500

Retained earnings 4,500
45,000
Investment in Daughter Ltd 16,200
Cash (20,000 – 16,200) 3,800
Other net assets 25,000
45,000

Note: The investment is shown as its fair value of 16,200 and the cash has been reduced by
consideration.

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Consolidated statement of financial position as at January 20X7

Parent Daughter Add Eliminate S of FP
(Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
45,000 10,800 55,800 45,000
Investment in
Daughter Ltd 16,200 16,200 10,800
Revaluation increase (1,200) 4,200
Cash 3,800 2,000 5,800 5,800
Other net assets 25,000 8,800 33,800 1,200 35,000
45,000 10,800 55,800 0 45,000

Note:

1. The net assets in the consolidated statement of financial position (S of FP) will
be increased by 1,200.

2. The fair value of the shares issued (16,200) exceeded the fair value of
the net assets acquired (12,000). This difference on consolidation will be
reported as goodwill and reviewed for impairment.

(b) Parent Ltd statement of financial position as at 1 January 20X7

Ordinary shares of 1 each (40,500 + (16,200/3)) 45,900

Share premium 10,800
Retained earnings 4,500
61,200
Investment in Daughter Ltd 16,200
Cash 20,000
Other net assets 25,000
61,200

Note: The investment is shown as its fair value of 16,200 and the shares are issued at
their fair value of 5,400 par value and 10,800 premium.

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Consolidated statement of financial position as at January 20X7

Parent Daughter Add Eliminate CBS
(Dr)/Cr
Ordinary shares 45,900 9,000 54,900 (9,000) 45,900
Share premium 10,800 10,800 10,800
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
61,200 10,800 72,000 61,200
Investment in
Daughter Ltd 16,200 16,200 10,800
Revaluation increase (1,200) 4,200
Cash 20,000 2,000 22,000 22,000
Other net assets 25,000 8,800 33,800 1,200 35,000
61,200 10,800 72,000 0 61,200

Note:

1. The net assets in the S of FP will be increased by 1,200.

2. The fair value of the shares issued (16,200) exceeded the fair value of the net assets
acquired (12,000). This difference on consolidation will be reported as goodwill
and reviewed for impairment.

Parent Ltd statement of financial position at 1 January 20X7

Answer (a) (b)

Business
Other net assets 25,000 25,000
Investing:
Investment in Daughter Ltd 16,200 16,200
Financing
Financing assets
Cash

3,800 20,000
–––––– ––––––
45,000 61,200
–––––– ––––––
Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 10,800
–––––– ––––––

45,000 61,200
–––––– ––––––

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Consolidated statement of financial position at 1 January 20X7

Business
Other net assets 35,000 35,000
Goodwill 4,200 4,200
Financing
Financing assets
Cash 5,800 22,000
45,000 61,200
Equity
Share capital 40,500 45,900
Retained earnings 4,500 4,500
Share premium 10,800
45,000 61,200

Question 4 – Parent Ltd

Parent Ltd statement of financial position as at 1 January 20X7
Ordinary shares of £1 each 40,500
Retained earnings 4,500
45,000
Investment in Daughter Ltd 6,000
Cash (20,000 – 6,000) 14,000
Other net assets 25,000
45,000

Note: The investment is shown as its fair value of 6,000 and the cash has been reduced by
consideration.

Consolidated statement of financial position as at 1 January 20X7

Parent Daughter Add Eliminate S of FP
(Dr)/Cr
Ordinary shares 40,500 9,000 49,500 (9,000) 40,500
Retained earnings 4,500 1,800 6,300 (1,800) 4,500
45,000 10,800 55,800 45,000
Investment in
Daughter Ltd 6,000 6,000 10,800 (4,800)
Cash 14,000 2,000 16,000 16,000
Other net assets 25,000 8,800 33,800 33,800
45,000 10,800 55,800 0 45,000

Note: Because the cash paid was less than the value of the net assets acquired, there was
a credit difference on consolidation, that is negative goodwill, which will be credited to the
retained earnings.

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Parent Ltd statement of financial position at 1 January 20X7

Business
Other net assets 25,000
Investing:
Investment in Daughter Ltd 6,000

Financing
Financing assets

Cash 14,000
45,000

Equity

Share capital 40,500

Retained earnings 4,500
45,000

Consolidated statement of financial position at 1 January 20X7

Business
Other net assets 33,800
Goodwill (4,800)

Financing
Financing assets
Cash 16,000
45,000

Equity
Share capital 40,500
Retained earnings 4,500
45,000

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Question 6 – Rouge plc

Statement of financial position as at 1 January 20X0
ASSETS €m
Non-current assets
Property, plant and equipment (100 + 60) 160
Goodwill (132 – 100) 32
Current assets (80 + 70) 150
342
Ordinary shares of €1 each 200
Retained earnings 52
Share capital and reserves 252
Current liabilities 90
342

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 CHAPTER 23

Preparation of consolidated statements of

financial position after the date of acquisition

Question 1 – Sweden
Statement of financial position as at 31 December 20X1

ASSETS Kr(m)
Non-current assets
Property, plant and equipment (264 + 120) 384
Goodwill [200 – (110 + 10 + 70) – 2] 8
Current assets (160 + 140) 300
Total assets 692
Common Kr10 shares 400
Revaluation reserve 20
Retained earnings (104 + 10 – 2) 112
Share capital and reserves 532
Current liabilities (100 + 60) 160
Total equity and liabilities 692

Question 2 – Summer plc

Statement of financial position as at 31 December 20X1
ASSETS €000
Non-current assets
Property, plant and equipment 200 + 200
400.0
Goodwill W1 18.0
Current assets 100 + 140 240.0
658.0
Equity shares 200.0
Retained earnings 161 + 60% (40 – 35) 164
Share capital and reserves 364.0
Non-controlling interests (40% of 220) + 6 94.0
Current liabilities 80 + 120 200.0
658.0

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W1 Goodwill
Cost of investment 141

60% of net assets of Winter at date of acquisition (180 + 35) 129

12

Fair value of non-controlling interest 92

40% of net assets of Winter at date of acquisition (86) 6
18

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Preparation of consolidated statements of

income, changes in equity and cash flows

Question 1 – Hyson and Green

£000
Revenue (23,500 + 6,400) 29,900
Cost of sales (16,400 + 4,700 + 200) 21,300
––––––
Gross profit 8,600
Expenses (4,650 + 1,240) 5,890
––––––
Profit before tax 2,710
Income tax expense (740 + 140) 880
––––––
Profit for the period 1,830
Attributable to:
Equity shareholders 1,800
of Hyson
Non-controlling interest [(320 – 200) × 25%] 30
–––––
1,830
=====

Additional depreciation on non-current assets £1,200,000/6 = £200,000

Question 2 – Forest and Bulwell plc

$000

Revenue (21,300 + 8,600 – 2,000) 27,900

Cost of sales (14,900 + 6,020 – 1,568) 19,352

(see below)

Gross profit 8,548

Expenses (3,700 + 1,750) 5,450

Profit before tax 3,098

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Taxation 1,070

Profit for the period 2,028

Attributable to:

Equity shareholders of Forest 1,912

Non-controlling interest (580 × 20%) 116

2,028

$000

Plant 2,000

Gross profit (30%) 600

Group profit in plant (80%) 480

Group cost of plant (2,000 – 480) 1,520

Depreciation on cost (10% × 1,520) 152

Depreciation on cost to Forest (10% × 2,000) 200 Reduction in depreciation (and cost of sales)
48

Adjustment to cost of sales in group financial statements:

Sales (2,000)
Less profit on plant 480
Reduced depreciation (48)
Total adjustment to cost of sales –1,568

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Question 3 – Bill plc

Bill plc
Consolidated statement of comprehensive income for the year ended 31 December 20X1

€
Revenue (300,000 + 180,000 – 12,000) 468,000
Cost of sales (30,000 + 90,000 – 12,000 + 2,000) 170,000
Gross profit 298,000
Expenses (88,623 + 60,000) 148,623
Impairment of goodwill 3,000
Profit before taxation 146,377
Taxation (21,006 + 9,000) 30,006
Profit after taxation 116,371
Attributable to:
Equity shareholders of Bill 109,021
Non-controlling interest (Note 1) 7,350
116,371
Note 1
Non-controlling interest:
NCI
€ €
Profit after tax 21,000
Dividends on preferred shares 4,500 90% 4,050
Profit after dividend 16,500 20% 3,300
Non-controlling interest 7,350

Question 4 – Morn Ltd

Consolidated statement of comprehensive income for the year ended
31 December 20X1

£
Gross profit (360,000 + 180,000) 540,000
Expenses (120,000 + 110,000) 230,000
Profit before taxation 310,000
Taxation (69,000 + 18,000) 87,000
Profit after taxation 223,000
Other comprehensive income
Gain on revaluation 30,000
Total comprehensive income 253,000

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Profit attributable to:

Equity shareholders of Morn 217,800
Non-controlling interest 5,200
223,000
Total comprehensive income for the
period attributable to:
Equity shareholders of Morn 247,800
Non-controlling interest 5,200
253,000

Question 5 – River plc

River plc
Consolidated statement of comprehensive income for
the year ended 31 December 20X1

£
Sales [100,000 + (9/12 × 60,000)] 145,000
Cost of sales [30,000 + (9/12 × 30,000)] 52,500
Gross profit 92,500
Expenses [20,541 + (9/12 × 15,000)] 31,791
Interest payable on 5% bonds [9/12 × (5,000 – 500)] 3,375
Impairment of goodwill 4,000
Profit before taxation 53,334
Taxation [7,002 + (9/12 × 3,000)] (9,252)
Profit after taxation 44,082
Other comprehensive income
Gain on revaluation 15,000
Total comprehensive income 59,082
Profit attributable to:
Equity shareholders of River 43,557
Non-controlling interest 525
44,082
Total comprehensive income attributable to:
Equity shareholders of River 58,557
Non-controlling interest (10% × 7,000 × 9/12) 525
59,082

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 CHAPTER 25

Accounting for associates and joint

arrangements

Question 1 – Continent plc

Statement of income of Continent plc for the year ended 31 December
20X9
Working €
1 1,035,650
Revenue
Cost of sales 2 (667,260)
Gross profit 368,390
Administration costs 3 (46,695)
Distribution expenses (25,300)
Goodwill impairment 4 (4,400)
Share in associate 5 22,550
Profit before tax 314,545
Tax 6 (88,000)
Profit for the period 226,545
Attributable to:
Shareholders of continent
206,767
Non-controlling interest 7 19,778
W1 226,545

Working
1. €
Revenue
Continental 825,000
Island 220,000
1,045,000
Less fee 5,500
1,039,500
Less inter-company sales 3,850
1,035,650

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2. €
Cost of sales
Continental
616,000
Island 55,000
671,000
Less inter-company sales 3,850
667,150
Add unrealised profit 10% of (3,850 – 2,750) 110
667,260

3. €
Administration costs
Continental 33,495
Island 18,700
52,195
Less management fee 5,500
46,695

€
4.
Goodwill impairment
Island 550
River 3,850
4,400

5. €
Share in River
Profit after tax
40% of 56,650 22,660
Less 40% of unrealised profit 40% of 275 110
22,550

6. €
Income tax
Continental 55,000
Island 33,000

88,000

7. Non-controlling interest 20% of (99,000 – 110) = €19,778

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Question 3 – Alpha, Beta and Gamma

(a)

(i) Consolidated statement of income for the year ended 30

September 20X6

$000
Revenue (W1) 230,000
Cost of sales (balancing figure) (168,200)
Gross profit (W2) 61,800
Distribution costs (7,000 + 6,000) (13,000)
Administrative expenses (8,000 + 7,000) (15,000)
Operating profit 33,800
Investment income (W3) 1,000
Finance cost (W4) (6,800)
Share of profits of associate (W5) 652
Profit before tax 28,652
Income tax expense (7,000 + 1,800) (8,800)
Profit for the period 19,852

Attributable to
Non-controlling interests (4,200 × 25%) 1,050
Alpha shareholders (balance) 18,802
Net profit for the period 19,852

(ii) Consolidated statement of changes in equity for the year

ended 30 September 20X6
Parent Non-controlling Total
interest
$000 $000 $000
Balance at 1 October 20X5 (W6) 189,850 22,750 212,600
Net profit for the period 18,802 1,050 19,852
Dividends (6,500) (750) (7,250)
Balance at 30 September 20X6 202,152 23,050 225,202

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Working 1 – Revenue
$000

Alpha + Beta 250,000

Sales from Alpha – Beta (20,000)

230,000

Working 2 – Gross profit

$000

Alpha + Beta 62,000

Unrealised profit adjustments:
Beta: [1/5 (3,000 – 2,000)] (200)

61,800

Working 3 – Investment income

$000

As per Alpha income statement 6,450

Inter entity dividends received:
Beta (75% × 3,000) (2,250)
Gamma (40% × 5,000) (2,000)
Intra-group interest receivable (6% × 20,000) (1,200)
Residue in consolidated income statement 1,000

Working 4 – Finance cost

$000

Alpha + Beta 8,000

Intra-group interest payable (1,200)
6,800

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Working 5 – Share of profits of associate

$000

Profit after tax of Gamma 9,000

Fair value adjustment (6,400 × 1/5) (1,280)
7,720
7,720 × 40% × 3/12 equals 772
Profit in inventory 1,500 × (25/125) × 40% (120)
652

Working 6 – Consolidated equity at 1 October 20X5

$000
Alpha 122,000
Beta (75% × 91,000) 68,250
Unrealised profit on opening inventory (1/5 × 2,000) (400)
189,850

(b) Part

The treatment of Beta in the consolidated financial statements is based on the principle
of control. IAS 27 – consolidated and separate financial statements – defines a
subsidiary as an entity that is controlled by its parent. IAS 27 states that control is
presumed to exist when the parent owns more than half of the voting power of another
entity, but in exceptional circumstances, such ownership may not constitute control,
and so, Beta is not automatically a subsidiary just because Alpha owns more than half
of the equity shares. In this case, however, there is no reason to suppose that voting
control does not give Alpha a control over the operating and financial policies of Beta,
so Beta is correctly treated as a subsidiary.

It is certainly true that Gamma should not be consolidated as a subsidiary because

Alpha does not control its operating and financial policies. This is evidenced by the
fact that on one occasion, Gamma has pursued a policy with which Alpha did not
agree. However, the fact that Alpha has a representative on the board of directors gives
Alpha the ability to significantly influence those policies. Therefore, under the
provisions of IAS 28 – investments in associates – Gamma would appear to be an
associate. The ownership of 40% of the voting shares (between 20% and 50%) is also
indicative of this fact, although on its own this is insufficient. As there is no contractual
relationship with the other investors in Gamma, it is not a joint venture. This means
that rather than being accounted for as an ‘available for sale’ financial asset, the
investment in Gamma should be accounted for under the equity method. This means
including the group share (40% in this case) of the profit after tax as a single line in the
consolidated income statement. Since Gamma did not become an associate until 1 July
20X6, only three months profits should be accounted for under the equity method in
this case.

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Question 7 – Epsilon
(a) Zeta is only 40% owned but Epsilon controls the board and can use that control to
control the company because a majority of board members can pass decisions at
board meetings. Zeta is a subsidiary.

Kappa is 25% owned and Epsilon has control over one of the positions on the
board. It is clear that Epsilon has influence but there is nothing to indicate that it is
controlled, so Kappa is an associate rather than a subsidiary.

Lambda is 25% owned, but the company has a 75% shareholder who appears to
have outright control over the company. That suggests that Lambda is an
investment and is not part of the Epsilon group.

(b)

Zeta – workings

(i) Equity acquired (40%)

Share capital 20.0
Retained earnings 20.0
40.0
Investment 100.0
Goodwill 60.0

(ii) Non-controlling interest (60%)

Share capital (50 × 60%) 30.0
Retained earnings (iii) (124 × 60%) 74.4

104.4

(iii) Retained earnings

At 31 October 2011 124.0

Pre-acquisition (50.0)

74.0

Group share 29.6

(iv) Kappa – workings (25%)

Cost of investment 55.0

Group share of post-acquisition profits
25% × (91 – 40) 12.8
Investment in Kappa 67.8

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(v) Retained earnings

Epsilon 1,563.0
Zeta 29.6
Kappa 12.8
1,605.4

Epsilon Group

Consolidated statement of financial position

As at 31 October 2011
$000
Non-current assets
Goodwill (i) 60.0
Property, plant and equipment 2,070.0
Investment in Kappa (iv) 67.8
Investment in Lamda 60.0
2,257.8
Current assets
Inventory 14.0
Trade receivables 17.0
Bank 9.0
40.0

Total assets 2,297.8

Equity
Share capital 500.0
Retained earnings (v) 1,605.4
2,105.4
Current liabilities
Non-current liabilities 50.0
Non-controlling interest (ii) 104.4
154.4
Current liabilities
Trade payables 38.0
2,297.8

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Introduction to accounting for exchange

differences

Question 2 – Fibre plc

(a) Income statement
Fibre
Income statement Fibre Fastlink Fastlink group
£000 $000 Rate £000 £000

Sales 200,000 50,000 2.25 22,222.2 222,222.2

–––––––– ––––––––– ––––––––– –––––––––

Opening inventories 20,000 8,000 2.5 3,200.0 23,200.0

Purchases 130,000 30,000 2.25 13,333.3 143,333.3
Closing inventories –40,000 –6,000 2.2 –2,727.3 –42,727.3
Cost of sales –––––––– –––––––– ––––––––– ––––––––
Gross profit 110,000 32,000 13,806.1 123,806.1
–––––––– ––––––––– ––––––––– –––––––––
90,000 8,416.2 98,416.2
18,000
Other expenses –––––––– ––––––––– ––––––––– –––––––––
–15,000 –2,888.9 –17,888.9
–6,500
2.25
–––––––– ––––––––– –––––––––– ––––––––––
Profit before tax 75,000 11,500 5,527.3 80,527.3
Taxation –15,000 –3,000 2 –1,500.0 –16,500.0
–––––––– ––––––––– –––––––– –––––––––
Profit after tax 60,000 8,500 4,027.3 64,027.3
======== ======== ======== ========

Note: The opening inventory is translated at the rate at 1 January 20X1 as this was the date of
acquisition (if the acquisition was at, say, 1 January 20X0, it would have been translated at a
rate of US$1 = R$1.8).

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(b) Statement of financial position

Statement of financial position

Fibre Fastlink Fastlink Fibre group
£000 $000 £000 £000
Non-current assets 90,000 25,000 2 12,500 102,500
Investment in 6,000 Goodwill 500
Fastlink N1

Current assets
Inventories 40,000 6,000 2 3,000 43,000
Trade receivables 27,000 5,000 2 2,500 29,500
Cash 2,000 4,000 2 2,000 4,000
––––––– ––––––––– ––––––––– ––––––––––
69,000 15,000 7,500 76,500
––––––– ––––––––– ––––––––– ––––––––––
Current liabilities
Trade payables 35,000 11,000 2 5,500 40,500
Taxation 15,000 3,000 2 1,500 16,500
––––––– ––––––––– ––––––––– –––––––––
Total current 50,000 14,000 7,000 57,000
liabilities
–––––––– ––––––––– ––––––––– –––––––––
Total assets less 115,000 26,000 13,000 122,500
liabilities
======= ======== ======== =======

Share capital 20,000 1,200 2 600 20,000

Share premium 800 2 400
Retained earnings 95,000 24,000 2 12,000 N3 99,900
––––––– ––––––––– ––––––––– ––––––––
115,000 26,000 13,000 119,900
Non-controlling N2 2,600
interest
––––––– ––––––––– ––––––––– –––––––––
115,000 26,000 13,000 122,500
======= ======== ======== ========

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N1 Goodwill calculation

$000 £000
Cost 15,000
Share capital 1,200

Share premium 800

Retained earnings 15,500

––––––––

17,500 × 80% 14,000 Rate £000 Rate £000 Gain

–––––––– --------- 1.1.20X1 31.12.X1

Goodwill 1,000 2.5 400 2 500 100

Note:

(a) For the statement of financial position, the goodwill is recalculated as at the
rate at the year-end to give us £500,000.

(b) The difference between the goodwill as at acquisition date and closing date is
taken to the retained earnings of the Parent.

N2 Non-controlling interest

NCI at 31.12.X1 $000 Rate £000 £000

Share capital 2 600
1,200
Share premium 800 2 400
Retained earnings 24,000 2 12,000
––––––––
13,000 × 20% 2,600
======== ========

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(c) N3 Post-acquisition profit of subsidiary attributable to parent

$000 Rate £000 £000 £000
Retained profit Parent NCI

Per income statement 4,027.3 3,221.8 805.5

At closing rate 8,500 2 4,250.0
–––––––
Gain on exchange 222.7 178.2 44.5
Gain on opening shareholders’funds
Share capital 1,200
Share premium 800
Retained earnings 15,500
––––––– Open rate

17,500 2.5 7,000

Close rate
2 8,750
Gain 1,750 1,400 350

Gain on goodwill Open rate

Goodwill 1,000 2.5 400
Close rate
2 500
–––––––––
Gain 100 100
–––––––––
Post-acquisition profit attributable to Fibre 4,900
=========

Post-acquisition profit attributable to NCI 1,200

Opening NCI (17,500 × 20%/2.5) 1,400

Closing NCI (26,000 × 20%/2) 2,600

=====
Group retained profit at 31.12.X1 £000
Fibre 95,000
Fastlink post-acq (above) 4,900
––––––––
Group retained profit 99,900
=======

Note: There is no post acquisition share premium as the subsidiary’s balance at acquisition and
at 31.12.X1 is the same at $800,000.

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Question 4 – IAS 21
(a) The answer is given in Section 26.4 of the text of the Chapter.

(b) All the items in the statement of financial position are translated at a rate of $1 =
€(Euro) 0.72425.

Eufonion – Statement of financial position at 31 October 2008

ASSETS €m Rate €m
Non-current assets 420 0.7425 565.7
Current assets
Inventories 26 0.7425 35.0
Trade and other receivables 42 0.7425 56.5
Cash and cash equivalents 8 0.7425 10.8
76 102.3
Total assets 496 668.0

EQUITY AND LIABILITIES

Equity
Share capital 200 0.7425 269.4
Retained earnings 107 0.7425 144.1
307 413.5
Non-current liabilities 85 0.7425 114.5
Current liabilities
Trade and other payables 63 0.7425 84.8
Current taxation 41 0.7425 55.2
104 140.0
Total liabilities 189 254.5
Total equity and liabilities 496 668.0

The new shares (in dollars ($)) are likely to be a different total from those in Euros
(e.g. the issued shares may be 200 million at $1 nominal each). If this is the case,
then an additional reserve ($69.4m) will be added to equity in the statement of
financial position. If it creates a negative reserve (i.e. 300 million shares of $1
each, which gives a negative reserve of $31.6m), then it may be deducted from
retained earnings.
(c) If the British pound is used as the functional currency for the year ended 31
October 2009, the opening statement of financial position will be translated at
the exchange rate ($ to £) at 1 November 2008. If the operating currency of
Eufonion remains Euros, then the income statement will be translated into £s
at the average rate for the year and the statement of financial position at 31
October 2009 will be translated at the rate from Euro to £s at 31 October 2009.

As a comment, it is undesirable for entities to switch functional currencies

frequently unless there are good reasons for doing so.

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(d) Most entities operating in a single country will use that country’s currency as
both its functional and presentation currency.

However, where most of the entity’s shareholders are in one country but most
of its operations are in a different country (with a different currency), it would
be appropriate for the functional currency to be that where most of the
operations take place but the presentation currency will be where the company
is registered.

Another example is companies which operate in the oil industry. Most of the
transactions are denominated in US dollars and this will be the functional
currency. However, if the company is registered in the UK, then the
presentation currency may be UK pounds.

The financial statements may be reported in two currencies where a significant

number of shareholders are resident in a different country from where the
entity is registered (e.g. a UK registered company where most of the
shareholders are resident in Japan).

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Interpretation

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Earnings per share

Question 2 – Beta Ltd

Beta Ltd weighted average number of shares

Time Bonus Bonus element

apportion adjustment in rights issue

1 January to 31 March

1,000,000 × 3/12 × 3/2 × 7/6 = 437,500

1 April to 30 April

1,500,000 × 1/12 × 3/2 × 7/6 = 218,750

1 May to 31 August

2,250,000 × 4/12 × × 7/6 = 875,000

1 September to 31 October

3,250,000 × 2/12 × × 7/6 = 631,944

1 November to 31 December

4,333,333 × 2/12 × × = 722,222

Weighted average number of shares 2,885,416

Note: Bonus element in rights issue calculated as follows:

Three shares at $5.60 = 16.80

One share at $2.40 = 2.40
Fair value of four shares 19.20
Theoretical ex-rights price $4.80
Fair value $5.60
Bonus factor = 5.6/4.8 = 7/6

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Question 3 – Nottingham Industries plc

(a) EPS complying with IAS 33 definition of earnings

Earnings for EPS calculation is ‘profit of the period shareholders after deducting ALL
preference dividends’.attributable to the parent company

Basic EPS calculation: £000

Equity earnings:
Profit after tax 580
Preference dividend (10% of £1,000,000) (100)
480

Weighted average number of ordinary shares (25p)

Actual no. Weight time Bonus Weighted

factor average
1.4.X5 in issue 16,000,000 3/12 6/5 4,800,000
1.7.X5 bonus issue 3,200,000
19,200,000 3/12 4,800,000
1.10.X5 purchase (500,000)
31.3.X6 in issue 18,700,000 6/12 9,350,000
18,950,000
Basic EPS for 20X6 £480,000/18,950,000 = £0.0253
Comparative for 20X5 = £0.022 × 5/6 = £0.0183

(b) Diluted EPS calculation

Equity earnings:

£000
As for Basic EPS 480
The computation of basic and diluted EPS is as follows:
Per share Earnings Shares
Net profit for 20X6 £480,000
Weighted average shares during 20X6 18,950,000
Basic EPS (£480,000/18,950,000) £0.02533
Number of shares under option 200,000
Number that would have been issued
At fair value (200,000 × £1.00)/ £1.10 (181,818)
Diluted EPS £0.0253 £480,000 18,968,182

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(c) Usefulness of EPS figures

It is helpful to users to have a standardised EPS figure. This is provided by applying

the IIMR calculation as follows.

IIMR headline EPS

Headline EPS are based upon the headline earnings figure stated in accordance with the
Institute of Investment Management and Research Statement of Practice No. 1: The
Definition of Headline Earnings and accordingly exclude profit on sale of the major
operation.
£000

Equity earnings:
Profit after tax 580
Exclude capital items such as profit on sale of a major operation:
£120,000 less tax £38,000 (82)
IIMR Headline EPS 498
Less: preference dividend (100)
398

Even when standardised, the ASB considers that there is too much emphasis on a
single profit figure and encourages users to refer to the information set as a whole
when appraising performance and predicting future earnings. Nevertheless, the EPS
figure has remained an important figure in the eyes of many investors and analysts.

Question 4 – Simrin plc

(a) Calculation of basic EPS

As per IAS 33:

Profit attributable to the ordinary shareholders

EPS =
Number of ordinary shares
£79,000 − £9,000
=
100,000

Basic EPS = 70p per share

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(b) Calculation of the diluted EPS

£

Subscription money received = £1.10 × 50,000

= 55,000
Notional number at fair value:
£55,000/£1.28 (fair value of a share) = 42,969
Notional number at no value = 7,031
50,000
Profit attributable to the ordinary shareholders 70,000

Number of shares:

At 1 January 20X0 100,000

From warrants at no value 7,031
Total number of shares 107,031
Diluted EPS = £70,000/107,031 = 65.4p per share

(c) (i) Need to disclose diluted EPS

• Company able to finance projects using convertible securities that carried fixed
interest rate and also future benefits causing dilution of shares on conversion in
the future.

• Trend revealed by diluted EPS is more meaningful to shareholders as it enables

them to identify the final effect on company’s EPS by using convertible debt.

(ii) Relevance to shareholders

• Relevance is questionable.

• It shows dilution of future EPS and it is reasonable that existing shareholders

should be given a warning of the potential dilution.

(d) Reliance on EPS as the single most important indicator of

financial performance

There is no one correct answer for this but a discussion of the Institute of Investment
Management and Research headline figure is required.

Question 5 – Gamma plc

There are two steps in arriving at the diluted EPS, namely,

Step 1 Determine the increase in earnings attributable to ordinary shareholders on

conversion of potential ordinary shares.

Step 2 Determine the potential ordinary shares to include in the diluted EPS.

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(a) Convertible preference shares receive a dividend of £2.50

Step 1: Determine the increase in earnings attributable to ordinary

shareholders on conversion of potential ordinary shares

Increase in Increase in number Earnings per

earnings of ordinary shares incremental
share

Convertible preference shares

Increase in net profit
50,000 shares × £2.50 125,000
Incremental shares
50,000/1 50,000 2.50

10% Convertible bond

Increase in net profit
£250,000 × 0.10 × (1 – 0.4) 15,000
Incremental shares
250,000/1000 × 500 125,000 0.12

Step 2: Determine the potential ordinary shares to include in the computation of

diluted EPS

Net profit
attributable to Ordinary
continuing operations shares Per share
As reported 5,000,000 1,000,000 5.00
10% Convertible loan 15,000 125,000
5,015,000 1,125,000 4.46 dilutive
Convertible preference shares 125,000 50,000
5,140,000 1,175,000 4.37 dilutive

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(b) Convertible preference shares receive a dividend of £6 per share

Step 1: Determine the increase in earnings attributable to ordinary shareholders

on conversion of potential ordinary shares

Earnings per
Increase in Increase in number incremental
earnings of ordinary shares share

Convertible preference shares

Increase in net profit

50,000 shares × £6.00 300,000

Incremental shares 50,000/1 50,000 6.00

10% Convertible loan

Increase in net profit

£250,000 × 0.10 × (1 – 0.4) 15,000

Incremental shares

250,000/1,000 × 500 125,000 0.12

Step 2: Determine the potential ordinary shares to include in the computation of

diluted EPS

Net profit
attributable to Ordinary
continuing operations shares Per share
As reported 5,000,000 1,000,000 5.00
10% convertible loan 15,000 125,000
5,015,000 1,125,000 4.46 dilutive
Convertible preference shares 300,000 50,000
5,315,000 1,175,000 4.52 anti-dilutive

• As the diluted EPS is increased when taking the convertible preference shares
into account (from 4.46p to 4.52p), the convertible preference shares are anti-
dilutive and are ignored in the calculation of diluted EPS.

• The lowest figure is selected and the diluted EPS will, therefore, be disclosed as
4.46p.

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Review of financial ratio analysis

Question 2 – Relationship plc

Current assets are 1.5 times the current liabilities = 1.5 × 156,000 = 234,000.

Liquid assets are 0.75 times the current liabilities = 0.75 × 156,000 = 117,000.

Inventory is current assets less liquid assets = 234,000 – 117,000 = 117,000.

The net assets are total assets less current liabilities = 587,000 – 156,000 = 431,000.

Sales are 1.4 times net assets = 1.4 × 431,000 = 603,400.

Weekly sales are 603,400/52 = 11,603.8.

Trade receivables have a 6-week collection period = 6 × 11,603.8 = 69,622.8.

Cash is liquid assets – trade receivables = 117,000 − 69,622.8 = 47,377.2.

Gross profit is 20% of 603,400 = 120,680.

Net profit is gross profit less administration expenses = 120,680 – 92,680 = 28,000.

Opening capital is net assets – retained earnings = 431,000 – (103,000 + 28,000) =

300,000.

Statement of financial position

€ €
Non-current assets 350,000
Current assets
Inventory 117,000
Trade receivables 69,623
Cash 47,377
234,000
Total assets 587,000
Less current liabilities 156,000
Net assets 431,000
Capital 300,000
Retained earnings (103,000 + 28,000) 131,000
431,000

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Question 3 – Esrever Ltd

Forecast statement of comprehensive income for the year ended
30 June 20X1
£ £
Revenue (87,007 × 100/32) (S3) 271,897
Opening inventory 22,040
Purchases (S5) 194,205
216,245
Closing inventory (184,890 × 61.9/365) (S5) 31,355
Cost of sales (271,897 × 68%) (S4) 184,890
Gross profit (20,290 × 100/23.32) (S2) 87,007
Depreciation
– buildings (132,000 × 2%) (S6) 2,640
– fixtures, etc. (96,750 × 20%) (S6) 19,350
Loan interest (50,000 × 12%) (S7) 6,000
Credit expenses (balancing figure) (S8) 33,655
61,645
Profit before tax 25,362
Corporation tax (20,290 × 20/80) (S9) 5,072
Profit after tax (181,808 × 11.16%) (S1) 20,290
Dividends (200,000 × 2.5p) (S10) 5,000
Profit retained (S11) 15,290
Profit retained b/f (S12) 66,518
Retained profit c/f (S13) 81,808

Forecast statement of financial position as at 30 June 20X1

£ £

Non-current assets (NBV)

Land and buildings (132,000 – 2,640) 129,360

Fixtures, fittings (96,750 – 19,350) 77,400
(S14) 206,760
Current assets
Inventories (S15) 31,355
Trade receivables [(271,897 × 42.6/365) × 1.15] (S16) 36,494
67,849

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Creditors: amounts falling due in less than one year

Bank overdraft (a balance figure based on Note 2) (S20) 9,756

Trade payables [(194,205 + 33,655) × (29.7/365) × 115%] (S17) 21,321
Other payables [5,072 tax + 5,000 dividends
(S18, S19) + 1,652 VAT] 11,724
42,801
Net current assets 25,048
Total assets less current liabilities (per Note 3) 231,808

Creditors: amounts falling due in more than one year

12% loan (S23) 50,000

181,808
Ordinary shares (S21) 100,000
Profit and loss account (balancing figure) (S22) 81,808
181,808
VAT: Output tax (271,897 × 15%) 40,785
Input tax [(194,205 + 33,655) × 15%] 34,179
Net amount for year 6,606
6,606 × 0.25 1,652

Approach to Esrever statement of comprehensive income

(S1) Start with post-tax profit, that is 11.16% of (231,808 –

50,000) per Notes 3 and 4

From post-tax profit 20,290 derive gross profit as = £20,290

(S2)
100/23.32 × 20,292 based on Note 4 = £87,007
(S3) Next, derive turnover as 100/32 × 87,007 based on Note 6
Cost of goods sold = 68% of turnover
Therefore, turnover = 100/32 × gross profit = £271,897
(S4) From sales and gross profit derive cost of goods sold as
271,897 – 87,007
= £184,890

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(S5) You can now find components of cost of sales (£184,890) as

(a) Opening inventory 22,040 (given in question)

(b) Purchases 194,205 (balance figure)
216,245
(c) Closing inventory (31,355) (61.9 × 184,890)
365
Total costs of goods sold 184,890

Note: Start with closing inventory 61.9 days based on Note 7; all other figures are
derived and the opening inventory is given as £22,040.

(S6) Depreciation: 2% × 132,000 for buildings = £ 2,640

20% × 96,750 for fixtures, etc. = £19,350

based on Note 1 and opening asset given

(S7) Loan interest is 12% of 50,000 = 6,000

(S8) Expenses – this is a balancing figure as we already have all the other figures in
the profit and loss account = 33,655

(S9) Taxation charge is 20/80 × 20,290 based on Note 5 = 5,072

(S10) Dividend – see Note 9 (200,000 × 2.5p) = 5,000

(S11) Retained profit = 15,290

(S12) Retained profit b/f is a balancing figure = 66,518

(S13) Retained profit c/d (see S22 below) = 81,808

Approach to Esrever statement of financial position

Projected statement of financial position as at 30/6/20X1 is built up as follows:

(S14) Non-current assets are derived from the opening figure

less depreciation = 206,760
(S15) Inventory has already been computed at = 31,355

(S16) Trade receivables, based on Note 10, assuming

42.6 days’ credit, are 42.6/365 × 271,897 = 31,734
× 1.15 to cover VAT = 36,494
(S17) Trade payables, assuming credit of 29.7 days, are
29.7/365 × 227,860 × 1.15 = (21,321)

(S18) Other payables (dividends 5,000 + tax 5,072) = (10,072)

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(S19) VAT 15% net of sales – purchases and

expenses is
15% (271,897 – 194,205 – 33,655) × 0.25 = (1,652)
(11,724)
(S20) Overdraft is balancing figure based on Note 2 = (9,756)

Current liabilities 42,801

Total assets less current liabilities per Note 3 231,808

(S21) Share capital given in question 100,000

(S22) Retained earnings (balancing figure) 81,808

(S23) 12% loan 50,000

231,808

Note: Retained profit is the balancing figure to make up £231,808.

The bank overdraft of £9,756 is the overall statement of financial position balancing
figure.

Question 4 – Saddam Ltd

(a) Profitability – ROCE

• Camel Ltd is the most profitable of the three companies.

• An inspection of the secondary ratios shows that this is due to efficient utilisation
of assets as its net profit ratio is well below that of the other two companies.

• Examination of gross profit percentages confirms the observation that Camel Ltd
seems a high-volume, low-margin business compared with the others.

Liquidity

• Ali Ltd has a current ratio that is out of line with the other two, being very much
higher, suggesting surplus investment in working capital.

• The acid test ratio reinforces this view and also indicates that Baba Ltd appears to
have a liquidity problem with current liabilities considerably greater than cash and
debtors (despite having the greatest number of weeks’ debtors outstanding of the
three companies).

• Baba Ltd also has considerably more weeks of stock outstanding than the other
two companies which may be linked with the high level of creditors.

• Ali Ltd also has stock levels well in excess of Camel Ltd explaining, in part at least, the
high current ratio.

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Dividends

Camel Ltd is paying out a higher proportion of profits in dividends, which may have
the effect of raising shareholder loyalty and the bid price.

Conclusion

• Baba Ltd appears to have considerable liquidity problems arising out of excess
investment in stock.

• Camel Ltd is a lean enterprise which is able to survive on a lower gross profit
margin because of superior asset utilisation. Why is the gross profit margin low?

Before a final decision is made, the absolute figures in the financial statements should
be studied and questions raised such as the following:

• Are the activities of the firms really the same?

• What are the relative turnovers?

• What is the growth over a period of years?

• What are the trends of all the ratios?

• How old are the assets?

• Are asset ages distorting ROCE comparisons between the companies?

Also managerial skills, product potential, etc. have to be assessed, which are not shown
in the financial statements.

(b) Why the statement of financial position is unlikely to show the true
market value of the business?

The accounting policy in the United Kingdom is to state fixed assets at cost less
depreciation or at historical cost (HC) modified by revaluation of all or selected classes
of fixed assets.

The true market value of a listed company is available from the market capitalisation
figure based on current share prices.

The true market value of an unquoted company is not readily available and would
require future cash flows to be evaluated.

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Analysis of published financial statements

Question 1 – Belt plc and Braces plc

The aim is to interrogate the differential performance of the two companies. There
is a temptation to merely comment that a ratio is better or worse than the other. In
this question, it is the differential strengths and weaknesses that need to be
highlighted.

(a)
Belt Braces
€m €m

Revenue 200 300

Operating expenses 180 275
Operating profit 20 25
Return on total assets 20/150 × 100 = 13.3% 25/125 × 100 = 20%
Net profit % 20/200 × 100 = 10% 25/300 = 8.3%
Turnover of total assets 200/150 = 1.33 300/125 = 2.4
Numerical relationship:
Rate of return on total assets 10 × 1.33 = 13.3% 8.33 × 2.4 = 20%

(b) Based on these ratios, Braces appears to be performing better with its rate of
return on total assets being 50% higher.
However, looking at the other ratios,
Belt has a marginally better net profit percentage. It would be helpful to learn
if this is due to achieving higher prices or a better control over operating cost.
Braces, on the other hand, achieves a much higher asset utilisation indicating a
more efficient use of the available resources.
(c) In addition to an appraisal such as that above Potential shareholders would enquire:

• How is the operating profit split between equity and loan funding?

• What is the gearing ratio?

• What are the P/E ratios?

Potential loan creditors would enquire:

• Is there asset security available?

• What is the interest cover?

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Question 2 – Quickserve plc

(a) Main concerns of the user groups

(i) Employees:

Job security

Training possibilities

Promotion prospects

Pay increases.

Information sought:

• Is the company profitable? If yes, job possibly safe; if not, possible redundancy,
short-time working.

• What are company policies on employment, training and union membership?

• How much are the directors awarding themselves by way of salary and bonuses?
Will this influence the amount we might get?

• What is the company policy on redundancy? Voluntary terms offered in the past?
Any indication of future policy?

• Is there a pension scheme? What are the terms? Is it defined benefit or contribution?

(ii) Bankers: Ability to repay any existing loans and overdrafts.

Ability to pay interest and any charges due.

Feasibility of company being able to support higher loan and overdraft

facilities.

Information sought:

• Current liquidity and gearing.

• Profitability sufficient to support current and possible higher interest charges.

• Is the company expanding its operations? If so, will it be safe for us to lend more?

(iii) Shareholders: Dividend trend

Capital growth

Financial statements give a fair view.

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Information sought:

• EPS and dividend per share.

• CAPEX policy and commitment.

• Anticipated future growth if increase in CAPEX.

• Directors remuneration – is it consistent with performance? are their interests the

same as the shareholders?

• Do the accounts have a clean audit certificate – if not, what are the implications for
the company as a going concern and future earnings, dividends and share prices?

(b) Relevant ratios could include the following:

20X9 20X8 % change
Gross profit % 25.0 26.0 –3.85
Profit before tax % 5.67 13.67 –58.52
Profit after tax % 3.67 8.87 –58.62
Profit after tax/total non-current assets % 9.17 17.05 –46.22
Profit after tax/shareholders funds % 6.98 18.22 –61.69
Earnings per share 4.4p 13.3 –66.92
Dividends per share 8.0p 6.0p +33.3
Current ratio 3.5:1 2.0:1 +75.00
Acid test ratio 3.25:1 1.8:1 +80.56
Gearing % 15.87 27.40 –42.08
Debt ratio 24.10 32.41 –25.64
Return on capital employed 6.03 14.30 –57.83
Dividend cover 0.55 2.21 –75.11

Possible comments

Employee perspective ratios: Profitability is declining and turnover and gross profit per
cent are both falling.

Administration expenses are normally reasonably fixed, so why this disproportionate

rise?

Profit after tax has fallen by 58.62%. No indication as to whether there had been a profit
or loss on the sale of non-current assets. There is no disclosure based on the assumption
that these are immaterial - however, this would need to be confirmed by further enquiry.

Why are dividends being paid out in excess of the current year’s after tax profit? Is this
a good sign indicating that shareholders might be looked to for a rights issue?

Who were the dividends paid to? Is there a large holding by the directors?

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Figures: Questions will be asked as to the reason for the increase in administration
expenses. Does this include directors remuneration? Has there been losses on the sale of
non-current assets included in this figure? It cannot be depreciation as assets have fallen
substantially.

Response: Employees would want to establish why non-current assets are being sold. Is
this the start of a reconstruction? If so, can employees be involved in any discussions?
Should they start looking quietly for alternative employment?

Bankers perspective:

Ratios: Profitability is falling.

Gearing is improving.

Current and acid test ratios are higher.

However, is this due in part to the significant disposal of non-current assets?

Short-term liquidity not a problem and borrowings can be repaid.

Figures: Trade receivables are being collected more quickly. Concern about dividend
policy.

Response: Short-term liquidity sound. Need more information on the long-term

strategy as this is not clear just from the financial statements. A meeting is needed to
clarify this and any implication for bank support by way of loan or overdraft. Any
future loans would need a debt covenant to address this happening in the future.

Shareholders perspective:

Ratios: Concerned with the fall in profitability and lower EPS, a higher dividend
would normally be welcome but it seems to have come out of reserves. Current ratios
are higher. This is normally regarded as an improvement from the viewpoint of
liquidity. However, given that this is in part due to the disposal of non-current assets
one should consider the implication on future profitability and revenue from the
reduction in non-current assets.

Figures: Questions about the increase in the administration costs and falling trend in
revenues.

Response: There will be pressure to learn from management what the company’s
medium-term strategy is and how this will impact on earnings and future dividends.
Difficult to interpret from the data whether aiming to renew non-current assets or in a
decaying market with prospect of reconstruction and possible call for further equity
finance. Feeling of unease until management makes a statement regarding the future.

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Question 3 – Bouncy plc

(a) Ratios for a potential shareholder

20X6 20X5

(i) Return on equity Profit after tax and preference 1,300/6,700 900/5,650
dividends/ordinary share capital = 19.4% = 15.9%
+ reserves
(ii) Earnings per share Profit after tax and preference 1,300/6000 900/6,000
dividends/no. of ordinary shares = 21.67p = 15p
(iii) Dividend cover Equity profits/proposed dividend 1,300/250 900/250
= 5.2 times = 3.6 times
(iv) Gearing Debt capital/debt + equity 1,500/8,200 1,500/7,150
= 18.3% = 21.0%

(b) Solvency ratios for a potential lender

(i) Debt equity Debt:equity 1,500:6,700 1,500:5,650

= 1:4.5 = 1:3.8
(ii) Solvency Current assets:current liabilities 3,810:1,960 3,610:2,060
= 1.9:1 = 1.8:1
(iii) Interest cover Profit before interest:interest 2,200/170 1,570/150
= 13 times = 10 times
(iv) Liquidity Current assets – stock:current 1,710:1,960 1,540:2,060
liabilities = 0.87:1 = 0.75:1

(c) Comments from potential shareholder’s viewpoint

The return on equity has improved by approximately 25%. The dividend is well
covered and has improved in 20X6 from 3.6 in 20X5 to 5.2 in current year. The EPS
figure is in line with the return on equity and is acceptable. The gearing is low at 18.3%
so that the business enjoys lower earnings risk.

Comments from viewpoint of lender

The current ratio at 1.9 and acid test ratio at 0.87 are both improving, and interest is
well covered at 13 times. Gearing is low and when coupled with the improving return
on equity and sound interest cover, it means that the company is able to increase its
long-term borrowing.

The increase in the share price over the last three years is understandable, given the
picture presented by the ratios.

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(d) Advising on scheme to choose

It is interesting to assess the schemes from their impact on earnings per share and
return on equity.

Assuming a rights issue

£000 £000
Profit before interest and tax 2200
Interest expense currently (170)
Less: debenture interest (10% of £1.5m) 150
Bank charge interest (20)
2180
Taxation (730)
Loss of interest allowance 40% of 150,000 (60)
(790)
Revised profit after tax 1390

Earnings per share:

Shares in issue £3,000,000/£0.5 = 6,000,000
New shares £6,000,000/£1.5 = 4,000,000
10,000,000

EPS = £1,390,000/10,000,000 = 13.9p

Return on equity = 1,390/(6,700 + 6,000) × 100 = 11%
13% Debentures
£000 £000
Profit before interest and tax 2,200
Interest expense (6,000 × 13%) (780)

1,420
Taxation 730
Less tax savings on loan interest (780 – 170) × 40% (244)
486
Revised profit 934
EPS = 934/6,000 = 15.6p
Return on equity = (934/6,700) × 100 = 14%

The decision based on EPS and return on equity supports the loan funding scheme.

Other factors to be taken into account:

Consider the increase in gearing from 18.3% to 47.2% (6,000/12,700).

Although not suggested by the question, it may be better to raise additional finance by a
combination of issuing new shares and additional loan funding. It could be argued that raising
only loans increases the gearing too much, issuing only shares dilutes the earnings and control
of existing shareholders too much.

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Question 5 – Growth plc

(a)

(i) Net asset value basis

(i) Based on book values
Historical cost
3,600
No. of shares 2,500
Value per share £1.44

(ii) Based on realisable values

£000

Buildings 2,500
Other tangible non-current assets 700
Current assets 2,500
5,700
Current liabilities 1,400
4,300
No. of shares 2,500
Value per share £1.72

(iii) Based on replacement costs

£000

Buildings 2,600
Other tangible non-current assets 1,800
Current assets 2,200
6,600
Current liabilities 1,400
5,200
No. of shares 2,500
Value per share £2.08

(ii) Earnings basis

(i) Based on historical earnings

P/E ratio 10 less 25% = 7.5

EPS based on historical cost profits = 750/2,500 = 30p
Value per share 30p × 7.5% = £2.25

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(ii) Based on projected earnings

EPS based on a profit increase of 25%

750 × 1.25 = 937.5

937.5/2,500 = 37.5p
Value per share 37.5 × 7.5 = £2.8

(b) Brief comment on each basis:

Historical cost – takes little account of changes in asset values and no account of
goodwill.

Realisable value – current break up values can be obtained but it is unrealistic to apply
this base if there is no intention to close the business.

Replacement cost – this gives an indication of the cost of setting up in a similar

business with similar age and condition assets. No account taken of goodwill.

Earnings basis requires a risk adjustment to the P/E ratio. This could well depend on
current economic conditions and expectation of future growth or profit falls.

Decision is required to the level of maintainable profits, i.e. past, current or extrapolated
trend. The offer seems reasonable if growth is expected.

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 PART 8

Accountability

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 CHAPTER 32

Integrated reporting: sustainability, environmental

and social

Question 1 – Geoworld Enterprises plc

(a) Geoworld Enterprises plc value added statement for the year

Value generated
Revenue 411,000,000
Less: payments to outsiders
Raw materials 100,000,000
Subcontractors 51,000,000
Energy 1,000,000
Total payments

152,000,000
Total value generated 259,000,000

Value added distribution

Compensation to employees 158,000,000 61.0 %
Providers of finance:
Interest 2,000,000
Dividends 3,000,000
Total to providers of finance 5,000,000 1.9%
Government 16,000,000 6.2%
Reinvested in the business
Retained earnings 79,000,000
Depreciation 1,000,000
Total reinvested 80,000,000 30.9 %
Total value distributed 259,000,000 100.0 %

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(b) Version one

The median income is the middle income. In descending order, the fulltime equivalent
incomes are:

Chief executive officer 1 1,000,000

Other employees
Senior executives 5 600,000
Other executives 10 400.000
Local fulltime 2,000 40,000
Local part-time 1,000 × .5 500 20,000
International f/t 2,000 20,000
International p/t 4,000 × .5 2,000 10,000

Total number of other equivalent employees is 6515 or actual number of other

employees is 9015.

The median income is the employee ranking 3257 or 4508 which falls in the
international f/t or 20,000. Thus, the chief executive officer is getting
1,000,000/20,000 or 50 times the median salary.

Version two is for situations where the subcontractor is not a genuine independent
supplier but is a way to circumvent employment laws. Then we need to add the
following to the list of employees:

Subcontractors f/t 2000 17,500

Subcontractors p/t 1000 16,000

The total number of other employees becomes 9515, so the median equivalent
employee is 4757 or median on the absolute numbers is 6508. Thus, based on
equivalent employees it is 5 senior executives, 10 other executives, 2000 local f/t,
500 local p/t, 2000 international f/t, and 242 subcontractors f/t, so the median pay is
17,500. The chief executive officer is getting 1,000,000/17,500 or 57.14 times the
median income. Using the absolute number, you also get a median income of
17,500.

The main justification to be discussed is whether to just take earnings on the total
remuneration each person gets or whether to convert it to a fulltime equivalent
wage. If the use of part-time employees is a device to keep employees submissive,
or if remuneration is lower for casual part time staff although working more than
half the hours worked in the location of the senior executives, then perhaps it could
be argued that the wages should not be converted to fulltime equivalent. On the
other hand, if employees choose to work part-time because of other commitments,
then perhaps the argument is stronger for using fulltime equivalents.

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Then if equivalents are used for calculating, the earning rate that of itself does not
necessarily mean the numbers of employees has to be based on equivalent numbers
rather than actual numbers.

The other area of contention is whether in some cases subcontractors are really
equivalent to employees. Such a case would be where the staff of the subcontractor
work in the production process of the main company and are effectively managed by
the staff of the main company. Many cases might fall into the questionable category
rather than being clearly in or out.

(a) Many large companies already produce employment statistics in their annual reports
so presumably they already have systems to capture that information. In relation to
wages, it is probably possible to extract such information for employees who work
the whole year based on earnings and personal taxes withheld for payment to the
government.

(b) There are several ways to make the ratio smaller and they include:

a. Taking a lower salary.

b. Getting benefits which are not included in the salary such as more generous
use of company money for accommodation and meals when travelling on
company business.
c. By using technology more to make employees more productive, so you employ
less staff but pay them more.

d. Use subcontractors to get employees off the books at lower rates of pay than
you would pay if your company did it in house, or just to outsource work
which is poorly paid so they do not count in the statistics although the wages
paid to them are the same as before.

e. Move production to low wage rate countries where minority owned and
controlled companies perform the work.

f. Move production to countries using suppliers who are located where there are
less health and safety requirements so production is cheaper.

The question then asked is whether the steps outlined above would be beneficial to
the company. In respect of a lower salary, it is a question of whether the executive
is previously over paid. Would it affect motivation, would the executive seek other
employment and if so, could another executive be recruited who could do the job
well for the same or lower pay? These matters are difficult to judge. The best paid
executives are not always the most productive as viewed by hindsight but it is
harder to tell at the time of recruitment.

As stated in (b) above, there is a problem of controlling the costs and from a
shareholder perspective, it is not making the cost less and, if anything, it is
circumventing shareholder oversight.

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In relation to (c), the use of technology to improve productivity is fine as long as all
the gains are not paid out as extra salary because there needs to be a reward for
capital providers investing in new technology.

Subcontracting low paid jobs, in itself, will not improve returns. However, if the
subcontractor is more efficient than the company, there may be gains. Efficiency
may come from specialisation. On the other hand, if it is perceived as a device to
pay lower rates of pay, this may cause resentment or lack of cooperation from
remaining staff or even bad publicity causing loss of sales. In the future, it may
make good potential employees harder to recruit.

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