International Financial Reporting and Analysis 5th Edition by David Alexander, SOLUTIONS MANUAL by ACADEMIAMILL

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Solutions to the Exercises Answers marked

 can also be found on the Student side of the website.

Chapter 1

1

Obviously the scope here is almost endless. Here are three interesting definitions from the USA which students are not very likely to come across (extracted from A.R. Belkaoui (1992) Accounting Theory, 3rd edn, Academic Press, London). The Committee on Terminology of the American Institute of Certified Public Accounting defined accounting as follows: Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. 1 The scope of accounting from this definition appears limited. A broader perspective was offered, by the following definition of accounting as: The process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information. 2 More recently, accounting has been defined with reference to the concept of quantitative information: Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature about economic entities that is intended to be useful in making economic decisions, in making resolved choices among alternative courses of action. 3

‘Review and resume’, Accounting Terminology Bulletin No.1, American Institute of Certified Public Accounts, New York, 1953, paragraph 5.

American Accounting Association, A Statement of Basic Accounting Theory, American Accounting Association, Evanston, IL, 1966, p.1. 3

financial statements of business enterprises’, American Institute of Certified Public Accountants, New York, 1970, paragraph 40.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

2

Accounting information is usually mainly past information, but user decisions are by definition future directed. Consider: ■ relevance v. reliability ■ objectivity v. usefulness ■ producer convenience v. user needs.

3

Perhaps it all depends on what ‘reasonably’ means. The needs of different users are certainly different (illustration required), but greater relevance from multiple reports would need to be set against: (a) costs of preparation (b) danger of confusion and the difficulties of user education.

4–6 We suggest that these three questions are treated as a set. There is scope for wide differences of view and considerable debate. We suspect that objectivity and prudence are likely to come higher up the ‘importance’ scale than they are up the ‘useful’ scale. This would lead to discussion of whether the user or the producer matters more!

7

It is really much less objective than people often claim. Examples of ‘unobjectivity’ include: ■ problem of determining purchase cost ■ overhead allocation ■ depreciation calculation ■ provisions and their estimation ■ prudence (a subjective bias by definition).

Completeness requires the inclusion of all relevant contents. The monetary measurement convention requires that which is not measurable be not recorded, even if it is clearly relevant. Discuss conflict.

The basic issue is matching (which says capitalize) v. prudence (which says write off as expense at once). Relevance, usefulness, etc. should again be brought out.

The more obvious conventions seem to be: ■ monetary measurement ■ historical cost ■ prudence (i.e. lower of cost and NRV) ■ realization (profits not realized until ‘sold’).

Historical cost accounts are certainly not very objective (see question 7). Analytically, they are not very useful - out of date, stewardship rather than forward-looking decision making etc. But people do accept them and use them, better the devil you know … etc.,

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 12

How prudent is prudent? (Again, this is a relative, not an absolute, term.) The normal accounting practice of revenue recognition is not the most prudent possible. Stating debtors at cost (i.e. not recognizing any profits until cash receipts are in) would be both feasible and more prudent than normal practice. Perhaps the normal practice suggests that accountants are ‘reasonably’ prudent (whatever ‘reasonably’ means!).

13–15

We suggest treating these three questions as a set. See discussion in the text. The whole process is subjective in principle and often arbitrary in practice (e.g. the date the invoice happened to get typed); the answer to question 15 is surely ‘no’.

This is about the balance sheet equation: resources equals claims. Revenue recognition increases claims (i.e. profits) and therefore increases resources; for example, inventory at cost may be replaced by debtors at selling price.

(a)

(i) Receipts €90 Payments €42 (ii) Revenue €60 Expenses €36

(b)

Receipts and payments basis is easier, more objective and makes fewer, possibly risky, assumptions about the future. Revenue and expense basis follows matching convention, is more realistic and is a better measure of economic progress.

Surplus €48 Surplus €24

Discussion required. Difficulties are the treatment of subscriptions still unreceived for 20X8 and the corresponding 60% expense.

Chapter 2

1

2

You will notice that the answer to this question will be influenced to a large extent by the national background of the student. In the Anglo-Saxon world students will more easily argue that accounting is, in essence, economics based. In those countries, accounting standards are rather broad and derived from general principles. These principles are often derived from economic valuation concepts. Students living under a codified law system and in countries with a creditor orientation will argue more often that accounting is law based. If we consider IAS we might argue that IAS is economics based (e.g. substance over form). The answer to this question is strongly influenced by the items put forward in the section ‘national differences will they still play a role in the future?’ in Chapter 2. As large companies become more global and seek multi-listings,

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN they will be strongly in favour of harmonization and even uniformity. For small local firms the national environment will remain an important factor shaping their financial reporting practices. 3

Check for your own country: ■ ■ ■ ■

■ ■ ■ ■

elements of the accounting environment the major sources of finance whether there is an active and important stock exchange is the legal system in your country more inspired by the common law system or the code law system. Did these systems ‘originate’ in your country or were they ‘exported’ to your country? the relation between accounting and taxation. Is taxable income in your country to a large extent determined by accounting income? elements of the accounting system sources of accounting regulation development of the accounting profession.

The importance of the different elements related to the accounting environment will differ in each country. Try to appraise the importance of these elements in your own country. If you list the important elements, you will be able to understand better your own national accounting standards and national reporting practices. 4

The cultural values that depict a country lie between the following extremes: ■ ■ ■ ■

individualism/collectivism large v. small power distance strong v. weak uncertainty masculinity v. femininity.

Appraise where your country is situated with regard to those four constructs. Make use of the explanations of the constructs given on page 26. 5

Changes in the accounting system could point to: ■ ■ ■

changes in the standard-setting process, e.g. more input from the private sector or vice versa an evolution in the contents of the national GAAP (e.g. a move towards substance instead of legal form) changes in the organization of the accounting.

These changes could be driven by several possible forces. For example: ■

changes in the national accounting environment.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■ ■ ■ ■ 6

changes in finance patterns, e.g. more companies become listed or go for multi-listings relation between accounting income and taxable income changes due to changes enacted by the government pressures from the business community changes introduced by EU legislation or other national legislation.

Gray’s adaptation of Hofstede’s cultural values is presented on page 30. The four accounting constructs are defined as follows: ■ ■ ■ ■

■ ■ ■ ■ ■

professionalism/statutory control investigate how corporate control and external control or audit are organized in your country uniformity v. flexibility appraise whether your national GAAP are rather uniform or do they allow many recognition and measurement alternatives? Do accounting regulations or standards in your country consist of detailed rules or do they comprise general principles? conservatism/optimism what are the important stakeholders in your country with regard to financial reporting (shareholders/creditors, the government?) how important is the prudence or the conservatism principle in your country? secrecy v. transparency appraise the disclosure levels of companies in your own country with disclosure levels of companies in other countries. Assess whether access to financial statements of companies is easy in your country. Do interested parties have to contact the company or are financial statements easily accessible with the use of organized databases?

This question builds on question 6. The construct secrecy v. transparency will, to a certain extent, explain the differences in levels of voluntary disclosure between different countries.

In different accounting journals (e.g. Journal of Accounting and Economics, Journal of Accounting Research, Accounting Review, Abacus, European Accounting Review, Accounting and Business Research) you will find articles which analyse whether or not accounting quality improves after the IFRS adoption. You will notice that the results will be different according to the characteristics of the research population (having adopted IFRS before on a voluntary basis), country differences etc.

The financial reporting infrastructure of a country is

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN determined by the existing legal system, the organization of the accounting and audit profession, the risk of litigation, the degree of enforcement, the link between accounting and taxation and other variables discussed in chapter 2. These variables have an impact on the quality of the IFRS accounts. * in case of low risk of litigation or low degree of enforcement, the quality of IFRS accounts might be lower * the cultural values, in countries characterized by optimism, IFRS GAAP will be applied in a less conservative way. Although IFRS in itself does not pursue conservatism. * in countries characterized by more professional than statutory control, preparers and accountants and auditors will rely more on their own judgment for the preparation and the audit of the annual accounts. In countries characterized by statutory control, one will seek for more interpretations of IFRS which will then be complied with in a “detailed legalistic way”.

Chapter 3

1

As so often, this is partly a matter of perception. In theory, the proposition is not correct, for two reasons. The first is that accounting regulation, and accounting practice, in Europe is bound by the contents of European Directives, especially the 4th, for individual companies, and the 7th, for groups. The second is the creation of the endorsement mechanism for emerging IFRSs, described in the text. Practice, however, seems set to be rather different. It should be remembered that the 4th Directive has been amended to allow consistency with IASB requirements in several respects, notably with regard to the use of fair values. The make-up of the IAS Board is also significant. Perhaps most importantly in practice, the entire IAS Board, including the European representatives, seems united on the broad thrust of developments.

Different views are likely here. Arguably, the statement is true, but one-sided, i.e. the IASB has also given the European Commission a formal continuing role in accounting standards creation that market forces could have removed from it.

There is much evidence broadly to support this proposition. The complexity of much Standard requirement, as Parts II and III show, is clearly designed for sophisticated (and wealthy) uses. The IASB is addressing the issue of accounting for small and medium enterprises (SMEs), but it is not obvious that either SMEs or developing country needs have a high priority at the time of writing. Personally,

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN we would regard this as a weakness. 4

These steps the IASB has to follow when issuing a standard – these are compulsory steps: ■ Consulting the SAC about the advisability of adding the topic to the IASB’s agenda ■ Publishing for public comment an exposure draft approved by at least nine votes of the IASB, including any dissenting opinions held by IASB members ■ Consideration of all comments received within the comment period on discussion documents and exposure drafts ■ Approval of a standard by at least nine votes of the IASB and inclusion in the published standard of any dissenting opinions (Source: see preface to the IFRSs – due process – International Financial Reporting Standards – 2009)

Chapter 4 1

2

3

The detail will obviously depend on the examples chosen. Fixed assets are likely to be all at cost, or partly at cost, with some at valuation; buildings etc. may or may not be depreciated; inventory will be basically at cost; debtors are at net realizable value. There is certainly no proper additivity in a mathematical sense. The two businesses will have different depreciation charges (if they depreciate the buildings at all) and significantly different capital employed totals. They will therefore certainly have different efficiency and return ratios, but are they, economically speaking, different situations? In one sense, yes: more money was put into one than the other; but in another sense, no: opportunity costs and future potential are logically identical. Discuss generally. A tricky one. In one sense, a capital maintenance concept must be defined before income can be determined, suggesting separation is not possible. But since one, in a sense, leads to the other, it could be suggested that perhaps we can define one of them and then automatically deduce the other (which therefore does not need separate definition). Discussion of interrelationships is the key issue. Outlined and discussed in the text. (a) Fisher’s thinking is discussed on pages 74–76. (b) Hick’s thinking is discussed on page 76-79.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (c) To summarise, for Fisher income is equal to consumption whereas for Hicks income is equal to consumption plus saving, where saving is defined as the difference in value of capital from the beginning of a period to the end. In essence, while Fisher is concerned purely with the individual’s enjoyment of consumption, Hicks is more concerned with the capacity to consume by building in to the model the concept of capital maintenance or savings. Hicks’ conception is therefore a more useful long term concept in the real world. Hicks’ views take into account that we live in an uncertain world where market values can change. Income should only be enjoyed after we have maintained capital. Fisher’s is an idealised concept of a certain world where capital maintenance is not an issue. 5

For the principles, see text. Income ex ante is calculated with expectations of the beginning of the period and income ex post is calculated with expectations of the end of the period, but both are essentially subjective as they are based on expectation to infinity (subject to materiality!).

Viewed as a reporting mechanism, economic income is certainly unattainable except under a multitude of subjective assumptions. Is it ideal? Theoretically, it seems to have a lot going for it, unless we argue that the real ‘ideal’ is Fisher with his psychic satisfaction - and this is obviously even more ‘unattainable’ as a measurement and reporting basis.

(i) Value of business at beginning of Year 1 (€): 400 1.1

500 (1.1)2

1000 (1.1)3

1528

(ii) Value of business at beginning of Year 2 (€): 500 (1.1)

1000 (1.1)2

1281

(iii) Value of business at beginning of Year 3 (€): 1000 (1.1)

909

(iv) Economic income (€): Year 1 Year 2 Year 3

1281 909 0

1528 1281 909

400 500 1000

153 128 91

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Year 1 2 3 4

Value of business at beginning of year 1528(1) 1281(2) 909(3) 0

Economic income for year 153(4) 128(4) 91(4) 0

Cash received in year

Economic income for year

Difference

Cumulative difference €

Cumulative difference reinvested 10% €

Year

€

1 2 3 4

400 500 1000 -

153 128 91 -

247 372 909 -

€

247 619 1528 1528

25 62 153

153 153 153 153

Chapter 5 1

2

For explanation and illustration, see text. The key point is that replacement cost accounting splits up the historical cost profit into two different elements: the current operating profit and the holding gains. These elements have different causes and different effects and reporting the split facilitates separate analysis and interpretation. An interesting question. Replacement cost accounting, given rising cost levels, leads to a lower operating profit figure, which is more prudent. It also leads to higher asset figures in the balance sheet, which is less prudent. These two effects considered together will lead to much lower profitability and return on resources ratios, which perhaps sounds more prudent! Make them think! Try and encourage an open discussion from students first. It all depends on the chosen capital maintenance concept. Realized gains follow a transaction, so, for example, the holding gain on stock already sold is realized. Holding gains are only part of profit after capital (as defined) has been maintained. Given an RC-based concept of capital maintenance, holding gains are a capital maintenance adjustment and therefore not part of profit at all, so they could not logically be distributable even if they realized and legally distributable.

The rationale for this proposition is that the holding gains element of historical cost profit is removed, leaving a current operating profit, which genuinely contains only the results of operations. Arguably, this is a better indication of repeatable performance. At minimum, the two elements of historical cost

Ideal economic income

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN profit are separated and can be analysed separately for trends as required. 5

6

Any cost-based balance sheet is not designed to show meaningful values of most of the items. Perhaps at minimum, however, a replacement cost balance sheet can be said to contain up-to-date estimates of future costs, whereas a historical cost balance sheet contains out-of-date elements of future costs. There is scope for some discussion. I.M Confused, computer dealer (a) Historical cost accounting

Profit and loss accounts for the years: 20X1 € Sales 3000 Cost of sales (2000) Gross profit 1000 Expenses - rent (600) Net profit 400 Tax @ 50% (200) Retained profit 200

20X2 € 3600 (2000) 1600 (700) 900 (450) 450

Balance sheets at year ends: 20X1 € (4) 4000 (2)` 2400 (0) 0 6400 3800 10200 10000 200 10200

Inventory @ €1000 @ €1200 @ €1400 Cash Capital Retained profits

20X2 € (2) 2000 (2) 2400 (2) 2800 7200 3450 10650 10000 650 10650

(b) Replacement cost accounting Profit and loss accounts for the years: 20X1 € Sales Cost of sales Gross profit Expenses - rent Operating profit Tax paid Profit/(loss) Realized holding gain

20X2 €

3000 3600 (2600) (2200) 800 1000 600 700 200 300 200 450 0 (150) 100)) 200 (2 x 300) 600

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Historical cost profit

200

450

4000 2400 0 6400 3800 10200 10000 200

20X2 € (2) 2000 (2) 2400 (2) 2800 7200 3450 10650 10000 650

10200

10800

Balance sheets at year ends: Inventory @ €1000 @ €1200 @ €1400

20X1 € (4) (2)` (0)

Cash Capital Retained holding gain Distributable profits Unrealized holding gains

0 1400 11600

(150) 1200 11850

(c) The figures show that, given an intention to continue the operations of the business at the current level, the historical cost profit figure is entirely mythical - indeed in the second year the business has an operating loss on this basis. 7

Mallard Ltd (i) Balance sheet as at 31 December 20X1

Fixed assets Less: depreciation Current assets Inventory Cash 10000 8000 47900 (9000) (35550)

€ 12600

€

€ Shareholders’ interest Shares

1260

11340 Profit Holding gains 4000

€ 10000 (20)

3600 950

4550

Current liabilities (13200) 8150 12150 Creditors 960 23490 23490 Trading and profit and loss account for the year to 31 December 20X1 € € € € Purchases 8000 Sales 7200 8250 10800 8500 15600 10800 35550 14300 Holding gains 950 36500 Closing inventory

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (40 x 100) Gross profit General expenses Loan in interest Depreciation

(ii) 1 Mar 1 Jun 1 Sep 1 Dec

(4000) 32500 15400 47900 13200 Gross profit 960 1260 Net loss 15420

100 - 60 = 40 x ( - 5) 210 - 150 = 60 x 10 310 - 280 = 30 x 5 432 - 390 = 40 x 10

47900 15400 20 15420

= (200) = 600 = 150 = 400 950

8 (a) (i) Historic cost Profit calculations Sales (110 + 120 + 130) Cost of Sales (100 + 100 + 120) Profit

L €

H € 360 330 30

Balance sheets 30 September Inventory

130 €

Capital Profit

0 0 0 100 €

100 30 130

100

Profit calculations Sales (110 + 120 + 130) Cost of Sales (100 + 100 + 120) Profit

360 360 0

0 0 0

Balance sheets 30 September Inventory Capital Holdings gain (3 x 10)

130 100 30

100 100 (1 x 30) 30 130

(ii) Replacement cost

130 (b)

Discussion required. Physically they are in identical positions: €100 invested, no cash, no drawings, 1 widget. Economically speaking, therefore, if they started in identical positions, and ended in identical positions, we must expect identical results for both L and H. Replacement cost achieves this and historic cost does not.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Chapter 6 1

This should lead to a discussion based on student proposals. It may be a good idea to get students to present their examples to their colleagues. The major difficulty will be to avoid the double counting of realized gains that have already been included as unrealized ones.

Again, student presentation would be useful, with discussion. Detail is a matter of following the logic of the figures, as in the example in the text.

 3

Arguably, the suggestion would give an income statement with a useful long-run operating perspective (note that this would perhaps be even more relevant if based on future RC rather than on current RC figures!) at the same time as a balance sheet of current cash equivalents, i.e. meaningful current market values. Discuss advantages of both of these. Against this, there would be a loss of internal consistency in the reporting package, which seems significant. Discuss this too.

It can be argued that a problem with RC accounting is that it uses RC figures in circum stances where an asset would not, or even could not, be replaced. Deprival value certainly removes this criticism, as it only reduces to the RC number when the asset would rationally be replaced. Against this, deprival value introduces more complexity and more subjectivity. Discussion of pros and cons required.

(a) The amount of the loss a rationally acting owner would suffer if deprived of an asset. (b) RC €000 1 2 3 4 5 6

8 8 10 10 12 12

NRV €000 10 12 8 12 8 10

EV €000 12 10 12 8 10 8

Deprival value RC RC RC RC EV NRV

6

Steward plc Trading and profit and loss account for the year ended 31 December:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 1 € 12000 8000 4000

Sales Less: cost of sales Gross profit Expenses Depreciation (note (c))

1000 1000

2 €

1200 1000

Holding gain (note (d))

2000 2000 1000

2200 1900 2500

3000

4400

Balance sheet as at 31 December:

Fixed assets Machine at NRV (note (a)) Current assets Inventory at NRV (note (b)) Bank

1 €

2 €

9000

8000

3000

10000

21000

19400 24000 33000 30000 3000 33000

Share capital Profit for year

29400 37400 30000 7400 37400

Notes (a)

Fixed assets. At the end of each year the machine is brought into the balance sheet at its net realizable value.

(b)

Inventory. The inventory is also brought into the balance sheet at the end of each year at its net realizable value.

31.12.1200 units x €15 = £3000 31.12.5500 units x €20 = £10000 (c)

Depreciation. The depreciation is the difference between the NRV of the asset at the end of each year, less the NRV of the asset at the beginning of the year. Year 1 €9000 - €10000 Year 2 €8000 - €9000

(d)

Holding gain. In Year 1 the holding gain is the unrealized holding gain on the closing stock: 200 units €5 (i.e. €15 x €10) = €1000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN In Year 2 the holding gain of Year 1 has now been realized (and therefore included in the trading account for Year 2) whilst there is an unrealized holding gain on the closing stock of: 500 units x €7 (i.e. €20 - €13) = €3500 Therefore, in Year 2 the holding gain is: Unrealized holding gain in Year 2 Less unrealized holding gain from Year 1 now realized in Year 2

€ 3500 1000 2500

If in Year 2 we were to include the €1000 holding gain from Year 1, we would be double counting the holding gain. 7 Stan € (a) Historic cost Capital Profit Inventory Cash (b) Replacement cost Capital Profit Holding gains Inventory Cash (c) Net realizable value Capital Profit - realized - unrealized Inventory Cash

Workings Stan Historic cost 1 Jan 1 Jan

100 80 180 130 50 180

100 100 100 100

100 50 30 180 130 50 180

100 30 130 130 130

100 80 30 210 160 50 210

100 60 160 160 160

Oliver Cash Inventory Profit 100 100 -

Oliver €

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 31 Mar 1 Apr 30 Jun 1 Jul 29 Sep 30 Sep Replacement cost

130 15 155 30 180 50

1 Apr 30 Jun 1 Jul 29 Sep 30 Sep 1 Apr 30 Jun 1 Jul 29 Sep 30 Sep

Profit

€

Profit

Cash

€

100 -

€ 100 -

€

Cash

Inventory

P-R

P-Unr

€ 100 -

€ 120 130

€ -

€ 20 30

100 115

Cash

Inventory

P-R

€ 100 130 115 15 15 155 125 30 15 180 130 50 30

€ 120) -

€ 30

PInr € 20 -

130)

140

140)

150

160)

160

15 30 30 50 50

15 25 25 30 30

15 155 30 180 50

Inventory

100 130

1 Jan 1 Jan 31 Mar

30 30 55 55 80 80

Cash

1 Jan 1 Jan 31 Mar Net realizable value

115 125 130

125 130 -

Refer to the text to start an open discussion.

Chapter 7

 1

In essence, CPP adjustments attempt to update financial measurements for changes in the value of the measuring unit, without altering or affecting the underlying basis of valuation -usually, but not necessarily, historical cost. They do it by using general averaged index adjustments usually, but again not necessarily, by means of a retail price index. Perhaps give or invite illustration.

Note the generality of the wording of the question - no particular valuation mechanism is mentioned. Perhaps, as authors and teachers, we should not give our own views. With the right group of students this could make a good discussion or even formal debate. In the end it may come back to relevance v. reliability. Is a general index relevant to anybody or anything?

Tricky! The figure is, perhaps, the original monetary investment re-expressed in current purchasing power

25 30 -

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN euros. It tells us the number of today’s euro equivalent to our original investment in terms of our spending power as an average family spending unit (which we are not). 4

The essential point is very simple. Current purchasing adjustments to historical cost figures do not lead to any kind of valuation in the proper sense of the word. They show outdated costs, re-expressed (but not re-measured) in terms of current monetary units.

Whether they are simple to apply is an open question. Once the index is chosen, the adjustments are, in a sense, objective. In our experience, however, they are certainly hard to explain and interpret. The concept of an ever flexible and variable euro is not an easy one.

STAGE 1 Convert the historical cost figures at the beginning of the year into euros of current purchasing power at the beginning of the year. 31 December Year 7 €C 000

Fixed assets Cost

500 X 220/180 300 X 220/180

Less: depreciation

611 366 245

Current assets Inventory

100 X 220/215

Debtors Bank

102 200 150 452

Less: Current liabilities Creditors

300

Share capital and P & L (balancing figure)

152 397

STAGE 2 Convert the historical figures at the end of the year into euros of current purchasing power at the end of the year. 31 December Year 8 €C 000 Fixed assets Cost

500 X 240/180 400 X 240/180

Depreciation

666 533 133

Current assets

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Inventory

150 X 240/235

153

Debtors Bank

300 350 803

Less: Current liabilities Creditors Share capital and P & L (balancing figure)

400

403 536

STAGE 3 Update the share capital and P & L figure calculated in Stage 1 from 31 December in year 7 euros of current purchasing power into 31 December year 8 euros of purchasing power. 31 December Year 8 €C 000 Share capital and P & L 397 x 240/220 Profit for year of £536 000 - €433000 = €103000

433 .

STAGE 4 Let us now prepare the profit and loss account for the year ended 31 December year 8 Historical cost €000 Sales Cost of goods sold Opening inventory Purchases Less: closing inventory Gross profit Expenses Depreciation Loss on net monetary items Net profit

1850

CPP €C 000 1931

x 240/230

100

x 240/215

112

1350 1450 150

x 240/230

1409 1521 153

x 240/235 1300 550

300 100 -

x 240/230 x 240/180 (see note) 400 150

1368 563 313 133 14 460 103

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN The loss on net monetary items is calculated as follows: €000 50 250 200

Net monetary items 31.12.7 Net monetary items 31.12.8

Since 50 has been held throughout the year this represents a purchasing power loss of: 50 x

20 220

The increase of 200 is assumed to have accrued evenly throughout the year and therefore represents a purchasing power loss of: 200 x

10 230

9 14

Calgary plc current cost profit and loss accounts for the year ended 30 June Year 4 €000 Sales Profit before interest and taxation on the historical cost basis Cost of sales (note I5)) Monetary working capital (note (6)) Depreciation (note (2))

7000 1560 57 11 32

Current cost operating profit Gearing adjustment (note (10) (7)) Interest 140 Current cost profit before taxation Taxation Current cost profit attributable to shareholders Dividends Retained current cost profit for the year Balance brought f forward Balance carried forward Current cost balance sheet a at 30 June Year 3 Fixed assets

100 1460

130 1330 300 1030 300 730 1420 2150 Year 4 €000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Land (note (1)) Plant and machinery (note (2)) Less depreciation Current assets Inventory (note (3)) Debtors Bank

1697 1277

2035 1359

(255) 2719

(544) 2850

662

912

830 10 1502

1300 620 2832

Less: Current liabilities Creditors

790

1060 712 3431 1040 271

Share capital Current cost reserve (note (4)) Profit and loss

(note (8))

1420 2731 700 3431

Loan capital

1772 4622 1040 732 2150 3922 700 4622

Workings 1 Land Year 3: Current cost at 30 June Year 3

€000 1500 x

241 213

1697

1500 x

289 213

2035

Year 4: Current cost at 30 June Year 4 2 Plant and machinery Year 3: Current cost at 30 June Year 3

€000 1200 x

Depreciation for year

1277 x

649 610 20% =

1277

691 610 20% =

1359

255

Year 4: Current cost at 30 June Year 4 1200 x Depreciation for year Current cost depreciation at 20% straight line Historical cost depreciation Depreciation adjustment Accumulated depreciation 1359 x 20% x 2 years 3 Stock Year 3: Current cost at 30 June Year 3

1359 x

272 272 240 32 544

650 x

431 423

900 x

462 456

€000 622

Year 4: Current cost at 30 June Year 4

4 Current cost reserve 30 June Year 3

912

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN €000 Net increase arising during Year 3 on the restatement of assets to current cost: Land Plant and machinery Inventory 5

197 62 12 271

COSA €000 900

Historical cost closing inventory Less: historical cost opening inventory

650 250

Less: 900 x

442

- 650 x 442 423

456 COSA 6 MWCA

193 57 €000 240

Monetary working capital 30 June Year 4 (debtors creditors) Monetary work capital 1 July Year 5 (debtors creditors)

40 200

Less 240 x

442

- 40 x 442 431

456

189 11

7 Gearing adjustment R = gearing ration L = average net borrowings S = average of net borrowings and the shareholders’ interest (based on CCA) R=

L L+S

Average net borrowings

Loan Less: bank Net borrowings Average

30 June Year 3 €000 700 10 690

30 June Year 4 €000 700 620 80 385

Average of net borrowings and shareholders’ interest 30 June Year 30 June 3 Year 4 €000 €000 Total of net assets (excluding bank) in CC accounts 3439 4007 Less: net 690 80

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN borrowings 2749

3927

Average Gearing ratio =

3338 385 = 10.3% 3723

Gearing adjustment Current cost operating adjustments €000 57 11

Cost of sales Monetary working capital Depreciation

32 100 x 10.3% = 10

8 Current cost reserve 30 June Year 4 Balance at 1 July Year 3 Net increase arising during Year 4 on the restatement of assets to current cost: Land Plant and machinery Inventory Cost of sales adjustment Monetary working capital adjustment Depreciation adjustment Gearing adjustment

€000 271

338 33 57 11 32 (10) 461 732

Balance as at 30 June Year 4

Chapter 8

 1

There are those who regard it as essentially a practical activity. Certainly, like any service industry, financial reports have to have a practical usefulness. It is also fair to say that financial reporting cannot be theorized about in the sense that pure science can be. However, in our view, theorizing about financial reporting is essential, for two main reasons. First, it will help to produce more consistent and therefore, hopefully, more useful treatments of accounting difficulties. Second, it will make clear to us all

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN what uncertainties and subjectivities still remain. Knowledge of one’s weaknesses is always useful!

 2

To paraphrase the question, the proposition is that we need to know what tends actually to happen, so that we can discuss what should happen instead in an informed, sensible and knowledgeable way, but automatic acceptance of what does actually happen is not acceptable. Discussion needed; we would agree with the proposition. Scope for debate here, of course. Briefly, major points would seem to be the following. ■ ■ ■

It provides consistent definitions and relevant considerations, which can help provide consistent and related approaches in particular standards. It is out of date and does not adequately reflect current thinking. It suggests outcomes which do not always seem intuitively sensible or useful (and are not always followed in Standards, for example a deferred government grant is not a liability, but this is allowed by the relevant Standard at the time of writing). It could be improved by updating and developing certain issues, notably the concept of fair value, which essentially post-dates 1989 and, further, is not treated consistently across recent Standards. Whether the way in which revenues and expenses are defined in a manner secondary to the definitions of balance sheet items, rather than the other way round, remains a debatable point.

This relates to the so-called ‘cookbook’ approach. IASB Standards claim to be principles based, rather than seeking to cover all eventualities, although this claim is not always justified. The collapse of Enron has given a boost to the idea of principles-based regulations, even in the USA. However, fundamental traditions and attitudes to law, life and regulation are involved here.

We guess not, except possibly as regards attitudes to the importance, or otherwise, of prudence.

Chapter 9 1

There are several reasons why fixed formats can be helpful, provided always that additional subsets of data can be inserted when unusual situations require it. It facilitates comparison and analysis and reduces the risk of non-specialists being deliberately confused by unusual presentations. The reason why several different formats are allowed, and are frequently found, is essentially

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN historical. National norms, often related to original user needs and attitudes, are still important.

 2

It is often argued that realized results must be distinguished from the results of valuation changes or capital-related movements and that the best way to do this is to produce two separate statements. The trouble with this in practice is that the existence of two statements may enable managers to put more favourable elements in the more high-profile statement (i.e. the income statement) and less favourable items in the other statement. Discussion generally.

There is strong evidence that such an assumption is not valid. But this leads to a more fundamental question, i.e. who are the financial statements prepared for - experts or the mass public? Experts can certainly be assumed to understand the intricate nuances of detailed accounting notes.

The essential point behind these new developments is to distinguish normal earnings from other increases in ownership equity. The IASB has been having considerable trouble in arriving at a coherent policy for distinguishing exactly where on the spectrum on normality and repeatability, particular types of transaction lie and the process is not complete. The 2007 version of IAS 1 goes part way down this road. Students should comment on the readability and usefulness of the particular presentations which they find in looking at different countries, attempting to take the viewpoint of a genuine user of the financial statements.

Chapter 10 1

Your answer to this will obviously depend on which enterprise you choose. However you should assess the information provided by the enterprise in terms of: ■ ■ ■ ■

relevance reliability understandability comparability.

You should also assess the usefulness of any additional information provided by the enterprise in the annual report, such as environmental information and forecasts. The question is also not specific about which user, so you will have to assess the information from the position of various users. 2

As a potential shareholder you would probably be seeking

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN information on the future prospects of the enterprise so that you can assess the potential for growth in your investment, both revenue and capital wise. Performance indicators such as those provided under ‘intellectual capital accounting’ would enable you to make a more detailed assessment of performance both internally and externally. Depending on your own personal agenda, you might wish to seek information such as that provided in ‘social corporate reports’. Added value statements will also provide you with an at-a-glance review of how the earnings of the enterprise are divided between shareholders, employers, government and internal reinvestment. 3

The value added statement shows that a very high proportion (77%) of the earnings is distributed to employees and that shareholders have a limited share, although this is higher than that retained in the business. The payment to lenders is relatively low, so we could perhaps conclude that the business is fairly low geared but for a proper assessment of this we would need to look at gearing ratios. The performance of the enterprise has only slightly improved on that of last year, growing by only 0.4%, but this has been achieved in a climate of increased cost of materials and a steep increase in depreciation charges. It is possible the enterprise has revalued its fixed assets or that it has increased its fixed assets through purchase/acquisition last year and the depreciation is only coming into full effect this year. It is, of course, very dangerous to draw any conclusions from just one statement provided by the enterprise and the value added statement must be assessed along with all other information.

The answer depends on which enterprise is chosen. Employees will be seeking information on future plans, as they are concerned with job security, continuation of a rising wage/salary to combat the effects of inflation on their personal finances, profit sharing. Examples are: ■ ■ ■ ■ ■ ■

state of the firm’s order book earnings per share and price earnings ratio value added statements details of profit-sharing schemes forecasts of future capital expenditure future plans for: - growth or retrenchment - acquisition or disposal - any moves towards further reduction in employee numbers etc.

The appraisal should be made from the aspect of placing reliance on the information provided. The annual financial

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN statements are accompanied by an auditor’s statement attesting to the truth and fairness of the information. The additional information is not subject to the same statement. You have to judge whether the information provided would be misleading without this auditor’s statement.

 6

This can be answered by determining the advantages and disadvantages of providing additional information. Advantages: ■ promotion of harmony between users and management ■ better educated users ■ possibly easier change management ■ possible influence on users ■ users having more relevant information on which to base their decisions. Disadvantages: ■ risk of providing information to competitors ■ possibly misleading as they are management opinion of the future in many cases ■ not audited ■ may not be produced at the appropriate level e.g. plant level, department level ■ increases costs.

 7

The answer here is similar to the disadvantages listed in question 6. Overcoming these disadvantages is something entities are currently working on evidenced by moves towards environmental and social report auditing.

Financial reporting is about providing useful information to users for them to make decisions. This must involve more than numbers or the decisions taken will be flawed.

Deliverable: ■ statement of environmental objectives and aims ■ compliance or not with company targets ■ environmental expenditure, e.g. waste collection ■ contingent liabilities ■ environmental audit. Desirable: ■ prospective environmental segmental basis ■ value-for-money data.

expenditure

Never deliverable: ■ ■

financial consequences of becoming an environmentally sustainable company effects of environmental expenditure on share price

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN etc. 10

The student should detail the development of CG from Cadbury through to the combined code. Whether the reports and codes have improved CG over time is a matter of opinion. Students should comment on the economic world crisis of 2008 and whether, even with further reporting requirements and more detailed disclosures, this crisis would have been avoided or minimised. The reports and codes have to some extent increased disclosure and the transparency of strategic decisions, internal controls and risk management but many would agree there is still a long way to go to meet the needs of stakeholders in the 21st century. It is also possible for businesses to presently pay lip service to the codes as much involves a tick box approach. Students should use this question as a research topic and search for relevant academic articles to support their answer.

The developments in CSR are amply covered in the text. The main issue is that the conventional FR framework makes no or little allowance for CSR and many businesses view CSR as distinct from FR. In addition CSR as it is currently produced lacks comparability, relevance and reliability. Whether such reporting alleviates social and environmental problems is questionable but it is a chain in the link to ensure that businesses take account of such issues in their business decisions. Students should use this question as a research topic and search for relevant academic articles to support their answer.

Again amply covered in the text but to reiterate the principles are: Integrity, objectivity, professional competence and due care, confidentiality, professional behaviour; and the threats are: self-interest, intimidation, self review and familiarity. Activity 10.12 covers the threats in more detail.

Chapter 11



(a) There are more than five ratios that will monitor operational performance. We provide six for you. ROCE 20X1 20X2 20X3

Alpha plc 957/4914 = 19.5% 1209/5652 = 21.4% 1409/7628 = 18.5%

Omega plc 240/7900 = 3.0% 360/8120 = 4.4% 640/9240 = 6.9%

Return is calculated by adding operating profit and investment income.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Capital employed is calculated by adding overdraft and short-term loans to total assets less current liabilities, as the interest payable in the P&L data is not separated into long- and short-term interest payable. Profit to sales 20X1 1157/16929 = 6.8% 20X2 1453/19036 = 7.6% 20X3 1685/20915 = 8.1%

440/16320 = 2.7% 560/15260 = 3.7% 860/19540 = 4.4%

The nearest figure to gross profit we can achieve from the data is operating profit and depreciation, so this figure is used in the above calculation. Asset utilization - sales to capital employed 20X1 16929/4766 = 3.55 16320/7660 = 2.13 20X2 19036/5451 = 3.49 15260/7840 = 1.95 20X3 20915/7394 = 2.83 19540/9020 = 2.16 Note that capital employed is the figure used in the ROCE calculation less the amount of investments, as sales income is not generated from investments. Stock turnover 20X2 1265/19036 = 24 days 20X3 1359/20915 = 23 days

2290/15260 = 54 days 3160/19540 = 59 days

Average stock is used in the above calculation. Stock has to be compared to sales here as we have no information in respect of cost of sales. Debtors’ turnover 20X1 57/16929 = 1 day 20X2 54/19036 = 1 day 20X3 65/20915 = 1 day

2040/16320 = 46 days 1920/15260 = 46 days 2660/19540 = 50 days

Note that average debtors figures could have been used in the above calculations. Creditors’ turnover 20X1 1381/16929 = 30 days 20X2 1521/19036 = 29 days 20X3 1651/20915 = 29 days

1020/1630 = 23 days 1620/15260 = 39 days 2700/19540 = 50 days

Again average creditors figures could have been used in the above calculations. The sales figures have to be used as we do not have information in respect of cost of sales. (b) Key ratios to monitor financial statements are as follows: Gearing 20X1 20X2 20X3

757/4157 = 18.2% 914/4738 = 19.3% 3534/4094 = 86.3%

7040/860 = 818% 6980/1140 = 612% 7720/1520 = 508%

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Debt is taken to be preference shares, long-term creditors, provisions, overdraft and short-term loans in the above calculations.

(c)

Current ratio 20X1 2017/2749 = 0.7 20X2 1978/2943 = 0.7 20X3 2567/3472 = 0.7

8060/3580 = 2.3 8940/3840 2.3 11240/5700 = 2.0

Acid test 20X1 20X2 20X3

6020/3580 = 1.7 6400/3840 = 1.7 7460/5700 = 1.3

800/2749 = 0.3 666/2943 = 0.2 1162/3472 = 0.3

The ratio analysis carried out above identifies the following:  Alpha has a much higher ROCE than Omega, but Alpha’s is falling, whereas Omega is rising.  Alpha has a higher margin on operating profits than Omega. However, Omega’s has nearly doubled in three years.  Alpha’s asset utilization is better than Omega’s but Omega’s is rising, whereas Alpha’s is falling.  Alpha appears to operate almost entirely by cash sales whereas Omega allows 50 days for debtor’s payment.  Creditor periods are one month for Alpha but two months for Omega. Note Omega’s does match its credit given period.  Alpha’s gearing is low when compared to Omega’s, but an increase occurred in 20X3 when preference shares were issued to finance expansion. Omega’s gearing is very highly although it has started to fall.  Not much change has occurred for both companies throughout the period in their liquidity. Alpha’s is lower than Omega’s but as it has been at this low level for three years then one would assume the business is viable. Omega’s liquidity is high and therefore too many resources are tied up in current assets. Overall Alpha benefits from high margins, high asset turnover and good use of working capital. The preference share issue has increased gearing but this is not a danger levels and could be expected to decrease as profits increase from the additional resources. Omega has low margins and low asset turnover and maintains high working capital in debtors and slow-moving stocks. Omega’s high gearing makes it sensitive to interest changes.

(d) Alpha, given its debtor strategy, high margin and high turnover may well be in the food retailing sector. Omega

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN may be a manufacturer in the engineering industry or something similar. (e) Improvements to financial statements. We have discussed these throughout this chapter and elsewhere in this book. Summarizing we would suggest that:  more relevant and reliable information is required that enables predictions to be made  that historical cost is not a suitable base, deprival value may be more relevant  that the change in the value of the pound over a period does not permit useful comparisons to be made  that the information is not timely enough  that different accounting policies used by companies distort the comparison. The constraints on the implementation of these improvements are centred around the problems of:  providing sensitive commercial information within the public domain  the subjectivity involved in measurement if historical cost is abandoned  identifying accounting policies that would reflect a true and fair view of the entities  identifying a conceptual accounting framework. 2

A supermarket is a commercial company whose objective it is to buy goods from manufacturers or wholesale companies and to sell it with a profit to the customers who is the end user of the product. A manufacturer is an industrial company, buying materials and components from other industrial companies or wholesalers and transforming these elements into finished or semi-finished products which are sold to either commercial or other industrial companies. Supermarkets are efficient when they have a high turnover rate of their products. Further in comparison to industrial companies, their customers pay most of the time immediately. Supermarkets have quite some buying power and therefore they can extend the payments to their suppliers. Probably supermarkets will have less resources tied up in inventory, they will have lower amounts under the heading receivables and they might have larger amounts under the heading suppliers than their industrial counterpart. Of course all this should be expressed in relative terms.

Question: You are required to comment on the financial position of Olivet Ltd as at 20X5. Calculate any ratios you feel necessary. Olivet Ltd

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Ratios return on capital employed

20 + 5 = 88.5

GP percentage NP percentage sales to capital employed return on owners’ equity gearing ratio current ratio acid test debtors’ turnover period creditors’ turnover period stock turnover period dividend cover interest cover

20X4 28.2%

50% 20% 1.13 52% 56.5% 49/30 = 1.6:1 0.72:1 73 days 146 days 201 days 2 5

10 + 7.5 = 129.5

40% 10% 0.77 18.3% 57.9% 57.5/42 = 1.37:1 0.6:1 91 days 182.5 days 198 days 1 2.3

From the information given in the question we can identify that • sales have remained static but cost of sales has increased • expenses other than interest have been slightly reduced • dividend has remained at 20X4 level even though profits were reduced; in fact in 20X5 all the profits earned have been paid out in dividend • land appears to have been revalued as the revaluation reserve has increased by £10 000 • further buildings, equipment and investments have been purchased during 20X5 • stock, debtors and creditors have all increased in 20X5 • there is a bank overdraft in 20X5. The above suggests that Olivet has attempted to expand by purchasing further fixed assets but this does not appear to have produced extra sales. Ratios of all types have worsened: indeed, the ROCE has halved, as has the net profit percentage. The return on owners’ equity has fallen sharply and the current dividend policy appears rather imprudent. It is possible that Olivet increased its investment in fixed assets towards the end of the year and so they will not have generated revenue for a full year. However, even if this is the case the decline in the profit percentages is still a potentially dangerous situation. 4

(a) This company has a number of features which appear unusual at first sight. The most obvious is that there are hardly any debtors. On the other hand the company seems to have over £2m as cash, in hand as well as positive bank balances. The stock turnover period is also short. In one sense this demonstrates a remarkably efficient organization. Stock is sold quickly, sales are paid

20X5 13.5%

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN for very quickly indeed – and creditors appear willing to wait for their money. The effect of this on the balance sheet is to produce a total of current assets which is very much lower than the current liabilities, which gives the impression of a very illiquid business. But the positive aspects of this situation surely outweigh the possible negative ones. Much of the company’s activities are being financed, presumably interest free, by the creditors! If we take the given figures literally, it appears that the company buys stock, sells it and makes its profit 21 days later, actually receives the sales proceeds 23 day’s after the purchase, but does not have to pay for its original purchase for another seven days after that. Gearing has risen by 5400%, but this figure is quite meaningless as it was virtually zero in 1991. Gearing is still low, there are enormous fixed assets which are presumably available as security for any further required borrowings, and the company has a large and apparently regular positive flow of funds trom its trading operations. In reality the company seems to have cash available on tap whenever it wants it. From a profitability point of view the position also seems very sound. Profit to sales may not be all that high, but the sales volume is clearly great, and profit to capital is good. It is hard to criticize EPS of 16 pence on a 10 pence nominal value share. It is important to note that the ROCE and ROOE figures given could be misleading if not interpreted carefully. The ROCE is before tax and the ROOE is after tax. Further, the ROOE relates to all shareholders. The enquiry here explicitly relates to an ordinary shareholder. A return on ordinary shareholders’ interest should perhaps be calculated. This might be 31 142 = 21.8% As an overall comment the company, probably in the retail or cash-and-carry sector, seems in a very strong position and there seems no reason to rush out and sell ordinary shares. (b) (i)

This is quite straightforward. The loan redemption fund represents a sum of money which is being put aside, obviously by transfer from the firm’s bank account, for the purpose of redeeming the loan related to it. The fund may simply be sitting in some separate bank or investment account, or perhaps invested in some kind of insurance policy.

(ii) An asset can be defined as a resource possessed or controlled by the business which is expected to benefit the business and which has reached the business through some market transaction. Thus something does not have to be in use to be an

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN asset: it merely has to be expected to be useful at some future time. The £49m therefore certainly represents assets. The point relating to these assets not being in use is that the process of depreciation should not yet have begun. Depreciation applies the matching principle in relating expenses to benefits. Since these assets are not yet in use there are not yet any benefits. Therefore there should not yet be any expenses, there will be no depreciation and therefore no effect on the reported profit. (iii) What is happening with the capitalisation of interest is that a transfer is being made from interest expense account to an asset account, almost certainly to a fixed asset account. This of course has the effect of increasing this year’s profit. It also increases the total recorded cost of the fixed asset, and therefore increases the amount which will be depreciated over the life of the asset. Expense is therefore being deferred rather than avoided. The rationale for doing it is the perfectly defensible one that the interest arises from loans taken out to finance the relevant fixed asset and so represents a part of the cost of acquiring that fixed asset. This argument can be criticized however, e.g. on the grounds that the link between loan and fixed asset is at best tenuous, and generally that the treatment lacks prudence. 5(a) 1991

1990

Current ratio

30 500 –––––– =127 24 000 16 500 –––––– =069 24 000 14 000 –––––– x 365 = 122 days 16 000 –––––– x 365 = 97 days 60 000 24 000 –––––– x 365 = 209 days 42 000 18 000 –––––– = 30% 60 000 300 –––––– = 0.5% 60 000 2 500 –––––– = 1.14 2 200

Quick assets ratio Stock (number days held) Debtors (number of day’s outstanding) Creditors (number of’ days outstanding) Gross profit % Net profit % (before taxation) Interest cover

28 500 –––––– =143 20 000 15 500 –––––– =078 20 000 13 000 –––––– x 365 = 140 (lays 15 000 –––––– x 365= 109 days 50 000 20 000 –––––– x 365 = 215 days 34 000 16 000 –––––– = 32% 50 000 1 700 –––––– = 3.4% 50 000 3 000 –––––– = 2.31 1 300

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Dividend cover ROOE (before taxation) ROCE Gearing

(b)

–50 –––––– = –0.08 600

1 100 –––––– = 1.83 600

300 –––––– = 2.3% 13 000 2 500 –––––– = 13% 19 000 6 000 –––––– = 32% 19 000

1 700 –––––– = 12% 14 000 3 000 –––––– = 15% 19 500 5 500 –––––– = 28% 19 500

The general position in 1990 might be characterized as dull. All the turnover ratios are high, especially creditors turnover, although this may partly be a question of the industry involved. Current and quick ratios are probably safe enough provided of course that the going-concern convention can be assumed, i.e. that we can assume the operating cycle will continue in the normal way. Profits and returns are distinctly unexciting, gearing is not excessive. In 1991 the position has clearly worsened. Turnover ratios are all slightly lower, the net effect being a fall in the current and quick assets ratios. Turnover has increased substantially, at least in money terms, but cost of sales has increased more than in proportion. Perhaps the most significant events relate to gearing and interest. Borrowing has increased somewhat, but interest expense has increased very substantially indeed; the interest cover ratio shows a very shaky Position. The other important point to emphasize is that the dividend payment is being fully maintained in spite of the complete absence of available profits from this year’s trading.

Chapter 12 1

Please refer to text. Note the emphasis on intended usage, rather than on the physical nature of the particular item.

Please refer to text. Note the significance of allocating the cost over the useful life in proportion to the benefit, i.e. the pattern of expected benefit is theoretically crucial. The relevance or otherwise of other ancillary expenses to the depreciation process is also important.

It seems to us that the logical answer is yes. There is a practical argument against this, in that it can be said to lead to a lack of comparability for similar assets where one company receives a grant and another company does not. Contrariwise, facts are facts and, if company A has a net cost lower than company B because A received a grant, what can be wrong with recording this situation?

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 4

Provided that the terms under which the grant is received have been fully met, the answer has to be no, as the IASB definition of a liability will confirm. The allowed treatment of showing ‘deferred income’ as a liability is therefore not logical.

Different views are likely to emerge here. Essentially, the matching principle may logically justify capitalisation, but prudence would point against it. If financial statements are regarded as primarily for creditor purposes, then capitalisation is likely to be regarded as unacceptable.

 6

 7

It certainly seems useful, and consistent, to require the revaluation of land, which, after all, does not depreciate. Such information increases relevance, but arguably at some sacrifice of reliability. Discussion needed. This is more difficult. There are two arguments in favour of requiring the revaluation of buildings. First, it makes balance sheet numbers more relevant and, second, through the resulting increase in depreciation changed to up-to-date cost levels, it makes the reported profit a better estimate of long-run future performance. Note that the resulting reported operating profit, being usually lower, is more prudent when upward revaluation takes place. But, again, there are reliability considerations.

If the buildings are current assets, which is quite possible, then depreciation is definitely not logical. For investment properties, we are into the general ‘fair value’ debate, about which strong, and different, views are likely to be found. If regular fair values are to be recognized, then again depreciation is not appropriate. However, if it is considered that the physical characteristics of an asset are more important than its intended use by management, the preceding arguments will be rejected.

A choice is not desirable and from our views on question 8 that the fair value treatment is the one that should be consistently required. Other views are very possible! (i) For many years there has been a fairly even debate as to whether borrowing costs should or should not be capitalized. Arguments in favour of capitalisation are: Borrowing costs are in principle no different to other costs that do qualify for capitalisation, thus capitalisation is consistent with the treatment of other costs. The accrual/matching concept intends that income generated in a period should be matched with the costs incurred in earning that income. Capitalisation of borrowing costs achieves this, as the depreciation of an

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN asset would include a proportion of the borrowing cost. It has been argued that for companies that construct their own assets, the inclusion of borrowing cost, gives a more consistent basis for comparison with those companies that choose to buy their assets. This is based on the presumption that the manufacturer of an asset would include interest as part of the costs it is trying to recover within the selling price. Arguments against capitalisation are: Interest is the cost of borrowing money over time and should be charged to the period to which it relates rather than a future period. It can create inconsistency. The same type of asset can have different costs depending upon the method of finance. In practice it is not always possible to determine how an asset has been financed. This is specifically true where an asset is financed from ‘general’ borrowings rather than specific borrowings. There is also the issue of whether ‘notional’ borrowings should be capitalized. Even where capitalisation of interest is permitted, it must cease when the asset is completed and ready for use. However the financing cost of an asset continues over its life. This again creates inconsistency. It is believed to be more prudent. In summary there are both valid arguments for and against capitalisation, It seems the IASB, in making noncapitalisation the benchmark treatment, comes down in favour of the arguments against, but in having an allowed alternative, it does not rule it out altogether. (ii)

The amount capitalized at the end of the year of $12 million would give an average carrying amount of $6 million ($12 million/2) throughout the year (based on an even expenditure through the year). The cost of borrowing should be based on the weighted average cost of the funds used specifically to finance similar projects: ($2 million x 15% + ($3 million x 8%) + ($5 million x 10%) ($2 million + $3 million + $5 million)

= 10.4%

IAS 23 says capitalisation should be suspended during an extended period of interruption of development. However, this does not apply to a necessary temporary delay. Although judgement is needed to interpret this requirement, it would seem that the two-week delay is a necessary delay, but the two-month delay would seem to be a period where capitalisation should be suspended. Thus the period of capitalisation is 10 months. This gives a calculation of:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN $6 million x 10.4% x 10/12

$520 000.

 10 Errsea – income statement extracts year ended 31 March 2007 Loss on disposal of plant – see note below ((90,000 – 60,000) – 12,000) Depreciation for year (wkg (i)) Less: Government grants (wkg (iv))

$ 18,000 75,000 (19,000)

Note: the repayment of government grant of $3,000 could alternatively have been included as an increase of the loss on disposal of the plant. Errsea – balance sheet extracts as at 31 March 2007

cost $ Property, plant and equipment (wkg (v)) Non-current liabilities Government grants (wkg (iv)) Current liabilities Government grants (wkg (iv))

360,000

accumulated depreciation $ 195,000

39,000 27,000

Workings (i) Depreciation for year ended 31 March 2007 On acquired plant (wkg (ii)) Other plant (wkg (iii))

$ 52,500 22,500 75,000

(ii) The cost of the acquired plant is recorded at $210,000 being its base cost plus the costs of modification and transport and installation. Annual depreciation over three years will be $70,000. Time apportioned for year ended 31 March 2007 by 9/12 = $52,500. (iii) The remaining plant is depreciated at 15% on cost (b/f 240,000 – 90,000 (disposed of) x 15%)

$ 22,500

(iv) Government grants Transferred to income for the year ended 31 March 2007: From current liability in 2006 (10,000 – 3,000 (repaid)) From acquired plant (see below):

carrying amount $ 165,000

$ 7,000 12,000 19,000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Non-current liability b/f transferred to current on acquired plant (see below)

$ 30,000 (11,000) 20,000 39,000

Grant on acquired plant is 25% of base cost only = $48,000 This will be treated as: To income in year ended 31 March 2007 (48,000/3 x 9/12) Classified as current liability (48,000/3) Classified as a non-current liability (balance)

12,000 16,000 20,000 48,000

Note: government grants are accounted for from the date when the qualifying conditions for the grant have been met.. Current liability Transferred from non-current (per question) On acquired plant (see above)

11,000 16,000 27,000

(v) cost $

accumulated depreciation $

carrying amount $

Property, plant and equipment Balances b/f Disposal Addition (wkg (ii)) Other plant depreciation for year (wkg (iii))

240,000 (90,000) 210,000

180,000 (60,000) 52,500 22,500

60,000 (30,000) 157,500 (22,500)

Balances at 31 March 2007

360,000

195,000

165,000

11 (a) The issue of depreciation of properties is dealt with in IAS 16 – Property, plant and equipment – and IAS 40 – Investment property. IAS 16 states that all property, plant and equipment with finite useful economic lives should be depreciated over those estimated lives. IAS 16 further states that land generally has an infinite useful economic life but that buildings have finite useful economic lives. IAS 16 requires that properties be split into components for depreciation purposes, the buildings component being depreciated but the land component not being depreciated. A depreciation calculation is therefore obligatory, but it is perfectly possible, especially perhaps with property, for the “depreciable amount” (i.e. cost less estimated residual value) to be negative. In such case the correct annual depreciation charge would be nil. This seems likely to be the case here, but the words used in the scenario are not explicit, as they seem to focus on the relatively short term.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Property 3 is being held for investment purposes and so is governed by the provisions of IAS 40. IAS 40 gives entities a choice regarding the accounting treatment of investment properties. One possibility is to use the ‘cost model’. If this model is used then the properties are dealt with in accordance with IAS 16. In this case, then as already explained, a depreciation calculation would be required. The other possibility is to use the fair value model. Under this model investment properties are measured at their fair values at each balance sheet date, with changes in fair value being reflected in the income statement. Therefore if the entity chooses the fair value model it would be unable to depreciate property 3. (b) All three properties can either be valued using the cost model or using the fair value model. Under IAS 16 (applicable for properties 1 and 2) a model is applied to property, plant and equipment on a class by class basis. Properties would be regarded as a separate class of property, plant and equipment. As stated in part (a), under IAS 40 (applicable for property 3) either model would be applied to all investment properties. Property 1 Where the cost model is used, upward changes in market value would be ignored. Where the fair value model is used, surpluses should be credited directly to equity. Therefore for the both years a surplus of $1 million would be credited to equity in respect of property 1. Property 2 Where the cost model is used, the increase in the year to 30 September 2005 would be ignored and the carrying amount retained at $10 million. The fact that the market value had declined to $9 million by 30 September 2006 may well indicate that the property has suffered impairment and an impairment review would certainly be necessary. If the fair value model is used, the surplus of $1 million in respect of property 2 in the year to 30 September 2005 is taken to equity as already explained for property 1. Where a revaluation results in a deficit then the appropriate treatment depends on whether or not there is an existing surplus in the revaluation reserve relating to the same asset. To the extent that there is, then the deficit is deducted from the revaluation reserve as a movement in equity. Any other deficit is charged to the income statement as it arises. Therefore the treatment of the deficit of $2 million arising in the year to 30 September 2006 is to deduct $1 million from equity (the revaluation reserve) and $1 million from income. Property 3

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN As already explained in part (a) the appropriate treatment of the surpluses ($1·5 million in the year to 30 September 2005 and $1 million in the year to 30 September 2006) depends on whether the cost model or the fair value model is used for investment properties. Where the cost model is used then the surpluses would be ignored but where the fair value model is used they would be taken to the income statement. 12

Transaction 1 Cost of production plant

Component Basic costs Sales taxes Employment costs Other overheads Dismantling costs

Amount $’000 10,000 ─ 800

Reason (as per IAS 16 – Property, Plant and Equipment) Purchase costs included Recoverable taxes not included Employment costs in period of getting the plant ready for use Abnormal costs excluded Recognised at present value where an obligation exists

600 1,360 13,260

Depreciation charge (income statement – operating cost) Per IAS 16 the asset is split into two depreciable components: 3,000 with a useful economic life useful economic life of four years 10,260 (the balance) with a useful economic life of eight years So the charge for the year ended 31 March 2007 is 3,000 x 1/4 x 10/12 + 10,260 x 1/8 x 10/12 = 1,694 Carrying value of asset (balance sheet – non current assets) 13,260 – 1,694 = 11,566 Unwinding of discount (income statement – finance cost) 1,360 x 5% x 10/12 = 57 Provision for dismantling (balance sheet – noncurrent liabilities) 1,360 + 57 = 1,417 Transaction 2 Under the provisions of IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations – the property would be classified as held for sale at 31 December 2006. This is because the intention to sell the property is clear and active steps are being taken to locate a buyer, with the property being marketed at a reasonable price. In addition

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN there is a clear expectation that the sale will be completed within 12 months. Where non-current assets are held for sale they need to be initially measured using up-to-date values under the current measurement basis that is being applied. In this case this is the revaluation model. The carrying value based on the latest valuation is $14·76 million ($15 million – ($8 million x 1/25 x 9/12)). This needs to be updated to market value at the date of classification as held for sale – $16 million. Therefore $1·24 million ($16 million – $14·76 million) is credited to the revaluation reserve. When the asset is classified as held for sale it is removed from non-current assets and presented in a separate caption on the balance sheet. The (non-mandatory) guidance in IFRS 5 shows this immediately below the current assets section of the balance sheet. The asset is measured at the lower of its existing carrying value ($16 million) and its fair value less costs to sell ($16 million – $500,000 = $15·5 million). In this case the asset is written down by $500,000 and this is recognised as an impairment loss in the income statement. No further depreciation is charged. At the year end the carrying value of the asset is the lower of the previously computed amount ($15·5 million) and the latest estimate of fair value less costs to sell ($15·55 million – the actual net proceeds). In this case no further impairment is necessary. The sale is recognised (and the revaluation reserve realised) on 30 April 2007 and will therefore impact on next year’s financial statements.

Chapter 13

 1

Intuitively, it seems to us that goodwill is an asset. The only difficulty with this, given IASB definitions, is whether or not an enterprise can control goodwill. It certainly can be expected to give benefit.

The general desirability of consistency would certainly support this proposition. Identifiable intangibles (which excludes goodwill) can usually be bought and sold just as easily as tangible assets. Often, however, they have no value on a forced disposal and this difference may be important to lenders and creditors.

This is all in the text of Chapter 13. Discussion and debate - and disagreement - are likely to result.

This proposition is not logical. Depreciation is about the allocation of cost (whether historical or current). Impairment is about the recoverability of unallocated

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN costs, i.e. a more forward-looking concept. The relationship between the two during the useful life is unpredictable. Only at the end of the useful life should we logically expect a relationship. 5

(i) Refer to the text. (ii) All of the necessary criteria seem to have been met by CD’s new process:    

It is technically feasible, it has been tested and is about to be implemented; It has been completed and CD intends to use it; The new process is estimated to increase output by 15% with no additional costs other than direct material costs; The expenditure can apparently be measured.

CD will treat the €180,000 development cost as an intangible non-current asset in its balance sheet at 30 April 2006. Amortisation will start from 1 May 2006 when the new process starts operation.

Chapter 14



This proposition is not logical. Depreciation is about the allocation of cost (whether historical or current). Impairment is about the recoverability of unallocated costs, i.e. a more forward-looking concept. The relationship between the two during the useful life is unpredictable. Only at the end of the useful life should we logically expect a relationship.

It is the higher of net realizable value and value in use (i.e. economic value).

The answer is D. Workings The overall impairment loss is $2 million [$27 million - $25 million]. This loss is first allocated to the asset that has suffered obvious impairment, leaving the balance of $1 million to be allocated to goodwill.

The answer is C. Workings The carrying value of the income generating unit in the consolidated accounts immediately before the impairment

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN review is: Unamortized goodwill [9/10 ($110 million - $100 million)] Net identifiable assets

$m 9 95 104

Therefore, the impairment loss is $8 million ($96 million $104 million). 5 (a) (i) An impairment loss arises where the carrying value of an asset, or group of assets, is higher than their recoverable amounts. IAS 36 says that assets should not appear on a balance sheet at a value which is higher than they are ‘worth’. The recoverable amount of an asset is defined as the higher of its net realizable value (i.e. the amount at which it can be sold for net of direct selling expenses) or its value in use (i.e. its estimated future net cash flows discounted to a present value). The Standard recognizes that many assets do not produce cash flows independently and therefore the value in use may have to be calculated for a group of assets - a cash-generating unit. The Standard recognizes that it would be too onerous for companies to have to test for impaired assets every year and therefore only requires impairment reviews when there is some indication (as described in (ii) below) that an impairment has occurred. Where any of the factors described below are relevant, an enterprise needs to make a formal assessment of the recoverable amounts of the potentially affected assets. The exception to this general principle is where goodwill or other intangible assets are being depreciated over a period of more than 20 years, in which case an impairment review is required at least annually. (ii) Impairments generally arise where there has been an event or change in circumstances. It may be that something has happened to the assets themselves (e.g. physical damage) or there has been a change in the economic environment relating to the assets (eg new regulations may have come into force). The Standard gives several examples of indicators of impairment which may arise from external or internal sources: - a significant decline in an asset’s market value (in excess of normal depreciation though use or the passage of time) - significant adverse changes on the enterprise. Evidence

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN of obsolescence (through market changes or technology) or physical damage. Problems in the economic or legal environment such as the entrance of a major competitor, loss of key employees or major customers, new statutory or regulatory rules - evidence of a reduction in the useful economic life or estimated residual value of assets - increases in long-term interest rates (this could materially impact on value in use calculations thus affecting the recoverable amounts of assets) - poor operating results. This could be a current operating loss or a low profit. A poor result for one year in itself does not necessarily mean there has been an impairment, but if there have been other recent losses or there are expected future losses then this is an indication of impairment - adverse changes in an indicator of value that has been used to value an asset (e.g. on acquisition a brand may have been valued on a ‘multiple of sales revenues’ and subsequently sales were below expectations) - the commencement or a future commitment to a significant reorganization or restructuring of the business is likely to have an effect on the assets that belong to that part of the business - where the carrying amount of an enterprise’s net assets is more than its market capitalisation. The Standard also points out that where there is an indicator of impairment, this may also indicate that there is a need to revise the life of an asset or its depreciation policy even if there is no recognized impairment. (b)

(i) If the company decides to replace the plant in the near future then it will only receive net sale proceeds of $50 000. On this basis it is clear that an impairment loss of $350 000 should be recognized. If Avendus intends to continue to use the asset it is necessary to determine the recoverable amount of the plant. To do this would require an assessment of the value in use of the plant. As the plant does not produce independent cash flows, the recoverable amount of the cash-generation unit of which it forms part must be investigated. From the question, the cash generation unit is not impaired as its value in use is $2 million more than its carrying value ($7 million $5 million). On this basis the plant is not impaired. However, as the information in the question indicates there would need to be an assessment of the depreciation policy for the plant, in particular there appears to be a need to depreciate it over a shorter estimated life.

(ii)

This is an example of economic and market factors which may indicate impairment. The recoverable amount of the property will depend upon the company’s cost of capital. Currently it is 10% per annum and at this rate the discounted cash flows from the rentals is $168 000 (40 000 - (40000 - 3.2)). If the expected interest rate rise occurs, this will cause the company’s cost of capital to rise

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN to 12%, and the recoverable amount of the property would fall to $160 000 (40 000 - (40000 - 3)). IAS 36 requires the discount rate to be based on a current assessment of the time value of money, thus $160 000 should be taken as the asset’s value in use. On this basis the net realizable value of $165 000 is higher than its value in use and an impairment loss of $35 000 (200 000 - 165000) should be recognized. (iii)

Carrying value impairment restated value Goodwill Fishing quotas Fishing boats Other fishing equipment Fishing processing plant Net current assets

$000 240000 400000

$000 (240000) not impaired

$000 nil 400000

1000000 100000

(550000) (10000)

450000 90000

200000

not impaired

200000

60000

not impaired

60000

2000000

(80000)

1200000

The impairment loss of $800 000 ($2 million - $1.2 million) is first allocated to any obviously impaired assets ($50000 to the boats as one has been lost), then to goodwill (as it is considered an asset of subjective value), then to the remaining assets on a pro-rata basis. However, no asset can be written down to less than its net realizable value, thus in this example the quotas and the fish processing plant are not impaired. As the net current assets are receivables and payables (monetary) they should not suffer any impairment. Applying this means the remaining assets to be written down are $600 000 (boat at $500000 and the other fishing equipment at $100 000) the remaining impairment loss is $60000 ($800 000 $500000 $240000) which represents a write down of 10% ($50 000 for the boat and $10 000 for the other fishing equipment). The impairment exercise does not require assets that have a realizable value greater than their carrying value to be revalued upwards. 6

See text in the chapter.

7 (a) (i) An impairment loss arises where the carrying amount of an asset is higher than its recoverable amount. The recoverable amount of an asset is defined in IAS 36 Impairment of assets as the higher of its fair value less costs to sell and its value in use (fair value less cost to sell

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN was previously referred to as net selling price). Thus an impairment loss is simply the difference between the carrying amount of an asset and the higher of its fair value less costs to sell and its value in use. Fair value: The fair value could be based on the amount of a binding sale agreement or the market price where there is an active market. However many (used) assets do not have active markets and in these circumstances the fair value is based on a ‘best estimate’ approach to an arm’s length transaction. It would not normally be based on the value of a forced sale. In each case the costs to sell would be the incremental costs directly attributable to the disposal of the asset. Value in use: The value in use of an asset is the estimated future net cash flows expected to be derived from the asset discounted to a present value. The estimates should allow for variations in the amount, timing and inherent risk of the cash flows. A major problem with this approach in practice is that most assets do not produce independent cash flows i.e. cash flows are usually produced in conjunction with other assets. For this reason IAS 36 introduces the concept of a cash-generating unit (CGU) which is the smallest identifiable group of assets, which may include goodwill, that generates (largely) independent cash flows. Frequency of testing for impairment: Goodwill and any intangible asset that is deemed to have an indefinite useful life should be tested for impairment at least annually, as too should any intangible asset that has not yet been brought into use. In addition, at each balance sheet date an entity must consider if there has been any indication that other assets may have become impaired and, if so, an impairment test should be done. If there are no indications of impairment, testing is not required. (ii)

Once an impairment loss for an individual asset has been identified and calculated it is applied to reduce the carrying amount of the asset, which will then be the base for future depreciation charges. The impairment loss should be charged to income immediately. However, if the asset has previously been revalued upwards, the impairment loss should first be charged to the revaluation surplus. The application of impairment losses to a CGU is more complex. They should first be applied to eliminate any goodwill and then to the other assets on a pro rata basis to their carrying amounts. However, an entity should not reduce the carrying amount of an asset (other than goodwill) to below the higher of its fair value less costs to sell and its value in use if these are determinable.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (b) (i) The plant had a carrying amount of $240,000 on 1 October 2004. The accident that may have caused an impairment occurred on 1 April 2005 and an impairment test would be done at this date. The depreciation on the plant from 1 October 2004 to 1 April 2005 would be $40,000 (640,000 x 12½% x 6/12) giving a carrying amount of $200,000 at the date of impairment. An impairment test requires the plant’s carrying amount to be compared with its recoverable amount. The recoverable amount of the plant is the higher of its value in use of $150,000, or its fair value less costs to sell. If Wilderness trades in plant it would receive $180,000 by way of a part exchange, but this is conditional on buying new plant which Wilderness is reluctant to do. A more realistic amount of the fair value of the plant is its current disposal value of only $20,000. Thus the recoverable amount would be its value in use of $150,000 giving an impairment loss of $50,000 ($200,000 – $150,000). The remaining effect on income would be that a depreciation charge for the last six months of the year would be required. As the damage has reduced the remaining life to only two years (from the date of the impairment) the remaining depreciation would be $37,500 ($150,000/ 2 years x 6/12). Thus extracts from the financial statements for the year ended 30 September 2005 would be: Balance sheet Non-current assets Plant (150,000 – 37,500)

$ 112,500

Income statement Plant depreciation (40,000 + 37,500) Plant impairment loss (ii)

77,500 50,000

There are a number of issues relating to the carrying amount of the assets of Mossel that have to be considered. It appears the value of the brand is based on the original purchase of the ‘Quencher’ brand. The company no longer uses this brand name; it has been renamed ‘Phoenix’. Thus it would appear the purchased brand of ‘Quencher’ is now worthless. Mossel cannot transfer the value of the old brand to the new brand, because this would be the recognition of an internally developed intangible asset and the brand of ‘Phoenix’ does not appear to meet the recognition criteria in IAS 38. Thus prior to the allocation of the impairment loss the value of the brand should be written off as it no longer exists. The inventories are valued at cost and contain $2 million worth of old bottled water (Quencher) that can be sold, but will have to be relabeled at a cost of £250,000. However, as the expected selling price of these bottles will be $3 million ($2 million x 150%), their net realizable value is $2,750,000. Thus it is correct to carry them at cost i.e. they are not impaired. The future expenditure on the plant is a matter for the following year’s financial statements. Applying this, the revised carrying amount of the net assets of

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Mossel’s cash-generating unit (CGU) would be $25 million (£32 million – $7 million re the brand). The CGU has a recoverable amount of $20 million, thus there is an impairment loss of $5 million. This would be applied first to goodwill (of which there is none) then to the remaining assets pro rata. However under IAS2 the inventories should not be reduced as their net realizable value is in excess of their cost. This would give revised carrying amounts at 30 September 2005 of: $’000 Brand nil Land containing spa (12,000 – 9,000 (12,000/20,000 x 5,000)) Purifying the bottling plant (8,0 6,000 (8,000/20,000 x 5,000)) Inventories 5,000 20,000

Chapter 15

 1

Students should be able both to quote the IAS 17 definitions and to explain them in their own words. The essential point is that with a finance base, the lessee is, in substance, in the same business position (but not legal position) as if it had actually bought the item.

Reactions here might be diverse. To us, IAS 17 gives a very clear ‘definitional distinction’, as in question 1. It certainly does not, however, give a clear operational process that can be guaranteed always to give an unarguable classification in practice. This is fully in accordance with ‘substance over form’, but may well be regarded as a weakness.

Yes and no. At a micro level, i.e. with the focus of the accounting function on the individual entity, such a statement is not a problem. Nevertheless, at a macro level it might be regarded as worrying. If planners wish to know the total finance lease exposure in an economy, do they look to the lessors or the lessees?

This is probably an overstatement. Note the word ‘useful’ in the proposition. If substance over form means following the economic logic rather than the legal position, then we suggest that it is definitely ‘essential’. However, if it means deliberately creating a definitional distinction, which is subjective in application (as IAS 17 of course does), then the issue is perhaps more debatable. It perhaps comes back to the general debate about rules or principles raised in Chapters 2 and 8 and inherent in much of accounting discussion.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 5

This question considers the proposals that all leases should be treated in the way that finance leases are under IAS 17. It can certainly be supported, in that an operating lease as currently defined does create an obligation and a right to receive, i.e. an asset. But so do other contracts. For example, an employment contract creates unavoidable obligations in relation to employees, which are currently regarded as neither liabilities nor even contingent liabilities. In support of the proposition, however, the difficulty of distinguishing between different types of lease would obviously be removed.

6 (a) (i) Lavalamp Income Statement Year to 30 September 2003 Sales revenue Cost of sales (w (i)) Gross profit Operating expenses (11400 + 2000 - 600 operating leases) Operating profit Finance costs (2000 + 220 (W Iiii)) and (iv)) Profit before tax Taxation Net profit for the period (ii)

$000 112500 (83 610) 28 890 (12 800) 16090 (2220) 13870 (3470) 10400

Lavalamp - Statement of Changes in Equity - Year to 30 September 2003

Balance at 1 October 2002 Rights issue (1 for 4 at $1.60) Surplus on revaluation of property (w (ii)) Net profit for the period Dividends paid Transfer to realized profits (5250/15 years) Balance at 30 September 2003

Share Capital $000 16 000

Share premium $000 7 600

4000

2 400

Revaluation reserve $000 nil

Accumulated profits $000 3 600

10000

5250

10400

(350)

(1200) 350

(1200) nil

4900

13150

48050

(iii) Lavalamp - Balance Sheet as at 30 September 2003 Non-current assets Intangible development costs (5000 - 500 (w (ii)))

$000 27 200 6 400

5250

20000

Total

$000

$000 4500

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Property, plant and equipment (w (ii))

42340 46840

Current Assets Inventory Accounts receivable Total assets Equity and liabilities: Ordinary shares of $1 each Reserves (from (b) above): Share premium Accumulated profits Revaluation reserve Non-current liabilities 8% loan note Lease obligations (w (iii)) Current liabilities Accounts payable Overdraft Taxation Accrued interest (w (iv)) Provision for damage to property (w (i)) Lease obligation (w (iii) Total equity and liabilities

21800 25550

47350 94190 20000

10000 13150 4900 25000 3621

28050 48050 28621

7300 4000 3470 1220 750 779

17519 94190

Notes: There is a contingent liability of $750 000 in respect of a claim from the landlord for alleged damage caused to a leased property. Workings (all workings in $000) (i) Cost of sales: Per question 78300 Capitalized development costs (5000) Provision for damage to property (see below) 750 Depreciation (w (ii)) 9560 83610 As there appears to be a dispute over the responsibility for the damage to the building, a reasonable approach would be to provide for half of the costs of the repair (it appears Lavalamp has accepted this much) and treat the remaining amount as a contingent liability. Alternatively, a more prudent view would be to provide for the whole amount. (ii)

Tangible non-current assets Property, plant and equipment:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Nonleased plant Leased plant 20-year leasehold

Cost/valuation

depreciation

34 800

19 360

carrying value 15 440

5000

500

4500

24000

1600

22400

63800

21460

42340

Depreciation for year (charged to cost of sales) Non-leased plant (34800 x 20%) Leased plant (5000/5 years x 6/12) 20-year leasehold (24000/15 years (see below)) Development costs (5000/10 years (see below))

6960 500 1600 500 9560

The original annual depreciation would have been $1250 (25 000/20 years). The accumulated depreciation at 1 October 2002 of $6250 represents 5 years depreciation. Therefore after the revaluation there would be a remaining life of 15 years. The revaluation reserve would be $5250 (24 000 - (25 000 - 6250)). Advertising expenditure cannot be included as part of the cost of developing a brand. Nor can a market valuation be used unless there is an active market. There cannot be an active market for brands as they are by definition unique. (iii) Leased asset: fair value of plant 1st rental (1 April 2003) capital outstanding at 30 September 2003 accrued interest at 10% for six months to 30 September 2003 payment due (1 October 2003) accrued interest at 10% for six months

5000 (600) 4400 220 4620 (600) 4020 201

The payments to be made in the year to 30 September 2004 of $1200 contains interest of $421 (200 201), this

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN means the capital element of next year’s payments is $779 which is a current liability. As the total capital outstanding at 30 September 2003 is $4400 then $3621 (4400 - 779) is a non-current liability. (iv)

 7

Annual interest on the 8% loan would be $2000 only $1000 has been paid leaving a required accrual of $1000. The accrued interest on the lease for the six months to 30 September 2003 is $220 (see (iii)). (i) The accounting treatment of leases is an example of the application of substance over legal form. If this principle is not followed it can lead to off balance sheet financing. The treatment of a lease is determined by the extent to which party receives the risks and rewards incidental to ownership. If a lease transfers substantially these risks and rewards to the lease it is classed as a finance lease; if not it is an operating lease. The accounting treatment for the lessee of an operating lease is that the income statement is simply charged with the periodic rentals and there is no effect on the balance sheet other than possibly an accrual or prepayment of the rentals. By contrast a finance lease is treated as a financing arrangement whereby the lessee is treated as having taken out a loan to purchase an asset. This means that both the obligations under the lease and the related asset are shown on the lessee’s balance sheet. The impact on the income statement of treating a finance lease as an operating lease is minimal. Over the life of the lease substantially the same amount would be charged to income, however the inter-period timing of the charges would differ. It is the effect on the balance sheet that is important. Treatment as an operating lease means that neither the asset nor the liability is included on the lessee’s balance sheet and this would hide the company’s true level of gearing and improve its return on capital employed - these are two important ratios. The Standard gives examples of situations that would normally lead to a lease being classified as a finance lease: - the lease transfers the ownership of the asset to the lessee at the end of the lease (in some countries these are described as hire purchase agreements) - the lessee has the option to purchase the asset (normally at the end of the lease) at a favourable price, such that the option is almost certain to be exercised - the term of the lease (including any secondary period at a nominal rent) is for the major part of the economic life of the asset - the present value of the minimum lease payments

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN to substantially the fair value of the asset - the asset is of such a specialized nature that only the lessee could use it without major modification - the lease is non-cancellable or only cancellable with a penalty to the lessee - fluctuations in residual gains or losses fall to the lessee. (ii) $

Gemini - Income statement extracts year to 31 March 2003 Depreciation of leased asset (w (i)) Lease interest expense (w (ii))

48 750 12 480

Balance sheet extracts as at 31 March 2003 Leased asset at cost Accumulated depreciation (w (i) Net book value

260 000 (113 750) 146 250

Current liabilities Accrued lease interest (w (ii)) Obligations under finance leases (w (ii))

12 480 47 250

Non-current liabilities Obligations under finance leases (w (ii))

108 480

Workings (i)

Depreciation for the year ended 31 March 2002 would be $65 000 ($260 000 x 25%) Depreciation for the year ended 31 March 2003 would be $48 750 (($260 000) - $65000) x 25%)

(ii)

The lease obligations are calculated as follows: Cash price/fair value at 1 April 2001 Rental 1 April 2001 Interest to 31 March 2002 at 8% Rental 1 April 2002 Capital outstanding 1 April 2002 Interest to 31 March 2003 at 8%

260 000 (60 000) 20 000 16 000 216 000 (60 000) 156 000 12 480

Interest expense accrued at 31 March 2003 is $12 480. The total capital amount outstanding at 31 March 2003 is $156 000 (the same as at 1 April 2002 as no further payments have been made). This must be split between current and non-current liabilities. Next year’s payment will be $60 000 of which $12 480 is interest. Therefore capital to be repaid in the next year will be $47 520 (60 000 12480). This leaves capital of $108 480 (156 000 47250) as a non-current liability.

Chapter 16 53

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

1 (a) Upright pianos. Since the stock is reduced to nil by 30 September then profits under all assumptions will be the same as differences in calculated profit arise only because of different assumptions about usage. € Sales Cost of sales Gross profit Value of closing stock

2 700 1 750 950 250

However, under replacement cost: Operating profit Holding loss realized

1 050 100 950

Grand pianos (i) FIFO Sales Opening stock Purchases

3 200 1 200 2 400 3 600

Closing stock (1 @ 800) (1 @ 900) Gross profit

1 700

1 900 1 300

€ (ii) LIFO Sales Opening stock Purchases Closing stock (1 @600) (1 @900)

3 200 1 200 2 400 1 500

2 100

(iii) Weighted average Stock 2 at € 600 = 1 at €700 =

€ 1200 700 1900

30 June weighted average = €633 2 @ €633 1 @ €800 3

€ 1 266 800 2 066

€ Sales

3 200

Cost of sales 1 @ 633 2 @ 689 Gross profit

2 011 1 189

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 30 September weighted average = €689 € 1 @ €689 = 689 1 @ €900 = 900 2 1589

Closing stock

(iv) Replacement cost € As at 30 June Replacement cost of stock 3 - €700 = Profit on sale = Holding gains =

2 100 300 200

As at 30 September Replacement cost of stock 3 €800

Profit on sale = Holding gains =

2400 600 200

As at 30 November Replacement cost of stock = 2 - €900 Holding gain = Operating profit = Holding gains =

1800 100 900 500

(b) FIFO - older, smaller expense figure. LIFO - older, smaller asset figure. Weighted average - a bit of both! RC - both expense and asset current. 2

We suggest you draw up a table of the different statement of income results and statement of financial position figures from exercise 1 and compare and contrast them.

You can use the answers to exercises 1 and 2 for this question.

IAS 2 ignores most of the difficulties involved in valuing closing inventory simply stating that it should be valued at lower of cost or NRV. IAS 2 also seems to assume that everything is calculated within a historical cost system. Cost guidance is given in terms of what comprises cost, but the real issue is not tackled as the Standard permits standard cost, FIFO, weighted average and LIFO. This all means that users have to take careful note of the inventory accounting policy of any enterprise compared with another when comparing results. The method chosen has an effect on the statement of income and the statement of financial position numbers.

The difference between the percentage completion method and the complete contract method is amply shown in Activity 15.9. The percentage completion method:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■ smoothes the profit over the life of the contract rather than taking all profit at the end of the contract life ■ depends on reliable assessment by management of percentage complete ■ depends on a subjective judgement by management on the future outcome of the contract. Useful information will be provided if the percentage completion method provides relevant, reliable, understandable and comparable information to users. This is where the discussion should centre.

 6

IAS 11 assumes that management can always make a judgement on contract costs, estimated costs to completion and the stage of completion, whereas USGAAP assumes there may be circumstances in which this judgement is questionable. We leave the debate to you. It is also worth noting that entities do receive stage payments for contracts and that IAS 11 treats these as income rather than a liability.

Inventory of Base Inventory should be valued as at the statement of financial position date at cost or net realizable value whichever is the lower. The evidence of the loss in value of the slow moving stock exists at the statement of financial position date and is therefore an adjusting event. The inventory should be valued at €26 million (28.5 − (4.5 − 2))

Reports to the Directors of Gear Software plc Although your entity is relatively small, there are no provisions under International Accounting Standards/International Financial Reporting Standards for a reduction in the amount of disclosure/compliance with those standards. (i) Cost centres IAS8 ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’ sets out the principles relating to changes in accounting policies. It helps to determine the correct treatment in the case of the changes in the allocation of over-heads and the accounting policy relating to the development of software. A change in accounting policy occurs when there is a change in the recognition, measurement and presentation of the item. A change in accounting policy should only be made if required by statute, or by an accounting standard setting body or if the change results in a more appropriate presentation of events or transactions. The accounting policies of the company should be the most appropriate to the company’s circumstances, giving due weight to the

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN impact on comparability. Estimates are bound to occur in the accounting process and are required in order to enable accounting policies to be applied. Accounting estimates will be based on judgement and should ensure the truth and fairness of the financial statements. However, unlike a change in accounting policy, a change to an accounting estimate should not be treated as a prior period adjustment unless it represents the correction of a fundamental error. The effect of an accounting estimate change should be included in the income statement for the current period if it affects the period only or in the income statement of the future period also if the change affects both periods. The indirect overhead costs have been directly attributable to the two cost centres and have been included in the inventory valuation in the statement of financial position. There is no change in the recognition policy of the company as regards the overhead costs; all that has changed is the ratio/allocation of those costs from 60:40 to 50:50. Similarly the basis of measurement of the overhead costs does not appear to have changed. However, part of the costs relating to the sale of computer games is now being shown as part of distribution costs and not cost of sales and, therefore, this constitutes a change in the presentation of that cost which in turn represents a change in accounting policy. IAS8 states that if the change results in a more appropriate presentation and more relevant or reliable information about the financial position, performance or cash flows, then it constitutes a change in accounting policy. The direct labour costs and attributable overhead costs relating to the development of the games was formerly carried forward as work-in-progress. In the year to 31 May 2003, these costs have been written off to the statement of income. This represents a change to the recognition and presentation of these costs and, therefore, is a change in accounting policy. Details of any changes to accounting policies need to be disclosed in the financial statements. These details include: (i)

the reasons for the change

(ii)

the amount of the adjustment recognised in net profit for the period; and

(iii)

the amount of the adjustment in each period for which pro-forma information is presented and the amount of the adjustment relating to periods prior to those included in the financial statements.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Under IAS8, a company can apply the benchmark treatment to a change in accounting policy which means that the opening balance of retained earnings will be adjusted for prior period amounts or the allowed alternative treatment, which means that the net profit for the period will be adjusted for prior period amounts. It appears that the first two items relating to the changes in accounting policy can be disclosed without too much difficulty. However, non-disclosure of the impact on the current year’s income statement of the write off of the development costs does not follow the guidance in IAS8. (ii)

Computer hardware and revenue recognition The capitalisation of interest on tangible non-current assets, is permitted under IAS23 ‘Borrowing Costs’. This represents a change in the recognition and presentation of the tangible non-current asset and is, therefore, a change in accounting policy which requires disclosure. The change in the depreciation method does not affect the recognition and measurement of the asset, and represents a change in an accounting estimate technique which is used to measure the unexpensed element of the asset’s economic benefits. However, as depreciation is now being shown as part of costs of sales rather than administrative expenses, then this represents a change in the presentation of the item and is a change in accounting policy. A change in an accounting estimate is not normally a change in accounting policy. Disclosure of the change in policy will have to be made (see above). IAS8 states that a company should judge the appropriateness of its accounting policy against the objectives of relevance and reliability. A company should implement a new accounting policy if it is judged more appropriate to the entity’s circumstances than the present accounting policy. Thus, for the reasons of relevance, the company should adopt the normal industry approach which would constitute a change in the measurement basis and thus a change in accounting policy with the necessary disclosure taking place (see above). Also given the potential charge against profits under IAS37 below, then the new accounting policy might alleviate the impact of the provision.

Inventory Sales of goods after the balance sheet date are normally a reflection of circumstances that existed prior to the year end. They are usually interpreted as a confirmation of the value of inventory as it existed at the year end, and are thus adjusting events. In this case the sale of the goods after the year-end confirmed that the value of the inventory

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN was correctly stated as it was sold at a profit. Goods remaining unsold at the date the new legislation was enacted are worthless. Whilst this may imply that they should be written off in preparing the financial statements to 30 September 2003, this is not the case. What it is important to realise is that the event that caused the inventory to become worthless did not exist at the year end and its consequent losses should be reflected in the following accounting period. Thus there should be no adjustment to the value of inventory in the draft financial statements, but given that it is material, it should be disclosed as a non-adjusting event. Construction contract On first appearance this new legislation appears similar to the previous example, but there is a major difference. Profits on an uncompleted long term construction contract are based on assessment of the overall eventual profit that the contract is expected to make. This new legislation will mean the overall profit is $500 000 less than originally thought. This information must be taken into account when calculating the profit at 30 September 2003. This is an adjusting event. 10

(a) (i) Long-term construction contracts span more than one accounting year-end. This leads to the problem of determining how the uncompleted transactions should be dealt with over the life of the contract. Normal sales are not recognized until the production and sales cycle is complete. Prudence is the most obvious concept that is being applied in these circumstances, and this is the principle that underlies the completed contract basis. Where the outcome of a long-term contract cannot be reasonably foreseen due to inherent uncertainty, the completed contracts basis should be applied. The effect of this is that sales revenue earned to date is matched to the cost of sales and no profit is taken. The problem with the above is that for say a three-year contract it can lead to a situation where no profits are recognized, possibly for two years, and in the year of completion the whole of the profit is recognized (assuming the contract is profitable). This seems consistent with the principle that only realized profits should be recognized in the income statement. The problem is that the overriding requirement is for financial statements to show a true and fair view which implies that financial statements should reflect economic reality. In the above case it can be argued that the company has been involved in a profitable contract for a three-year period, but its financial statements over the three years show a profit in only one period. This also leads to volatility of profits which many companies feel is undesirable and not favoured by analysts. An alternative approach is to apply the matching/ accruals concept which underlies the

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN percentage of completion method. This approach requires the percentage of completion of a contract to be assessed (there are several methods of doing this) and then recognizing in the income statement that percentage of the total estimated profit on the contract. This method has the advantage of more stable profit recognition and can be argued shows a more true and fair view than the completed contract method. A contrary view is that this method can be criticized as being a form of profit smoothing which, in other circumstances, is considered to be an (undesirable) example of creative accounting. Accounting standards require the use of the percentage of completion method where the outcome of the contract is reasonably foreseeable. It should also be noted that where a contract is expected to produce a loss, the whole of the loss must be recognized as soon as it is anticipated. (ii)

Linnet – statement of income - year to 31 March 2004 (see working below): $million Sales revenue Cost of sales (64 17) Loss for period

70 (81) (11)

Linnet – statement of financial position extracts - as at 31 March 2004 Current assets Gross amounts due from customers for contract work (w (iii)) 59 Workings:

Sales Cost of sales Rectification costs Profit(loss)

Cumulative 1 April 2003 $million 150 (112)

Cumulative 31 March 2003 $million (w (i)) (220) (w (ii)) (176)

Amounts for year $million 70 (64)

nil

(17)

(w (ii)) 27

(11)

- progress payments received are $180 million. This is 90% of the work certified (at 29 February 2004), therefore the work certified at that date was $200 million. The value of the further work completed in March 2004 is given as $20 million, giving a total value of contract sales at 31 March 2004 of $220 million. - the total estimated profit (excluding rectification costs) is $60 million:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN $ million Contract price Cost to date Estimated cost to complete Estimated total profit

300 (195) (45) 60

The degree of completion (by the method given in the question) is 220/300. Therefore the profit to date (before rectification costs) is $44 million ($60 million 220/300). Rectification costs must be charged to the period they were incurred and not spread over the remainder of the contract life. Therefore, after rectification costs of $17 million the total reported contract profit to 31 March 2004 would be $27 million. With contract revenue of $220 million and profit to date of $44 million, this means contract costs (excluding rectification costs) would be $176 million. The difference between this figure and total cost incurred of $195 million is part of the $59 million of the amount due from customers shown in the balance sheet. (iii)

The gross amounts due from customers is cost to date ($195 million $17 million) plus cumulative profit ($27 million) less progress billings ($180 million) $59 million.

HS construction contract Total revenue Total costs (170+100) Total profit

$000 300 270 30

Stage of completion:

165/300= 55%

In statement of income: Revenue (55%x300) Profit (30x55%)

165 16.5

In statement of financial position: Gross amount due from customer Cost 170 Profit 16.5 186.5 less receipts 130 56.5

Chapter 17

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

 1

FIs have a significant impact on an enterprise’s financial performance, position and cash flow. If these FIs are carried off balance sheet then the movement in the instrument in favour of or against the enterprise can significantly change its risk profile.

This is amply defined by IAS 32 and 39 in the text. The student should provide examples to demonstrate his understanding, such as those given in Activity 17.1.

An FI is differentiated from other assets and liabilities by the presence of a contract, whether written or otherwise.

This is defined in the text in accordance with the Standard and examples are given at Activity 17.2.

The requirements for the accounting for the gain or loss on revaluation are shown in table 17.4 on page 408 of the text and the student should be able clearly to demonstrate the effect on income from this. The whole issue of the recognition of these gains and losses is highly controversial, as it requires the recognition of unrealized gains and losses in the income statement in some instances and in others no recognition.

We suggest you refer to Activity 17.7 here and note the differences in the income statement and balance sheet from using both methods.

See text section referring to possible revisions to IAS 39.

 8

Discussion should revolve around the issues of realization and the provision of useful information to users. Whether a gain or loss has to be realized before it is recognized in financial statements is at the heart of this discussion. Note that emphasis is now placed on recognition and measurement with reasonable certainty rather than realization. Report to the Directors of Ambush, a public limited company (a) The following report sets out the principal aspects of IAS 39 in the designated areas. (i) Classification of financial instruments and their measurement Financial assets and liabilities are initially measured at fair value which will normally be the fair value of the consideration given or received. Transaction costs are included in the initial carrying value of the instrument unless it is carried at ‘fair value through profit or loss’ when these costs are recognised in the statement of

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN income. Financial assets should be classified into four categories: (i) (ii) (iii) (iv)

financial assets at fair value through profit or less loans and receivables held-to-maturity investments (HTM) available-for-sale financial assets (AFS).

The first category above has two sub-categories which are ‘held for trading’ and those designated to this category at inception/initial recognition. This latter designation is irrevocable. Financial liabilities have two categories: those at fair value through profit or loss, and ‘other’ liabilities. As with financial assets those liabilities designated as at fair value through profit or loss have two sub-categories which are the same as those for financial assets. Reclassifications between categories are uncommon and restricted under IAS 39 and are prohibited into and out of the fair value through profit or loss category. Reclassifications between AFS and HTM are possible but it is not possible from loans and receivables to AFS. The held to maturity category is limited in its application as if the company sells or reclassifies more than an immaterial amount of the portfolio, it is barred from using the category for at least two years. Also all remaining HTM investments would be reclassified to AFS. Subsequent measurement of financial assets and liabilities depends on the classification. The following table summarises the position: Financial Assets Financial assets at fair value through profit or loss Loans and receivables Held to maturity investments Available-for-sale financial assets Financial liabilities at fair value through profit or loss Other financial liabilities

Measurement fair value amortised cost amortised cost fair value fair value amortised cost

Amortised cost is the cost of an asset or liability adjusted to achieve a constant effective interest rate over the life of the asset or liability. It is not possible to compute amortised cost for instruments that do not have fixed or determinable payments, such as for equity instruments, and such instruments therefore cannot be classified into these categories.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN A company must apply the effective interest rate method in the measurement of amortised cost. The effective interest rate method determines how much interest income or interest expense should be reported in profit and loss. For financial assets at fair value through profit or loss and financial liabilities at fair value through profit or loss, all changes in fair value are recognised in profit or loss when they occur. This includes unrealised holding gains and losses. For available-for-sale financial assets, unrealised holding gains and losses are deferred in reserves until they are realised or impairment occurs. Only interest income and dividend income, impairment losses, and certain foreign currency gains and losses are recognised in profit or loss. Investments in unquoted equity instruments that cannot be reliably measured at fair value are subsequently measured at cost. Unrealised holding gains/losses are not normally recognised in profit/loss. (ii)

Fair value option As set out above, the standard permits entities to designate irrevocably on initial recognition any financial asset or liability as one to be measured at fair value with gains and losses recognised in profit or loss. The fair value option was generally introduced to reduce profit or loss volatility as it can be used to measure an economically matched position in the same way (at fair value). Additionally it can be used in place of IAS 39’s requirement to separate embedded derivatives as the entire contract is measured at fair value with changes reported in profit or loss. Although the fair value option can be of use, it can be used in an inappropriate manner thus defeating its original purpose. For example, companies might apply the option to instruments whose fair value is difficult to estimate so as to smooth profit or loss as valuation of these instruments might be subjective. Also the use of this option might increase rather than decrease volatility in profit or loss where, for example, a company applies the option to only one part of a ‘matched’ position. Finally, if a company applied the option to financial liabilities, it might result in the company recognising gains or losses for changes in its own credit worthiness. The IASB has issued an exposure draft amending IAS 39 in this area restricting the financial assets and liabilities to which the fair value option can be applied. I hope that the above information is useful.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (b) (i) IAS 39 requires an entity to assess at each statement of financial position date whether there is any objective evidence that financial assets are impaired and whether the impairment impacts on future cash flows. Objective evidence that financial assets are impaired includes the significant financial difficulty of the issuer or obligor and whether it becomes probable that the borrower will enter bankruptcy or other financial reorganisation. For investments in equity instruments that are classified as available for sale, a significant and prolonged decline in the fair value below its cost is also objective evidence of impairment. If any objective evidence of impairment exists, the entity recognises any associated impairment loss in profit or loss. Only losses that have been incurred from past events can be reported as impairment losses. Therefore, losses expected from future events, no matter how likely, are not recognised. A loss is incurred only if both of the following two conditions are met: (i) (ii)

there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’), and the loss event has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated.

The impairment requirements apply to all types of financial assets. The only category of financial asset that is not subject to testing for impairment is a financial asset held at fair value through profit or loss, since any decline in value for such assets are recognised immediately in profit or loss. For loans and receivables and held-to-maturity investments, impaired assets are measured at the present value of the estimated future cash flows discounted using the original effective interest rate of the financial assets. Any difference between the carrying amount and the new value of the impaired asset is an impairment loss. For investments in unquoted equity instruments that cannot be reliably measured at fair value, impaired assets are measured at the present value of the estimated future cash flows discounted using the current market rate of return for a similar financial asset. Any difference between the previous carrying amount and the new measurement of the impaired asset is recognised as an impairment loss in profit or loss. (ii) There is objective evidence of impairment because of the financial difficulties and reorganisation of Bromwich. The

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN impairment loss on the loan will be calculated by discounting the estimated future cash flows. The future cash flows will be $100,000 on 30 November 2007. This will be discounted at an effective interest rate of 8% to give a present value of $85,733. The loan will, therefore, be impaired by ($200,000 – $85,733) i.e. $114.267. (Note: IAS 39 requires accrual of interest on impaired loans at the original effective interest rate. In the year to 30 November 2006 interest of 8% of $85,733 i.e. $6,859 would be accrued.) 10

1. If a FI fulfils the characteristics of a liability then it should be classified as such not as equity. The nonredeemable preference shares carry a fixed rate of interest payable in respect of each accounting period and therefore are long-term liabilities not equity. 2. The convertible bonds are more difficult to classify as they have characteristics of both liability and equity. IAS 32 suggests that the liability element of a convertible bond should be valued using an equivalent market rate of interest for non-convertible bonds, with equity as the residual amount. (see activity 17.8). Thus PV of capital element of bond of $6m at rate of 8% Interest payable for 4 years at pv is 6m x 6% x 3.312 Value of liability element Equity element (residual)

4.41 1.19 5.6 0.4 6.0

Thus both 1 and 2 options (except for $0.4m) will need to be classified as debt (9.6m) with a consequential effect on gearing. The only issue proposed by the directors that would not be classified as debt/liability is the rights issue. 11 (a) The three characteristics are: (i) Its value changes in response to the change in a specified interest or exchange rate, or in response to the change in price, rating, index or other variable. (ii) It requires no initial net investment (iii) It is settled at a future date (b) Derivatives are recognised as assets or liabilities at fair value on recognition and subsequently. (c) AZG Extract from statement of income for the year ended 31 March 2008. 2008 2007 $ $ Gain on derivative 73891 68966 AZG Extract from statement of financial position as at 31 March 2008 Derivative asset 142857 68966

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Workings Value of forward foreign exchange contractFL6m/3 = $2m 31 March 2007 fair value = FL6m/2.9= $2.068966 31 march 2008 fair value = FL6m/2.8= $2.142857 Gain recognised year ended 31 March 2007 2068966-2000000 = 68966 Gain recognised year ended 31 March 2008 2142857-2000000= 73891 Derivative at fair value 31 march 2008 142857 12

Purchase of held for trading investment The held for trading investment should be classified as an asset held at fair value through profit or loss. it is initially measured at fair value, i.e. $1.75m. The transaction costs are not included in the cost but written off to statement of income as a period cost. The investment is subsequently measured at 30 June 2009 at fair value again which is $1.825m which gives rise to a gain on the investment in statement of income of $75000.

Chapter 18

 1

Revenue is regarded by many as simply the cash that you are paid for selling things and this simple idea also implies exchange - cash for things. We have carried this idea of exchange through to the statement of financial position. Consider the simple exchange of selling an item of inventory for cash: the accounting entries would be to derecognize the item of inventory in the statement of financial position and recognize the asset of cash. The asset of cash would qualify as revenue and against this we would match relevant expenses to determine profit. Traditionally, we have not regarded the item of inventory as revenue until it is sold or at least until we have exchanged it for another asset, perhaps a debtor. This approach seems to equate revenue with economic activity involving exchange with a customer and ignores other items such as gains on assets that are revalued or carried at current value. IAS 18 defines revenue as: ‘The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an enterprise when those inflows result in increases in equity, other than increases relating to contributions from equity participants. (para. 7)

Activity 18.2 demonstrates this restriction. The debate needs to revolve around whether this provides useful information.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 3

Activities 18.9 and 18.10 can be used to demonstrate the use of substance over form in the Standard.

We leave this one to you to debate, but remember to bring out the issue of holding gains that IAS 18 does not permit the recognition of. These holding gains might be regarded by some as relevant information.

Prudence is not now regarded as an overriding principle. Accountants are required to be free from bias, including any prudent bias. However, management has to take decisions on: ■ what constitutes the ordinary activities of the enterprise ■ whether or not significant risks and rewards of ownership have been transferred to a buyer ■ whether the amount of revenue involved can be measured reliably, i.e. can its fair value be determined ■ if it is probable that economic benefits associated with the transaction (sale) will flow to the enterprise ■ whether the costs in respect of the transaction can be reliably measured ■ at what stage a particular service has reached in its delivery ■ management could make these judgements in a very prudent manner to ensure they do not overstate revenue in any period. However, management may be more upbeat in its decisions and could potentially overstate revenue. It might be useful to consider the accounting of ‘Worldcom’ in this respect.

Generally, what is revenue for one enterprise will be an asset of another and therefore the amount of revenue recognized equates to the value of the asset. Use Activity 18.4 to demonstrate here and note para. 9 of IAS 8.

The need for discounting possibly arises when revenue is not received by the seller for a period of time but the sale needs to be recognized. The consideration eventually received will, due to time differences, be less than that originally agreed and therefore, in order to provide relevant information, discounting will need to be used. However, discounting requires subjective judgements in respect of the discount rate, which draws into question the reliability and comparability of the information.

 8

Given that the recognition of revenue requires management to make a number of subjective decisions, it

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN would be difficult to describe it as objective. 9

(a) The Framework advocates that revenue recognition issues are resolved within the definition of assets (gains) and liabilities (losses). Gains include all forms of income and revenue as well as gains on non-revenue items. Gains and losses are defined as increases or decreases in net assets other than those resulting from transactions with owners. Thus in its Framework, the IASB takes a statement of financial position approach to defining revenue. In effect a recognizable increase in an asset results in a gain. The more traditional view, which is largely the basis used in IAS 18 ‘Revenue’, is that (net) revenue recognition is part of a transactions-based accruals or matching process with the statement of financial position recording any residual assets or liabilities such as receivables and payables. The issue of revenue recognition arises out of the need to report company performance for specific periods. The Framework identifies three stages in the recognition of assets (and liabilities): initial recognition, when an item first meets the definition of an asset; subsequent remeasurement, which may involve changing the value (with a corresponding effect on income) of a recognized item; and possible derecognition, where an item no longer meets the definition of an asset. For many simple transactions both the Framework’s approach and the traditional approach (IAS 18) will result in the same profit (net income). If an item of inventory is bought for $100 and sold for $150, net assets have increased by $50 and the increase would be reported as a profit. The same figure would be reported under the traditional transactions-based reporting (sales of $150 less cost of sales of $100). However, in more complex areas the two approaches can produce different results. An example of this would be deferred income. If a company received a fee for a 12-month tuition course in advance, IAS 18 would treat this as deferred income (on the statement of financial position) and release it to income as the tuition is provided and matched with the cost of providing the tuition. Thus the profit would be spread (accrued) over the period of the course. If an asset/liability approach were taken, then the only liability the company would have after the receipt of the fee would be for the cost of providing the course. If only this liability is recognized in the statement of financial position, the whole of the profit on the course would be recognized on receipt of the income. This is not a prudent approach and has led to criticism of the Framework for this very reason. Arguably the treatment of government grants under IAS 20 (as deferred income) does not comply with the Framework as deferred income does not meet the definition of a liability. Other standards that may be in conflict with the Framework are the use of the accretion approach in IAS 11 ‘Construction Contracts’

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN and a deferred tax liability in IAS 12 ‘Income Tax’ may not fully meet the Framework’s definition of a liability. The principle of substance over form should also be applied to revenue recognition. An example of where this can impact on reporting practice is on sale and repurchase agreements. Companies sometimes ‘sell’ assets to another company with the right to buy them back on predetermined terms that will almost certainly mean that they will be repurchased in the future. In substance this type of arrangement is a secured loan and the ‘sale’ should not be treated as revenue. A less controversial area of the application of substance in relation to revenue recognition is with agency sales. IAS 18 says, where a company sells goods acting as an agent, those sales should not be treated as sales of the agent, instead only the commission from the sales is income of the agent. Recently several Internet companies have been accused of boosting their revenue figures by treating agency sales as their own. (b)

Sales made by Derringdo of goods from Gungho must be treated under two separate categories. Sales of the A grade goods are made by Derringdo acting as an agent of Gungho. For these sales Derringdo must only record in income the amount of commission (12.5%) it is entitled to under the sales agreement. There may also be a receivable or payable for Gungho in the statement of financial position. Sales of the B grade goods are made by Derringdo acting as a principal, not an agent. Thus they will be included in sales with their cost included in cost of sales. Sales revenue (4600 (w (i) 11400 w (ii) Cost of sales (w (ii)) Gross profit Working: (all figures in $000) (i) Opening inventory Transfers/purchases Closing inventory Cost of sales Selling price (to give 50% gross profit) Gross profit Commission (12.5% 36,800) (ii) Opening inventory Transfers/purchases Closing inventory Cost of sales Selling price (8550 4/3 see below)

16000 (8550) 7450 A grade 2400 18000 20400 (2000) 18400 36800 18400 4600 B grade 1000 8800 (1250) 9800 8550 11400

A gross profit margin of 25% is equivalent to a mark up on cost of 1/3. Thus if cost of sales is multiplied by 4/3 this will give the relevant selling price.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN



10 (a) In this example we need to consider whether economic benefits, the £0.6m and £0.4m will flow to A entity. There is some uncertainty that this will happen as it is dependent upon Connect receiving the funding and therefore the revenue should not be recognised until the uncertainty surrounding the funding is resolved. (b) We need to consider here whether economic benefits will flow to A. this will not be settled until negotiations with the insurance company are complete and the amount can then be reliably measured. In this case revenue can only be recognised on completion of the negotiations not on billing. (c) In this example there are two distinct components, the equipment and maintenance contract. The discount on the dual purchase by the customer is £24 and we can reasonably apportion this £16 to maintenance and £8 to equipment. On delivery of the equipment Z will recognise £144 as revenue and the remaining £72 will be taken to revenue evenly over the 12-month period. This solution will also be applied to the provision of mobile phones and the monthly service provision contract as long as we can determine stand-alone prices for the components in the mobile phone deal. (d) A sale has again occurred here of two components. The total package has cost £52 250 (discount £2750). The discount can be apportioned as we did for the broadband supplier, i.e: Boat 50000/55 000 – 2750 = 2500 thus cost of boat £47 500 Moorings 5000/55 000 –2750 = 250 thus cost of moorings £4750. The revenue of £47 500 will be recognised on sale of the boat and £4750 for the moorings will be recognised evenly over the year. OR The discount can be apportioned based on profit margins: Boat

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (12500/912 500 + 2500) – 2750 = £2290 thus cost of boat £47 710 Moorings 2500/15 000 _ 2750 = £460 thus cost of moorings £4540. (e) Revenue cannot be recognised as the service provided in this case is uncertain until the outcome of the court case. Revenue will only be recognised if the outcome is a ‘win’ situation. The outcome of the court case is the ‘trigger point’ for recognition of revenue, if any is to be. (f)

A to X A will recognise the revenue of £10 per door from X. If A buys the doors from X he will record the cost in inventory and the subsequent revenue when he sells on to the house builder. A to Y The transactions of sale and purchase are linked in this deal and therefore A should not recognise the £10 revenue on provision of materials to Y but retain the cost of the materials £5 in inventory and record the £10 received from Y as a liability. When the door is repurchased the additional £40 paid by A will be recorded as inventory giving an inventory total of £45. No sale or revenue will be recognised until the door is sold on to the house builder.

(g) Members obtain a £2 discount per visit and over an estimated life of 100 visits this equates to £200. Thus the £50 paid by members on joining over and above the discount can be regarded as revenue at the point of joining. The discount of £200 should be regarded initially as a liability and then spread over the expected two years of active membership probably on a time basis (this is in accordance with IAS 18 appendix, para. 17). (h) Again the answer to this problem is contained in the appendix to IAS 18 which states that where orders are taken for goods not currently held in inventory revenue cannot be recognised until goods are delivered to the buyer. (i) Again the answer is contained within IAS 18 appendix, para. 16. Revenue has to be recognised over the period of instruction. This if a student has paid the fee for a three-year course then this fee must be spread over the three years not recognised in full in the first year. 11

LMN appears to derive the following benefits from the contract:  Determines the range and models in the inventory

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN  Protected against price increases between the date of delivery and the date of sale as price is determined at the point of delivery  Has access to inventory for demonstration purposes. LMN has the following risks within the contract;  IJK retains legal title and therefore is likely to be able to recover its property in case of dispute  LMN has to incur the cost of insurance against loss and damage  LMN may have to pay a rental charge on demonstration vehicles  If price reduction incurs between date of delivery and date of sale LMN will have to pay the higher price specified at delivery. The entity that receives the benefits and bears the risks of ownership should recognise the vehicles as inventory. The above bullet list is not conclusive for LMN and indeed IJK bears the substantial risk of slow moving inventory as LMN can return any vehicle to it without incurring a penalty. On balance therefore IJK should recognise the inventory not LMN. IJK will only recognise a sale when the vehicle is transferred to a third party as it is not until that point that IJK will transfer the benefits and risks associated with a vehicle. 12

(i) Criteria for income recognition in IAS 18 is:  the significant risks and rewards of ownership of the goods have been transferred to the buyer  the entity selling does not retain any continuing influence or control over the goods  revenue can be measured reliably  it is reasonable certain that the buyer will pay for the goods  the costs to the selling entity can be measured reliably (ii) EJ can recognise $50000 revenue and related costs of $40000 for the year ended 31 October 2007. EJ cannot recognise the further 4 months of sales and will therefore need to treat the $100000 as deferred income and include it under current liabilities in the statement of financial position as at 31 October 2007.

The licence acquired by Johan needs to be accounted for under IAS 38 and we reference you to chapter 13 for the detail required here. The licence will be capitalised as an intangible asset and depreciated over its useful life which will be 5 years as from I December 2007 – first year no use – i.e. $24m per annum. There are indications that the licence value may be impaired as the market take up has been poor and therefore once the licence and network

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN assets have been designated as a cash generating unit impairment tests must be carried out. Extensions to network We need to reference IAS 16 here and so we refer you to chapter 12 for the detail. However generation of revenue from the intial feasibility study is not certain and therefore this must be expensed $250,000-as incurred. The further study of $50,000 can under IAS 16 be capitalised as part of the costs of the site. The payment to the government of $300,000 and $60,000 per annum for 12 years should be treated as an operating lease as not substantially all of the risks and rewards have been transferred by the Government to Johan – indeed the lease is only for 12 years and land has an indefinite life, nor can Johan sell the land. Handsets The handsets must be recognised as inventory at the lower of cost or nrv. Here the nrv is $149 and therefore $51 a set must be written off. The call revenue of $21 should be recognised as deferred revenue initially and $18 recognised as revenue over the first 6 months. The other £3 will be recognised as revenue when the card expires. Handsets to dealers The dealer is acting as an agent for Johan and Johan has not transferred any risks and rewards with the handset. The revenue from the service contract will be recognised as the service is rendered. The $150 cannot be recognised as revenue under IAS 18. However the net payment of $130 by Johan may be recognised as an intangible asset – acquisition of customer and amortised over a 12 month period. The cost of the handset to Johan $200 will be recognised as part of cost of good sold.

Chapter 19 1

All these are defined in the text. Remember to include definitions of liability, obligation, constructive obligation and onerous contract etc. in your answer. Activity 19.6 can be used to illustrate the meaning of all the definitions or you could make up some more examples.

Activities 19.1 and 19.2 demonstrate other methods. You will need to discuss why IAS 37 bans big bath accounting, creation of provisions where no liability exists and the use of provisions to smooth profits. These are all banned

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN because they do not provide useful information to users in the IASB’s opinion. 3

This needs to be debated in terms of: ■

What is the meaning of a true and fair view?

■

Does a true and fair set of financial statements provide usefulness information to users?

See answer to Question 2 above.

Another one for debate, using information given in the text.

 6

A provision and a contingent liability have been distinguished throughout the text, so refer to the definitions. In order to provide relevant information to users, it is generally accepted that the provision should be accounted for in the financial statements, whereas the contingent liability should only be disclosed by way of note. This is so that the accounts do not take an overly prudent view of the state of affairs at the balance sheet date.

See text for answer. Debate is similar to that used at question 3.

Define ‘best estimate’ as per the Standard and demonstrate by using Activity 18.7. Note that ‘best estimate’ can be extremely subjective. The best estimate is determined by the judgement of management supplemented by experience of similar transactions and/or reports from independent experts. The emphasis on present obligation in the measurement rule is deliberate and this means that the effect of future events in this measurement must be carefully evaluated. It is only where such future events are expected with some certainty and objectivity to occur that they will be taken account of.

 9

Many people would argue that IAS 37 lacks prudence in that it does not require the recognition of and accounting for all future expenses. We would not argue this, as we view prudence as a state of being free from bias, not being overly pessimistic. Provisions Under IAS37 ‘Provisions, Contingent Liabilities and Contingent Assets’, a provision should be made if: (a) (b) (c)

there is a present obligation as a result of a past event it is probable that a transfer of economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN The assessment of a legal claim is one of the most difficult tasks in the area of provisioning because of the inherent uncertainty in the judicial process. A provision or disclosure could in fact prejudice the outcome of any case. A provision will be required if on the basis of the evidence, it can be concluded that a present obligation is more likely than not to exist (subject to meeting the other conditions). In determining whether a transfer of economic benefits is likely to occur, account should be taken of expert advice and the probability of the outcome determined. Only in rare cases will a reasonable estimate of the obligation not be possible. In the case of the invoice from the accountants, it seems as though the solicitors feel confident that the amount will not be payable and, therefore, it constitutes a contingent liability which, under IAS37, means that the estimated financial effects, any uncertainties relating to the amount or timing of any outflow, and the possibility of any reimbursement should be disclosed. As regards the plagiarism case the following table illustrates the potential outcomes: Present values at 5%

Best case Most likely Worse case

$000

Year

500 1000 2000

1 2 3

PV $000 476 907 1728

Probability 30% 60% 10%

Total $ 142857 544218 172768 859843

The most likely outcome seems to indicate that a provision for $907 000 is required whereas when probability is introduced then this is reduced to $859 843. The difference, considering that an accounting estimate has been used, is not material and, therefore, a provision of $860 000 should be made as this is based on a more ‘scientific’ approach. A company should, under IAS1 ‘Presentation of Financial Statements’, prepare its financial statements on a going concern basis. IAS1 defines a going concern as an enterprise having neither the intention nor the need to liquidate or to cease its operations within at least 12 months from the balance sheet date. Management is required to assess the enterprise’s ability to continue as a going concern at each balance sheet date. If there are material uncertainties about a company’s ability to continue as a going concern then those uncertainties should be disclosed. Thus, the fears concerning the viability of the company in the event of the worst outcome of the court case may have to be disclosed.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 11 (a) IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ only deals with those provisions that are regarded as liabilities. The term provision is also generally used to describe those amounts set aside to write down the value of assets such as depreciation charges and provisions for diminution in value (e.g. provision to write down the value of damaged or slow moving inventory). The definition of a provision in the Standard is quite simple; provisions are liabilities of uncertain timing or amount. If there is reasonable certainty over these two aspects the liability is a creditor. There is clearly an overlap between provisions and contingencies. Because of the ‘uncertainty’ aspects of the definition, it can be argued that to some extent all provisions have an element of contingency. The IASB distinguishes between the two by stating that a contingency is not recognised as a liability if it is either only possible and therefore yet to be confirmed as a liability, or where there is a liability but it cannot be measured with sufficient reliability. The IASB notes the latter should be rare. The IASB intends that only those liabilities that meet the characteristics of a liability in its Framework for the Preparation and Presentation of Financial Statements should be reported in the balance sheet. IAS 37 summarizes the above by requiring provisions to satisfy all of the following three recognition criteria: - there is a present obligation (legal or constructive) as a result of a past event - it is probable that a transfer of economic benefits will be required to settle the obligation - the obligation can be estimated reliably. A provision is triggered by an obligating event. This must have already occurred, future events cannot create current liabilities. The first of the criteria refers to legal or constructive obligations. A legal obligation is straightforward and uncontroversial, but constructive obligations are a relatively new concept. These arise where a company creates an expectation that it will meet certain obligations that it is not legally bound to meet. These may arise due to a published statement or even by a pattern of past practice. In reality constructive obligations are usually accepted because the alternative action is unattractive or may damage the reputation of the company. The most commonly quoted example of such is a commitment to pay for environmental damage caused by the company, even where there is no legal obligation to do so. To summarize: a company must provide for a liability where the three defining criteria of a provision are met, but conversely a company cannot provide for a liability where they are not met. The latter part of the

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN above may seem obvious, but it is an area where there has been some past abuse of provisioning as is referred to in (b). (b)

The main need for an accounting standard in this area is to clarify and regulate when provisions should and should not be made. Many controversial areas including the possible abuse of provisioning are based on contravening aspects of the above definitions. One of the most controversial examples of provisioning is in relation to future restructuring or reorganization costs (often as part of an acquisition). This is sometimes extended to providing for future operating losses. The attraction of providing for this type of expense/loss is that once the provision has been made, the future costs are then charged to the provision such that they bypass the income statement (of the period when they occur). Such provisions can be glossed over by management as ‘exceptional items’, which analysts are expected to disregard when assessing the company’s future prospects. If this type of provision were to be incorporated as a liability as part of a subsidiary’s net assets at the date of acquisition, the provision itself would not be charged to the income statement. IAS 37 now prevents this practice as future costs and operating losses (unless they are for an onerous contract) do not constitute past events. Another important change initiated by IAS 37 is the way in which environmental provisions must be treated. Practice in this area has differed considerably. Some companies did not provide for such costs and those that did often accrued for them on an annual basis. If say a company expected environmental site restoration cost of $10 million in 10 years time, it might argue that this is not a liability until the restoration is needed or it may accrue $1 million per annum for 10 years (ignoring discounting). Somewhat controversially this practice is no longer possible. IAS 37 requires that if the environmental costs are a liability (legal or constructive), then the whole of the costs must be provided for immediately. That has led to large liabilities appearing in some companies’ balance sheets. A third example of bad practice is the use of ‘big bath’ provisions and over provisioning. In its simplest form this occurs where a company makes a large provision, often for non-specific future expenses, or as part of an overall restructuring package. If the provision is deliberately overprovided, then its later release will improve future profits. Alternatively the company could charge to the provision a different cost than the one it was originally created for. IAS 37 addresses this practice in two ways: by not allowing provisions to be created if they do not meet the definition of an obligation; and specifically preventing a provision made for one expense to be used for a different expense. Under IAS 37 the original

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN provision would have to be reversed and a new one would be created with appropriate disclosures. Whilst this treatment does not affect overall profits, it does enhance transparency. Note: other examples would be acceptable. (c)

Guarantees or warranties appear to have the attributes of contingent liabilities. If the goods are sold faulty or develop a fault within the guarantee period there will be a liability, if not there will be no liability. The IASB view this problem as two separate situations. Where there is a single item warranty, it is considered in isolation and often leads to a discloseable contingent liability unless the chances of a claim are thought to be negligible. Where there are a number of similar items, they should be considered as a whole. This may mean that whilst the chances of a claim arising on an individual item may be small, when taken as a whole, it should be possible to estimate the number of claims from past experience. Where this is the case, the estimated liability is not considered contingent and it must be provided for. (i)

Bodyline’s 28-day refund policy is a constructive obligation. The company probably has notices in its shops informing customers of this policy. This would create an expectation that the company will honour its policy. The liability that this creates is rather tricky. The company will expect to give customers refunds of $175 000 ($1750000 10%). This is not the liability. 70% of these will be resold at the normal selling price, so the effect of the refund policy for these goods is that the profit on their sale must be deferred. The easiest way to account for this is to make a provision for the unrealized profit. This has to be calculated for two different profit margins: Goods manufactured by Header (at a mark up of 40% on cost): $24500 ($175 000 40/140

70%

20%) $7000

Goods from other manufacturers (at a mark up of 25% on cost) $98000 ($175 000 25/125

70%

80%) $19600

The sale of the remaining 30% at half the normal selling price will create a loss. Again this must be calculated for both group of sales: Goods manufactured by Header were originally sold

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN for $10 500 (175 000 30% 20%). These will be resold (at a loss) for half this amount i.e. $5 250. Thus a provision of $5 250 is required. Goods manufactured by other manufacturers were originally sold for $42 000 (175000 30% 80%). These will be resold (at a loss) for half this amount i.e. $21000. Thus a provision of $21 000 is required. The total provision in respect of the 28 day return facility will be $52 850 (7000 (ii)

19600

5250

21000).

Goods likely to be returned because they are faulty require a different treatment. These are effectively sales returns. Normally the manufacturer will reimburse the cost of the faulty goods. The effect of this is that Bodyline will not have made the profit originally recorded on their sale. This applies to all goods other than those supplied by Header. Thus these sales returns would be $128 000 (160 000 80%) and the credit due from the manufacturer would be $102 400 (128 000 100/125 removal of profit margin). The overall effect is that Bodyline would have to remove profits of $25 600 from its financial statements. For those goods supplied by Header, Bodyline must suffer the whole loss as this is reflected in the negotiated discount. Thus the provision required for these goods is $32 000 (160 000 20%), giving a total provision of $57 600 (25 600 32000).

(d) The Directors’ proposed treatment is incorrect. The replacement of the engine is an example of what has been described as cyclic repairs or replacement. Whilst it may seem logical and prudent to accrue for the cost of a replacement engine as the old one is being worn out, such practice leads to double counting. Under the Directors’ proposals the cost of the engine is being depreciated as part of the cost of the asset, albeit over an incorrect time period. The solution to this problem lies in IAS 16 ‘Property, Plant and Equipment’. The plant constitutes a ‘complex’ asset i.e. one that may be thought of as having separate components within a single asset. Thus part of the plant $16.5 million (total cost of $24 million less $7.5 assumed cost of the engine) should be depreciated at $1.65 million per annum over a 10-year life and the engine should be depreciated at $1 500 per hour of use (assuming machine hour depreciation is the most appropriate method). If a further provision of $1 500 per machine hour is made, there would be a double charge against profit for the cost of the engine. IAS 37 also refers

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN to this type of provision and says that the future replacement of the engine is not a liability. The reasoning is that the replacement could be avoided if, for example, the company chose to sell the asset before replacement was due. If an item does not meet the definition of a liability it cannot be provided for. 12

(a) The ‘Framework’ for the Preparation and Presentation of Financial Statements’ provides a conceptual underpinning for the International Financial Reporting Standards (IFRS). IFRS are based on the Framework and its aim is to provide a framework for the formulation of accounting standards. If accounting issues arise which are not covered by accounting standards, then the ‘Framework’ can provide a basis for the resolution of such issues. The Framework deals with several areas: (i) the objective of financial statements (ii) the underlying assumptions (iii) the qualitative characteristics of financial information (iv) the elements of financial statements (v) recognition in financial statements (vi) measurement in financial statements (vii) concepts of capital and capital maintenance. The Framework adopts an approach which builds corporate reporting around the definitions of assets and liabilities and the criteria for recognizing and measuring them in the balance sheet. This approach views accounting in a different way to most companies. The notion that the measurement and recognition of assets and liabilities is the starting point for the determination of the profit of the business does not sit easily with most practising accountants who see the transactions of the company as the basis for accounting. The Framework provides a useful basis for discussion and is an aid to academic thought. However, it seems to ignore the many legal and business roles that financial statements play. In many jurisdictions, the financial statements form the basis of dividend payments, the starting point for the assessment of taxation, and often the basis for executive remuneration. A balance sheet, fair value system which the IASB seems to favour would have a major impact on the above elements, and would not currently fit the practice of accounting. Very few companies fit this practice of accounting. Very few companies take into account the principles embodied in the Framework unless those principles themselves are embodied in an accounting standard. Some International Accounting Standards are inconsistent with the Framework primarily because they were issued earlier than the Framework. The Framework is a useful basis for financial reporting but a fundamental change in the current basis of financial reporting will be required for it to have any practical application. The IASB

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN seems intent on ensuring that this change will take place. The ‘Improvements Project’ (IAS8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’) makes reference to the use of the ‘Framework’ where there is no IFRS or IFRIC in issue. (b)

(i) Situation Under IAS37 ‘Provisions, Contingent Liabilities and Contingent Assets’, a provision should be made at the balance sheet date for the discounted cost of the removal of the extraction facility because of the following reasons: - the installation of the facility creates an obligating event - the operating licence creates a legal obligation which is likely to occur - the costs of removal will have to be incurred irrespective of the future operations of the company and cannot be avoided - a transfer of economic benefits (i.e. the costs of removal) will be required to settle the obligation - a reasonable estimate of the obligation can be made although it is difficult to estimate a cost which will be incurred in 20 years time (IAS 37 says that only in exceptional circumstances will it not be possible to make some estimate of the obligation). The cost to be incurred will be treated as part of the cost of the facility to be depreciated over its production life. However, the costs relating to the damage caused by the extraction should not be included in the provision, until the gas is extracted which in this case would be 20% of the total discounted provision. The accounting for the provision is as follows: Balance Sheet at 31 May 2004 (extracts) Tangible non-current assets: Cost of extraction facility Provision for decommissioning less depreciation (240 ÷ 20 years) Carrying value Other provisions: Provision for decommissioning Unwinding of discount ($40m 5%) Provision for damage

$m 200 40 240 (12)

(note 1)

228 $m 40 2 42 1.33 43.33

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Income statement Depreciation Provision for damage Unwinding of discount (finance cost)

$m 12.00 1.33 2.00

Note 1 IAS37 - Appendix IAS16 ‘Property, Plant and Equipment’ para. 15 Note 2 A simple straight line basis has been used to calculate the required provision for damage. A more complex method could be used whereby the present value of the expected cost of the provision ($10 m) is provided for over 20 years and the discount thereon is unwound over its life. This would give a charge in the year of $0.5 m $10 m 5% i.e. $1 m. (ii) The International Accounting Standards Board’s ‘Framework’ would require recognition of the full discounted liability for the decommissioning. The problem is that this can only be achieved by creating an asset on the other side of the balance sheet. This asset struggles to meet the Framework’s definition of an asset and is somewhat dubious by nature. An asset is a resource controlled by the company as a result of past events and from which future economic benefits are expected to flow. It is difficult to see how a future cost can meet this definition. The other strange aspect to the treatment of this item is that depreciation (and hence part of the provision) will be treated as an operating cost and the unwinding of the discount could be treated as a finance cost. This latter treatment could fail any qualitative test in terms of the relevance and reliability of the information. A liability is defined in the Framework as a present obligation arising from past events, the settlement of which is expected to result in an outflow of economic benefits. The idea of a ‘constructive obligation’ utilized in IAS37 is also included as a requirement in the Framework. Assets and liabilities are essentially a collection of rights and obligations. The provision for deferred taxation does not meet the criteria for a liability (or an asset) as set out in the Framework. The only tax liability (present obligation as a result of past events) is in fact the ‘current tax’ due to the tax authorities. A deferred tax liability can be avoided, for example, if a company makes future losses, and with suitable tax planning strategies it may never result in taxable amounts. A deferred tax asset is dependent upon the certainty of future profits or tax planning opportunities. It can be

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN argued that a deferred tax asset does not confer any ‘right’ to future economic benefits as future profits are never certain. Additionally the grant of $2 million has been treated as a liability in the financial statements. Unless there are circumstances in which the grant has to be repaid, it is also unlikely to meet the definition of a liability. 13 Memo To: Production Manager From: Trainee Management Accountant Date: January 2004 International Accounting Standard (IAS) 37 requires that any future obligations arising out of past events should be recognised immediately. The drilling licence includes a clause that requires the land to be returned to the state it was in before drilling commenced. The past event occurs as soon as the licence is granted and the de-commissioning costs are incurred as soon as the oil well has been drilled on the site. The full obligation must be recognised in the accounts ending 31March 2003. The full cost of the de-commissioning has been estimated ($20 million); this is then discounted to present value and recorded as a provision in the balance sheet at 31 March 2003. Where the expenditure gives access to future economic benefits such as access to oil reserves for the next 20 years, the decommissioning costs are treated as capital expenditure and added on to the cost of the non-current asset. The new total cost of the oil well would then need to be reviewed to ensure that its book value was not greater than its recoverable amount. The cost of the oil well (including the provision) should be depreciated each year and charged to the income statement. The provision will remain in the balance sheet until the oil well is de-commissioned in 20 years’ time. 14

Answer to come.

Chapter 20 1

Major arguments in favour: ■ profit after accounting for tax provides a better guide to the performance of the company ■ matching ■ prudence ■ quantifiability.

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 2

Arguments for providing only when it is probable that a liability will crystallize: ■ an apparently ever-increasing liability figure on the balance sheet does not indicate probable future sacrifice ■ prudence is ‘a state of mind’, not a requirement to provide for all remote occurrences. Difficulties with approach: ■ changes in taxation system ■ how probable is probable? - difficult to quantify ■ how far should we look into the future?

The discussion needs to take on board the arguments in favour of the flow-through method of providing for tax. Tax is assessed on taxable profits not accounting profits (although this could be the same in some countries) and therefore the only liability for tax is that assessed. Future years’ tax depends on future events and therefore it is difficult to regard this as a liability. However, arguments against using the flow-through approach are that: ■

■

 4

As tax changes can be traced to individual transactions and events then any future tax consequences arising from these should be provided for at the outset. Flow-through method can understate an entity’s liability to tax.

These are fully explained in the text. You are expected to demonstrate your understanding by the use of examples similar to but not identical to those used in the text.

Full explanations are given in the text. Do you agree with the choice made by the IASC? Allow the students to debate this question, but note that the following points should be covered: ■ ■

liability method is consistent with aim of partial provision deferral method creates a tax charge relating solely to that period and is not distorted by any adjustments relating to prior periods.

Consider for acceptability the answer to question 2. Consider for unacceptability the answer to question 1. Note the change brought about by full provision now required.

 7

You should set your answer out in a clear style covering the following areas: 

definition of deferred tax - what is it?

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN  

approach to providing for deferred tax flow through, full deferral, partial deferral? provision for deferred tax - deferral vs liability? Liability method Calculates deferred tax on current rate of tax thus showing the best estimate of a future liability. Emphasis on balance sheet. Deferral method Calculates deferred tax at the tax rate at date difference arose. The balance on deferred tax account is not affected by change in tax rate. Emphasis on income statement. The approach adopted by the IASB which clearly opts for a balance sheet view full provisioning where the tax is seen as a liability - not an income statement view which advocates flow-through or at best partial provision. A conclusion to the memo can be formed from questions 1 and 2 and it would be useful to make mention of discounting which reduces the effect of full provisioning.

The arguments need to be posed in the light of what would provide reliable, relevant, comprable and understandable information to users. Discounting may produce a figure that is closer to the actual tax that will be paid in the future and thus is relevant but its reliability is questionable as judgement is required on the discount rate. Understandability is also debatable as it is an area even accountants have difficulty understanding. Comparability is dependent on the subjective judgements made by management on the discount rate.

There are a number of areas in which the application of the IAS could give rise to different amounts being calculated for deferred tax although the circumstances might be similar. We will comment on two such areas: assessment of forecasts and revaluations. Assessment of forecasts Any provision depends on an assessment of the forecast’s accuracy and this depends on the individual making the forecast. As a result, consistency of treatment between companies is unlikely. Treatment of revaluations The Standard is unsatisfactory in that it lacks clarity over the appropriate treatment, which means that it is up to each individual company whether or not it makes a provision for a forecast tax liability depending on a decision as to the possible sale or scrapping of the fixed assets, e.g. it is extremely easy for the management to revalue but profess an intention not to sell any of the

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN revalued assets, thereby avoiding the need for any provision. 10 (i) An explanation of the origins of why deferred tax is provided for lies in understanding that accounting profit (as reported in a company’s financial statements) differs from the profit figure used by the tax authorities to calculate a company’s income tax liability for a given period. If deferred tax were ignored (flow through system), then a company’s tax charge for a particular period may bear very little resemblance to the reported profit. For example if a company makes a large profit in a particular period, but, perhaps because of high levels of capital expenditure, it is entitled to claim large tax allowances for that period, this would reduce the amount of tax it had to pay. The result of this would be that the company reported a large profit, but very little, if any, tax charge. This situation is usually ‘reversed’ in subsequent periods such that tax charges appear to be much higher than the reported profit would suggest that they should be. Many commentators feel that such a reporting system is misleading in that the profit after tax, which is used for calculating the company’s earnings per share, may bear very little resemblance to the pre tax profit. This can mean that a government’s fiscal policy may distort a company’s profit trends. Providing for deferred tax goes some way towards relieving this anomaly, but it can never be entirely corrected due to items that may be included in the income statement, but will never be allowed for tax purposes (referred to as permanent differences in some jurisdictions). Where tax depreciation is different from the related accounting depreciation charges this leads to the tax base of an asset being different to its carrying value on the balance sheet (these differences are called temporary differences) and a provision for deferred tax is made. This ‘balance sheet liability’ approach is the general principle on which IAS 12 bases the calculation of deferred tax. The effect of this is that it usually brings the total tax charge (i.e. the provision for the current year’s income tax plus the deferred tax) in proportion to the profit reported to shareholders. The main area of debate when providing for deferred tax is whether the provision meets the definition of a liability. If the provision is likely to crystallize, then it is a liability, however if it will not crystallise in the foreseeable future, then arguably, it is not a liability and should not be provided for. The IASB takes a prudent approach and IAS 12 does not accept the latter argument. (ii)

IAS 12 requires deferred tax to be calculated using the ‘balance sheet liability method’. This method requires the temporary difference to be calculated and the rate of income tax applied to this difference to give the deferred tax asset or liability. Temporary differences are the differences between the carrying amount of an asset and

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN its tax base. Carrying value at 30 September 2003 Cost of plant Accumulated depreciation at 30 September 2003 (200 400)/8 years for 3 years Carrying value Tax base at 30 September 2003 Initial tax base (original cost) Tax depreciation Year to 30 September 2001 (2000 40%) Year to 30 September 2002 (1200 20%) Year to 30 September 2003 (960 20%) Tax base 30 September 2003 Temporary differences at 30 September 2003 (1400 768) Deferred tax liability at 30 September 2003 (632 25% tax rate) Income statement credit - year to 30 September 2003 ((200 192) 25%) 11

$000

$000 2000 (600) 1400 2000

800 240 192

1232 768 632 158

(a) The ‘Framework for the Preparation and Presentation of Financial Statements’ provides a conceptual underpinning for the International Financial Reporting Standards (IFRS). IFRS are based on the Framework and its aim is to provide a framework for the formulation of accounting standards. If accounting issues arise which are not covered by accounting standards then the ‘Framework’ can provide a basis for the resolution of such issues. The Framework deals with several areas: (i) (ii) (iii) (iv) (v) (vi) (vii)

the objective of financial statements the underlying assumptions the qualitative characteristics of financial information the elements of financial statements recognition in financial statements measurement in financial statements concepts of capital and capital maintenance.

The Framework adopts an approach which builds corporate reporting around the definitions of assets and liabilities and the criteria for recognizing and measuring them in the balance sheet. This approach views accounting in a different way to most companies. The notion that the measurement and recognition of assets

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN and liabilities is the starting point for the determination of the profit of the business does not sit easily with most practising accountants who see the transactions of the company as the basis for accounting. The Framework provides a useful basis for discussion and is an aid to academic thought. However, it seems to ignore the many legal and business roles that financial statements play. In many jurisdictions, the financial statements form the basis of dividend payments, the starting point for the assessment of taxation, and often the basis for executive remuneration. A balance sheet, fair value system which the IASB seems to favour would have a major impact on the above elements, and would not currently fit the practice of accounting. Very few companies fit this practice of accounting. Very few companies take into account the principles embodied in the Framework unless those principles themselves are embodied in an accounting standard. Some International Accounting Standards are inconsistent with the Framework primarily because they were issued earlier than the Framework. The Framework is a useful basis for financial reporting but a fundamental change in the current basis of financial reporting will be required for it to have any practical application. The IASB seems intent on ensuring that this change will take place. The ‘Improvements Project’ (IAS8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’) makes reference to the use of the ‘Framework’ where there is no IFRS or IFRIC in issue. (b) (i) Situation A provision for deferred tax should be made under IAS12 ‘Income Taxes’ as follows:

Building: Tax written down value Net book value Less deferred credit Deferred tax liabilities - temporary differences Total temporary differences - deferred tax liabilities Temporary differences - deferred tax assets: Warranty

(75% $8 m)

$m 6

$9 m ($1.8 m)

7.2

Temporary difference $m

1.2 40 41.2

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Tax losses Total temporary differences - deferred tax assets The company would recognize a deferred tax asset of at least $41.2 million of the temporary differences of $74 million at the tax rate of 30%. If the company could prove that suitable taxable profits were available in the future or that tax planning opportunities were available to create suitable taxable profits, then the balance of the deferred tax asset ($32.8 million at tax rate of 30%) could be recognized. (ii) The International Accounting Standards Board’s Framework’ would require recognition of the full discounted liability for the decommissioning. The problem is that this can only be achieved by creating an asset on the other side of the balance sheet. This asset struggles to meet the Framework’s definition of an asset and is somewhat dubious by nature. An asset is a resource controlled by the company as a result of past events and from which future economic benefits are expected to flow. It is difficult to see how a future cost can meet this definition. The other strange aspect to the treatment of this item is that depreciation (and hence part of the provision) will be treated as an operating cost and the unwinding of the discount could be treated as a finance cost. This latter treatment could fail any qualitative test in terms of the relevance and reliability of the information. A liability is defined in the Framework as a present obligation arising from past events, the settlement of which is expected to result in an outflow of economic benefits. The idea of a ‘constructive obligation’ utilized in IAS37 is also included as a requirement in the Framework. Assets and liabilities are essentially a collection of rights and obligations. The provision for deferred taxation does not meet the criteria for a liability (or an asset) as set out in the Framework. The only tax liability (present obligation as a result of past events) is in fact the ‘current tax’ due to the tax authorities. A deferred tax liability can be avoided, for example, if a company makes future losses, and with suitable tax planning strategies it may never result in taxable amounts. A deferred tax asset is dependent upon the certainty of future profits or tax planning opportunities. It can be argued that a deferred tax asset does not confer any ‘right’ to future economic benefits as future profits are never certain. Additionally the grant of $2 million has been treated as a liability in the financial statements. Unless there are circumstances in which the grant has to be repaid, it is also unlikely to meet the definition of a liability. 12

One possible answer:

70 74

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Tax for current year Balance brought forward 1 January 2003 Deferred tax increase Income statement

1,000,000 (5,000) 150,000 1,145,000

A second possible answer: Income tax for the year Under provision in previous year Increase in deferred tax Income statement

1,000,000 5,000 150,000 1,155,000

Both answers are correct, depending on your reading of the question. It depends on whether the debit balance is seen as an over-payment or an under-provision. If the assumption is an over-payment that will be refunded, the first answer is correct. If the assumption is that there was an under-provision which needs to be corrected in the following year, the second answer is correct. 13 (a) (i) IAS12 ‘Income Taxes’ adopts a balance sheet approach to accounting for deferred taxation. The IAS adopts a full provision approach to accounting for deferred taxation. It is assumed that the recovery of all assets and the settlement of all liabilities have tax consequences and that these consequences can be estimated reliably and are unavoidable. IFRS recognition criteria are generally different from those embodied in tax law, and thus ‘temporary’ differences will rise which represent the difference between the carrying amount of an asset and liability and its basis for taxation purposes (tax base). The principle is that a company will settle its liabilities and recover its assets over time and at that point the tax consequences will crystallise. Thus a change in an accounting standard will often affect the carrying value of an asset or liability which in turn will affect the amount of the temporary difference between the carrying value and the tax base. This in turn will affect the amount of the deferred taxation provision which is the tax rate multiplied by the amount of the temporary differences (assuming a net liability for deferred tax.) (ii) A company has to apply IAS12 to the temporary differences between the carrying amount of the assets and liabilities in its opening IFRS balance sheet (1 November 2003) and their tax bases (IFRS1 ‘First time adoption of IFRS’). The deferred tax provision will be calculated using tax rates that have been enacted or substantially enacted by the balance sheet date. The carrying values of the assets and liabilities at the opening balance sheet date will be determined by reference to IFRS1 and will use the applicable IFRS in the first IFRS financial statements. Any

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN adjustments required to the deferred tax balance will be recognised directly in retained earnings. Subsequent balance sheets (at 31 October 2004 and 31 October 2005) will be drawn up using the IFRS used in the financial statements to 31 October 2005. The deferred tax provision will be adjusted as at 31 October 2004 and then as at 31 October 2005 to reflect the temporary differences arising at those dates. (b) (i) The tax deduction is based on the option’s intrinsic value which is the difference between the market price and exercise price of the share option. It is likely that a deferred tax asset will arise which represents the difference between the tax base of the employee’s service received to date and the carrying amount which will effectively normally be zero. The recognition of the deferred tax asset should be dealt with on the following basis: (a) if the estimated or actual tax deduction is less than or equal to the cumulative recognised expense then the associated tax benefits are recognised in the income statement (b) if the estimated or actual tax deduction exceeds the cumulative recognised compensation expense then the excess tax benefits are recognised directly in a separate component of equity. As regards the tax effects of the share options, in the year to 31 October 2004, the tax effect of the remuneration expense will be in excess of the tax benefit. Tax effect of the remuneration expense is 30% x $40 million ÷ 2 Tax benefit is 30% of $16 million ÷ 2

$m 6 2·4

The company will have to estimate the amount of the tax benefit as it is based on the share price at 31 October 2005. The information available at 31 October 2004 indicated a tax benefit based on an intrinsic value of $16 million. As a result, the tax benefit of $2.4 million will be recognised within the deferred tax provision. At 31 October 2005, the options have been exercised. Tax receivable will be 30% x $46 million i.e. $13.8 million. The deferred tax asset of $2.4 million is no longer recognised as the tax benefit has crystallised at the date when the options were exercised. For a tax benefit to be recognised in the year to 31 October 2004, the provisions of IAS12 should be complied with as regards the recognition of a deferred tax asset. (ii) Plant acquired under a finance lease will be recorded as property, plant and equipment and a corresponding liability for the obligation to pay future rentals. Rents payable are

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN apportioned between the finance charge and a reduction of the outstanding obligation. A temporary difference will effectively arise between the value of the plant for accounting purposes and the equivalent of the outstanding obligation as the annual rental payments qualify for tax relief. The tax base of the asset is the amount deductible for tax in future which is zero. The tax base of the liability is the carrying amount less any future tax deductible amounts which will give a tax base of zero. Thus the net temporary difference will be:

NPV Depreciation

Value in financial statements $m 12 (2.4) 9.6

Liability Repayment Interest (8% x 12)

Liability

Temporary Difference

$m 12 (3) 0.96 9.96

0.36

A deferred tax asset of $0.36m at 30% i.e. $108,000 will arise.

(iii) The subsidiary, Pins, has made a profit of $2 million on the transaction with Panel. These goods are held in inventory at the year end and a consolidation adjustment of an equivalent amount will be made against profit and inventory. Pins will have provided for the tax on this profit as part of its current tax liability. This tax will need to be eliminated at the group level and this will be done by recognising a deferred tax asset of $2 million x 30%, i.e. $600,000. Thus any consolidation adjustments that have the effect of deferring or accelerating tax when viewed from a group perspective will be accounted for as part of the deferred tax provision. Group profit will be different to the sum of the profits of the individual group companies. Tax is normally payable on the profits of the individual companies. Thus there is a need to account for this temporary difference. IAS12 does not specifically address the issue of which tax rate should be used to calculate the deferred tax provision. IAS 12 does generally say that regard should be had to the expected recovery or settlement of the tax. This would be generally consistent with using the rate applicable to the transferee company (Panel) rather than the transferor (Pins). (iv)

The recognition of the impairment loss by Nails reduces the carrying value of the property, plant and equipment of the company and hence the taxable temporary difference. The deferred tax liability will, therefore, be reduced accordingly. No deferred tax would have been recognised on the good will in accordance with IAS12 and, therefore, the impairment loss relating to the goodwill does not cause an adjustment to the deferred tax position. Goodwill

Property, plant and

Tax base

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Balance 31 October 2005 Impairment loss

$m 1

equipment $m 6

(1) -

(0.8) 5.2

The deferred tax liability before the impairment loss is (6 – 4) at 30% i.e. $0.6 million. After the impairment loss it is (52 – 4) at 30% i.e. $0.36 million, thus reducing the liability by $0.24 million. 14

Figures per accounts: annual depreciation is (220 000 – 10 000)/5 = 210 000/5 = 42 000 annual depreciation 2007/08 (189 000 – 10 000)/3 = 59 667 $ 220 000 42 000 178 000 42 000 136 000 53 000 189 000 59 667 129 333 $ 220 000 110 000 110 000 27 500 82 500 20 625 61 875

Cost Depreciation 2005/06 Depreciation 2006/07 Revaluation 1/10/07 Depreciation 2007/08 (1/3) Netbook value at 30/9/08 Tax Balances Cost First year allowance 50% Allowance 2006/07 25% Allowance 2007/08 25% Tax Base 30/9/08

Temporary difference is the difference between the accounting net book value and the tax base. $ 129 333 61 875 67 458

Accounting net book value Tax base Temporary difference

Total deferred tax provision required = $ 67 458 x 25% = $ 16 865 15 Cost First year to 31.3.08

Tax value 220 000 - 66 000

Book value 220 000 - 27 500

154 000

192 500 50 000 242 500

1.4.08 revaluation 154 000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN To 31.3.09

30 800 123 200

34 600* 207 900

*242 500/7 = 34 600 Deferred tax balance carried forward is difference between net book value and tax written down value at the year end. 207 900 – 123 200 = 84 700 x 25% = 21 175 Movement calculated as difference between opening and closing balance: opening balance 66 000 – 27 500 = 38 500 at 25% = 9 625 closing balance: 21 175 movement = 9 625 – 21 175 = 11 550 16

Current taxes for the year = 0,22 (946 000) = 208 120 Increase in deferred tax provision from 642 000 to 759 000 = 117 000 Overestimation last year 31 000 Tax expense= 208 120 + 117 000 – 31 000 = 294 120

Chapter 21

 1

In this assignment the terms of the arrangement provide the counterparty with a choice of settlement. In this situation a compound financial instrument has been granted, i.e. a financial instrument with debt and equity components (see discussion of IAS 39); IFRS 2 requires the entity to estimate the fair value of the compound instrument at grant date, by first measuring the fair value of the debt component, and then measuring the fair value of the equity component, taking into account that the employee must forfeit the right to receive cash in order to receive the equity instruments. If we apply this to this assignment, we will start by measuring the fair value of the cash alternative = 3000 €30 = €90 000. The fair value of the equity alternative is 2 500 - €28 = €70 000. The fair value of the equity component of the compound instrument is a 20 000 (€90 000 - €70 000). This share-based payment transaction will be recorded as C follows. Each year an expense will be recognized. The expense will consist of the change in the liability due the remeasurement of the liability. The fair value of the equity component is allocated over the vesting period. The following amounts will be recognized:

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Year 1

Calculation Liability component (3000 _ €33)/3 = 33 000 Equity component (20 _ 1/3) = 6 666 Liability component (3000 _ €36)2/3 _ 33 000 = 39000 Equity component (20.000 _ 1/3) = 6 666 Liability component (3000 _ 40) _ 72 000 = 48 000 Equity component (20 000 _1/3) = 6 667

Expense 39666

Equity 6666

Liability 33000

45666

13332

72000

54667

20000

120000

Suppose that at the end of year 3 the directors choose the cash alternative. In that situation €20 000 will be paid to the directors and the value of the liability will be nil afterwards. The equity component remains unchanged. When the directors choose a payment in shares then 25 000 shares will be issued. The liability amount will be transferred to the equity account.

 2 (a) Defined contribution plans: These are relatively straightforward plans that do not present any real problems. Normally under such plans employers and employees contribute specified amounts (often based on a percentage of salaries) to a fund. The fund is often managed by a third party. The amount of benefits an employee will eventually receive will depend upon the investment performance of the fund’s assets. Thus in such plans the actuarial and investment risks rest with the employee. The accounting treatment of such plans is also straightforward. The cost of the plan to the employer is charged to the income statement on an annual basis and (normally) there is no further on-going liability. This treatment applies the matching concept in that the cost of the post-retirement benefits is charged to the period in which the employer received the benefits from its employee. Postretirement benefits are effectively a form of deferred remuneration. Defined benefit plans: These are sometimes referred to as final salary schemes because the benefits that an employee will receive from such plans are related to his/ her salary at the date they retire. For example, employees may receive a pension of 1/60th of their final year’s salary for each year they have worked for the company. The majority of defined benefit plans are funded, i.e. the employer makes cash

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN contributions to a separate fund. The principles of defined benefits plans are simple, the employer has an obligation to pay contracted retirement benefits when an employee eventually retires. This represents a liability. In order to meet this liability the employer makes contributions to a fund to build up assets that will be sufficient to meet the contracted liability. The problems lie in the uncertainty of the future, no one knows what the eventually liability will be, nor how well the fund’s investments will perform. To help with these estimates employers make use of actuaries who advise the employers on the cash contribution required to the fund. Ideally the intention is that the fund and the value of the retirement liability should be matched, however, the estimates required are complex and based on many variable estimates, e.g. the future level of salaries and investment gains and losses of the fund. Because of these problems regular actuarial estimates are required and these may reveal fund deficits (where the value of the assets is less than the postretirement liability) or surpluses. Experience surpluses or deficits will give rise to a revision of the planned future funding. This may be in the form or requiring additional contributions or a reduction or suspension (contribution holiday) of contributions. Under such plans the actuarial risk (that benefits will cost more than expected) and the investment risk (that the assets invested will be insufficient to meet the expected benefits) fall on the company. Also the liability may be negative, in effect an asset. Accounting treatment: The objective of the new standard is that the financial statements should reflect and adequately disclose the fair value of the assets and liabilities arising from a company’s post-retirement plan and that the cost of providing retirement benefits is charged to the accounting periods in which the benefits are earned by the employees. In the balance sheet: An amount should be recognized as a defined benefit liability where the present value of the defined benefit obligations is in excess of the fair value of the plan’s assets (in an unfunded scheme there would be no plan assets). This liability will be increased by any unrecognized net actuarial gains (see below). Where an actuarial gain or loss arises (caused by actual events differing from forecast events), IAS 19 requires a ‘10% corridor test’ to be made. If the gain or loss is within 10% of the greater of the plan’s gross assets or gross liabilities then the gain or loss may be recognized (in the income statement) but it is not required to be. Where the gain or loss exceeds the 10% corridor then the excess has

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN to be recognized in the income statement over the average expected remaining service lives of the employees. The intention of this requirement is to prevent large fluctuations in reported profits due to volatile movements in the actuarial assumptions. The following items should be recognized in the income statement: - current service cost (the increase in the plan’s liability due to the current year’s service from employees) - interest cost (this is an imputed cost caused by the ‘unwinding’ of the discounting process; i.e. the liabilities are one year closer to settlement) - the expected return on plan assets (the increase in the market value of the plan’s assets) - actuarial gains and losses recognized under the 10% corridor rule - costs of settlements or curtailments. (b) Income statement Current service cost Interest cost (10% _ 500) Expected return on plan’s assets (12% _ 500) Recognized actuarial gain in year Post-retirement cost in income statement

$000 160 150 (180) (5) 125

Balance sheet Present value of obligation Fair value of plan’s assets 100 Unrecognized actuarial gains (see below) Liability recognized in balanced sheet Movement in unrecognized actuarial gain Unrecognized actuarial gain at 1 April 2001 Actuarial gain on plan assets (w (i)) Actuarial loss on plan liability (w (i)) Loss recognized (w (ii)) Unrecognized actuarial gain 31 March 2002

$000 1750 (1650) 140 240 200 10 (65) (5) 140

Workings: Plan assets

Plan liabilities

$000

Balance 1 April 2001 1500 Current service cost Interest Expected return 180 Contributions paid 85 Benefits paid to employees (125) Actuarial gain (balance) 10

1500 160 150

(i)

(125)

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Actuarial loss (balance) Balance 31 March 2002

65 1750

1650

(ii) Net cumulative unrecognized actuarial gains at 1 April 2001 200 10% corridor (10% _ 1 500) 150 Excess 50 /10 years = $5 000 actuarial gain to be recognized.



3 Year Calculation 1 2 3



Expense

(1000 _ 0.85 _ 20)/3 5666 (1000 _ 0.88 _ 20)2/3 _ 5 666 (10 _ 86 _ 20) _ 11 733 5467

5 Year

5666 6067 11733 17200

Since IFRS requires the entity to recognize the services received from a counter-party who satisfies all other vesting conditions (e.g. services received from an employee who remains in service for the specified period), irrespective of whether that market condition is satisfied, it makes no difference whether the share price target is achieved. The possibility that the share price target might not be achieved has already been taken into account when estimating the fair value of the share options at grant date.

Year Calculation 1 2 3

Expense

(20000 _ 0.98 _ 48)/3 313600 ((20 000 _ 0.98 _ 48)2/3) _ 313 600 313600 (1000 _ 17 _ 48) _ 627 200 188800 Calculation

Expense

1 2

(100 _ (200 _ 25) _ 31)/2 = 271 250 (100 _ (200 _ 26 _ 74) _ 36) _ 271 250 = 88 750 + 74 _ 100 _ 30 = 222 000 360000 3 _ 360 000 + 100 _ 100 _ 40 = 400 000 40000 0 6

Equity and cumulative expense

Equity 313600 627200 816000 Liability 271250 310750

The only function of the corridor approach is to reduce the volatility of reported earnings. There is no element of the conceptual framework of the IASB that can be used to defend this corridor approach. It seems that the preparers of financial statements are afraid that external decision makers cannot interpret the pension information in a correct manner. The corridor approach could, as such, be regarded as a mechanism that guides the interpretation of

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN external stakeholders in a certain direction, meaning disregard short-term fluctuations in differences between actuarial assumptions and reality. It could be interesting to discuss with the students how far the technicality of Standards might go; what level of insight in the technicality of Standards one might expect from external stakeholders. In the light of these comments, it is not surprising that the IASB is considering abolishing the corridor approach. 7

First of all, the choice of a particular actuarial cost method for accounting purposes enhances the comparability of pension costs between companies. Under the accrued benefit cost method, without future salary increases the current service cost would rise steeply at the end of the service period of an employee. Including future salary increases in the calculation of the current service cost somehow smoothes the steep rise of the pension cost towards the end of the career of an employee. The differences described appear in an out-spoken way if one calculates the pension cost of an individual. In the case, however, of a so-called ‘stationary population’ of the workforce these differences will disappear at the level of the current service cost of the total population. With an increasing workforce or a decreasing workforce, the differences between ABCM without salary increase and ABCM with salary increase appear again. The projected unit credit method ABCM with future salary increases is also the basis for the determination of pension liability. This implies that future salary increases are taken into account to determine liabilities. Some people might have a problem with that.

In fact, they should be separated as they represent elements resulting from a different origin. The discount factor takes into account the time value of money. Only when the pension assets are invested in fixed income securities might there somehow be a relation between the discount factor and the expected market return. When pension assets are divided over fixed income securities, shares and other financial products, the two elements will diverge. So it was indeed a good choice to separate the two.

By now it should be clear to students why ‘discount factor’ and ‘expected market return’ must be separated. If companies fund their pension plan at a higher level than that required by the projected unit credit method, this will have a positive impact on the total pension cost. When, for example, pensions have been funded using a projected benefit method, substantially more pension assets are available than if the company had used the projected unit credit method for financing purposes. The breakdown between ‘discount factor’, ‘expected market

100

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN return’ and ‘actuarial gains and losses’ will give the external stakeholder an idea about the positive impact of the financial pattern of the pension benefits on the total pension cost. 10

In order to discuss the question, the definition of a multiemployer plan can be analysed and compared with the characteristics of most state pension plans. Students will realize that most state pension plans have the characteristics of a defined contribution plan, as in most countries the employer has fulfilled his commitment if he has transferred the contributions in relation to the state pension plan to the government. Stimulate the students to think of possible situations in which a state pension could have the characteristics of a defined benefit plan.

Two sources of information can be used to discuss this question. First of all, the knowledge students have acquired in finance courses with regard to the valuation of options can be used here. Will the intrinsic value of the option be appropriate for accounting purposes or do we need more sophisticated models (e.g. Black & Scholes)? Second, the exposure draft on share-based payment could be taken as a starting point for discussion. Students should state what kind of recognition and measurement methods they require for equity benefits and what kind of disclosures they want.

The answer is A. Workings Statements (i) and (ii) are both true. The net pension asset is the market value of the assets of the scheme [which decreases when share prices fall] less the present value of the scheme liabilities [which decreases when interest rates rise]. Statement (iii) is false. Variations to benefits that relate to past service should be recognized immediately if they vest immediately.

The answer is C. Workings The net pension liability reconciled as follows: Opening net liability Reduction due to exceptional gain Current service cost Expected return on plan assets Unwinding of discount on plan liabilities Actuarial loss (balancing figure) Closing net liability

101

$000 60000 (4000) 8000 (6000) 4000 3000 65000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 14

Answer A Pension obligation Unrecognized actuarial loss Pension plan assets Pension Liability

1 634 000 224 000 1 337 000 73 000

15 (a) The actuarial gain or loss for the period is the difference between the expected return on assets and the realized return on assets Expected return on assets: 9, 4% (1 8360 000) = 1 725 840 Realized return on assets: Fair Value plan assets (2006) = 17 770 000 + contributions 997 000 - Benefits paid 1 860 300 Value at 31 oct 2007 16 906 700 Fair value at 31 oct 2007 18 417 180 Realized return (18 417 180 – 16 906 700) = 1 510 480 Actuarial loss for the year of: 1 725 840 – 1510 480 = 215 360 (b)

Amount of unrecognized losses last year 802 000 Actuarial loss current year 215 360 Total amount of unrecognized losses 1 017 360 This amount is smaller than 10% of the projected benefit obligation and the plan assets at 2006. In case of the 10% corridor no amount should be recognized.

Salaries paid in cash would of course have an immediate impact on liquidity. It is true that payment of salaries in the form of cash would have an immediate impact on profitability as well as liquidity. The payment of a salary would be an employee benefit as defined in IAS 19 – Employee benefits. IAS 19 gives such a payment as a specific example of a shortemployee benefit and states that it should be recognised as an expense when the related services have been provided by the employee. Therefore, provided the salary payments are not made in advance (and this is uncommon) there will normally be an immediate impact on profitability. The only exception to this principle would be if the salary cost could be included in the carrying amount of another asset of the entity, such as inventory, or property, plant and equipment. Accounting for the potential issue of share options to employees is governed by the provisions of IFRS 2 – share based payment. IFRS 2 deals with share based payments that are made in the form of cash (cash settled share based payments) and those made by the issue of equity instruments of the entity (equity settled share based payments). Equity settled share based payments include the granting of share options. The basic principle is that the cost of the share based payment should be treated in

102

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN just the same way as if the payment were made in cash, in other words, the cost will normally be recognised as an expense in the income statement, although it may occasionally be included in the carrying amount of another asset. Therefore although such payments do not have the same immediate impact on liquidity as salary payments, they do affect earnings per share as they are charged to the income statement. If the share options vest and are exercised there is a double impact on earnings per share since the additional shares issued will increase the denominator of the earnings per share calculation. Where the payment is in the form of equity instruments two other issues arise. The first is how the cost of the payment should be measured. Where the payment is made in return for employee services then IFRS 2 requires that it be measured using the fair value of the instruments actually issued. In the case of share options, unless the options are listed this means estimating their fair value using an option pricing model. The fair value estimate is made at the grant date and is not revised subsequently. The second issue is when the instruments do not vest immediately, and the vesting is subject to future conditions. The basic principle is that the estimated cost of the options that are expected to vest is recognised in the income statement on a straight-line basis over the vesting period. Unless the vesting condition is related to the future share price of the entity (a market condition) then the estimate is initially made at the date the option is granted and then revised over the vesting period if the expected outcome of the vesting conditions changes. Where the vesting condition is a market condition then the likelihood (or otherwise) of the shares vesting is factored into the fair value of the option. Therefore no account is taken of changed perceptions in this area since this would result in double counting. Given that no cash is paid to the employees over the vesting period, the credit entry that corresponds to the debit to the income statement or to assets is directly to equity as a separate component. Once the entry is made, the balance in this component is transferred to share capital or retained earnings as an equity transfer when the options are exercised or lapse. 17

Actuarial gain = realized return > expected return Actuarial loss = realized return < expected return Realized return = (11 204 000 + 662 400 – 550 000 – 10 660 000) = 656 400 Expected return= 6,2 % (10 660 000) = 660 920 Actuarial loss of 4 520

18 (a) Charge to income statement

103

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Service cost Interest cost Expected return (8.219% x $73m) Actuarial loss (W1) Income statement charge

7.8 10. 2 (6.0) 0.08 12.08

Workings W1 Actuarial loss to be recognised FDE adopts the corridor approach for the recognition of actuarial gains and losses. the corridor is 10% of the higher of opening plan assets/ liabilities 10% of $80m = 8 m Unrecognised actuarial losses brought forward totalled $5.8m, which is above the corridor so FDE will be recognising part of the loss. The amount recognised in the income statement = $(8.8m-8.0m)/10 years = 0.08 (b) Balance sheet PV of defined benefit plan liabilities Less FV of defined benefit plan assets Unrecognised actuarial losses (W2) Net pension liability W2 Unrecognised actuarial losses 31.3.09 Unrecognised actuarial losses 31.3.08 Actuarial loss on plan liabilities (W3) Actuarial gain on plan assets (W3) Recognised in the period (corridor approach) (W1) Unrecognised actuarial losses 31/3/09

$m 95.0 (84.0) 11.0 (9.52) 1.48 $m (8.8) (1.0) 0.2 0.08 (9.52)

Actuarial gains/ losses in period

Chapter 22

 1

IAS 29 is adjusting for general inflation, i.e. for the fall in the value of money. It applies a general inflation adjustment to the original, i.e. normally, historical cost figures. It is in no sense, therefore, concerned with valuation of financial statement items.

The short answer has to be yes. This is an illustration of the general problem caused by the creation of arbitrary numerical distinctions. To be fair to IAS 29, however, it does go out of its way to emphasize that the numerical criterion is only one of several guiding factors. Unfortunately, it is the one factor on which people have tended to focus in practice.

This is, of course, pure revision. See the appropriate

104

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN suggested solutions for Chapter 7. Note also that this serves as a reminder that apparently theoretical considerations usually have direct real world relevance.

Chapter 23 1

Usefulness of funds flow statements: ■ ■ ■ ■ ■

shows the movement in assets and liabilities over a period of time control of working capital is essential shows how a business is financed, distinguishing between external and internal sources shows how resources have been used reveals the effects of acquisition or disposal of a subsidiary.

Usefulness of cash flow statements: ■ ■ ■ ■

■

■ ■ ■ ■

movements relevant to liquidity are not obscured cannot be manipulated (reference to David Tweedie) guide as to ability to pay dividends historical cash flows may be a better method of forecasting than historical funds flow. 2 Cash flow statements must be used in conjunction with other statements, as they will not alone provide all answers: They can be ‘changed’ at balance sheet date by delaying purchase of fixed assets and stock, payment of creditors and improving debtor collection. Definition of cash equivalents can lead to misleading results. Discussion required on the following: evaluation of liquidity and solvency cash is more objective than profit, therefore difficult to ‘fiddle’ identification within the cash flow of all significant cash inflows and outflows.

This is purely discussion based and therefore there is no suggested solution.

Refer to text for answer.

The analysis should centre on the following: ■ decrease in operating profit and gross cash from operating from the previous year ■ increase in net cash for 2001 compared to 2000 due to the major change in working capital at the two balance sheet dates ■ significant but no greater than previous year’s expenditure on fixed assets ■ significant decrease in acquisitions compared to previous year which was 4125 million; this decrease

105

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN has led to a positive cash flow for current year debt issuance and redemption is matched in current year whereas previous year issuance outstripped redemption significantly (this issuance of debt was probably to finance acquisition in previous year) previous year saw a major decrease in cash held due to the acquisitions whereas this year a more stable position prevail view from analysis is that Bayer has had a more stable year while recovering from and incorporating the major acquisitions of the previous year. The incorporation has probably led to increased expenditure which has affected the cash flow from operating. This analysis must be tested out and enhanced by analysis of other information available. The analysis cannot be made from cash flow statements alone!

■

■ ■

 5

Statement of cash flow must be looked at together with statement of financial position and statement of income. It cannot be used in isolation. The cash flow provides additional information as follows:     

cash flow generated from operations cash flow effect of taxation charge amounts expended on capital and financial investment are nearly as great as that generated from operations capital expenditure and investments have been financed from operations, issued share capital and long-term debt minority interest payments and cash from associates can be clearly seen l whether acquisition of subsidiary has had a positive effect on cash flow.

See text for answer.

Objective of the cash flow is to provide information that assists in the assessment of liquidity, solvency and financial adaptability. Students should discuss whether the cash flow as currently defined would aid any user in assessing these areas or whether increases or decreases in cash method would provide more relevant, reliable, understandable and comparable information.

8 (a)

Reconciliation of operating profit to net cash flow from operating £m Profit before interest and tax (190+6net interest) Depreciation (from IS) Impairment (from IS) Profit on sale (from IS)

106

60 40 (16)

£m 196

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 280 Increase in inventory (from BS changes) Decrease in trade receivables (from BS changes) Increase in trade payables (from BS changes) Net cash flow from operating activities

(8) 4 8

4 284

Calculations : Purchase of property, plant and equipment net change in assets on balance sheet (778-640) = 138 nbv item sold (72-16 profit on sale ) = 56 Depreciation 60 254 Statement of cash flows for the year ended 30th September 2007 Net cash inflow from operating activities Tax paid (90+80-80) Interest paid Net cash used in investing activities Payments to acquire intangible non-current assets (280-240+40 impairment) Payments to acquire property, plant and equipment Sale of non-current assets Interest received Net cash used in financing activities Dividends paid (30+80-40) Issue of shares (660-540 ordinary shares and premium) Non-current liabilities raised (240-200) Increase in cash balances

£m 284 (90) (16)

£m 178

(80) (254) 72 10

(252)

(70) 120 40

90 16

Cash is the lifeblood of an organisation but the statement of cash flows is historical. If we are concerned over the liquidity of a business, the ability to pay its debts, then a cash flow forecast would be more useful. Cash flow from operating activities is derived by either the direct or indirect method. Indirect method uses information from the accruals based accounting system. The direct method reflects cash transactions and therefore should be used. The indirect method has the potential to confuse uses. Cash flow bottom line is change in cash and cash equivalents. The definition of cash equivalents may not be precise.

9 a) Reconciliation of operating profit to net cash flow from operating £m Profit before interest and tax (285+9net interest) Depreciation (from IS) Impairment (from IS) Profit on sale (from IS)

90 60 (24)

Increase in inventory (from BS changes) Decrease in trade receivables (from BS changes)

(12) 6

107

£m 294 126 420

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Increase in trade payables (from BS changes) Net cash flow from operating activities

6 426

Calculations: Purchase of property, plant and equipment net change in assets on balance sheet (1167-960) nbv item sold (108-24 profit on sale ) Depreciation

207 84 90 381

Statement of cash flows for the year ended 31 December 2007 Net cash inflow from operating activities Tax paid (135+120-120) Interest paid Net cash used in investing activities Payments to acquire intangible non-current assets (420-360+60 impairment) Payments to acquire property, plant and equipment Sale of non-current assets Interest received Net cash used in financing activities Dividends paid (45+120-60) Issue of shares (900-750+ 90-60ordinary shares and premium) Non-current liabilities raised (360-300) Increase in cash balances

£m 426 (135) (24)

£m 267

(120) (381) 108 15

(378)

(105) 180 60

135 24

b) Cash flow statements identify: Net cash inflows from operations Net cash inflows from investments in non-current assets Net flows from financing activities Payments in respect of interest, dividends and taxation None of the above are identifiable from the income statement and balance sheet Also identifies the extent to which reported profit is matched by cash flows and thus the distinction between cash and profit is clearly made. The user of the statement of cash flows has more relevant information on which to assess the solvency of the entity. 10 TEX – Statement of cash flows for the year ended 30 September 2003 $000 $000 Cash receipts from customers (W1) 14,300 Cash paid to suppliers and employees (W2) (8,290) Cash generated from operations 6,010 Interest paid (124) Income taxes paid (W4) (485) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W6) (8,000) Proceeds from sale of equipment 730 Net cash used in investing activities

108

5,401

(7,270)

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Cash flows from financing activities Proceeds from issue of share capital (W5) 3,019 Repayment of long term borrowings (1,200) Dividends paid (W3) (1,000) Net cash from financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at 30 September 2002 Cash and cash equivalents at 30 September 2003

819 (1,050) 1,200 150

Notes 1 During the period the company acquired property, plant and equipment with an aggregate cost of $8 million. These were paid for by cash. 2 Cash and cash equivalents consist of cash on hand and balances with banks. Cash and cash equivalents included in the cash flow statement comprise the following balance sheet amounts:

Cash on hand and balances with banks

2002 $000 1,200

2003 $000 150

Workings $000 W1 Cash receipts from customers Trade Receivables Balance at 30 September 2002 Revenue from Income statement Balance at 30 September 2003` Receipts W2 Cash paid to suppliers and employees Cost of Sales Income Statement Less depreciation (W6) Less loss on disposal Income Statement cost of sales Less inventory at 30 September 2002 Add inventory at 30 September 2003 Purchases Trade Payables Balance at 30 September 2002 Purchases

800 15,000 15,800 1,500 14,300

9,000 (2,640) (970) 5,390 (1,100) 4,290 1,600 5,890

Less balance at 30 September 2003 Payments to suppliers

800 5,890 6,690 (700) 5,990

Total payments to suppliers and employees Payments to suppliers Other expenses from Income Statement Total

5,990 2,300 8.290

109

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

W3 Dividends Balance at 30 September 2002 Income statement Less balance at 30 September 2003 Paid W4 Income Taxes Balance at 30 September 2002 Taxes Deferred tax Income Statement Less balance at 30 September 2003 Taxes Deferred tax

W5 – Share capital Balance at 30 September 2002 Balance at 30 September 2003 Cash issue

600 1,100 1,700 (700) 1,000

685 400 1,085 1,040 2,125 (1,040) (600) 485 7,815 10,834 3,019

W6 – Tangible non-current assets Property Balance at 30 September 2002 Balance at 30 September 2003 Purchased Depreciation in year Plant Balance at 30 September 2002 Less disposal Balance at 30 September 2003 Purchased Depreciation in year Total purchases Property Plant

CostDepreciation $000 $000 8,400 1,300 1,540 11,200 2,800 240 CostDepreciation $000 $000 10,800 3,400 2,600 900 8,200 2,500 13,400 4,900 5,200 2,400 $000 2,800 5,200 8,000

Total depreciation Property Plant

240 2,400 2,640

110

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

AG – Statement of cash flows for the year ended 31 March 2005 $000 Cash flows from operating activities Profit before taxation 255 Adjustments for: Depreciation 720 Development expenditure amortisation 80 Finance cost 45 Gain on disposal of non-current tangible asset (W1) (23) Operating profit before working capital changes Increase in inventory Increase in trade receivables Increase in trade payables Increase in accrued expenses (W2)

$000

1,077 (110) (95) 130 10

Cash generated from operations Interest paid (W3) (120) Income taxes paid (W4) (200) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W5) (370) Proceeds from sale of equipment 98 Development expenditure (W6) (50) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital (W7) 1,050 Repayment of loans (1,000) Equity dividends paid* (100) Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at 1 April 2004 Cash and cash equivalents at 31 March 2005 552

(65) 1,012 (320) 692

(322)

(50) 320 232

*this could be shown as an operating cash flow instead Workings (W1) – Gain on disposal of property plant and equipment $ 5 98 23

Net book value Cash Gain (W2) – Accrued expenses Balance b/fwd Interest b/fwd

$ 172 (87)

Balance c/fwd Interest c/fwd

107 (12)

$ 85

111

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 95 10 (W3) -Interest paid $ 87 45 132 12 120

Balance b/fwd P&L Balance c/fwd Paid (W4) – Income Taxes paid

$ 190 200

Balance b/fwd – corporate income tax - deferred tax

$ 390 140 530

Income statement Balance c/fwd – corporate income tax – deferred tax Tax paid

80 250

330 200

(W5) – Purchase of property, plant and equipment $ Balance b/fwd 4,800 Disposals (75) 4,725 Revaluation

125 4,850

Depreciation for year

(720)

Balance c/fwd Purchases

4,500 370

4,130

(W6) – Development expenditure Balance b/fwd Amortised in year

$ 400 80

Balance c/fwd New expenditure

370 50

320

(W7) – Proceeds from issue of share capital Shares Share premium Received 12

1,400 x 0.5 = 1,400 x 0.5 x 0.5 =

CJ –Statement of cash flows for the year ended 31 March 2006 $000 Cash flows from operating activities Profit before taxation 4,398

112

$ 700 350 1,050

$000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Adjustments for: Other income Depreciation Finance cost Gain on disposal of plant (W2)

(200) 4,055 1,302 (23) 9,532 (214) (306) 420 9,432 (1,602) (1,796)

Increase in inventory Increase in trade receivables Increase in trade and other payables (W6) Cash generated from operations Interest paid (W3) Income taxes paid (W4) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W1) (2,310) Investment income received 180 Proceeds from sale of equipment 118 Proceeds from disposal of available for sale investments (W5) 620 Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital (W7) 10,000 Repayment of interest bearing borrowings (6,000) Equity dividends paid * (800) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at 1 April 2005 Cash and cash equivalents at 31 March 2006 6,962

6,034

(1,392)

3,200 7,842 (880)

* this could also be shown as an operating cash flow Workings (W1) Net book values $000 Balance b/fwd Revaluation

Property $000 18,000 1,500 19,500 Disposal 0 Depreciation for year (2,070) 17,430 Acquired in year (to balance) 1,730 Balance c/fwd 19,160

Plant Available for sale investments $000 10,000 2,100 0 0 10,000 2,100 (95) (600) (1,985) 0 7,920 1,500 580 0 8,500 1,500

Total purchases = 1,730 + 580 = 2,310 (W2) Gain on disposal of plant $000 95 118 23

Net book value Cash received

113

$000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (W3) Interest paid Balance b/fwd Finance cost in income statement Balance c/fwd Interest paid in year

650 1,302 1,952 (350) 1,602

(W4) Tax paid Balance b/fwd – Current tax Deferred tax Income statement charge Balance c/fwd – Current tax Deferred tax Paid in year

1,810 800 1,914 999

2,610 2,099 4,709 2,913 1,796

(W5) Proceeds from disposal of available for sale investments Disposal per (W1) 600 Add gain on disposal 20 620 (W6) Increase in trade payables Trade and other payables balance b/fwd Less: Interest b/fwd Trade and other payables balance c/fwd Less: Interest c/fwd Increase in trade payables

1,700 (650) 1,050 1,820 350

1,470 420

(W7) Proceeds from issue of equity share capital Equity shares Share premium

5,000 5,000 10,000

13 (a) Statement of cash flows for Casino for the Year to 31 March 2005: $m $m Cash inflows from operating activities Operating loss (32) Adjustments for: Depreciation – buildings (w (i)) 12 – plant (w (ii)) 81 – intangibles (510 – 400) 110 Loss on disposal of plant (from question) 12 215

114

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ––––– 183 70 (436) 15 ––––– (168) (16) (81) ––––– (265)

Operating profit before working capital changes Decrease in inventory (420 – 350) Increase in trade receivables (808 – 372) Increase in trade payables (530 – 515) Cash generated from operations Interest paid Income tax paid (w (iii)) Net cash outflow from operating activities Cash flows from investing activities Purchase of – land and buildings (w (i)) – plant (w (ii)) Sale of plant (w (ii)) Interest received (12 – 5 + 3) Cash flows from financing activities Issue of ordinary shares (100 + 60) Issue of 8% variable rate loan (160 – 2 issue costs) Repayments of 12% loan (150 + 6 penalty) Dividends paid

(110) (60) 15 10 ––––– 160 158 (156) (25) –––––

Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of period (120 + 75) Cash and cash equivalents at end of period (125 – (32 +15))

Workings (in $ million) Land and buildings net book value b/f revaluation gains depreciation for year net book value c/f difference is cash purchases

420 70 (12) (588) ––––– (110) –––––

(ii) Plant: cost b/f additions from question balance c/f difference is cost of disposal

115

137 ––––– (273) 195 ––––– (78) –––––

Interest and dividends received and paid may be shown as operating cash flows or as investing or financing activities as appropriate.

(i)

(145)

445 60 (440) ––––– 65

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN loss on disposal proceeds

(12) (15) –––––

difference accumulated depreciation of plant disposed of depreciation b/f less – disposal (above) depreciation c/f charge for year (iii) Taxation: tax provision b/f deferred tax b/f income statement net charge tax provision c/f deferred tax c/f difference is cash paid (iv) Revaluation reserve: balance b/f revaluation gains transfer to retained earnings balance c/f (v) Retained earnings: balance b/f loss for period dividends paid transfer from revaluation reserve balance c/f (b)

38 ––––– 105 (38) (148) ––––– (81) ––––– (110) (75) (1) 15 90 ––––– (81) ––––– 45 70 (3) ––––– 112 ––––– 1,165 (45) (25) 3 ––––– 1,098 –––––

The accruals/matching concept applied in preparing an income statement has the effect of smoothing cash flows for reporting purposes. This practice arose because interpreting ‘raw’ cash flows can be very difficult and the accruals process has the advantage of helping users to understand the underlying performance of a company. For example if an item of plant with an estimated life of five years is purchased for $100,000, then in the cash flow statement for the five year period there would be an outflow in year 1 of the full $100,000 and no further outflows for the next four years. Contrast this with the income statement where by applying the accruals principle, depreciation of the plant would give a charge of $20,000 per annum (assuming straight-line depreciation).

116

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Many would see this example as an advantage of an income statement, however it is important to realise that profit is affected by many subjective items. This has led to accusations of profit manipulation or creative accounting, hence the disillusionment of the usefulness of the income statement. Another example of the difficulty in interpreting cash flows is that counter intuitively a decrease in overall cash flows is not always a bad thing (it may represent an investment in increasing capacity which would bode well for the future), nor is an increase in cash flows necessarily a good thing (this may be from the sale of non-current assets because of the need to raise cash urgently). The advantages of cash flows are: – it is difficult to manipulate cash flows, they are real and possess the qualitative characteristic of objectivity (as opposed to subjective profits). – cash flows are an easy concept for users to understand, indeed many users misinterpret income statement items as being cash flows. – cash flows help to assess a company’s liquidity, solvency and financial adaptability. Healthy liquidity is vital to a company’s going concern. – many business investment decisions and company valuations are based on projected cash flows. – the ‘quality’ of a company’s operating profit is said to be confirmed by closely correlated cash flows. Some analysts take the view that if a company shows a healthy operating profit, but has low or negative operating cash flows, there is a suspicion of profit manipulation or creative accounting. 14

EAG group Consolidated statement of cash flows for the year ended 30 April 2008 $ million

Cash flows from operating activities Profit before taxation Depreciation Impairment of goodwill (1865.3-1662.7) Amortisation of intangibles Interest expense Profit on disposal of associate Share of profit of associate Increase in inventories 95217 – 4881) Decrease in receivables (4670 – 4633.6) Increase in payables (5579.3 – 5356.3) Cash generated from operations Interest paid W1 Income taxes W2 Net cash from operating activities

117

$ million

2604.2 2024.7 202.6 93.1 510.9 (3.4) (1.6) (336.0) 36.4 223.0

2826.3 5430.5 (76.6) 5353.9 (390) (831) 4132.9

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Cash flows from investing activities (4917.0)

Purchase of property, plant and equipment W3

(27.2)

Purchase of intangibles W4

18.0

Proceeds from sale of associates Dividend received from associate W5

0.8 (4925.4)

Net cash used in investing activities

(792.5)

Cash flows from financing activities Proceeds from issue of share capital (4300-3600) Dividends paid to minority interest W6

700.0

(88.0) 612.0

Net cash from financing activities

(180.5) Net decrease in cash and cash equivalents (419.4) Cash at the beginning of the period (599.9) Cash at the end of the period

W1 Interest Date

Balance b/f

1.5.2006 1.5.2007 1.5.2008 1.5.2009 1.5.2010

5900.0 6013.0 6133.9 6263.9 6401.7

Interest at 7% 413.0 420.9 429.4 438.4 448.1

Interest paid 5% (300) (300) (300) (300) (3000

Balance c/f 6013.0 6133.9 6263.3 6401.7 6549.8

Total finance cost in statement of comprehensive income 510.9 Less interest on long term borrowings (420.9) Balance therefore interest on short term borrowings 90 Total cash outflow in respect of interest 90 + 300 = 390 W2 Income taxes Balance b/f

884.7

118

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Statement of income provision 723.9 Paid (balancing figure) (831) Balance c/f 777.6 W3 Purchase of PPE Net book value b/f Depreciation Additions balancing figure Net book value c/f

19332.8 (2024.7) 4917 22225.1

W4 Purchase of intangibles Balance b/f 372.4 Amortisation (372.4x25%) (993.1) Purchase if patent balancing figure 27.2 Balance c/f 306.5 W5 Investment in associate for dividend calc Balance b/f 13.8 Share of profit to 31.12.07 1.6 Disposal proceeds (18) Dividend received 1.6.07 balancing figure (0.8) Profit on disposal

3.4

W6 minority interest Balance b/f Profit attributable to minority Dividend paid balancing figure Balance c/f 15

1870.5 228 (88) 2010.5

Consolidated statement of cash flows for MIC group for the year ended 31 March 2009 $000s

Cash flow from operating activities Profit before tax Add back non-operating and non-cash items Depreciation Goodwill impairment W1 Share of profit of associate Gain on held for trading investment (22001800) Changes in working capital Decrease in inventories W7 Increase in receivables W7 Decrease in payables W7 Cash inflow from operating activities Less tax paid (900+600-600)

$000s

1,990 1,800 500 (500) (400) 2,600 (500) (2000) 3,490 (900) 2,590

Net cash inflow from operating activities Cash flow from investing activities Purchase of PPE W2

119

(2,200)

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Purchase of subsidiary net of cash acquired (460-200) Dividend received from associate W3

(260) 300 (2,160)

Cash outflow from investing activities Cash flows from financing activities Proceeds of share issue W4 Dividend paid to shareholders of parent W5 Dividend paid to non-controlling interest W6 Repayment of loan (18,000-14,000)

1,200 (200) (130) (4,000) (3,130)

Cash outflow from financing activities (2,700) Net outflow of cash and cash equivalents 4,100 Cash and cash equivalents at 1 April 2008 1,400 Cash and cash equivalents at 31 March 2009

W1 Goodwill Opening balance Arising on acquisition (below) Impairment bal.fig Closing balance Goodwill on acquisition Consideration given 1mx$3.60+$460,000 Non-controlling interest 10%x$3,400,000 Less fair value of net assets acquired Goodwill W3 Dividend received from associate Opening balance Share of profit of associate Dividend rec. from assoc. bal.fig.

$000s

W2 Purchase of PPE 2,400 Opening net book value 1,000 Acquisition PPE

15,600 800

3,400 (500) Depreciation 2,900 Purchases bal.fig Closing balance 4,060 W4 proceeds of share issue 340 Opening balance

16,400 (1,800) 14,600 2,200 16,800

(3,400) Issued on acquisition

3,600

1,000 Issue for cash bal.fig. Closing balance

13,600 1,200 14,800

7,800 W5 Dividend paid to shareholders of parent 500 Opening balance

6,300

8,300 Profit for year (300)

1,200 7,500

120

10,000

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Closing balance W6 Dividend paid to non-controlling interest Opening balance of NCI NCI on acquisition 10%x3,400 Profit for year Dividend paid to NCI bal.fig. Closing balance NCI

8,000 Dividend paid bal.fig. Closing balance

(200) 7,300

6,100 340 6,440 190 6,630 (130) 6,500

W7 changes in working capital Inventories Receivables Payables $000s $000s $000s Opening balance 12,000 8,200 10,200 On acquisition 2,200 700 500 14,200 8,900 10,700 Movement bal.fig. (2,600) 500 (2,000) Closing balance 11,600 9,400 8,700 Chapter 24

 1

(a) Basic eps Profit Loan interest

€ 1 100000 100000 1 00000 350000 650000 35000 615000

Tax at 35% Preference dividends eps € 61500000 4000000 €15:4c (b) Fully diluted eps Profit Loan interest Tax at 35%

€ 1 100000 1 100000 385000 715000 35000 680000

Preference dividends Number of shares (conversion)

= 4 000 000 + 12 500 - 120 = 5 500 000

Fully diluted eps

¼ 68 000 000 5500000 ¼ 12:36c



The reporting to the chief decision maker is based on

121

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN regions. So the operating segments to be reported in the notes to the balance sheet and income statement can be on the basis or regions. According to IFRS 8 revenues, costs, results and assets must be disclosed in the notes. Operating liabilities might be disclosed. Quantitative thresholds for the decision on the number of reportable individual operating segments: (a) segment revenue (internal and external) above 10% of the total revenue – ok for all segments (b) Europe is the only segment with a loss so it represents 100% of the loss making operating segments (c) the assets of Europe just fall below the threshold of 10% with regard to the total segment assets The management discloses all three operating segments as individual reportable segments.



(a) (b) (c)

(d)

this would be an adjusting event - since these structural problems were probably already present at year end would be a non-adjusting event there is strong indication that the customer was already unable to pay before the balance sheet date. Therefore, the provision for bad debts should be recognized at balance sheet date although this might look like an adjusting event, it is not because at year end, the recognition and measurement criteria of IAS 37 were not met..

In fact, events occurring after the balance sheet date can be divided into three groups: ■ ■

■

those that provide additional evidence of conditions existing at the balance sheet date those that provide evidence of conditions that did not exist at the balance sheet date, but whose disclosure is arguably necessary for a proper understanding of the financial position those that relate purely to the new financial period. Only the first of the three is an adjusting postbalance sheet event, the second is a non-adjusting post-balance sheet event. An adjusting event means that changes in the amounts of the financial statements are necessary. The same holds for the situation in which it occurs after the balance sheet date that the application of the going concern concept to the company is not appropriate.

■

Some examples which should be classified as adjusting events are: fixed assets: the subsequent determination of the purchase price or of the proceeds of sale of assets purchased or sold before the year end

122

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■ ■ ■ 5

claims: amounts received or receivable in respect of insurance claims which were in the course of negotiation at the balance sheet date discoveries: the discovery of errors or frauds which show that the financial statements were incorrect debtors: the renegotiation of amounts owing by debtors or the insolvency of a debtor.

The main difficulty in disclosing segmental information is the definition of a separate reportable segment. This may change over time and the Standard requires entities to redefine segments when appropriate. A second difficulty is the treatment of common costs. The directors may either apportion these common costs to segments on the basis they consider the most appropriate or they may treat common costs as a total to be deducted from the total segment results. The main argument against segmental reporting is that it discloses too much information to competitors, particularly entities, abroad who may not have to report segmentally. Where the directors consider that segmental reporting would be seriously prejudicial to the interest of their entity, they might be tempted not to comply with the Standard.

The development item constitutes a change in the accounting policy and should therefore be accounted for retrospectively: ■ ■ ■

■ 7

The write-off of the bad debt is simply a change in the estimate of bad debts and therefore will be accounted for prospectively. The litigation cost is again just a change in the provision for the liability, a change in estimate, and therefore will be accounted for prospectively. A change in depreciation method might be regarded as a change in accounting policy but IAS mentions it explicitly under changes in accounting estimates, so it should be accounted for in an appropriate way. The last item in relation to depreciation may appear to be a change in accounting policy.

Advantages: ■ ■

includes all profit whether distributed or not universally available.

Disadvantages: ■ ■

does not relate earnings to amount invested to achieve earnings comparisons are invalidated due to different share structures

123

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■ 8

several EPS are calculated.

(a) (i)

The disclosure of a company’s basic eps is thought to give a more reliable measure of the trend of a company’s profits than the trend shown by the profits themselves. This is because the eps takes into account (in the denominator) any extra investment in the company’s equity shares that would be expected to lead to higher earnings. A comparison of absolute profits has no ‘correction’ for any additional investment that may have generated additional earnings. Thus it would be quite possible for a company’s profits to show an increasing trend and its eps to show a decreasing trend. In these circumstances the trend of eps is a more reliable measure of performance. It is worth noting that a comparison of two companies’ eps is not meaningful, i.e. if two companies’ eps are the same, it does not mean they are performing equally. This is because the eps takes no account of each company’s share price. This problem can be corrected by calculating and comparing each company’s PE ratio (market price/eps).

(ii)

The diluted eps effectively acts as a warning to shareholders. Circumstances may exist where certain providers of finance (other than existing ordinary shareholders) or holders of share options may become ordinary shareholders in the future (e.g. holders of convertible debt or directors share options). When or if these circumstances ‘crystallize’, the company’s earnings may be spread over a greater number of shares thus diluting the eps. The diluted calculation is forward looking whereas the basic eps could be said to be backward looking. Because of the forward looking aspect of the diluted eps figure, the test for dilution is based on the profit from continuing ordinary operations (after deducting any preference dividends) and excludes the effects of any extraordinary items. IAS 33 requires only truly dilutive circumstances to be included in the calculation; any potential anti-dilutive conversions (which would increase the eps) are ignored. It should be stressed that although the test for dilution is based on the continuing ordinary operations, the actual calculation of the diluted eps is based upon the earnings used for the basic eps calculation. The diluted eps is not a forecast of future eps. It is the current eps adjusted for a future capital base that may or may not occur.

124

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (b) Bovine - basic eps (Note: money amounts in $000, shares expressed in thousands) Profit after tax and extraordinary items (1150 - 120)1030 Deduct preference dividends - 6% non-redeemable shares ($500 6%) (30) - 10% convertible shares ($1000 10%) (100) (130) 900 Number of shares (1.8 million 4) 7200 EPS (900/7200 100) 12.5 cents Diluted eps: In order to determine if a potential conversion is dilutive each circumstance has to be ranked in order of its dilutive effect: Increase in number of shares (w 1200

Increase in earnings

Options nil (i)) 100 10% (w(i)) 10% convertible preference shares ((1000/5) 3) 8% 1800 (1 500 90 convertible 8% 75%) loan stock (1500/100 120)

Earnings per incremental share nil 16.7 cents

5.0 cents

The results of the above are that the directors’ options are the most dilutive, then the loan stock and finally the preference shares. Determining the potential shares to be included in the dilution calculation:

ordinary shares in issue bonus element of directors options (w (i)) 8% convertible loan stock 10% convertible

125

Control earnings 1300

Ordinary shares 7200

nil

1200

1300

8400

1800

1390

10200

100

600

eps 18.1 cents

15.5 cents dilutive 13.6 cents dilutive

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN preference shares 1490

1080

13.8 cents antidilutive

The diluted eps is calculated as: Net profit (900 as above 90 re 8% convertible loan stock) 990 Number of shares (7200 1200 1800) 10200 Diluted eps 9.7 cents Working: (i) The exercise of the directors’ option would yield proceeds of $5.6 million (4 million $1.40) This would be sufficient to purchase 2.8 million shares at the full market price ($5.6 million/$2 each). Thus the bonus or ‘free’ number of shares is 1.2 million (4.0 million 2.8 million). 9 (a)

Events after the balance sheet date are those events, both favourable and unfavourable, that occur between the balance sheet date and the date the financial statements are authorized for issue. Traditional financial statements report the results of entities historically. On this basis, it would seem that events occurring after the balance sheet date should properly be reported in the following year’s financial statements. However, there are broadly two reasons why events occurring after the balance sheet date are relevant to the preparation of the preceding year’s financial statements. Periodic reporting requires incomplete transactions to be incorporated in financial statements. It may be that the values of these transactions and other assets and liabilities can only be confirmed by events that happen after the year end. It is also widely recognized that although financial statements are backward looking, many users (particularly analysts) use financial statements (together with other information) to attempt to assess the future performance of the company. Therefore, the disclosure of material events occurring after the balance sheet date, even where they do not impact on balance sheet values, can be of great relevance. The first types of event are referred to as adjusting events because they provided evidence of conditions that existed at the balance sheet date and therefore require the financial statements to be adjusted to reflect the event. The second types are referred to as non-adjusting events. These are indicative of conditions that arose after the balance sheet date and do not require the financial statements to be adjusted. However, where they are significant to a proper understanding of the financial position of the reporting entity, they should be disclosed by way of a note.

126

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN A notable exception to the above is where post-balance sheet events indicate that the going concern of an enterprise is in doubt. Such evidence may be poor operating results, or withdrawal of credit facilities by banks etc. If such events occur it means that the enterprise should not prepare its financial statements on the going concern basis, and this will dramatically affect its reported results. Although the above principles are quite clear, there can be practical problems with their implementation. It may be that there is post-balance sheet evidence of a fall in value of an asset (say some inventory), but it is unclear whether the fall occurred before the year end or after it. If it was before, the inventory should be written down; if not it should merely be noted in the financial statements (assuming it is material). It is also possible that more specific Standards on impairments (IAS 36) and provisions (IAS 37) may require adjustment for what are in effect events occurring after the balance sheet date. (b) The discovery of the fraud is in the post-balance sheet period. The effect of the fraud is that the overall profit on the contract will be $1 million less than it should have been. It is likely, given the progression of the contract, that Penchant will have recognized some of the profit on this contract. The appropriate treatment of the discovery would be to recalculate the contract costs (based on the lower tender figure) and the contract’s estimated profit. Then, based on these revised costs and profit, recalculate the amount of profit recognized to 30 September 2003. Assuming it is not possible to recover the cost of the fraud from the employee or the subcontractor, it should be charged in full ($1 million) to the income statement for the current year to 30 September 2003. The earthquake occurred after the balance sheet date and does not provide evidence of the values relating to the contract at 30 September 2003. The cost of the earthquake should be charged in the accounting period to 30 September 2004 (possibly as an extraordinary item) and, all other estimates remaining the same, should not affect the reported costs and revenues for the other years of the contract. This is both an adjusting and non-adjusting event. The subsidence is almost certain to have occurred before the year end and the fall in value attributable to this of $800000 ($2 million - $1.2 million) should be charged to the income statement. The carrying value of the building should also be restated at $11.2 million. The fall in price ($1.2 million) due to an unexpected increase in interest

127

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN rates occurring after the balance sheet date is a nonadjusting event that may require disclosure by a note if it is considered significant/material. As the amount receivable is denominated in a foreign currency its value will change as the exchange rate changes. It may seem as if the information in the postbalance sheet period is giving evidence of the value of this asset at the year end, but this is not the case. The exchange rate at the year end was good evidence of the value of the amount receivable at that date, and the gains or losses related to subsequent movements in exchange rates should be charged to the period when they occur. If the exchange loss is considered material it should be disclosed as a note of a non-adjusting event. 10

(a)

this would be an adjusting event - since these structural problems were probably already present at year end

(b)

would be a non-adjusting event

(c)

there is strong indication that the customer was already unable to pay before the balance sheet date. Therefore, the provision for bad debts should be recognized at balance sheet date

(d)

although this might look like an adjusting event, it is not because at year end, the recognition and measurement criteria of IAS 37 were not met.

11 (a)(i) IAS8 ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’ advocates that in order for financial statements to be comparable over a period of time the consistent application of accounting policies is important. However, there are circumstances where the principle of consistency should be departed from: -a change may be required by statue -a new accounting standard may render a previous accounting policy no longer appropriate/acceptable or -if the change will result in a more appropriate presentation of events and transactions leading to more relevant and reliable financial statements. Changes in accounting policies commonly occur where subsidiaries are acquired that have different accounting policies from the rest of the group. In some cases there may be an amount of confusion as to what constitutes a change of accounting policy. For example, a change in the method of depreciation (e.g.

128

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN reducing balance to straight-line) is not regarded as a change of policy, but a change from not depreciating an asset to depreciating it would normally be regarded a change in policy. Also adopting an accounting policy for the first time is not a change of policy nor is applying a different policy where transactions or circumstances differ substantially from previous transactions or circumstances. (ii) Income statement year to:30 September 2003 $000 Amortization of development Expenditure 610 Balance sheet 610

30 September 2002 (restated) $000 450 450

Intangible non-current assets Development expenditure - cost (720 640 900 400) 2660 (2660 720 500)2 240 - amortization (bal figure) (910) (800) - net book value (see below) 1750 1640 Accumulated profit 1 October 2001 2500 Prior period adjustment (see below) 1450 Accumulated profit 1 October 2001 as restated 3950 Workings (figures in brackets are $ million): Net book value 30 September 2003 (720 (640 75%) (400 25%))

(900 50%) 1750

Net book value 30 September 2002 (640 (900 75%) (400 50%) (500 25%))

1640

Amortization as at 30 September 2003 25% (500 400 900 640) 610 Amortization as at 30 September 2002 25% (500 400 900) 450 Prior period adjustment The amount of the prior period adjustment would be $1450 million being the net book value of the development expenditure that would have been included in the balance sheet at 30 September 2001 (effectively 1 October 2001). This would be a gross amount of $1 800 million (500 400 million (500 50% 400 25%). 12 Earnings Weighted average number of shares 10 000 000 x 7/12

129

3 000 000 5 833 333

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 12 000 000 x 5/12

5 000 000 10 833 333

Basic eps 3000000/10833333

27.7 cents

Earnings Post tax saving of interest 70% x (7% x 2000000)

3 000 000 98 000

Weighted average number of shares Shares to be issued on conversion (2000000/100 x 50)

10 833 333 1 000 000

3 098 000

Diluted earnings 3098000/11833333

per

11 833 333 26.2 cents

13 Post tax earnings Weighted average number of shares in issue: 1 May – 30 September 5 million x 5/12 months 1 October – 30 April 7 million x 7/12 months Basic eps 440 000/6166666

440 000 2 083 333 4 083 333 6 166 666 7.1 cents share

14 (a) EPS

191.4/1000 (W1) 195.7 (W2) /1150 (W3)

Diluted EPS

2008 19.1 cent 17.0 cent

182.7/1000 (W1) 187.1 (W2) /1150 (W3)

2007 18.3 cent 16.3 cent

W1: bonus issue of shares: 1new share for every 3 already in issue = 750 million/3 x 4 = 1000 million W2 diluted earnings adjustments: Profit for the period Add back interest Less: tax effect

2008 191.4

2007 182.7

6.3

6.2

(2.0)

(1.8) 4.3 195.7

4.4 187.1

W3: fully diluted shares If all conversion options are taken up: 75m/100 x 200 = 150m Added to the existing shares this gives a fully diluted number of shares of 1 150 m (1 000 m + 150 m) (b) Bonus shares are issued for no consideration, and so

130

per

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN there is no increase in resources associated with them. All other things being equal, no increase in earnings can be expected following a bonus issue; the effect is that the same amount of earnings is divided by a greater number of shares. In order to ensure continuing comparability, the bonus issue is adjusted for as if it had taken place at the beginning of the earliest period presented. 15

Basic EPS= 100 Mio / 27 Mio = 3, 7 $ New potential shares if bond of 50 Mio is converted: 600 000 shares (12 shares for 100$) Interest cost on bond = 6 Mio (12% on 50 Mio) Interest cost after taxes = 4, 8 Mio ( 6 Mio – 1, 8 Mio) whereby 30% tax rate Diluted EPS = 104, 2 Mio/ 27, 6 Mio = 3, 775 $

Chapter 25



Please refer to text in Chapter.

This is dealt with in depth within the Chapter.

Refer to text.

Dealt with within the Chapter.

5 Consolidated statement of financial position of Hardy as at 31 March 20X8 €000 €000 Non-current assets Land and buildings (working 1) 37 500 Plant and equipment (working 2) 32 270 Goodwill 2 480 72 250 Current assets Inventory (working 4) 16 365 Accounts receivable (11 420 + 3830_240 current accs) 15 010 Cash 490 31 865 Current liabilities Accounts payable (6400 + 4510 _ 240) 10 670 Bank overdraft 570 Provision for taxation 4 450 15 690 16 175 Long-term liabilities Loans (16 000) Net assets 72 425 Common shares 10 000 Revaluation reserve 1 200 Retained profits (working 6) 54 804 Minority interests (working 5) 6 421 72 425

131

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Working 1 and 2 Balance from question Hardy Sibling Revaluation Additional depreciation

Land and buildings 22 000 12 000 3 500 37 500

Plant 20 450 10 220 4 000 (2 400) 32 270

Working 3 Goodwill Paid common shares preference shares

18 000 500

18 500

Bought 80% common shares Preference shares 80% pre-acquisition reserves 80% revaluations at date of acquisition

4 000 500 6 720 4 800

16 020 2 480

Working 4 Balance as per question 9850 + 6590 16 440 less Unrealized profit on transfer still in inventory (75) 16 365 Working 5 Minority interest Net assets Sibling less preference shares 19 589 _ 20% add Minority preference shares add Revaluations of 7500 _ 20% less adjustments for: Additional depreciation 2400 x 20% Unrealized profit on inventory 75 x 20% Working 6 Retained profits Hardy Post-acquisition profits Sibling less Additional depreciation less Unrealized profit on inventory

3 916 1 500 1 500 (480) (15) 6 421 51 840

6 180 (2 400) (75) 3 705 x 80% =

6 Dividend adjustments: Mat has included 80% * 550 + 60% * 440 on dividends from Rug and Pet in revenue = 704 Current years additions to retained earnings: Mat Rug Pet Profit after tax 1700 730 560 Less dividends paid 600 550 440 Addition to RE current year 1100 180 120 RE 31.12.07 6780 130 340 Thus pre acq RE 5680 (50)220

132

2 964 54 804

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Cost of control Mat in Rug £000 Cost of 80% control 2680 Ordinary shares 80%*1300 1040 Share premium 80%*700 560 Retained earnings at acquisition date (50))*80% see above (40) 1560 Goodwill on consolidation 1120 Impairment on review 10% (112) 1008 Non-controlling interest Ordinary shares 20%* 1300 260 Share premium 20%*700 140 Attributable to NCI from retained earnings 20%*130 26 426 Cost of control Mat in Pet £000 Cost of 60% control 860 Ordinary shares 60%*1450 870 Share premium 60%*110 66 Fair value adjustment 750*60% 450 Retained earnings at acquisition date (220*60% 132 1518 Goodwill on consolidation (658) Negative goodwill taken to income statement (658) Non-controlling interest Ordinary shares 40% *1450 580 Share premium 40*110 44 Attributable to NCI from retained earnings 40*340 136 40% fair value adjustment of 750 300 Adjustment for fv depreciation (6) 1054 Total non-controlling interest (426 + 1054) = 1480 Depreciation required on fair value of property 750/50 =15 (depreciation on nc interest share is 15 x 40% = 6) Intergroup sales reduce Rug’ s revenue by 6200 and reduce mat’s cost of sales by 6200 Unrealised profit 15% * 1000= 150

133

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Consolidated statement of income for the year ended 31 December 2007 Revenue Cost of sales

23500+11700+8900-704-6200 15400+8700+6800-6200 + unrealised profit 150

Expenses

4600+1800+900 Goodwill Impairment 112 Negative goodwill Extra depreciation

Taxation

1800+470+640

Attributable to NC.I. Retained profits for the year

20%*730+40%*560 -6

£000s 37196 (24850) 12346 (7300 (112) 658 (15) 5577 (2910) 2667 (364) 2303

Retained earnings after dividends 2303 – 600 = 1703 Consolidated statement of financial position as at 31 December 2007 Non-current assets Property, plant and equipment Goodwill Current assets Inventory Trade receivables Cash

7030+2130+1760+750-15

1008 12663 1230+570+490-150 1100+190+560 430+110

Total assets Equity and liabilities Equity Ordinary shares Share premium Earnings 1.1 07 Current year earnings Non-controlling interest Non current liabilities Loans Current liabilities Trade payables Bank overdraft Taxation

2140 1850 540 4530 17193 2900 700 5680 1703 10983 1480

760+340+90

1190

990+120+430+ 70 1200+230+500

1540 70 1930 3540 17193

Total equity and liabilities

11655

We can draw the relationship as follows: D 80%

134

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN E 60% F The effective interest of D in F is 48% but as D controls E it also controls F and therefore F is a subsidiary of D as from 1 January 1996. Pre acquisition profits in F are $30m-$4m = $26m and the group share is 48%*$16m = $7.68. 8

Disposal proceeds 125 Share of net assets disposed of 20%*400= (80) Less share of remaining goodwill (120-36)20/80 (21) Consolidated profit on disposal 24

U charges a mark-up on cost of 25% so the unrealised profit in the inventory of S is 25/125*16,000 = 3200. In the consolidated statement of financial position inventory is reduced by 3200 In the consolidated statement of income 100,000 is deducted from income and from cost of sales. In addition we need to add back the unrealised profit of 3200 to cost of sales.

10 (a) Alpha in Beta 40m shares out of 50m = 80% Alpha MI Cost of control (20m x $6 = incremental costs of issue 1.2m) 121.2 (the other 0.8m will be charged to alpha’s share premium account) Bought 80% of net assets at date of acquisition 80% x shares 50 40 10 80% x pre acquisition retained earnings 35 28 7 80% revaluation (10 + 8) 14.4 3.6 80% contingency of 3 2.4 0.6 80% of customer relationships of 20 16 4 80% deferred tax adjustment on above 41 x 25% (8.2) (2.05) 92.6 23.15 Goodwill on consolidation 28.6 MI share of post acquisition 20%(44-35 – 2 depreciation on excess plant and equipment - 3 contingency - 4 amortisation on customer relations + def tax 25% x (41 –32)) 0.45 23.6 Alpha in gamma 20m shares out of 50m = 40% consolidate using equity method as only significant influence not control. Cost 20m x 1.6 32 Share of post acquisition profits since acq 1.4.05 (28 – 15)40% 5.2 Unrealised profits in inventory (16/5 x 40%) (1.28) 35.92

Consolidated statement of financial position for alpha 31March 2007

135

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Non-current assets Property, plant and equipment Goodwill Other intangible assets (Beta) Equity investments gamma

125 + 85 +10 + 8 – 2) See above working 20 - 4 See above

Current assets Inventories Trade receivables Cash and cash equivalents

33 + 30 – 20/5 43 + 30 – 5 11 + 10

$m 226 28.6 16 35.92 306.52 59 68 21 148 454.52

Total assets Equity Share capital

Retained earnings

Only Alpha + the issue on acquisition of Beta 20m 20m x 5 - .8 (see cost of beta above) See below

Minority interest

See above

23.6 271.54

50 + 25 35 + 12 + 25% x 32 + 5.2 x 25% gamma profits – 25% inventory unrealised profits beta and gamma 5.28

75 54.98

Share premium

Non-current liabilities Long term borrowings Deferred tax

90 99.2 58.74

129.98 Current liabilities Trade payables Current tax payable

25 + 17 – 5 9+7

37 16 53 454.52

Total equity and liabilities Retained earnings Alpha as own statement 55 Acquisition costs added back 2 Beta post acquisition 80% x 2.25 see MI calculation 1.8 Unrealised profit beta in inventory (4) Gamma (5.2-1.28) 3.92 Deferred tax on gamma profits (1.3) Deferred tax on unrealised profits 5.28 x 25% 1.32 58.74

(b) The additional cash payment of $20m is a contingent consideration and Alpha would have to assess whether the payment was likely. If likely then the payment forms part of consideration paid and increases goodwill in the cost of control calculation. The $20m would also need to be included as payable – a liability. This liability and the addition to the purchase consideration would need to be shown at present value and therefore an

136

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN unwinding of the discount rate would also occur. If payment considered unlikely then the contingency consideration would only be included in the notes to the financial statements. 11

Alpha in beta is 80% ownership, and gamma 75% and therefore need to include post acquisition profits in consolidated income statement. For the year ended 30 September 2006 include all of Beta but only 8 months of Gamma.

Consolidated statement of income for Alpha 30 September 2006 Revenue Cost of sales Gross profit

Other operating expenses Income from investments Finance costs Profit before tax Income tax Profit after tax Attributable to equity shareholders of alpha Attributable to minority Interest

125+100+8/12 x 90 – 13 interco. sales Balancing figure 55+40+8/12 x 39 – unrealised profit on sales in inventory 25/125(2-1.2) – 25/125 x 1 – extra depreciation on revaluations beta plant 1 – extra depreciation on gamma brand 27/15 x 8/12 20+15+8/12 x 15 9+5+8/12 x 4.5 – dividends from beta 4 –interest from gamma 8/12 x 8% x 20 11+8+8/12 x 7.5 – interest from gamma 8/12 x 8% x 20

$m 272 153.56 118.44

45 11.933 (22.933) 62.44 (18.6) 43.84 38.54

9+6+8/12 x 5.4

Beta 20%(16 –1 extra dep) + gamma 25%((8/12 x 15.6) – 1.2 brand dep)

5.3

Consolidated statement of changes in equity for the year 30 September 2006 Balance 1 October 2005 Profit for year Dividends paid MI increase due to acquisition of Gamma

See 1 below See profit and loss above MI 20% x 5 beta See 2 below

Group $m 138.56

MI $m 14.2

Total $m 152.76

38.54

5.3

43.84

(14)

(1)

(15)

22.05

40.55

203.65

163.1

Working 1 Equity 1 October 2005 Alpha

137

110

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 80% share of Beta post acq prior to current year (80% x 60-35) 20 80% share of land fair value adjustment on Beta (35-25) 8 80% share of plant fair value adjustment Beta (16-12-3dep) 0.8 unrealised profit opening inventory (25/125 x 1.2) (0.24) 138.56

MI 20% share of equity 1 October 2005 (20% 60) share of revaluation land (20% x 10) share of revaluation plant (20% x 1)

12 2 0.2 14.2

Working 2 MI in equity of Gamma 1 October 2005 (25% x 56) Mi in revaluation of brand (25% x 27) MI in earnings first 4 months of year (25% x 4/12x 15.6)

14 6.75 1.3 22.05

Ownership of Parentis in Offspring is 600m shares of 800m shares therefore 75% ownership Consolidated statement of financial position of Parentis 31 March 2007

Assets Non-current assets Property, plant and equipment Intellectual property Goodwill on consolidation

$m 640+340 + revaluation 40-2 Revalued to zero see working 1 below

Current assets Inventory Trade receivables Receivable for intellectual property Bank

Total assets Equity and liabilities Shares of Parentis Share premium Retained earnings

Minority interest

76+22 – unrealised profit in inventory 6/15 x 5 84+44 – 11 inter group Payment due from government

1018 108 1126 96 117 10

0+4

4 227 1353

300 + 75 on acquisition of Offspring 300m x .25 Offspring issue 300 x .50 Parentis 300 + 75%(20 offspring post acq – unrealised profit in inventory 2 – additional depreciation 2 – write down of intellectual property 20) – impairment of goodwill 27 – unwinding interest on deferred consideration (600 x .11cents/1.1 discount of 10%)10% = 6

375

25%( 340 net assets at 31.3.07 + fair value 40 – unrealised profit 2 additional dep 2 – wd intellectual property 20

150 264

789 89

878

138

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Non-current liabilities 10% loan notes Current liabilities Trade payables Current tax payable Overdraft Cash consideration due from acquisition

120 + 20

140

130 +57 –7 intergroup 45+23 25 – 4 cash in transit

180 68 21 66 335 1353

Total equity and liabilities Working 1 Cost of control Equity shares 600/2 X .75 225 10% loan notes 120 Deferred cash consideration at pv 600 x .11/1.1 60 405 Bought 75% shares of 200 75% retained earnings 1 April 2006 120 75% fair value adj. to property 40 Goodwill on consolidation Impairment during year Goodwill 31 march 2007

150 90 30 270 135 27 108

Chapter 26 1

Please refer to the text.

Cost of control of C in D: 75% of D cost Bought 75% net assets at date of acquisition 14 75% of revaluation 2 Goodwill

16 10.5 1.5 12 4

Report to the directors of Barking Financial plans for year ended 30 November 2004 The following comments relate to your plans for the year ended 30 November 2004 and set out the financial reporting implications of such plans. Takeover of Ash and stock exchange listing This takeover is known as a ‘reverse acquisition’. The occurrence of this type of acquisition has been increasing in recent years and allows unlisted companies to obtain a stock exchange quotation by taking over a smaller listed company. As the listed company, Ash, is issuing a large number of shares to acquire Barking, control will pass to the shareholders of Barking. The legal position will

139

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN probably be that Ash is regarded as the parent or continuing enterprise but the substance of the transaction is that Barking, whose shareholders now control the combined business, is in fact the acquirer especially as the executive management of the new group will be that of Barking. Accounting for reverse acquisitions under IAS is an area which requires greater attention by the IASB. IAS22 ‘Business Combinations’ requires that the entity issuing the shares is deemed to be acquired by the other. Barking will be deemed to be the acquirer and will apply the purchase method to the assets and liabilities of Ash. The effects of adopting reverse acquisition accounting will be significant for the group accounts with problems relating to the determination of the fair value of the consideration and the asset values appearing in the financial statements. The redemption of the zero dividend preference shares at $1.10 per share requires the company to account for the shares at cost which is the fair value of the consideration. Subsequently the preference shares should be carried at amortized cost subject to an impairment test (IAS39). Therefore, in the year to 30 November 2004, a finance cost will be charged to the income statement at the effective interest rate of the instrument. Additionally for the purpose of determining the purchase consideration, if purchase accounting is used, the preference shares should be valued at fair value. If there is no market price available, then the discounted redemption proceeds may be suitable for fair valuing the consideration. Again a fair value should be placed on the loan notes (IAS39) and this value used for the purpose of determining the purchase consideration if acquisition accounting is used. This could be the value of the underlying security into which there is an option to convert. As the loan notes are unlikely to be repaid but converted into shares, then the loan notes are in substance equity and should be reclassified as such. If a capital instrument contains no genuine commercial possibility that the option to transfer economic benefits will be exercised, then the instrument should be reported as part of shareholders’ funds. This view is consistent with IAS32 ‘Financial Instruments: disclosure and presentation’ para. 18, which says that a financial instrument should be classified in accordance with the substance of the contractual arrangement on initial recognition. Retirement benefits As regards the freezing of the defined benefit pension scheme of Barking, IAS19 ‘Employee benefits’ would require that an estimate of the present value of any asset

140

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN or liability arising from the scheme be made and reflected in the balance sheet of the company. As the scheme will be closed and as the age profile of the employees will rise, under the projected unit credit method, the current service cost would be expected to increase as the employees/ members of the scheme approach retirement age. The accounting for the defined contribution scheme is straightforward under IAS19. As the employer has no obligation beyond the payment of the contributions, the cost of providing pensions is simply the amount of the contributions payable in respect of the accounting period. Where it is not possible to identify the scheme’s share of the underlying assets and liabilities of the employer in a multi-employer plan, then the defined benefit scheme can be accounted for as if it were a defined contribution scheme (IAS19 para 30). However, this fact has to be disclosed and, in addition, any available information about the existence of the surplus or deficit in the scheme, the basis used to determine the surplus or deficit and the latter’s implication for the employer. Ash will have to determine the underlying net assets of the scheme in order that on transfer to the new group scheme, the net liability or asset relating to the old scheme can be established. Revenue recognition The new revenue recognition policy is more prudent than its old policy but it still allows revenue to be recognized before there is a legal contract. The work may be physically completed but this does not mean that a contract has been signed and exchanged for the sale of the properties. Also any deposit paid is refundable, thus indicating the lack of a contractual arrangement. Often the purchase of a property is completed when the cash is paid for the property and many construction companies recognize revenue on this basis. This policy will make performance comparisons between other construction companies and the Barking Group quite difficult. Further the solicitor’s and legal costs incurred internally by the company should be expensed. These costs do not constitute research and development expenditure, nor an intangible asset and, therefore, should not be recognized in the balance sheet as an asset. They are simply employee costs incurred as part of the selling process. IAS18 ‘Revenue’ in Appendix A indicates that a ‘real estate sales’ revenue is normally recognized when legal title passes to the buyer. A key element is whether there are any substantial acts which need to be completed under the contract. If there are and the equitable interest has passed, the revenue could be recognized as the acts are performed.

141

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Investment properties IAS40 ‘Investment property’ states that transfers to, or from, investment property should only be made when there is a change in use. An example of this would be the commencement of an operating lease. Where the investment property will be carried at fair value and the transfer is from ‘trading’ properties or inventory, then any difference between the fair value of the property on the date of transfer and its previous carrying amount should be recognized in the income statement. This treatment is consistent with the treatment of sales of inventories. Impairment review An impairment review in accordance with IAS36 ‘Impairment of assets’ will compare the carrying value of the non-current assets with their recoverable amount being the higher of net selling price (NSP) and value in use. It is likely that the NSP will be higher than the carrying amount in the case of properties held given the upturn in the business sector. If this is the case then there will be no need to ascertain their value in use as there will be no impairment. The main problem with the planned impairment test is the length of time over which the cash flows are being estimated and the discount rate being used. IAS36 (para. 27) states that projections should only cover a maximum period of five years unless a longer period can be justified. Management will have to demonstrate the accuracy of these projections based on past experience. Additionally the discount rate being used is quite high and the projections are likely to be inaccurate given the length of time which they are covering and given the industrial sector in which the company is operating. Therefore, a lower discount rate and a shorter time frame may have to be used for the projections. An impairment loss involving a revalued asset should be set first against any revaluation surplus on the asset and only thereafter against the income statement (IAS36). Thus if there is an impairment loss, then the assets should be itemized and segregated into those which have and have not been revalued and the loss treated accordingly. I hope that the above information is helpful. 4

Ejoy Group Statement of income for year ended 31 May 2006 $m 4000 (3,026) ––––– 974

Revenue Cost of sales Gross profit

142

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Other income Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for period from continuing operations Discontinued operations: Profit for the period from discontinued operations Profit for the period Attributable to: Equity holders of the parent Minority interest

53 (250) (190) (128) ––––– 459 (226) ––––– 233 13 ––––– 246 ––––– 241 5 ––––– 246 –––––

Working 1: Goodwill Cost of investment Dividend Less net assets acquired: 80% of 600 60% of 310

Zbay $m 520 (480) –––––– 40

Goodwill

Tbay $m 216 (24) (186) –––––– 6 ––––––

Test for impairment: Unrecognised minority interest

10 –––––– 50 Fair value 1 June 2004 600 Profit year to 31 May 2005 20 Loss year to 31 May 2006 (7·1) –––––– 612·9 –––––– Notionally adjusted carrying amount 662·9 Recoverable amount (630) –––––– Impairment loss (32·9) –––––– Impairment loss allocated to goodwill is 80% of 32·9, i.e. $26·3 million. Working 2: Joint Venture The gain on disposal of the assets to the joint venture is $6 million. 50% of the gain on the disposal should be

143

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN eliminated as this is the proportion of the interest the group retains. Therefore, $3 million will be eliminated from other income. Working 3: Financial Asset, Zbay: $m Present value of future cash flows at 1 June 2005: Loan 20 i.e. $17·8 million (1·06)2 Therefore an impairment loss of $42·2 million has occurred on 1 June 2005. Additionally interest of $17·8 million 6%, i.e. $1·1 million will be accrued in the financial statements for the year ended 31 May 2006. Effectively the discounting of the future payment is being unwound under IAS 39. Working 4: Financial Asset, Ejoy: At 31 May 2006 the bond has accrued interest of $2·5 million (5% of $50 million) which has to be included in the income statement. The fair value of the bond has declined by $(50 – 48·3) million, i.e. $1·7 million. As the bond is classified as a hedged item, and the hedge is a fair value hedge, the loss on the bond will be recognised in profit or loss. Normally profits or losses on ‘available for sale assets’ are recorded in equity. As the hedge is 100% effective, the gain on the swap will be exactly the same ($1·7 million) and will also be recorded in profit or loss. The $0·5 million of net interest payments received from the swap will be included in profit or loss. Working 5: Dividend, Tbay The payment of the dividend under IAS27 ‘Consolidated and Separate Financial Statements’ (paragraph 4) should be treated as a return on the investment and should reduce the cost of the investment accordingly. Dividend $40 million

60% = $24 million

Reduce other income and cost of investment by $24 million. Working 6: Ejoy $m 2,500 –––––––

Revenue

144

Zbay $m 1,500 –––––––

Total $m 4,000 –––––––

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Cost of sales Impairment loss (Working 1) Other income Gain on Joint Venture Dividend (60% of 40) Distribution cost Administrative expenses Finance costs Impairment (Working 3) Interest (Working 3/4) Hedge (Working 4) Swap (Working 4) Interest (Working 4) Profit before tax Income tax expense Profit/(Loss) for period

(1,800) (26.3)

(1,200)

––––––– 70 (3) (24) ––––––– (130) ––––––– (100) ––––––– (50)

––––––– 10

2·5 (1·7) 1·7 0·5 ––––––– 439·7 (200) ––––––– 239·7

––––––– (120) ––––––– (90) ––––––– (40) (42·2) 1·1

––––––– 18·9 (26) ––––––– (7·1)

(3,026·3) ––––––– 53 ––––––– (250) ––––––– (190) –––––––

(128·1) ––––––– 458·6 (226) ––––––– 232·6

Working 7: Tbay $m $m Profit after tax 30 ––––– Profit for six months to 31 May 2006 15 ––––– Fair value of net assets at 1 December 2005 310 Profit 1 December 2005 – 31 May 2006 15 Dividend (40) –––––––––– Net assets 31 May 2006 285 x 60% 171 Goodwill 6 –––––––––– –––––– Carrying value 177 –––––––– $m $m Fair value of net assets 300 x 60% 180 Less selling costs (5) –––––––––– 175 –––––––––– As Tbay is a discontinued operation, it has to be recorded separately in the income statement and valued at the lower of its carrying value and fair value less costs to sell. The carrying value is $177 million. Therefore, an impairment loss of $2 million occurs.

145

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN This amount will be recognised in the income statement, and netted off the profit from discontinued operations giving a figure of $(15 – 2) million i.e. $13 million (IFRS5 para 33aii). Note that if the dividend had not been treated as a reduction of the cost of investment, then the goodwill figure above would have been increased by the dividend amount to $30 million. This would have meant that the impairment loss recognised would have increased to $26 million which is the gross impact on the income statement of the impairment loss ($2 million) and the elimination of the pre acquisition dividend ($24 million). Working 8: Minority Interest Zbay 20% of ($7·1 million) Tbay 40% of $15 million

$m (1·4) 6 –––– 4·6

Consolidated statement of comprehensive income for the AB group for the year ended 31 May 2009

Revenue (6000+3000)` Cost of sales (4800+2400) Gross profit Distribution costs (64+32) Administration expenses (336+168) Finance costs(30+15) Share of profit of associate (30%x100) Profit before tax Income tax expenses(204+102) Profit for the year Other comprehensive income Revaluation of PPE (200+100) Actuarial gain on pension plan assets Actuarial loss on pension plan liabilities Gain on AFS investment Tax effect of other comprehensive income (42+21) Share of OCI of associate net of tax (30%x24) Other comprehensive income for the year net of tax Total comprehensive income for the year Profit for the period attributable to: Owners of parent entity Non-controlling interests (20%x283) Total comprehensive income attributable to: Owners of the parent entity Non-controlling interests (20%x362)

146

£000 9000 (7200) 1800 (96) (504) (45) 30 1185 (306) 879 300 40 (52) 14 (63) 7 246 1125 822.4 56.6 879 1052.6 72.4 1125

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN CD is a subsidiary and therefore fully consolidated. EF is an associate and therefore use equity accounting 6 (a) JKA have not transferred the risks and rewards associated with the land and thus the asset should not be derecognised and sale must be reversed. PPE is increased by $520,000, liabilities are increase by $500,000 and retained earnings by $20,000 (b) Consolidate statement of financial position for JKA as at 31 May 2009 £000s ASSETS Non-current assets Property, plant and equipment (11000+7500/2+520) Current assets Inventories (3100+1200/2-5) Receivables (3300+1400/2 –34/2) Cash and cash equivalents (600+400/2) Total assets EQUITY AND LIABILITIES Equity Share capital Revaluation reserve (1500+500/2) Other reserves Retained earnings (2000+4500/2-5+20) Non-current liabilities (2000+500) Current liabilities(4000+1500/2-17) Total equity and liabilities

15270 3695 3983 800 8478 23748

10000 1750 500 4265 16515 2500 4733 23748

Unrealised profit on inventories 50%(20% x 50000) = 5000

Chapter 27 1

 2

This is explained in the text. Proportional consolidation is explained in the text and amply demonstrated in Activities within Chapter 27. Equity accounting is also explained. Equity accounting is used for the consolidation of an investment in an associated enterprise. Proportional consolidation is the benchmark treatment for the consolidation of jointly controlled entities although an alternative is permitted, equity method.

Chapter 28 1

Please refer to text

147

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 3

 4.

There is lots of information in respect of Enron on various websites. We suggest the students gather this information and attempt to identify whether the SPEs were in substance controlled. Consolidated Statement of financial position as at 30 November 20X3 $m Non-current assets Tangible non-current assets Intangible non-current assets - brand Intangible non-current assets - goodwill Investment in associate Current assets Total assets Capital and reserves Called up share capital Share premium account Accumulated Reserves Minority interest

665.9 7 80.3 12.6

Non-current liabilities Current liabilities (i)

The business combination should not be accounted for as a uniting of interests because of the following reasons: (a)

(b)

the fair value of the net assets of Fusion and Spine ($315 million $119 million) is significantly smaller than those of Largo ($650 million). The employees of Largo number fifty per cent more than the combined total of Fusion and Spine and the market capitalization of Largo is significantly larger than that of the two companies ($644 million, Largo, as against $310 million, Fusion, $130 million Spine, i.e. $440 million). the new board of directors comprises mainly directors from Largo. (Seven directors out of ten directors sitting on the Board.) The arguments concerning the equity holdings are not strong enough to override the overwhelming size and control dominance set out above. The business combination should be treated as an acquisition.

(ii)

Largo acquired Fusion and Spine on 1 December 20X2 and, therefore, control was gained for the purpose of the group accounts on that day. For the

148

Largo $m

765.8 218 983.8 460 264 121.2 50.6 895.8 69 19 983.8

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN purpose of the Largo Group, the date of acquisition of Spine by Fusion is not relevant.

(iii)

Shareholdings Largo

Fusion 90%

Minority Interest

10%

Spine 26% 90% of 60% 80% 20%

Equity of Fusion Total

Ordinary share capital Share premium account Accumulated reserves Fair value adjustment (w(vii)) Adjustment for depreciation (w(vii)) Impairment of brands (w(vi))

110

PrePostacquisition acquisition 99

138

122.4

44.1

Minority Interest 11 2

1.8

13.8 4.9

(3.2)

(2.9)

(0.3)

(2)

(1.8)

(0.2)

(2.9)

31.2

PrePostacquisition acquisition 40

Minority Interest 10

311.8 Cost of investment (w(v)) Goodwill

283.5 345 (61.5)

Equity of Spine Total Ordinary share capital Share premium account Accumulated reserves Fair value adjustment (w(vii)) Adjustment for depreciation (w(vii)) Cost of

50 10

23.2

(1.9)

122.1

149

95.2

2 4

7 5.8

(1.5)

(0.4)

2.5

24.4

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN investment (w(v)) Cost of investment indirect (90:10) Goodwill

69 45

(5)

19.5

18.8

Minority interest is $31.2 m $19.4 m, i.e. $50.6 million. Goodwill arising on acquisition of (61.5 + 18.8) i.e. $80.3 million. (iv)

Deferred tax and fair values Deferred tax should be taken into account in calculation of the fair values of the net assets acquired. The increase in the value of the net assets to bring them to fair value is attributable to the property. This increase is used to calculate deferred tax which should be deducted from the fair value of the net assets. The fair value of the net assets should be decreased by the deferred tax on the property. Fusion Fair value $330 million (tax $15 million). Spine Fair value $128 million ($9 million). Total increase in deferred tax provision $24 m

(v)

Cost of investment: The group accounts are utilizing acquisition accounting which requires that the consideration should be measured at fair value. Therefore, the cost of the investments in Fusion and Spine should be measured at the market price. The market price on the day of acquisition was $644 million ÷ (460 150 30) i.e. $2.30 per share. Therefore, the fair value of the consideration is: Fusion 150 m $2.30 Spine 30 m $2.30

$m 345 69

The share premium account of Largo will then become: Balance at 31 May 2004

150

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Arising on issue of shares - Fusion - Spine (vi)

195 39 264

Brand name IAS22 ‘Business Combinations’ and IAS38 ‘Intangible assets’ require that intangible assets acquired as part of an acquisition should be recognized separately as long as a reliable value can be placed on such assets. There is no option not to show the intangible asset separately under IAS38. In this case the brand can be separately identified and sold. Therefore, it should be shown separately. Also the brand should be reviewed for impairment as its fair value has fallen to $7 million. The brand should, therefore, be reduced to this value and $2 million charged against the income statement.

(vii) Tangible non-current assets $m 329 185 64 (9)

Largo Fusion Spine Brand Fair value adjustment - Fusion (330 - 110 - 20 136) - Spine (128 - 50 - 10 30) Additional depreciation Fusion

64 38 (3.2)

- Spine (1.9) 665.9

(increase in fair value $64 m _5%) (increase in fair value $38 m_5%)

(viii) Group reserves Largo Fusion Spine Income from associate (ix)

1$m 1120 1(2.9) 12.5 1119.6 11.6 1121.2

Micro When an associate is first acquired, the share of the underlying net assets should be fair valued and goodwill accounted for. This has not been carried out in the case of Micro.

Fair value of shares at acquisition (40% - $20m)

151

$m 8

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Goodwill Carrying value of investment

3 11

The investments are to be marked to market by Micro and, therefore, a profit will have arisen during the period of $24 million$20 million, i.e. $4 million. The investment in Micro will, therefore, be stated at (11(40% 4)) million, i.e. $12.6 million. 5

If we look at the individual statements in this question in turn we can easily arrive at the correct answer. Statement (a) is not true as an associate relationship is determined by reference to significant influence not percentage ownership. Thus (i) and (iv) are not correct. Statement (b) is correct as if K controls L then L is a subsidiary not an associate. Statement © is also correct as what is eliminated is the profit or loss in transactions between K and L not the amounts payable. Thus as statements (b) and (c) are correct then (iii) is the correct answer.

It is generally agreed that provision of related party information does aid users’ decision making. It is generally assumed that all transactions are made between enterprises at ‘arm’s length’. If this is not the case, which is likely for related parties, then if this fact is disclosed users can attempt to assess the significance of the related party transaction on their decisions.

Special purpose enterprises are those entities set up to carry out a specific objective. They are tightly controlled legally and sponsors can transfer assets and liabilities to them. Problems could arise if sponsors can hide liabilities in these SPEs. Mention must be made here of Enron and its SPEs. The IASB requires these SPEs to be consolidated with the sponsor if the relationship is such that the sponsor controls the SPE. The IASB emphasizes substance of control as the overriding factor here. Note that US GAAP did not emphasize the substance of control, which is why Enron was able to keep its SPEs off balance sheet.

8 (a)

Acquisition of Sunlee by Hosterling $m 80% of 20m shares bought for 3 for 5 exchange i.e 9.6m shares issued at $5 48 Bought 80% of shares 80% of retained profits 18m 80% of revaluation (IP4+L 3+P 5) Goodwill on consolidation

152

16 14.4 9.6 40 8

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (b) Cost of investment in Amber equity method 40% ownership Cash 6m x 3 18 6% loan notes6/100 x 100 6 24 Share of post acquisition earnings 1 July 2006 to 30 September 2006 3/12 (20) x 40% (2) Amount to consolidated balance sheet 22

Consolidated statement of income for Hosterling group for the year ended 30 September 2006 Revenue Cost of sales

Gross profit Distribution costs Administration expenses Finance costs Impairment losses: Goodwill Sunlee Investment in associate Share of loss from associate Profit before tax Income tax Profit after tax Attributable to: Equity holders of Hosterling MI



105+62 – 18 interco 68+36.5 – interco.18 + extra dep.5/5years + unrealised profit in inventories 7.5 x 25/125 4+2 7.5+7 1.2+.9 22 -21.5 See (b) 8.7+2.6

(13 –1 extra dep)20%

$m 149 (89)

60 (6) (14.5) (2.1) (1.6) (0.5) (2) 33.3 (11.3) 22 19.6 2.4

(a) Consolidated Statement of financial position for Hapsburg as at 31 March 2004: $000 Non current assets Goodwill (16 000 (w (i))) Property, plant and equipment (41 000 + 34800 + 3750 (w (i))) Investments: - in associate (w (iv)) - ordinary 3 000 + 1500 (fair value increase)

$000 16000 79550 15900 4500 115950

Current Assets Inventory (9 900 + 4800 - 300 (w (v))) Trade receivables (13 600 + 8600) 22200 Cash (1 200 + 3800) 5000 Total assets Equity and liabilities Ordinary share capital

153

20400

14400 41600 57550

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (20 000 + 16000 (w (i)))

36000

Reserves: Share premium (8 000 + 16000 (w (i))) Accumulated profits (w (ii)) Minority interests (w (iii)) Non-current liabilities 10% Loan note (16 000 + 4200) Deferred consideration (18 000 + 1800 (w (vi)))

24000 12000

36000 72000 9150

20200 19800 40000

Current liabilities: Trade payables (16 500 + 6900) Taxation (9 600 + 3400) Total equity and liabilities

23400 13000

36400 157550

Note: all working figures in $000. The 80% (24 m/30 m shares) holding in Sundial is likely to give Hapsburg control and means it is a subsidiary and should be consolidated. The 30% (6 m/20 m shares) holding in Aspen is likely to give Hapsburg influence rather than control and thus it should be equity accounted. (i) Investments at cost (see below)

50000

Cost of control Ordinary shares (30 000 80%) Share premium (2 000 80%) Pre acq profit (w (ii)) Fair value adjustments (see below) Goodwill

50000

24000 1600 3200 5200 16000 50000

The purchase consideration for Sundial is $50 million. This is made up of an issue of 16 million shares (24/3 - 2) at $2 each totalling $32 million and deferred consideration of $24 million ($1 per share) which should be discounted to $18 million (24 million $0.75). The share issue should be recorded as $16 million share capital and $16 million share premium. Fair value adjustments: IAS22 requires the full fair value adjustment to be recorded with the minority being allocated their share.

154

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Fair value adjustment Property, plant and equipment Investments

minority

Total

group share (80%)

5000

4000

1000

1500 6500

1200 5200

300 1300

(20%)

The fair value adjustment of $5 million to plant will be realized evenly over the next four years in the form of additional depreciation at $1.25 million per annum. In the year to 31 March 2004 the effect of this is $1.25 million charged to Sundial’s profits (as additional depreciation); and a net of $3.75 million added to the carrying value of the plant. Goodwill on acquisition of Aspen: Purchase consideration (6 million $2.50) Share capital Profits up to acquisition (8 000 - (6000 - 6/12)) Net assets at date of acquisition Difference goodwill (ii)

15000

20000 5000 25000 - 30%

(7500) 7500

Accumulated profits Hapsburg Additional depreciation (w (i)) URP in inventory (w (v)) Unwinding of interest (w (vi))

Sundial 1250

Hapsburg Per question

Sundial 10600

300

Post acq. profit

2600

1800

Share of Aspen’s profit (6000 6/12 30%)

900

1450

Minority interest ((8 500 1250) 20%)

155

8500

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Pre-acq profit ((8 500 4500) 80%) Post acq profit (4500 1250) 80%) Balance c/f

3200

2600

12000 14100

8500

14100

(iii)

Balance c/f (iv)

Minority interest Ordinary shares (30 000 - 20%) Share premium (2 000 - 20%) Accumulated profits (w (ii)) 9150 Fair value adjustments (w (i)) 9150

6000 400 1450 1300 9150

Unrealized profit in inventory As the transaction is with an associate, only the group share of unrealized profits must be eliminated: $1.6 million - 2.5 million/4 million - 30% = $300 000 (b) In recent years many companies have increasingly conducted large parts of their business by acquiring substantial minority interests in other companies. There are broadly three levels of investment. Below 20% of the equity shares of an investee would normally be classed as an ordinary investment and shown at cost (it is permissible to revalue them to market value) with only the dividends paid by the investee being included in the income of the investor. A holding of above 50% normally gives control and would create subsidiary company status and consolidation is required. Between these two, in the range of over 20% up to 50%, the investment would normally be deemed to be an associate (note, the level of shareholding is not the only determining criterion). The relevance of this level of shareholding is that it is presumed to give significant influence over the operating and financial policies of the investee (but this presumption can be rebutted). If such an investment were treated as an ordinary investment, the investing company would have the opportunity to manipulate its profit. The most

156

8500

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN obvious example of this would be by exercising influence over the size of the dividend the associated company paid. This would directly affect the reported profit of the investing company. Also, as companies tend not to distribute all of their earnings as dividends, over time the cost of the investment in the balance sheet may give very little indication of its underlying value. Equity accounting for associated companies is an attempt to remedy these problems. In the income statement any dividends received from an associate are replaced by the investor’s share of the associate’s results. In the balance sheet the investment is initially recorded at cost and subsequently increased by the investor’s share of the retained profits of the associate (any other gains such as the revaluation of the associate’s assets would also be included in this process). This treatment means that the investor would show the same profit irrespective of the size of the dividend paid by the associate and the balance sheet more closely reflects the worth of the investment. The problem of off balance sheet finance relates to the fact that it is the net assets that are shown in the investor’s balance sheet. Any share of the associate’s liabilities is effectively hidden because they have been offset against the associate’s assets. As a simple example, say a holding company owned 100% of another company that had assets of $100 million and debt of $80 million, both the assets and the debt would appear on the consolidated balance sheet. Whereas if this single investment was replaced by owning 50% each of two companies that had the same balance sheets (i.e. $100 million assets and $80 million debt), then under equity accounting only $20 million ((100 -80) 50% -2) of net assets would appear on the balance sheet thus hiding the $80 million of debt. Because of this problem, it has been suggested that proportionate consolidation is a better method of accounting for associated companies, as both assets and debts would be included in the investor’s balance sheet. IAS 28 ‘Accounting for Investments in Associates’ does not permit the use of proportionate consolidation of associates, however IAS 31 ‘Financial Reporting of Interests in Joint Ventures’ sets as its benchmark proportionate consolidation for jointly controlled entities (equity accounting is the allowed alternative). 10

Jay Consolidated Statement of financial position at 31 May 2005 $m Tangible non-current assets Goodwill

157

353.2 3·2

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Investment in associate Investment (10 – 0·5) Current assets (120 – 6) Total assets m Share capital of $1 Share premium Revaluation reserve (15 + 1·2) Retained earnings Minority Interest Total equity Non-current liabilities (60 + 4) Current liabilities Total equity and liabilities

13·2 9·5 114 –––––– 492·9 –––––– 100 50 16·2 130·7 12 –––––– 308·9 64 120 –––––– 492·9 ––––––

Workings (1) Goodwill calculation – Gee IFRS3 ‘Business Combinations’ states that where a business combination involves more than one transaction, the cost of the combination is the aggregate cost of each individual transaction at each date of acquisition irrespective of any change in Jay’s books of the original investment in Gee. 1 June 2003 1 June 2004 Purchase consideration less net assets acquired: 30% of fair value $40 million 50% of fair value $50 million

$m 15 (12) ––– 3 –––

Goodwill

Goodwill will be $3 million + $5 million – impairment of $4·8 million (W8), i.e. $3·2 million. (2) Minority Interest 20% of $46 million Revaluation surplus

$m 9·2 2·8 ––– 12 –––

(3) Inter company profit Jay Selling price of goods

158

$m 30

$m 19

(25) ––– 5 –––

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Cost price

(13) ––– Profit 6 ––– Depreciation overcharged (10% x 6 x 1/2) 0·3 ––– (Any impact on minority interest is immaterial) (4) Machinery and instalment The outstanding debt of $6 million is not going to be received. Therefore, an impairment loss of $6 million will be reported. This will be offset by the inclusion of the machine’s carrying value in the financial statements of Jay at $5 million less depreciation of $0·1 million (3/12 x 10% x 5) i.e. $4·9 million. The title to the machine has not passed therefore the machine will be held in the financial statements at its original carrying value less depreciation. The net profit on the sale will be $1·9 million. In the income statement this will have been recorded by taking the original sale profit of $3 million and deducting the impairment of the receivable of $1·1 million. (see 5 below) (5) Group reserves Retained earnings – Jay less profit on fair valuation of Gee at 31 May 2005 11 Post acquisition reserves of Gee: 30% x (46 – (40 – 10)) 4·8 50% x (46 – (50 – 14)) 5 ––– Inter company profit (6 – 0·3) Loss on impairment of receivable (6 – 4·9) 1 Impairment of goodwill Associate’s profit less inter company (1 – 0·5)

(6) Revaluation of land and tangible non-current assets Increase in value of land Goodwill: 30% x $10 million 50% x $14 million Minority interest Revaluation reserve (30% x 14 – 10)

$m 14 –––– 3 7·2 2·8 1·2 –––– 14·2 ––––

Tangible non-current assets are therefore $m

159

$m 135 (3)

9·8 (5·7) (1·1) (4·8) 0·5 ––––– 130·7 –––––

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Jay Gee Revaluation of land Inter company profit (net of depreciation) Machine

300 40 ––––– 340·2 14 (5·7) 4·9 ––––– 353·2 –––––

(7) Associated Company – Goodwill and investment in Hem $m Cost of investment 12 less fair value of net assets (25% of 32) (8) ––– Goodwill 4 ––– Cost of investment 12 Profit for year (30 – (32 – 6)) x 25% 1 ––– Associate’s carrying value in balance sheet 13 ––– Recoverable amount 25% x $68 million 17 ––– Therefore, the investment in the associate is not impaired. Because goodwill is not separately recognised in the carrying amount of the investment, it is not tested separately for impairment by applying IAS 36. Instead it is tested by comparing the recoverable amount of the investment with its carrying amount. Inter company profit of (25% x $2 million) i.e. $0·5 million, should be deducted from the investment purchased from the associate and consolidated reserves. The investment in the associate will be stated at $13 million. (8) Impairment test of Gee at 31 May 2005 Goodwill Net assets $m $m Carrying value 8 46 Fair value adjustment 14 ––– ––– Carrying amount (80%) 8 60 Unrecognised minority interest (20%) 2 ––– ––– Notionally adjusted carrying amount 10 60 Recoverable amount Impairment Impairment of goodwill will be 80% of $6m, i.e. $4·8 million.

160

Total $m 54 14 ––– 68 ––– 70 64 ––– 6 –––

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 11

(i) Importance and criteria determining a related party relationship Related party transactions form part of the normal business process. Companies operate their businesses through complex group structures and acquire interests in other entities for commercial or investment purposes. Control or significant influence is exercised by companies in a wide range of situations. These relationships affect the financial position and results of a company and can lead to transactions that would not normally be undertaken. Similarly those transactions may be priced at a level which is unacceptable to unrelated parties. It is possible that even where no transactions occur between related parties, the operating results and financial position can be affected. Decisions by a subsidiary company can be heavily influenced by the holding company even though there may be no inter company transactions. Transactions can be agreed upon terms substantially different from those with unrelated parties. For example the leasing of equipment between group companies may be at a nominal rental. The assumption in financial statements is that transactions are carried out on an arm’s length basis and that the entity has independent discretionary power over its transactions. If these assumptions are not true, then disclosure of this fact should be made. Even if transactions are at arm’s length, disclosure of related party transactions is useful information as future transactions may be affected. The Framework document says that information contained in financial statements must be neutral, that is free from bias. Additionally the document says that information must represent faithfully the transactions it purports to represent. Without the disclosure of related party information, it is unlikely that these qualitative characteristics can be achieved. IAS24 ‘Related Party Disclosures’ defines a related party (paragraph 9). The definition includes the following: A party is related to an entity if: (a) (i) the party controls, is controlled, or is under common control with the entity or (ii) has an interest in the entity that gives it significant influence over the entity or (iii) has joint control over the entity (b) the party is an associate or joint venture

161

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (c) the party is a member of the key management personnel of the entity or its parent (d) the party is a close family member of anyone referred to in (a) or (c) above (e) the party is controlled or significantly influenced by an individual in (c) or (d) above Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. The power does not need to be used for control to exist. Entities subject to common control from the same source are related parties because of the potential effect on transactions between them. Common control will exist where both entities are subject to control from management boards having a controlling nucleus of directors in common. Significant influence is the power to participate in the financial and operating policy decisions of the entity without controlling those policies. Significant influence can occur by share ownership, statute or agreement. (ii)

Egin Group Group Structure:

Atomic 30%

Egin 80% Briars

60% Doye

30% Eye

Spade 40% Briars, Doye and Eye are all related parties of Egin because Briars and Doye are controlled and are under the common control of Egin and Egin has significant influence over Eye. Additionally because there is a controlling nucleus of directors in common (i.e. the directors of Egin are also the directors of Briars and Doye), Briars and Doye are also related parties. Briars and Doye are not necessarily deemed to be related parties of Eye. There is only one director in common so any influence will probably be exerted by the four other directors. It will be necessary to determine whether the director is deemed to be a key member of management of the companies or can control or significantly influence policies in their dealings. Additionally, relationships between parents and subsidiaries should be disclosed even if there have not been any transactions between them (IAS24 paragraph

162

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 12). Thus there should be disclosure of the relationship between Tang and Egin during the period even though Tang has now been sold. The company, Blue, is a related party of Briars as the director controls Blue and is a member of the key management personnel of Briars. If the director is considered to be a related party of Egin, i.e. because the director acts as a consultant to the group, then this information should be disclosed in the group financial statements. Spade and the Group Spade, being an investor in Doye, is a related party of that company and disclosure of the sale of plant and equipment will have to be made. The fact that Egin and Spade have an investment in the same company, Doye, does not itself make them related parties. The Egin group and Spade will only be related parties if there is the necessary control or influence. For example if Spade persuaded Egin to sell plant and equipment at significantly below its retail value then Egin would have subordinated its interests in agreeing to the transaction. Atomic and the Group Atomic is a related party to Egin and to Briars and Doye as Atomic has significant influence over Egin which controls Briars and Doye. The same does not necessarily apply to Eye. It would have to be proven that Atomic could significantly influence Eye because of its holding in Egin. It may be difficult to exercise such influence in an associate (Eye) of an associated company (Egin). Management should describe the basis of the pricing between related parties which is the normal list selling price. However, related party transactions are between parties where one party has control or significant influence are by definition are not at arm’s length. Therefore, the transactions between related parties should not be described as arm’s length. 12

AC has 90% control in BD and therefore controls the financial and operating policies of BD. This was also the case when the holding was only 70%. BD should be accounted for using full consolidation from the time of the purchase of the 70%. The investment in CF is 40% and therefore implies significant influence and the use of equity accounting to bring CF into the group statements of AC. The remaining investment is an available for sale investment and as per IAS 39 will be held at fair value at

163

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN balance sheet date with any gains or losses taken to reserves. (b) WORKINGS GOODWILL BD Cost of investment 70%/20% share capital 70%/20% revaluation reserve 70% retained earnings 1 March 2003 20% retained earnings 1 July 2008 (9,000 – 50% x 1.6m) Group share Goodwill Total goodwill

70%

stake 20% 18,000

stake 7,000

14,000

4,000

700

200

2,100 1,640

5,840 1,160

16,800 1,200 2,360

AVAILABLE FOR SALE INVESTMENTS Total investments as per SFP 34,300 Investment in BD at cost (18+7) 25,000 Investment in CF at cost 7,000 32,000 Available for sale investment carried on SFP 2,300 Available for sale investment at fair value 2,600 Gain taken to reserves 300 CONSOLIDATED RETAINED EARNINGS Retained earnings AC Post acquisition retained earnings of BD (70%x(9000-3000) +20% x 800) Group share of post acquisition earnings of CF 40%(9000-6000) Adjustment for unrealised profit on inventories 40%(800x25%x50%) Impairment of goodwill on CF (30% x 1.4m)

22,000 4,360 1,200 (40) (420) 27,100

MINORITY INTEREST Net assets of BD at 31 December 2008 Minority interest 10%

30,000 3,000

GOODWILL CF Cost of investment 40% share capital at acquisition

164

7,000 3,200

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (40%x8,000) 40% retained earnings at acquisition date (40%x6,000)

2,400

Goodwill

5,600 1,400

INVESTMENT IN ASSOCIATE Cost of investment Group share of post acquisition profits (40% (90006000)) Less unrealised profit on inventories (see consolidated retained earnings working) Less impairment of goodwill (30%x1.4) Group share of revaluation gains (40%x1m CF)

7,000 1,200 (40) (420) 400 8,140

AC consolidated statement of financial position as at 31 December 2008 $000s Non-current assets Property, plant and equipment (25,700+28,000) Goodwill on acquisition Investment in associate Available for sale investments Current assets (17,000+14,000)

$000s

53,700 2,360 8,140 2,600

66,800 31,000 97,800

Total assets

Equity Share capital Revaluation reserve (AC3,000+group share CF 40%x1m) Other reserves (AC 1,000+gain on AF investment 300) Retained earnings Minority interest Non-current liabilities (6,000+4,000) Current liabilities (15,000+8,000)

30,000 3,400 1,300 27,100

Total equity and liabilities

Chapter 29 1 (a) Closing rate/net investment method:

165

61,800 3,000 10,000 23,000 97,800

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■ ■ ■ ■ ■

Assumes investment is made for purposes of receiving dividends. Foreign company is not seen as an extension of home country but as independent of currency of home country. Assets and liabilities are translated at balance sheet date. Equity capital is translated at rate when acquired. Profit and loss translated at closing rate or average.

(b) Temporal method: ■ ■ ■ ■ ■

Regards foreign enterprise as an extension of investing company, therefore views transactions as those of investing company. Monetary assets, current liabilities and long-term liabilities are translated at rate ruling at the end of the year. Non-monetary assets and depreciation are translated at date of purchase. Equity capital is translated at rate when acquired. Profit and loss translated at average rate.

individual company transactions

■

when preparing consolidations and the foreign company can be regarded as an extension of home company.

To summarize: Translation of foreign currency transactions as if the transactions had occurred in the domestic currency the temporal method. Balance sheet monetary items, inventory and investments are translated at current exchange rate; items at past prices are translated using historical rate. The P&L account is translated at average rate, except cost of goods sold and depreciation, which are translated at historical rate. Translation so as to provide translated information that is compatible with the effect of exchange rate changes on cash flows - the closing rate method. The balance sheet and P&L account are translated at end of period exchange rate. See activities in the text contrasting both methods. 2.

 3.

demonstrating

and

This is amply dealt with in the text. With the temporal method exchange gains and losses are put through the income statement; unrealized gains are the problem. With the

166

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN closing rate method exchange gains and losses are put through reserves as exchange rate changes will have no effect on cash flow to the holding company. This avoids distortion of income statement due to factors unrelated to trading performance. Losses are the problem with this method. 4

 5

Essentially, conversion is required when dealing with a completed foreign currency transaction, translation when dealing with a non-completed transaction at year end. Translation involves accounting for assets, liabilities, revenue and expenditure in a currency different from the one in which the event initially occurred. Critical appraisal is required of the concept behind closing rate as compared with temporal method. The closing rate is based on the idea that the holding company has a net investment in the foreign operation and that what is at a risk from currency fluctuations is the net financial investment. The temporal method is based on the idea that the foreign operations are simply a part of the group, that is, the reporting entity. Thus the closing rate method assumes that business is carried on overseas by semiindependent units that are dependent on the local currencies, whereas the temporal method assumes overseas units are extensions of the home business. The mode of business operation requires assessment to determine which method of translation should be used and the factors involved in this assessment are detailed in the regulations of IAS 21, which are covered in the text.

This is covered in Activity 29.5 and the text immediately prior to it.

First translate the subsidiary into the presentation currency, the $, using the closing rate.

Foreign statement of income 31 July 2006 Revenue Cost of sales Gross profit Distribution costs Administration expenses Finance costs Profit before tax

Crowns 000s 650 550 100 (41) (87) (10) (38)

167

Rate 2.4 2.4 2.4 2.4 2.4

$000s 270.8 229.2 41.6 (17.1) (36.3) (4.2) (16)

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Income tax Profit after tax

10 (28)

2.4

4.2 (11.8)

We also note that Home has a foreign currency transaction which needs translating using the temporal method and the exchange gain/loss will be taken to the statement of income. Asset Trade payable Exchange to income statement

Florinss000s 32 32

Rate 1.5 1.6

$ 000s 21.3 20 1.3

Now we need to deal with the goodwill impairment. Goodwill at date of acquisition was 204 – (1 +180) = 23 crowns Goodwill at 31.7.06 after 20% impairment =18.4 crowns The impairment of 4.6 is translated at 2.2 and 2.1$ charged to income statement. Consolidated statement of income for Home for the year ended 31 July 2006 Revenue Cost of sales Gross profit Distribution costs Administration expenses Finance costs

3000+270.8 2400+229.2 32 +17.1 168+36.3 15+4.2

Exchange gain on Home plant Impairment of goodwill Profit before tax Income tax Consolidated profit after tax

102+(4.2)

$ 000s 3270.8 2629.2 641.6 (49.1) (204.3) (19.2) 369 1.3 (2.1) 368.2 97.8 270.4

Memo Group Consolidated Statement of financial position for the year ended 30 April 2004 Tangible non-current assets Goodwill Current Assets Ordinary shares of $1 Share premium account Accumulated profits Minority Interest Non-current liabilities Current liabilities

$m 367 8 403 778 60 50 372 482 18 44 234 778

Consolidated Statement of income for the year ended 30 April 2004

168

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN $m 265 (163) 102 (40) (2) (1) 4 1 64 (24) 40 (2) 38

Revenue Cost of Sales Gross Profit Distribution and Administrative expenses Goodwill impairment Interest payable Interest receivable Exchange gains Profit before taxation Tax Profit after taxation Minority Interest

1 Consolidated statement of financial position - workings

Tangible Non- current Assets Current Assets Current Liabilities Non-current Liabilities

Crowns Adj (m) 146

Rate $m Notes Notes 2.1 69.5

102

2.1

(60)

(1.2) 2.1

(41)

147 32 Ordinary Share Capital Share 20 Premium Account Accumulated profits: Pre80 acquisition 132 Post Acquisition 2

48.6

2.5

(29.1) Exchange loss on inter company debt (18.6) Exchange gain on inter 70.4 12.8

2.5

8.0

2.5

2.1

52.8

0.8

17.6

147

70.4

Net assets at acquisition

Goodwill $m

Crowns Cost of acquisition (120 ‚ 2.5) Less net assets acquired: 75% of

169

120

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN $52.8 million (above)

(39.6) 8.4

(99) 21

Goodwill is treated as a foreign currency asset which is translated at the closing rate. Essentially under this method, goodwill is being included in the retranslation of the opening net investment with any gain or loss going to reserves. Therefore, goodwill is 21 million crowns ‚ 2.1 = $10 million. Therefore a gain of $1.6 million will be recorded in the statement of financial position: $2 million will be written off as impairment, giving a balance of $8 m for goodwill. 3

Minority Interest Net assets of Random at 30 April 2004 Minority interest 25% thereof

$m 70.4 17.6

Post acquisition reserves are 75% of $17.6 million (working 1)

13.2

5 Consolidated statement of financial position at 30 April 2004

Tangible Noncurrent Assets Loan to Random Current assets Goodwill

Ordinary Share Capital Share Premium Account Accumulated profits

Memo $m 297

Random $m 69.5

5 355

Adjustment $m

Total $m 366.5

(5) 48.6

(0.6)

403 8

360

13.2

(0.6) (0.4)

Minority Interest Non-current Liabilities Current Liabilities

372.2 282.2 17.6 30

18.6

205

29.1

(5)

43.6 234.1 777.5

Adjustments are: Elimination of inter company loan ($5 m), inter company

170

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN profit in inventory ($0.6 m) and goodwill gain on retranslation of $1.6 million less impairment of $2 million, i.e. ($0.4 million) 6

Consolidated statement of income Workings

$m 200 (120)

Inter Company Random and $m 71 (48)

(30)

(10)

Memo Revenue Cost of sales Inventory inter company profit (W8) Distribution and Administrative Expenses Goodwill Interest receivable Interest payable Exchange gain - loan (W7) Exchange loss purchases (W8) Taxation Minority Interest Dividends (to statement of changes in equity)

adjustment

Goodwill

Total

$m 265 (162.6)

(6) 6 (0.6)

(40)

(2) 4

(20) 34

(1)

(0.6)

(4.5) 7.9 (2)

(0.6)

(2)

5.9

(0.6)

(2)

The statement of income for Random has been translated at 2 crowns = $1, i.e. at the average rate. The closing rate is not allowed under IAS21. Minority interest is 25% of $7.9 million, i.e. $2 million 7

Loan to Random There is no exchange difference in the financial statements of Memo as the loan is denominated in dollars. However, there is an exchange gain arising in the financial statements of Random. CRm

Loan at 1 May 2003 $5 million at 2.5 Loan at 30 April 2004 $5 million at 2.1

171

(24.5) 39.3 (2) (8)

(8)

(2) 4

12.5 10.5

29.3

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Exchange gain

2.0

This will be translated into dollars at 30 April 2004 and will appear in the consolidated statement of income (2 million crowns ‚ 2, i.e. $1 million). The reason being that the loan was carried in the currency of the holding company and the subsidiary was exposed to the foreign currency risk. 8

Purchase of raw materials

Profit made by Memo $6 million _ 20% Profit remaining in inventory at year end (1/2) Purchase from Memo ($6 million _ 2) less payment made ($6 million _ 2.2) Exchange loss to profit/loss

$m 1.2 0.6 12 (13.2) (1.2)

The exchange loss will be translated at the average rate (2 CR to $1) into dollars, i.e. $0.6 million. Again the fact that the group cash flows have been affected by foreign currency fluctuations could mean that this loss will be reported in the group statement of income.

Movement on consolidated reserves $m 334.0 29.3 7.3 1.6 372.2

Balance at 1 May 2003 Consolidated profit for the period Exchange gain on translation Exchange gain on goodwill Balance at 30 April 2004 Analysis of exchange gain Gain on retranslation of opening equity interest (132 ‚ 2.5 - 132 ‚ 2.1)

10.1

Loss on translation of income statement 7.9 - (7.9 - 2/2.1) Exchange gain

(0.4) 9.7

75% of exchange gain $9.7 m is $7.3 million 9 Step 1 - pre-adjust net assets for accounting policy change: Date of acquisitionBalance sheet FI000 date FI000 Issued capital Revaluation reserve Accumulated profits Net assets for the consolidation

40000 6000 20000 66000

40000 11000 44000 95000

Step 2 - translate the statement of financial position of Small into

172

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN $s (after incorporating the above adjustments) FI000

Rate

$000

Non-current assets Inventories Receivables Cash

91000 40000 32000 4000 167000

5 5 5 5

18200 8000 6400 800 33400

Share capital Revaluation reserve: Pre-acquisition Post-acquisition (see tutorial note below) Accumulated profits: Pre-acquisition Post acquisition

40000

6667

6000

1000

5000

1000

20000 24000 95000

6 Balance

3333 7000 19000

FI000 Interest bearing borrowings 30000 Deferred tax 9000 Trade payables 15000 Tax 18000 167000

Rate 5 5 5 5

$000 6000 1800 3000 3600 33400

Whilst IAS 21 requires that exchange differences be taken to reserves through the statement of changes in equity, it does not specify which reserve should be used. The approach taken here is to translate the post-acquisition revaluation reserve at closing rate, thereby including a portion of the exchange differences within it. An alternative approach would have been to leave the revaluation reserve at the rate at which it was originally created and report all exchange differences in accumulated profits. Step 3 - prepare the consolidated statement of financial position $000 $000 Non-current assets: Property, plant and equipment [60 000 18200] 78200 Intangible assets (W4) 500 78700 Current assets: Inventories [30 000 8000 1200 (W2)] Receivables [25 000 6400 6000 (W2)] Cash [3000 800 6000 (W2)]

36800 25400 9800 72000

173

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 1 50700 Capital and reserves: Issued capital Revaluation reserve [15 000 75% 1000] Accumulated profits (W5)

30000 15750 37800 83550 4750

Minority interest (W3) Non-current liabilities: Interest bearing borrowings [15 000 6000] 21000 Deferred tax [5000 1800] 6800

27800 Current liabilities: Trade payables [12 000 3000] Tax [16 000 3600]

15000 19600 34600 150700

Workings (W1) Group structure Big owns 60 million of the 80 million Small shares in issue. This is a 75% subsidiary. (W2) Intra-group trading The unrealised profit made by Big is 25/125 $6 million $1.2 million. There is cash in transit of $6 million which needs adding onto consolidated cash and taking out of consolidated receivables. (W3) Minority interest 25% 19000

4,750.

(W4) Goodwill $000 Original goodwill: 9500 75% [6667 1000 3333] Amortised to date [6/10] So unamortized

1250 (750) 500

(W5) Accumulated profits Big Small [75% 7000] Goodwill amortized (W4) Unrealized profit (W2)

174

$000 34500 5250 (750) (1200) 37800

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN

Little needs to be translated using the closing rate i.e spot rate on the balance sheet and weighted average on the statement of income, as it operates relatively independently. Exchange differences will be taken to equity. Little’s statement of financial position also needs adjusting to take account of group accounting policies. Translation of Little statement of financial position Property, plant and equipment Inventories Trade receivables Cash

F 000s 80 – 6 revaluation (Large does not revalue) 30 28 5 137

Rate 5

$ 000s 14.8

5 5 5

6 5.6 1 27.4

40 6 –6

6.7

26 8

6 Balancing figure

4.3 3.8

Total assets Share capital Revaluation reserve Accumulated profits Pre acquisition Post acquisition Interest bearing borrowings Deferred tax Trade payables Tax

74 25 10 20 8 63 137

5 5 5 5

14.8 5 2 4 1.6 12.6 27.4

Total equity and liabilities

Consolidated statement of financial position of Large group 31 March 20X4 Non-current assets Property, plant and equipment Current assets Inventories Trade receivables Cash

$000s 63+14.8 25+6 - .25 unrealised profit 20+5.6-1 cash in transit 6+1+1 CIT

$000S 77.8

30.75 24.6 8

63.35 141.15

Total assets Share capital Accumulated profits

Minority interest

35+share of postacq 90% x3.8 – goodwill amortised 2.1 - .225 unrealised profit 10% net assets little 14.8 - .025 unrealised

175

30 36.095

1.455

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN profit 67.55 Non-current liabilities Interest bearing borrowings Deferred tax Current liabilities Trade payables Tax Bank overdraft Total equity and liabilities

20+5

6+2

25+4 7+1.6

29 8.6 3

40.6 141.15

Large owns 36000 shares from 40000 i.e. 90% ownership Cost of control (72/6) Bought: 90% shares 36/6 90% profits at acq. date (26/6 x 90%) Goodwill on acquisition

12 6 3.9 9.9 2.1 all impaired

(a) Functional currency is the currency of the primary economic environment in which the entity operates. Following factors need to be considered in determining the functional currency of an entity:  Which currency primarily influences selling prices for goods and services  Which country’s competitive forces and regulations principally determine the selling prices of the entity’s goods and services  In which currency are funds for financial activities generated.  In which currency are receipts from operations generally kept  Which currency influences labour, material and other costs of providing goods or services. (b)

EY S of CI Revenue Expenses Profit

Rate

Franc 1,200,000 2.60 1,000,000 2.60 200,000

S of FP 31 October 2008 PPE 1,500,000 2.70 Investment Current 2,000,000 2.70 assets 3,500,000 50,000 2.0 Share capital Retained 1,650,000 Balance

EY $ 461,538 383,615 76,923

555,556 740,741

Consolidation consolidated adjustment $ $ 3,600,000 4,061,538 2,800,000 3,184,615 800,000 876,923

5,000,000 25,000 4,400,000

5,555,556 (25,000) 5,140,741

1,296,297 9,425,000 (25,000) 10,696,297 25,000 1,000,000 (25,000) 1,000,000 604,630

176

4,825,000

5,429,630

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN earnings Current liabilities

1,800,000 2.70

666,667

3,600,000

4,2666,667

3,500,000

1,296,297 9,425,000 (25,000)

10,696,297

(c) Statement of changes in equity for the year ended 31 October 2008 $ Brought forward at 1 November 2007 (see W1) Profit for the period from SCI Dividend Exchange loss (balancing figure) Closing equity 91,000,000 + 5,429,630)

5,852,174 876,923 (200,000) (99,467) 6,429,630

W1 Post acquisition retained earnings in EY Opening equity in EY(1,650,000+50,000-200,000)1,500,000francs @2.30 652,174 Less share capital in EY (50,000@2.0) (25,000) 627,174 DX equity 5,225,000 5,852,174 Exchange loss for the year (proof of balance above) Opening equity in EY (1,500,000 francs as above): Translated at opening rate (1,500,000/2.30) 652,174 Translated at closing rate (1,500,000/2.70) 555,556 Exchange loss 96,618 Profit for the year in EY (200,000): Translated at average rate (200,000/2.60 76,923 Translated at closing rate 9200,000/2.70) 74,074 Exchange loss 2,849 99,467 Chapter 30 1

If you read again on page 778 the section on accounting method choice, you will find already a number of choices. However you could systematically screen all IAS/IFRS and look for choices not represented in chapter 30 e.g. evaluation of agricultural products: historical cost vs. fair value or valuation choices with regard to investment properties.

Before calculating ratios with regard to profitability and solvency one needs to take into account the impact of accounting policy choices: - company B’s profitability improves due to the write off of the goodwill against retained profit. In future years there is no impact on the result of company B, whereas there will be an impact on the results of companies A and C. - with regard to equity, the equity base of company B will be lower due to the decision to write off goodwill from equity.

177

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN These elements need to be taken into account if one starts comparing companies 3

The value drivers of fast food restaurants are a.o. easy accessibility, low cost with acceptable quality, speed of service. Very often the outlets are owned through franchise agreements whereby the fast food chain is not the owner of the premises. In the fast food industry low margins are applied in combination with high turnover in order to be profitable. In companies like EADS (Airbus) and Boeing the turnover of assets is much slower and in prosperous economic times sales margins are higher than in a downturn period. The current assets will also be much higher (i.e. construction contracts) for the airline manufacturers as well as their investments in R&D.

If you read the case on the airline Sabena in the appendix to chapter 30, you will find a number of examples: e.g. - operational leasing vs. ownership or financial leasing will influence the debt structure of the company - fair value vs. historical cost valuation with depreciation will have an impact on the amounts reported as assets - differences in the amounts of impairment recorded, affect this years’ profit but also future profits

NB. There is a typo in the question - it should read ‘Consider again the examples you listed in answering Question 4’. Depending on the contents of your national GAAP a number of choices will not be possible or more choices will be possible: e.g. * valuation of inventory fifo, lifo, and weighted average * the use of provisions for repair and maintenance, * the use of variable costing for valuation purposes of the inventory of finished goods and goods in process instead of the full costing method, * the use of the completed contract method for the valuation of construction contracts instead of the percentage of completion method.

This answer depends on the characteristics of the national GAAP of your country. Quite often in code law countries more flexibility is possible, than the flexibility allowed under IAS/IFRS.

Flexibility is a two-edged sword. Too much flexibility allows the presentation of low quality accounting information. However some flexibility is needed because management must be able to convey reliable and relevant data on their firm specific situation.

Companies operating in the same business lines can be chosen for benchmarking purposes. Next it is important to evaluate whether these companies are active in the same

178

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN geographical markets (risk differences) and how they are financed. Adjustments for accounting policies can only be done, if sufficient information is disclosed in the notes of the annual accounts of all companies. Chapter 31 1 (a) Report on the relative profitability of Hone and Over. To evaluate the financial performance and the financial position of Hone and Over several techniques are available like horizontal and vertical analysis, ratio analysis and industry analysis. Since we only have information available for a time-frame of two years, the results of the horizontal analysis must be interpreted with caution. It seems that both companies face a decline in profitability although the revenue increases. The results of the horizontal analysis show that Over managed to keep its other operating expenses more under control, this resulted in less decline of profit from operations. The increase in the net profit for Over, whereas the net profit for Hone declines must have other causes. Horizontal analysis based on

Hone Over

The two years available, whereby The first year has a value of 100% Evolution in revenue Evolution in cost of goods sold Evolution in other operating expenses Evolution in profit from operations 98% Evolution in net profit

109% 107% 120% 123% 114% 105% 93% 91% 104%

Since the management of Expand is not interested in liquidity data, we will not calculate the current ratio, the acid test ratio, the inventory turnover, the collection period for the revenues and the credit days granted by suppliers. Using vertical analysis and ratio analysis we obtain the following data:

Gross profit margin Net profit margin Total profit margin Total asset turnover

Hone 2001 50% 30% 18% 0,8

179

Hone 2000 54% 35% 22% 0,7

Over 2000 48% 33% 17% 1,00

Over 1999 53% 38% 18% 0,95

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Cost of sales/sales Other expenses/sales ROA ROE Equity/Equity+debt Debt/Equity+debt Interest cover Dividend cover

50% 20% 24% 21% 68% 32% 8 1,57

45% 19% 27% 25% 65% 34% 10 1,7

51% 14% 34% 37% 47% 52% 9,5 1,3

46% 15% 36% 39% 45% 54% 10 1,3

The data above show us that although on the operational side the differences between Over and Hone are not that large, Over is more profitable since it is using debt to a larger extent than Hone and at a much cheaper interest rate than Hone. This might be due to local circumstances (remember the firms are from different jurisdictions). (b) Comments on the validity of this financial information as a basis to compare the profitability of the two companies. We have no information to which industry these two companies belong, so we assume for the analysis that both companies belong to the same industry. Only in this way are the data on the operational performance of both firms comparable. Figures like cost structures, asset and inventory turnover, sales margins, profit margins, collection period of receivables and credit granted by suppliers become really comparable if companies belong to the same industries. In order to judge whether Hone and Over are ‘best in class’ or the worst performers of the industry, industry data must be available in order to benchmark the performance of Hone and Over against industry averages and the best in class in the industry. Further we observe that both companies belong to different countries. This should be explicitly taken into account. The annual accounts are prepared in the local GAAP of these countries. Are both local GAAP’s of high quality? Of low quality? Or of different quality levels? Are the institutional characteristics of both companies the same? What about enforcement of accounting standards, risk of litigation, the audit quality and the rules of the local stock exchange (if Hone and Over are listed companies)? Since both annual accounts are prepared using different domestic GAAP systems, the accounting flexibility of both systems should be analysed and the accounting method and estimate choices taken by the management should be investigated before the data can be compared. We observe that the year-ends are different. What about the economic situation of the industry? Was it the same in each of these three years or is it improving or deteriorating?

180

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Given that the companies are located in different countries, local operating and financial characteristics might influence the figures. For example differences in labour cost, financial costs, etc. Another comment relates to the exchange rate which is used to translate the financial statements of Over into $. Using an exchange rate which differs for monetary and non-monetary assets might create another picture. 

2 (a) Cash is exact, profits are calculated via concepts which permit various interpretations/judgments. Profit is a moving target. Cash balances can be boosted at year end quite easily by withdrawing payments, taking out loans, encouraging by incentives early debtor settlement etc. (b) Company needs cash flow and profit to survive. Concentration on increasing cash balances is bad policy as the money will not be earning unless it is invested somehow. 3

What students should do is, somehow, replicate the analysis of the airlines presented throughout Chapter 27. Starting from the difference in ROE, students have to dig deeper in order to explain the causes of differences between the two observed ROEs: ■

Operational aspects: ROA divided up into profit margin and turnover, breakdown of the different types of cost in relation to revenue (e.g. cost of goods sold, marketing costs, R&D costs).

■

Financial aspects: spread and leverage, how these companies are financed.

■

Market appreciation: if the companies are listed, what is BEPS and DEPS in relation to P/E ratio?

■

When students carry out a horizontal and vertical analysis of the components of the balance sheet and profit and loss account, they should check first the pitfalls for comparability (e.g. different balance sheet dates, changes in company structure, different presentations of the balance sheet and the profit and loss account, different recognition and measurement methods used for assets, liabilities, expenses and revenues).

■

If the companies are active in different markets and business lines a segmental analysis could provide extra information on the composition on the overall corporate risk. Are the competitors active in the same geographical markets, do their business segments differ?

181

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■

A cash flow analysis can shed light on the way both companies are financed.

4 & 5 For both questions the answers could be formulated along similar lines of thought. P/E reflects the multiple of earnings the market is willing to pay. These multiples could differ as a result of a different appreciation of the evolution of the market in which the firm is active. The crucial point related to this ‘aspect’ of evolution of the market is the question ‘What is the market?’. Is Ryanair’s market the same as that of Lufthansa? Apparently, until at least the end of 2001, these companies were, to a large extent, targeting different markets (Ryanair - low-cost transport, Lufthansa - classical air transport airlinerelated activities). Further, the following aspects play a role:

■

the markets might appreciate differently the capabilities of different firms to cope with opportunities in the market

■

the current performance of the firm

■

the economic climate and the future evolution of the economic climate.

Inventory turnover will be higher in companies active in ‘perishable goods’, consumer products and products with a shorter lifecycle. Due to constant product innovation and technological progress the lifecycle of products becomes much shorter. This has an impact not only on inventory turnover, but also on asset turnover. Companies active in the market of industrial goods will face higher inventory turnover when the products they sell have a short lifecycle and a short production time (e.g. integrated electronic circuits). Companies such as Boeing and Airbus will face lower turnover ratios.

The profit margin of a company will be influenced to a large extent by the type of competition the company is facing (the different elements are discussed in the section on industry analysis in Chapter 6: perfect competition). Profit margins will also be influenced by the adopted strategy by the firm. How do firms position their products in the market (as unique)? Will they try to obtain a premium price for this? In industries with low turnover ratios, we expect profit margins to be higher. In this way, a higher ROA and ROE can be achieved. Profit margins will also be influenced by the economic climate. In times of economic downturn

182

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN price discounts are given to attract customers (e.g. Boeing and Airbus offered higher discounts to attract orders from the airlines in 2001 and 2002). 8 (a) The report should cover the following in a coherent form: ■ liquidity – increased, lower stock holding, quick ratio higher than industry, cash rich ■ asset utilization – fluctuated, lower than industry average, very low fixed asset turnover ratio, twice the industry rate for stock turnover, debtors’ turnover four days (possible factoring of debts), takes twice as long to pay creditors than industry average. ■

interest cover – good

■

gearing – high-dependence long-term debt, lowlevel short-term financing, debt equity ratio higher than industry average.

■

profitability – slightly lower operating profit twice industry.

than

industry,

Conclusions are that fixed asset base has been increased but without a corresponding increase in sales. gross profit margins constant, financially sound, 5CO~C to increase borrowing and thereby increase equity return. (b)

(i)

The following points should be covered: ■

inflationary effects

■

accounting policies

■

cash flow statement

■

identification of other useful ratios, e.g. sales per employee

■

balance sheet is at a point in time

■

industry averages averages.

are

exactly

that

–

(ii) Liquidity ratios can be distorted by year-end window dressing ■

asset utilization ratios can be distorted by revaluations of fixed assets

■

gearing can be affected by revaluations as this increases the equity amount

■

profitability ratios can be distorted by accounting policies chosen, e.g. depreciation

183

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN ■

ratio analysis identifies areas for further enquiry

9 (a) (i) Current ratio Version 1 2000 2001

Version 2 2000

2001

Current assets ––––––––––––– Creditors: due within one year 684 + 471 + 80 –––––––––––––– 336 + 140 + 80

2.2:1

679 + 511 + 117 –––––––––––––––––––––––– 308 + 190 + 80

2.3:1

(684–40–28) + (471–40) + 80 –––––––––––––––––––––––– 336 + 140 + 80 + 80

1.8:1

(679–40–28) + (511–40) + 117 –––––––––––––––––––––––– 308 + 190+80+85

1.8:1

Version 2 excludes stocks subject to reservation of title, obsolete and slow moving stocks and debtors overdue by more than one year and includes contingent liabilities. (ii)

Interest cover Version 1 2000 2001

Version 2 2000

2001

Operating profit ––––––––––––––––– Interest payable 636 ––––– 45

14 x

698 ––––––––––––––––– 636 – (90 + 38) ––––––––––––––––– 45 698–95 ––––––––––––––––– 55

184

13x

11 x 11 x

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Version 2 reclassifies the reorganization costs as an exceptional item and reclassifies the gain on disposal of property as an extraordinary item. An adjustment adding back depreciation would he acceptable.

(iii)

Debt/equity ratio Version 1 2000 2001

Version 2 2000

2001

Creditors: due after more than one year ––––––––––––––––– Capital and reserves 450 –––– x 100% 1608

28%

450 + 100 –––– x 100% 1981

28%

450 + 8 –––––––––––––– x 100% 1608 – 247 – 144

38%

450 + 100 + 7 –––––––––––––– x 100% 1981 – 298 – 144

36%

Version 2 excludes from net worth all intangibles and the revaluation reserve, and 1 provides for deferred taxation in full. An alternative version 2 using the market value of equity would be acceptable. (iv)

Earnings per share Version 1 2000 2001 Earnings –––––––––––––– Number of shares 4.51 ––– 800

56p

453 ––– 800

57p

451 – 90 – 8

185

Version 2 2000

2001

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN –––––––––– 800

44p

4.53–95– 7 ––––––––– 800

44p

Version 2 reclassifies the reorganization costs as an exceptional item and the gain on disposal as an extraordinary item and provides for deterred tax in full. (v)

After tax return on equity Version 1 2000 2001

Version 2 2000

2001

Profit after taxation ––––––––––––––––– Capital and reserves 451 –––– x 100% 160

28%

453 –––– x 100% 1981

23%

451–90 –––––––––––– x 100% 1608–247–144

30%

453 –95 –––––––––––––– x 100% 1981 – 298 – 144

23%

Version 2 reclassifies the reorganization costs as an exceptional item and the gain on disposal as an extraordinary item and excludes from equity intangibles and the revaluation reserve. Tax implications of gain on disposal of property have been ignored. (vi)

PIE ratio Version 1 2000 2001 Price per share ––––––––––––––– Earnings per share £2.20 ––––––––––––––– 56p (see part (a)(iv)) £2.50 ––––––––––––––– 57p (see part (a)(iv))

186

3.9

4.4

Version 2 2000

2001

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN £2.20 ––––––––––––––– 44p (see part (a)(iv))

5.0

£2.50 ––––––––––––––– 44p (see part (a)(iv))

5.7

Those indicators of particular interest to potential investors as equity holders are the: • debt/equity ratio • earnings per share • after tax return on equity • price/earnings ratio and students should comment on each of these. Those indicators of interest to potential investors as debt holders are the • current ratio • interest cover • debt/equity ratio and students should expand on each of these. (b) (i)

Right issue

Loan

Debt/equity ratio Creditors: due after more than one year Capital and reserves 450 + 100 –––––––– x 100% 3038

450 + 100 + 800 ––––––––––––– x 100% 2230

18.1%

60.5%

Alternative versions are acceptable 450 + 100 –––––––––––––– x 100% 3038 – 298 – 144 450 + 100 + 800 –––––––––––––– x 100% 2230 – 298 – 144

187

21.2%

75.5%

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN (ii) Interest cover Operating profit –––––––––––––– Interest payable 903 W1 –––– 55 W1

16 x

903 W1 –––– 175 W1

(iii) After tax return on equity Profit after taxation ––––––––––––––––– Capital and reserves 551 ––––– x 100% 3038

18.1%

473 ––––– x 100% 2230

21.2%

Alternative versions are acceptable 551 ––––––––––––––– x 100% 3038 – 298 – 144

21.2%

473 ––––––––––––––– x 100% 2230 – 298 – 144

Debt/equity ratio Interest cover Return on equity

26.5% Right issue

Loan

18.1% 16 x 18.1%

60.5% 5x 21.1%

The rights issue provides very low risk, lower return finance whereas the loan provides higher risk, higher return finance. An interest cover of 5 x indicates that the higher risk is acceptable. The directors must compromise between increased risk and increased return. However, the directors must consider other factors which should influence their choice of financial structure. For example, the higher the inherent risk of the project the less

188

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN suitable is loan finance, whether the articles may specify borrowing powers as a multiple of share capital and reserves, the colateral available and the matching of longterm projects to long-term finance W1 Forecast profit and loss account extract year ended 31 December 2002 Rights issue £000 Operating profit as at 2001 698 gain on disposal (95) 603 additional profit 300 903 Interest payable 350 x 10% 45 100 x 10% 10 800 x 15% – (55) Profit before Taxation 848 Taxation at 35% (297) Profit after taxation 551 Dividend (150) Retained 401 W2 Forecast balance sheet extract as at 31 December 2002 Rights issue £000 Capital and reserves Ordinary share capital 800 additional shares 800/2.00 400 1200 Reserves as 2001 1037 share premium 400 retained profit 401 3038 10

Loan £000 698 (95) 603 300 903 45 10 120 (175) 728 (255) 473 (80) 393

Loan £000 800 – 800 1037 – 393 2230

(a) Financial performance of Recycle - report format required. The following ratios should be calculated: 1997 1996 GP/S 46.6% 53.6% OE/S 26.7% 21.4% NP/S 13.3% 28.5% Dividend cover 1.25 2.75 Interest cover 3 9 Current ratio 0.91:1 1.09:1 Quick ratio 0.62:1 0.77:1 Stock holding 114days 98days Debtor period 122days 104days Gearing ratio 25% 25% R on CE 13.6% 27.6% S to CE 1.017 0.966

189

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN Points to be made:  poor managment of working capital  stock holding increased  tangible assets have increased by £1500m but have been financed from short term means  expenses and interest increasing  liquidity may be in question  increased sales have not delivered increased profit (b)    

Reference should be made to: lack of social and environmental reporting in annual accounts none is audited information that is generally provided is of a public relations nature no GAAP or statutory regulations to report.

11 (a) Ratios need to be benchmarked Trends over years give more insight into volatility (b) X Fast growth - danger is overtrading - management cannot cope Margins squeezed to grow sales Stock levels rising Rapid increase in gearing VOLATILE 12

Y Steady growth Margins maintained Constant current ratios Steady gearing STABLE

Points to make:  Gross profit margin 32.4% to 30%  Interest paid increased 3.4 times and interest cover from 3.8 to 1.3  Business expanded using borrowed funds principally so gearing gone from 37% to 48%  Stock turnover 117 days to 129 days  Creditors turnover 78 to 58 days  Quick assets 0.7:1 from 08:1  Expansion financed from borrowing not equity  Conclusion need to address gearing position. Point 1: Cash inflows and outflows are driven by operating, investment and financing activities. The client refers to two of them namely operating activities and financing activities. Further he seems to confuse profit with incoming cash. In order to find out whether the cash balance of the

190

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN company has increased or decreased all three sources (operating, investment and finance) should be taken into account. With regard to the operating activities the client considers only the profit figure. However, to arrive at the cash flow resulting from operating activities, the profit before taxation should be adjusted for depreciation (4000), interest expense (only 200), the increase in trade receivables, increase in inventory and increase in trade payables and income taxes. Further the client should take into account the cash flow from investing activities as the company invested in property, plant and equipment. The amount can be found when one compares the book values of the two consecutive years and one makes adjustments for the depreciation and the revaluation which has taken place that year. The client considered the impact of the financing activities, however, the increase in the zero-debt bonds due to the valuation at year end does not represent incoming cash. Finally, the amount of dividends paid during the past 12 months represents a cash outflow. Point 2: The revaluation surplus stems from the revaluation of non-current assets. This revaluation is allowed under IAS 16 (paras 31-42). The revaluation amount however should not be recognized as revenue but as an increase in equity. Para. 39 of IAS 16 states explicitly ‘If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be credited directly to equity under the heading of revaluation surplus.’ Under IAS certain gains and losses are recognized directly under equity. In GAAP-systems where all changes in equity except capital increases and decreases made by the owners always pass through the profit and loss account, a statement of changes in equity is less useful. Since, in that case, an increase or decrease in equity is always equal to the result of the profit and loss account. Because under IAS, equity will be influenced by many different items, this statement of changes in equity is compulsory. It explains to the reader of the annual accounts the different origins of all changes in the equity of the company. Point 3: The valuation rule to apply to these zero-bonds is found in IAS 39. It is the intention of the management to hold the bonds to maturity which determines the valuation rule, although the bonds are quoted on a stock-exchange. The

191

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN fair value which is the price at which the bonds are listed on the stock-exchange does not influence the valuation of the zero-bond in the financial accounts. The valuation of the zero-bond which is held to maturity is found in para. 54 (a) of IAS 39, which stipulates that in the case of a financial asset with a fixed maturity, the gain or loss shall be amortised to profit or loss over the remaining life of the held-to-maturity investment using the effective interest method. You can tell the client that the increase in the bond value and the finance cost of 400 000 is part of the loss (6 802 450 5000000) which is amortized over a period of four years using the effective interest method. So there is no accounting error. 14 (a) With regard to the calculation of the basic earnings per share, the nominator can be calculated as either: - the profit or loss from continuing operations attributable to the parent entity or - the profit or loss attributable to the parent entity (IAS 33 para. 12). If one takes the result from continuing operations, the bottom line result should be adjusted with the result from the discontinuing operations and the tax impact of these discontinuing operations. Since there are no preference shares, no corrections have to be made for preference dividends. With regard to the denominator, we have to use the number of ordinary shares outstanding during the period. Because of the rights issue we need to use the weighted average number of ordinary shares outstanding during the period 120000000

6/12 (30 000 000)

135000000

(b) The EPS figure combines the earnings of the company with the number of shares out standing. Differences can occur with the other company with which the nonexecutive director is familiar, because of nominator or denominator differences. Although revenue and material costs are roughly identical, a large number of items can still influence the earnings figure and lead to a difference. For example: - different cost structures (labour employed, different equipment, plant and property, different elements outsourced or produced in house, . . .) - different accounting policies - different financing strategies - effect of ‘one-off’ items. Furthermore, a different amount of outstanding shares might cause a difference as well. (c) Exchange losses on loans are normally recorded in the

192

INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN profit and loss account (IAS 21), except when the loan is part of a hedging transaction (IAS 39). In this company, the loan is part of a hedge transaction and therefore the loss on the loan will appear under equity. (For further explanation see page 589 of Chapter 25 in the book.) For actuarial losses or actuarial gains, there is no single treatment prescribed in IAS 19. Companies may opt to choose for the corridor approach or they might recognize all actuarial gains and losses immediately. If a company chooses to apply the corridor approach foreseen in IAS 19, paras 92-93, then part of the actuarial gains and losses will not be recognized in the income statement (for further explanation see page 513 of Chapter 21 in the book). Apparently this company has chosen for the corridor approach. (d) A ‘gain on a curtailment of benefits’ is of a different nature than an actuarial gain. A curtailment of benefits implies that the pension liability is reduced; as the employees will be entitled to lower benefits than the amount taken into account in the past, the pensions liability shall be less. Since the liability has been built largely by charges to the profit and loss account, it is logical to take the reversal to the profit and loss account as well. A curtailment of benefits for the sponsoring employer can occur when subsidiaries of the company are disposed of. 15 (a) Profitability: The first three ratios present information on the profitability of company Target. The comparison of the GPM with the OPM reveals a first problem. Company Target seems to have a problem with controlling all operating costs except the cost of goods sold. The fact that company Target drops from nearly the top with GPM to the lower part of the population in relation to OPM points at this problem. The acquirer should investigate if there are cost-reduction opportunities available in company Target. A successful cost-reduction programme might bring the operational profit margin to the top of the table. Return on capital (ROC): Company Target moves for this ratio to the top five, but at the lower side. Relating ROC to the operating profit margin figure, it could be that a smaller capital amount creates this position among the top five. The interest cover ratio and the gearing ratio inform us about the solvency of the company Target. An acquirer should notice that company Target is financing its activities with more debt capital then most of its competitors (see gearing ratio). This high leverage results in comparatively more finance costs for Target than for its

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INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN competitors (see interest cover ratio). If an acquirer can substitute debt through equity, the net profit of the company will increase. The three last ratios indicate that the company Target might be short on liquidity. The collection period for receivables is shorter than the collection period of most its competitors. The same impression is given by the turnover of inventory, the turnover is faster than most competitors. This might be due to efficient inventory management or a necessity due to liquidity problems. Given the high gearing ratio and low interest cover ratio, an increase in debt capital to make the liquidation situation less tight is not feasible. An acquirer should investigate whether or not customers are lost due to this short collection period and whether or not opportunities are lost due to tight inventory turnover. The ratio dividend cover is less important, when the acquirer has gained control, they can change the dividend policy. A high ratio in the past indicates whether or not a large part of the profit has left the company. For company Target in the financial year 2002 the pay-out was very low. (b) - The selection of comparative enterprises, this should be done with great care. The business lines should be comparable, as well as the geographical markets, the technology employed and the value chain of the individual companies. If you select the total population then the median is a better value than the average, which might be biased because of outliers in this case. - In the list of ratios provided, the ratio ‘return on equity’ is missing. It is an important ratio since it highlights the impact of the gearing or leverage on the profitability of the firm and it indicates the impact of items other than operating costs and revenues on the profitability of the firm. The firm might have, for example, some financial revenue or extraordinary items that might have influenced the bottom-line profit after tax-figure. - An analysis based on ratios of only one year is not representative. That particular year might be an outlier in the company’s performance. So a five-year period is necessary for a useful analysis. Trends could then confirm the position of company Target in 2002 as representative. Further it is important to know which valuation rules the competitors have applied for the preparation of their financial statements. For an acquirer not only the past is important but also the future. Projected figures will show whether or not there is growth potential.

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INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS, 5TH EDITION ALEXANDER, BRITTON, JORISSEN 16 (a)

 Earnings per share, mainly used by shareholders.

Shareholders combine this ratio with the P/E ratio to look for opportunities to buy shares. This ratio is less used by companies wanting to invest in other companies. Shareholders can use this ratio when the make the initial investment and when they want to evaluate an ongoing investment.  Dividend yield mainly used by shareholders. If companies control other companies they also control dividend pay – out. For controlling companies total earnings, realized as well as unrealized are useful to analyse.  Gearing: this ratio is used to measure the financial risk of the company. The total risk of the company is composed of the operational risk and the financial risk. This is an important ratio as leverage has an impact on return on equity. Further the degree of leverage determines the interest cost charged by creditors. It is important to analyse this ratio at acquisition and later on.  Gross profit margin. The assistant provides the right reasons to support the use of this ratio. It will be used when the investment is evaluated, but also after the investment in the process of the continuing evaluation of the performance of the company BGH has invested in.  Asset turnover ratio: a company will use this ratio at both times namely at acquisition and later on. The ratio shows how efficient assets are used

(b) If you read chapter 30 and 31 you will find plenty of examples which hinder inter-firm and international comparisons e.g. in the case of international comparisons one needs to take into account differences in the GAAP applied, differences in the institutional environment which might have an impact on accounting quality, differences in ownership structures of companies e.g. when undertaking inter-firm comparisons one needs to take into account differences in strategy, presence of different segments, different balance sheet dates, different valuation and estimation methods applied, different financial structure. 17

Solution (d).

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