Test Bank & Solution Manual for Financial Reporting, 3rd Edition by Ace Test Banks

Test Bank & Solution Manual for Financial Reporting, 3rd Edition

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Hong Nee Ang

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter1: Accounting regulation and the conceptual framework.

Chapter 1: Accounting regulation and the conceptual framework Comprehension questions 1. What are the key sources of regulation in Australia for a listed company? The key sources of regulation for a listed company in Australia are: • The Corporations Act, which is administered by the Australian Securities and Investments Commission • Australian Accounting Standards and the Conceptual Framework, issued by the Australian Accounting Standards Board • Australian Securities Exchange Listing Rules.

2. Describe the standard-setting process of the AASB. Accounting standards are developed through a consultation process to ensure that the accounting information prepared and presented in the financial statements following these standards is of high quality and valuable to all users of financial statements. If an accounting issue is added to the AASB’s agenda, AASB will start by researching the issue, then will consider solutions and consult with stakeholders. The AASB may then issue exposure drafts, invitations to comment, draft interpretations and discussion papers. For standards intended for profit-seeking entities, the exposure drafts issued by the AASB typically incorporate exposure drafts issued by the IASB, along with Australian-specific matters for comment as applicable. The consultation process may involve focus groups and roundtable discussions with stakeholders and responses to exposure drafts. The AASB may also draw on project advisory panels and interpretation advisory panels.

3. Distinguish between the roles of the FRC and the AASB. Both the FRC and the AASB are involved in accounting standard setting. The AASB is responsible for developing a Conceptual Framework and issuing accounting standards. Another function of the AASB is to participate in and contribute to the development of a global set of accounting standards. The FRC’s role in standard setting is essentially a broad oversight function; it oversees the processes for setting accounting standards. The FRC’s oversight function also extends to the auditing standard setting process, including monitoring the effectiveness of auditor independence requirements in Australia. The FRC appoints members of the AASB and approves its priorities, business plans, budgets and staffing arrangements. The FRC determines the AASB’s broad strategic direction (e.g., the FRC directed the AASB to adopt International Financial Reporting Standards, such that compliance with Australian Accounting Standards by profit seeking entities results in compliance with IFRS). The FRC advises the AASB and provides feedback on policy matters.

4. How does the IASB influence financial reporting in Australia? Australia has adopted International Financial Reporting Standards since 2005. Hence technical issues on the IASB work program are also included on the AASB work program. The AASB members and staff can identify issues requiring consideration. Some of these issues can be

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

referred to the IASB for consideration and some can be addressed domestically. In fact the issue of an accounting standard by the IASB would result in a corresponding and consistent standard being issued by the AASB. The text of the international accounting standard may be modified to the extent necessary to take account of the Australian legal or institutional environment and, in particular, to ensure that any disclosure and transparency provisions in the standard are appropriate to the Australian legal or institutional environment. This is often reflected in modifications to standards for application by not-for-profit entities in Australia.

5. Explain the potential benefits and problems that can result from the adoption of IFRSs in Australia. The adoption of Australian Accounting Standards that are equivalent of IFRSs is essentially an example of implementing a global set of accounting standards. It reflects the view that doing so is, on the whole, in the best interests of the Australian economy. These benefits may manifest in reduced cost of capital and reduced reporting costs for Australian companies that seek finance in global capital markets. It also make listing on the stock exchange in Australia more attractive to multinational corporations because Australian investors’ will have greater understanding of financial statements prepared in accordance with IFRSs. The problem that can result from the adoption of IFRSs in Australia is the ‘one size fits all’ approach used in the implementation of IFRSs in Australia. IFRSs were initially drafted to be used solely by large for-profit entities. In Australia, however, they have been applied across the board to all entities, including small and medium-sized entities, not-for-profit and government entities. This resulted in unnecessary costs to the small and medium-sized entities, especially in regards to satisfying the disclosure requirements in IFRSs. The AASB has recently recognised this issue and has implemented a differential system — reduced disclosure regime — whereby certain entities may not have to abide by the full disclosure requirements of Australian equivalents to IFRSs.

6. What is the difference between Australian Accounting Standards and IFRSs? While IFRSs are developed for application by profit-seeking entities, Australian Accounting Standards are also applied by not-for-profit entities in the public and private sectors. Accordingly, Australian Accounting Standards may include additional or different requirements or exemptions for not-for-profit entities. These differences introduced by the AASB can be easily identified in the text of the standards. For example, paragraphs added by the AASB are prefixed with “Aus” while paragraphs deleted by the AASB are indicated as “deleted by the AASB”. Australian Accounting Standards may also cover additional matters, such as disclosure requirements on issues not covered by IFRSs (typically in a separate standard).

7. Specify the objectives of general purpose financial reporting, the nature of users and the information to be provided to users to achieve the objectives as provided in the Conceptual Framework. The Conceptual Framework specifies the objective of general purpose financial reporting as providing financial information about the reporting entity that is useful to existing and potential

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Chapter1: Accounting regulation and the conceptual framework.

investors, lenders and other creditors in making decisions about providing resources to the entity. It adopts the ‘entity perspective’; that is, the entity is the object of general purpose financial reporting, not its owners and others having an interest in it. In other words, the focus is placed on reporting the entity’s resources (assets), the claims to the entity’s resources (liabilities and equity) and the changes in them. Shareholders are seen not so much as owners of the entity but merely as providers of resources to the entity, in much the same way as lenders or creditors. Both present and potential shareholders, lenders and other creditors are seen as constituting a single primary user group. This group makes decisions about the allocation of resources as well as decisions relating to protecting or enhancing their claim on the entity’s resources. Other potential user groups; for example, government and other regulatory bodies, customers, employees and their representatives, are not the focus of financial reporting. It appears odd that in times when environmental and social issues are of great importance to society, and the desire for triple-bottom line reporting is growing, that these issues are still ignored in the revised Conceptual Framework. However, this omission may not be important as currently shareholders themselves are interested in environmental and social issues and that provides incentives to entities to provide further information related to those issues. 8. One of the functions of the FRC is to ensure that the Australian Accounting Standards are ‘in the best interests of both the private and public sectors in the Australian economy’. How might the FRC assess this? The FRC is required under the ASIC Act to promote the adoption of international best practice, provided that doing so would be in the best interests of both the private and public sectors in the Australian economy. The success of this mandate may be assessed by considering whether the Australian Accounting Standards, developed based on IFRSs, contribute to the reduction in the cost of capital and reporting costs for Australian companies that seek finance in global capital markets and improve the attractiveness to multinational corporations of listing on stock exchanges in Australia. In doing so, feedback obtained via various stakeholder mechanisms may be assessed. For example, stakeholder groups represented on the FRC will be consulted regularly by the FRC member they have nominated, and stakeholder views will be brought to FRC meetings, as appropriate. 9. Outline the fundamental qualitative characteristics of information that is useful to users of financial statements. The fundamental qualitative characteristics of financial information are relevance and faithful representation. Paragraphs 2.6 to 2.10 of the Conceptual Framework elaborate on the qualitative characteristic of relevance. Information is relevant if: • it is capable of making a difference in the decisions made by the capital providers as users of financial information • it has predictive value, confirmatory value or both. Predictive value occurs where the information is useful as an input into the users’ decision models and affects their expectations about the future. Confirmatory value arises where the information provides feedback that confirms or changes past or present expectations based on previous evaluations. • it is capable of making a difference whether the users use it or not. It is not necessary that the information has actually made a difference in the past or will make a difference in the future. © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Paragraphs 2.12 to 2.19 of the Conceptual Framework elaborate on the fundamental qualitative characteristic of faithful representation. Information is faithfully represented if:  it is complete. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. (paragraph 2.14)  it is neutral. A neutral depiction is without bias in the selection or presentation of financial information. (paragraph 2.15)  it is free from error. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. (paragraph 2.18).

10. Discuss the importance of the going concern assumptions to the practice of accounting. Financial statements are prepared under the assumption that an entity will continue to operate in the foreseeable future. This going concern assumption is important as it may be used to justify the use of historical costs in accounting for liabilities and assets and, in the case of noncurrent assets, for the systematic allocation of their costs to depreciation expense over their useful lives. As such the assumption is made that current market values of assets are sometimes of little importance. It also ensures that the financial statements are not prepared on the basis of expected liquidation or forced sale values.

11. Discuss the essential characteristics of an asset as described in the Conceptual Framework. An asset is defined in paragraph 4.3 of the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’. Paragraph 4.4 defines an economic resource as ‘a right that has the potential to produce economic benefits’. As such, the essential characteristics of an asset are:  it is a right – the potential to produce the economic benefits for the entity and to be controlled by the entity (paragraph 4.9)  it has potential to produce economic benefits – the potential does not need to be certain, or even likely. It is only necessary that the right already exists and that, in at least one circumstance, it would produce for the entity economic benefits beyond those available to all other parties (paragraph 4.14)  it is controlled by the entity – the entity has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it (paragraph 4.20).

12. Discuss the essential characteristics of a liability as described in the Conceptual Framework. A liability is defined in the current Conceptual Framework as ‘a present obligation of the entity to transfer an economic resource as a result of past event’. The important aspects of this definition are:

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Chapter1: Accounting regulation and the conceptual framework.

• the entity has an obligation – which is a duty or responsibility of the entity to act or perform in a certain way. The entity has little, if any, discretion in avoiding this obligation. • the obligation is to transfer an economic resource. This transfer is to take place in the future and may be required on demand, at a specified date, or on the occurrence of a specified event. • the obligation is a present obligation that exists as a result of past events. For example, wages to be paid to staff for work they will do in the future is not a liability as there is no past event and no present obligation.

13. A government gives a parcel of land to a company at no charge. The company builds a factory on the land and employs people at the factory to produce jam that is sold in local and interstate markets. Considering the definition of income in the Conceptual Framework, do you think the receipt of the land is income to the company? Would your answer depend on how the land is measured? Under the Conceptual Framework, income is defined in paragraph 4.68 as follows: ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’. Some users or preparers of accounting information may argue that the receipt from the government free of change of land may need to be recognised directly as equity, while others argue that it should be treated as an income. A summary of the arguments proposed for those 2 options is listed below. Argument for direct credit to equity:  Those who would argue that the government’s contribution of land to the company is not income say that the grant is not earned in the same way as income from the sales of goods and services is earned. Rather, it is simply an incentive provided by the government without any related costs. Therefore the land should be recognised as a direct credit to equity. It would be reported in the statement of financial position as a capital contribution from government. Sometimes this is described as ‘donated capital’. Arguments for income recognition:  On the other hand, some accountants argue that the receipt of land from movement is income because the land is owned by the company, that it increases the assets attributable to the shareholders of the company, and that after the company meets its obligations to employ the specified number of people for the specified period of time, the company can sell the land and distribute the proceeds to shareholders.  Also, while the land is held, it helps to generate profits (benefits) for the company, and those profits benefit the shareholders in the form of increased dividends and/or share value.  Additionally, grants come with ‘strings attached’ — in this case the company must employ a certain number of people for a specified time. This involves a cost. The grant is income to be matched against that cost.  Also, government grants are like a ‘reverse income tax’ — where the government gives something to the taxpayer rather than the taxpayer giving something to the government. Grants, like taxes, are determined based on a country’s fiscal and social policies. When a company pays taxes, it recognises tax expense. When a company receives a grant, it should recognise grant income.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Under AASB 120/IAS 20 Accounting for Government Grants and Disclosure of Government Assistance: 7. Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attaching to them; and (b)the grants will be received. 12. Government grants shall be recognised as income over the periods necessary to match them with the related costs, which they are intended to compensate, on a systematic basis. They shall not be credited directly to shareholders’ interests.

14. Discuss the difference, if any, between income, revenue and gains. The Conceptual Framework defines income as ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.’ This definition of income is linked to the definitions of assets and liabilities. The definition is wide in its scope, in that income in the form of inflows or enhancements of assets can arise from the provision of goods or services, the investment in or lending to another entity, the holding and disposing of assets, and the receipt of contributions such as grants and donations. To qualify as income, the inflows or enhancements of assets must have the effect of increasing the equity and not be capital contributions by owners. Income can exist as well through a reduction in liabilities that increase the entity’s equity. An example of a liability reduction is if a liability of the entity is ‘forgiven’. Income arises as a result of that forgiveness, unless the forgiveness of the debt constitutes a contribution by equity holders. Under the current Conceptual Framework, income encompasses both revenue and gains. A definition of revenue arises in accounting standard AASB 118/IAS 18 Revenue as follows: ‘the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.’ Revenue therefore represents income which has arisen from ‘the ordinary activities of an entity’. On the other hand, gains represent income which does not necessarily arise from the ordinary activities of the entity; for example, gains on the disposal of non-current assets or on the revaluation of marketable securities. Gains are usually disclosed in the income statement net of any related expenses, whereas revenues are reported at a gross amount.

15. Describe the qualitative characteristics of financial information according to the Conceptual Framework, distinguishing between fundamental and enhancing characteristics. Chapter 3 of the Conceptual Framework for Financial Reporting (the Conceptual Framework) discusses the qualitative characteristics of useful financial information. For financial information to be useful (e.g. to existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report), it must be relevant and faithfully represent what it purports to represent. Therefore, the fundamental qualitative characteristics are relevance and faithful representation.

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Chapter1: Accounting regulation and the conceptual framework.

Paragraphs 2.6 to 2.10 of the Conceptual Framework elaborate on the qualitative characteristic of relevance. Information is relevant if: • it is capable of making a difference in the decisions made by the capital providers as users of financial information • it has predictive value, confirmatory value or both. Predictive value occurs where the information is useful as an input into the users’ decision models and affects their expectations about the future. Confirmatory value arises where the information provides feedback that confirms or changes past or present expectations based on previous evaluations. • it is capable of making a difference whether the users use it or not. It is not necessary that the information has actually made a difference in the past or will make a difference in the future. Paragraphs 2.12 to 2.19 of the Conceptual Framework elaborate on the fundamental qualitative characteristic of faithful representation. Information is faithfully represented if:  it is complete. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. (paragraph 2.14)  it is neutral. A neutral depiction is without bias in the selection or presentation of financial information. (paragraph 2.15)  it is free from error. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. (paragraph 2.18) The usefulness of financial information is enhanced by comparability, verifiability, timeliness and understandability. These are the enhancing characteristics. Paragraphs 2.24 to 2.29 of the Conceptual Framework elaborate on the enhancing qualitative characteristic of comparability. Financial information is comparable if it:  can be compared with similar information about other entities or the same entity across for another period or another date.  enables users to identify and understand similarities in, and differences among, items. Paragraphs 2.30 to 2.32 of the Conceptual Framework elaborate on the enhancing qualitative characteristic of verifiability. Financial information is verifiable if:  different knowledgeable and independent observers could reach consensus different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.  can be directly or indirectly verified. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology. Paragraphs 2.33 of the Conceptual Framework elaborate on the enhancing qualitative characteristic of timeliness. Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Paragraphs 2.34 to 2.36 of the Conceptual Framework elaborate on the enhancing qualitative characteristic of understandability. Financial information is understandable if it is classified, characterised and presented clearly.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

16. Define ‘equity’, and explain why the Conceptual Framework does not prescribe any recognition criteria for equity. The Conceptual Framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. Equity cannot be identified independently of the other elements in the statement of financial position/balance sheet. The characteristics of equity are that equity is a residual, i.e. something left over after the entity has determined its assets and liabilities. In other words: Equity = Assets –Liabilities. There is no need for recognition criteria for equity as it is a residual, determined after recognition criteria are applied to the other elements.

17. In relation to the following multiple choice questions, discuss your choice of correct answer: (a) Which of the following statements about the Conceptual Framework is incorrect? (i) The Conceptual Framework overrides any accounting standard that is in conflict with the International Financial Reporting Standards (IFRS). (ii) The Conceptual Framework states that the elements directly related to the measurement of financial position are assets, liabilities and equity. (iii) The Conceptual Framework determines capital provides as the primary user group of general purpose financial statements. (iv) In accordance with the Conceptual Framework, income is recognised if it provides users of financial statements with information that is relevant and faithfully represented. (b) The Conceptual Framework’s enhancing qualitative characteristics include: (i) understandability, timeliness, verifiability and comparability. (ii) faithful representation, relevance, understandability and verifiability. (iii) comparability and reliability. (iv) substance over form and relevance. (c) Which of the following statements about the Conceptual Framework’s definition of expenses is correct? (i) Expenses include distributions to owners. (ii) Expenses are always in the form of outflows or depletions of assets. (iii) Expenses exclude losses. (iv) Expenses are always decreases in economic benefits. (d) In accordance with the Conceptual Framework, from the perspective of the lender the forgiveness of its $20 000 interest-free loan results in: (i) an increase in income and a decrease in a liability. (ii) an increase in an expense and a decrease in an asset. (iii) an increase in an asset and an increase in income. (iv) an increase in an expense and a decrease in a liability. (a) (b) (c) (d)

(i) (i) (iv) (ii)

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Chapter1: Accounting regulation and the conceptual framework.

Case studies Case study 1.1 The AASB Visit the AASB website (www.aasb.gov.au) and answer the following: 1. Who is the Chair of the AASB? 2. Who are the members? 3. Which accounting standards have been issued in the past year? 4. Why are there differences in the numbering systems for current accounting standards (e.g. AASB x, AASB xxx and AASB xxxx)? 5. What current projects (if any) is the AASB working on in cooperation with the IASB? 1. On the AASB website, go to “AASB Board”, then “Current Board Members”. Locate current Chair. 2. Stay in the same location, as the names of the members of the AASB are all shown. 3. On the AASB website, go to “Quick Links” and select “Table of Standards”. Read from this table all of the standards issued in the last year. 4. See “Pronouncements” for information, plus section 1.7.4 in the text. AASB x represent those standards adopted by the AASB from the IFRSs of the IASB. AASB xxx represent those standards adopted by the AASB from the IASs of the IASB and its predecessor the IASC. AASB xxxx represent those standards issued exclusively by the AASB for companies in the Australian context. In addition, the AAS standards consist of standards issued by the AASB for special organisations e.g. superannuation plans, government. 5. On the AASB website, go to “Work in Progress”, then “Project Summaries”. As of the end of 2019, there are 5 projects being worked on by the AASB in cooperation with the IASB. The AASB is one of several standard setting boards that liaise with the IASB and provide submissions to the IASB on various topics. See also AASB Submissions to the IASB here under “Submissions from AASB”. Also check the “News” section on the website.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 1.2 The IASB Visit the website of the International Accounting Standards Board (www.ifrs.org). Report on: 1. 2. 3. 4.

the resources that are provided by the IASB for the accounting profession the membership of the IASB and which countries the members come from the goals of the IASB. a current project being undertaken by the IASB.

1. Go to the IASB website and see “Resources for” and select “Accounting profession”. 2. Go to the IASB website and see “About us”. Click on “Our structure” and there you will find the link to “International Accounting Standards Board”. Click on the “Members” tab and you will find information about the Chair, the Vice-Chair and all members of the IASB, and the countries from which they came by reading each person’s information sheet. 3. Go to the IASB website and see “About us”. Click on “Who we are” and under the tab “Our constitution” you will find the IFRS Foundation’s constitution document. In it, you will be able to find the objectives of the IFRS Foundation. IASB is the standard-setting body of the IFRS Foundation. 4. Go to the IASB website and see “Projects”. Click on “Work plan” and you will find the current projects organised under 5 tabs: “All”, “Research projects”, “Standard-setting projects”, “Maintenance projects” and “Other projects”. One example of a current project as of December 2019 is the research project on “Financial instruments with characteristics of equity”.

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Chapter1: Accounting regulation and the conceptual framework.

Case study 1.3 ASIC Visit the website of the Australian Securities and Investments Commission (www.asic.gov.au). Report on: 1. what ASIC is and its role 2. the types of investigations and enforcement performed by ASIC 3. the policy statements and practice notes issued by ASIC. 1. On the ASIC website, go to “About ASIC” and look up “Our role” under “What we do”. 2. On the ASIC website, go to “About ASIC” and look up “ASIC investigations and enforcement”. 3. On the ASIC website, go to “Regulatory resources” then to “Regulatory guides” under “Find a document”. The regulatory guides that replace the old policy statements and practice notes are accessible here.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 1.4 The FRC Visit the website of the Financial Reporting Council (www.frc.gov.au). Locate its strategic plan and report on: 1. the strategic priorities of the FRC’s current strategic plan. 2. the key environmental factors that impact the FRC. 1. On the FRC website under “About the FRC” there is a link information about FRC’s strategic plans. As of December 2020, the latest strategic plan is under “Strategic plan 2017-20”. As this document notes, the FRC’s objectives are to facilitate the development of high quality accounting standards, auditing and assurance standards, and related guidance. The FRC aims to achieve these objectives by developing task forces for specific areas of interest. 2. The key environmental factors listed in the strategic plan 2017-20 under “Section 2 Environmental scan” are as follows: General • Global economic growth and financial market conditions - economic growth is low, financial markets are very cognisant of risk, and in many jurisdictions public sector debt is high. • The increasing interconnectedness of the global economy, including financial markets. • The explosion of information available via the internet, and the ease with which stakeholders' views can be disseminated and contested often within a very short period. • The continuing shift in economic power from western economies to major developing countries (for example, China and India). • The expected increase in the stock of financial assets in Australia through superannuation savings, placing greater focus on the corporate governance and reporting standards applicable to superannuation funds. • The constrained resources available to business and government (including the FRC). The Financial Reporting System • Australia adopted International Financial Reporting Standards (IFRS) in 2005 and has since been actively promoting IFRS as the preferred global reporting standard as issued by the International Accounting Standards Board. It has also played a leading role in promoting public sector and not-for-profit reporting based on IFRS. • Australia's auditing standards are based on the international standards issued by the International Auditing and Assurance Standards Board.

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Chapter1: Accounting regulation and the conceptual framework.

Application and analysis exercises Exercise 1.1 Requirements to prepare a financial report Apple Isle Transport Pty Ltd operates tours and transport services throughout Tasmania. The company has 50 employees. Its accounting records show that it has total assets of $30 million, equity of $25 million and revenue of $50 million. The directors of Apple Isle Transport Pty Ltd have not received a request for a financial report from the shareholders or ASIC. Is Apple Isle Transport Pty Ltd required to prepare a financial report? If so, explain whether Apple Isle Transport Pty Ltd needs to apply Tier 1 or Tier 2 reporting requirements. (LO1) Section 45A of the Corporation Act classifies proprietary companies as small or large, as follows. A small proprietary company is a proprietary company that satisfies at least two of the following criteria, specified in s. 45A(2). • The consolidated revenue for the financial year of the company and the entities it controls is less than $50 million. • The value of the consolidated gross assets at the end of the financial year of the company and the entities it controls is less than $25 million. • The company and the entities it controls have fewer than 100 employees at the end of the financial year. A large proprietary company is any proprietary company that does not satisfy the definition of a small proprietary company. As Apple Isle Transport Pty Ltd only satisfies one criteria to be classified as a small proprietary company, it doesn’t satisfy the definition of a small proprietary company. As such, it will be classified as a large proprietary company. Therefore, as can be seen in Figure 1.1, Apple Isle Transport Pty Ltd will have to prepare a financial report unless it has received relief from ASIC from that requirement. AASB 1053 Application of Tiers of Australian Accounting Standards was issued in 2010 to apply a two-tier differential reporting system. In terms of Tier 1 reporting requirements, paragraph 11 of AASB 1053 states: The following types of entities shall prepare general purpose financial statements that comply with Tier 1 reporting requirements: • for-profit private sector entities that have public accountability and are required by legislation to comply with Australian Accounting Standards; and • the Australian Government and State, Territory and Local Governments. Appendix A of AASB 1053 specifies that an entity has public accountability if: • its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or • it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. Entities that hold assets in a fiduciary capacity on behalf of others as a primary business include banks, insurance companies, and securities brokers.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In terms of Tier 2 reporting requirements, paragraph 13 of AASB 1053 states: Tier 2 reporting requirements shall, as a minimum, apply to the general purpose financial statements of the following types of entities: • for-profit private sector entities that do not have public accountability; • not-for-profit private sector entities; and • public sector entities, whether for-profit or not-for-profit, other than the Australian Government and State, Territory and Local Governments. There is not enough information provided in the question about Apple Isle Transport Pty Ltd to decide whether it needs to apply Tier 1 or Tier 2 requirements. However, most probably Apple Isle Transport Pty Ltd does not have public accountability as it is highly unlikely that it will have debt or equity instruments traded in a public market. Therefore, it will probably need to comply only with Tier 2 reporting requirements.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.2 Relevant information A year ago you bought shares in an investment company. The investment company in turn buys, holds and sells shares of business enterprises. You want to use the financial statements of the investment company to assess its performance over the past year. Required 1. What financial information about the investment company’s holdings would be most relevant to you? 2. The investment company earns profits from appreciation of its investment securities and from dividends received. How would the concepts of recognition in the Conceptual Framework apply here? (LO5 and LO8) 1. The performance of an investment company results from income earned on its investments (dividends and interest) and changes in the fair values of its investments while they are held. You would probably like to know:  Fair values of the securities that the investment company holds and how those fair values changed during the year. It would not matter much to you whether the investment company actually sold the investments (in which case they would have to replace them with other investments) or held on to the investments. Either way, the fair value changes represent gains and losses to the investment company and, therefore, to you as an investor in the investment company.  How the fair value changes of investments managed by this investment company compared to changes in similar investments in the market as a whole.  Turnover of the portfolio and related transaction costs such as commissions.  Interest and dividends earned.  Information about risks in the portfolio.  How the fair value changes were split between ‘realised’ (relating to investments that have been sold) and ‘unrealised’ (relating to investments that are still held). In many countries, investment companies that distribute their earnings rapidly to the investors do not themselves pay taxes — only the investors pay the taxes on realised gains and dividend and interest income. 2. Under the Conceptual Framework, an item that meets the definition of an asset, liability, income, or expense should be recognised if it provides users of financial statements with useful information that is: (a) relevant; and (b) faithfully represented. With respect to income, the Conceptual Framework states that income is recognised in the income statement when there are increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. Appreciation of the fair value of investment securities does represent an increase in an asset. The appreciation of its investment securities means it is probable that future economic benefit will flow to the entity and the fair value can be measured with reliability. Hence, it fulfils both of the definition of income and the recognition criteria. As to dividends, when the investment company’s right to receive payment is established, it can recognise dividends as revenue. Because fair value changes and dividends are different in nature, they would be reported separately.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 1.3 Measuring inventories AASB 102/IAS 2 Inventories allows producers of gold and silver to measure inventories of these commodities at selling price even before they have sold them, which means income is recognised at production. In nearly all other industries, however, income from the sale of goods is recognised only when the inventories are sold to outside customers. What concepts in the Conceptual Framework are reflected in accounting for gold and silver production? (LO8) Under the Conceptual Framework, an item that meets the definition of an asset, liability, income, or expense should be recognised if it is: (a) relevant; and (b) faithfully represented. The AASB concluded that because of the nature of the market in which gold and silver are bought and sold, the conditions for income recognition are met at the time of production. Unlike with other ordinary goods, for gold and silver there is a liquid market with quoted prices, minimal transaction costs, minimal selling effort, minimal after-costs, and immediate cash settlement. That means that the information available at the time of production about the gold and silver produced is relevant and faithfully represents the income to be generated.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.4 Recognising a loss The law in your community requires store owners to shovel snow and ice from the footpath in front of their shops. You failed to do that and a pedestrian slipped and fell, resulting in serious and costly injury. The pedestrian has sued you. Your lawyers say that while they will vigorously defend you in the lawsuit, you should expect to lose $30 000 to cover the injured party’s costs. A court decision, however, is not expected for at least a year. What aspects of the Conceptual Framework might help you in deciding the appropriate accounting for this situation? (LO8) The definition of liability can help decide the accounting treatment of the situation. Under the Conceptual Framework a liability is a present obligation of the entity to transfer an economic resource as a result of past event. In this case, the past event is the fall and injury to the pedestrian. Present obligation depends on the probability of payment. The attorney has advised that a $30 000 loss is probable. Therefore appropriate accounting involves recognising a liability for the probable payment. An expense would also be recognised. Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. In this case, the expense arises at the time the pedestrian is injured because a liability has also arisen at that time.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 1.5 Financial statements An entity purchases a rental property for $5 000 000 as an investment. The building is fully rented and is in a good area. At the end of the current year, the entity hires an appraiser who reports that the fair value of the building is $7 500 000 plus or minus 15%. Depreciating the building over 40 years would reduce the carrying amount to $4 875 000. 1. What are the relevance and faithful representation accounting considerations in deciding how to measure the building in the entity’s financial statements? 2. Does the Conceptual Framework lead to measuring the building at $7 500 000? Or at $4 875 000? Or at some other amount? (LO5 and LO9) 1. With regards to relevance, the following aspects need to be taken into consideration:  Information in financial statements is relevant when it influences the economic decisions of users. It can do that both by (a) helping them evaluate past, present, or future events relating to an enterprise and by (b) confirming or correcting past evaluations they have made.  Materiality is a component of relevance. Information is material if its omission or misstatement could influence the economic decisions of users.  Timeliness is another component of relevance. To be useful, information must be provided to users within the time period in which it is most likely to bear on their decisions. With regards to faithful representation, the following aspects need to be taken into consideration:  Information in financial statements is a faithful representation if it is complete, neutral and free from material error and bias and can be depended upon by users to represent events and transactions faithfully. Information is not a faithful representation when it is purposely designed to influence users’ decisions in a particular direction.  There is sometimes a trade-off between relevance and faithful representation — and judgement is required to provide the appropriate balance.  Faithful representation is affected by the use of estimates and by uncertainties associated with items recognised and measured in financial statements. These uncertainties are dealt with, in part, by disclosure and, in part, by exercising prudence in preparing financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, prudence can only be exercised within the context of the other qualitative characteristics in the Conceptual Framework, particularly relevance and the faithful representation of transactions in financial statements. Prudence does not justify deliberate overstatement of liabilities or expenses or deliberate understatement of assets or income, because the financial statements would not be neutral and, therefore, not have the quality of reliability. In our case, the following points should be discussed:  The fair value of the property is relevant to the investors in the enterprise. The enterprise — and therefore its owners — are better off because the value of the property has gone up. Better off means that their wealth increased.  Is the fair value reported by the appraiser reliable? Certainly, appraisals involve judgements,

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Chapter1: Accounting regulation and the conceptual framework.

and different valuation methods and different assumptions can generate different valuations. The objectivity and other qualifications of the appraiser should be considered. The Conceptual Framework acknowledges that accounting information can be reliable even if it is not precise. The appraiser acknowledged that there is a potential for error of plus or minus 10%. That does not mean that the value information is not reliable. 2. The Conceptual Framework does not include concepts or principles for selecting which measurement basis should be used for particular elements of financial statements or in particular circumstances. However, the qualitative characteristics do provide some guidance, particularly the characteristics of relevance and faithful representation. As such, the amount that the building should be measured at should be the amount that is relevant and faithfully represents the value of the building.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 1.6 The Conceptual Framework versus interpretations Applying the Conceptual Framework is subjective and requires judgement. Would the IASB be better off to abandon the Conceptual Framework entirely and instead rely on a very active interpretations committee that develops detailed guidance in response to requests from constituents? (LO3, LO4, LO8 and LO9) The fact that the Conceptual Framework involves judgement does not mean that it should be abandoned. The guidance developed by the interpretations committee would be ad hoc – that is, developed case by case without the foundation of the framework to look to. The standards themselves would suffer from the same problem if there were no framework. The Conceptual Framework provides guidance and direction to the standard setters, and therefore will lead to consistency among the standards. But it is a set of concepts. It provides a boundary for the exercise of judgement by the standard setter and the interpretive body.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.7 Meaning of ‘decision useful’ What is meant by saying that accounting information should be ‘decision useful’? Provide examples. (LO5) The Conceptual Framework identifies the principal classes of users of general purpose financial statements as the existing and potential investors, lenders and other creditors. All of these categories of users rely on financial statements to help them in making various kinds of decisions. Investors need to decide whether to buy, sell, or hold shares. Lenders need to decide whether to lend and at what price. Suppliers need to decide whether to extend credit. Information is decision-useful if it helps these people make their decisions. Existing and potential investors, lenders and other creditors have the most critical and immediate need for the information in financial reports and many cannot require the entity to provide the information to them directly. The general purpose financial statements shall focus on the needs of participants in capital markets, which include not only existing investors but also potential investors and existing and potential lenders and other creditors. Information that meets the needs of the specified primary users is likely to meet the needs of users both in jurisdictions with a corporate governance model defined in the context of shareholders and those with a corporate governance model defined in the context of all types of stakeholders. Individual primary users have different, and possibly conflicting, information needs and desires. Reporting entities shall seek to provide the information set that will meet the needs of the maximum number of primary users. However, focusing on common information needs does not prevent the reporting entity from including additional information that is most useful to a particular subset of primary users. The Conceptual Framework notes that financial statements cannot provide all the information that users may need to make economic decisions. In developing financial reporting requirements that meet the objective of financial reporting, reporting entities shall rely on the qualitative characteristics of, and the cost constraint on, useful financial information to avoid providing too much information. While the concepts in the Conceptual Framework are likely to lead to information that is useful to the management of a business enterprise in running the business, the Conceptual Framework does not purport to address their information needs. The same can be said for the regulators and fiscal-policy decision makers.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 1.8 Performance of a business entity A financial analyst said: I advise my clients to invest for the long term. Buy good shares and hang onto them. Therefore, I am interested in a company’s long-term earning power. Accounting standards that result in earnings volatility obscure long-term earning power. Accounting should report earning power by deferring and amortising costs and revenues. Is this analyst’s view consistent with the fundamental characteristics of financial information established in the Conceptual Framework? (LO5) Accounting standards should help provide relevant and faithfully represented financial information. Companies that operate in risky business environments or that enter into risky kinds of transactions are likely to experience real ups and downs in their performance. In such cases, volatility of reported earnings results from the real transactions and activities of the company. In other words, the statement of profit or loss and other comprehensive income reflects the underlying risks. It is not the role of financial accounting and reporting to try to smooth the company’s earnings by, say, deferring profits in good years and deferring expenses in bad years. The amounts reported in the financial statements would not be faithfully represented because they do not reflect real phenomena.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.9 Going concern What measurement principles might be most appropriate for a company that has ceased to be a going concern (e.g. creditors have appointed a receiver who is seeking buyers for the company’s assets)? (LO6 and LO9) Net realisable value is an asset’s selling price or a liability’s settlement amount less disposal or settlement costs. If a company ceases to be a going concern, that means it is either being wound up or sold. Either way, the relevant measurements to users of financial statements would be the net realisable value of the company’s net assets.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 1.10 Assessing probabilities in accounting recognition The Conceptual Framework defines an asset as a present economic resource controlled by the entity as a result of past events. At the same time the Conceptual Framework establishes that an asset is to be recognised only if it provides information to the users of the financial statements that is relevant and has faithful representation. Discuss the recognition criteria of ‘relevance’ and ‘faithful representation’ and provide examples, if any, when an asset may not be recognised in the financial statements. (LO7 and LO8) With regards to relevance, the following aspects need to be taken into consideration:  Information in financial statements is relevant when it influences the economic decisions of users. It can do that both by (a) helping them evaluate past, present, or future events relating to an enterprise and by (b) confirming or correcting past evaluations they have made.  Materiality is a component of relevance. Information is material if its omission or misstatement could influence the economic decisions of users.  Timeliness is another component of relevance. To be useful, information must be provided to users within the time period in which it is most likely to bear on their decisions. With regards to faithful representation, the following aspects need to be taken into consideration:  Information in financial statements is a faithful representation if it is complete, neutral and free from material error and bias and can be depended upon by users to represent events and transactions faithfully. Information is not a faithful representation when it is purposely designed to influence users’ decisions in a particular direction.  There is sometimes a trade-off between relevance and faithful representation — and judgement is required to provide the appropriate balance.  Faithful representation is affected by the use of estimates and by uncertainties associated with items recognised and measured in financial statements. These uncertainties are dealt with, in part, by disclosure and, in part, by exercising prudence in preparing financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, prudence can only be exercised within the context of the other qualitative characteristics in the Conceptual Framework, particularly relevance and the faithful representation of transactions in financial statements. Prudence does not justify deliberate overstatement of liabilities or expenses or deliberate understatement of assets or income, because the financial statements would not be neutral and, therefore, not have the quality of reliability. An example of assets that may not be recognised in the financial statements are internally generated intangible assets.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.11 Definition of elements Explain how Beachside Ltd should account for the following items/situations, justifying your answer by reference to the Conceptual Framework’s definitions and recognition criteria. 1. Receipt of artwork of sentimental value only. 2. Beachside Ltd is the guarantor for an employee’s bank loan: (a) You have no reason to believe the employee will default on the loan. (b) As the employee is in serious financial difficulties, you think it likely that he will default on the loan. 3. Beachside Ltd receives 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a grateful client. 4. The panoramic view of the coast from Beachside Ltd’s café windows, which you are convinced attracts customers to the café. 5. The court has ordered Beachside Ltd to repair the environmental damage it caused to the local river system. You have no idea how much this repair work will cost. (LO7 and LO8) 1.

Trinket of sentimental value: • Fails the paragraph 4.3 asset definition as it does not constitute a present economic resource controlled by the entity. Furthermore, it does constitute a right that has the potential to produce economic benefits paragraph 4.4). • Recognition criteria are irrelevant, as there is no asset to recognise.

Guarantor for an employee’s loan. (i) Employee unlikely to default on his/her loan • Meets the paragraph 49(b) liability definition: (1) present obligation — legal obligation via the guarantor contract; (2) transfer an economic resource — payment of the guarantee; (3) past event — signing the guarantor contract. • Fails probability recognition criterion, as it is not likely that Beachside Ltd will be required to pay on the guarantee. Hence, no liability can be recognised. However, note disclosure of the guarantee may be warranted. (ii) Employee likely to default on his loan. • Again, meets the liability definition as per (i) above. • Meets both recognition criteria — relevant and can be faithfully represented. Hence, a liability should be recognised. • Also meets the expense definition and recognition criteria. Definition: (1) an increase in a liability — Beachside Ltd now owes the amount of the employee’s loan; (2) during period — the liability increase arose during period; (3) results in equity decrease — if liabilities increase and assets do not change, equity decreases. Recognition criteria: The decrease in future economic benefits has arisen, as Beachside Ltd now owes the amount of the employee’s loan. The bank can advise exactly how much the employee owes and so it can be reliably measured.

Receipt of 5 000 shares in Monty Ltd, trading at $6 each, as a gift from a grateful client. • The receipt of the shares meets the asset definition: (1) present economic resource (via future sales or dividend stream); (2) controlled by Beachside Ltd (only Beachside Ltd can benefit from either selling them or receiving

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• •

dividends); (3) past event (their receipt). They also meet the asset recognition criteria: relevant and faithfully represented (via sale or dividend stream, trading at $6 each). The shares also meet the income definition and recognition criteria. Definition: (1) increase in assets — Beachside Ltd now owns the shares; (2) during period — the shares were received during period; (3) results in equity increase — if assets increase and liabilities do not change, equity increases. Recognition criteria: The increase in assets has arisen, as Beachside Ltd now owns the shares (asset). The shares’ value is known and so can be faithfully represented.

Café’s panoramic view. • The view fails the definition as the entity does not control the economic resources that are expected to produce economic benefits — the entity cannot deny or regulate access by others to the view. • Recognition criteria are irrelevant, as there is no asset to recognise.

Court order to repair environmental damage caused to the local river system. You have no idea how much this repair work will cost. • The court order meets the liability definition: (1) legal obligation; (2) obligation to transfer economic resources — future payment for repair of damage (3) past event — order has been made; • Fails reliable measurement recognition criterion, as you have no idea as yet how much the repair work will cost. Hence, no liability can be recognised. However, note disclosure of the court order may be warranted (paragraph 88). • However, if you know a minimum amount that Beachside Ltd will have to pay, then the reliable measurement criterion is met for this amount. The probability criterion is met as it is certain (given that Beachside Ltd has been ordered by the court) that Beachside Ltd will have to pay the repair cost. Again, note disclosure may still be warranted advising that the cost may be well in excess of this amount.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.12 Definition and recognition criteria Explain how Simpkins Ltd should account for the following items, justifying your answer by reference to the definitions and recognition criteria in the Conceptual Framework. Also state, where appropriate, which ledger accounts should be debited and credited. Required 1. Photographs of the company’s founders, which are of great sentimental and historical value. 2. (a) Simpkins Ltd has been sued for negligence — likely it will lose the case. (b) Simpkins Ltd has been sued for negligence — likely it will win the case. 3. Obsolete machinery now retired from use. 4. Simpkins Ltd receives a donation of $5 000. (LO7 and LO8) 1. Photographs of the company’s founders, which are of great sentimental value. • The asset definition criteria are not met, as the photographs do not represent future economic benefits (paragraph 49(a)). Future economic benefits constitute the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to an entity (paragraph 53). • Recognition criteria are thus irrelevant, as there is no asset to recognise. 2(a) Simpkins Ltd has been sued for negligence — likely it will lose the case. Assume that the amount Simpkins Ltd has to pay is at least $20 000.  The liability definition (paragraph 49(b)) is met as all 3 characteristics are present. - Past event: The act of negligence or the act of being sued. - Present obligation: paragraph 60 states that an obligation is a duty or responsibility to act or perform in a certain way. The key question here is whether there is a present obligation. Does the lawsuit create a present obligation? Or will the obligation only arise when a court decision against you is handed down? The definition requires the existence of a present, not a future, obligation (paragraph 61). I believe that the lawsuit (arising from being sued) gives rise to a present obligation. - Transfer an economic resource: If a present obligation is accepted as existing, its settlement will involve the outflow of economic benefits, namely cash. • The liability recognition criteria (paragraph 91) are met, as it is relevant (cash will be paid), and the amount can be faithfully represented. • Therefore, at this stage a liability must be recognised. If the damages firm up to another amount as the case progresses, the amount must be adjusted. • The expense definition (paragraph 70(b)) is met as all 3 characteristics are present. - Decrease in economic benefits during the period: The loss represents a decrease in economic benefits and Simpkins Ltd was sued during the period. - In the form of a liability increase: See above liability discussion — Simpkins Ltd now owes at least $20 000. - Results in a decrease in equity: If liabilities increase and assets remain unchanged, equity decreases. • The expense recognition criteria (paragraph 4.69) are met. It is relevant, as Simpkins Ltd now owes $20 000 minimum, and the amount ($20 000 minimum) can be faithfully represented.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• •

Therefore, at this stage an expense of $20 000 must also be recognised. If the damages firm up to another amount as the case progresses, the amount must be adjusted accordingly. Note that in this case the recognition of a liability has resulted in the simultaneous recognition of an expense (paragraphs 91 and 98).

2(b) Simpkins Ltd has been sued for negligence — likely it will win the case. • The liability definition (paragraph 49(b)) is met as all 3 characteristics are present. See discussion in (b)(i) above. • However, the liability probability recognition criterion (paragraph 91) is failed, as it is not probable that an outflow of economic benefits will result from settling the liability. As Simpkins Ltd is likely to win the case, it is unlikely that it will have to pay damages. • Therefore, the liability cannot be recognised. However, if material, the lawsuit should be disclosed in the notes. 3. Obsolete machinery now retired from use. • The asset definition is failed as the plant no longer represents future economic resources (paragraph 49(a)). • The machinery must now be written off from the accounts. • Recognition criteria are thus irrelevant, as there is no asset to recognise. 4. Donation of $5 000 received. • The asset definition (paragraph 49(a)) is met as all 3 characteristics are present. - Past event: The receipt of the donation. - Present economic resource: The donation represents an inflow of $5 000 cash into Simpkins Ltd. - Controlled by the entity: Simpkins Ltd will benefit from this $5 000 cash inflow and can deny or regulate the access of others to this cash inflow. The asset recognition criteria (paragraph 89) are met, as it is probable (actually, it is • certain) that an inflow of economic benefits (cash) will flow to the entity, and the amount ($5 000) can be faithfully represented as it is known. • Therefore, an asset of $5 000 must be recognised. • The income definition (paragraph 70(a)) is met as all characteristics are present. - Increase in assets during the period: The inflow of $5 000 cash represents an increase in economic benefits, and Simpkins Ltd received and cleared the donation during this period. - Results in an increase in equity: If assets increase and liabilities remain unchanged, equity increases. • The income recognition criteria are met, as the increase in economic resources is relevant (as Simpkins Ltd now has additional cash), and the amount ($5 000) is known. • Therefore, income of $5 000 must also be recognised. • Note that in this case the recognition of an asset has resulted in the simultaneous recognition of income.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.13 Definition and recognition criteria Gunnedah Accounting Services has just invoiced one of its clients $4 800 for accounting services provided to the client. Explain how Gunnedah Accounting Services should recognise this event, justifying your answer by reference to relevant Conceptual Framework definitions and recognition criteria. Would your answer be different if the services had not yet been provided; that is, the payment is in advance? (LO7 and LO8) The Conceptual Framework defines an asset as a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. Invoicing the client gives rise to an asset as all 3 characteristics are present: • Rights: The issuing of the invoice or the provision of the services for which the invoice was issued. • Potential to produce economic benefits: The invoice represents a future cash inflow to the firm; • Control: The firm has control over the economic benefits via its contractual right to the future cash inflow; and Under the Conceptual Framework an asset must be recognised when it is relevant and faithfully represented. These recognition criteria are met as: • It is more than 50% likely (probably certain) that the firm will receive the cash (otherwise it would not have provided the services); and • The value ($4 800) can be reliably measured as it is known. Therefore, an asset (receivable) of $4 800 must be recognised. The Conceptual Framework defines income as increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. Invoicing gives rise to income as all characteristics are present: • Increase in assets (economic resources) during the period: The right to a future cash inflow arose during the period resulting in an asset increase as the receivable meets the asset definition and recognition criteria; and • Increase in equity: As assets have increased and liabilities have not changed, equity has increased. Under the Conceptual Framework, income must be recognised when an increase in economic resources, related to an asset increase or liability decrease, has arisen that can be faithfully represented (measured reliably). These recognition criteria are met as: • The asset increase has arisen (on issue of the invoice); and • The increase ($4 800) can be reliably measured as it is known.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Therefore, income (fee revenue) of $4 800 must be recognised. However, if the services had not yet been provided it is not probable that there is an increase of economic resources (the firm will only entitle to the payment once the service is provided). Hence, an asset (receivable) of $4 800 cannot be recognised.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.14 Recognition and derecognition The following events occurred in relation to assets and liabilities recognised by Watson Ltd. (a) Watson Ltd settled (paid) an account payable. (b) Watson Ltd sold an item of inventory to a customer. (c) Watson Ltd had been using the fair value measurement base for its plant but estimates of fair value have become unreliable due to changes in market conditions. (d) A debtor, Holmes Pty Ltd, is facing financial difficulties and has advised that it might be unable to pay the amount owing to Watson Ltd. Required For each event, state whether it would be likely to result in derecognition of an asset or liability in accordance with the Conceptual Framework. Give reasons for your answer. (LO8) An entity must remove all or part of a recognised asset or liability from an entity’s statement of financial position when the item no longer meets the definition of an asset or a liability. For an asset, derecognition normally occurs when the entity loses control of all or part of the recognised asset or the potential benefits are fully used or expire. For a liability, derecognition normally occurs when the entity no longer has a present obligation for all or part of the recognised liability. Paragraphs 5.27 and 5.28 of the Conceptual Framework stipulate that derecognition aims to faithfully represent both: • any assets and liabilities retained after the transaction or other event that led to the derecognition (the control approach) • the change in the entity’s assets and liabilities as a result of that transaction or other event (the risks-and-rewards approach). This aim can be achieved by: • derecognising any assets or liabilities that have expired or have been consumed, collected, fulfilled or transferred, and recognising any resulting income and expenses (referred to as the transferred component) • continuing to recognise the assets or liabilities retained (referred to as the retained component), if any • including in the financial statement: o presentation of any retained component separately in the statement of financial position o presentation separately in the statement of financial performance any income and expenses recognised as a result of the derecognition of the transferred component o explanatory information. The event described under (a) is likely to result in derecognition of the asset cash and the liability accounts payable for the amount paid.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The event described under (b) is likely to result in derecognition of the asset inventory for the inventory sold. The event described under (c) is likely to result in a change in measurement base for the plant and not in derecognition of the asset plant unless the new value attached to the plant is $0. The event described under (d) is likely to result in a recognition of an allowance for doubtful debts for the amount owed By Holmes Pty Ltd and not in derecognition of the asset accounts receivable unless Watson Ltd does not expect to be able to collect the amount owed.

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Chapter1: Accounting regulation and the conceptual framework.

Exercise 1.15 Asset definition and recognition Recently, $16 000 cash was stolen from Fisher Ltd’s night safe. Explain how Fisher should account for this event, justifying your answer by reference to relevant Conceptual Framework definitions and recognition criteria. (LO7 and LO8) The Conceptual Framework defines expenses as decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. The theft of the $16 000 cash satisfies the expense definition as: • It is a decrease in assets during the period, as cash (economic benefits) has decreased; and • It has resulted in a decrease in equity, as assets have decreased and liabilities have not changed. In accordance with the Conceptual Framework an expense must be recognised when: • A decrease in economic resources related to an asset decrease or a liability increase is relevant (has arisen); and • The decrease can be faithfully represented (reliably measured). The theft of the cash satisfies both recognition criteria as: • The decrease in economic benefits related to an asset decrease (a decrease in cash) has occurred; and • The decrease can be faithfully represented, as the amount of cash lost is known (i.e. $16 000). Accordingly, an expense (Dr) and asset decrease (Cr) of $16 000 must be recognised.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 1: Accounting regulation and the Conceptual Framework Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 1: Accounting regulation and the Conceptual Framework Multiple choice questions 1. With regards to the Australian accounting standards, IASB stands for: a. International Auditing Standards Board. b. International Accounting Securities Body. *c. International Accounting Standards Board. d. International Accounting Statements Body. Answer: c Learning objective 1.3: explain the structure, role and processes of the International Accounting Standards Board (IASB) and the IFRS Interpretations Committee (IFRIC).

2. Which of the following statements is false? *a. The IFRS Advisory Council is directly accountable to the Monitoring Board. b. Australia adopted international accounting standards issued on or after 1 January 2005. c. The IASB and IFRS Interpretations Committee are appointed and overseen by a geographically and professionally diverse group called the IFRS Foundation Trustees. d. The IASB is an independent standard-setting board that develops and approves International Financial Reporting Standards. Answer: a Learning objective 1.3: explain the structure, role and processes of the International Accounting Standards Board (IASB) and the IFRS Interpretations Committee (IFRIC).

3. Which of the following is not a chapter in the IASB’s Conceptual Framework? a. measurement. b. qualitative characteristics of useful financial reporting. c. the objective of general purpose financial reporting. *d. the issues with financial reporting. Answer: d Learning objective 1.4: explain the key components of the Conceptual Framework.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following statements about the Conceptual Framework is true? a. The Conceptual Framework deals only with the objective of special purpose financial statements. b. The Conceptual Framework for Financial Reporting provides guidelines intended to meet the information needs of a range of users who are able to command that reports be prepared to their own particular needs. *c. The Conceptual Framework deals only with the objective of general purpose financial statements. d. the Conceptual Framework for Financial Reporting, SAC 1, and SAC 2 provides guidelines on the preparation of financial statements for a specific group of users. Answer: c Learning objective 1.4: explain the key components of the Conceptual Framework.

5. The two fundamental qualitative characteristics of useful information are: a. materiality and timeliness. b. understandability and verifiability. c. faithful representation and comparability. *d. relevance and faithful representation. Answer: d Learning objective 1.5: explain the qualitative characteristics that make information in financial statements useful.

6. For information to be considered material: a. it must be complete. b. it must not include any bias. *c. its omission or misstatement could influence users’ decision-making. d. it has a predictive or confirmatory value. Answer: c Learning objective 1.5: explain the qualitative characteristics that make information in financial statements useful.

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Chapter 1: Accounting regulation and the Conceptual Framework Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Costs of providing useful information include: a. collection and processing costs. b. dissemination costs. c. verification costs. *d. All of these options are costs of providing useful information. Answer: d Learning objective 1.5: explain the qualitative characteristics that make information in financial statements useful.

8. If different independent observers could reach the same general conclusions that the information represents then the quality of the information has achieved: a. neutrality. b. understandability. *c. verifiability. d. comparability. Answer: c Learning objective 1.5: explain the qualitative characteristics that make information in financial statements useful.

9. Which of the following statements about the going concern assumption is not true? a. it can justify the use of historical costs when measuring non-current assets. b. it supports the use of assets such as Prepaid Expenses. c. it supports the systematic allocation of depreciation over an asset’s useful life. *d. it is used when an entity goes into liquidation. Answer: d Learning objective 1.6: describe the objective and scope of financial statements prepared by a reporting entity.

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Testbank to accompany Financial reporting 3e by Loftus et al.

10. Which of the following are the three essential criteria in the definition of an asset: I. II. III.

Future sacrifices of economic benefits Future economic benefits. Present obligation.

IV.

Past event.

V. VI.

Ownership. Control.

a. I, III, VI. *b. II, IV, VI. c. II, III, VI. d. I, III, V. Answer: b Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

11. The only financial statement element which cannot be defined independently of the other elements under the Conceptual Framework is: *a. equity. b. assets. c. income. d. expenses. Answer: a Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

12. Which of the following statements is correct? a. Equity is defined as ‘the residual interest in the assets of the entity after deducting all its expenses’. *b. Equity is increased by profit and owner contributions. c. Equity is decreased by an entity’s income. d. Equity cannot be sub-classified in the statement of financial position. Answer: b Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

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Chapter 1: Accounting regulation and the Conceptual Framework Not for distribution in full. Instructors may assign selected questions in their LMS.

13. An example of an expense, as defined in the Conceptual Framework, is: a. Payment to a supplier for purchases made on credit. b. Dividends paid to shareholders. c. Cash purchase of office equipment. *d. Wages paid on a weekly-basis to employees. Answer: d Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

14. Which of the following statements about income is not true? *a. Income includes capital contributed by owners of the entity. b. Income can be in the form of decreases of liabilities. c. Income arises when there is control over the increase in economic benefits. d. Income results in increases in economic benefits. Answer: a Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

15. The two recognition criteria for the elements of financial statements are: a. Faithful representation and Existence of economic benefits. b. Existence of economic benefits and Control. *c. relevant and faithful representation. d. Probability of occurrence and Control. Answer: c Learning objective 1.8: explain the criteria for recognising and derecognising the elements of financial statements.

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Testbank to accompany Financial reporting 3e by Loftus et al.

16. Georgetown Ltd purchased a block of land on 31 March and paid $400 000 cash to the land owner. An independent evaluation reveals that the land is worth $500 000. Using historical cost as a measurement base, how should Georgetown Ltd recognise this purchase of land in its financial statements? a. $400 000 recognised as an asset (land) and $100 000 as a liability. *b. $400 000 recognised as an asset (land). c. $500 000 recognised as an asset (land). d. The land should not be recognised as an asset as it cannot be reliably measured. Answer: b Learning objective 1.9: compare alternative measurement bases for measuring the elements of financial statements.

17. In order to comply with the Australian Accounting Standards, which of the following assets cannot be recorded at its historical cost? *a. inventories. b. buildings. c. motor vehicles. d. land. Answer: a Learning objective 1.9: compare alternative measurement bases for measuring the elements of financial statements. 18. In measuring the value of a liability, which measurement base uses the discounted future net cash outflows that are expected to settle the obligation in the normal course of business? a. Realisable value. b. Current cost. c. Historical cost. *d. Present value. Answer: d Learning objective 1.9: compare alternative measurement bases for measuring the elements of financial statements.

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Chapter 1: Accounting regulation and the Conceptual Framework Not for distribution in full. Instructors may assign selected questions in their LMS.

19. Which of the following is not an example of a settlement of a liability? a. cash payment. b. provision of services. *c. owner contribution. d. creditor waiving their rights to the obligation. Answer: c Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

20. Bruce’s Bouquets rents a small shop located in the outskirts of Melbourne. In accordance with the Conceptual Framework, Bruce’s Bouquets should recognise the monthly payment for the shop rental as: a. an increase in income and a decrease in liabilities. b. a decrease in assets and an increase in equity. c. a decrease in assets and a decrease in income. *d. a decrease in assets and an increase in expense. Answer: d Learning objective 1.7: define the basic elements in financial statements — assets, liabilities, equity, income and expenses.

21. Which of the following statements is incorrect about the physical capital concept? *a. The general price level accounting system follows the physical capital concept. b. Capital is seen as the operating capability of the entity’s assets. c. Profit is earned after an entity has set aside enough capital to maintain the operating capability of the entity’s assets. d. Physical capital may be measured under a current value system. Answer: d Learning objective 1.10: outline concepts of capital.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Janice Loftus

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 2: Application of accounting theory

Chapter 2: Application of accounting theory Comprehension questions 1. Describe the four components of an accounting policy. Illustrate your answer with examples. Accounting policies involve the following four components: • • •

•

Definition – does the transaction or event give rise to an item that meets the definition of one of the elements of financial statements? e.g., whether expenditure on building improvements gives rise to an asset. Recognition – when does the item satisfy the recognition criteria? e.g., recognising cost of goods sold as an expense when goods are delivered to the customer. Measurement – how should it be measured on initial recognition and, in the case of an asset or a liability, how should it be measured subsequent to initial recognition? e.g., whether to measure property, plant and equipment at cost or fair value, and how to measure depreciation. Disclosure – how should information be presented and disclosed? e.g., how much detail should be included about the calculation of depreciation, should an item be presented in the financial statement or in the notes?

2. Differentiate normative accounting theory from positive accounting theory. Provide an example of each. A normative theory prescribes what should be done based on a specific goal or objective. The outcome of a normative theory is derived from logical development based upon a stated objective; e.g., the Conceptual Framework prescribes principles, such as recognition criteria for elements of financial statements, based upon an explicit objective of financial reporting. In contrast, the role of a positive theory is to describe, explain or predict. For example, agency theory is a positive theory because it is used to explain why managers prefer accounting policies that increase profit in certain situations, such as when there is a bonus plan linked to accounting profit.

3. What is the difference between the deductive and inductive processes of developing a theory? Developing a theory using inductive reasoning commences with observing definable activities and actions, which form the basis for inferring the principles that conform to the observations. The theorist would then attempt to infer higher-level assumptions and objectives. Developing a theory using deductive reasoning commences with setting objectives, which may be based on assumptions. For example, an objective of providing information that is useful for © John Wiley & Sons Australia, Ltd 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

decision making involves assumptions about the users of financial statements and their information needs for decision making. Principles (e.g., that items reported in financial statements should be faithfully represented) are derived logically from both the objectives and the assumptions. Definitions and observable actions are, in turn, derived from the principles. Thus, under inductive reasoning, observations of practice lead the development of principles. However, under deductive reasoning, the objectives and principles lead to the actions prescribed by the theory.

4. What is an agency relationship? Explain how monitoring costs, bonding costs and residual loss arise in agency relationships. An agency relationship occurs when one party, who is referred to as the principal, employs another party, the agent, to undertake some activity on their behalf. Costs incurred by the principal to observe, evaluate and control the agent’s behaviour are referred to as monitoring costs. Examples of monitoring activities incurred by shareholders to monitor management include having the financial statements audited. Bonding costs are those costs incurred by the agents to provide assurance to the principal that they are acting in the principal’s best interests. The time and effort expended in producing and providing quarterly accounting reports to lenders is an example of bonding costs. Residual loss is the reduction in value of the firm that results from the separation of ownership of control, when the marginal cost of additional monitoring or bonding exceeds the expected benefit. 5. Why would managers’ interests differ from those of shareholders? Agency theory assumes that parties, such as manager (agent) and shareholders (principal), will act in their own interests, that is, to maximise their own wealth. Accordingly, given separation of ownership and control, managers are expected to act in their own interests through excessive consumption of perquisites and avoidance of effort. While this may offer the manager more income for less effort, it would reduce the wealth generation for shareholders by increasing expenses for perquisites and reducing income through reduced managerial effort. The interests of managers and shareholders can also diverge because managers have shorter horizons in evaluating decisions, are more risk aversion and prefer dividend retention because it gives them control over more resources.

6. Explain the following agency problems that can arise in the relationship between owners and managers: (a) The horizon problem (b) Risk aversion (c) Dividend retention. (a) Horizon problem: Shareholders are concerned with the long term growth and value of the firm, which reflects the market’s expectations of the present value of the future cash flows. However, management’s interest in the cash flow potential may be limited to the period over which they expect to be employed by the firm. This horizon problem may be exacerbated if © John Wiley & Sons Australia, Ltd 2020

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Chapter 2: Application of accounting theory

the manager is approaching retirement. Managers generally adopt a shorter horizon than shareholders when evaluating proposed actions or investments, e.g., management’s preference for delaying research and development expenditure may increase short-term profitability but may also have adverse long-term consequences, such as missed opportunities for innovation and new product development. (b) Risk aversion: Managers are generally more risk averse than shareholders because managers are less able to diversify risk. Shareholders typically spread their investment (and hence, their risk) across a range of securities and other assets. Their liability is limited to the unpaid capital on their shares. Shareholders may also receive income from sources, such as employment, that are independent of the company. Managers, however, have less diversifiable ‘human capital’ invested in the company. Their management compensation (remuneration) is likely to be their primary source of income. (c) Dividend retention: Managers prefer to maintain a greater level of funds within the company through dividend retention. This helps managers to expand the size of the business they control (empire building) and to pay their own salaries and benefits. Shareholders may have preference for increased dividend. In particular, this would occur where the retention of dividends results in lower returns because the firm has insufficient investment opportunities. Under such circumstances funds would be held in low return investments, such as cash and cash equivalents, or perhaps invested in negative net present value projects.

7. Outline the four agency problems that can arise in the relationship between lenders and managers. Four agency problems that can arise between lenders and managers include: excessive dividend payments to owners; asset substitution; claim dilution; and underinvestment. Management may pay excessive dividend, which can leave the company with insufficient funds to service the debt. To reduce this problem managers and lenders agree to covenants that restrain dividend policy and restrict dividend payouts as a function of profits. Asset substitution refers to management investing in riskier assets after the loan has been arranged, e.g., borrow money to invest in local production facilities but actually spending it on overseas investments with additional foreign currency risk. Managers may use the debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. Lenders bear the risk of this strategy as they are subject to the increased risk of default, but do not share in any benefit in the form of higher returns if the investment project becomes more successful. Claim dilution arises when firms take on debt that has a higher priority in repayment in the event that the firm becomes insolvent. For example, after obtaining an unsecured loan, management might obtain additional loan funds by offering floating charge over its working capital to another lender. This reduces the assets available to unsecured creditors in the event of default.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Lastly, underinvestment can arise if the borrower is struggling to repay the principal and interest components of debt. Extra cash flows that might be generated by additional projects would go to repaying the debt rather than increasing shareholder wealth because creditors would rank above shareholders if the company were liquidated. Thus any funds generated by these projects would go towards debt rather than equity if the company were liquidated. Managers, acting on behalf of owners, may lack incentive to undertake projects that could lead to increased funds being available to lenders.

8. What is a debt covenant and why is it used in a lending agreement? Debt covenants are restrictions or undertakings imposed in debt contracts. Debt covenants reduce the risk to the lender, resulting in lower interest costs being imposed on the borrower. Some debt covenants use accounting numbers. For example, a debt covenant may restrict leverage to a maximum of 60 per cent of total assets. By agreeing to debt covenants, managers may be able to borrow funds for the firm at lower rates of interest. Debt contracts will often restrict investment opportunities of the firm, including mergers and takeovers, to protect debtholders against the additional risk arising from asset substitution. Establishing a maximum ratio of debt to tangible assets can also mitigate asset substitution by restricting investment in intangible assets. Restricting higher priority debt is a common method of reducing the risk of claim dilution.

9. Why would managers agree to enter into lending agreements that incorporate covenants? Lenders expect to be compensated for risk. Debt covenants reduce the risk to the lender and thus result in lower interest costs being imposed on the borrower. As a result of agreeing to debt covenants, managers may also be able to borrow more funds for the firm and/or for longer periods.

10. How does accounting information reduce agency problems in relationships between management and shareholders? Accounting information is used in contracts that are designed to reduce agency problems in the relationship between shareholders and management. Accounting numbers are used to specify targets, monitor performance and determine rewards. For example, a bonus might be calculated as 1% of profit, provided return on equity exceeds 7%. Thus, the accounting information is used to specify the target (e.g., return of equity greater than 7%). Reported accounting numbers are used to measure performance against the target to determine eligibility for a bonus (e.g., whether the hurdle of 7% return on equity has been exceeded) and to determine the amount of the bonus, if any, payable to the manager (e.g., 1% of reported profit).

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Chapter 2: Application of accounting theory

11. How does accounting information reduce agency problems in relationships between management and debt holders? Accounting information is used in debt covenants to reduce the risk to the lender. Accounting numbers are used to specify debt covenants. For example, a debt covenant may restrict leverage to a maximum of 60 per cent of total assets, thus reducing the lender’s risk of claim dilution. Debt covenants may also restrict dividend payouts as a function of profits, again using accounting information. Reported accounting numbers are used to monitor compliance with debt covenants. For example, the lender would refer to the statement of financial position to assess whether the leverage ratio exceeds the maximum allowed in the debt contract.

12. What are the factors a manager might consider in making various expensingcapitalisation choices? While accounting standards play a very important role in determining accounting treatment, this does not remove the need for professional judgement in the application of accounting principles. According to agency theory, the application of judgement in accounting policy choice may be influenced by incentives arising from the economic consequences, particularly in relation to the outcomes for contracting parties. In deciding whether to account for an item of expenditure (e.g., cost of maintenance that also enhances the efficiency of the asset) as an asset or an expense, management may consider the effect of the alternative accounting treatments on their remuneration, the firm’s proximity to debt covenants, and the political visibility of the firm. 13. Linking managerial remuneration to firm performance motivates managers to act in the interests of shareholders. However, it also burdens managers with greater risks than they may like. How do organisations balance these two considerations in management remuneration plans? Management compensation packages typically comprise fixed salary and at-risk components. The at-risk remuneration refers to that part of a manager’s income that is subject to meeting or maintaining performance targets. Also, some remuneration schemes link at-risk remuneration to performance over a longer period, which reduces the risk borne by management for intermittent fluctuations in performance over a period of several years. Benchmarking against other firms or the industry can also be used in compensation arrangements to reduce the manager’s exposure to industry-wide risks.

14. Bonus plans are used to reduce agency problems between managers and shareholders. Discuss two of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that may be included in a bonus plan to address the issues identified. While all three problems that can arise in the shareholder-manager agency relation are considered in this solution, students need only address two of them in answering the question. © John Wiley & Sons Australia, Ltd 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Managers generally adopt a shorter horizon than that of shareholders in making decisions about various courses of action the company may take. According to agency theory, the manager will act to secure income and wealth during the period of his or her employment. In contrast, shareholders’ wealth is linked to the long-term prospects of the firm. Even if shareholders sell their shares, their wealth is affected by the price they obtain for their shares, which, in turn, reflects the market’s expectations of the firm’s future prospects. The horizon problem can be reduced by linking management rewards to the company’s performance over a longer period, for example, through share-based remuneration, such as shares or executive share options. Paying a portion of managerial remuneration as shares provides management with an incentive to focus on long-term performance because it is likely to affect their own wealth. Managers’ prefer to maintain retain a greater level of funds within the company, even in excess of available investment opportunities, in order to increase their power and prestige. In contrast, shareholders may have a preference for increased dividends. The dividend retention problem can be mitigated by aligning the interest of managers with those of the firm through the use of incentive-based payment. In particular, bonuses linked directly to dividends and share-based remuneration increase managers wealth with dividends payments. Bonuses linked to return on investment and return on equity can discourage managers from retaining funds in excess of available investment opportunities, because doing so would lower returns. Managers, who have undiversified human capital, may be more risk averse than shareholders who can readily diversify their risk through portfolio management. Managerial remuneration contracts can include incentives to encourage managers to invest in more risky projects. For instance, linking a bonus to profits can encourage managers to consider more risky projects that have the potential to increase profits. However, share-based compensation, such as executive shares and share option schemes, can be less effective in encouraging managers to invest in more risky projects because the cost to the manager of diversifying risk increases with managerial share ownership.

15. What are political costs? How might political visibility influence accounting policy choice? Political contracts are implicit and refer to the expectations of government and society in relation to how companies exercise power over resources. Political costs refer to the effects on the firm of political actions such as lobbying and increased regulation. Political action is more likely to be taken against larger, more profitable companies, which control more resources and have power to affect more people. Accordingly, managers of companies with high political sensitivity may prefer accounting policies that result in lower profits to reduce political visibility. 16. Distinguish between the three forms of market efficiency? Which form is more relevant for financial reporting? Justify your answer. Market efficiency is the rapid and unbiased adjustment of prices in response to information. Different forms of market efficiency can be distinguished in terms of the information set impounded in share prices, that is, the information set to which the market is efficient. © John Wiley & Sons Australia, Ltd 2020

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Chapter 2: Application of accounting theory

The weak form of market efficiency is the rapid and unbiased adjustment of prices in response to information in past prices, such that prices reflect all information contained in past prices. The semi-strong form of market efficiency is the rapid and unbiased adjustment of prices in response to all publicly available information. Accordingly, if a securities market is efficient in the semi-strong form, security prices reflect all publicly available information. The semi-strong form is most important for financial reporting because it forms part of the set of publicly available information. Further, sophisticated capital markets are considered to be better categorised by semistrong efficiency than other forms. The strong form of market efficiency is the rapid and unbiased adjustment of prices in response to all information, including private information. Under the strong form of market efficiency, prices reflect all private and public information.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 2.1 Accounting policy decision Mandy Ltd made the following disclosure in the notes to its financial statements about how it accounts for insurance premiums:

Required 1. List the four components of an accounting policy decision. 2. Analyse Mandy Ltd’s policy for accounting for the insurance premium in terms of each component. 1. An accounting policy decision may comprise four components: • definition, that is whether the transaction or event gives rise to an item that satisfies the definition of an element of financial statements; • recognition, that is whether or when it should be recognised; • measurement, that is how it should be measured, which may include a decision about subsequent measurement as well as initial measurement; and • disclosure, that is how information about the item should be presented and what information should be disclosed. 2. The insurance policy is accounted for as an asset, namely prepaid insurance. This is appropriate because it satisfies the definition of an asset. First, it is a resource controlled by Mandy Ltd as a result of a past event, being the payment of the insurance premium in accordance with the insurance policy (the insurance contract). The other criterion, that future economic benefits are expected to flow to Mandy Ltd, is evident to the extent of the unexpired period of the insurance cover. The insurance policy is recognised as an asset at the time of settlement, that is, when Mandy Ltd pays the insurance premium. It is subsequently expensed as the period of the insurance policy expires. The prepaid insurance asset is initially measured at cost and amortised to expenses on a time proportionate (straight-line) basis. Thus subsequent measurement of the prepaid insurance asset reflects the cost of the unexpired portion of the insurance policy.

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Chapter 2: Application of accounting theory

Mandy Ltd includes the prepaid insurance asset in ‘other current assets’ in the statement of financial position and discloses the carrying amount and the accounting policy in the notes to the financial statements.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 2.2 Agency theory At the beginning of the current reporting period City Retail Ltd launched a new logo and spent $500 000 on new signage for all its premises. The expenditure on signage was originally accounted for as part of property, plant and equipment. It was recognised as a depreciable asset with a useful life of 10 years. Tony has been engaged as the new accountant for City Retail Ltd. Tony believes that the expenditure for signage should be recognised as an expense because it is in the nature of advertising and the signage has no resale value. Eager to impress the senior managers, Tony gave a presentation on how he would ‘improve’ the forthcoming financial statements, by expensing signage costs. An extract from his presentation is provided below: Before change $’000

% of total assets

Total assets (includes signage with carrying amount of $450 000) Total liabilities (includes a long-term debt agreement)

4 200

100

2 500

Shareholders’ equity

1 700

600

Profit (includes depreciation expense of $50 000)

Tony was puzzled by the senior managers’ response: ‘You don’t understand our business. What might look like an improvement for your financial statements, looks like devastating economic consequences for us.’ Additional information • Managers receive a bonus, subject to profit exceeding 10% of total assets. • The long term debt agreement restricts borrowing to a maximum of 65% of total assets. Required For simplicity, assume that the change in accounting treatment has no implications on tax or tax expense. 1. Describe and quantify the effects of recognising the signage costs as an expense in City Retail Ltd’s financial statement for the year ended 30 June. 2. How would agency theory explain why the managers of City Retail Ltd did not welcome Tony’s accounting treatment for the expenditure on signage? 1. Ignoring tax, if the signage costs were recognised as an expense for the year ended 30 June, profit would decrease by a net amount of $450 000, comprising an increase in signage expense of $500 000 and a decrease in depreciation expense of $50 000. This would flow through to a reduction in equity of $450 000. Thus profit for the period would be $150 000 and shareholders’ equity would be $1 250 000 at 30 June. Assets would decrease by $450 000, being the carrying © John Wiley & Sons Australia, Ltd 2020

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Chapter 2: Application of accounting theory

amount of the signage, to $3 750 000 at 30 June if the signage were expensed. The accounting treatment of the signage costs has no effect on liabilities. 2. Agency theory suggests that managers with bonus plans linking remuneration to accounting profit are more likely to prefer accounting policies that increase profit. City Retail Ltd has a remuneration scheme that links the managers’ bonus to profit. The change of accounting policy reduces profit to $150 000 and assets to $3 750 000. Profit would be only 4% of total assets, which is below the hurdle of 10% of total assets. Accordingly, the managers would not be eligible for a bonus for current period. Agency theory suggests that management of firms with high leverage, or in close proximity to leverage constraints, are more likely to prefer accounting policies that increase reported profit so as to avoid breaching restrictive debt covenants. Management of City Retail Ltd would prefer to account for the expenditure on signage as an asset because expensing it would reduce assets and thus increase the firm’s leverage ratio to 67% (i.e., $2 500 000/$3 750 000), which exceeds the maximum leverage ratio of 65% permitted by its long-term debt contract. Management would be keen to avoid the breach of the debt covenant because it might cause the lender to demand repayment in full, resulting in costly refinancing.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 2.3 Accounting theories Rocky Retail Ltd had experienced a difficult year with declining sales as a result of increased competition from online retailers. The accountant for Rocky Retail Ltd presented a set of draft financial statements to management to review before the final set of financial statements were published. Management was very worried because the draft financial statements showed a profit of only $460 000 for 2022, compared with $600 000 in 2021. They were concerned that a reduction in profit would result in a fall in the company’s share price. The statement of profit or loss and other comprehensive income included an expense of $160 000 for stamp duty on long-term rental properties. One of the managers announced a ‘clever plan’ to increase profit, suggesting the company ‘classify the stamp duty as an asset and expense it over the term of the lease’. The accountant did some calculations and advised that if Rocky Retail Ltd accounted for the stamp duty costs of $160 000 as ‘Prepayments’, and then progressively allocated it to expenses over the term of each lease, only $10 000 would be recognised as an expense in 2022. Everyone seemed happy with that plan and the accountant got to work writing the note disclosure about the accounting policy. She explained, ‘We must disclose this to comply with accounting standards, but don’t worry...I think the shareholders and investors will be too busy looking at the profit to read what is says in the notes’. Required 1. Ignoring taxes, calculate Rocky Retail Ltd’s profit for 2022 after the decision to account for stamp duty as an asset. 2. Explain which of the theories discussed in this chapter best describes the managers’ expectations about how shareholders and investors will react to the reported profit for 2022. 3. Define the semi-strong form of market efficiency and discuss its implications for how the investors, and therefore, the share price, might respond to the release of the financial statements. Assume that the market is efficient in the semi-strong form. 1. Rocky Retail Ltd’s profit for 2022 would be $610 000 if the stamp duty is accounted for as a prepaid expense and allocated to expenses over the period of the lease. This is calculated by adding back the $160 000 stamp duty expense to profit and subtracting the $10 000 expense, being the amount of prepaid stamp duty that would be allocated to the current period ($460 000 + $160 000 - $10 000 = $610 000). 2. Rocky Retail Ltd’s managers’ expectations of how shareholders and investors will react is consistent with the mechanistic hypothesis, which predicts that investors are systematically deceived by cosmetic accounting changes, which affect reported profit but have no cash flow consequences). It is based on the assumption that investors take a mechanistic approach, fixating on the numbers and ignoring the methods used to derive accounting numbers.

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3. If the market is efficient in the semi-strong form the share price makes a rapid and unbiased response to the release of publicly available information, such that the share price reflects all publicly available information. Thus the market will not be tricked into thinking the company is more profitable; instead the share price will reflect the understanding that the increase in profit resulted from a cosmetic change of accounting policy, such that there will be no response unless it has indirect implications for expected future cash flows, such as reduced probability of breaching a debt covenant.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis questions Exercise 2.1 Debt covenants and accounting information You have recently been appointed as a lending officer in the commercial division of a major bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. Required Prepare a report outlining what agency problems the bank should be concerned with, how covenants in debt agreements can be used to reduce those problems, and how accounting information can be used to assist in this process. (LO4) The bank should consider four agency problems of debt that may arise when lending to companies: • excessive dividend payments to owners; • asset substitution; • claim dilution; and • underinvestment. Each of these problems is considered in turn, followed by some suggestions as to how debt covenants may be used to mitigate them. Some of the debt covenants rely on accounting information. Excessive dividends payments may increase the risk of the company being unable to service the debt. This problem may be reduced if managers agree to debt covenants that restrain dividend policy. Accounting numbers may form the basis of the dividend restriction, such as a maximum dividend payout expressed as a percentage of profit. Asset substitution refers to management investing in riskier assets after the loan has been arranged. This generates a problem of adverse selection. If the lender had known that the managers would invest in riskier assets, a different decision option may have been selected, such as not granting the loan, or charging a higher interest rate to compensate the bank for the higher level of risk. Debt covenants can restrict the investment opportunity set of the firm by establishing a maximum ratio of debt to tangible assets. This discourages investment in intangible assets which may be less liquid than some tangible assets and thus be less useful to the bank and other creditors in the event of the company defaulting on the loan. Claim dilution arises when firms take on debt of an equal or higher priority. This reduces the assets available to unsecured creditors in the event of default. Lenders can mitigate the risk of claim dilution by restricting higher priority debt. Another debt covenant employed in many debt contracts is a maximum leverage ratio. This accounting-based debt covenant can also reduce the risk of claim dilution by limiting further borrowing when the firm approaches the maximum.

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Lastly, there is the risk of underinvestment which may occur if the borrower is struggling to service the loan. Management may be reluctant to invest in new, positive net present value projects because the extra cash flows that might be generated by additional projects would go to repaying the debt rather than increasing shareholder wealth. The bank and other creditors rank above shareholders in order of payments. Thus any funds generated by these projects would go towards debt rather than equity if the company were liquidated. It is very difficult for lenders to protect themselves against the risk of underinvestment because management has control over the use of resources unless the firm is facing severe financial difficulties such that management loses control (for example, if control of the company is placed in the hands of an administrator).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 2.2 Management remuneration plans and performance XYZ is a global financial institution with an executive remuneration scheme that includes both cash-based and share-based remuneration and a mix of shorter term and longer term awards. At least 80% of the performance-based award is deferred. At least 50% of the total performance award (or bonus) is awarded through a share ownership plan, in which the executive receives XYZ shares that vest in three instalments over 3 to 5 years. The senior executives do not become legally entitled to the shares until they vest. In addition, 30% of the total performance award is awarded under a deferred contingent capital plan. This award does not vest for 5 years and is conditional upon further performance targets being satisfied. The award is reduced if XYZ makes a loss during the 5 years until it vests. Required 1. Explain how the use of a bonus plan linked to performance and the deferral of part of the bonus can reduce the agency problems of the owner-manager relationship. 2. How does the senior executive equity ownership plan reduce agency problems beyond that which is achieved by the bonus plan? (LO4) 1. Agency problems that arise in the owner-manager relationship include the horizon problem, dividend retention and risk aversion. The horizon problem refers to management’s tendency to adopt a shorter horizon in decision making than that preferred by shareholders. A bonus plan linked to firm performance can help to align management’s interests with those of shareholders because shareholders prefer more profit. However, the use of performance hurdles could potentially encourage management to focus on the short term in order to meet performance hurdles. XYZ’ deferral of equity-based remuneration can encourage a longer term focus by providing an incentive to maintain or improve the share price over a longer period, such as five years. Making vesting contingent upon meeting performance targets in subsequent periods provides additional incentive for management to adopt a longer horizon so that previous equity-based rewards vest. Dividend retention may result in overinvestment (investment in negative present value projects), with consequential adverse effects on share price. Similarly, risk aversion has an adverse effect on share price through under investment (rejection of positive net present value projects). Equitybased remuneration linked to firm performance can mitigate these agency problems by providing an incentive to invest in (only) positive net present value projects that increase share price. Deferral of the equity based remuneration further discourages dividend retention and risk aversion by providing management with incentives to take actions that maintain or increase the share prices, in order to increase the value of the remuneration. Conditional provisions, such as those introduced by XYZ further discourage dividend retention and risk aversion as managers attempt to continue to maintain performance targets, so that previously granted awards vest. 2. The bonus plan linked to profit targets helps to align the interest of managers with those of shareholders, who also benefit from corporate profits because they contribute to shareholder © John Wiley & Sons Australia, Ltd 2020

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wealth. However, short-term profit targets do not capture the long-term interests of shareholders. The use of equity-based remuneration by XYZ helps to align the interest of managers with those of shareholders because managers benefit directly from increased share prices if they also own shares. Even if the shares have not vested, the manager has an incentive to maximise share value so as to increase his or her wealth when the shares ultimately vest. Further, XYZ defers a significant proportion of the performance-based remuneration. The deferral of remuneration provides additional incentives by facilitating the imposition of additional conditions, such as not making a loss. Such conditions reduce the incentive to manage earnings so as to achieve a performance target because these techniques can result in lower profit in subsequent periods. E.g., if management capitalises expenditure to achieve a profit target in one year, the depreciation or amortisation of the capitalised expenditure reduced profit in subsequent years. This increases the risk of a loss which would result in a reduction of the deferred remuneration.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 2.3 Agency theory and management remuneration Publicly listed companies provide a remuneration report as a component of the annual report, which is often available on the company’s website. Required Obtain the remuneration report for a publicly listed company. Examine the remuneration arrangement for the chief executive officer (CEO). Prepare a report which summarises your findings for each of the following: 1. What amount of the CEO’s remuneration is in the nature of salary and cash bonus for the current year, and for the previous year? 2. What forms of remuneration other than salaries and cash bonuses does the CEO receive? 3. What proportion of the CEO’s pay for the current reporting period is fixed and what proportion is performance based? 4. What measures of accounting performance, if any, are used to determine the CEO’s bonus? 5. Explain the incentives for accounting policy choice that arise from the CEO’s remuneration contract according to agency theory. Use specific accounting policies to illustrate your answer. 6. Can agency theory provide an explanation for the various remuneration components? Justify your answer. (LO4) Answers to this exercise will vary over time and with the student’s choice of company. For illustrative purposes, the Commonwealth Bank’s 2016 remuneration report has been selected (refer to www.commbank.com.au). Details of the compensation contract and remuneration for the CEO can be found in the “Directors’ Report – Remuneration Report” on pages 47-69 of the Annual Report 2016. The Commonwealth Bank reports that its CEO’s total remuneration for 2016 was $8 768 352. While this seems a very large sum, analysis of the remuneration reveals that less than half of the remuneration was paid in cash. In the following discussion and analysis of the remuneration arrangement for the CEO all page references are to the Commonwealth Bank’s Annual Report 2016. 1. For the year ended 30 June 2016 the remuneration of Ian Narev, Managing Director and CEO of the Commonwealth Bank, included salary (including superannuation) of $2 650 000 ($2 650 000 in 2015) and cash bonus (short term-incentive payment at risk) of $2 862 000 ($3,180,000 in 2015). Note, accrual-based accounting numbers are used (refer to the Executive Statutory Remuneration, page 63). Accordingly, both the 50% of STI paid in cash and the 50% of STI deferred are included. Although not paid until September, the deferred component is treated as a cash bonus, as distinct from share-based remuneration.

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2. Other forms of remuneration include non-monetary fixed remuneration in the form of car parking, interest accrued on short term incentive awards that have been deferred, annual leave, long service leave, and share-based payments, including the Group Leadership Reward Plan (GLRP) (page 63). While the preceding analysis of the CEO’s remuneration is helpful in understanding the cash flow implications, considering how much is fixed versus at-risk (performance-based) provides additional insights into how the Commonwealth Bank uses its remuneration package to provide incentives and reward management for performance that furthers the interests of shareholders. 3. The fixed proportion of the CEO’s remuneration is 32% [($2 650 000 + $15 052 + $35 870 + $137 211)/$8 768 352]; 68% [($2 862 000 + $3 068 219)/$8 768 352] is performance based (at risk). Refer to note 9 on page 64. 4. An accounting-based measure of Total Shareholder Return, relative to a set peer group, forms a hurdle for long-term incentives (page 54). Short-term performance incentives are based on both financial and non-financial performance measures, managed through a balance scorecard approach. Financial performance is measured using “group cash net profit after tax” and “group profit after capital charge” (pages 51-52). The capital charge refers to an adjustment for the level of risk, such that a larger charge against profit is applied if more risk was involved in generating the profit. 5. The reliance on profit may provide an incentive to select accounting policies that temporarily increase profit, particularly in periods in which the reported profit would otherwise fall below the hurdle. For example, a policy of straight-line depreciation increases profit in the earlier periods of the asset’s useful life, compared with the reducing-balance method, which recognises more depreciation expense in the first few years of asset’s useful life. Estimating a longer useful life for an asset would similarly delay the recognition of depreciation expenses, resulting in more reported profit in the short term. Another example of an accounting policy choice that affects profit is in relation to the timing of the recognition of income arising from bank fees charged to customers, particularly large fees associated with granting loans. Specifically, the accounting policy decision is whether to recognise bank fees as income immediately, or to spread them across the term of the loan. However, the deferral of the long-term incentive reward, subject to meeting performance targets at the end of a four-year period, mitigates the incentive to manage earnings to achieve current period targets. 6. Agency theory assumes that managers, acting in self-interest, will prefer investments that maximise returns over a shorter horizon than that preferred by shareholders. The use of a four-year performance period for long-term incentives (refer to page 53) and the deferral of the incentive award payments may be considered as an attempt to motivate the managers to consider a longer horizon. Linking management remuneration to risk-adjusted profit measures can also be viewed as an attempt to align the interests of managers with those of shareholders, both in terms of achieving shareholder returns and avoiding use of excessive risk in the process.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Further, the payment of awards in shares rather than in cash can also be viewed as seeking to align the managers’ interests with those of shareholders by linking their wealth to the value of the bank’s shares.

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Exercise 2.4 Debt covenants and agency relationships On 1 July 2019, Medical Supplies Ltd borrowed $15 million to finance an investment in a laboratory for developing and testing surgical supplies. The loan is due 30 June 2029. The lender insisted on a debt covenant in the loan agreement, specifying that the ratio of total liabilities to total tangible assets not exceed 65%. Medical Supplies Ltd complied with the requirement in 2020 when the ratio of total liabilities to total tangible assets was 64%. Medical Supplies Ltd also invested in plant and equipment used exclusively to manufacture latex gloves. However, due to a decline in demand for latex gloves, analysts are predicting that the company may need to write-down some of its plant and equipment. Required 1. Debt covenants or restrictions are commonly used in Australian lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between management and lenders. 2. Why would management choose to enter into a lending agreement that contains a covenant that restricts the company’s leverage? 3. How might a write-down of plant and equipment increase the risk of breaching debt contracts? 4. If a company is close to breaching its leverage covenant what actions might it take? (LO4) 1. Debt covenants reduce the risk to the lender by restricting the actions that may be taken by the firm, such as mergers and takeovers, thus protecting creditors from the additional risk arising from asset substitution. Establishing a maximum ratio of debt to tangible assets can mitigate claim dilution by reducing further borrowing, (and can mitigate asset substitution by restricting investment in intangible assets, assuming intangible assets are more risky). Restricting higher priority debt is a common method of reducing the risk of claim dilution. 2. A debt covenant may restrict leverage, for example, to a maximum of 60 per cent of total assets. By agreeing to debt covenants, managers can reduce the creditors’ risk of claim dilution, so that the company is able to borrow funds at lower rates of interest and/or more favourable terms, such as over a longer period. 3. Asset impairment reduces assets and increases expenses, with consequential effects on profit and equity. To the extent that assets, profit and equity numbers are used in debt covenants in debt contracts, the recognition of an impairment loss may increase the likelihood of breaching a debt covenant, even though the entity may still be servicing the debt. For example, assume an entity has a debt covenant that restricts leverage to a maximum of 65% of total assets. If the entity’s total liabilities and total assets are $6 000 000 and $10 000 000, respectively, it would have a leverage ratio of 60%, in compliance with its debt covenant. However, if assets or a cash generating unit © John Wiley & Sons Australia, Ltd 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

were to become impaired, such that an impairment loss of $1 000 000 were recognised, the assets would be reduced to $9 000 000, resulting in a leverage ratio of 66.7%, which would place the company in breach of its debt covenant. These effects are in addition to any difficulties in servicing debt that may arise from the reduced capacity to generate cash flows from the impaired assets. 4. The company may make changes that affect operating, investing and financing activities, such as deferring actual expenditures or restructuring finance, or renegotiating the leverage covenant. Agency theory suggests that the company, through its managers, may also, or alternatively, choose accounting policies that reduce the proximity to restrictive debt covenants. Such accounting policy choices might involve earlier recognition of revenue. For example, some complex contracts with customers may involve multiple components, some of which may be delivered immediately while others involve ongoing service. Allocating more of the consideration paid or payable by the customer to delivered components can result in earlier recognition of revenue. Other techniques involve deferring the recognition of expenses, which may be achieved by allocating expenditure to assets, such as leasehold improvements, rather than expenses, such as repairs and maintenance, or spreading costs over more accounting periods though a longer useful life or straight-line depreciation rather than accelerated depreciation techniques. Another approach is to use offbalance sheet forms of financing, such as leases that are classified as operating leases, rather than those which require an asset and liability to be recognised on the statement of financial position. However, the ability of entities to use leases as a form of off-balance sheet financing was reduced when AASB 16/IFRS 16 Leases became operative.

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Exercise 2.5 Accounting policies In small teams, obtain the financial statements of three publicly listed companies. Refer to the notes to the financial statements pertaining to accounting policies and the note pertaining to property, plant and equipment reported in the statement of financial position. Required 1. Describe the measurement and disclosure components of each company’s policy for accounting for each class of property, plant and equipment. 2. Prepare a report on the comparability of the accounting policies used by the three companies. Drawing on theories explored in this chapter, do you think all companies should be required to use identical accounting policies? (LO1, LO2, LO3 and LO4) The answers to this question will vary with the choice of companies. The following three companies from the Food, Beverage and Tobacco industry group are used to illustrate a response to this question: Bega Cheese Limited (www.begacheese.com.au); Clean Seas Tuna Limited (www.cleanseas.com.au); and Refresh Group Limited (www.refreshgroup.com.au). 1. This discussion draws on information provided in Notes 11 and 32 (p) of the 2016 financial statements of Bega Cheese Limited. Four classes of Property, Plant and Equipment are presented, namely, Land and buildings, Plant and equipment, Leased assets and Construction in progress. Land and buildings, Leased assets and Plant and equipment are measured at cost, less accumulated depreciation. Land is not depreciated. Construction in progress is measured at cost. Construction in progress is not depreciated. When the constructed item is completed and ready for use, it is transferred to Land and buildings, or Plant and Equipment, as appropriate. Leased assets are measured at cost less accumulated depreciation. The carrying amount of leased assets is nil because they are fully depreciated. Straight-line depreciation is used for buildings and plant and equipment. Carrying amounts and a reconciliation of the movement in carrying amounts for each class of asset are provided and details of the range of useful lives of buildings and property, plant and equipment are disclosed. This discussion is based on information in Notes 4.10 and 15 of the 2016 financial statements of Clean Seas Tuna Limited. The Company separately reports carrying amounts and reconciliations of movements in carrying amounts for four classes of Property, Plant and Equipment: Marina Lease; Dams and fishponds; Land and buildings; and Plant and equipment. All classes of PPE are measured at cost, less accumulated depreciation and accumulated impairment (if applicable). The Marina Lease and Dams and fishponds were derecognised during the year ended 30 June 2016, as disclosed in Note 15. Straight-line depreciation is used for buildings, plant and equipment. Separate depreciation rates are disclosed for different classes, such as buildings, and types of assets included in plant and equipment, such as vessels, cages and nets, computers, motor vehicles, and other plant and equipment.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

This discussion is based on information reported in Notes 3.4 and 12 of Refresh Group Limited’s 2016 financial statements. The Company separately reports carrying amounts and reconciliations of movements in carrying amounts for seven classes of Property, Plant and Equipment: Plant and equipment; Furniture and fittings; Office equipment; Motor vehicles; Pallets; Leased equipment; and Work in progress. All categories of Property, plant and equipment (except Work in progress) are measured at cost less accumulated depreciation and accumulated impairment, if applicable. Work in progress is measured at cost and transferred to another class when complete and ready for use. The Company discloses that the straight-line basis of depreciation is used for all depreciable assets other than motor vehicles, which are depreciated using the reducing balance method. Leased assets are depreciated over the shorter of the assets useful life and the term of the lease. Assets are otherwise depreciated over their useful life. The Company discloses the range of useful life for leasehold improvements and plant and equipment. The useful life of motor vehicles is disclosed as 10 years. 2. The measurement policies are extremely consistent. However, differences can be observed in the level of detail provided, particularly with respect to depreciation rates and expected useful life of types of assets. The disclosure of depreciation rates, or useful lives, was often describes as a range which makes it difficult to understand the effects of differences in depreciation charges. Agency theory suggests that regulation prescribing the use of identical accounting policies would potentially reduce firm value. The prescription of certain accounting policies may prevent some firms from choosing the accounting policy that maximises the interests of the firm in terms of its contracts with other parties. For example, changing to a prescribed accounting policy may place some firms in breach of debt covenants. The mechanistic hypothesis suggests that investors focus on reported profit numbers without regard for how they have been calculated. For example, an increase in profit might result from reduced depreciation expenses after assets have become fully depreciated. According to the mechanistic hypothesis investors would ignore the effect of reduced depreciation when reviewing trends in the company’s profit. The mechanistic hypothesis implies that investors would be less likely to be misled when comparing different firms’ financial statements if all companies were required to use the same accounting policies. Lastly, the efficient market hypothesis suggests that if the market is efficient in the semi-strong form, the share price reflects all publicly available information. Accordingly, the use of different accounting policies is not expected to mislead the market provided that information about the accounting policies is disclosed.

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Exercise 2.6 Leases and efficient market hypothesis Accounting standard setters introduced changes to the requirements for accounting for leases, from 1 January 2019. Prior to then, if a lease was classified as a finance lease, the leased asset and a corresponding lease liability were recognised in the statement of financial position of the lessee. However, if a lease was classified as an operating lease, a lease asset and a lease liability were not recognised by the lessee. Instead, lease payments are recognised as expenses as incurred and lease commitments were disclosed in the notes to the financial statements. The following statement has been made in relation to the 2019 changes to accounting for leases. If the efficient market hypothesis is correct, management would be indifferent between classifying the lease as a finance lease or as an operating lease. Required Critically evaluate this statement. (LO5) The evaluation of this statement commences with an explanation of the claim made, and then considers both its strengths and weaknesses. This evaluation argues that there is some merit in the statement but it reflects a misunderstanding of the implications of an efficient market and ignores other reasons why management might be reluctant to recognise a lease liability and corresponding asset. The author (of the statement) asserts that managers would have no preference for classifying a lease as either operating or financing if the market is efficient. The classification of a lease as either operating or financing under AASB 117/IAS 17 Leases has implications for its effect on financial statements. Specifically, when a lease was classified as a finance lease, the leased asset and a corresponding lease liability for the present value of the minimum lease payments are recognised in the statement of financial position. Conversely, when a lease is classified as an operating lease, lease rental is expensed as incurred and the leased asset and corresponding liability are not recognised on the statement of financial position. (The treatment of a lease classified as a finance lease was comparable to the recognition of the right-of-use asset and obligation to pay lease rentals prescribed by AASB 16/IFRS 16 Leases. In contrast, the treatment of a lease classified as operating was comparable to the treatment permitted by AASB 16/IFRS 16 for short-term leases and those for which the underlying asset is of low value.) Market efficiency suggests that the share price would impound all information disclosed about the lease, irrespective of whether it is in the financial statements or in the notes. Although the statement is not specific, the implied form of market efficiency is the semi-strong form in which share prices respond in a rapid and unbiased manner to new publicly available information. Information included in general purpose financial reports is publicly available, irrespective of whether the item is recognised in the financial statements, or only disclosed in the notes to the financial statements. Thus, if the effect on the share price is the same irrespective of whether the lease is classified as a

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

finance lease or an operating lease, management might be expected to be indifferent between the alternative accounting treatments for leases. The claim in the statement and the above argument contain some assumptions, including that managers believe the market to be efficient and act on that belief. Market efficiency does not rely on market participants believing in it. Management might still make choices on a mistaken belief in inefficiency; that some managers act as if the market is not efficient, does not mean it is not efficient. Indeed, market efficiency may be promoted by this disbelief as it acts as an incentive to search out and act upon more information – the so-called paradox of the efficient market hypothesis. Another limitation of the statement is that it ignores other reasons why managers may prefer one accounting treatment over another. For example, debt constraints may give rise to preference for using off-balance sheet finance to keep the firm within a maximum leverage ratio permitted by a debt covenant. Managers may be more concerned about the relative consequences of breaching debt covenants than the market’s reactions to leasing. More generally, the efficient market hypothesis only considers the relationship between the release of information and market reaction, which reflects only one user group (investors). It does not attempt to explain the reactions or financial information literacy of credit analysts, which may influence management’s preference for alternative accounting treatments for leases. In conclusion, the statement that if the market were efficient, share price reactions would be robust to alternative lease classifications is only partly correct. It assumes the classification of leases has no other economic consequences. The extension of the efficient market implications to management’s indifference to alternative lease classifications relies on an invalid assumption that market efficiency relies on management believing in it. The claim is also incorrect to the extent that other factors may influence managers’ preference for lease classifications, and their effect on financial statement numbers. Financial statements can be used to monitor compliance with the debt covenants based on accounting numbers. The use of audited financial statements provided more reassurance of that the financial statements present a true and fair view of the company and are in compliance with accounting standards.

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Exercise 2.7 Mechanistic hypothesis and efficient market hypothesis Hudson Ltd had always classified interest paid as an operating cash flow. In 2022 Hudson Ltd changed its accounting policy and classified interest paid of $50 000 as a financing cash flow in its statement of cash flows. The reported amounts are summarised below.

Net cash inflows from operating activities Net cash outflows for investing activities Net cash outflows from financing activities Net movement in cash

2021 $’000

2022 $’000

400 (300) (50)

450 (300) (100)

Required 1. Describe the mechanistic hypothesis. What does the mechanistic hypothesis predict about how investors and, therefore, share prices will respond to the increase in operating cash flows reported in Hudson Ltd’s 2022 financial statements? 2. Describe the semi-strong form of market efficiency. What does the efficient market hypothesis predict about how investors and, therefore, share prices will respond to the increase in operating cash flows reported in Hudson Ltd’s 2022 financial statements? (LO5) 1. The mechanistic hypothesis predicts that investors will focus on the reported numbers and ignore the underlying methods and classifications used to calculate them. Accordingly, in the absence of other news, the mechanistic hypothesis predicts that the share price would respond favourably to the increase in operating cash flows. 2. The semi-strong form of market efficiency assumes the rapid and unbiased adjustment of prices in response to all publicly available information. Accordingly, if a securities market is efficient in the semi-strong form, security prices reflect all publicly available information. Assuming the market is efficient in the semi-strong form, the efficient market hypothesis predicts that investors would respond to the information contained in the notes to Hudson Ltd’s financial statements as well as to the numbers reported in its statement of cash flows. As this is a cosmetic change in accounting policy, merely impacting on the classification of cash flows rather than the amount of cash generated or used, it would not be expected to have any effect on share prices.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 2.8 Mechanistic hypothesis and efficient market hypothesis Due to a change of accounting standards Lily Ltd reclassified some of its financial instruments in preparing its financial statements for the year ended 30 June 2022. The fair value of the financial instruments actually declined by $2 000 000. The effect of the reclassification was that changes in the fair value of the financial instruments were no longer recognised in the financial statements and this enabled Lily Ltd to report a profit of $6 000 000, which was an increase of 5% over the previous year’s profit. The amount of the decline in the fair value of the financial instruments was disclosed in the notes to the financial statements. Required 1. What does the mechanistic hypothesis predict about how investors and, therefore, share prices will respond to information about the profit reported in Lily Ltd’s 2022 financial statements? 2. Distinguish between the mechanistic hypothesis and the semi-strong form of market efficiency. What does the efficient market hypothesis predict about how investors and, therefore, share prices will respond to information about the profit reported in Lily Ltd’s 2022 financial statements? (LO5) 1. The mechanistic hypothesis suggests that investors respond mechanistically to changes in accounting numbers when analysing financial statements. This hypothesis is based on an assumption that investors ignore differences in the way that those numbers are calculated. In other words, investors fixate on accounting numbers, such as profit, ignoring the implications of any differences or changes in accounting policies. Ceteris paribus (other matters being equal), according to the mechanistic hypothesis, the share price will increase in response to Lily Ltd’s increase in profit. The disclosure of the decline in fair value will not affect the share price because it does not affect reported profit. 2. Rather than assuming investors fixate on accounting numbers reported in financial statements and ignore other information, the semi-strong form of market efficiency suggests that the share price has a rapid and unbiased response to all publicly available information. With reference to the semi-strong form of market efficiency, the efficient market hypothesis suggests that the share price would impound all information disclosed about the change in fair value of the financial instruments, irrespective of whether there are reported in the financial statements or in the notes. It is reasonable to anticipate that the release of information about a decline in the value of assets would result in a drop in the share price, unless the market had already predicted the occurrence and its impact on the firm’s capacity to generate future cash flows.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 2: Application of accounting theory Multiple choice questions 1. In which of the following contexts would accountants be required to exercise professional judgement? a. Deciding whether property, plant and equipment should be measured at fair value after its initial recognition. b. Determining the most appropriate depreciation method to be used for non-current assets. c. Measuring the net realisable value of inventories. *d. All of the options are correct. Answer: d Learning objective 2.1: describe the role of professional judgement in the preparation of financial reports.

2. Considering whether a past event has arisen relates to which of the following components in accounting policy decisions: *a. Definition. b. Recognition. c. Measurement. d. Disclosure. Answer: a Learning objective 2.2: identify the major decision areas in considering policies to account for transactions and other events.

3. Positive theories: a. explain why managers choose a particular accounting method. b. might be descriptive of accounting practice. *c. All of these options are correct. d. rely on real-world observations. Answer: c Learning objective 2.3: explain how normative and positive theories are used in accounting.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. Normative theories are developed using the following process: a. Principles → Assumptions → Objectives → Definitions/Actions. b. Objectives → Definitions/Actions → Assumptions → Principles. c. Definitions/Actions → Principles → Assumptions → Objectives. *d. Objectives → Assumptions → Principles → Definitions/Actions. Answer: d Learning objective 2.3: explain how normative and positive theories are used in accounting.

5. Marcus observes that the bank overdraft account is a liability account and has a credit balance. He also notices that the accounts payable account is a liability account and has a credit balance. Therefore, Marcus comes to the conclusion that all liability accounts have a credit balance. Which approach is Marcus using in developing his theory that all liability accounts having credit balances? a. Conceptual reasoning. b. Conclusive reasoning. *c. Inductive reasoning. d. Deductive reasoning. Answer: c Learning objective 2.3: explain how normative and positive theories are used in accounting.

6. A limitation of the use of inductive reasoning in the development of an accounting theory is that it: *a. does not question the appropriateness of the observed actions. b. attempts to improve a particular process. c. is based on identifying a set of objectives. d. is only useful for developing normative theories. Answer: a Learning objective 2.3: explain how normative and positive theories are used in accounting.

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Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following statements is correct? a. Accounting is only concerned with recording transactions and does not require professional judgement. b. Normative theories tend to maintain the status quo. *c. The process of deductive reasoning starts with objective setting. d. The conceptual framework is developed through an inductive approach. Answer: c Learning objective 2.3: explain how normative and positive theories are used in accounting.

8. Positive accounting theory is based on an economic assumption that all individuals act in their own self-interest and are wealth maximisers. This economic assumption is referred to as the: a. responsible economic person assumption. b. logical economic person assumption. *c. rational economic person assumption. d. reasonable economic person assumption. Answer: c Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

9. Which of the following is not a relationship focused on by positive accounting theory? a. debt contracts. b. political contracts. c. managerial contracts. *d. creditor contracts. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Testbank to accompany Financial reporting 3e by Loftus et al.

10. Which of the following statements is not consistent with agency theory? a. Managers are employed to conduct business on behalf of the shareholders. b. Managers have a legal and fiduciary duty to act in the best interests of the shareholders. *c. Managers are more likely to favour the interests of lenders in managing debt contracts. d. Costs are incurred in monitoring and controlling agent’s behaviour. Answer: c Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

11. An example of monitoring costs is: *a. implementing a management remuneration plan. b. preparing quarterly financial statements for lenders. c. linking management incentives to entity performance. d. measuring the residual loss of the manager purchasing office supplies for his/her own personal use. Answer: a Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice. 12. The majority of monitoring and bonding costs will be borne by: a. shareholders. b. creditors. *c. agents. d. principals. Answer: c Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Residual loss, as an agency cost, refers to: a. the costs incurred by the agent when implementing assurances that they are acting in the principal’s best interests. b. the costs incurred by the principal in observing, evaluating and controlling the agent’s behaviour. c. the amount by which the marginal cost is less than the expected benefit of additional monitoring and bonding. *d. the amount by which the marginal cost exceeds the expected benefit of additional monitoring and bonding. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

14. Positive accounting theory suggests that the separation of ownership and control within an entity means managers, as agents, are likely to act: *a. in their own interests. b. in the interests of the debtholders. c. in the interests of the shareholders. d. in the interests of the directors. Answer: a Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

15. Which of the following is not identified as one of the major problems that can arise in owner-manager agency relationships? a. Risk aversion. b. Dividend retention. *c. Reduced incentives. d. Horizon problems. Answer: c Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Testbank to accompany Financial reporting 3e by Loftus et al.

16. In an owner–manager agency relationship the problem of risk aversion arises because: a. shareholders prefer the managers to take fewer risks in order to maximise the returns on their investment. *b. managers prefer to make decisions that are less risky for the entity as they have more to lose than the shareholders. c. managers have less capital invested in the entity than shareholders. d. shareholders generally have no other sources of income. Answer: b Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

17. An agreement between managers and lenders to maintain a minimum ratio of working capital can assist which of the following problems in relation to increased lender’s risk? a. claim dilution. b. asset substitution. c. underinvestment. *d. excessive dividend payments. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

18. Claim dilution arises when: a. the entity is unable to repay a loan. b. a lender restricts an entity from obtaining debt of a lower priority. *c. the entity takes out a secured loan after obtaining an unsecured loan from another lender. d. a lender restricts an entity from obtaining debt with an earlier maturity date. Answer: c Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

19. The problem of ‘underinvestment’ occurs when managers are reluctant to undertake projects with positive net present value because: a. shareholders prefer less risk than do lenders and managers. *b. the increased funds obtained from the projects will rank higher in priority of payments to creditors over shareholders in the event of the entity being liquidated. c. the projects would result in a reduction of managers’ incentives. d. managers prefer to maintain a high level of funds within the entity. Answer: b Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

20. The following statements about asset substitution are true except for: a. Managers have incentives to use debt finance to invest in higher-risk assets with the expectation of obtaining higher returns for shareholders. *b. Lenders are willing to share higher returns earned when managers invest in higher-risk projects. c. A debt covenant that restricts investment opportunities of the entity can reduce the entity’s borrowing costs. d. Asset substitution arises when an entity uses borrowed funds to invest in higher risk assets than those agreed upon in the debt contract. Answer: b Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

21. An example of political costs is: a. lower taxes on mining companies. *b. economic sanctions imposed on retailers who purchase their supplies from overseas businesses that use child labour. c. excessive consumption of perquisites. d. having a debt covenant. Answer: b Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Testbank to accompany Financial reporting 3e by Loftus et al.

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Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

22. Under the debt hypothesis for accounting policy choice: a. managers act in their own interests and therefore prefer more remuneration. b. managers of entities with bonus plans prefer accounting policies that increase profit in the long-term. c. managers have no discretion in choosing accounting policies relating to debt. *d. managers of entities with high leverage are likely to choose accounting policies that increase profit and equity. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

23. Which of the following statements is true with regards to the political cost hypothesis? a. Political costs arise as a result of an entity’s relationships with shareholders and lenders. b. Managers of financial institutions may prefer to increase profits to reduce government pressure to pass on interest rate cuts. c. Smaller entities are more likely to be the target of environmental groups. *d. Managers of entities that are more politically visible are expected to choose accounting policies that reduce profit in order to avoid political costs. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

24. The horizon problem in owner-manager agency relationships can be reduced by: a. paying a bonus linked to the dividend pay-out ratio. b. encouraging managers to invest in higher risk projects. c. linking management’s bonus to profits. *d. aligning manager’s interests with the longer-term interests of shareholders through sharebased remuneration schemes. Answer: d Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice.

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Testbank to accompany Financial reporting 3e by Loftus et al.

25. Which of the following is not an example of a debt covenant? a. a maximum leverage ratio of 70%. *b. a maximum interest cover of 2.5 times. c. a restriction in the amount of dividends distributed as a percentage of profit. d. a restriction in undertaking mergers and takeovers unless approved by the lender. Answer: b Learning objective 2.4: explain the implications of positive accounting theory for accounting policy choice. 26. Which of the following statements about the efficient-market hypothesis is not correct? a. Security prices in an efficient market rapidly respond to new information. b. Investors in an efficient-market are unable to earn returns greater than those commensurate with the level of risk. *c. Good news of an entity’s future prospects would lead to a decrease in demand for the entity’s shares. d. Increased demand for shares will lead to an increase in the share price. Answer: c Learning objective 2.5: compare the implications of the mechanistic hypothesis and the efficient market hypothesis for financial reporting.

27. The mechanistic hypothesis of capital markets means that: *a. investors are assumed to ignore differences in accounting policies when analysing financial statements. b. investors are not easily fooled by changes in the depreciation rates. c. investors respond differently to increases in profit when they result from cash flow implications as opposed to non-cash flow implications. d. available information can be used to earn returns beyond those that compensate for the risk involved. Answer: a Learning objective 2.5: compare the implications of the mechanistic hypothesis and the efficient market hypothesis for financial reporting.

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Chapter 2: Application of accounting theory Not for distribution in full. Instructors may assign selected questions in their LMS.

28. Which of the following statements about the strong form of market efficiency is not correct? a. Security prices fully reflect all information, including that which is not publicly available. *b. Investors are able to participate in ‘insider trading’. c. Investors are unable to earn abnormal returns through private information. d. Capital markets are not considered to be efficient in the strong form. Answer: b Learning objective 2.5: compare the implications of the mechanistic hypothesis and the efficient market hypothesis for financial reporting.

29. A weak form of market efficiency implies that: a. investors would be able to earn abnormal returns by using publicly available information. *b. a security’s price at a particular time fully reflects the information contained in its sequence of past prices. c. investors would be unable to earn abnormal returns by trading on private information. d. a security’s price at a particular time fully reflects both publicly and privately available information. Answer: b Learning objective 2.5: compare the implications of the mechanistic hypothesis and the efficient market hypothesis for financial reporting.

30. The most relevant form of market efficiency to financial reporting is: a. the weak form. *b. the semi-strong form. c. the strong form. d. None of the options is correct. Answer: b Learning objective 2.5: compare the implications of the mechanistic hypothesis and the efficient market hypothesis for financial reporting.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 3: Fair value measurement

Chapter 3: Fair value measurement Comprehension questions 1. Name three current accounting standards that permit or require the use of fair values for the measurement of assets or liabilities. A list of current accounting standards that permit or require the use of fair values for the measurement of assets or liabilities is as follows: • AASB 2 Share-based payment paragraph 6A • AASB 3 Business combinations paragraph 32 • AASB 5 Non-current assets held for sale and discontinued operations paragraph 15 • AASB 9 Financial instruments paragraph 4.1 • AASB 16 Leases paragraph 34 • AASB 116 Property, plant and equipment paragraph 31 • AASB 127 Separate financial statements paragraph 11 • AASB 136 Impairment of Assets paragraph 18 • AASB 138 Intangibles paragraphs 33, 75 • AASB 140 Investment property paragraph 30 • AASB 141 Agriculture paragraph 13.

2. What are the main objectives of AASB 13/IFRS 13? Discuss why such a standard was considered necessary. The main objectives are of AASB 13/IFRS 13: • to define fair value • to establish a framework for measuring fair value • to require disclosures about fair value measurement (AASB 13, paragraph 1). In response to various accounting scandals and corporate collapses, the International Accounting Standards Board (IASB) issued IFRS 13 Fair Value Measurement in 2011 to provide a more regulated and consistent approach to how companies determine the fair values of their assets and liabilities. The standard also requires companies to disclose more details about their fair value measurements. 3. What are the key elements of the definition of ‘fair value’? Explain the effects of inclusion of each element in the definition. Fair value measurement is based on a hypothetical transaction that includes three key elements: (i)

Current exit price: to sell an asset or paid to transfer a liability.

The current exit price is based on the perspective of the entity that holds the asset or owes the liability. For an asset, the exit price is the expected future cash inflows generated by the acquiring entity from the use of the asset or from the sale of the asset. For a liability, the exit price is the expected future cash outflows for the settlement of the liability or the price to transfer the liability to a market participant. © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(ii)

In an orderly transaction.

AASB 13 defines an orderly transaction as “a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation of distress sale)”. An orderly transaction is one where both parties to the transaction are considered to be at arm’s length. That is, the goods are sold at their full market value, and not at a ‘sale’ or ‘discounted’ price. Factors that would indicate a transaction is not orderly include: • the seller is in or near bankruptcy • the seller was forced to sett to meet regulatory or legal requirements. (iii)

Between market participants.

AASB 13 defines market participants as “buyers and sellers in the principal (or most advantageous) market for the asset or liability”. The market participants must be: • independent of each other. • knowledgeable – have a reasonable understanding of the asset or liability and the transaction using all available information. • able and willing to enter into a transaction for the asset or liability (i.e. they are not forced to enter into the transaction).

4. Compare entry price to exit price for specialised plant. How does AASB 13/IFRS 13 resolve the debate on which price to use? An entry price is one that would be paid to buy an asset or that would be received to incur a liability. An exit price is one that would be received to sell an asset or paid to transfer a liability. They are expected to be the same if they relate to the same asset or liability on the same date in the same form in the same market. This is probably only true in an active market.

5. What are market participants? Is the entity applying AASB 13/IFRS 13 a market participant? The transaction being considered to determine an asset’s or liability’s fair value is a hypothetical one. The entity observes the current market for the same or similar items that are being transacted at their full market price. The market participants in the observed market are the buyers and sellers in the principal (or most advantageous) market that are independent of each other, are knowledgeable and have a reasonable understanding of the transaction and the asset or liability involved, they have the capacity to enter into the transaction, and they are willing (not forced or compelled) to enter into the transaction. The entity applying AASB 113 is not a market participant as per AASB 13. Assumptions made by market participants are not those made by the entity itself. The fair value is not entityspecific. © John Wiley and Sons Australia Ltd, 2020

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Chapter 3: Fair value measurement

6. Does the measurement of fair value take into account transport costs and transactions costs? Explain. Transaction costs are the incremental direct costs to sell an asset or transfer a liability, while transport costs are the costs necessarily incurred to transfer an asset to its most advantageous market. The measurement of fair value requires both costs to be taken into consideration in the determination of the most advantageous market. However, only transport costs are used in the calculation of the fair value number. Transaction costs are entity-specific, transport costs are not; they relate to the asset itself.

7. How does the measurement of the fair value of a liability differ from that of an asset? What are the key steps in determining a fair value measure? The fair value measurement of a liability is the amount paid to transfer a liability to another market participant. It assumes that: the liability will remain outstanding; the transferee will now be required to fulfil the obligation; and the liability is not settled at measurement date. When considering the fair value of an asset, the entity must determine: 1. The particular asset that is the subject of the measurement (consistent with its unit of account). 2. For a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use). 3. The principal (or most advantageous market) for the asset. 4. The valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use in pricing the asset and the level of the fair value hierarchy within which the inputs are categorised. When considering the fair value of a liability, the entity must determine the same steps as for an asset except for step 2. That is, no valuation premise (in-combination or stand-alone) is required for liabilities.

8. Explain the difference between the current use of an asset and the highest and best use of that asset. The current use is how the reporting entity is currently using an asset. The highest and best use is based on how market participants will use the asset. An example of where the two may differ is where land is currently used as a site for a factory, but the land could be used for residential purposes. The current use is industrial while the highest and best use could be either industrial or residential.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

9. Explain the difference between the in-combination valuation premise and the standalone valuation premise. In-combination valuation premise is defined as: • A basis used to determine the fair value of an asset that provides maximum value to market participants principally through its use in combination with other assets and liabilities as a group (as installed or otherwise configured for use). Stand-alone valuation premise is defined as: • A basis used to determine the fair value of an asset that provides maximum value to market participants principally on a stand-alone basis. The highest and best use of an asset establishes the valuation premise used to measure the fair value of that asset. 10. What is the difference between an entity’s principal market and its most advantageous market? Appendix A to ED 181 contains the following definitions: Most advantageous market: • The market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Principal market: • The market with the greatest volume and level of activity for the asset or liability. Because there may be buyers and sellers who are willing to pay high prices and deal outside the principal market, the most advantageous market may not be the principal market. However, an entity may assume that the principal market is the most advantageous market provided that the entity can access the principal market.

11. What are the issues associated with fair value measurement of assets without an active market? Without an active market in which the entity can observe the market participants for the same or similar asset, it is much more difficult to determine the exit price of an asset. According to AASB 13 paragraph 21, if there is no observable market for a particular asset such as a patent or a trademark, the entity must still assume that a transaction takes place at the measurement date. The entity must consider who the market participants might be and how the asset would be dealt with by those participants. When applying a valuation technique to measure fair value, the entity would be considering Level 3 (unobservable) inputs. For the measurement of trademarks, a Level 3 input would be to measure the expected royalty rate that could be obtained by allowing other entities to use the trademark to produce the products covered by the trademark. © John Wiley and Sons Australia Ltd, 2020

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Chapter 3: Fair value measurement

12. What valuation techniques are available to measure fair value? There are three valuation techniques available to measure fair value: • • •

The market approach: prices generated by market transaction The cost approach: prices based on amounts required to replace the service capacity of an asset. The income approach: prices generated by considering future cash flows or future income and expenses.

13. Discuss the differences between the various levels in the fair value hierarchy. Do you agree that the outcomes at all three levels should be described as ‘fair values’? The fair value hierarchy is a hierarchy of inputs into the fair value measurement. The inputs are the assumptions that market participants make when using a valuation technique in pricing an asset or liability. The inputs are classified as observable or unobservable. The fair value hierarchy gives the highest priority to observable inputs and the lowest to unobservable inputs. The hierarchy does NOT prioritise the valuation techniques, just the inputs to those techniques. The fair value hierarchy prioritises inputs into 3 levels – Level 1, 2 and 3. The hierarchy is also used in the disclosure process as a fair value measure is classified in its entirety based on the lowest level input that is significant to the entire measurement.

14. Discuss the use of entity-specific information in the generation of fair value measurements under AASB 13/IFRS 13. Entity-specific factors are only considered to affect the fair value measurement of an asset and do not apply to liabilities. This is due to the fact that an asset can be used for varying purposes by market participants, whereas liabilities are not seen as having alternative uses. Information that is specific to an entity is required to be ignored when considering the fair value of an asset. This is because the fair value is measured on observations of market participants and not with any particular entity. An example of an entity-specific factor would be blockage – discounts on sale of items in blocks or bulk quantities. Assuming all criteria for fair value measurement are met, if a buyer purchases one item, the value of the asset would be its ‘highest and best use’. However, when an entity is offered a discount for purchasing multiple items of the same product, the discounted price per item is lower than its highest or best use. The offering of discounts for bulk purchases in the market place is therefore ignored when determining fair value. Another example of an entity-specific factor is the way in which a particular acquirer would use the asset if they were to purchase it. The fair value must be determined based on the potential uses, and not specific uses, by market participants.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 3.1 Fair values causing tension in the accounting profession Find and read the following article: Cain, A 2013, ‘Fair value continues to captivate’, 2 July, Charter, vol. 84, no. 6, pp. 31–2.

Required What difficulties have been identified by accounting practitioners in relation to the application of fair value measurement? Accounting practitioners have identified the following difficulties in applying fair value measurement: • Although fair value is defined by AASB 13/IFRS 13 Fair Value Measurement, the risk of confusion and misinterpretation arises from the use of other definitions of fair value for other purposes, such as taxation. • The use of fair value may increase the volatility of items reported in the statement of financial position which, in turn, would increase the volatility of reported profits • Amounts reported may be sensitive to the reporting date, as illustrated in the article by a hypothetical example of a share with daily movement in prices of 30%. • Users of financial statements might not understand the implications of fair value measurements on financial statements. • Too much judgement and subjectivity in determining amounts reported in financial statements. • Different approaches to estimation of fair value may reduce the comparability of financial statements. • The highest and best use might yield a valuation that exceeds the future economic benefits expected to be derived from the entity’s use of the asset, particularly in the context of not-for-profit entities.

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Chapter 3: Fair value measurement

Case study 3.2 Fair values and Enron Find and read the following article: Benston, G 2006, ‘Fair value accounting: a cautionary tale from Enron’, Journal of Accounting and Public Policy, vol. 25, no. 4, pp. 465–84.

Required Describe the fair value accounting practices that emerged from the Enron scandal. In your view, are there sufficient safeguards to prevent a similar scandal in future? Benston (2006) describes several fair value practices that were identified in the Enron scandal. The following discussion focuses on the less complex practices, that is, the fair value applications practised by Enron that are less dependent on an understanding of accounting issues covered in subsequent chapters of this book. The fair value measurements used by Enron were typically based on estimated cash flows. They were fair value estimates that would currently be classified as using Level 3 inputs under AASB/IFRS 13 Fair Value Measurement, thus triggering higher levels of disclosure about the estimates used. Fair value accounting for energy contracts: Enron entered into contracts for the long term supply of energy at fixed prices. Based on assumptions of expected future increases in prices, Enron then estimated the fair value of the contract and used that value to record the contract as an asset with a corresponding gain recognised in profit or loss. This practice is effectively capitalising expected future profits as an asset and recognising the corresponding gain in reported profits. Fair value accounting for ‘merchant’ investments: Enron established investment vehicles, such as other companies, which are referred to as merchant investments to embark upon some investment projects. It accounted for its investments in merchant companies as financial assets rather than including all of their assets and liabilities in its consolidated financial statements. Treating the merchant investments as financial assets meant that Enron was permitted to apply fair value measurement in accounting for them. Their fair value was estimated based on assumptions about the future profits and cash flows to be derived from the long term investment projects undertaken by the merchant investment entities. There was inconsistency in the application of fair value in that revaluation increments were recognised but revaluation © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

decrements were ignored or delayed. This practice effectively combined off-balance sheet financing and investment with capitalisation of expected future profits as an asset and recognising the corresponding gain in reported profits. Energy management contracts: These involved two applications of fair value accounting. First, Enron’s investment in ‘Enron Energy Services’, a retail energy supply business, was revalued and the corresponding gain, recognised in profit or loss. This was similar to the treatment of ‘merchant investments’ described above. Second, contracts with companies and institutions for the supply of energy were marked to fair value, based on assumptions of expected future profits from the contracts. This practice is effectively recognising profits when entering into the contract, rather than as the energy is supplied in accordance with the terms of the contract. Investment in broadband services: Enron’s business model for this venture involved swapping surplus (dark) fibre on its network for the right to use the fibre of other networks. Enron recognised gains in profit or loss by revaluing dark fibre. It also established a tech startup, Avici Systems, which it floated on the stock exchange. Enron revalued its shares in the Avici Systems based on the observed market price but this was not actually applicable to Enron’s holding of Avici Systems securities, which was subject to trading restrictions. The gain on revaluing the shares was also recognised in profit or loss, which would be typical for securities held for trading. Blockbuster partnership: Enron entered into a partnership with Blockbuster to broadcast films. Although Enron did not have the technology to required, and Blockbuster did not have the rights to broadcast the films, Enron measured its investment in the project at fair value based on assumed future profits. Subsequent increments in fair value, based on assumed growth in future profits, were recognised in profit or loss even though the project did not generate any revenue. Derivative financial instruments: Enron accounted for its holding of derivative financial instruments at fair value through profit or loss. While this is normal practice and consistent with both US GAAP (Generally Accepted Accounting Principles) and IFRSs at the time, the measurement of fair value was questionable. Benston reports that it was common practice for yield curves to be manipulated to manage reported numbers. As will be seen in later chapters in this book, accounting for contracts with customers at fair value and recognising income from initial measurement or subsequent remeasurement is not consistent with AASB 16/IFRS 16 Revenue from Contracts with Customers. That standard requires revenue to be recognised as each performance obligation is satisfied. Some of the other applications of fair value by Enron involved complex contractual arrangements that may be affected by multiple accounting standards. For instance, some contracts included embedded derivatives and the appropriate treatment can vary depending on specific terms of the contract, such as whether the parties can settle on a net basis instead of delivery of the commodity. However, AASB 13/IFRS 13 Fair Value Measurement prescribes extensive disclosure requirements for fair value estimates that use Level 3 inputs. These disclosure requirements are likely to deter scandalous applications of fair value such as those adopted by Enron, and at the very least would provide users with more information with which to assess the credibility of the estimates used.

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Chapter 3: Fair value measurement

Case study 3.3 Fair values and the conceptual framework Find and read the following article: Whittington, G 2008 ‘Fair value and the IASB/FASB Conceptual Framework project: an alternative view’, Abacus, vol. 44, no. 2, pp. 139–68.

Required Whittington argues there are two broad schools of thought in relation to measurement: the fair value view and the alternative view. What are the main conceptual features of these two views? Explain which view you prefer. The fair value view assumes markets are relatively perfect and complete and therefore financial reports should meet the needs of passive investors and creditors by reporting fair values derived from current market prices. Fair value is considered to be an exit value (the price received to sell an asset) and does not include transaction costs. The emphasis is on the best price that could be gained from a hypothetical market as opposed to the actual price that would be obtained between specific entities involved in the transaction. The main conceptual features of the fair value view are: • Usefulness for economic decisions is the sole objective of financial reporting. • Current and prospective investors and creditors are the reference users for general purpose financial statements. • Forecasting future cash flows, preferably as directly as possible, is the principle need of those users. • Relevance is the primary characteristic required in financial statements. • Reliability is less important and is better replaced by representational faithfulness, which implies a greater concern for capturing economic substance, and less with statistical accuracy. © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

Accounting information needs ideally to reflect the future, not the past, so past transactions and events are only peripherally relevant.

The implications of the fair value view are: • Stewardship is not a distinct objective of financial statements, although its needs may be met incidentally to others. • Present shareholders have no special status amongst investors as users of financial statements. • Past transactions and events are relevant only insofar as they can assist in predicting future cash flows. • Prudence is a distortion of accounting measurement, violating faithful representation. • Cost (entry value) is an inappropriate measurement basis because it relates to a past event (acquisition) whereas future cash flow will result from future exit, measured by fair value. • Fair value, as market selling (exit) price, should be the measurement objective. • The balance sheet is the fundamental financial statement, especially if it is fair valued. • Comprehensive income is an essential element of the income statement: it is consistent with changes in net assets reported in the balance sheet. The alternative view assumes markets are relatively imperfect and incomplete and such a market setting suggest that financial reports should meet the monitoring requirements of current shareholders (stewardship) by reporting past transactions and events using entityspecific measurements that reflect the opportunities actually available to the reporting entity. The main features of the alternative view are: • Stewardship, defined as accountability to present shareholders, is a distinct objective, ranking equally with decision usefulness. • Present shareholders of the holding company have a special status as users of financial statements. • Future cash flows may be endogenous: feedback from shareholders (and markets) in response to accounting reports may influence management decisions. • Financial reporting relieves information asymmetry in an uncertain world, so reliability is an essential characteristic. • Past transactions and events are important both for stewardship and as inputs to the prediction of future cash flows (as indirect rather than direct measurement). • The economic environment is one of imperfect and incomplete markets in which market opportunities will be entity-specific. The implications of the alternative view are: • The information needs of present shareholders, including stewardship requirements must be met. • Past transactions and events are relevant information and, together with reliability of measurement and probability of existence, are critical requirements for the recognition of elements of accounts, in order to achieve reliability. • Prudence, as explained in the current IASB Framework and in the ASB's Statement of Principles, can enhance reliability. • Cost (historic or current) can be a relevant measurement basis, for example as an input to the prediction of future cash flows, as well as for stewardship purposes.

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Chapter 3: Fair value measurement

•

The financial statements should reflect the financial performance and position of a specific entity, and entity specific assumptions should be made when these reflect the real opportunities available to the entity. Performance statements and earnings measures can be more important than balance sheets in some circumstances (but there should be arithmetic consistency— articulation—between flow statements and balance sheets).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 3.4 Fair values of property, plant and equipment in the United States Find and read the following article: Hermann, D, Saudagaran, S. & Thomas, W 2006, ‘The quality of fair value measures for property, plant and equipment’, Accounting Forum, vol. 30, no. 1, July, pp. 43–59.

Required Summarise the history of revaluations of property, plant and equipment in the United States. What concerns led the United States to prevent property, plant and equipment being carried at an amount above cost to the entity? Revaluation of property, plant and equipment (PPE) fell within the range of Generally Accepted Accounting Principles in the US (US GAAP) until around 1940. Although never explicitly prohibiting the use of fair values, the Securities and Exchange Commission (SEC) began discouraging the use of fair value accounting for PPE and the disclosure of fair values of PPE in the financial statements in the late 1930s. By the 1940s the SEC effectively removed the option to recognise PPE at fair value through its regulation of information filed by companies with the SEC. By the 1950s, this had been extended to banning the disclosure of the fair value of PPE in the notes to the financial statements. The formal prohibition of fair value accounting was made by the Accounting Principles Board of the AICPA in 1965. The SEC’s attitude towards fair value accounting for PPE reflected concerns about the use of unsubstantiated valuations in the 1920s (before the SEC came into existence) (Zeff 1995) and the view that the fair value measurements are too soft, i.e., too subjective (Schuetze 2001).

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Chapter 3: Fair value measurement

Case study 3.5 Fair value accounting: the shortcomings Find and read the following article: Benston, G 2008, ‘The shortcomings of fair value accounting described in SFAS 157’, Journal of Accounting and Public Policy, vol. 27, no. 2, March–April, pp. 101–14.

Required Summarise Benston’s main criticisms of fair value accounting in the United States and discuss if they are also applicable to AASB 13/IFRS 13. Benston (2008) argues that fair value measurements that are not based on actual market prices are costly to determine and difficult to verify. The estimation of fair value require identification of what the market would consider to be the highest and best use of the asset. This problem applies equally to the measurement of fair value under AASB 13/IFRS 13 Fair Value Measurement. Benston (2008) criticises the illustrative examples in the implementation guidance in Appendix A of SFAS 157 because they include calculations of value-in-use and entrance values. The value-in-use is inconsistent with the definition of fair value because it is entity-specific rather than capturing how a hypothetical market would value the asset. The use of entry prices is considered to be inconsistent with the exit value approach adopted in the definition of fair value. These criticisms also apply to AASB 13/IFRS 13. The cost approach as a valuation technique is permitted (refer AASB 13/IFRS 13 Appendix B, paragraphs B8-B9). Similarly, the income approach, in particular present value techniques, involves very similar calculations to value in use (refer AASB 13/IFRS 13 Appendix B, paragraph B10-B30). However, as noted in AASB 13/IFRS 13 Illustrative Examples, paragraph IE4, there are circumstances in which the entry price and exit price are the same. Further, it should be noted the present value techniques may provide be a reasonable approximate of the value that would be placed on the asset by the market, particularly where there is no reason to expect that the entity’s use of the asset is different from the highest and best use. Another reason for Benston (2008)’s criticisms of the illustrations provided in the implementation guidance for SFAS 157 is the inclusion of transactions costs, contrary to the definition in the Standard. This problem does not appear to apply to AASB 13/IFRS 13 where

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

transaction costs are only used to determine which market is most advantageous in the absence of a principal market for the asset. Benston (2008) is concerned that the examples for SFAS 157 do not include inventories and non-current assets acquired in a business combination. He suggests that work-in-progress inventories may have a fair value below cost because of the difficulty of selling unfinished goods. He further suggests that this would result in the recognition of losses. This argument is inconsistent with the current requirements under AASB 3/IFRS 3 Business Combinations for accounting for a business combination as fair value adjustments are not recognised as income or expenses of the acquirer. Lastly, Benston (2008) suggests that fair values relying on Level 2 or Level 3 inputs are easily manipulated. Further, such estimates of fair value are costly to measure and difficult for auditors to verify and challenge. This criticism also applies to fair values measured using Level 2 and Level 3 inputs under AASB 13/IFRS 13.

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Case study 3.6 Fair value measurement disclosures Find a recent annual report of a top 50 company listed on the Australian Securities Exchange (www.asx.com.au) that includes some assets and/or liabilities measured at fair value at the reporting date. Required Consistent with the requirements of AASB 13/IFRS 13, what disclosures have been made in the notes to the financial statements regarding the fair value measurement of assets and liabilities? Describe why the disclosures provide useful information to the users of the financial statements. Students should find an annual report of a top 50 company listed on the ASX website (www.asx.com.au) and comment on the fair value disclosures that are included in the report.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 3.1 Valuation premise for measurement of fair value Maple Ltd conducts a business that makes women’s handbags. It operates a factory in an inner suburb of Perth. The factory contains a large amount of equipment that is used in the manufacture of handbags. Maple Ltd owns both the factory and the land on which the factory stands. The land was acquired in 2013 for $400 000 and the factory was built in that year at a cost of $1 040 000. Both assets are recorded at cost, with the factory having a carrying amount at 30 June 2023 of $520 000. In recent years a property boom in Perth has seen residential house prices double. The average price of a house is now approximately $1 000 000. A property valuation group used data about recent sales of land in the area to value the land on which the factory stands at $2 000 000. The land is now considered prime residential property given its closeness to the city and, with its superb ocean views, its suitability for building executive apartments. It would cost $200 000 to demolish the factory to make way for these apartments to be built. It is estimated that to build a new factory on the current site would cost around $1 560 000. Required The directors of Maple Ltd want to measure both the factory and the land at fair value as at 30 June 2023. Discuss how you would measure these fair values. (LO3) The following steps should be followed in the measurement of these fair values: 1. Determine the asset or liability that is the subject of measurement: In this case, there are 2 assets that could be measured at fair value, namely land and factory. An alternative would be to consider the land and the factory as a single asset. 2. Determine the valuation premise consistent with the highest and best use: The land could be sold for residential purposes for an estimated $2 000 000. Given the cost to demolish the existing factory of $200 000, the land could be sold for residential purposes for $1 800 000. Measuring fair value in this fashion assumes a specific use and is based on an in-exchange valuation premise as the land is considered on a stand-alone basis. The land and factory could also be sold as a package for use by market participants in conjunction with other assets. The factory has been depreciated by the reporting entity to half its original cost. Given the cost to build a new factory is $1 560 000, a depreciated replacement cost of the existing factory could be said to be $780 000. However, as the factory could presumably be viably built on a cheaper block of land i.e. one not usable for residential purposes, it is unlikely that there is a market for the land and the factory on an in-use basis. A market participant would be forced to pay the $1 800 000 for the factory and the land given the alternative use of the land for residential purposes. 3. Determine the most advantageous market for the assets: The most advantageous market would appear to be the selling of the property for residential purposes. 4. Determine the valuation technique: The market approach would be the appropriate valuation technique given that there are observable market inputs in relation to the selling © John Wiley and Sons Australia Ltd, 2020

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prices of similar properties. The land has a fair value based on market prices for similar properties of $1 800 000. The factory has a zero fair value as a separate asset. Illustrative Example 3.2 considers a similar situation to this case. The highest and best use of the land is determined by comparing: (i) the value of the land as a vacant block for residential purposes which would include the factory at a zero fair value, and (ii) the value of the land as currently developed for industrial use which would include the factory as an ongoing asset. The highest and best use is the higher of these two values. • If (i) is chosen, then the factory has a zero fair value and no subsequent depreciation would be determined. • If (ii) is chosen, then it would be necessary to determine the fair value of the land separate from the fair value of the factory in order to depreciate the factory. It could be argued that the fair value of the factory equals the difference between the fair value of the land for residential purposes and the fair value of the combined assets.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.2 Valuation techniques and inputs used An entity acquired a machine in a business combination that is held and used in its operations. The machine was initially acquired from a supplier and was then customised by the entity for use in its own operations. The highest and best use of the machine is its use in combination with other assets as a group. The valuation premise is then ‘incombination’. Required 1. What two valuation techniques could be used to determine the fair value of the machine? 2. What would be the level of the inputs to the two valuation techniques? (LO3) 1. The two valuation techniques that could be used to determine the fair value of the machine are: • The market approach: the entity would need to obtain quoted prices for comparable machines then adjust the price for factors such as wear and tear, age, location, transport costs and the customisation costs for use in its own operations. • The cost approach: the entity would need to determine the cost of a custom-made machine that is identical in size and usefulness to the one it already has. Another option would be to acquire a new machine that is similar to the one required and then determine the costs to customise the new machine for its own operations. 2. The inputs used for each valuation technique are: • Market approach – Level 2 inputs – costs for a machine are observable, but are not for an identical asset. • Cost approach – Level 2 inputs – the costs would include the raw materials and labour incurred by the entity to build the customised machine itself. Alternatively, the costs would be the payment to another entity to build the machine for them. If a similar machine is purchased, the cost would be that paid for the similar asset plus costs incurred to customise it for the entity’s own operations.

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Exercise 3.3 Highest and best use A response to the IASB’s Exposure Draft 2009/5 Fair Value Measurements, stated: In practical terms we doubt that an asset measured on any other basis than its intended use will provide more useful information to readers. The fact that, say, a site used for production would have a higher market value if it were redeveloped for retail purposes, is not relevant if the entity is not engaged in retail or, more obviously, needs the site in order to carry out its production operations. The risk here is that the fair value measure, as redefined, results in irrelevant information. Required Discuss the issues associated with measuring the fair value of a site currently used for production, but which could be redeveloped for retail purposes. (LO3) Fair value is to be measured by considering the ‘highest and best use’ of the asset. AASB 13 paragraph 28 has the following requirements for determining the highest and best use: • it must be physically possible to use the asset for the entity’s purposes. • it must be legally permissible, that is, not subject to any legal restrictions (e.g. heritagelisted, zoning regulations). • it must be financially feasible and capable of generating sufficient income or cash flows to produce the required investment return. The value to be applied would be the one that maximises the value of the asset or the group of assets and liabilities within which it is to be used. It is not based on the current use of the asset, instead, it is based on how the market participants would use the asset. Once the asset’s highest and best use has been established, the next step in determining its fair value is to select one of two valuation premises: in-combination; and stand-alone. In this example, there are two possible uses for the site: 1. Continue to use the site for its current production purposes. In this instance the valuation premise would be the in-combination valuation premise. Both the land and the production facilities would be sold together so that the market participant could continue to use the site for the same production purposes. The fair value of the land would be based on its suitability to continue being used for production. The fair value of any production facilities would be based on their ability to maintain existing production. 2. Redevelop the site for retail purposes. In this instance, the valuation premise is the standalone valuation premise. The land on which the production takes place would be sold as a stand-alone asset, separate to the production facilities, which, in turn, would be expected to be demolished to make way for the redevelopment. The production facilities would therefore have a zero fair value and the fair value of the land would be based on the amount that would be received on sale to the redevelopers.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.4 Highest and best use Cellar Ltd is in the business of bottling wine, particularly for small wineries that cannot afford sophisticated technical equipment and prefer to concentrate on the growing of the grapes. The white wine and champagne bottles used by Cellar Ltd have a built-in insulation device that keeps the contents of the bottle cold even when held in the hand. In January 2023, Solar-Blue, a company experimenting with energy sources useful in combating climate change, produced a device which, when attached to the outside of a container, could display the actual temperature of the liquid inside. The temperature was displayed by the highlighting of certain colours on the device. How this device could exactly be used with wine bottles had yet to be specifically determined. However, Cellar Ltd believed that its employees had the skills that would enable the company to determine the feasibility of such a project. Whether the costs of incorporating the device into wine bottles would be prohibitive was unknown. Cellar Ltd was concerned that competing wine-bottling companies might acquire the device from Solar-Blue, so it paid $100 000 for the exclusive rights to use the device in conjunction with bottles. Required The accountant wants to measure the fair value of the asset acquired. Discuss the process of determining this fair value. (LO3) The following steps should be followed in the measurement of this fair value: 1. Determine the asset or liability that is the subject of measurement. In this case, the asset is the right to use the temperature-revealing device. 2. Determine the valuation premise consistent with the highest and best use. To measure the fair value of the asset at initial recognition, the highest and best use of the asset is determined on the basis of its use by market participants. There are a number of possible uses for the asset: (a) Cellar Ltd could continue to develop the device for use with bottles - how the device could be used with wine bottles has yet to be specifically determined. Cellar Ltd believes its employees have the skills to be able to investigate this possibility. The fair value measured would then be based on a stand-alone valuation premise and would be based on the price that would be received in a current transaction to sell the device to market participants, assuming that there are other wine makers, or even soft drink companies that would be able to use the device in conjunction with their bottling activities. (b) Cellar Ltd could decide to cease development of the device in relation to its applicability to use with bottles. In valuing the asset, the assumption is then that other market participants would also lock up the device based upon a defensive competitive strategy, reducing the risk that competitors could achieve a significant marketing edge and so substantially increase market share. The appropriate assumption is then a standalone valuation premise. (c) Cellar Ltd could consider that the highest and best use of the asset is to cease development of the project as other market participants would also cease development © John Wiley and Sons Australia Ltd, 2020

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if they acquired the asset. This may be the case where market participants do not consider that the device will eventually be able to be used with bottles and so the device will not provide a market rate of return if completed. The fair value would be determined by considering what market participants would pay for the rights to use the device for bottles if Cellar Ltd sold this asset to them. 3. Determine the principal (or most advantageous market) for the assets. The most advantageous market would be determined by considering the three scenarios in part 2 above, and taking into account the transport and transaction costs. 4. Determine the valuation technique. This asset is a unique asset. There are no similar assets on the market. Hence a market valuation approach is not applicable. An income valuation approach could be used based on the expected extra cash flows that could be derived from sales once the device has proved to be successful. Given that the device still has to be proved to be useful in relation to bottles, this requires a great deal of judgement. The cost approach would require the determination of the costs required to develop a similar device and have the rights to its use. This would be difficult for Bream Ltd to be able to calculate with any reliability. It is expected that the income valuation approach would be the most applicable method. In deciding to pay Solar-Blue $100 000 for the rights to use the device, it is assumed that Cellar Ltd would have investigated the possible effects on its profits and market share if its competitors had acquired the device from Solar-Blue.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.5 ‘In-combination’ valuation premise Palm Ltd acquired a business that used a large number of assets that worked in combination to produce a product saleable in offshore markets. The assets of the business include a computer program that transfers the inputs to the manufacturing process around the assets that work together to produce the output. In measuring the fair value of the computer program, management of Palm Ltd determined that the valuation premise was ‘in-combination’ as the program worked together with other assets in the business. Required Discuss how the various valuation approaches may be applied in the determination of the fair value of the computer program. (LO3) The computer program would provide the best value to market participants through its use with other assets as the program works with other assets in the manufacturing process. Hence, the in-combination valuation premise is appropriate for this asset while the highest and best use for the asset is its current use within the manufacturing process. The market valuation approach would not be applicable if the software program is unique. Use of the market valuation approach would require the existence of comparable software assets. The income approach could be applied with a present value technique being used. The cash flows used in this technique would be based on the income stream expected to result from the use of the computer program over its economic life. This may be determined by considering what market participants would pay as a licence fee to be able to use the computer program in their businesses. The cost approach could also be used. This approach would require the estimation of what it would cost currently to construct a substitute computer program that would perform the same tasks as the program being valued. A difficulty in this process could arise if some of the components of the program are unique and difficult to replicate by another market participant.

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Exercise 3.6 Most advantageous market Asset PYJ is sold in three different active markets. • In Market I, the price that would be received is $54; transaction costs are $4 and the transport costs are $6. • In Market II, the price that would be received is $52; transaction costs are $4 and the transport costs are $2. • In Market III, the price that would be received is $58; transaction costs are $8 and the transport costs are $2. Required 1. What is the most advantageous market for Asset PYJ and what is its fair value? 2. If the principal market for Asset PYJ were Market I, then what would be the fair value of Asset PYJ ? (LO3) 1. The most advantageous market is the one that maximises the amount that would be received to sell the asset after taking into account transaction costs and transport costs.

Price that would be received Transaction costs Transport costs Net amount receivable

Market I Market II Market III $54 $52 $58 (4) (4) (8) (6) (2) (2) $44 $46 $48

Market III is the most advantageous market as it has the highest net amount receivable of $48. 2. The fair value of an asset is not adjusted for transaction costs as they are specific to the transaction in the specific market and therefore would change depending on the market participant. The transport costs, however, are specific to the location of the asset. Therefore, they do affect the fair value of an asset. In this example, if the principal market for the asset was Market I, the fair value of the asset would be $48. ($54 less the transport costs of $6).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.7 Characteristics of an assets Dr Mosby owned a large house on a sizeable piece of land in Darwin. His ancestors had been some of the first settlers in the area and the property had been in the family since around 1889. Dr Mosby was 92 years old and had become incapable of taking care of the large property. He wanted to move into a retirement village and so sold his property to the RuralMed Group, which was an association of doctors. The doctors wanted to use the house for their medical practice as it was centrally situated, had many rooms and had an ‘old-world’ atmosphere that would make patients feel comfortable. The house was surrounded by a large group of trees that had been planted by the Anderson family over the years. The trees covered a large portion of the land. RuralMed did not want to make substantial alterations to the house as it was already suitable for a doctors’ surgery. Only minor alterations to the inside of the house and some maintenance to the exterior were required. However, RuralMed wanted to divide the land and sell the portion adjacent to the house. This portion was currently covered in trees. The property sold would be very suitable for up-market apartment blocks. It was a condition of the sale of the property to RuralMed that while Dr Mosby remained alive the trees on the property could not be cut down, as it would have caused him great distress. This clause in the contract would restrict the building of the apartment blocks. However, this restriction would not be enforceable on subsequent buyers of the property if RuralMed wanted to sell the property in the future. A further issue affecting the building of the apartment blocks was that across one corner of the block there was a gas pipeline that was a part of the city infrastructure for the supply of gas to Darwin residents. Required Outline any provisions in AASB 13/IFRS 13 that relate to consideration of restrictions on the measurement of fair values of assets. Describe how the restrictions would affect the measurement of the fair value of the property by RuralMed. (LO3) The relevant paragraphs of AASB 13 are: • Paragraph 11: Fair value measurement shall consider the characteristics of an asset or liability e.g. condition, location and restrictions on sale or use. • Paragraph 20: although an entity must have access to the market at the measurement date, it does not need to be able to sell the particular asset or transfer the liability on that date if there are restrictions on the sale of the asset. • Paragraph 28(b): Highest and best use must be a legally permissible use, taking into account any legal restrictions on the use of the asset. Paragraph BC46 states that restrictions on the sale or use of an asset affect its fair value if market participants would take the restrictions into account when pricing the asset at the measurement date. Paragraph BC100 states that restrictions on the transfer of an asset relate to the marketability of an asset. The inclusion of a restriction preventing the sale of an asset typically results in a lower fair value for the restricted asset than for the non-restricted asset, all other factors being equal. © John Wiley and Sons Australia Ltd, 2020

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Note that the adjustment for a restriction is not a Level 1 input, and if the adjustment is significant, the fair value measure would be categorised at a lower level of the fair value hierarchy. The asset considered in this case is the house and the land. There are no restrictions on the house but there are restrictions on the land. There are 2 restrictions on the land: • the trees cannot be cut down until Dr Mosby dies; and • there is a gas pipeline across one corner of the land. The restriction on the cutting down of the trees is enforceable on RuralMed but not on any subsequent buyers of the property. Because the restriction is specific to RuralMed and not to other market participants the restriction is not considered in measuring the fair value of the property – fair value measurement is not entity-specific. Therefore the fair value of the land is based on the higher of its fair value as the grounds of the current property, i.e. on an incombination valuation premise – and its fair value in exchange to market participants i.e. on a stand-alone valuation premise, considering the use of the property as a residential building site. The restriction on the property in relation to the felling of the trees is not a consideration in this measurement process. The restriction in relation to the gas pipeline is a condition specific to the asset itself in the same way as the condition or location of an asset is specific to an asset. This restriction is transferred to subsequent buyers of the property, the market participants. Measurement of the fair value of the property must then take into consideration the existence of the restriction and the effect on the valuation of the property. For example, if a building cannot be built over the pipeline as the gas authorities may need access to the pipeline, then this restricts the size of any building that could be built on the property. This affects the value of the land regardless of whether an in-use or an in-exchange valuation premise is applied.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.8 Market participants Brumby Ltd recognises that the concept of ‘market participants’ is an important part of the measurement of fair value. It has determined that market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that have the following characteristics: • They are independent of each other. • They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction. • They are able to enter into a transaction for the asset or liability. • They are willing to enter into a transaction for the asset or liability. Required The group accountant for Brumby Ltd has asked for your advice on the following matters. Provide a response to the group accountant, referring to relevant paragraphs of AASB 13/IFRS 13. 1. Does an entity have to specifically identify market participants? 2. How should an entity determine what assumptions a market participant would make in measuring fair value? 3. If an entity is unwilling to transact at a price provided by a market participant, can that price be disregarded? (LO3) 1. According to AASB 13 paragraph 23, an entity does not have to identify specific market participants. Instead the entity should consider what type of entities normally trade in these markets i.e. what are the characteristics of market participants that would generally transact for the asset in question? The object is to determine what factors/assumptions would be made or considered by the entities that trade in these markets. 2. Fair value is not the value specific to the reporting entity, but is a market-based measurement. If market participants would consider adjustments for liquidity, uncertainty and/or nonperformance risk then the fair value determined must take these into account. In general the reporting entity should rely on market observable data. Where this is not available an entity can use its own data as a basis for its assumptions. However, adjustments should be made to the entity’s own data if readily available market data indicates that market participants would differ from the assumptions specific to that reporting entity. An entity needs to consider: • the asset itself and any specific characteristics of the asset, • the features of the principal (most advantageous) market, and • the market participants themselves. 3. Determination of fair value is based on a transaction between market participants at the measurement date, not between the reporting entity and another market participant. • Market participants are assumed to act in their own economic best interest (paragraph 22) i.e. in a manner consistent with the objective of maximising the value of their business.

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•

Market participants must be willing to enter into a transaction i.e. they are motivated to do so but are not compelled or forced to do so.

Hence the question to be answered is why is the entity unwilling to transact at that price? If other participants are willing to transact at that price and that is the current price in the market then that price cannot be disregarded. Hence, if the entity prefers not to trade for a period of time but rather prefers to hold onto the asset(s) until the market picks up then it cannot use this reason to disregard the price.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.9 Determination of fair value Pine Ltd holds an asset that is traded in three different markets: Market A, Market B and Market C. Pine Ltd normally trades in Market C. Some information gathered in relation to these three markets is as follows.

Required Using the above information, explain how Pine Ltd should measure the fair value of the asset it holds. (LO3) Firstly, Pine Ltd needs to establish the most advantageous market for the asset. This is the market that maximises the amount that would be received to sell the asset – net of transaction and transport costs.

Total amount that would be received Transport costs Transaction costs Net amount received

Market A Market B Market C $3 000 000 $1 152 000 $636 000 (180 000) (72 000) (48 000) (60 000) (48 000) (24 000) $2 760 000 $1 032 000 $564 000

The most advantageous market for Pine Ltd is Market A with a total of $2 760 000 that could be received from the sale of the asset. Now that the most advantageous has been determined the fair value of the asset can be determined. The fair value of the asset is $2 820 000, being the amount receivable less transport costs.

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Exercise 3.10 Liability held as an asset On 1 January 2022, Kangaroo Ltd issues at par $2 million A-rated 5-year fixed rate debt securities with an annual coupon interest of 8%. On 31 December 2022, investments in the debt securities are trading as an asset in an active market at $1 900 per $2 000 of par value after payment of accrued interest. Kangaroo Ltd uses the quoted price of the asset in an active market as its initial input into the fair value measurement of the debt securities liability. Required Determine the fair value of the debt securities at 31 December 2022. What other factors may need to be included when determining the fair value of the liability? (LO3 and LO4) The debt securities are trading in an active market, therefore, the fair value of the liability is to be based on the quoted market price at 31 December 2022. The liability would be reported in Kangaroo Ltd’s statement of financial position at 31 December 2022 as $1 900 000. That is, $1 900 x ($2 000 000 / $2 000). Other considerations would be whether or not the quoted price of $1 900 per $2 000 includes the effect of factors that are not applicable to the fair value of a liability - for example, the effect of third-party credit ratings.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.11 Present value technique: decommissioning liability On 1 July 2022, Panda Ltd assumed a decommissioning liability in a business combination. The entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is estimated to be 10 years. If Panda Ltd were contractually allowed to transfer its decommissioning liability to a market participant, Panda Ltd considers that the market participant would need to take into account the following inputs. • • • • • • •

Expected labour costs: $152 500 Allocation of overhead costs: $115 000 Contractor’s profit margin: 20% of total labour and overhead costs Inflation factor: 4% p.a. for 10 years Market risk premium paid for undertaking risks involved: 5% Time value of money, represented by the risk-free rate: 5% Non-performance risk including Panda Ltd’s own credit risk: 3.5%

Required Determine the fair value of the decommissioning liability at 1 July 2022 using the present value technique. (LO4) The fair value of Panda Ltd’s decommissioning liability is calculated as follows:

Expected labour costs Allocated overhead costs Contractor’s profit margin [0.2 x ($152 500 + $115 000)] Expected cash flows before inflation adjustment Inflation factor (4% for 10 years = 1.0410) Expected cash flows adjusted for inflation Market risk premium (0.05 x $475 144) Expected cash flows adjusted for market risk Expected present value (discount rate 8.5% for 10 years = 0.4423)

Expected cash flows ($) at 1 July 2022 152 500 115 000 53 500 321 00 1.4802 475 144 23 757 498 901 $220 664

Therefore, the fair value to be reported in Panda Ltd’s financial statements is $220 664.

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Exercise 3.12 Valuation of liabilities and non-performance risk Wallaby Ltd and Dingo Ltd enter into a contractual obligation to pay cash of $50 000 to Bandicoot Ltd in 5 years’ time. Wallaby Ltd has a AA credit rating and can borrow at 4%. Dingo Ltd has a BBB credit rating and can borrow at 10%. At initial recognition, the fair value of the liability of each entity must reflect the credit standing of that entity. Required 1. Determine the fair values of the contractual obligations of Wallaby Ltd and Dingo Ltd to Bandicoot Ltd on initial recognition. 2. Assume Wallaby Ltd’s credit rating decreases to AA– by the end of the first year and its borrowing rate changes to 6%, while Dingo Ltd’s credit rating improves to BB and its borrowing rate changes to 8%. Determine the fair value measurements of the contractual obligations after based on the new credit ratings. If the change in fair value of the liability was recognised, would a decline in the credit rating give rise to a gain or loss? (LO4) 1. Wallaby Ltd would calculate the fair value of its obligation based on its own ability to pay the debt as affected by its own credit risk. Therefore, the fair value of Wallaby Ltd’s liability is calculated using the present value technique. $50 000 x 0.8219 (PV of single amount at the end of 5 years at 4%) = $41 095 The fair value of the contractual obligation for Dingo Ltd is calculated the same way as that for Wallaby Ltd except the interest rate of 10% must be used. Therefore, the fair value of Dingo Ltd’s liability is calculated using the present value technique. $50 000 x 0.6209 (PV of single amount at the end of 5 years at 10%) = $31 045 2. If Wallaby Ltd’s credit rating decreases and its borrowing rate changes to 6%, the fair value of its contractual obligation will be calculated as: $50 000 x 0.7473 (PV of single amount at the end of 5 years at 6%) = $37 365 If Dingo Ltd’s credit rating improves and its borrowing rate changes to 8%, the fair value of its contractual obligation will be calculated as: $50 000 x 0.6806 (PV of single amount at the end of 5 years at 8%) = $34 030 When an entity’s credit rating decreases its cost of borrowing increases. The fair value of a liability based on the present value technique may decrease as a result, giving rise to a gain from the re-measurement.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 3.13 Present value technique: debt obligation On 1 January 2022, Koala Ltd issued at par in a private placement $2 million BBB-rated 5-year fixed rate debt securities with an annual 10% interest coupon rate. At 31 December 2022, Koala Ltd still carried a BBB credit rating. Market conditions, including interest rates and credit spreads for a BBB-quality credit rating and liquidity, remain unchanged from the date of issue. However, Koala Ltd’s credit spread had deteriorated by 50 basis points because of a change in its risk of non-performance. If the debt securities were issued at 31 December 2022, they would be priced at an interest rate of 10.5%. Required Determine the fair value of the debt securities at 31 December 2022 using the present value technique. (LO5) The fair value of the debt securities should reflect the price that would be paid by Koala Ltd to transfer the liability to market participants at 31 December 2022 under the current market conditions. Due to the change in the credit risk the appropriate measure of fair value for the debt securities is the present value technique. Koala Ltd would assume that a market participant would use the following inputs: • The annual interest payments: 10% of $2 million = $200 000 • Principal amount: $2 000 000 • Term: 5 years At 31 December 2022 the interest rate is 10.5%.

$200 000 x 3.7429 (PV of annuity at 10.5% over 5 years) $2 000 000 x 0.6070 (PV of lump sum at 10.5% and end of 5 years) Total present value of debt securities

Present Value $748 580 $1 214 000 $1 962 580

The liability would therefore be reported in Koala Ltd’s statement of financial position at 31 December 2022 as $1 962 580.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 3: Fair value measurement Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 3: Fair value measurement Multiple choice questions 1. The two most common valuation measures used in Accounting Standards are: a. Fair value less costs to sell and carrying amount. b. Net realisable value and fair value. c. Value in use and net realisable value. *d. Cost and fair value. Answer: d Learning objective 3.1: identify the need for an accounting standard on fair value measurement.

2. All of the following statements are key reasons given by the IASB for issuing a standard on fair value measurement except for: *a. To require the use of fair value when accounting for all non-financial assets. b. To establish a single source of guidance for all fair value measurements required or permitted by IFRSs to reduce complexity and improve consistency in their application. c. To clarify the definition of fair value and related guidance in order to communicate the measurement objective more clearly. d. To enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used and to inform them about the inputs used to derive those fair values. Answer: a Learning objective 3.1: identify the need for an accounting standard on fair value measurement.

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Testbank to accompany Financial reporting 3e by Loftus et al.

3. Which of the following documents issued alongside AASB 13 do not form an integral part of the standard? I II III IV

Appendix A: Defined terms Appendix B: Application guidance Basis for Conclusions Illustrative Examples

a. I and II b. II and III *c. III and IV d. IV and I Answer: c Learning objective 3.1: identify the need for an accounting standard on fair value measurement.

4. Appendix A of AASB 13 Fair Value Measurement defines fair value as: a. The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. b. The price that would be paid to purchase an asset or transfer a liability. c. A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). *d. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Answer: d Learning objective 3.2: explain the definition of fair value.

5. Fair value is determined as: *a. the current exit price. b. the current entry price. c. a future entry price. d. a future exit price. Answer: a Learning objective 3.2: explain the definition of fair value. 6. AASB 13 defines exit price as: © John Wiley and Sons Australia, Ltd 2020

3.2

Chapter 3: Fair value measurement Not for distribution in full. Instructors may assign selected questions in their LMS.

a. A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). *b. The price that would be received to sell an asset or paid to transfer a liability. c. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. d. The amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Answer: b Learning objective 3.2: explain the definition of fair value.

7. Which of the following is not a characteristic of a market participant under AASB 13? a. Buyers and sellers that are able to enter into a transaction for the asset or liability. *b. Buyers and sellers that are related parties. c. Buyers and sellers that are willing to enter into a transaction for the asset or liability. d. Buyers and sellers that are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information. Answer: b Learning objective 3.2: explain the definition of fair value.

8. Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date are an example of: *a. b. c. d.

a Level 1 input. a Level 2 input. a Level 3 input. a Level 4 input.

Answer: a Learning objective 3.3: measure the fair value of non‐financial assets.

3.3

Testbank to accompany Financial reporting 3e by Loftus et al.

9. The following are examples of an inactive market except for: a. Price quotations vary substantially over time. b. Price quotations vary substantially among market-makers. *c. Price quotations are based on current market information. d. There are few recent transactions. Answer: c Learning objective 3.3: measure the fair value of non‐financial assets..

10. The fair value of an asset is based on its: *a. highest and best use. b. current use. c. proposed use. d. value in use. Answer: a Learning objective 3.3: measure the fair value of non‐financial assets.

11. The market with the greatest volume and level of activity for the asset or liability is defined as the: a. most active market. b. current market. *c. principal market. d. most advantageous market. Answer: c Learning objective 3.3: measure the fair value of non‐financial assets.

3.4

Chapter 3: Fair value measurement Not for distribution in full. Instructors may assign selected questions in their LMS.

12. Valuation techniques that reflect the amount that would be required currently to replace the service capacity of an asset is an example of: a. the fair value approach. b. the income approach. *c. the cost approach. d. the market approach. Answer: c Learning objective 3.3: measure the fair value of non‐financial assets.

13. The following are valuation techniques prescribed by AASB 13 except for: a. The cost approach. b. The income approach. c. The market approach. *d. The fair value approach. Answer: d Learning objective 3.3: measure the fair value of non‐financial assets.

14. Which type of input is the primary measurement basis for trademarks? a. Level 1 inputs. b. Level 2 inputs. *c. Level 3 inputs. d. Level 4 inputs. Answer: c Learning objective 3.3: measure the fair value of non‐financial assets.

3.5

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Inputs, other than quoted prices, that are observable for the asset or liability, either directly or indirectly, are an example of: a. a Level 1 input. *b. a Level 2 input. c. a Level 3 input. d. a Level 4 input. Answer: b Learning objective 3.3: measure the fair value of non‐financial assets.

16. Which of the following is not an example of a level 2 input? a. Quoted prices for identical or similar assets or liabilities in markets that are not active. b. Inputs such as interest rates and yield curves, volatilities, prepayment speeds, and credit risks. *c. Measuring accounts receivable based on the entity’s historical records of recoverability. d. Inputs that are derived from or corroborated by observable market data by correlation or other means. Answer: c Learning objective 3.3: measure the fair value of non‐financial assets.

17. Which of the following steps is not relevant when measuring liabilities? a. The particular liability that is the subject of the measurement. b. The principal (or most advantageous) market for the liability. *c. The valuation premise that is appropriate for the measurement. d. The valuation technique(s) appropriate for the measurement. Answer: c Learning objective 3.4: apply the fair value measurement principles to liabilities.

3.6

Chapter 3: Fair value measurement Not for distribution in full. Instructors may assign selected questions in their LMS.

18. When measuring the fair value of a liability, it is assumed that: *a. the liability will be settled by the market participant. b. the liability will not be settled. c. the liability will be settled by the holder. d. the liability is settled with the counterparty on measurement date. Answer: a Learning objective 3.4: apply the fair value measurement principles to liabilities.

19. Where a liability is held as a corresponding asset by another entity, the fair value of the liability is determined from the perspective of a market participant that: a. applies a present value technique to measure the liability. b. applies the cost approach to valuing the liability. c. calculates the amount required to settle the present obligation. *d. holds the identical item as an asset at measurement date. Answer: d Learning objective 3.4: apply the fair value measurement principles to liabilities.

20. Which of the following statements relating to non-performance risk is incorrect? a. The entity’s own credit risk is included. *b. The holder of a corresponding asset will not fulfil the obligation. c. The entity will not fulfil the obligation. d. It applies to liabilities. Answer: b Learning objective 3.4: apply the fair value measurement principles to liabilities.

21. Which of the following is an example of a liability where there is no corresponding asset? a. A debenture issued by a listed company. b. A mortgage. c. A provision for warranties. *d. A provision for decommissioning. Answer: d Learning objective 3.4: apply the fair value measurement principles to liabilities.

3.7

Testbank to accompany Financial reporting 3e by Loftus et al.

22. In measuring an equity instrument at fair value the objective is to estimate an exit price at measurement date from the perspective of: a. the entity issuing the equity instrument. b. the party planning to repurchase the instrument. c. the party to whom the instrument will be transferred. *d. a market participant who holds the instrument as an asset. Answer: d Learning objective 3.5: discuss the measurement of the fair values of an entity’s own equity instruments.

23. The fair value of an equity instrument is based on determining a/an _________ price which may relate to the price paid for an entity to repurchase its shares. a. entry *b. exit c. transfer d. settlement Answer: d Learning objective 3.5: discuss the measurement of the fair values of an entity’s own equity instruments. 24. The fair value of an entity’s own equity instruments will be determined under which of the following circumstances? a. Where the entity participates in a share buy-back. b. Where the entity is preparing for listing. *c. Where the entity undertakes a business combination and issues its own equity instruments in exchange for a business. d. Where there is a major change in the shareholding of the entity. Answer: c Learning objective 3.5: discuss the measurement of the fair values of an entity’s own equity instruments.

3.8

Chapter 3: Fair value measurement Not for distribution in full. Instructors may assign selected questions in their LMS.

25. The following assumptions are made when measuring the fair value of an equity instrument except for: a. The market participant transferee will take on the rights and responsibilities associated with the instrument. b. An entity’s own equity instrument would remain outstanding. c. The instrument would not be cancelled or otherwise extinguished on the measurement date. *d. An entity’s own equity instruments are transferred to a market participant at transfer date. Answer: d Learning objective 3.5: discuss the measurement of the fair values of an entity’s own equity instruments.

26. Where a market has both a bid and an ask process, the price used in measuring fair value is: a. the average of the bid-ask prices over a 3 month period. *b. the most representative price for the transaction. c. the ask price. d. the bid price. Answer: b Learning objective 3.6: explain some of the issues relating to financial instruments.

27. An entity holding both financial assets and liabilities is allowed to offset and determine fair value on the net position as long as: I II III IV

the entity holds a net short position the entity holds a net long position the entity has a documented risk management strategy the entity manages the group of net financial assets and liabilities on a net exposure basis

a. I and II. b. I and III. c. II and IV. *d. III and IV. Answer: d Learning objective 3.6: explain some of the issues relating to financial instruments.

3.9

Testbank to accompany Financial reporting 3e by Loftus et al.

28. Which of the following disclosures are not required under AASB 13? *a. Quantitative information about all unobservable inputs used in the fair value measurement. b. The valuation techniques used to measure fair value. c. The fair value measurement for each class of asset and liability at the end of the reporting period. d. The input level of the fair value hierarchy within which the fair value measurements are categorised. Answer: a Learning objective 3.7: appreciate the disclosures required where assets, liabilities or equity is measured at fair value.

29. Which of the following disclosures are required under AASB 13: a. The valuation techniques used to measure fair value. b. Non-recurring fair value measurements. c. Changes in the inputs used to measure fair value. *d. All of the options are correct. Answer: d Learning objective 3.7: appreciate the disclosures required where assets, liabilities or equity is measured at fair value.

3.10

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 4: Inventories

Chapter 4: Inventories Comprehension questions 1. Define ‘cost’ as applied to the valuation of inventories. The cost of inventories is the aggregate of: • The costs of purchase • The costs of conversion • Other costs to bring the inventories to their present location and condition. Discuss each type of cost with appropriate examples. 2. What is meant by the term ‘net realisable value’? Is this the same as fair value? If not, why not? Net realisable value is the net amount that an enterprise expects to realise from the sale of inventory in the ordinary course of business and is defined in AASB 102 paragraph 6 as: the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. As such, net realisable value is specific to an individual enterprise and is not necessarily equal to fair value less costs to sell. Fair value is defined as ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’ (AASB 102, paragraph 6).

3. Explain the concept of lower of cost and net realisable value for inventories. Paragraph 9 of AASB 102 requires that ‘Inventories shall be measured at the lower of cost and net realisable value’. As the purpose of acquiring or manufacturing inventory items is to sell them at a profit, inventories will initially be recognised at cost. This cost is periodically compared to the inventories’ net realisable value to determine if the sale of the inventories will recover at least their cost. If the cost of some inventories is not expected to be recovered the inventories are written down to net realisable value. The purpose of this measurement rule is to ensure that inventory items are not reported at values above their expected future benefits. Two specific industry groups have been exempted from applying the lower of cost and net realisable value rule, namely: 1. Producers of agricultural and forest mineral products, to the extent that they are measured at net realisable value. 2. Commodity broker-traders who measure their inventories at fair value less costs to sell.

4.24.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. Which is more expensive to maintain: a perpetual method or a periodic method? Why? Under the periodic method, the amount of inventory is determined periodically (normally annually) by conducting a physical count and multiplying the number of units by a cost per unit to value the inventory on hand. This amount is then recognised as a current asset. This balance remains unchanged until the next count is taken. Under the perpetual method, inventory records are updated each time a transaction involving inventory takes place. Thus, at any one time, information about the quantity and cost of inventory on hand will be available enabling the enterprise to provide better customer service and to maintain better control over this essential asset. Obviously, this system is more complicated and expensive than the periodic method, but with the advent of user-friendly, pc-based computerised accounting packages and point of sale machines which link directly to accounting records most businesses today use the perpetual method.

5. In what circumstances must assumptions be made in order to assign a cost to inventories when they are sold? One of the major problems in accounting for inventories is assigning the cost of acquiring inventories between those items sold during the year and those items still on hand at the reporting date. Ideally, costs should be individually identified for each inventory item. However, this is only practical for entities whose inventory consists of a small number of easily identifiable items such as art galleries or manufacturers of specialised equipment. Where a specific cost cannot be identified because of the nature of the item sold then some formula has to be adopted to estimate that cost. This process is known as “assigning” cost. Most inventory items fall into this category, for example, identical items of food and clothing and bulk items like oil and minerals. How can you measure the cost of a tonne of wheat when it is extracted from a stockpile consisting of millions of tonnes acquired at different prices over the accounting period? There are many formulas used to assign a cost to inventory items sold but AASB 102 paragraph 25 restricts entities to a choice between two formulas – FIFO and weighted average.

‘Estimating the value of inventories is not sufficiently accurate to justify using such an approach. Only a full physical count can give full accuracy’. Discuss.

A full physical count will certainly provide an accurate picture of what is on hand, provided appropriate procedures are put in place. (Discuss problems that may arise during the count). However, an accurate count may not provide an accurate picture of the value of inventory owned by the entity at reporting date due to: • inadequate cut-off procedures • goods in transit • consignment arrangements • damaged or obsolete items • inaccurate prices • inadequate reconciliation of count to accounting records • net realisable values below cost. © John Wiley and Sons Australia Ltd, 2020

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Chapter 4: Inventories

7. What is the difference between the first-in, first-out formula and the weighted average formula of assigning cost? The first-in, first-out formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the weighted average formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of the period and the cost of similar items purchased or produced during that period. The average may be calculated on a period basis, or as each additional shipment is received, depending upon the circumstances of the entity.

8. Compare and contrast the impact on the reported profit and asset value for an accounting period of the first-in, first out formula and the weighted average formula. The key issue for discussion in this question is the relevance and reliability of financial information produced under each formula. FIFO values the asset at the latest price and includes the earliest purchases in inventories and thus in times of rising prices may defer losses to the next accounting period and may overstate assets. Weighted average ‘smooths’ the impact of price rises across income and asset values but may mask problems with obsolescence.

9. Why is the lower of cost and net realisable value rule used in the accounting standard? Is it permissible to revalue inventories upwards? If so, when? Net realisable value is the net amount than an enterprise expects to realise from the sale of inventories in the ordinary course of business. Where net realisable value is lower than cost, the inventory items must be written down. The rationale for this measurement rule is stated in AASB 102 paragraph 28, ‘assets should not be carried in excess of amounts expected to be realised from their sale or use’. Inventories cannot be revalued upwards unless there has been a previous write-down. If the circumstances that previously caused inventories to be written down below cost change, or if a new assessment confirms that net realisable value has increased the amount of a previous write-down can be reversed (subject to an upper limit of the original write-down). This could occur if an item of inventory, written down to net realisable value because of falling sales prices, is still on hand at the end of a subsequent period and its selling price has recovered. Under no circumstances can inventories be valued beyond their original cost.

10. What effect do the terms of trade have on the determination of the quantity and value of inventories on hand where goods are in transit at the end of the reporting period? Accounting for goods in transit at end of reporting period will depend upon the terms of trade. Where goods are purchased on an FOB shipping basis, the goods belong to the purchaser from the time they are shipped, and should be included in inventories/accounts payable at reporting date. If goods are purchased on FOB destination terms, no adjustment is required as the goods still legally belong to the supplier. If goods are sold on FOB destination terms, then they belong to the enterprise until they arrive at the customer’s premises. If the sale has been recorded in the current year it will need to be derecognised.

4.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 4.1 Calculation of inventories As a part of the auditing team assigned in relation to Mandurah Ltd, you have been asked to verify the inventories at the Halls Head branch at 30 June 2023. The company uses a perpetual method to account for inventories. In undertaking the task you note that there is a shipping container beside the main warehouse containing goods that Mandurah Ltd wants to sell. You ask the accountant at the Halls Head branch whether he plans to include the goods in the truck in the calculation of the inventories on hand at 30 June 2023. The accountant says that the goods will not be included. You then obtain a copy of the invoice in relation to the container of goods. The container was shipped on 24 June from Sydney, marked FOB Sydney, and the total invoice price was $200 000. The freight bill amounted to $12 000, with terms requiring payment within 30 days. The accountant says he will not pay the invoice until mid-July, and so the inventories will not be included in determining the inventories on hand at 30 June 2023. Required Write a report to your supervisor informing them: 1. Does Mandurah Ltd have a liability that should be recorded at 30 June 2023? 2. Should the container of goods should be included in the determination of the inventories balance at 30 June 2023? If so, what journal entry would be required? 1. There is a liability for payment of the inventories of $200 000 and the freight costs of $12 000. The goods are FOB Sydney, so the buyer is responsible for the freight costs. These should be recorded prior to 30 June 2023. 2. The goods in the container should be included in the inventories balance at 30 June 2023. The inventory has been received. In fact, the inventory has been the property of the company since it left Sydney as it was FOB Sydney, the point of shipping. The journal entry is: Inventory Payable to supplier Freight payable

Dr Cr Cr

212 000

200 000 12 000

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Chapter 4: Inventories

Case study 4.2 Inventories costs You have been assigned a new graduate as part of your audit team and they have asked you a number of questions in relation to accounting for inventories at the Lake Clifton Ltd plant.

Required Prepare a response providing an answer and reasoning to their questions, as follows. 1. Should Lake Clifton Ltd include in its inventories normal brand-name goods purchased from its suppliers but not yet received if the terms of purchase are FOB shipping point? 2. Should Lake Clifton Ltd include freight-in expenditures as an inventories cost? 3. If Lake Clifton Ltd acquires its goods on terms 5/10, n/30, should the purchases be recorded gross or net? 4. What are products on consignment, and should they be included in the inventories balance in the statement of financial position? 1. Accounting for goods in transit at end of reporting period depends upon the terms of trade. Where goods are purchased on an FOB shipping basis the goods belong to the purchaser from the time they are shipped, and should be included in inventories/accounts payable at reporting date. If goods are purchased on FOB destination terms no inventories are recorded until they arrive at their destination. Until then the goods legally belong to the supplier. 2. If goods are sold FOB shipping, freight costs incurred from the point of shipping are paid by the buyer and included in the cost of purchase. If goods are sold FOB destination, the seller pays all freight costs. 3. Purchases of inventories are to be recorded at their gross amount regardless of the payment terms. 4. Consignment inventories are held by an agent (the consignee) on behalf of the consignor (the legal owner of the inventory). The consignee agrees to sell the goods on behalf of the consignor on a commission basis. These goods are not to be included in any physical count of the consignee’s inventory as that entity is not the legal owner of the goods. The legal ownership of these goods remains with the consignor and therefore must be included in the consignor’s physical inventory count.

4.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 4.3 Purchase discounts Bunker Bay Ltd is considering alternative methods of accounting for the cash discounts it takes when paying for its supplies promptly. Required From a theoretical standpoint, discuss the acceptability of each of the following methods: 1. financial income when payments are made 2. reduction of cost of sales for the period when payments are made 3. direct reduction of purchase cost. Cash or settlement discounts are offered as incentives for early payment of amounts owing on credit sales. In contrast, trade discounts are incentives relating to the purchase of the item by the customer. The cash discounts then relate to the financing of the company rather than the costs of purchasing inventory. 1. Financial income: as cash discounts relate to financing this is the correct way of accounting for cash discounts. 2. and 3. Both of these relate to the costs of purchase rather than costs of financing and are then inappropriate ways of accounting for cash discounts.

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Chapter 4: Inventories

Case study 4.4 Inventories costs As a new graduate you have been assigned to the accounting team led by Andy Steel. Andy wants to determine your expertise in relation to accounting for inventories and has given you the following list of questions. Required Andy has asked you to provide a detailed response. 1. A company is involved in the wholesaling and retailing of tyres for foreign-made cars. Most of the inventories are imported, and are valued on the company’s records at the actual inventories cost plus freight-in. At year end, the warehousing costs are prorated over costs of goods sold and ending inventories. Are warehousing costs a product cost or a period cost? 2. A certain portion of the company’s inventories consists of obsolete items. Should obsolete items be classified as part of inventories? 3. A company purchases aeroplanes for sale to other entities. However, until they are sold, the company charters and services the planes. What is the proper way to report these aeroplanes in the company’s financial statements? 1. Warehouse costs: According to paragraph 16 of AASB 102, storage costs – unless these costs are necessary in the production process before a further production stage – are excluded costs in relation to measuring the purchase cost of inventories. Purchase price relates to the costs of acquisition rather than costs incurred subsequent to acquisition. 2. Obsolete items: It depends on what plans the company has for disposing of the obsolete items. Note that the definition of inventories relates to goods held for sale or to items consumed in the production process. • If the items are to be sold at a sale at a cheaper price then they are still inventories. • If the items are no longer saleable but will be scrapped, then they are no longer inventories. Even if they are sold as scrap they are not inventories as they are not being sold “in the ordinary course of business”. 3. Aeroplanes: Reference must be made to the definition of inventories. The assumption here is that the charters are for short-term charters rather than a lease to an airline for a fixed period. As the goods are held for sale – that is why they were purchased – they remain as inventories. Presumably a buyer could buy the aircraft while it was on charter, with the delivery being delayed until the charter is finished.

4.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 4.1 Statement of financial position classification Where, if at all, should the following items be classified on a statement of financial position? 1. Goods held by customers pending their approval of a sales contract 2. Goods in transit that were recently purchased FOB destination 3. Land held by a real estate firm for sale 4. Raw materials 5. Goods received on consignment 6. Stationery supplies (LO1) 1. As these goods are still owned by the entity they would be classified as inventory (current asset). 2. These goods still legally belong to the supplier and would not be recognised by the entity. 3. Key issue here is ownership – is the real estate firm merely offering the land for sale on behalf of the owner in which case the land would not be an asset of the real estate firm. Alternatively, if the land is owned by the real estate firm, and they sell land as part of their ordinary activities, the land would be recorded as inventory (current asset). 4. Raw materials would be included in inventories (current asset). 5. Goods received on consignment would not legally belong to the consignee and would not be recognised. 6. Stationery supplies would be classified as ‘other’ current assets unless the entity sells stationery or uses stationery as part of a production process in which case the supplies would be part of inventories.

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Chapter 4: Inventories

Exercise 4.2 Disclosures relating to inventories Ballina Pty Ltd reported inventories in its statement of financial position as follows: Inventories

$12 094 300

What additional disclosures might be necessary to present the inventories fairly? (LO9) AASB 102, paragraph 36 requires Ballina Pty Ltd to disclose the following information about inventories (if appropriate): • The accounting policies adopted in measuring inventories, including the cost formula used. • The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity • The carrying amount of inventories carried at fair value less costs to sell • The amount of inventories recognised as an expense during the period • The amount of any write-down of inventories recognised as an expense in the period in accordance with paragraph 34 • The amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as an expense in accordance with paragraph 34 • The circumstance or events that led to the reversal of a write-down of inventories in accordance with paragraph 34 • The carrying amount of inventories pledged as security for liabilities.

4.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 4.3 Recording inventories transactions William Ltd began business on 1 March 2024. William balances the books at month-end and uses the periodic method. William’s transactions for March 2024 are detailed below. March

William Ltd invested $32 000 cash and $20 000 office equipment into the business.

Purchased merchandise from B Broome on account for $4 800 on terms of 2/15, n/30.

Sold merchandise to S Moree on account for $2 400 on terms of 2/10, n/30.

Purchased merchandise for cash, $860 on cheque no. 003.

Purchased merchandise from N Narrabri on account for $4 000 on terms of 2/10, n/30.

Paid B Broome for 2 March purchase on cheque no. 004.

Received $2 400 from S Moree in payment of the account.

Sold merchandise to Forbes Ltd on account for $3 200 on terms of n/30.

Paid N Narrabri for 12 March purchase on cheque no. 005.

Purchased merchandise from B Geelong on account for $2 400 on terms of 2/15, n/30.

Sold merchandise for $2 600 cash.

Returned defective merchandise that cost $600 to B Geelong.

Paid salaries of $1 800 on cheque no. 006.

Required Prepare journal entries for March 2024, using the pro-forma journals provided. (LO3 and LO4)

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Chapter 4: Inventories

Date

Account

Cash receipts journal Cash Disc. all Sales

A/c rec.

Other

f 2024 01/0 15/0 23/0

Date 2024 08/03 14/03 21/03 28/03

Capital 3 S Moree 3 Sales 3

32 000 ✓

Account

Ch.

Purchases B Broome N Narrabri Salary expense

003 004 005 006

Date Account 2024 02/03 B Broome

32 000

2 352

2 400

2 600

_____

36 952

2 600

2 400

32 000

Purch

Cash

Disc Rec

860

860 4 704 3 920 1 800 11 284

96 80 ___ 176

Cash payments journal Ref Other A/c Pay. ✓ ✓ 1 800 1 800

4 800 4 000 _____ 8 800

___ 860

Purchases journal Terms 2/15 n/30

Ref ✓

Amount 4 800 4.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

12/03 N Narrrabri 22/03 B Geelong

✓ ✓

2/10 n/30 2/15 n/30

Date Account 2024 05/03 S Moree 21/03 Forbes Ltd

Sales journal Terms 2/10 n/30 2/10 n/30

General journal Date Account 2024 01/03 Office equipment Capital (Office equipment contributed by owner) 25/03 Accounts payable/B Geelong Purchase returns (Return of defective goods)

Ref

4 000 2 400 11 200 Amount

✓ ✓

Ref

2 400 3 200 5 600 Dr

20 000 20 000

600 ✓

600

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Chapter 4: Inventories

Exercise 4.4 Determining inventories cost and cost of sales (periodic method) Select the correct answer. Show any workings required and provide reasons to justify your choice. 1. The cost of inventories on hand at 1 January 2023 was $25 000 and at 31 December 2023 was $35 000. Inventories purchases for the year amounted to $160 000, freight outwards expense was $500, and purchase returns were $1400. What was the cost of sales for the year ended 31 December 2023? (a) $148 100 (b) $148 600 (c) $149 100 (d) $150 000 2. The following inventories information relates to K Cooroy, who uses a periodic method and rounds the average unit cost to the nearest dollar.

What is the cost of ending inventories using the weighted average costing formula? (a) $625 (b) $620 (c) $618.75 (d) $610 (LO3 and LO4)

1. (b) See workings (i). 2. (a) See working (ii). Workings: (i) Cost of Goods Sold Opening inventories Purchases Purchase returns Goods available for sale Closing inventories Cost of Goods Sold

25 000 160 000 (1 400) 183 600 35 000 148 600

(ii) Weighted average cost Opening inventories Purchases Total cost of inventories

$ 250 1 734 $1 984

(240 + 1 014 + 480)

4.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Total units Cost per unit Closing inventories

79 $25 $625

(10 + 10 + 39 + 20) (1 984 / 79 rounded to nearest $) (25 units x $25)

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Chapter 4: Inventories

Exercise 4.5 Assigning cost (perpetual method) Select the correct answer. Show any workings required and provide reasons to justify your choice. Cairns Ltd uses the perpetual method. Cairns Ltd’s inventories transactions for August 2024 were as follows.

1. Using this information, assume that Cairns Ltd uses the FIFO cost formula and that the sales returns relate to the 20 August sales. The sales return should be costed back into inventories at what unit cost? (a) $4.00 (b) $4.20 (c) $4.30 (d) $4.60 2. Assuming that Cairns Ltd uses the moving weighted average cost formula, the 12 August sales should be costed at what unit cost? (a) $4.16 (b) $4.07 (c) $4.06 (d) $4.00 (LO4) 1. (d) See workings (i). 2. (a) See workings (ii). Workings: (i) FIFO assumes sales returns are valued at the latest purchase price. Cost of August 12 sales = 15 x $4.00 + $60.00 Cost of August 20 sales = 5 x $4.00 + 10 x $4.20 + 20 x $4.30 + 5 x $4.60 = $171.00 Cost of August 28 returns = 3 x $4.60 = $13.80 (ii) Moving average calculations: 1 August Opening balance 20 x $4.00 7 August Add Purchase: 10 x $4.20 $80 + $42 10 August Add Purchase: 20 x $4.30 $122 + $86

= $80.00 (WAG = 80/20 = 4.00) = $122.00 (WAG = 122/(20 + 10) = 4.07) = $208.00 (WAG = 208/(30 + 20) = 4.16)

4.16

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Exercise 4.6 End-of-period adjustments An extract from Geebung Ltd’s unadjusted trial balance as at 30 June 2023 appears below. Geebung Ltd’s reporting period ends on 30 June and it uses the perpetual method to record inventories transactions. $ Inventories Sales Sales returns Cost of sales Inventories losses

97 200 315 885 3 205 234 320 6 339

Additional information • On 24 June 2023, Geebung Ltd recorded a $660 credit sale of goods costing $600. These goods, which were sold on FOB destination terms and were in transit at 30 June 2023, were included in the physical count. • Inventories on hand at 30 June 2023 (determined via physical count) had a cost of $97 800 and a net realisable value of $97 370. Required 1. Prepare any adjusting journal entries required on 30 June 2023. 2. Prepare the trading section of the statement of profit or loss and other comprehensive income for the year ended 30 June 2023. (LO5) 1. Workings: Reconciliation Inventories account balance Add goods in transit

$ 97 200 600 97 800 97 800

Physical count NRV Test Inventories at cost Inventories at net realisable value Write-down required 30 June 2023 Sales revenue Accounts receivable (Reverse sale incorrectly recorded in June) Inventory Cost of goods sold (Amendment for goods in transit)

97 800 97 370 430 Dr Cr

660

Dr Cr

600

660

600

4.17

Chapter 4: Inventories

Inventory write-down expense Inventory (Write-down to net realisable value)

Dr Cr

430 430

2. GEEBUNG LTD Statement of profit or loss and other comprehensive income (extract) for the year ended 30 June 2023 $ Sales revenue 315 225 Less: Sales returns 3 205 Net sales 312 020 Less: Cost of goods sold 233 720 Gross profit 78 300 Note: Inventory shortage and write-down expenses would be shown as other expenses (selling).

4.18

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Exercise 4.7 End-of-period adjustments A physical count of inventories at 31 December 2023 revealed that Karalee Pty Ltd had inventories on hand at that date with a cost of $441 000. Karalee Pty Ltd uses the periodic method to record inventories transactions. Inventories at 1 January 2023 were $397 000. The annual audit identified that the following items were excluded from this amount. • Merchandise of $61 000 is held by Karalee Pty Ltd on consignment. The consignor is Romsey Ltd. • Merchandise costing $38 000 was shipped by Karalee Pty Ltd FOB destination to a customer on 31 December 2023. The customer was expected to receive the goods on 6 January 2024. • Merchandise costing $46 000 was shipped by Karalee Pty Ltd FOB shipping to a customer on 29 December 2023. The customer was scheduled to receive the goods on 2 January 2024. • Merchandise costing $83 000 shipped by a vendor FOB destination on 31 December 2023 was received by Karalee Pty Ltd on 4 January 2024. • Merchandise costing $51 000 purchased FOB shipping was shipped by the supplier on 31 December 2023 and received by Karalee Pty Ltd on 5 January 2024. Required 1. Based on the above information, calculate the amount that should appear for inventories on Karalee Pty Ltd’s statement of financial position at 31 December 2023. 2. Prepare any journal entries necessary to adjust the Inventories general ledger account to the amount calculated in requirement 1. (LO5) 1. Inventory balance at 31 December 2023

(a) (b) (c) (d) (e)

$ 441 000 38 000 51 000 $530 000

Physical count Consignment stock not owned by Karalee Goods in transit still owned by Karalee Goods in transit owned by customer Goods in transit still owned by supplier Goods in transit owned by Karalee Adjusted inventory balance

2. 31 December 2023 Inventory Cost of goods sold (Goods in transit sold FOB destination) Inventory Accounts payable (Goods in transit purchased FOB shipping)

Dr Cr

38 000

Dr Cr

51 000

38 000

51 000

4.19

Chapter 4: Inventories

Exercise 4.8 Consignment of inventories Weijing Ltd reported in a recent financial statement that approximately $12 million of merchandise was received on consignment. Should the company recognise this amount on its statement of financial position? Explain. (LO5) Under a consignment arrangement, an agent (the consignee) may agree to sell goods on behalf of the consignor on a commission basis. The transfer of goods to the consignee is not a legal sale/purchase transaction. Legal ownership remains with the consignor until the agent sells the goods to a third party. Steps must be taken to ensure that goods held on consignment are not included in the physical count. Equally, goods owned by the enterprise that are held by consignees must be added to the physical count. Thus, Weijing Ltd will not report the consignment merchandise as inventories on its statement of financial position.

4.20

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Exercise 4.9 Selection of formulas for assigning costs Under what circumstances would each of the following formulas for assigning costs to inventories be appropriate? 1. Specific identification 2. Last-in, first-out 3. Average cost 4. First-in, first-out 5. Retail method (LO6) 1. Specific identification should always be used where it is possible to clearly identify the cost of the item sold. 2. Last-in-first-out is prohibited under AASB 102. 3. Average cost is best used where prices are subject to considerable variation or have a consistent rising trend. Using the FIFO method in this situation means that inventories are always valued at the highest price. Additionally, average cost is particularly suited to inventories where homogenous products are mixed together, like iron ore or spring water. 4. First-in-first-out best reflects the physical movement of inventories, particularly perishable goods or those subject to changes in fashion or rapid obsolescence. 5. Retail method is not a formula of assigning cost, but a method of measuring cost used by the retail industry where inventories comprise large numbers of rapidly changing items with similar margins where other methods of measuring cost are not practicable.

4.21

Chapter 4: Inventories

Exercise 4.10 Applying the lower of cost and NRV rule The following information relates to the inventories on hand at 30 June 2023 held by Canberra Ltd. Cost per unit Item No. Quantity $

Cost to replace $

Estimated selling price $

Cost of completion and disposal $

A1458

1 200

4.30

4.41

5.75

2.49

A1965

1 630

5.40

5.26

5.50

2.55

B6730

1 498

9.34

9.35

12.00

2.95

D0943

196

3.23

3.14

3.00

2.12

G8123

312

5.56

7.70

2.67

W2167

2 984

8.12

8.15

9.66

2.36

Required Calculate the value of inventories on hand at 30 June 2023. (LO7) (NRV = estimated selling price less cost of completion and disposal) Item No. A1458 A1965 B6730 DO943 G8123 W2167

Qty

1 200 1 630 1 498 196 312 2 984

Cost per unit $ 4.30 5.40 9.34 3.23 5.56 8.12

Total Cost $ 5 160.00 8 802.00 13 991.32 633.08 1 734.72 24 230.08 54 551.20

NRV per unit $ 3.26 2.95 9.05 0.88 5.03 7.30

Total NRV $ 3 912.00 4 808.50 13 556.90 172.48 1 569.36 21 783.20 45 802.44

Lower

Adjust

Cost NRV Cost NRV Cost Cost

$ -3 993.50 -460.6 -4 454.10

Therefore, inventory on hand would be: Inventory (at cost) Inventory (at NRV) Total inventory

$45 116.12 $4 980.98 $50 097.10

(5 160 + 13 991.32 + 1 734.72 + 24 230.08) (4 808.50 + 172.48)

The calculation can alternatively be done by deducting from the total cost of $54 551.20 the total adjustments of $4 454.10 related to inventory items for which the net reliable value was lower that their cost.

4.22

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Exercise 4.11 Assignment of cost (periodic and perpetual methods) Darwin Ltd’s inventories transactions for April 2024 are shown below.

Required For each question, select the correct answer. Show any workings required and provide reasons to justify your choice. 1. If Darwin Ltd uses the perpetual method with the moving weighted average cost formula, the 18 April sale would be costed at what unit cost? (a) $8.60 (b) $8.46 (c) $8.44 (d) $8.42 2. If Darwin Ltd uses the periodic method with the FIFO cost formula, what would be the cost of sales for April? (a) $1303.00 (b) $1508.60 (c) $1310.00 (d) $1324.00 3. If Darwin Ltd uses the perpetual method with the FIFO cost formula, the 21 April sale return (relating to the 18 April sale) would be costed at what unit cost? (a) $8.00 (b) $8.60 (c) $8.40 (d) $8.50 4. If Darwin Ltd uses the periodic method with the weighted average cost formula, what would be the value of closing inventories at 30 April 2024? (Round average cost to the nearest cent.) (a) $295.40 © John Wiley and Sons Australia Ltd, 2020

4.23

Chapter 4: Inventories

(b) $301.00 (c) $253.20 (d) $297.50 (LO4, LO5 and LO6) 1. (c) See workings below. Date Purchases No. Unit Total Cost Apr 01 04 90 $8.40 $756.00 07 100 $8.60 $860.00 10 13 (20) $8.60 ($172.00) 18 21 29 170 $1 444.00

No.

Sales Unit Cost

Total

$8.46

$423.00

70 (5) 40 155

$8.44 $8.44 $8.44

$590.80 ($42.20) $337.60 $1 309.20

No. 20 110 210 160 140 70 75 35

Balance Unit Total Cost $8.00 $160.00 $8.33 $916.00 $8.46 $1 776.00 $8.46 $1 353.00 $8.44 $1 181.00 $8.44 $590.20 $8.44 $632.40 $8.44 $294.80

2. (a) The FIFO method of assigning cost assumes that the earliest purchases are sold first meaning that the closing inventory is valued at the latest purchase price, which in this question is $8.60. Under the periodic system, the cost of goods sold is assumed to be equal to the difference between the total value of goods available for sale and the total value of goods still on hand. Opening inventory Purchases (net of returns) Goods available for sale Closing inventory* Cost of goods sold

$160.00 1 444.00 1 604.00 301.00 $1 303.00

* 35 units x 8.60 (latest purchase price) 3.(b) The first-in, first-out method also assumes that the last goods sold are the first goods returned. Thus, the five items returned would be costed at the last price of $8.60. This assures that inventory is always valued at the lasted purchase price. Date No.

Purchases Unit Total Cost

Apr 01 04

$8.40

$756.00

100

$8.60

$860.00

10 13 (20)

No.

20 30 $8.60

Sales Unit Cost

$8.00 $8.40

Total

$160.00 $252.00

($172.00)

No. 20 20 90 20 90 100 60 100 60

Balance Unit Total Cost $8.00 $160.00 $8.00 $160.00 $8.40 $756.00 $8.00 $160.00 $8.40 $756.00 $8.60 $860.00 $8.40 $504.00 $8.60 $860.00 $8.40 $504.00

4.24

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18 21 29 170

$1 444.00

60 10 (5) 40 155

$8.40 $8.60 $8.60 $8.60

$504.00 $86.00 ($43.00) $344.00 $1 303.00

80 70

$8.60 $8.60

$688.00 $602.00

75 35

$8.60 $8.60

$645.00 $301.00

4. (a) Under the periodic system, the weighted average is calculated by dividing the total number of units available for sale during the year by the total cost of those units. This average cost is then used to value inventory on hand in order to calculate cost of goods sold. Total cost

Unit cost Closing inventory

= = = = =

$160.00 Opening inventory $1 444.00 Add Purchases (net of returns) $1 604.00 Goods available for sale $1 604.00/190 units $8.44 $295.40 (35 x $8.44)

Note: Exercises 4.12, 4.13 and 4.14 concern the same entity, Pacific Emporium, because the three exercises have been designed so that they can be combined to form a single comprehensive exercise.

4.25

Chapter 4: Inventories

Exercise 4.12 Assignment of cost Pacific Emporium is a gift shop situated in a small fishing village. The business carries a range of merchandise that it accounts for under the perpetual method. Cost is assigned using the FIFO cost formula. All purchases are on FOB shipping terms, with 30 days credit. The end of the reporting period is 30 June. The following information lists the transactions during October 2022 for one item of inventories (wind chimes). Date

Detail

Number

Unit cost

Oct. 1

Opening balance

8.40

Purchase

8.50

Sale

Purchase

8.60

Purchase return

8.60

Sale

Sale return (on 19 Oct. sale)

Purchase

8.70

Required For the inventories item (wind chimes), calculate October’s cost of sales expense and the cost of inventories on hand at 31 October 2022. Round all figures to the nearest cent. (LO4, LO5 and LO6) Purchases Date 2022

Details

COGS

No. units

Unit Cost ($)

Total Cost ($)

8.50

340.00

1-Oct 4-Oct

Inventory balance Purchase

8-Oct

Sale

11-Oct

Purchase

8.60

516.00

14-Oct

Purchase return

-10

8.60

-86.00

19-Oct

Sale

24-Oct 28-Oct

Sale return Purchase

8.70

No. units

Balance Unit Cost ($)

Total Cost ($)

35.00 15.00

6.40 8.50

224.00 127.50

25.00 35.00 -5.00

8.50 8.60 8.60

212.50 301.00 -43.00

261.00 1031.00

811.00

No.

35 35 40

Unit Cost ($) 8.40 8.40 8.50

Total Cost ($) 294.00 294.00 340.00

25 25 60 25 50

8.50 8.50 8.60 8.50 8.60

212.50 212.50 516.00 212.50 430.00

15 20 20 30 50

8.60 8.60 8.60 8.70

129.00 172.00 172.00 261.00 433.00

units

October’s cost of sales expense is $811.00. Cost of inventories on hand at 31 October 2022 is $433.00. © John Wiley and Sons Australia Ltd, 2020

4.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 4.13 End-of-reporting-period reconciliation and NRV Pacific Emporium is a gift shop situated in a small fishing village. The business carries a range of merchandise that it accounts for under the perpetual method. Cost is assigned using the FIFO cost formula. All purchases are on FOB shipping terms, with 30 days credit. The end of the reporting period is 30 June. A physical count of inventories at 30 June 2023 found inventories worth $284 475. The Inventories control ledger account at that date had a balance of $290 550. Investigations of the discrepancy between these two figures revealed the following. • An unopened carton containing posters worth $630 had not been included in the count. • Seven large conch shells were found to be damaged beyond repair and were not recorded in the count. The shells, worth $330, are still recorded in the inventories records. • Goods costing $885 were ordered on 27 June 2023 and delivered to the transport company by the supplier on 29 June. As the goods were in transit on 30 June, they were not included in the count. The purchase was recorded when the goods arrived at the shop on 2 July 2023. • Pacific Emporium has a number of paintings on display in local restaurants on a consignment basis. The paintings are worth $6300 and were not included in the count. • A telescope had been sold for $1800 on 30 June. As the telescope was still in the shop awaiting collection by the owner, it was included in the count. The telescope cost $1425. • Five missing dolphin statues worth $240 could not be located and are presumed to have been stolen from the shop. Required 1. Reconcile the inventories control ledger account balance with the physical count figure (adjust both figures as necessary). 2. Prepare any journal entries necessary to achieve the reconciliation. (LO5 and LO7) 1. Calculate the balance of the inventory control account at 30 June 2023. Unadjusted balance Damaged goods written off Goods in transit Adjust for stolen goods Adjusted balance (cost) Reconcile to physical count Physical count Posters not counted Goods in transit not counted Consignment stock Item incorrectly included Adjusted count Control account balance

$290 550 (330) 885 (240) $290 865 $284 475 630 885 6 300 (1 425) $290 865 $290 865

4.27

Chapter 4: Inventories

2. 30 June 2023 Inventory Accounts payable

Dr Cr

885

Damaged inventory expense Inventory

Dr Cr

330

Inventory shortage expense Inventory

Dr Cr

240

885

330

240

4.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 4.14 End-of-reporting-period reconciliation and NRV Pacific Emporium is a gift shop situated in a small fishing village. The business carries a range of merchandise that it accounts for under the perpetual method. Cost is assigned using the FIFO cost formula. All purchases are on FOB shipping terms, with 30 days credit. The end of the reporting period is 30 June. Inventories must be recorded at the lower of cost and net realisable value. C Bligh, the owner of Pacific Emporium, assessed the net realisable value of her inventories at 30 June 2023 and concluded that the net realisable value of all items (except barometers) exceeded cost. The six barometers on hand cost $120 each, but C Bligh is of the opinion that they will need to be discounted to $70 in order to sell them. Required Explain what is meant by the term ‘net realisable value’ and detail the action C Bligh must take in respect to the wall barometers. (LO5 and LO7) Net realisable value is defined by AASB 102 as “the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale”. In other words, it is an assessment of the future benefits embodied in the inventory item – what we can get from selling the item. With the wall barometers, the expected benefits of selling the items $420 ($70 x 6) is less than the cost of $720 ($120 x 6) so the barometers must be written down to $420 to avoid overstating the value of the asset. The journal entry required is: 30 June 2023 Write-down inventory expense Inventory

Dr Cr

300

4.29

Chapter 4: Inventories

Exercise 4.15 Allocating cost (weighted average formula), reporting gross profit and applying the NRV rule Nanning Ltd wholesales bicycles. It uses the perpetual method and allocates cost to inventories using the moving weighted average formula. The company’s reporting date is 31 March. At 1 March 2024, inventories on hand consisted of 400 bicycles at $92 each and 54 bicycles at $96 each. During the month ended 31 March 2024, the following inventories transactions took place (all purchase and sales transactions are on credit). March 1

Sold 200 bicycles for $150 each.

Five bicycles were returned by a customer. They had originally cost $92 each and were sold for $150 each.

Purchased 60 bicycles at $94 each.

Purchased 80 bicycles at $98 each.

Sold 62 bicycles for $165 each.

Returned one damaged bicycle to the supplier. This bicycle had been purchased on 9 March.

Sold 74 bicycles for $155 each.

Purchased 82 bicycles at $104 each.

Two bicycles, sold on 22 March, were returned by a customer. The bicycles were badly damaged so it was decided to write them off. They had originally cost $94 each.

Required 1. Calculate the cost of inventories on hand at 31 March 2024 and the cost of sales for the month of March. (Round the average unit cost to the nearest cent, and round the total cost amounts to the nearest dollar.) 2. Prepare the Inventories general ledger control account (in T-format) as it would appear at 31 March 2024. 3. Calculate the gross profit on sales for the month of March 2024. (LO4, LO5, LO6 and LO7) 1. Calculate the cost of inventories on hand and cost of goods sold (moving average).

Date 1-Mar 1-Mar 3-Mar 9-Mar 10-Mar 15-Mar 17-Mar 22-Mar

Details Balance Sales Sales return Purchases Purchase Sales Purchase return Sales

No. units

60 80

Purchases Unit Total Cost Cost

94 98

No. units

COGS Unit Total Cost Cost

200

92.48

-5

92.48

- 462

259

92.48

23 952

5 817

319 399 337

92.77 93.82 93.82

29 594 37 434 31 617

336

93.82

31 524

262

93.82

24 581

5 640 7 840 62

-1

18 496

No. units 454 254

Balance Unit Total Cost Cost 92.48 41 986 92.48 23 490

93.82

- 94 74

93.82

6 943

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Purchase No entry*

104

8 528

344

21 914

30 794

96.25

33 110

344

33 110

*The damaged goods returned would not be placed back into stock. 2. Show the general ledger inventories account at 31 March 2024. Inventories control Date 2024 01/03 31/03 30/03

Details

Ref

Balance b/d Cost of goods sold A/c payable

GJ PJ

01/04

Balance b/d

$ Date 2024 41 986 17/03 462 31/03 22 009 31/03 64 457 *33 107

Details

Ref

A/c payable GJ Cost of goods sold SJ Balance c/d

94 31 256 33 107* 64 457

*Note: there is an adjustment in this balance c/d due to calculation of the weightedaverage per unit and rounding. 3. Gross profit for the month of March 2024. Sales revenue Less sales returns Net sales revenue Less cost of goods sold* Gross profit

$51 700 1 060 50 640 30 606 $20 034

* The damaged bikes returned on 29 March would require the following journal entry to be recorded: 31 March 2024 Inventory losses Cost of goods sold (Damaged inventories written off)

Dr Cr

188

4.31

Chapter 4: Inventories

Exercise 4.16 End-of-year adjustments The inventories control account balance of St George Fashions at 30 June 2023 was $110 510 using the perpetual method. A physical count conducted on that day found inventories on hand worth $110 100. Net realisable value for each inventories item held for sale exceeded cost. An investigation of the discrepancy revealed the following. • •

• • • •

Goods worth $3300 held on consignment for Rockhampton Accessories had been included in the physical count. Goods costing $600 were purchased on credit from Springbrook Ltd on 27 June 2023 on FOB shipping terms. The goods were shipped on 28 June 2023 but, as they had not arrived by 30 June 2023, were not included in the physical count. The purchase invoice was received and processed on 30 June 2023. Goods costing $1200 were sold on credit to Noosa Pty Ltd for $1950 on 28 June 2023 on FOB destination terms. The goods were still in transit on 30 June 2023. The sales invoice was raised and processed on 29 June 2023. Goods costing $1365 were purchased on credit (FOB destination) from Launceston Handbags on 28 June 2023. The goods were received on 29 June 2023 and included in the physical count. The purchase invoice was received on 2 July 2023. On 30 June 2023, St George Fashions sold goods costing $3150 on credit (FOB shipping) terms to Kurnell’s Boutique for $4800. The goods were dispatched from the warehouse on 30 June 2023 but the sales invoice had not been raised at that date. Damaged inventories valued at $1325 were discovered during the physical count. These items were still recorded on 30 June 2023 but were omitted from the physical count records pending their write-off.

Required Prepare any journal entries necessary on 30 June 2023 to correct any errors and to adjust inventories. (LO5)

Balance prior to adjustment Less consignment stock incorrectly counted Add goods in transit Add sale incorrectly recorded, FOB destination Add unrecorded purchase Less unrecorded sale Less damages goods write-off not processed

30 June 2023 Sales revenue Accounts receivable (Correction – sale recorded in error) Inventories

Recorded balance $ 110 510 1 200 1 365 (3 150) (1 325) 108 600

Dr Cr

1 950

1 200

Physical count $ 110 100 (3 300) 600 1 200 108 600

1 950

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cost of goods sold (Correction – sale recorded in error)

1 200

Inventory Accounts payable (Correction – unrecorded purchase)

Dr Cr

1 365

Accounts receivable Sales revenue (Correction – unrecorded sale)

Dr Cr

4 800

1 365

4 800

Cost of goods sold Dr Inventory Cr (Correction – cost of sales on unrecorded sale)

3 150

Inventory losses Inventory (Damaged inventories written off)

1 325

Dr Cr

3 150

1 325

4.33

Chapter 4: Inventories

Exercise 4.17 Allocating cost (FIFO), reporting gross profit and applying the NRV rule Zixingche Ltd wholesales bicycles. It uses the perpetual method and allocates cost to inventories using the first-in, first-out formula. The company’s reporting period ends on 31 March. At 1 March 2023, inventories on hand consisted of 175 bicycles at $164 each and 22 bicycles at $170 each. During the month ended 31 March 2023, the following inventories transactions took place (all purchase and sales transactions are on credit). March 1 3 9 10 15 17 22 26 29

Sold 100 bicycles for $240 each. Five bicycles were returned by a customer. They had originally cost $164 each and were sold for $240 each. Purchased 85 bicycles at $182 each. Purchased 52 bicycles at $192 each. Sold 75 bicycles for $270 each. Returned one damaged bicycle to the supplier. This bicycle had been purchased on 9 March. Sold 45 bicycles for $250 each. Purchased 68 bicycles at $196 each. Two bicycles, sold on 22 March, were returned by a customer. The bicycles were badly damaged so it was decided to write them off. They had originally cost $182 each.

Required 1. Calculate the cost of inventories on hand at 31 March 2023 and the cost of sales for the month of March. 2. Show the Inventories general ledger control account (in T-format) as it would appear at 31 March 2023. 3. Calculate the gross profit on sales for the month of March 2023. 4. AASB 102/IAS 2 requires inventories to be measured at the lower of cost and net realisable value. Identify three reasons why the net realisable value of the bicycles on hand at 31 March 2023 may be below their cost. 5. If the net realisable value is below cost, what action should Zixingche Ltd take? (LO3, LO4, LO5, LO6 and LO7) 1. Calculate the cost of inventory on hand and cost of goods sold (FIFO). Purchases Date

Details

No. units

Unit Cost ($)

Total Cost ($)

COGS No. units

Unit Cost ($)

Total Cost ($)

1-Mar

Inventory balance Sales

100

164

16 400

3-Mar

Sales return

-5

164

-820

1-Mar

Balance No. units 175 22 75 22 80 22

Unit Cost ($) 164 170 164 170 164 170

Total Cost ($) 28 700 3 740 12 300 3 740 13 120 3 740

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. 9-Mar

Purchases

182

15 470

10-Mar

Purchase

192

9 984

15-Mar

Sales

17-Mar

Purchase return

22-Mar

Sales

26-Mar

Purchase

29-Mar

No entry*

-1

182

164

196

164 170 182 164 170 182 192 164 170 182 192

13 120 3 740 15 470 13 120 3 740 15 470 9 984 820 3 740 15 470 9 984

164

820

22 84 52 66 52

170 182 192 182 192

3 740 15 288 9 984 12 012 9 984

66 52 68

182 192 196

12 012 9 984 13 328

-182

5 22 18 68

12 300

80 22 85 80 22 85 52 5 22 85 52

164 170 182

820 3 740 3 276

13 328

38 600

35 716

186

35 324

Details

Ref

A/c payable COGS Balance c/d

GJ SJ

182 36 536 35 324 72 042

* The damaged goods returned would not be placed back into stock

2. Show the general ledger inventory account at 31 March 2023. Inventories control Date 2023 01/03 31/03 30/03

Details

Ref

Balance b/d COGS A/c payable

GJ PJ

31/03

Balance b/d

$ Date 2023 32 440 17/03 820 31/03 38 783 31/03 72 042 35 324

3. Gross profit for the month of March 2023: Sales revenue Less sales returns Net sales revenue Less cost of goods sold* Gross profit

$55 500 1 700 53 800 35 352 $18 448

* The damaged bikes returned on 29 March would require the following journal entry to be recorded: $ $ 31 March 2023 Inventory losses Dr 364 Cost of goods sold Cr 364 (Damaged inventories written off)

4.35

Chapter 4: Inventories

4. Reasons why net realisable value may decline below cost included: • Inventories are damaged • Inventories are wholly or partially obsolete • Selling prices have declined below cost • A decision taken by the entity to sell products for the time being at a loss as part of an overall marketing strategy • Miscalculation or errors in purchasing. 5. If the net realisable value of the bikes falls to $184, the inventories value should be reduced to $34 224 (186 bikes at $184 each) by passing the following entry: 31 March 2023 Inventories losses Inventory (Write down to net realisable value)

Dr Cr

1 100

4.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 4.18 Assigning costs and end-of-period adjustments

Kempsey Ltd is a food wholesaler that supplies independent grocery stores. The company operates a perpetual method, with the first-in, first-out formula used to assign costs to inventories. Freight costs are not included in the calculation of unit costs. Transactions and other related information regarding two of the items (baked beans and plain flour) carried by Kempsey Ltd are given below for June 2023, the last month of the company’s reporting period.

Unit of packaging Inventories @ 1 June 2023 Purchases

Purchase terms June sales Returns and allowances

Physical count at 30 June 2023 Explanation of variance Net realisable value at 30 June 2023

Baked beans

Plain flour

Case containing 25 × 410 g cans 350 cases @ $29.60 1. 10 June: 200 cases @ $29.50 plus freight of $140 2. 19 June: 470 cases @ $29.70 per case plus freight of $215

Box containing 12 ×4 kg bags 625 boxes @ $48.40 1. 3 June: 150 boxes @ $48.45 2. 15 June: 200 boxes @ $48.45 3. 29 June: 240 boxes @ $49.00 n/30, FOB destination 950 boxes @ 50.00 As the 15 June purchase was unloaded, 10 boxes were discovered damaged. A credit of $484.50 was received by Kempsey Ltd.

n/30, FOB shipping 730 cases @ $38.50 A customer returned 50 cases that had been shipped in error. The customer’s account was credited for $1925.

326 cases on hand No explanation found — assumed stolen

15 boxes on hand Boxes purchased on 29 June still in transit on 30 June

$39.00 per case

$48.50 per box

Required 1. Calculate the number of units in inventories and the FIFO unit cost for baked beans and plain flour as at 30 June 2023 (show all workings). 2. Calculate the total dollar amount of the inventories for baked beans and plain flour, applying the lower of cost and net realisable rule on an item-by-item basis. Prepare any necessary journal entries (show all workings). (LO3, LO4, LO5, LO6 and LO7) 1. Calculation of inventory (FIFO). Baked Beans Qty

Price

Value 4.37

Chapter 4: Inventories

Opening balance Purchase 10-Jun Purchase 19-Jun Sales

Sales returns Perpetual balance Inventory shortage Physical count

350 200 470 -350 -200 -180 50 340 14 326

$ 29.60 29.50 29.70 29.60 29.50 29.70 29.70 29.70 29.70 29.70

$ 10 360 5 900 13 959 10 360 5 900 5 346 1 485 10 098 416 9 682

Price $ 48.40 48.45 48.45 49.00 48.40 48.45 48.45 -

Value $ 30 250 7 268 9 690 11 760 30 250 7 268 8 479 12 971 485 11 760 727

Plain Flour Qty Opening balance Purchase 3-Jun Purchase 15-Jun Purchase 29-Jun Sales

Perpetual balance Damaged goods Goods in transit Physical count

625 150 200 240 -625 -150 -175 265 -10 -240 15

48.45 49.00 48.45

2. Inventory: Qty Baked Beans Plain Flour

30 June 2023 Inventories losses Inventory (Baked Beans) (Write off missing inventories)

Cost $ 9 682 727 10 409

326 15

NRV Lower $ 12 714 Cost 728 Cost

Dr Cr

416

Inventories losses Inventory (Plain Flour) (Write off damaged cases)

Dr Cr

485

Accounts payable Inventory (Plain Flour) (Goods in transit – FOB destination)

Dr Cr

11 760

416

485

11 760

4.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 4.19 Allocating cost (moving weighted average), end-of-period adjustments and write-downs to NRV Part A Swims Ltd uses the perpetual method and special journals, balances the books at monthend, and uses control accounts and subsidiary ledgers for all accounts receivable and accounts payable. All sales and purchases are made on 2/10, n/30, FOB destination terms. The moving weighted average formula is used to assign cost to inventories. The following information has been extracted from Swims Ltd’s books and records for May and June 2024. $ Inventories control ledger account balance at 31 May

21 007.30

Accounts payable control ledger account balance at 31 May

8 015.40

Inventories purchases on credit during June

11 618.90

Cash paid to trade creditors during June

10 445.90

Inventories sales on credit during June

16 250.00

Inventories ledger card balances at 1 June: Pool filters

43 @ $242.50

10 427.50

Pool pumps

21 @ $503.80

10 579.80 21 007.30

The inventories purchased during June comprised the following. June 4

5 pool pumps @ $486.10 each

2 430.50

3 pool pumps @ $501.30 each

1 503.90

12 pool filters @ $246.70 each

2 960.40

2 pool pumps @ $501.30 each

1 002.60

15 pool filters @ $248.10 each

3 721.50 11 618.90

The inventories sold during June comprised the following. June 1

1 pool pump @ $540 and 1 pool filter @ $320

860.00

18 pool filters @ $320 each

5 760.00

4 pool pumps @ $570 each

2 280.00

15 pool filters @ $350 each

5 250.00

6 pool filters @ $350 each

2 100.00 16 250.00

Other movements in inventories during June were: June 9 20

2 pool filters, sold 5 June (not paid for) were returned by the customer 3 pool filters purchased 18 June (not paid for) were returned to the supplier © John Wiley and Sons Australia Ltd, 2020

4.39

Chapter 4: Inventories

$ 26

1 pool pump, purchased 4 June (paid for) was returned to the supplier

Required 1. Prepare the perpetual inventories records for June 2024. 2. Prepare the inventories control and accounts payable control general ledger accounts (in T-format) for the month of June 2024. Part B At 30 June 2024, Swims Ltd conducted a physical stocktake that found 14 pool filters and 26 pool pumps on hand. An investigation of discrepancies between the inventories card balances and the physical count showed that the 15 pool filters purchased on 29 June 2024 were still in transit from the supplier’s factory on 30 June 2024, and one pool pump, sold on 18 June, had been returned by a customer on 30 June. No adjustment has been made in the books for the sales return. The customer had not paid for the returned pump. Required Prepare any general journal entries necessary to correct the Inventories control general ledger account balance as at 30 June 2024. (Narrations are not required, but show all workings.) Do not adjust the perpetual inventories records prepared in Part A. Part C On 30 June 2024, Swims Ltd determined that his inventories have the following net realisable values. Pool filters Pool pumps

$252 each $566 each

Required 1. What does the term ‘net realisable value’ mean? 2. What sources of evidence could Swims Ltd examine to determine net realisable value? 3. What action should Swims Ltd take as at 30 June 2024 with respect to these net realisable values? Why? (LO4, LO5 and LO7) Part A 1. Perpetual inventory records: Pool filters DATE 1/06/2024 1/06/2024 5/06/2024 9/06/2024 18/06/2024

PURCHASES Unit Total No. Cost $ $

No.

1 18 -2 12

246.70

SALES Unit Cost $ 242.50 242.50 242.50

Total $ 242.50 4 365.00 -485.00

2 960.40

No. 43 42 24 26 38

BALANCE Unit Total Cost $ $ 242.50 10 427.50 242.50 10 185.00 242.50 5 820.00 242.50 6 305.00 243.83 9 265.40

4.40

-3

246.70

-740.10 15 6

248.10

3 721.50 5 941.80

243.58 243.58

3 653.70 1 461.48

COGS:

9 237.68

35 20 14 29

243.58 243.58 243.58 245.92

8 525.30 4 871.60 3 410.12 7 131.62

Pool pumps DATE 1/06/2024 1/06/2024 4/06/2024 17/06/2024 18/06/2024 24/06/2024 26/06/2024

PURCHASES Unit Total No. Cost $ $

SALES Unit Cost $

No.

5 3

486.10 501.30

2 430.50 1 503.90

2 -1

501.30 486.10

1 002.60 -486.10 4 450.90

Total $

503.80

500.37

2 001.49

COGS:

2 505.29

No. 21 20 25 28 24 26 25

BALANCE Unit Total Cost $ $ 503.80 10 579.80 503.80 10 076.00 500.26 12 506.50 500.37 14 010.40 500.37 12 008.91 500.44 13 011.51 501.02 12 525.41

2. Ledger accounts: Inventories control Date 2024 31-May 9-Jun 30-Jun

Details

Ref

Balance b/d COGS AP

GJ PJ

21 007.30 485.00 11 618.90

Date 2024 20-Jun 26-Jun 30-Jun

Details

Ref

AP AR* COGS Balance c/d

GJ GJ SJ

740.10 486.10 12 227.97 19 657.03 33 111.20

33 111.20 1-Jul

Balance b/d

19 657.03

* The amount of $486.10 on 26 June is receivable from the supplier as Swims Ltd returned 1 pool pump for which they already paid and are now entitled to a refund. Accounts payable control Date 2024 20-Jun 30-Jun

Details

Ref

Inventory Cash & disc Balance c/d

GJ CPJ

740.10 10 445.90 8 158.30 19 344.30

Date 2024 31May 30-Jun

1-Jul

Details

Ref

Balance b/d Inventory

8 015.40 11 618.90 19 634.30 8 158.30

Balance b/d

Part B 30 June 2024 Accounts payable Dr 3 722 Inventory Cr (Removal of inventory purchase not yet completed) Sales returns and allowances Accounts receivable (Sales return)

Dr Cr

3 722

570

4.41

Chapter 4: Inventories

Inventory Cost of goods sold (Return of one pool pump)

Dr Cr

501 501

Part C 1. Net realisable value is defined by AASB 102 as the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. 2. Swims Ltd should examine the following sources of evidence to determine net realisable value: • expected selling price • estimated costs of completion (if any), and • estimated selling costs. These estimates take into consideration fluctuations of price or cost occurring after end of reporting period to the extent that such events confirm conditions existing at end of reporting period. The purpose for which inventories are held should be taken into account when reviewing net realisable values. For example, the net realisable value of inventories held to satisfy firm sales or service contracts is based on the contract price. If the sales contracts are for less than the inventories quantities held, the net realisable value of the excess is based on general selling prices. Estimated selling costs include all costs likely to be incurred in securing and filling customer orders such as advertising costs, sales personnel salaries and operating costs, and costs of storing and shipping finished goods. 3. AASB 102 requires that inventories must be carried at the lower of cost and net realisable value and that this rule be applied to each individual inventory item. As the NRV of the pool filters is less than their average cost Swims Ltd should write down the pool filter stock. No adjustment is required to the cost of pool pumps.

4.42

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 4: Inventories Multiple choice questions 1. Which of the following are common classifications for inventories in the financial statements:

Raw materials Finished goods Work in progress Assets held for resale

I. No Yes No Yes

II. Yes Yes No No

III. No Yes Yes No

IV. Yes Yes Yes Yes

a. I. b. II. c. III. *d. IV. Answer: d Learning objective 4.1: explain the definition of inventories.

2. AASB 102 Inventories applies to the accounting for: a. biological assets. b. financial instruments. c. work in progress under construction contracts. *d. materials consumed in the manufacture of lawn mowers for sale. Answer: d Learning objective 4.1: explain the definition of inventories. 3. When an entity’s operating cycle is not clearly identifiable it is assumed to have a duration of: a. three months. b. six months. *c. 12 months. d. 2 years. Answer: c Learning objective 4.1: explain the definition of inventories.

4.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following measurement rules applies to inventories subsequent to their initial measurement? a. b. c. *d.

Historical cost Fair value Replacement cost Lower of cost and net realisable value

Answer: d Learning objective 4.2: explain how to initially recognise and measure inventories.

5. Inventories are to be measured at the lower of cost or net realisable value. Net realisable value is defined in AASB 102/IAS 2 Inventories as: a. b. *c. d.

the fair value of the inventories at purchase date. the amount paid for the purchase of the inventories in an arm’s length transaction. the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. the estimated buying price in the ordinary course of business.

Answer: c Learning objective 4.2: explain how to initially recognise and measure inventories.

6. AASB 102 allows which of the following to be capitalised into the cost of inventories? a. *b. c. d.

Selling costs. Normal costs of material wastage. Storage costs for finished goods. Administrative overheads.

Answer: b Learning objective 4.3: explain what costs are included in the cost of inventories.

7. Which of the following is specifically excluded by AASB 102 from the cost of inventories measurement? a. *b. c. d.

Trade discounts received Freight (where the terms of sale are FOB destination) Costs of designing inventory for an individual customer. Costs of converting supplies into specific products for sale.

Answer: b Learning objective 4.3: explain what costs are included in the cost of inventories. © John Wiley and Sons Australia, Ltd 2020

4.2

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

8. Taxes may be included in the cost of inventories except for those taxes that are: a. *b. c. d.

levied on the inventories by a foreign government. recoverable by the entity from the taxation authority. in the nature of import duties. imposed on the raw materials component of manufactured inventories.

Answer: b Learning objective 4.3: explain what costs are included in the cost of inventories. 9. The terms ‘2/10, n/30’ appearing on an invoice for the sale/purchase of inventories means that the buyer: a. *b. c. d.

will receive a 10% discount if paid within 2 days of the invoice date, otherwise the full amount must be paid within 30 days of the invoice date. will receive a 2% discount if paid within 10 days of the invoice date, otherwise the full amount must be paid within 30 days of the invoice date. has 10 days from the invoice date to pay the full amount or a 2% surcharge will be applied and total amount owing must be paid within 30 days of invoice date. has 2 days from the invoice date to pay the full amount or a 7% surcharge will be applied and total amount owing must be paid within 30 days of invoice date.

Answer: b Learning objective 4.3: explain what costs are included in the cost of inventories.

10. Under the periodic inventories approach, the cost of goods sold is calculated as: a. b. *c. d.

Opening inventories + net purchases + closing inventories Opening inventories – net purchases + closing inventories Beginning inventories + net purchases – ending inventories Beginning inventories – net purchases – ending inventories

Answer: c Learning objective 4.4: account for inventories transactions using both the periodic and the perpetual methods.

4.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. Which of the following statements is correct? a.

*b. c. d.

The relationship between the closing inventories balance under the periodic and perpetual methods will depend on whether the FIFO or weighted average method is used to value inventories. Closing inventories will always be the same under the periodic and perpetual methods. The periodic method of accounting for inventories will always result in a lower closing inventories balance than the perpetual method. The periodic method of accounting for inventories will always result in a higher closing inventories balance than the perpetual method.

Answer: b Learning objective 4.4: account for inventories transactions using both the periodic and the perpetual methods.

12. Which of the following is an appropriate journal entry to recognise inventories items that have been stolen? a.

DR Inventories (asset) CR Provision for inventories losses (liability) *b. DR Inventories losses (expense) CR Inventories (asset) c. DR Cost of goods sold (expense) CR Inventories (asset) d. DR Provision for inventories losses (liability) CR Inventories (asset) Answer: b Learning objective 4.5: explain and apply end‐of‐period procedures for inventories under both the periodic and the perpetual methods.

4.4

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Under the periodic inventories approach, an appropriate journal entry to measure closing inventories would be: a.

DR Opening inventories (cost of goods sold expense) CR Inventories (asset)

DR Purchases (expense) CR Inventories (asset)

*c. DR Inventories (asset) CR Closing inventories (cost of goods sold expense) d.

DR Purchases returns (cost of goods sold expense) CR Inventories (asset)

Answer: c Learning objective 4.5: explain and apply end‐of‐period procedures for inventories under both the periodic and the perpetual methods.

14. Stock take discrepancies between a count sheet and recorded quantities in the ledger may arise due to which of the following: I. II. III. IV. a. b. *c. d.

Stock in transit purchased under FOB destination terms Consignment stock included in the physical count by the consignee Sales returns not being processed into the ledger Theft of stock during the year

I, II and III I, III and IV II, III and IV I, II and IV

Answer: c Learning objective 4.5: explain and apply end‐of‐period procedures for inventories under both the periodic and the perpetual methods.

4.5

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Trio Ltd uses a periodic inventories system and rounds the average unit cost to the nearest dollar. The following data relates to Trio Ltd for the year ended 30 June 2021. Opening inventories January purchases March purchases June purchases September purchases Ending inventories

150 units @ average cost of $32 each 35 units @ $35 each 18 units @ $38 each 50 units @ $30 each 27 units @ $32 each 65 units

The cost of ending inventories using the weighted average cost method (rounded to the nearest dollar) is: *a. b. c. d.

$2 106 $2 136 $4 273 $6 966

Answer: a Learning objective 4.6: explain why cost flow assumptions are required and apply both the FIFO and weighted average cost formulas.

4.6

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

16. White Cotton Ltd uses a periodic inventories system and rounds the average unit cost to the nearest dollar. The following data relates to White Cotton Ltd for the year ended 30 June 2021. Opening inventories January purchases February sales March sales returns June sales July purchases August sales October purchases November sales

1000 units @ average cost of $20 each 2500 units @ $22 each 1200 units 50 units 500 units 3000 units @$25 each 2400 units 5000 units @$24 each 4000 units

The cost of goods sold for the year using the weighted average method is: a. b. c. *d.

$194 400 $186 300 $193 200 $185 150

Answer: d Learning objective 4.6: explain why cost flow assumptions are required and apply both the FIFO and weighted average cost formulas.

17. The weighted average inventories costing method is particularly suitable to inventories where: a. dissimilar products are stored in separate locations. *b. homogeneous products are mixed together. c. the entity carries stocks of raw materials, work-in-progress and finished goods. d. goods have distinct use-by dates and the goods produced first must be sold earliest. Answer: b Learning objective 4.6: explain why cost flow assumptions are required and apply both the FIFO and weighted average cost formulas.

4.7

Testbank to accompany Financial reporting 3e by Loftus et al.

18. When an inventories costing formula is changed, the change is required to be applied: a. prospectively and the adjustment taken through the current profit or loss. b. prospectively and the current period adjustment recognised directly in equity. *c. retrospectively and the adjustment taken through the opening balance of retained earnings. d. retrospectively and the adjustment recognised as an extraordinary gain or loss. Answer: c Learning objective 4.6: explain why cost flow assumptions are required and apply both the FIFO and weighted average cost formulas.

19. AASB 102 Inventories specifies that the measurement rule for inventories is: a. b. c. *d.

higher of initial cost and realisable value. higher of production costs and selling price. lower of fair value and selling price. lower of cost and net realisable value.

Answer: d Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

20. Net realisable value of inventories may fall below cost for a number of reasons including: I. II. III. IV. V.

Product obsolescence Physical deterioration of inventories An increase in the expected replacement costs of the inventories An increase in the estimated costs of completion An error in quantities purchased causing overstocking

*a. I, II, IV and V only b. I, IV and V only c. II, III and IV only d. I, II and V only Answer: a Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

4.8

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

21. ‘Net realisable value’ of inventories is defined in AASB 102 as the estimated selling price in the ordinary course of business: a. in a forced sale. b. plus the estimated costs necessary to make the sale. *c. less the estimated costs of completion and the costs necessary to make the sale. d. plus the estimated costs of completion and the estimated costs necessary to make the sale. Answer: c Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

22. When determining the net realisable value of inventories, estimates must be made of which of the following: I. II. III. IV.

Estimated selling costs Expected selling price Expected replacement cost Estimated costs of completion (if any)

a. I, II, III and IV b. I, II and III only c. II and IV only *d. I, II and IV only Answer: d Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

23. AASB 102 Inventories requires service providers to write down their inventories to net realisable value: a. *b. c. d.

on a class-by-class basis (e.g raw materials). on an item-by-item basis. on a group basis. according to location or geographical segment within the entity.

Answer: b Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

4.9

Testbank to accompany Financial reporting 3e by Loftus et al.

24. Where the net realisable value of inventories falls below cost, AASB 102 Inventories requires that: a. b. c. *d.

no adjustment be made, but the difference between net realisable value and cost be disclosed in the notes to the financial statements. the difference be added to the carrying amount of the inventories. inventories continue to be carried in the statement of financial position at cost. inventories be written down to net realisable value.

Answer: d Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

25. Missy Limited sells household cleaners and had the following items of inventories at reporting date. Item Window cleaners Vacuum cleaners

Quantity Cost/unit NRV/unit 50 $25 $20 20

$150

$160

What is the adjustment necessary at reporting date? a. DR Inventories $250 b. DR Inventories $0 c. CR Inventories $100 *d. CR Inventories $50 Answer: d Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value.

26. The write down of inventories to net realisable value in a prior period: a. b. *c. d.

can be reversed in a later period with no upper limit from a previous write down. cannot be reversed in a later period.. can be reversed in a later period but only to the upper limit of the original write down. can be reversed in a later period so long as the value is recovered within 2 years of the original write down.

Answer: c Learning objective 4.7: explain the net realisable value basis of measurement and account for adjustments to net realisable value. © John Wiley and Sons Australia, Ltd 2020

4.10

Chapter 4: Inventories Not for distribution in full. Instructors may assign selected questions in their LMS.

27. Which of the following is not recognised as an expense in accordance with AASB 102: a. b. c. *d.

Write-downs of inventories to net realisable value Reversal of write downs to net realisable value Cost of goods sold Inventories items used by an entity as components in self-constructed property, plant or equipment

Answer: d Learning objective 4.8: account for inventories expense.

28. AASB 102 Inventories requires items of inventories that are used by a business as components in a self-constructed property asset to be: a. *b. c. d.

added to a ‘property construction’ provision account. capitalised and depreciated. expensed directly into equity in the period in which the items are used. aggregated into ‘cost of goods sold’ in the period in which the items are used.

Answer: b Learning objective 4.8: account for inventories expense.

29. AASB 102 Inventories requires separate disclosure of: a. b. c. *d.

the amount of inventories recognised as an expense. the carrying amount of inventories pledged as security for loans. the circumstances that led to a reversal of a previous write down of inventories. All of these options.

Answer: d Learning objective 4.9: identify the disclosure requirements of AASB 102/IAS 2.

4.11

Testbank to accompany Financial reporting 3e by Loftus et al.

30. AASB 102 requires disclosure of which of the following? I. The carrying amount of inventories by class. II. The accounting policy adopted by the entity in relation to inventories valuation. III. Separate disclosure of the carrying amount of inventories carried at cost and those carried at net realisable value. IV. Details of reversals of prior year write-downs. a. II and III only b. I, II and III only c. II, III and IV only *d. I, II, III and IV Answer: d Learning objective 4.9: identify the disclosure requirements of AASB 102/IAS 2.

4.12

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Belinda Luke

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 5: Property, plant and equipment

Chapter 5: Property, plant and equipment Comprehension questions 1. What assets constitute property, plant and equipment? Paragraph 6 of AASB 116/IAS 16 defines property, plant and equipment (PPE) as follows. Property, plant and equipment are tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period. 2. What are the recognition criteria for property, plant and equipment? Paragraph 7 of AASB 116/IAS 16 contains the following recognition criteria. The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably. 3. How should items of property, plant and equipment be measured at point of initial recognition? Paragraph 15 of AASB 116/IAS 16 requires the initial measurement to be at cost. The measurement rule applies regardless of how the entity obtains the asset. A gift has a zero cost. 4. How is cost determined? Paragraph 16 of AASB 116/IAS 16 states: The cost of an item of property, plant and equipment comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. (c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. 5. What choices of measurement model exist subsequent to assets being initially recognised? Paragraph 29 of AASB 116/IAS 16 states: An entity shall choose either the cost model in paragraph 30 or the revaluation model in paragraph 31 as its accounting policy and shall apply that policy to an entire class of property, plant and equipment.

5.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

6. What factors should entities consider in choosing alternative measurement models? The factors that entities should consider in choosing alternative measurement models are: • Relevance of information provided: generally current information is preferred to past information. • Reliability of the information: cost measures are generally more reliable than valuation measures. • Cost of providing the information: Adoption of the valuation model entails costs of valuation and audit. 7. What is meant by ‘depreciation expense’? Paragraph 6 of AASB 116/IAS 16 defines depreciation as: Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

8. How is useful life determined? Paragraph 6 of AASB 116/IAS 16 states: Useful life is: (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an entity. Paragraphs 56-57 of AASB 116/IAS 16 further state: 56. The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economic benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset: (a) expected usage of the asset. Usage is assessed by reference to the asset's expected capacity or physical output. (b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle. (c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset. (d) legal or similar limits on the use of the asset, such as the expiry dates of related leases. 57. The useful life of an asset is defined in terms of the asset's expected utility to the entity. The asset management policy of the entity may involve the disposal of assets after a specified time or after consumption of a specified proportion of the future economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter than its economic life. The estimation of the useful life of the asset is a matter of judgement based on the experience of the entity with similar assets.

5.3

Chapter 5: Property, plant and equipment

9. What is meant by ‘residual value’ of an asset? Paragraph 6 of AASB 116/IAS 16 states: The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. 10. How does an entity choose between depreciation methods, for example, straight-line versus diminishing balance models? Paragraph 60 of AASB 116/IAS 16 states: The depreciation method used shall reflect the pattern in which the asset's future economic benefits are expected to be consumed by the entity. Choice is based on which method best reflects the pattern of benefits expected to be consumed by a specific asset given its use in a specific entity. 11. What is meant by ‘significant parts depreciation’? Note paragraphs 43-47 of AASB 116/IAS 16: 43. 44.

45.

46.

47.

Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease. A significant part of an item of property, plant and equipment may have a useful life and a depreciation method that are the same as the useful life and the depreciation method of another significant part of that same item. Such parts may be grouped in determining the depreciation charge. To the extent that an entity depreciates separately some parts of an item of property, plant and equipment, it also depreciates separately the remainder of the item. The remainder consists of the parts of the item that are individually not significant. If an entity has varying expectations for these parts, approximation techniques may be necessary to depreciate the remainder in a manner that faithfully represents the consumption pattern and/or useful life of its parts. An entity may choose to depreciate separately the parts of an item that do not have a cost that is significant in relation to the total cost of the item.

Components depreciation means breaking an asset down into its component parts for separate depreciation of those parts. 12. Under the revaluation model, how is a revaluation increase accounted for? Paragraph 39 of AASB 116/IAS 16 states: If an asset's carrying amount is increased as a result of a revaluation, the increase shall be recognized in other comprehensive income and accumulated equity under the heading of

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revaluation surplus. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.

13. Under the revaluation model, how is a revaluation decrease accounted for? Paragraph 40 of AASB 116/IAS 16 states: If an asset's carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall be recognized in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease recognized in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus.

14. Should accounting for revaluation increments and decrements be done on an assetby-asset basis or on class-of-assets basis? Paragraphs 36-38 of AASB 116/IAS 16 state: 36. 37.

38.

If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued. A class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity's operations. The following are examples of separate classes: (a) land; (b) land and buildings; (c) machinery; (d) ships; (e) aircraft; (f) motor vehicles; (g) furniture and fixtures; and (h) office equipment. The items within a class of property, plant and equipment are revalued simultaneously to avoid selective revaluation of assets and the reporting of amounts in the financial statements that are a mixture of costs and values as at different dates. However, a class of assets may be revalued on a rolling basis provided revaluation of the class of assets is completed within a short period and provided the revaluations are kept up to date.

15. When should property, plant and equipment be derecognised? Paragraph 67 of AASB 116/IAS 16 states: The carrying amount of an item of property, plant and equipment shall be de-recognised: (a) on disposal; or (b) when no future economic benefits are expected from its use or disposal.

5.5

Chapter 5: Property, plant and equipment

Case studies Case study 5.1 Fair value basis for measurement The management of Rocky Ltd has decided to use the fair value basis for the measurement of its equipment. Some of this equipment is difficult to obtain and has in fact increased in value over the current period. Management is arguing that, as there has been no decline in fair value, no depreciation should be charged on these pieces of equipment. Required Discuss management’s position. Depreciation is an allocation of an asset’s depreciable amount over its useful life. Hence, depreciation is necessary to account for the use of an asset. If management considers that the fair value of the asset has increased, separate journal entries are required to reflect this detailing: 1) write off of accumulated depreciation, and 2) revaluation of the asset.

Case study 5.2 Straight-line vs. diminishing balance depreciation Ag Ltd uses tractors as part of its operating equipment, and it applies the straight-line depreciation method to these assets. Ag Ltd has just taken over Spector Ltd, which uses similar tractors in its operations. However, Spector Ltd has been using a diminishing balance method of depreciation for these tractors. The accountant in Ag Ltd is arguing that for both entities the same depreciation method should be used for tractors. Required Provide arguments for and against this proposal. The depreciation method used should reflect the pattern of future economic benefits expected to be received by the entity. As such, choice is based on which method best reflects the pattern of benefits expected to be received by the asset given its use in the specific entity. While the accountant’s suggestion would make comparability of the two companies’ performance easier, convenience should not be the basis for choosing the appropriate deprecation method.

Case study 5.3 Annual depreciation charge A company is in the movie rental business. Movies are generally rented for 2 years and then either sold or destroyed. However, management wants to show increased profits, and believes that the annual depreciation charge can be lowered by keeping the movies for 3 years. Required Discuss management’s position.

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Useful life is the period over which an asset is expected to be available for use. Hence, if movies are typically kept for 2 years based on past business experience, this timeframe should be used as the useful life. As such, there is no reasonable basis for management’s suggestion/position.

Case study 5.4 Depreciation charges A new accountant has been appointed to Outlander Ltd and has implemented major changes in the calculation of depreciation. As a result, some parts of the factory have much larger depreciation charges. This has angered some operations managers who believe that, as they take particular care with the maintenance of their machines, their machines should not attract large depreciation charges that reduce the profitability of their operations and reflect badly on their management skills. The operations managers plan to meet the accountant and ask for change. Required Explain how the new accountant should respond. Depreciation is a systematic allocation of the depreciable amount of an asset over its useful life. It is a necessary expense to reflect the pattern of economic benefit derived from the asset, and the accountant should make this clear to the mangers. However, if maintenance of the machines is extending their useful lives, this should be examined by the accountant to consider if a change to the depreciation calculation is required.

Case study 5.5 Depreciation charges The management of Predator Ltd has been analysing the financial reports provided by the accountant, who has been with the firm for a number of years. Management has expressed its concern over depreciation charges being made in relation to the company’s equipment. In particular, they believe that the depreciation charges are not high enough in relation to the factory machines because new technology applied in that area is rapidly making the machines obsolete. Management’s concern is that the machines will have to be replaced in the near future and, with the low depreciation charges, the funds will not be sufficient to pay for the replacement machines. Required Discuss management’s position. The impact of new technology on existing machines (i.e. making them obsolete) is relevant to depreciation calculations, as it impacts on their useful life. Hence, if the useful life has not been updated to reflect this information, such changes are necessary. The concern regarding low depreciation charges resulting in insufficient funds for replacement machines is unfounded. Depreciation is not a cash expense, and therefore has no effect on cash flow. Cash would normally have been spent at the time of purchase/acquisition.

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Chapter 5: Property, plant and equipment

Application and analysis questions Exercise 5.1 Revaluation adjustments and reversals On 1 January 2022, Lima Ltd revalued land from $200 000 to $400 000. On 1 January 2023, the company subsequently revalued the land to $320 000. And on 1 January 2024, the company again revalued the asset downwards to $160 000. Required Prepare the journal entries required to record the revaluation adjustment for the year ended: 1. 30 June 2022. 2. 30 June 2023. 3. 30 June 2024. (LO6) 1. 30 June 2022 Land Gain on revaluation – Land (OCI) (Revaluation of Land from $200 000 to $400 000) Gain on revaluation – Land (OCI) Asset revaluation surplus – Land (Accumulation of revaluation gain in equity)

Dr Cr

200 000

Dr Cr

200 000

2. 30 June 2023 Loss on revaluation – Land (OCI) Dr 80 000 Land Cr 80 000 (Revaluation of land from $400 000 to $320 000, partially reversing a revaluation increase) Asset revaluation surplus – Land Loss on revaluation – Land (OCI) (Accumulation of revaluation loss in equity)

Dr Cr

80 000 80 000

3. 30 June 2024 Loss on revaluation – Land (OCI) Dr 120 000 Loss on revaluation – Land (P&L) Dr 40 000 Land Cr 160 000 (Revaluation of land from $320 000 to $160 000, partially reversing a revaluation increase, and recognising a further decrease beyond the original accounting value) Asset revaluation surplus – Land Loss on revaluation – Land (OCI) (Accumulation of revaluation loss in equity)

Dr Cr

120 000 120 000

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Exercise 5.2 Revaluation adjustments and reversals The following data from Lyre Ltd’s accounts relates to two assets at 30 June 2021. Asset Land Plant and equipment

Value $ 2 400 000 $ 300 000

Accumulated depreciation 0 $ 60 000

Carrying amount $ 2 400 000 $ 240 000

At 30 June 2021 Lyre Ltd decides to adopt the revaluation model for both these assets. On this date land has a fair value of $2 250 000 and plant and equipment has a fair value of $330 000. On 30 June 2022 Lyre Ltd reviews the value of its assets. The fair value of land is reassessed as $2 325 000. Plant and equipment has no change in value on that date. Required Prepare the journal entries required to revalue the assets for the year ended 30 June 2021 and the 30 June 2022. (LO6) 30 June 2021 Loss on revaluation – Land (P&L) Dr Land Cr (Revaluation of land from $2 400 000 to $2 250 000)

150 000

Accumulated depreciation – P&E Dr Plant and Equipment Cr (Writing the plant & equipment down to carrying amount)

60 000

150 000

60 000

Plant and Equipment Dr 90 000 Gain on revaluation – P&E (OCI) Cr (Revaluation of plant & equipment from $240 000 to $330 000)

90 000

Gain on revaluation – P&E (OCI) Dr 90 000 Asset revaluation surplus – P&E Cr (Accumulation of revaluation gain of plant & equipment in equity)

90 000

30 June 2022 Land

Dr 75 000 Gain on revaluation – Land (P&L) Cr 75 000 (Revaluation of land from $2 250 000 to $2 325 000, partially reversing a previous revaluation decrease)

5.9

Chapter 5: Property, plant and equipment

Exercise 5.3 Revaluation model One of the directors of Crane Ltd has proposed that the company adopt the revaluation model for fixed assets. Some of these assets are hard to obtain and certain items have increased in value in the current period, however it is difficult to know what their fair value is. The director is arguing that fair value will improve the ‘look’ of the company’s statement of financial position, and may eliminate the need for depreciation. Required Prepare a report to the board on whether it should adopt the director’s proposal. (LO6) Under AASB 116/IAS 16, depreciation measures the change in value due to the use of an asset over the period; not changes in value due to other factors such as changes in market values. The consumption of benefits is considered to be separate from changes in the fair value of an asset (see solution to Case study 5.1). Hence, adopting the revaluation method will not eliminate the need for depreciation. With respect to the choosing the revaluation method, AASB 116/IAS 16 requires that revaluations are made on a regular basis, such that the carrying amount of an asset does not materially differ from its fair value. As noted in paragraph 36, the revaluation model is applied to classes of assets. Hence, it may be worthwhile to consider: 1. applying the fair value model to each class of asset, and 2. electing to use the cost model for a class of assets where fair value is difficult to ascertain for any particular asset within that class. Ultimately, choice of the cost or fair value model should be based on what is most relevant and reliable, rather than what improves the ‘look’ of the company’s Statement of Financial Position.

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Exercise 5.4 Purpose of depreciation Recently Sea Eagle Ltd experienced a strike that affected a number of its operating plants. The group accountant of Sea Eagle Ltd indicated that it was not appropriate to report depreciation expense during this period as the equipment was not used during the strike. She stated that during the strike the equipment did not depreciate and an inappropriate matching of costs and revenues would result if depreciation were charged. She based her position on the following points. 1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production. 2. The basic factor of depreciation in this instance is wear and tear, and because the equipment was idle, no wear and tear occurred. Required You are a part of the auditing team that analyses the accounts of Sea Eagle Ltd. Write a report to your supervisor in relation to the views of the group accountant of Sea Eagle Ltd. (LO5) Depreciation is an allocation of cost to a period. It is not a measure of movement in fair value nor a function of the use of PPE – unless a usage method of depreciation is applied. Paragraph 55 of AASB 116/IAS 16 states: […] depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated. However under usage methods of depreciation the depreciation charge can be zero while there is depreciation. The usage of an asset may affect the estimation of useful life – see paragraph 56 of AASB 116/IAS 16. If a strike was long enough it may change the expected useful of PPE. However, this may also have an effect on expected residual value. In other words, having determined the method of depreciation e.g. straight-line, the measurement of the factors in that calculation will be affected by economic events such as strikes. The existence of an economic event such as a strike does not mean suspension of the allocation process. The measurement of depreciation is not part of a matching process. The determination of depreciation is not a function of the revenues earned in a particular year.

5.11

Chapter 5: Property, plant and equipment

Exercise 5.5 Determination of cost Seagull Ltd purchased land for use as its corporate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began. Furthermore, a substantial amount of rock blasting and removal of soil had to be done to the site before construction of the foundations of the building began. Because the office building was set back from the public road, Seagull Ltd had the construction company build a paved road that led from the public highway to the entrance to the office building. Required Write a report to the group accountant of Seagull Ltd detailing which of the above expenditures should be capitalised. (LO2) According to paragraph 16 of AASB 116/IAS 16, the cost includes “any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management”. For the current case, these costs may include: • Costs of dismantling small factory: Necessary to get the land ready for constructing new building. Therefore capitalise into cost of land. • Costs of rock blasting and removal of soil: Necessary to get site ready for building. Therefor capitalise into cost of building. • Costs of paved road: Not necessary for the building itself. Capitalise as a separate asset and depreciate separately. It is not a component of the building itself.

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Exercise 5.6 Costs of acquisition Rainbow Ltd has recently acquired a machine for an invoice price of $75 000. Various other costs relating to the acquisition and installation of the machine include transportation, electrical wiring, and preparing a platform for installation. These amounted to $11 250. The machine has an estimated useful life of 10 years, with no residual value at the end of that period. One of the accounting team has suggested that the incidental costs of $11 250 be charged to expense immediately for the following reasons. 1. If the machine is sold, these costs cannot be recovered in the sales price. 2. The inclusion of the $11 250 in the machinery account on the records will not necessarily result in a closer approximation of the market price of the asset over the years because of the possibility of changing demand and supply levels. 3. Charging the $11 250 to expense immediately will lower the depreciation expense in future years. Required Prepare a response to these arguments to be presented at the next meeting of the Rainbow Ltd accounting team. (LO3) The costs relating to acquisition and installation should be capitalised into the cost of the machine as they are necessary to bring the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. In relation to the specific arguments by the member of the accounting team: • The machine is measured at cost not fair value. Under AASB 136 Impairment of assets, there is a test relating to the recoverability of the asset. However recoverability may be higher via use of the asset than by sale of the asset. • As with the previous answer, the asset is measured at cost not fair value and there will be impairment tests to determine whether the asset should be written down based on recoverable amount. • The object of measuring depreciation is not to manage future profits. If the whole asset were expensed, there would be no depreciation in future years.

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Chapter 5: Property, plant and equipment

Exercise 5.7 Purpose of depreciation A new accountant has been appointed to Flamingo Ltd and has implemented major changes in the calculation of depreciation. As a result, some parts of the factory are now subject to higher depreciation charges. This has incensed some operations managers who argue that they take particular care in the maintenance of their machines and, as a result, should not attract such large depreciation charges. They are concerned that these extra charges will reduce the profitability of their sections and may therefore lead to lower bonuses and maybe even the firing of some employees. These operations managers have complained to the group accountant. Required Write a report to these operations managers explaining the reasons for the depreciation policies adopted by Flamingo Ltd. (LO5) The determination of the depreciation charge relies on the consideration of a large number of factors such as useful life, residual value, and consumption of benefits. Some parts of the factory may have: • assets with high initial costs • low residual values • high patterns of use on initial acquisition. These parts of the factory will attract high depreciation charges. However, careful maintenance may lead to: • higher residual values • longer useful lives. The depreciation charge per annum can then be reduced. Good management will not judge performance on factors outside the control of the employees. Cost savings may be a better measure of performance than profitability.

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Exercise 5.8 Determination of cost Grantham Ltd has acquired a new building. Assess which of the following items should be included in the cost of the building. Provide a reason for your conclusions. 1. Stamp duty 2. Real estate agent’s fees 3. Architect’s fees for drawings for internal adjustments to the building required to be made before use 4. Interest on the bank loan to acquire the building, and an application fee to the bank to get the loan, which is secured on the building 5. Cost of changing the name on the building 6. Cost of changing the parking bays 7. Cost of refurbishing the lobby to the building to attract customers and make it more user-friendly (LO3) See paragraph 16 of AASB 116/IAS 16. We should include in the cost of the building the following: 1. Stamp duty. 2. Real estate agent’s fees. 3. Architect’s fees for drawings for internal adjustments to the building required to be made before use. 4. (probably) Interest on the bank loan to acquire the building, and an application fee to the bank to get the loan, which is secured on the building – AASB 123 Borrowing Costs establishes criteria for the recognition of interest as a component of the carrying amount of a self-constructed item of PPE]. Under AASB 123, an entity will capitalise borrowing cost that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use. In this example the interest and the application fee would probably be capitalised. 5. Costs of changing name on building. 7. Costs of refurbishing lobby to the building to attract customers and make it more user friendly. We should exclude from the cost of the building the following: 6. Cost of changing the parking bays - these may be considered as a separate asset, depends for example whether the parking bays are an integral part of the building or external to the building.

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Chapter 5: Property, plant and equipment

Exercise 5.9 Determination of cost Corella Ltd has acquired a new equipment, which it has now installed in its factory. Assess which of the following items should be capitalised into the cost of the building. Provide a reason for your conclusions. 1. Labour and travel costs for managers to inspect possible new items of equipment and for negotiating for the new equipment. 2. Freight costs and insurance to get the new equipment to the factory. 3. Costs for renovating a section of the factory, in anticipation of the new equipment’s arrival, to ensure that all the other parts of the factory will have easy access to the new equipment. 4. Cost of cooling machine to assist in the efficient operation of the new equipment. 5. Costs of repairing the factory door, which was damaged by the installation of the new equipment. 6. Training costs of workers who will use the equipment. (LO3) See paragraph 16 of AASB 116/IAS 16. We should include in the cost of the equipment the following: 1. Labour and travel costs for managers to inspect possible new items of equipment and for negotiating for a new equipment. 2. Freight costs and insurance to get the new equipment to the factory. 3. Costs of renovating a section of the factory, in anticipation of the new equipment’s arrival, to ensure that all the other parts of the factory will have easy access to the new equipment. 4. Cost of cooling machine to assist in the efficient operation of the new equipment. We should exclude from the cost of the equipment the following: 5. Costs of repairing the factory door, which was damaged by the installation of the new equipment: these are not directly attributable to bringing the asset to its location & condition for operation. These costs should be expensed. 6. Training costs of workers who will use the equipment: these benefits cannot be controlled.

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Exercise 5.10 Determination of cost Kingfisher Ltd has acquired a new building for $1 500 000. It has incurred incidental costs of $30 000 in the acquisition process for legal fees, real estate agent’s fees and stamp duties. Management believes that these costs should be expensed because they have not increased the value of the building and, if the building was immediately resold, these amounts would not be recouped. In other words, the fair value of the building is considered to still be $1 500 000. Required Discuss how these costs should be accounted for. (LO3) According to paragraph 16 of AASB 116/IAS 16, the cost of an asset includes any directly attributable costs. This includes professional fees (paragraph 17). The $30 000 incidental costs should therefore be included in the cost of the asset. The cost is then $1 530 000. Paragraph 15 of AASB 116/IAS 16 requires an asset to be recognised initially at cost – in this case $1 530 000. If the asset is subsequently measured under the cost model: Whether or not the asset should be written down depends on whether the asset is impaired. Paragraph 63 of AASB 116/IAS 16 requires an entity to apply AASB 136 Impairment of Assets. If the asset is a part of a cash generating unit, and the recoverable amount of the CGU is greater than the carrying amount of the assets of the CGU then the building will not be written down. If the asset is subsequently measured under the revaluation model: As the fair value is only $1 500 000, a revaluation decrement would be determined and an expense recognised.

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Chapter 5: Property, plant and equipment

Exercise 5.11 Depreciation and revaluation of assets In the 30 June 2022 annual report of Wombat Ltd, the equipment was reported as follows: Equipment (at cost) Accumulated depreciation

250 000 75 000 175 000

The equipment consisted of two machines, Machine A and Machine B. Machine A had cost $150 000 and had a carrying amount of $90 000 at 30 June 2022. Machine B had cost $200 000 and had a carrying amount of $85 000. Both machines are measured using the cost model and depreciated on a straight-line basis over a 10-year period. On 31 December 2022, the directors of Wombat Ltd decided to change the basis of measuring the equipment from the cost model to the revaluation model. Machine A was revalued to $90 000 with an expected useful life of 6 years, and Machine B was revalued to $77 500 with an expected useful life of 5 years. At 1 July 2023, Machine A was assessed to have a fair value of $81 500 with an expected useful life of 5 years, and Machine B’s fair value was $68 250 with an expected useful life of 4 years. Required 1. Prepare journal entries to record depreciation during the year ended 30 June 2023, assuming there was no revaluation. 2. Prepare the journal entries for Machine A for the period 1 July 2022 to 30 June 2023 on the basis that it was revalued on 31 December 2022. 3. Prepare the journal entries for Machine B for the period 1 July 2022 to 30 June 2023 on the basis that it was revalued on 31 December 2022. 4. Prepare the revaluation journal entries required for 1 July 2023. 5. According to accounting standards, on what basis may management change the method of asset measurement, for example from cost to fair value? (LO5 and LO6) 1. 30 June 2023 Depreciation expense – Machine A Accumulated depreciation – Machine A (10% x $150 000) Depreciation expense – Machine B Accumulated depreciation – Machine B (10% x $100 000) 2. 31 December 2022 Depreciation expense – Machine A Accumulated depreciation – Machine A (1/2 x 10% x $150 000)

Dr Cr

15 000

Dr Cr

10 000

Dr Cr

7 500

15 000

10 000

7 500

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Machine A: Cost Accum. depreciation Fair value Increment

$ 150 000 67 500 82 500 90 000 7 500

Accumulated depreciation – Machine A Machine A (Writing the asset down to carrying amount)

Dr Cr

67 500

Machine A Dr Gain on revaluation – Machine A (OCI) Cr (Revaluation of machine from $82 500 to $90 000)

7 500

Gain on revaluation – Machine A (OCI) Asset revaluation surplus – Machine A (Accumulation of net revaluation gain in equity)

Dr Cr

7 500

Dr Cr

7 500

Dr Cr

5 000

Dr Cr

20 000

Loss on revaluation – Machine B (P&L) Dr Machine B Cr (Revaluation of machine from $80 000 to $77 500)

2 500

30 June 2023 Depreciation expense – Machine A Accumulated depreciation – Machine A (1/2 x $90 000/6yrs) 3. 31 December 2022 Depreciation expense – Machine B Accumulated depreciation – Machine B (1/2 x 10% x $100 000) Machine B Cost Accum. depreciation Fair value Decrement

67 500

7 500

5 000

$ 100 000 20 000 80 000 77 500 2 500

Accumulated depreciation – Machine B Machine B (Writing the asset down to carrying amount)

30 June 2023 Depreciation expense – Machine B Accumulated depreciation – Machine B (1/2 x $77 500/5yrs)

Dr Cr

20 000

2 500

7 750 7 750

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Chapter 5: Property, plant and equipment

4. Machine A Revalued amount Accum. Deprec. Carrying amount Fair value Decrement

$ 90 000 7 500 82 500 81 500 1 000

Machine B Revalued amount Accum. Deprec. Carrying amount Fair value Decrement

$ 77 500 7 750 69 750 68 250 1 500

Accumulated depreciation – Machine A Machine A (Writing down to carrying amount) Loss on revaluation – Machine A (OCI) Machine A (Revaluation downwards)

Dr Cr

7 500

Dr Cr

1 000

Asset revaluation surplus – Machine A Loss on revaluation – Machine A (OCI) (Reduction in accumulated equity due to revaluation decrement)

Dr Cr

1 000

Accumulated depreciation – Machine B Machine B (Writing down to carrying amount)

Dr Cr

7 750

Loss on revaluation – Machine B (P&L) Machine B (Writing down to fair value)

Dr Cr

1 500

7 500

1 000

7 750

1 500

5. Basis for change in accounting policy: Consider the cost basis method and the fair value method in relation to the relevance and reliability of information. Current information is generally more relevant than past information. Determination of cost is generally more reliable than determination of fair value. Consider the trade-off between relevance and reliability, that is, as information becomes less reliable it also loses its relevance. A fair value measure may, because of its timeliness, be more relevant but if the measure becomes more unreliable, the relevance of the information decreases.

5.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.12 Revaluation of assets On 30 June 2022, the statement of financial position of Kookaburra Ltd showed the following non-current assets after charging depreciation. Building $ 600 000 Accumulated depreciation (200 000) $ 400 000 Motor vehicle Accumulated depreciation

240 000 (80 000)

160 000

The company has adopted fair value for the valuation of non-current assets. This has resulted in the recognition in previous periods of an asset revaluation surplus for the building of $28 000. On 30 June 2022, an independent valuer assessed the fair value of the building to be $320 000 and the vehicle to be $180 000. Required 1. Prepare any necessary entries to revalue the building and the vehicle as at 30 June 2022. 2. Assume that the building and vehicle had remaining useful lives of 25 years and 4 years respectively, with zero residual value. Prepare entries to record depreciation expense for the year ended 30 June 2023 using the straight-line method. (LO5 and LO6) 1. Accumulated depreciation – Building Building (Writing down to carrying amount)

Dr Cr

200 000

Loss on revaluation – Building (P&L) Loss on revaluation – Building (OCI) Building (Revaluation downwards of building)

Dr Dr Cr

52 000 28 000

200 000

80 000

Asset revaluation surplus - Building Dr 28 000 Loss on revaluation – Building (OCI) Cr 28 000 (Reduction in accumulated equity due to revaluation decrement on building) Accumulated depreciation – Vehicle Vehicle (Writing down to carrying amount)

Dr Cr

80 000

Vehicle Dr Gain on revaluation – Vehicle (OCI) Cr (Revaluation to fair value)

20 000

Gain on revaluation – Vehicle (OCI)

20 000

80 000

20 000

5.21

Chapter 5: Property, plant and equipment

Asset revaluation surplus - vehicle

20 000

2. Depreciation expense – Building Dr Accumulated depreciation – Building Cr ($320 000 / 25 years)

12 800

Depreciation expense – Vehicle Dr Accumulated depreciation – Vehicle Cr ($180 000 / 4 years)

45 000

12 800

45 000

5.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.13 Depreciation Willow Ltd was formed on 1 July 2020 to provide delivery services for packages to be taken between the city and the airport. On this date, the company acquired a delivery truck from Lyons Trucks. The company paid cash of $50 000 to Lyons Trucks, which included government charges of $600 and registration of $400. Insurance costs for the first year amounted to $1200. The truck is expected to have a useful life of 5 years. At the end of the useful life, the asset is expected to be sold for $24 000, with costs relating to the sale amounting to $400. The company prospered in its first year, and management decided at 1 July 2021 to add another vehicle, a flat-top, to the fleet. This vehicle was acquired from a liquidation auction at a cash price of $30 000. The vehicle needed some repairs for the elimination of rust (cost $2300), major servicing to the engine (cost $480) and the replacement of all tyres (cost $620). The company believed it would use the flat-top for another 2 years and then sell it. Expected selling price was $15 000, with selling costs estimated to be $400. On 1 July 2021, both vehicles were fitted out with a radio communication system at a cost per vehicle of $300. This was not expected to have any material effect on the future selling price of either vehicle. Insurance costs for the 2021–22 period were $1200 for the first vehicle and $900 for the newly acquired vehicle. All went well for the company except that, on 1 August 2022, the flat-top that had been acquired at auction broke down. Willow Ltd thought about acquiring a new vehicle to replace it but, after considering the costs, decided to repair the flat-top instead. The vehicle was given a major overhaul at a cost of $6500. Although this was a major expense, management believed that the company would keep the vehicle for another 2 years. The estimated selling price in 3 years’ time is $12 000, with selling costs estimated at $300. Insurance costs for the 2022–23 period were the same as for the previous year. Required Prepare the journal entries for the recording of the vehicles and the depreciation of the vehicles for each of the 3 years. The end of the reporting period is 30 June. (LO5 and LO6) 1 July 2020 Vehicles Cash (Acquisition of delivery truck) Insurance expense Cash (Truck insurance)

Dr Cr

50 000

Dr Cr

1 200

30 June 2021 Depreciation expense – Vehicles Dr Accumulated deprec. – Vehicles Cr (Annual depreciation: 1/5 x ($50 000 - $23 600))

50 000

1 200

5 280 5 280

1 July 2021

5.23

Chapter 5: Property, plant and equipment

Vehicles Cash (Acquisition of flat-top truck)

Dr Cr

Vehicles Dr Cash Cr (Amounts paid on flat-top truck: $2 300 + $620) Servicing expense Dr Cash Cr (Service of flat-top truck)

30 000 30 000

2 920 2 920 480 480

Vehicles Cash (Installation of radios to trucks)

Dr Cr

600

Insurance expense Cash (Insurance on trucks)

Dr Cr

2 100

600

2 100

30 June 2022 Depreciation expense – Vehicles Dr 14 665 Accumulated deprec. – Vehicles Cr 14 665 (Annual depreciation: 1/5 ($50 000 - $23 600) + ¼ x $300 + ½ ($32 920 + $300 – $14 600)) 1 July 2022 Insurance expense Cash (Insurance on trucks)

Dr Cr

2 100 2 100

1 August 2022 Depreciation expense – Vehicles Dr 776 Accumulated deprec. – Vehicles Cr 776 (Annual depreciation on flat-top: 1/12 x ½ ($32 920 + $300 - $14 600)) Accumulated depreciation – Vehicles Dr 10 086 Vehicles Cr 10 086 (Write-down of flat-top truck to carrying amount: $9 310 + $776) Vehicles Cash (Overhaul of flat-top truck)

Dr Cr

6 500 6 500

30 June 2023 Depreciation expense – Vehicles Dr 10 835 Accumulated deprec. – Vehicles Cr 10 835 (Annual depreciation: delivery truck: $5 355 as per previous year; flat-top truck: 11/12 x [1/3 x ($32 920 + $300 - $9 310 - $776 + $6 500 - ($12 000 - $300)] = $5 480)

5.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.14 Depreciation Sejenis Ltd constructed a building for use by its freight department. The completion date was 1 July 2015, and the construction cost was $840 000. The company expected to remain in the building for the next 20 years, at which time the building would probably have no real salvage value. In December 2021, following some severe weather in the city, the roof of the administration building was considered to be in poor shape so the company decided to replace it. On 1 July 2022, a new roof was installed at a cost of $220 000. The new roof was of a different material to the old roof, which was estimated to have cost only $140 000 in the original construction, although at the time of construction it was thought that the roof would last for the 20 years that the company expected to use the building. Because the company had spent the money replacing the roof, it thought that it would delay construction of a new building, thereby extending the original life of the building from 20 years to 25 years. Required Discuss how you would account for the depreciation of the building and how the replacement of the roof would affect the depreciation calculations. (LO5 and LO6) I. If the roof were treated as a separate component of the building: Roof: depreciation p.a. = $140 000 x 1/20 = $7 000 Rest of building: depreciation p.a. = $700 000 x 1/20 = $35 000 At 1 July 2022, the roof would have been depreciated to $91 000 (being $140 000 less 7 x $7 000). This would then be written off on replacement of the roof. The new roof would be depreciated at $12 222, being 1/18 x $220 000 p.a. Further, the rest of the building would have a carrying amount of $455 000, being $700 000 less 7 x $35 000. Depreciation p.a. for the next 18 years would be $25 278. Total depreciation is then $37 500. II. If the roof were not treated as a separate component: Depreciation p.a. = 1/20 x $840 000 = $42 000 At 1 July 2022, the building would have been depreciated to a carrying amount of $546 000, being $840 000 – 7 x $42 000. On replacement of the roof, the total depreciable cost is $766 000, being $546 000 + $220 000. Depreciation p.a. for the next 18 years is $42 556.

5.25

Chapter 5: Property, plant and equipment

Exercise 5.15 Calculation of depreciation On 1 July 2022, Eagle Airlines acquired a new aeroplane for a total cost of $20 million. A breakdown of the costs to build the aeroplane was given by the manufacturers. Aircraft body Engines (2) Fitting out of aircraft: Seats Carpets Electrical equipment: Passenger seats Cockpit Food preparation equipment

$6 000 000 8 000 000 2 000 000 100 000 400 000 3 000 000 500 000

All costs include installation and labour costs associated with the relevant part. It is expected that the aircraft will be kept for 10 years and then sold. The main value of the aircraft at that stage is the body and the engines. The expected selling price is $4.2 million, with the body and engines retaining proportionate value. Costs in relation to the aircraft over the next 10 years are expected to be as follows. (a) Aircraft body. This requires an inspection every 2 years for cracks and wear and tear, at a cost of $20 000. (b) Engines. Each engine has an expected life of 4 years before being sold for scrap. It is expected that the engines will be replaced in 2026 for $9 million and again in 2030 for $12 million. These engines are expected to incur annual maintenance costs of $600 000. The manufacturer has informed Eagle Airlines that a new prototype engine with an extra 10% capacity should be on the market in 2028, and that existing engines could be upgraded at a cost of $2 million. (c) Fittings. Seats are replaced every 3 years. Expected replacement costs are $2.4 million in 2025 and $3 million in 2031. The repair of torn seats and faulty mechanisms is expected to cost $200 000 p.a. Carpets are replaced every 5 years. They will be replaced in 2028 at an expected cost of $130 000, but will not be replaced again before the aircraft is sold in 2032. Cleaning costs amount to $20 000 p.a. The electrical equipment (such as the TV) for each seat has an annual repair cost of $30 000. It is expected that, with the improvements in technology, the equipment will be totally replaced in 2028 by substantially better equipment at a cost of $700 000. The electrical equipment in the cockpit is tested frequently at an expected annual cost of $500 000. Major upgrades to the equipment are expected every 2 years at expected costs of $500 000 (in 2021), $600 000 (in 2023), $690 000 (in 2025) and $820 000 (in 2030). The upgrades will take into effect the expected changes in technology. (d) Food preparation equipment. This incurs annual costs for repair and maintenance of $40 000. The equipment is expected to be totally replaced in 2028.

5.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required 1. Discuss how the costs relating to the aircraft should be accounted for with respect to each of the following. (a) Aircraft body (b) Engines (c) Fittings (d) Food preparation equipment 2. Determine the expenses recognised for the 2022–23 financial year. (LO5) 1. Discuss how the costs relating to the aircraft should be accounted for: Consider: • The advantages of a components approach versus a simple depreciation of the $20 million dollars over the 10-year period. • The treatment of the upgrades of cockpit equipment. • Accounting for inspections. 2. Aircraft body: • Average annual expense of $20 000 for inspection for cracks • Depreciation expense = 1/10 ($6 000 000 – 3/7 x $4 200 000) = $420 000 Engines: • Depreciation expense = $8 000 000/4 = $2 000 000 • Maintenance expense = $600 000 p.a. Fittings: • Seats: - Depreciation = 1/3 x $2 000 000 = $666 667 - Annual expense = $200 000 • Carpets: - Depreciation = 1/5 x $100 000 = $20 000 - Cleaning = $20 000 p.a. • Electrical: - Passenger ▪ Annual expense = $30 000 ▪ Depreciation = 1/6 x $400 000 = $66 667 • Electrical: - Cockpit ▪ Annual expense = $500 000 ▪ Depreciation = 1/10 x $3 000 000 = $300 000 Food preparation equipment: • Annual expense = $40 000 • Depreciation = $500 000/6 = $83 333 For the 2022-23 year: • Total other expenses = $1 400 000 • Annual depreciation = $5 556 666

5.27

Chapter 5: Property, plant and equipment

Exercise 5.16 Acquisition and sale of assets, depreciation Simon’s Turf Farm owned the following items of property, plant and equipment as at 30 June 2022.

Additional information (at 30 June 2022) • The straight-line method of depreciation is used for all depreciable items of PPE. Depreciation is charged to the nearest month and all figures are rounded to the nearest dollar. • The office building was constructed on 1 April 2018. Its estimated useful life is 20 years and it has an estimated residual value of $40 000. • The turf cutter was purchased on 21 January 2019, at which date it had an estimated useful life of 5 years and an estimated residual value of $3200. • The water desalinator was purchased and installed on 2 July 2021 at a cost of $200 000. On 30 June 2022, the plant was revalued upwards by $7000 to its fair value on that day. Additionally, its useful life and residual value were re-estimated to 9 years and $18 000 respectively. The following transactions occurred during the year ended 30 June 2023. (Note: All payments are made in cash.) (i) On 10 August 20122 new irrigation equipment was purchased from Pond Supplies for $37 000. On 16 August 2022, the business paid $500 to have the equipment delivered to the turf farm. William Wagtail was contracted to install and test the new system. In the course of installation, pipes worth $800 were damaged and subsequently replaced on 3 September. The irrigation system was fully operational by 19 September and William Wagtail was paid $9600 for his services. The system has an estimated useful life of 4 years and a residual value of $0. (ii) On 1 December 2022, the turf cutter was traded in on a new model worth $80 000. A trade-in allowance of $19 000 was received and the balance paid in cash. The new machine’s useful life and residual value were estimated at 6 years and $5000 respectively. (iii) On 1 January 2023, the turf farm’s owner decided to extend the office building by adding three new offices and a meeting room. The extension work started on 2 February and was completed by 28 March at a cost of $49 000. The extension is expected to increase the useful life of the building by 4 years and increase its residual value by $5000. (iv) On 30 June 2023, depreciation expense for the year was recorded. The fair value of the water desalination plant was $165 000. Required

5.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Prepare general journal entries to record the transactions and events for the reporting period ended 30 June 2023 in relation to the following assets: (a) Office building (b) Turf cutters (c) Water desalinator (d) Irrigation equipment (LO2, LO3, LO5 and LO6) 10 August 2022 Irrigation equipment Dr 37 000 Cash Cr 37 000 16 August 2022 Irrigation equipment Cash

Dr Cr

500

3 September 2022 Repairs and maintenance expense Cash

Dr Cr

800

19 September 2022 Irrigation equipment Cash

Dr Cr

9 600

1 December 2022 Depreciation expense – Turf cutter Dr Accum. deprec. – Turf cutter Cr (($65 000 - $3 200) / 5 years x 5/12 = $5 150)

5000

800

9 600

5 150 5 150

Carrying amount – Turf cutter Accum. deprec. – Turf cutter Turf cutter

Dr Dr Cr

17 620 47 380

Turd cutter Cash Proceeds on sale – Turf cutter

Dr Cr Cr

80 000

28 March 2023 Depreciation expense – Office building Dr Accum. deprec. – Office building Cr (($150 000 - $40 000) / 20 years x 9/12 = $4 125)

65 000

61 000 19 000

4 125 4 125

Accum. deprec. – Office building Office building ($23 375 + $4 125)

Dr Cr

27 500

Office building Cash

Dr Cr

49 000

7 292

30 June 2023 Depreciation expense – Turf cutter

27 500

49 000

5.29

Chapter 5: Property, plant and equipment

Accum. deprec. – Turf cutter Cr (($80 000 - $5 000) / 6 years x 7/12 = $7 292)

7 292

Depreciation expense – Water desalinator Dr Accum. deprec.– Water desalinator Cr (($189 000 – $18 000) / 9 years = $19 000)

19 000

Depreciation expense – Irrigation eq. Dr Accum. deprec. – Irrigation eq. Cr (($47 100 - $0) / 4 years x 9/12 = $8 831)

8 831

19 000

8 831

Depreciation expense – Office building Dr 1 665 Accum. deprec. – Office building Cr 1 665 ((($150 000 - $27 500 + $49 000) – ($40 000 + $5 000)) / (20 - 5 + 4) years x 3/12 = $1 665) Accum. deprec.– Water desalinator Dr 19 000 Water desalinator Cr Writing down water desalinator to carrying amount)

19 000

Revaluation loss - Water des. (OCI) Dr 5 000 Water desalinator Cr 5 000 (Revaluation decrement from $170 000 carrying amount to $165 000 fair value reversing a previous increment) Asset revaluation surplus Dr 5 000 Revaluation loss - Water des.(OCI) Cr 5 000 (Reduction in equity due to revaluation decrement that reverses a previous increment)

5.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.17 Acquisitions, disposals, depreciation Swan Ltd purchased equipment on 1 July 2021 for $119 400 cash. Transport and installation costs of $12 600 were paid on 5 July 2021. Useful life and residual value were estimated to be 10 years and $5400 respectively. Swan Ltd depreciates equipment using the straight-line method to the nearest month, and reports annually on 30 June. In June 2023, changes in technology caused the company to revise the estimated useful life from 10 years to 5 years, and the residual value from $5400 to $3600. This revised estimate was made before recording the depreciation for the reporting period ended 30 June 2023. (a) On 30 June 2023, the company adopted the revaluation model to account for equipment. An expert valuation was obtained showing that the equipment had a fair value of $90 000 at that date. (b) On 30 June 2024, depreciation for the year was charged and the equipment’s carrying amount was remeasured to its fair value of $48 000. (c) On 30 September 2024, the equipment was sold for $25 200 cash. Required 1. Prepare general journal entries to record depreciation of the equipment for the years ended 30 June 2022 and 2023. 2. Prepare general journal entries to record the transactions and events for the period 1 July 2022 to 30 September 2024 for items (i) to (iii). (Narrations are not required.) (Show all workings and round amounts to the nearest dollar.) (LO5, LO6 and LO7) 1. 30 June 2022 Depreciation expense – Equipment Dr Accum. deprec. – Equipment Cr (($132 000 - $5 400) / 10 years = $12 660)

12 660 12 660

30 June 2023 Depreciation expense – Equipment Dr 28 935 Accum. deprec. – Equipment Cr (($132 000 - $5 400 - $12 660) / 4 years = $28 935) 2. 30 June 2023 Accum. deprec. – Equipment Equipment (Write-down to carrying amount)

Dr Cr

28 935

41 595 41 595

Loss on revaluation – Equipment (P&L) Dr 405 Equipment Cr 405 (Revaluation decrement of $405 from carrying amount $90 405 to fair value $90 000) 30 June 2024 Depreciation expense – Equipment

28 800

5.31

Chapter 5: Property, plant and equipment

Accum. deprec. – Equipment (($90 000 - $3 600) / 3 years = $28 800)

Accum. deprec. – Equipment Equipment (Write-down to carrying amount)

Dr Cr

28 800 28 800 28 800

Loss on revaluation – Equipment (P&L) Dr 13 200 Equipment Cr 13 200 (Revaluation decrement of $13 200 from carrying amount $61 200 to fair value $48 000) 30 September 2024 Depreciation expense – Equipment Dr Accum. deprec. – Equipment Cr (($48 000 - $3 600) / 2 years x 3/12 = $28 800)

5 550 5 550

Accum. deprec. – Equipment Carrying amount – Equipment Equipment

Dr Dr Cr

5 550 42 450

Cash

Dr Cr

25 200

Proceeds on sale – Equipment

48 000

25 200

5.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.18 Revaluation model On 1 July 2022, Resonante Ltd acquired two assets within the same class of plant and equipment. Information on these assets is as follows. Cost

Expected useful life

Machine A

$200 000

5 years

Machine B

120 000

3 years

The machines are expected to generate benefits evenly over their useful lives. The class of plant and equipment is measured using fair value. At 30 June 2023, information about the assets is as follows. Fair value Expected useful life Machine A $168 000 4 years Machine B

76 000

2 years

On 1 January 2024, Machine B was sold for $58 000 cash. On the same day, Resonante Ltd acquired Machine C for $160 000 cash. Machine C has an expected useful life of 4 years. Peewee Ltd also made a bonus issue of 20 000 shares at $1 per share, using $16,000 from the general reserve and $4000 from the asset revaluation surplus created as a result of measuring Machine A at fair value. At 30 June 2024, information on the machines is as follows. Machine A Machine C

Fair value

Expected useful life

$ 122 000 137 000

3 years 3.5 years

Required 1. Prepare the journal entries in the records of Resonante Ltd to record the events for the year ended 30 June 2023. 2. Prepare journal entries to record the events for the year ended 30 June 2024. (LO2, LO3, LO5, LO6 and LO7) 1. 1 July 2022 Machine A Machine B Cash 30 June 2023 Depreciation expense – Machine A Accumulated depreciation – Machine A (1/5 x $200 000)

Dr Dr Cr

200 000 120 000

Dr Cr

40 000

320 000

40 000

5.33

Chapter 5: Property, plant and equipment

Depreciation expense – Machine B Accumulated depreciation – Machine B (1/3 x $120 000)

Dr Cr

40 000

Accumulated depreciation – Machine A Machine A (Writing down to carrying amount)

Dr Cr

40 000

Machine A Gain on revaluation – Machine A (OCI) (Revaluation increment: $160 000 to $168 000)

Dr Cr

8 000

Gain on revaluation – Machine A (OCI) Asset revaluation surplus – Machine A (Accumulation of net revaluation gain in equity))

Dr Cr

8 000

Accumulated depreciation – Machine B Machine B (Writing down to carrying amount)

Dr Cr

40 000

Loss on revaluation – Machine B (P&L) Machine B (Revaluation to fair value at 30/6/23)

Dr Cr

4 000

2. 1 January 2024 Machine C Cash (Acquisition of Machine C)

40 000

8 000

40 000

4 000

Dr Cr

160 000

Depreciation expense – Machine B Accumulated depreciation – Machine B (1/2 x /1/2 x $76 000)

Dr Cr

19 000

Cash

Dr Cr

58 000

Carrying amount – Machine B Accumulated depreciation – Machine B Machine B (Carrying amount of machine sold)

Dr Dr Cr

57 000 19 000

General reserve Asset revaluation surplus – Machine A Share capital

Dr Dr Cr

16 000 4 000

30 June 2024 Depreciation expense – Machine A Accumulated depreciation – Machine A (1/4 x $168 000)

Dr Cr

42 000

Proceeds on sale – Machine B (Sale of Machine B)

160 000

19 000

58 000

76 000

20 000

42 000

5.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Depreciation expense – Machine C Accumulated depreciation – Machine C (1/4 x ½ x $160 000)

Dr Cr

20 000

Accumulated depreciation – Machine A Machine A (Writing down to carrying amount)

Dr Cr

42 000

20 000

42 000

Loss on revaluation – Machine A (OCI) Dr Machine A Cr (Write down of Machine A from $126 000 to $122 000)

4 000

Asset revaluation surplus – Machine A Loss on revaluation – Machine A (OCI) (Accumulation of revaluation loss to equity)

Dr Cr

4 000

Accumulated depreciation – Machine C Machine C (Writing down to carrying amount)

Dr Cr

20 000

Loss on revaluation – Machine C (P&L) Machine C (Revaluation to fair value at 30/6/24)

Dr Cr

3 000

4 000

20 000

3 000

5.35

Chapter 5: Property, plant and equipment

Exercise 5.19 Determining the cost of assets Magpie Ltd uses many kinds of machines in its operations. It constructs some of these machines itself and acquires others from the manufacturers. The following information relates to two machines that it has recorded in the 2023–24 period. Machine A was acquired, and Machine B was constructed by Magpie Ltd itself. Machine A Cash paid for equipment, including GST of $4000 $ Costs of transporting machine — insurance and transport Labour costs of installation by expert fitter Labour costs of testing equipment Insurance costs for 2023–24 Costs of training for personnel who will use the machine Costs of safety rails and platforms surrounding machine Costs of water devices to keep machine cool Costs of adjustments to machine during 2023–24 to make it operate more efficiently Machine B Cost of material to construct machine, including GST of $3500 Labour costs to construct machine Allocated overhead costs — electricity, factory space etc. Allocated interest costs of financing machine Costs of installation Insurance for 2023–24 Profit saved by self-construction Safety inspection costs prior to use

44 000 1 500 2 500 2 000 750 1 250 3 000 4 000 3 750

38 500 21 500 11 000 5 000 6 000 1 000 7 500 2 000

Required Determine the amount at which each of these machines should be recorded in the records of Magpie Ltd. For items not included in the cost of the machines, note how they should be accounted for. (LO3) Machine A: Cost of machine

$44 000 (4 000) 1 500 2 500 2 000 3 000 4 000

GST Transport Installation Testing Safety rails Coolers

5.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3 750 $56 750

Adjustments

Expense the insurance costs of $750 and training $1 250. Machine B: Cost of machine

$38 500 (3 500) 21 500 11 000 5 000 6 000 2 000 $80 500

GST labour overheads interest * installation safety

* Under AASB 123 Borrowing Costs interest must be capitalised. Expense the insurance cost of $1 000. Disregard the profit saved by self-construction.

5.37

Chapter 5: Property, plant and equipment

Exercise 5.20 Classification of acquisition costs Harrier Ltd began operations on 1 July 2022. During the following year, the company acquired a tract of land, demolished the building on the land and built a new factory. Equipment was acquired for the factory and, in March 2023, the factory was ready. A gala opening was held on 18 March, with the local parliamentarian opening the factory. The first items were ready for sale on 25 March. During this period, the following inflows and outflows occurred. (a) While searching for a suitable block of land, Harrier Ltd placed an option to buy with three real estate agents at a cost of $200 each. One of these blocks of land was later acquired. (b) Payment of option fees $ (c) Receipt of loan from bank (d) Payment to settlement agent for title search, stamp duties and settlement fees (e) Payment of arrears in rates on building on land (f) Payment for land (g) Payment for demolition of current building on land (h) Proceeds from sale of material from old building (i) Payment to architect (j) Payment to council for approval of building construction (k) Payment for safety fence around construction site (l) Payment to construction contractor for factory building (m) Payment for external driveways, parking bays and safety lighting (n) Payment of interest on loan (o) Payment for safety inspection on building (p) Payment for equipment (q) Payment of freight and insurance costs on delivery of equipment (r) Payment of installation costs on equipment (s) Payment for safety fence surrounding equipment (t) Payment for removal of safety fence (u) Payment for new fence surrounding the factory (v) Payment for advertisements in the local paper about the forthcoming factory and its benefits to the local community (w) Payment for opening ceremony (x) Payments to adjust equipment to more efficient operating levels subsequent to initial operation

600 800 000 20 000 10 000 200 000 24 000 11 000 46 000 24 000 6 800 480 000 108 000 80 000 6 000 128 000 11 200 24 000 22 000 4 000 16 000 1 000 12 000 6 600

5.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required Using the information provided, determine what assets Harrier Ltd should recognise and the amounts at which they would be recorded. (LO2 and LO3) Land:

Option cost Settlement agent Rates Land Demolition of old building Proceeds on sale of material

$200 20 000 10 000 200 000 24 000 (11 000) $243 200

Building

Architects Council Fence Building Safety inspection Removal of safety fence

$46 000 24 000 6 800 480 000 6 000 4 000 $566 800

Improvements: Driveway et al New fence

$108 000 16 000 $124 000

Equipment:

$128 000 11 200 24 000 22 000 6 600 $191 800

Cost Freight & Insurance Installation Safety equipment Adjustments

Options on land not acquired: expense $400. Interest: $80 000 must be capitalised if relates to a qualifying asset; otherwise it is expensed. The only possible qualifying asset is the factory. In this example, it may be necessary to apportion the interest, depending on what loan was used for – see AASB 123 Borrowing Costs. Advertising: expense $1 000. Opening ceremony: expense $12 000.

5.39

Chapter 5: Property, plant and equipment

Exercise 5.21 Acquisitions, disposals, trade-ins, overhauls, depreciation Li Na is the owner of Kestrel Fishing Charters. The business’s final trial balance on 30 June 2022 (end of the reporting period) included the following balances. Processing plant (at cost, purchased 4 April 2020) Accumulated depreciation — processing plant Charter boats Accumulated depreciation — boats

148 650 (81 274) 291 200 (188 330)

The following boats were owned at 30 June 2022. Boat 1 2 3 4

Purchase date 23 February 2018 9 September 2018 6 February 2019 20 April 2020

Cost Estimated useful life $62 000 $66 400 $78 600 $84 200

5 years 5 years 4 years 6 years

Estimated residual value $3 000 $3 400 $3 600 $3 800

Kestrel Fishing Charters calculates depreciation to the nearest month using straight-line depreciation for all assets except the processing plant, which is depreciated at 30% using the diminishing balance method. Amounts are recorded to the nearest dollar. Required 1. Prepare general journal entries (with narrations) to record the transactions and events for the year ended 30 June 2023. 2. Assume the transactions and events listed in (a) to (d) below occurred during the year ended 30 June 2023. Prepare general journal entries (with narrations) to record the transactions and events for the year ended 30 June 2023, incorporating the information detailed in (a) to (d). 2022 (a) July 26

(b) Dec. 4

Traded in Boat 1 for a new boat (Boat 5) which cost $84 100. A trade-in allowance of $8900 was received and the balance was paid in cash. Registration and stamp duty costs of $1500 were also paid in cash. Li Na estimated Boat 5’s useful life and residual value at 6 years and $4120 respectively. Overhauled the processing plant at a cash cost of $62 660. As the modernisation significantly expanded the plant’s operating capacity and efficiency, Li Na decided to revise the depreciation rate to 25%.

2023 (c) Feb. 26

Boat 3 reached the end of its useful life but no buyer could be found, so the boat was scrapped. (d) June 30 Recorded depreciation. 3. On 26 March, Li Na was offered fish-finding equipment with a fair value of $9500 in © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

exchange for Boat 2. The fish-finder originally cost its owner $26 600 and had a carrying value of $9350 at the date of offer. The fair value of Boat 2 was $9100. If River Song accepts the exchange offer, what amount would the business use to record the acquisition of the fish-finding equipment? Why? Justify your answer by reference to the requirements of AASB 116/IAS 16 relating to the initial recognition of a PPE item. (LO2, LO3, LO4, LO5, LO6 and LO7) 1. 30 June 2023 Depreciation expense - boats Dr 56 550 Accumulated depreciation - boats Cr 56 550 (Depreciation charge for the year: Boat 1: ($62 000 - $3 000) / 5 years = $11 800; Boat 2: ($66 400 – $3 400) / 5 years = $12 600; Boat 3: ($78 600 - $3 600) / 4 years = $18 750; Boat 4: ($84 200 – $3 800) / 6 years = $13 400) Depreciation expense – processing plant Dr 20 213 Accum. depreciation – processing plant Cr 20 213 (Depreciation charge for the year: ($148 650 – $81 274) x 30% = $20 213) 2. 26 July 2022 Depreciation expense - boats Dr 983 Accumulated depreciation - boats Cr 983 (Depreciation charge for the year: Boat 1: ($62 000 - $3 000) / 5 years x 1/12 = $983) Accum. depreciation – boats Carrying amount of boat sold Boats (Derecognition of boat 1 on sale)

Dr Dr Cr

52 117 9 883

Boats Proceeds on sale of boat Cash (Purchase of boat 5 and trade in of boat 1)

Dr Cr Cr

85 600

62 000

8 900 76 700

4 December 2022 Depreciation expense – processing plant Dr 8 422 Accumulated depreciation - processing plant Cr 8 422 (Depreciation to date of overhaul: ($148 650 - $81 274) x 30% x 5/12 = $8 422) Accum. depreciation – processing plant Dr Processing plant Cr (Write down to carrying amount before overhaul)

89 696

Processing plant Cash

Dr Cr

62 660

Dr Cr

12 500

26 February 2023 Depreciation expense - boats Accumulated depreciation - boats

89 696

62 660

12 500

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Chapter 5: Property, plant and equipment

(Depreciation charge to date of scaping: ($78 600 - $3 600) / 4 years x 8/12 = $12 500) Accum. depreciation – boats Dr Carrying amount of boat scrapped Dr Boats Cr (Derecognition of boat 3 at the end of useful life)

75 000 3 600 78 600

30 June 2023 Depreciation expense - boats Dr 38 448 Accumulated depreciation - boats Cr 38 448 (Depreciation charge for the year: Boat 2: ($66 400 – $3 400) / 5 years = $12 600; Boat 4: ($84 200 – $3 800) / 6 years = $13 400; Boat 5: ($85 600 – $4 120) / 6 years x 11/12 = $12 448) Depreciation expense – processing plant Dr 17 735 Accum. depreciation – processing plant Cr (Depreciation charge for the year: ($121 614 x 25% x 7/12 = $17 735)

17 735

3. AASB 116/IAS 16 requires property, plant and equipment items to be initially recognised at cost. Cost is further defined as the ‘amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction’. In this situation, the fish finder is acquired by exchange – no cash is paid – hence, the ‘cost’ of the asset will be measured by reference to the fair value of the consideration given in exchange, that is, boat 2. Thus, the fish finder would be recognised at a cost of $9 100 this being the fair value of boat 2.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.22 Acquisitions, revaluations, replacements, depreciation Robin Trading operates in a very competitive field. To maintain its market position, it purchased two new machines for cash on 1 January 2021. It had previously rented its machines. Machine A cost $40 000 and Machine B cost $100 000. Each machine was expected to have a useful life of 10 years, and residual values were estimated at $2000 for Machine A and $5000 for Machine B. On 30 June 2022, Robin Trading adopted the revaluation model to account for the class of machinery. The fair values of Machine A and Machine B were determined to be $32 000 and $90 000 respectively on that date. The useful life and residual value of Machine A were reassessed to 8 years and $1500. The useful life and residual value of Machine B were reassessed to 8 years and $4000. On 2 January 2023, extensive repairs were carried out on Machine B for $66 000 cash. Robin Trading expected these repairs to extend Machine B’s useful life by 3.5 years, and it revised Machine B’s estimated residual value to $9450. Owing to technological advances, Robin Trading decided to replace Machine A. It traded in Machine A on 31 March 2023 for new Machine C, which cost $64 000. A $28 000 tradein was allowed for Machine A, and the balance of Machine C’s cost was paid in cash. Transport and installation costs of $950 were incurred in respect to Machine C. Machine C was expected to have a useful life of 8 years and a residual value of $8000. Robin Trading uses the straight-line depreciation method, recording depreciation to the nearest month and the nearest dollar. The end of its reporting period is 30 June. On 30 June 2023, fair values were determined to be $140 000 and $65 000 for Machines B and C respectively. Required Prepare general journal entries to record the above transactions and the depreciation journal entries required at the end of each reporting period up to 30 June 2023. (LO2, LO3, LO5, LO6 and LO7) 1. 1 January 2021 Machine A Machine B Cash

Dr Dr Cr

40 000 100 000

30 June 2021 Depreciation expense – Machine A Accumulated depreciation – Machine A (($40 000 – $2 000) / 10 years x 6/12 = $1 900)

Dr Cr

1 900

Depreciation expense – Machine B Accumulated depreciation – Machine B ($100 000 – $5 000) / 10 years x 6/12 = $4 750)

Dr Cr

4 750

140 000

1 900

4 750

5.43

Chapter 5: Property, plant and equipment

30 June 2022 Depreciation expense – Machine A Accumulated depreciation – Machine A (($40 000 – $2 000) / 10 years = $3 800)

Dr Cr

3 800

Depreciation expense – Machine B Accumulated depreciation – Machine B ($100 000 – $5 000) / 10 years = $9 500)

Dr Cr

9 500

Accumulated depreciation – Machine A Machine A (Writing the asset down to carrying amount)

Dr Cr

5 700

3 800

9 500

5 700

Loss on revaluation – Machine A (P&L) Dr 2 300 Machine A Cr 2 300 (Revaluation of Machine A from carrying amount $34 300 = $40 000 – $5 700 to fair value $32 000; Revaluation decrease $2 300) Accumulated depreciation – Machine B Machine B (Writing the asset down to carrying amount)

Dr Cr

14 250

Machine B Dr Gain on revaluation – Machine B (OCI) Cr (Revaluation of Machine B from $85 750 to $90 000)

4 250

Gain on revaluation – Machine B (OCI) Asset revaluation surplus – Machine B (Accumulation of net revaluation gain in equity)

Dr Cr

4 250

Accumulated depreciation – Machine B Machine B (Writing down to carrying amount)

Dr Cr

7 750

Loss on revaluation – Machine B (P&/L) Machine B (Writing down to fair value)

Dr Cr

1 500

14 250

4 250

7 750

1 500

2 January 2023 Depreciation expense – Machine B Dr 5 375 Accumulated depreciation – Machine B Cr 5 375 (Depreciation to date of overhaul: ($90 000 – $4 000) / 8 years x 6/12 = $5 375) Accumulated depreciation – Machine B Machine B (Writing the asset down to carrying amount)

Dr Cr

5 375

Machine B Cash

Dr Cr

66 000

5 375

66 000

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31 May 2023 Depreciation expense – Machine A Dr 2 859 Accumulated depreciation – Machine A Cr 2 859 (Depreciation to date of sale: ($32 000 – $1 500) / 8 years x 9/12 = $2 859) Accumulated depreciation – Machine A Machine A (Writing the asset down to carrying amount)

Dr Cr

2 859

Machine C Dr Loss on sale of Machine A Dr Cash Cr Machine A Cr (Trade-in of Machine A as part cost of Machine C)

64 000 1 141

Machine C Cash (Installation costs for Machine C)

Dr Cr

2 859

36 000 29 141

950 950

30 June 2023 Depreciation expense – Machine B Dr 6 417 Accumulated depreciation – Machine B Cr 6 417 (($90 000 – $5 375 + $66 000 - $9 450) / (8 – 0.5 + 3.5) years x 6/12 = $6 417) Depreciation expense – Machine C Accumulated depreciation – Machine C ($64 950 – $8 000) / 8 years x 3/12 = $1 780) Accumulated depreciation – Machine B Machine B (Writing the asset down to carrying amount)

Dr Cr

1 780

Dr Cr

6 417

1 780

6 417

Loss on revaluation – Machine B (OCI) Dr 4 208 Machine B Cr 4 208 (Revaluation of Machine B from carrying amount $144 208 = $150 625 – $6 417 to fair value $140 000; Revaluation decrease $4 208 that reverses a previous increment) Asset revaluation surplus – Machine B Loss on revaluation – Machine B (OCI)

Dr Cr

4 208

Accumulated depreciation – Machine C Machine C (Writing the asset down to carrying amount)

Dr Cr

1 780

4 208

1 780

Machine C Dr 1 830 Gain on revaluation – Machine C (OCI) Cr 1 830 (Revaluation of Machine C from $63 170 ($64 950 - $ 1 780) to $65 000) Gain on revaluation – Machine C (OCI) Asset revaluation surspuls - Machine C

Dr Cr

1 830 1 830

5.45

Chapter 5: Property, plant and equipment

Exercise 5.23 Depreciation calculation Dove Ltd operates a factory that contains a large number of machines designed to produce knitted garments. These machines are generally depreciated at 10% p.a. on a straight-line basis. In general, machines are estimated to have a residual value on disposal of 10% of cost. At 1 July 2023, Dove Ltd had a total of 50 machines, and the statement of financial position showed a total cost of $630 000 and accumulated depreciation of $195 000. During 2023–24, the following transactions occurred. 1. On 1 September 2023, a new machine was acquired for $22 500. This machine replaced two other machines. One of the two replaced machines was acquired on 1 July 2020 for $12 300. It was traded in on the new machine, with Dove Ltd making a cash payment of $13 200 on the new machine. The second replaced machine had cost $13 500 on 1 April 2021 and was sold for $10 950. 2. On 1 January 2024, a machine that had cost $6000 on 1 July 2014 was retired from use and sold for scrap for $750. 3. On 1 January 2024, a machine that had been acquired on 1 January 2021 for $10 500 was repaired because its motor had been damaged from overheating. The motor was replaced at a cost of $7200. It was expected that this would increase the life of the machine by an extra 2 years. 4. On 1 April 2024, Dove Ltd fitted a new form of arm to a machine used for putting special designs onto garments. The arm cost $1800. The machine had been acquired on 1 April 2021 for $15 000. The arm can be used on a number of other machines when required and has a 15-year life. It will not be sold when any particular machine is retired, but retained for use on other machines. Required 1. Record each of the transactions. The end of the reporting period is 30 June. 2. Determine the depreciation expense for Dove Ltd for 2023–24. (LO5) 1. 1 September 2023 Depreciation expense Dr 185 Accumulated depreciation Cr (Depreciation on machine to be sold: 1/6 x 10% x [$12 300 – $1 230])

185

Machine Dr 22 500 Accumulated depreciation Dr 3 506 Cash Cr 13 200 Gain on sale Cr 506 Machine Cr 12 300 (Trade-in of machine: Carrying amount of machine sold: $12 300 less 38/12 x 10% x [$12 300 – $1 230] = $8 795) Depreciation expense Dr 203 Accumulated depreciation Cr (Depreciation on machine sold: 1/6 x 10% x [$13 500 – $1 350])

203

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cash

Dr Cr Cr Cr

Gain on sale of machine Accumulated depreciation* Machine (Sale of machine) * 29/12 x 10% x [$13 500 – $1 350] = $2 937

10 950 387 2 937 13 500

1 January 2024 Depreciation expense Dr 240 Accumulated depreciation Cr (Depreciation on machine sold: ½ x 10% x [$6 000 – $600]) Cash Loss on sale of machine Accumulated depreciation* Machine (Sale of machine) *9.5 x 10% x [$6 000 – $600] = $5 130

Dr Dr Cr Cr

240

750 120 5 130 6 000

Working: Cost Depreciation (3 x 10% x $9 450)

$10 500 2 835 7 665 New motor 7 200 Carrying amount $14 865 New depreciation per annum = 1/9 [$14 865 – $1 486] = $1 487 Depreciation expense Dr 473 Accumulated depreciation Cr (Depreciation on machine overhauled: ½ x 10% x [$10 500 – $1 050]) Machine Accumulated depreciation Cash (Adjustment due to overhaul of machine) 1 April 2024 Arm Cash (Acquisition of equipment)

Dr Dr Cr

4 365 2 835

Dr Cr

1 800

473

7 200

1 800

2. Workings: Machinery on hand at 1 July 2023 and still on hand at 30 June 2024: = $630 000 + $22 500 – $12 300 – $13 500 – $6 000 + $4 365 = $625 065 Depreciation = 10% x [$625 065 – $62 507] = $56 256 Depreciation on new or replaced machines: 10% x 10/12 x [$22 500 – $2 250] = $1 688 ½ x 1/9 x [$14 865 – $1487] = $744

5.47

Chapter 5: Property, plant and equipment

Depreciation on arm: 1/15 x 3/12 x $1 800 = $30 Total depreciation for 2023-24 = $56 256 + $1 688 + $744 + $30 = $58 718

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 5.24 Depreciation Hawk Ltd started operations on 1 September 2017. Hawk Ltd’s accounts at 31 December 2020 included the following balances.

Equipment (at cost) Accumulated depreciation — equipment Vehicles (at cost; purchased 21 November 2019) Accumulated depreciation — vehicles Land (at cost; purchased 25 October 2017) Building (at cost; purchased 25 October 2017) Accumulated depreciation — building

182 000 96 400 93 600 39 312 162 000 371 440 57 228

Details of equipment owned at 31 December 2020 are as follows.

Equipment

Purchase date

Cost

1 2

7 October 2017 $86 000 4 February 2018 $96 000

Useful life

Residual value

5 years 6 years

$5 000 $6 000

Additional information • Hawk Ltd calculates depreciation to the nearest month and balances the records at month-end. Recorded amounts are rounded to the nearest dollar, and the end of the reporting period is 31 December. • Hawk Ltd uses straight-line depreciation for all depreciable assets except vehicles, which are depreciated on the diminishing balance at 40% p.a. • The vehicles account balance reflects the total paid for two identical delivery vehicles, each of which cost $46 800. • On acquiring the land and building, Hawk Ltd estimated the building’s useful life and residual value at 20 years and $10 000 respectively. Required Prepare general journal entries to record the following transactions which occurred from 1 January 2021. (LO5) 2021 Jan. 3

June 22 Aug. 28

Bought a new equipment (Equipment 3) for a cash price of $114 000. Freight charges of $884 and installation costs of $3516 were paid in cash. The useful life and residual value were estimated at 5 years and $8000 respectively. Bought a second‐hand vehicle for $30 400 cash. Repainting costs of $1310 and four new tyres costing $690 were paid for in cash. Exchanged Equipment 1 for office furniture that had a fair value of $25 000 at the date of exchange. The fair value of Equipment 1 at the date of exchange was

5.49

Chapter 5: Property, plant and equipment

Dec. 31 2022 April 30 May 25 June 26

Dec. 31 2023 Jan. 5

June 20

Oct. 4 Dec. 31

$23 000. The office furniture originally cost $72 000 and, to the date of exchange, had been depreciated by $48 200 in the previous owner’s books. Hawk Ltd estimated the office furniture’s useful life and residual value at 8 years and $1080 respectively. Recorded depreciation. Paid for repairs and maintenance on the equipment at a cash cost of $1856. Sold one of the vehicles bought on 21 November 2019 for $13 200 cash. Installed a fence around the property at a cash cost of $11 000. The fence has an estimated useful life of 10 years and zero residual value. (Debit the cost to a land improvements asset account.) Recorded depreciation. Overhauled Equipment 2 at a cash cost of $24 000, after which Hawk Ltd estimated its remaining useful life at 1 additional year and revised its residual value to $10 000. Traded in the remaining vehicle bought on 21 November 2019 for a new vehicle. A trade-in allowance of $7400 was received and $44 000 was paid in cash. Stamp duty of $1000 and registration and third-party insurance of $1600 were also paid for in cash. Scrapped the vehicle bought on 22 June 2021, as it had been so badly damaged in a traffic accident that it was not worthwhile repairing it. Recorded depreciation.

3 January 2021 Equipment 3 Dr 118 400 Cash Cr (Equipment 3 acquired: $114 000 + $884 + $3 516) 22 June 2021 Vehicles Dr Cash Cr (Vehicle acquired: $30 400 + $1 310 + $690) 28 August 2021 Depreciation expense – Equipment Dr Accum. depreciation – Equipment Cr (Equipment 1 depreciation: $81 000/5 x 8/12)

118 400

32 400 32 400

10 800 10 800

Office furniture Dr 23 000 Accum. depreciation – Equipment* Dr 63 450 Gain on sale ** Cr 450 Equipment 1 Cr 86 000 (Disposal of Equipment 1 and acquisition of office furniture) * 1/5 x ($86 000 – $5 000) x 47/12 ** Proceeds: $23 000; Carrying amount: $86 000 – $63 450 = $22 550

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

31 December 2021 Depreciation expense – Buildings Dr 18 072 Depreciation expense – Equipment Dr 37 080 Depreciation expense – Vehicles Dr 28 196 Depreciation expense – Office furniture Dr 914 Accum. depreciation – Buildings Cr 18 072 Accum. depreciation – Equipment Cr 37 080 Accum. depreciation – Vehicles Cr 28 196 Accum. depreciation – Office furniture Cr 914 (Depreciation of assets: Buildings: ($371 440 – $10 000) / 20 years; Equipment: [Equipment 2: ($96 000 – $6 000) / 6 years = $15 000] + [Equipment 3: ($118 400 – $8 000) / 5 years = $22 080]; Vehicles: [($93 600 – $39 312) x 40% = $21 716] + [$32 400 x 40% x 6/12 = $6 480]; Office furniture: [($23 000 – $1 080)/8 x 4/12 = $914) Note: CA of old vehicles is now = $54 288 – $21 716 = $32 572; CA of new vehicle is now = $32 400 – $6 480 = $25 920) 30 April 2022 Repairs and maintenance expense Dr 1 856 Cash Cr (Repairs and maintenance on equipment) 25 May 2022 Depreciation expense – Vehicles Dr 2 714 Accumulated depreciation – Vehicles Cr (One year old vehicle depreciation: $32 572/2 x 40% x 5/12) Accumulated depreciation – Vehicles * Dr 33 228 Cash Dr 13 200 Loss on vehicle sold ** Dr 372 Vehicles Cr (Disposal of 1 old vehicle) * ($39 312 + $21 716)/2 + $2 714 ** Proceeds of sale $13 200; Carrying amount $13 572 26 June 2022 Land improvements Cash (Installation of fence)

Dr Cr

31 December 2022 Depreciation expense – Buildings Dr Depreciation expense – Equipment Dr Depreciation expense – Vehicles Dr Depreciation expense – Office furniture Dr Depreciation expense – Land improvements Dr Accum. deprec. – Buildings Cr Accum. deprec. – Equipment Cr Accum. deprec. – Vehicles Cr Accum. deprec. – Office furniture Cr Accum. deprec. – Land improvements Cr

1 856

2 714

46 800

11 000 11 000

18 072 37 080 16 882 2 740 550

5.51

Chapter 5: Property, plant and equipment

(Depreciation of assets: Buildings: ($371 440 - $10 000) / 20 years = $18 072; Equipment: [Equipment 2: ($96 000 – $6 000) / 6 years = $15 000] + [Equipment 3: ($118 400 – $8 000) / 5 years = $22 080]; Vehicle: [$16 286 + $25 920] x 40% = $16 882; Office furniture: ($23 000 - $1 080) / 8 years = $2 740; Land improvements: [($11 000 – $0) / 10 years x 6/12 = $550) CA of old vehicle is now = $16 286 – [$16 286 x 40%] = $9 772) CA of new vehicle is now = $25 920 – [$25 920 x 40%] = $15 552 5 January 2023 Accumulated depreciation – Equipment Dr 73 750 Equipment 2 Cr (Machine 2 written down to carrying amount: $15 000 x 59/12) Equipment 2 Cash (Equipment 2 overhauled)

Dr Cr

73 750

24 000 24 000

Equipment 2’s total cost ($96 000 + $24 000) $120 000 Accum. depreciation to 31/12/21 - ($15 000 x 59/12) (73 750) Carrying amount at 05/01/22 46 250 Revised estimated residual value (10 000) Revised depreciable amount $36 250 Equipment 2’s remaining useful life = 6 years – 4 years 11 months + 1 year = 2 years 1 month = 25 months Equipment 2’s depreciation expense p.a. = $36 250 / 25 x 12 = $17 400 20 June 2023 Depreciation expense – Vehicles Dr Accumulated depreciation – Vehicles Cr (Vehicle depreciation: $9 772 x 40% x 6/12)

1 954 1 954

Vehicles * Dr 54 000 Accumulated depreciation – Vehicles ** Dr 38 982 Loss on sale of vehicle *** Dr 418 Cash **** Cr 46 600 Vehicles Cr 46 800 (Trade-in of old vehicle for new vehicle) * $7 400 + $44 000 + $1 000 + $1 600 **$30 514 at 31/12/20 + $6 514 + $1 954 = $38 982 *** Carrying amount = $7 818 = $46 600 - $38 982; Proceeds = $7 400 **** $44 000 + $1 000 + $1 600 4 October 2023 Depreciation expense – Vehicles Dr Accumulated depreciation – Vehicles Cr (Depreciation of vehicles: $15 552 x 40% x 9/12) Accumulated depreciation – Vehicles * Loss on scrapping of vehicles **

Dr Dr

4 666 4 666

21 514 10 886

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Vehicles (Vehicle scrapped) * $6 480 + $10 368 + $4 666 ** $32 400 – $21 514

32 400

31 December 2023 Depreciation expense – Buildings Dr 18 072 Depreciation expense – Equipment Dr 39 480 Depreciation expense – Vehicles Dr 10 800 Depreciation expense – Office furniture Dr 2 740 Depreciation expense – Land improvements Dr 1 100 Accum. deprec. – Buildings Cr 18 072 Accum. deprec. – Equipment Cr 39 480 Accum. deprec. – Vehicles Cr 10 800 Accum. deprec. – Office furniture Cr 2 740 Accum. deprec. – Land improvements Cr 1 100 (Depreciation expense: Buildings: ($371 440 - $10 000) / 20 years; Equipment: [Equipment 2 = $17 400] + [Equipment 3 = $110 200 /5 years = $22 080]; Vehicles: [$54 000 x 40% x 6/12]; Office furniture: $21 920 / 8 years; Land improvements: $11 000/10 years) Note: CA of vehicles is now = $54 000 – $10 800 = $43 200

5.53

Chapter 5: Property, plant and equipment

Exercise 5.25 Applying accounting theory to property, plant and equipment Beatrix was recently appointed as the accountant for Lorikeet Ltd. She was surprised to learn that the company uses the cost model for its buildings. Her previous employer, Raven Ltd, had used the revaluation model for its buildings. Eager to make a good impression with management, Beatrix proposed to adopt the fair value model for buildings, effective from 1 July 2021, in preparing the financial statements of Lorikeet Ltd for the year ended 30 June 2022. She presented the following analysis to senior management to show the effect of adopting the revaluation model. LORIKEET LTD Summarised statement of financial position at 1 July 2021

Additional information • Profit before interest and taxes is usually about $20 million each year. • The remaining useful life of the buildings is 10 years. • Lorikeet Ltd’s senior management are paid a fixed salary plus a share-based bonus if return on investment (ROI) exceeds 10%, where ROI is calculated as profit before interest and taxes/total assets at the beginning of the year. Required 1. Calculate the effect of the revaluation of buildings on depreciation expense for the year ended 30 June 2022. Assume the straight-line depreciation method is used. 2. Using the positive accounting theory perspective discussed in chapter 2 of this text, explain why senior management of Lorikeet Ltd might not be in favour of adopting the revaluation model for buildings. (LO5 and LO6) 1. Depreciation expense would increase by $5 million as a result of the revaluation of the buildings. The carrying amount of the buildings increases by $50 million to $120 million. The increment of $50 million allocated over the remaining useful life of 10 years increases depreciation expense by $5 million per annum. 2. According to positive accounting theory management would not be supportive of the revaluation model because it would reduce the likelihood of a bonus. Depreciation expense would increase by $5 million, decreasing estimated profit before interest and taxes from $20 million to $15 million. The asset base would increase to $200 million. Thus in the year of the revaluation, the ROI would be expected to decrease from 13.3% (20/150) to 7.5% [(20 – 5)/200]. Management would not expect to be eligible for the bonus if the revaluation model is adopted. However, they would expect to be eligible for the bonus if Lorikeet Ltd continues to use the cost model for its buildings.

5.54

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 5: Property, plant and equipment Multiple choice questions 1. Property, plant and equipment includes items that: a. have no physical substance. b. are held for resale. *c. held for rental to others. d. are expected to be used up within one year from date of purchase. Answer: c Learning objective 5.1: discuss the nature of property, plant and equipment.

2. Property, plant and equipment are assets that: a. are expected to be used up within twelve months from purchase date. *b. are physical in nature. c. are held for resale within the current period. d. have a remaining productive life of less than one year. Answer: b Learning objective 5.1: discuss the nature of property, plant and equipment.

3. The cost of property, plant and equipment is only recognised as an asset if it is probable that the future economic benefits will flow to the entity and: a. the asset has been fully paid for in cash. b. the asset has been sent to the buyer. c. it is a physical asset. *d. the cost can be reliably measured. Answer: d Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

5.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The cost of property, plant and equipment is only recognised if the cost of the asset can be reliably measured and: a. the asset has been paid for in cash. b. the asset has been received by the purchaser. c. the cost is not directly attributable to the asset. *d. it is probable that future economic benefits associated with the asset will flow to the entity. Answer: d Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

5. An entity acquired an item of machinery in exchange for a motor vehicle. The carrying amount of the machinery is $8000 and its fair value is $10 000. The journal entry to record the acquisition of the machinery will include: a. a loss on acquisition of $2000. *b. a gain on sale of $2000. c. proceeds on sale of motor vehicle of $2000. d. proceeds on sale of machinery of $2000. Answer: b Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

6. For the purposes of recognising property, plant and equipment assets the acquisition date is the date: a. the consideration is paid. *b. on which the acquirer obtains control of the asset. c. the contract to exchange assets is signed. d. on which the contract to acquire the asset becomes unconditional. Answer: b Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

5.2

Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Gemma Limited acquired a number of assets for $400 000 cash. The fair values of the assets on date of acquisition were: building $320 000, furniture and fittings $80 000. The correct journal entry to record this acquisition is: a.

*c.

DR Property, plant and equipment CR Cash

$400 000

DR Property, plant and equipment CR Cash

$440 000

DR Building DR Furniture and fittings CR Cash

$320 000 $ 80 000

DR Building DR Furniture CR Cash

$352 000 $ 88 000

$400 000

$440 000

$400 000

$440 000

Answer: c Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

8. Costs that may be included in the cost of acquisition of property, plant and equipment assets include:

Site preparation Initial delivery and handling costs Installation and assembly costs Testing whether the asset is functioning

I No No No No

II Yes Yes No No

III Yes Yes Yes Yes

IV Yes No Yes Yes

a. I. b. II. *c. III. d. IV. Answer: c Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

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Testbank to accompany Financial reporting 3e by Loftus et al.

9. After an item of property, plant and equipment has been initially recognised at cost it may be measured using which measurement method? a. *b. c. d.

liquidation value. revaluation. accrual. net realisable value.

Answer: b Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

10. Subsequent to the initial recognition of an asset an entity has a choice on the measurement basis to be adopted. The entity can choose either: *a. cost or revaluation. b. cash or accrual. c. tax or accounting. d. current or non-current. Answer: a Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

11. When applying the revaluation measurement model to assets, the model: a. may only be applied to current assets. b. is applied permanently and may not be changed. *c. applies to the entire class of non-current assets. d. is applied to individual assets within a class of non-current assets. Answer: c Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

12. Depreciation is a process that is designed to: *a. allocate the cost of an asset across its useful life to an entity. b. reduce the carrying amount of an asset to reflect the diminishing fair value of the asset. c. spread the cost of an asset across a period no greater than 10 years. d. reflect the change in value of an asset due to advances in technology. Answer: a Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

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Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Under AASB 116, the depreciation charge for a period reflects: a. the fall in the re-sell value of the asset across the period. *b. the consumption of economic benefits over the period. c. a change in the market value of the asset that has occurred over the period. d. a reduction in the estimated fair value of the asset across the period. Answer: b Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

14. Under the cost model, after initial recognition of a property, plant and equipment asset the item must be carried at its: *a. b. c. d.

cost less accumulated depreciation and less accumulated impairment losses. historical cost. initial cost. net present value.

Answer: a Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

15. Wombat Limited applies the straight-line method of depreciation to its non-current assets. The cost of the buildings was $400 000, the depreciable amount is $350 000, the residual value is $50 000 and the useful life is 10 years. The annual depreciation charge is: *a. b. c. d.

$35 000. $40 000. $50 000. $100 000.

Answer: a Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

16. Roland Limited acquired an item of plant with an expected useful life of 5 years. Expected total production output over this period was: Year 1, 40 000 units; Year 2, 40 000 units; Year 3, 32 000 units; Year 4, 28 000 units Year 5, 15 000 units. The plant cost $200 000 and associated installation costs amounted to $50 000 and residual value is $20 000. The amount of depreciation charged in the first year is: *a. b. c. d.

$57 500 $62 500 $67 500 $92 000

Answer: a Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

17. If a residual value is determined to be of a material amount the entity is required to review the residual value: a. *b. c. d.

monthly. at the end of each reporting period. when completing interim reports. at no time.

Answer: b Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

18. Which of the following statements regarding depreciation is incorrect? a. b. *c. d.

Depreciation is an allocation of the cost of the asset over its useful life. The depreciation method used should best reflect the pattern of usage of the asset over its useful life. Depreciation is a measure of the asset’s change in value. Depreciation is a systematic allocation of the cost of the asset over its useful life.

Answer: c Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

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Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

19. A company depreciates an item of machinery using the straight-line method. The asset was revalued upwards after two years of use. The remaining useful life of four years and the residual value are determined to remain the same. Which of the following relationships reflects the effect of the revaluation on the prospective depreciation of the machinery? a. Depreciation rate = Same; Annual depreciation expense = Same. b. Depreciation rate = Higher; Annual depreciation expense = Higher. *c Depreciation rate = Same; Annual depreciation expense = Higher. d. Depreciation rate = Higher; Annual depreciation expense = Same. Answer: c Learning objective 5.6: explain the revaluation model of measurement.

20. AASB 116 Property, Plant and Equipment requires revaluations to be applied to: a. all assets on an individual basis. *b. assets on a class-by-class basis. c. individual current assets only. d. individual non-current assets only. Answer: b Learning objective 5.6: explain the revaluation model of measurement.

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Testbank to accompany Financial reporting 3e by Loftus et al.

21. Use the following information to answer this question. The draft statement of financial position for Banjo Ltd as at 30 June 2021 discloses the following: Machinery (at cost) Less Accumulated depreciation

$750 000 400 000

$350 000

On the same date, Banjo Ltd assessed the fair value of the machinery to be $400 000. The tax rate is 30%. Depreciation rates are 10% p.a. (accounting) and 12.5% p.a. (tax) using the straight-line method. In accordance with IAS 16 Property, Plant and Equipment, the journal entries necessary to record the revaluation of machinery (ignoring any tax effect) at 30 June 2021 is: *a. Accumulated depreciation — Machinery Machinery

Dr Cr

400 000

Machinery Gain on revaluation — OCI

Dr Cr

50 000

Machinery Gain on revaluation — OCI

Dr Cr

50 000

Gain on revaluation — OCI Asset revaluation surplus

Dr Cr

50 000

Dr Dr — Cr

350 000 50 000

400 000

50 000

b. 50 000

c. 50 000

d. Machinery Gain on revaluation — OCI Accumulated depreciation Machinery

400 000

Answer: a Learning objective 5.6: explain the revaluation model of measurement.

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Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

22. Use the following information to answer this question. The draft statement of financial position for Banjo Ltd as at 30 June 2021 discloses the following: Machinery (at cost) Less Accumulated depreciation

$750 000 400 000

$350 000

On the same date, Banjo Ltd assessed the fair value of the machinery to be $400 000. The tax rate is 30%. Depreciation rates are 10% p.a. (accounting) and 12.5% p.a. (tax) using the straight-line method. The journal entries to adjust for the tax effect of the revaluation at 30 June 2021 is: a. Income tax expense — OCI Deferred tax liability

Dr Cr

15 000

Asset revaluation surplus Income tax expense — OCI

Dr Cr

15 000

Income tax expense — OCI Asset revaluation surplus

Dr Cr

15 000

Income tax expense — OCI Deferred tax liability

Dr Cr

15 000

Gain on revaluation — OCI Income tax expense — OCI Asset revaluation surplus

Dr Cr Cr

50 000

15 000

b. 15 000

c. 15 000

*d. 15 000

15 000 35 000

Answer: d Learning objective 5.6: explain the revaluation model of measurement.

23. Tully Limited had an existing revaluation surplus in respect to an item of plant that has now been derecognised. The appropriate journal entry to transfer the surplus to retained earnings would include: *a. b. c. d.

CR Retained earnings. CR Asset revaluation surplus. DR Gain on revaluation — OCI. DR Retained earnings.

Answer: a Learning objective 5.6: explain the revaluation model of measurement.

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Testbank to accompany Financial reporting 3e by Loftus et al.

24. The resulting gain or loss from the sale of a non-current asset is: a. b. *c. d.

recognised in other comprehensive income, normally with separate disclosure of income and the carrying amount of the asset. recognised in other comprehensive income, normally on a net basis. recognised in current period profit or loss, normally on a net basis. recognised in current period profit or loss, normally with separate disclosure of income and the carrying amount of the asset.

Answer: c Learning objective 5.7: account for derecognition.

25. Footloose Limited acquired furniture and fittings on 1 July 2019 for $42 000. The estimated useful life of the furniture and fittings at acquisition date was 8 years and the residual value was $2000. The company sold all the furniture and fittings on 1 January 2025 for $18 000. The journal entry to reflect the sale is: a. DR Cash DR Accumulated depreciation CR Furniture and fittings CR Gain on sale

$18 000 $30 000

DR Cash CR Proceeds on sale DR Carrying amount of F & F CR Furniture and fittings

$18 000

DR Cash DR Loss on sale CR Furniture and fittings

$18 000 $ 3 500

DR Cash DR Accumulated depreciation CR Furniture and fittings CR Gain on sale

$18 000 $27 500

$42 000 $ 6 000

b. $18 000 $27 500 $27 500

$21 500

*d.

$42 000 $ 3 500

Answer: d Learning objective 5.7: account for derecognition.

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Chapter 5: Property, plant and equipment Not for distribution in full. Instructors may assign selected questions in their LMS.

26. Which of the following statements is incorrect in relation to disclosure of balances for property, plant and equipment? a. b. c. *d.

An entity must disclose the useful life estimates for each class of assets. A summary of movements in the revaluation surplus is required to be disclosed. The gross carrying amounts of the assets at both the beginning and the end of the financial period must be disclosed. Information on assets carried at revalued amounts must be disclosed on an individual asset basis.

Answer: d Learning objective 5.8: outline the disclosure requirements of AASB 116/IAS 16.

27. AASB 116 requires which of the following disclosures for each class of property, plant and equipment? a. b. c. *d.

The type of deprecation methods used. The useful lives or the depreciation rates used. Whether the class of assets is valued using the cost or revaluation method. All of the options are correct.

Answer: d Learning objective 5.8: outline the disclosure requirements of AASB 116/IAS 16.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Ken Leo

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 6: Intangible assets

Chapter 6: Intangible assets Comprehension questions 1. What are the key characteristics of an intangible asset? Paragraph 8 of AASB 138/IAS 38 defines an intangible asset as: An identifiable non-monetary asset without physical substance. Key characteristics are: • Identifiable [see answer to comprehensive question 2 below]: because of its emphasis on markets is inserted to exclude many possible intangibles that are difficult to measure e.g. staff morale, good customer relations. • Non-monetary: this characteristic excludes financial assets such as receivables from being classified as intangibles. • Without physical substance: excludes items of PP&E covered by AASB 116/IAS 16. 2. Explain what is meant by ‘identifiability’. Paragraph 12 of AASB 138/IAS 38 states: An asset meets the identifiability criterion in the definition of an intangible asset when it: (a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. (a) Excludes goodwill, and other possible assets such as staff morale. (b) Is included to allow such assets as water rights, where these were allocated by a government but if not used were unable to be on-sold and so were not separable, to be classified as intangible assets.

3. How do the principles for amortisation of intangible assets differ from those for depreciation of property, plant and equipment? The basic principle of allocation of the depreciable amount on a systematic basis over useful life is the same. With intangibles, straight-line method is the default method where the pattern of receipt of benefits cannot be reliably determined; not so for PPE. Intangibles can have indefinite lives, not so for PPE. For intangibles with finite lives, residual value is assumed to be zero unless criteria in paragraph 100 of AASB 138/IAS 38 are met; not so for PPE.

4. How is the useful life of an intangible asset determined? Useful life must be assessed as finite or indefinite. Note paragraph 90 of AASB 138/IAS 38 in relation to assessment of whether an indefinite useful life exists:

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Many factors are considered in determining the useful life of an intangible asset, including: (a) the expected usage of the asset by the entity and whether the asset could be managed efficiently by another management team; (b) typical product life cycles for the asset and public information on estimates of useful lives of similar assets that are used in a similar way; (c) technical, technological, commercial or other types of obsolescence; (d) the stability of the industry in which the asset operates and changes in the market demand for the products or services output from the asset; (e) expected actions by competitors or potential competitors; (f) the level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the entity's ability and intention to reach such a level; (g) the period of control over the asset and legal or similar limits on the use of the asset, such as the expiry dates of related leases; and (h) whether the useful life of the asset is dependent on the useful life of other assets of the entity.

5. What intangible assets can never be recognised if internally generated? Why? Paragraph 63 of AASB 138/IAS 38 states: Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. Paragraph 64 of AASB 138/IAS 38 gives the reason: Expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognised as intangible assets. 6. Explain the difference between ‘research’ and ‘development’. Paragraph 8 of AASB 138/IAS 38 contains the following definitions: Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use. Paragraph 56 of AASB 138/IAS 38 gives examples of research activities: (a) activities aimed at obtaining new knowledge; (b) the search for, evaluation and final selection of, applications of research findings or other knowledge; (c) the search for alternatives for materials, devices, products, processes, systems or services; and (d) the formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services. © John Wiley and Sons Australia Ltd, 2020

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Chapter 6: Intangible assets

Paragraph 59 of AASB 138/IAS 38 gives examples of development activities: (a) the design, construction and testing of pre-production or pre-use prototypes and models; (b) the design of tools, jigs, moulds and dies involving new technology; (c) the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and (d) the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.

7. Explain when development outlays can be capitalised. Paragraph 57 of AASB 138/IAS 38 states that when all the following criteria are met, development outlays can be capitalised: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale. (b) its intention to complete the intangible asset and use or sell it. (c) its ability to use or sell the intangible asset. (d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. (f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.

8. Explain how intangible assets are initially measured, and whether the measurement differs dependent on whether the assets are acquired in a business combination or internally generated by an entity. Paragraph 24 of AASB 138/IAS 38 states that an intangible asset must be initially measured at cost. When internally generated, cost is based upon capitalisation of development costs. When acquired in a business combination, cost is measured as the fair value of the asset at acquisition date, and a hierarchy of measures of fair value is available – see paragraphs 39-41 of AASB 138/IAS 38.

9. What are the recognition criteria for intangible assets? Paragraph 21 of AASB 138/IAS 38 states: An intangible asset shall be recognised if, and only if: (a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and (b) the cost of the asset can be measured reliably.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

10. Explain the application of the revaluation model for intangible assets. The relevant paragraphs from AASB 138/IAS 38 that deal with the application of the revaluation model to intangible assets are: 75. After initial recognition, an intangible asset shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. For the purpose of revaluations under this Standard, fair value shall be determined by reference to an active market. Revaluations shall be made with such regularity that at the balance sheet date the carrying amount of the asset does not differ materially from its fair value. 81. If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset shall be carried at its cost less any accumulated amortisation and impairment losses. 82. If the fair value of a revalued intangible asset can no longer be determined by reference to an active market, the carrying amount of the asset shall be its revalued amount at the date of the last revaluation by reference to the active market less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. 85. If an intangible 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. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss. 86. If an intangible asset's carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall be debited directly to equity under the heading of revaluation surplus to the extent of any credit balance in the revaluation surplus in respect of that asset. Method is basically the same as that under AASB 116IAS 16 for PPE. AASB 138/IAS 38 has a restriction on use of fair value in that it must be measured by reference to an active market.

11. Explain the use of fair values in the accounting for intangible assets. 1. Initial recognition: Fair values are used to measure cost when intangibles are acquired in a business combination. Fair values may be measured in a variety of ways – see paragraphs 3941. 2. Subsequent to initial recognition: After initial recognition, all intangibles may be measured under the cost model or the revaluation model. However, to use the revaluation model, fair value can only be measured by reference to an active market. AASB 13 defines an active market as “a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis”.

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Chapter 6: Intangible assets

Case studies Case study 6.1 Accounting for brands West Ltd is a leading company in the sale of frozen and canned fish produce. These products are sold under two brand names. • Fish caught in southern Australian waters are sold under the brand ‘Antarctic Fresh’, which is the brand the company developed when it commenced operations and which is still used today. • Fish caught in the northern oceans are sold under the brand name ‘Tropical Taste’, the brand developed by Fishy Tales Ltd. West Ltd acquired all the assets and liabilities of Fishy Tales Ltd a number of years ago when it took over that company’s operations. West Ltd has always marketed itself as operating in an environmentally responsible manner, and is an advocate of sustainable fishing. The public regards it as a dolphinfriendly company as a result of its previous campaigns to ensure dolphins are not affected by tuna fishing. The marketing manager of West Ltd has noted the efforts of the ship, the Steve Irwin, to disrupt and hopefully stop the efforts of whalers in the southern oceans and the publicity that this has received. He has recommended to the board of directors that West Ltd strengthen its environmentally responsible image by guaranteeing to repair any damage caused to the Steve Irwin as a result of attempts to disrupt the whalers. He believes that this action will increase West Ltd’s environmental reputation, adding to the company’s goodwill. He has told the board that such a guarantee will have no effect on West Ltd’s reported profitability. He has explained that, if any damage to the Steve Irwin occurs, West Ltd can capitalise the resulting repair costs to the carrying amounts of its brands, as such costs will have been incurred basically for marketing purposes. Accordingly, as the company’s net asset position will increase, and there will be no effect on the statement of profit or loss and other comprehensive income, this will be a win–win situation for everyone. Required The chairman of the board knows that the marketing manager is very effective at selling ideas but knows very little about accounting. The chairman has, therefore, asked you to provide him with a report advising the board on how the proposal should be accounted for under accounting standards and how such a proposal would affect West Ltd’s financial statements. 1. Accounting for the guarantee: • Is there a liability? Legal or constructive? What is the past event? What obligation exists? • Should it be recognised? • How is it to be measured? • Contingent liability? We can expect that a provision/contingent liability would need to be raised in relation to the guarantee. Measurement issues may lead to the need for a contingent liability.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. Can costs be capitalised into brands? •

• • • •

Note one brand is internally generated and one is acquired. The internally generated brand “Antarctic Fresh” will not be recognised, while “Tropical Taste” was acquired in a business combination and it will be recognised on acquisition. Note that accounting for internally generated brands differs from that for brands acquired in a business combination. Extra outlays on the brand cannot be capitalised into an already existing brand as the outlays are generally to maintain the existing asset rather than increase the asset. Also, it is hard to distinguish the expenditure from the amount spent to develop the business as a whole. AASB 138/IAS 38 says that brands cannot be revalued as no active market exists. Can the outlay be related to the brand or is it internally generated goodwill: does it relate to the entity as a whole rather than a single asset? Cannot recognise internally generated goodwill. Expected result is that any outlays would need to be expensed.

3. Effects on financial statements: • Liability? Provision? • Contingent liability – notes only. • Asset? No. • Profit: expense relating to the guarantee provision?

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Chapter 6: Intangible assets

Case study 6.2 Accounting for intangible assets Mags Ltd is an Australian mail-order company. Although the sector in Australia is growing slowly, Mags Ltd has reported significant increases in sales and net income in recent years. Sales increased from $50 million in 2015 to $120 million in 2021, profit increased from $3 million to $12 million over the same period. The stock market and analysts believe that the company’s future is very promising. In early 2022, the company was valued at $350 million, which was three times 2021 sales and 26 times estimated 2022 profit. Company management and many investors attribute the company’s success to its marketing flair and expertise. Instead of competing on price, Mags Ltd prefers to focus on service and innovation, including: • free delivery • a free gift with orders over $200. As a result of such innovations, customers accept prices that are 60% above those of competitors, and Mags maintains a gross profit margin of around 40%. Nevertheless, some investors have doubts about the company as they are uneasy about certain accounting policies the company has adopted. For example, Mags Ltd capitalises the costs of its direct mailings to prospective customers ($4.2 million at 30 June 2021) and amortises them on a straight-line basis over 3 years. This practice is considered to be questionable as there is no guarantee that customers will be obtained and retained from direct mailings. In addition to the mailing lists developed by in-house marketing staff, Mags Ltd purchased a customer list from a competitor for $800 000 on 4 July 2022. This list is also recognised as a non-current asset. Mags Ltd estimates that this list will generate sales for at least another 2 years, more likely another 3 years. The company also plans to add names, obtained from a phone survey conducted in August 2022, to the list. These extra names are expected to extend the list’s useful life by another year. Mags Ltd’s 2021 statement of financial position also reported $7.5 million of marketing costs as non-current assets. If the company had expensed marketing costs as incurred, 2021 net income would have been $10 million instead of the reported $12 million. The concerned investors are uneasy about this capitalisation of marketing costs, as they believe that Mags Ltd’s marketing practices are relatively easy to replicate. However, Mags Ltd argues that its accounting is appropriate. Marketing costs are amortised at an accelerated rate (55% in year 1, 29% in year 2, and 16% in year 3), based on 25 years’ knowledge and experience of customer purchasing behaviour. Required Explain how Mags Ltd’s costs should be accounted for under AASB 138/IAS 38 Intangible Assets, giving reasons for your answer. AASB 138/IAS 38 definitions: • Asset: A resource: (a) controlled by an entity as a result of past events; and (b) from which future economic benefits are expected to flow to the entity. • Intangible asset: An identifiable non-monetary asset without physical substance. • Identifiable: An asset is identifiable when it:

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) is separable – i.e. can be separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (b) arises from contractual or other legal rights. Costs of direct mailings to prospective customers (capitalised and amortised): • Under AASB 138/IAS 38 internally generated customer lists and items similar in substance shall not be recognised as intangible assets. • Accordingly, Mags Ltd should: - Write off all costs capitalised to date; and - Expense all such costs as incurred from now on. Purchased customer list (capitalised and amortised): • It meets the asset definition. Mags Ltd has control as it has the power to obtain the future economic benefits flowing from it and can restrict the access of others to it. Future economic benefits exist in the form of potential sales. • It also meets the intangible asset definition, as it is non-monetary, has no physical substance, and is identifiable as it can be sold. • Assuming that it is probable that future economic benefits will be obtained from this list, Mags Ltd’s treatment is correct – i.e. recognise it as an intangible asset at cost and then, as the question indicates that Mags Ltd has chosen the cost model, amortise it. Cost of phone survey conducted after customer list purchased (to be capitalised): • Under AASB 138/IAS 38 subsequent expenditure on customer lists and items similar in substance (whether externally acquired or internally generated) is always expensed as incurred. • Hence, Mags Ltd should expense the cost of the phone survey. Marketing costs (capitalised and amortised): • They do not meet the asset definition. Mags Ltd cannot demonstrate control over the future economic benefits flowing from them, as it cannot restrict the access of others to those benefits. AASB 138/IAS 38 states that control normally arises from legal rights (e.g. restraint of trade agreements). Without such rights it is difficult to demonstrate control. • Mags Ltd’s marketing practices and flair are known to competitors and accordingly could be replicated. • Hence, Mags Ltd should: - Write off all costs capitalised to date; and - Expense all such costs as incurred from now on.

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Chapter 6: Intangible assets

Application and analysis questions Exercise 6.1 Financial statements and intangible assets Upton (2001, p. 50) notes: There is a popular view of financial statements that underlies and motivates many discussions of intangible assets. That popular view often sounds something like this: If accountants got all the assets and liabilities into financial statements, and they measured all those assets and liabilities at the right amounts, stockholders’ equity would equal market capitalization. Right? Required Comment on the truth of this ‘popular view’. (LO1) Upton argues that ensuring all the assets and liabilities are in the statement of financial position has never been an objective of accounting. He argues that financial reporting tries to provide information about economic resources and the two groups that hold claims against those resources. It helps to correct or confirm expectations. He provides an example of the mild climate at the entity’s home office. This is not an asset of the entity but it may affect the value of items that are economic resources such as the value of the home office building. Four criteria must be met before including items in a statement of financial position: • definitions • measurability of a relevant attribute • relevance, and • reliability: representationally faithful, verifiable and neutral. Information about some intangibles may be relevant, but many items are not measurable. Some assets may be measurable, but the measurement attribute may not be relevant, for example capitalisation of research costs. Recognition of assets for expenditure for which economic benefits are not probable does not provide relevant information. In outlaying the funds, management’s intention was to generate future benefits. However, the degree of certainty that economic benefits will flow to the entity beyond the current period is insufficient to warrant the recognition of an asset.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 6.2 Useful life of trademark Snapper Ltd holds a trademark that is well known within consumer circles and has enabled the company to be a market leader in its area. The trademark has been held by the company for 9 years. The legal life of the trademark is 5 years, but is renewable by the company at little cost to it. Required Discuss how the company should determine the useful life of the trademark, noting in particular what form of evidence it should collect to justify its selection of useful life. (LO2, LO4 and LO6) 1. Does the company have an asset beyond the 5 years: • are there expected future benefits? • Can the entity control those benefits [are they controlled by the government that issues the licence? Compare with the employee who may leave] • What is the past transaction given the renewal of the trademark for any subsequent term has not yet been granted? 2. Evidence of control is the crucial element. In particular evidence relating to whether the company controls the variables that determine renewal of the trademark. For example, does renewal depend on the company meeting certain criteria which it can control, such as having good business practices, or does it depend on the whim of a government bureaucrat, which the entity cannot control. 3. Note paragraph 90 of AASB 138/IAS 38: • Many factors are considered in determining the useful life of an intangible asset, including: (a) the expected usage of the asset by the entity and whether the asset could be managed efficiently by another management team; (b) typical product life cycles for the asset and public information on estimates of useful lives of similar assets that are used in a similar way; (c) technical, technological, commercial or other types of obsolescence; (d) the stability of the industry in which the asset operates and changes in the market demand for the products or services output from the asset; (e) expected actions by competitors or potential competitors; (f) the level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the entity's ability and intention to reach such a level; (g) the period of control over the asset and legal or similar limits on the use of the asset, such as the expiry dates of related leases; and (h) whether the useful life of the asset is dependent on the useful life of other assets of the entity.

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Chapter 6: Intangible assets

Exercise 6.3 Research and development Sandy Beach Ltd’s research and development section has come up with an idea for a project on using cane toad poison for medicinal purposes. The board of directors of Sandy Beach Ltd believes that the project has promise and could lead to future profits for the firm. The project is, however, very expensive and needs approval from the board. The company’s chief financial officer, Mr Stone, has expressed concern that the profits of the firm have not been strong in recent years and he does not want to see research and development costs charged as expenses to the profit or loss. Mr Stone has proposed that Sandy Beach Ltd should hire an outside firm, Shell Ltd, to undertake the work and obtain the patent. Sandy Beach Ltd could then acquire the patent from Shell Ltd, with no effect on the profit or loss of Sandy Beach Ltd. Required Discuss whether Mr Stone’s proposal is a sound idea, particularly in relation to the effect on the profit or loss of Sandy Beach Ltd. (LO4) If the project is undertaken internally then all costs of research must be expensed, while costs of development cannot be capitalised until all the criteria in paragraph 57 of AASB 138/IAS 38 are met. Mr Stone is correct in his assertion that undertaking this project internally will have an effect on future profits as the project progresses. Mr Stone is also correct in relation to the use of outside consultants, Shell Ltd. Sandy Beach Ltd could acquire in-process research/development from Shell Ltd and recognise this as an asset. Recognition of any asset needs to meet the recognition requirements in the Framework, however the expected benefits would have to be probable. This means that in relation to early research this test may be hard to meet. It would be better to make large payments at extended intervals, e.g. $x in 1 years’ time, rather than monthly payments, as at the first monthly payment it would be harder to meet the probable expected benefits test.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 6.4 Recognition of intangible assets Arrow Ltd has the following: 1. an investment in a subsidiary company 2. training costs associated with a new product 3. the cost of testing in search for product alternatives 4. legal costs incurred in securing a patent 5. long-term receivables. Required Which of these should be included as an intangible asset in the accounts of Arrow Ltd? Give reasons for your answers. (LO3) 1. Investment in a subsidiary company: • Paragraph 2 of AASB 138/IAS 38 excludes financial assets from AASB 138/IAS 38 as these are accounted for under AASB 132. 2. Training costs: • These are not separable; hence training costs are not identifiable as an asset. Paragraph 29(b) of AASB 138/IAS 38 also excludes costs of staff training as part of the cost of an intangible asset as it is not a directly attributable cost. 3. Cost of testing in search of product alternatives: • Paragraph 56(c) of AAB 138/IAS 38 gives as an example of research “the search for alternatives for materials, devices, products, products, systems or services;” Being research these costs are expensed. 4. Legal costs incurred in securing a patent: • These would be costs that are directly attributable to preparing the asset for its intended use and would be capitalised into the cost of the patent as an intangible asset. 5. Long-term receivables: • Monetary items are money held and assets to be received in fixed or determinable amounts of money. • Receivables – short or long term – are monetary assets. • Hence they are not intangible assets.

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Chapter 6: Intangible assets

Exercise 6.5 Recognition of intangible assets Nemo Ltd has the following: 1. the cost of purchasing a trademark 2. unrecovered costs of a successful lawsuit to protect a patent 3. goodwill acquired in the purchase of a business 4. costs of developing a patent 5. the cost of engineering activity to advance the design of a product to the manufacturing stage 6. payments to an advertising agency for advertisements to increase the goodwill of the company. Required Which of these should be included as an intangible asset in the accounts of Nemo Ltd? Give reasons for your answer. (LO3) The key characteristics of an intangible asset are: • identifiable • non-monetary • lack of physical substance. 1. Cost of purchasing a trademark: • A trademark meets each of the above characteristics of an intangible asset. Hence acquisition of a trademark would mean that an intangible asset could be recognised. Initially intangible assets are measured at cost. 2. Unrecovered costs of a successful law suit to protect a patent: • These cannot be recognised as an asset as they are not separable. • Can they be capitalised into the cost of the patent? As they do not add to the benefits of the patent no extra asset is acquired. The costs are of the same nature as “repairs and maintenance costs” for PPE and should be expensed. • In the late 1990s, Walt Disney Company faced the loss of its copyright on “Mickey Mouse” which could have led to the loss of millions of dollars of sales. It went to the Supreme Court and won an extension of copyright lives from 50 to 70 years. These court costs could be capitalised into the copyright on Mickey Mouse as there was an extension to the useful life of the copyright. 3. Goodwill acquired in the purchase of a business: • This can be recognised as an asset under AASB 3. • However goodwill is not an intangible asset as it is not separable. 4. Costs of developing a patent: • The costs of developing a patent must be assessed under the accounting for research and development principles. • Any research costs must be expensed. • Development costs can only be capitalised after the criteria in paragraph 57 of AASB 138/IAS 38 are all met.

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5. Costs of engineering activity to advance the design of a product to the manufacturing stage: • If the criteria listed in paragraph 57 of AASB 138/IAS 38 are all met then these costs can be capitalised into an intangible asset, being the design of the product. 6. Deposits with an advertising agency for advertisements to increase the goodwill of the company: • Internally generated goodwill cannot be recognised. Only acquired goodwill can be recognised as an asset – but not as an intangible asset. • These costs are not costs of acquiring goodwill – goodwill cannot be acquired as a separate asset. • The costs must be expensed.

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Chapter 6: Intangible assets

Exercise 6.6 Brands and formulas Wayne Upton (2001, p. 71) in his discussion of the lives of intangible assets noted that the formula for Coca-Cola has grown more valuable over time, not less, and that Sir David Tweedie, former chairman of the IASB, jokes that the brand name of his favourite Scotch whisky is older than the United States of America — and, in Sir David’s view, the formula for Scotch whisky has contributed more to the sum of human happiness. Required Outline the accounting for brands under AASB 138/IAS 38, and discuss the difficulties for standard setters in allowing the recognition of all brands and formulas on statements of financial position. (LO3 and LO4) Accounting for brands under AASB 138/IAS 38: (a) Internally generated: • Internally generated intangibles must meet the recognition criteria in paragraph 57. • Paragraph 63 specifically excludes the recognition of internally generated brands. (b) Acquired brands: • Recognised at cost. • If acquired as part of a business, AASB 3 states that no recognition criteria need be applied. Provided the asset meets the definition of an intangible asset, it must be recognised as a separate asset. As with separately acquired intangible assets, paragraph B33 of AASB 3 provides that, where intangible assets are acquired as part of a business combination, the effect of probability is reflected in the measurement of the asset. Hence the probability recognition criterion is automatically met. – see also paragraphs 11-12 of AASB 3. • Initially measured at cost = fair value. • Subsequently can be measured at cost or revalued amount, but use of the latter requires the existence of an active market. • Amortisation based on useful life, or non-amortisation on indefinite life Consider a major brand of whisky – Chivas Regal, Johnny Walker etc. – and debate the argument that the brand name is worthless if separated from the company, for example, could Chivas Regal sell the brand name to another company making whisky that tastes different from the Chivas Regal whisky? Or is the brand an integral part of the whole company? Compare with Coca-Cola – would a lemonade company buy the brand name Coca Cola or is the brand an integral part of the whole product of the company?

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Exercise 6.7 Internally generated intangible assets In their article entitled ‘U.S. firms challenged to get “intangibles” on the books’, Byrnes and Aubin (2011) noted that in the United States some companies were accounting for intangibles such as brands, patents and information technology differently when they were developed internally rather than being acquired. This could mean major differences in accounting numbers where internally generated intangibles developed at low costs by one company were sold for large amounts to another company. They noted: The accounting difference could result in distorted behaviour, warns Abraham Briloff, a professor emeritus of accountancy at Baruch College, tempting companies to buy intellectual property rather than doing research themselves . . . Required 1. Explain the accounting for internally generated intangible assets in AASB 138/IAS 38. 2. Discuss any differences between accounting for internally generated intangible assets and acquired intangible assets in AASB 138/IAS 38. 3. Discuss why companies may be reluctant to press for changes in AASB 138IAS 38 to require more recognition of internally generated intangible assets. (LO4) 1. Where there is no related expenditure on the existence of an internally generated asset it cannot be recognised because, under paragraph 24 of AASB 138/IAS 38, intangible assets are initially measured at cost. Expenditure on the development of internally generated intangibles may be capitalised dependent on whether the expenditure is classified as research or development. Research is original and planned investigation with the prospect of new knowledge – see paragraph 56 of AASB 138/IAS 38 for examples. Development is the application of research findings - see paragraph 59 of AASB 138/IAS 38 for examples. Research expenditure is expensed as incurred – paragraph 54 of AASB 138/IAS 38. Development expenditure may be capitalised if all the six criteria in paragraph 57 of AASB 138/IAS 38 are met. Paragraph 63 of AASB 138/IAS 38 states that certain internally generated intangibles such as brands and mastheads cannot ever be recognised. This list does not include patents. Note that “customer relationships” are mentioned in the beginning of the quoted article. This should never be recognised as an intangible asset as it does not been the definition of an asset as the company has no control over that asset. Even it were regard as an asset it does not meet the criterion of identifiability – as it cannot be sold or exchanged – in the definition of an intangible asset. If recognised internally generated intangibles must be amortised unless they have indefinite lives.

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Chapter 6: Intangible assets

2. It is easier to recognise intangibles when they are acquired in comparison to when they are internally generated. For acquired intangibles there is a market transaction and the acquired assets are measured at cost – measured at fair value for business combinations. For assets acquired in a business combination fair values may be used compared with having to determine a cost. With acquired assets, the assets prohibited in paragraph 63 of AASB 138/IAS 38 for recognition as internally generated intangibles, may be recognised. Once recognised, all intangible assets are subsequently treated the same. 3. Some reasons are: • Managers prefer to inflate future profits. Where major investments in research and development are written off, this is a guarantee that future revenues and earnings derived from these acquisitions will be reported unencumbered by the major expense item, the amortisation of the intangible asset. The effects on ratios such as rates of return on assets and equity are better in the future if write-offs occur now rather than periodic amortisations later. • Investors generally consider write-offs as one-time items, of no consequence for valuation. A number of large hits is considered better than periodic amortisation. Investors discount the effect of one-time write-offs and cheer the improved profitability of subsequent years. • Immediate expensing obviates the need to provide explanations in case of failure. Writing off assets denotes failure, and managers prefer to avoid questions and lawsuits. Further failure always attracts more attention than success. • Cost and benefit. Accounting rules involve entities in incurring costs, such as those for running analytical models, measuring fair values, and paying auditors to review the measures. • Lack of relevance of capitalised numbers. Is there a sufficient link between the capitalised costs and the expected future benefits? For knowledge-based assets, the measurement of the benefits may be impossible.

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Exercise 6.8 Intangible assets acquired in a business combination Blue Sky, an internet services provider, acquired ConnectUs, a social networking company, for US$2.4 billion. At the date of acquisition, it recognised three amortisable intangible assets, namely: $’000 Developed technology Customer contracts and related relationships Trade name

1 256 800 473 500 244 000

These intangible assets were acquired as part of a business combination. Required Discuss the accounting for intangible assets acquired in a business combination and how it differs from the recognition and measurement of other intangible assets. (LO4) Separate acquisition

Recognition criteria 1. Benefits to the entity are probable 2. Cost can be reliably measured Measurement

Acquired as part of business combination

Internally generated Research Development

Never recognise Always met

Always met

Usually met

Always met

Cost

Fair value

1. Recognise if the 6 criteria in paragraph 57 are all met. 2. Never recognise assets in paragraph 63. Cost – limited to those incurred after the paragraph 57 criteria are met.

Recognition Before assets are recognised in the accounting records they must meet asset recognition criteria. There are normally two recognition criteria for assets, namely (i) the expected future economic benefits are probable and (ii) the cost can be reliably measured. Paragraph 33 of AASB 138/IAS 38 states that in a business combination, the effect of probability of the existence of future economic benefits is reflected in the measurement of the asset at fair value, hence any probability recognition criteria is automatically met.

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Paragraph 33 of AASB 138/IAS 38 also states that the reliability of measurement recognition test is always met as sufficient information is always available in a business combination to reliably measure intangible assets. As per the table above, with a business combination, there are effectively no recognition criteria for intangible assets as they are always considered to be met. Measurement For intangible assets, the general measurement rule is measurement at cost. However with intangible assets acquired in a business combination cost is measured at fair value, measured in accordance with AASB 13. Provided the intangible assets meet the definition of an asset, they must be recognised as separate assets. Note in particular the asset “Developed technology”: it may be possible that ConnectUs had expensed all development outlays as the criteria in paragraph 57 of AASB 138/IAS 38 had not been met. However in a business combination, development becomes an acquired asset in contrast to an internally developed asset. Blue Sky will recognise any development asset that exists and not also that, it does not have to consider the costs that had been incurred by ConnectUs in relation to development as Blue Sky will measure this asset at fair value.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 6.9 Recognising intangible assets The Global Alliance (2013) provided the following statement in a press release on its website. During an event organised by the Spanish Association of Communication Directors, Dircom, in the framework of the 8th World Public Relations Forum, due to be held in Madrid from 21 to 23 September 2014, Gregory has made it clear that CEOs have a key role to play in this new business environment, which should be governed by authenticity and the heart. ‘Nowadays over 80% of company assets are intangible, which means we need to communicate what makes us unique through our business values.’ She believes this shift has changed the roles within organisations: ‘Intangible assets are increasingly important with regard to other areas of the organisation, such as the finance department. Reputation, brand and the meaning our job conveys to society, the company and our stakeholders are taking precedence over figures and transactions.’ Required Discuss the limitations placed on the recognition of intangible assets in the financial statements of by AASB 138/IAS 38 Intangible Assets. (LO3, LO6 and LO7) Limitations include: 1. The definition of an intangible asset – particularly the criterion of “separability”. Requiring separability means that potential assets such as human resources, reputation, customer relationships labour relations and the “meaning our job conveys to societ y” cannot be recognised as intangible assets. 2. The restrictions in paragraph 63 of AASB 138/IAS 38 on recognition of internally generated brands, mastheads, publishing titles, customer lists and items similar in substance. 3. The requirement to have an active market in order to be able to apply the revaluation method. AASB 138/IAS 38 allows intangible assets acquired in a business combination to be able to be measured at fair value without there being an active market. Why not just allow AASB 13 Fair Value Measurement to apply. 4. The criteria in paragraph 57 of AASB 138/IAS 38 in relation to internally generated intangibles – again why not allow fair value to be used as an upper limit on capitalisation of cost?

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Exercise 6.10 Recognition of intangible assets The latest annual report of Local Media Ltd states that the principal activities of the group are ‘the production and broadcasting of television programs, local and national radio production and broadcasting, the sale of advertising airtime and space in these media’. In the statement of financial position of Local Media Ltd, although goodwill is recognised, no intangible assets are identified. Required 1. List intangible assets that Local Media Ltd is likely to own and state the arguments for and against capitalising each in the statement of financial position. 2. Explain why the statement of financial position excludes some assets that could have been separately identified. (LO3 and LO4) 1. Intangible assets likely to be owned by Local Media Ltd may include: • Distribution networks. • Intellectual property. • Customer contracts. • Licences and mastheads. The above intangible assets are shown on an entity’s statement of financial position at cost less accumulated depreciation and impairment losses where applicable. The notes to the financial statements include additional details about intangible assets to assist with the decision making of the users of those financial statements. Part of the notes for intangibles assets would state whether or not they include capitalised development costs. Which assets are capitalised depends on meeting the requirements of AASB 138 /IAS 38. These differ dependent on whether intangibles are acquired separately, acquired in a business combination or internally developed. 2. The key reason for exclusion of intangible assets from the statement of financial position is that the measurement of such assets is unreliable. This applies particularly to internally developed intangible assets. Whether the criteria for recognition should be as strict as those in paragraph 57 of AASB 138/IAS 38, and whether blanket exclusions such as in paragraph 63 of AASB 138/IAS 38 should be required is subject to debate. The 2008 Discussion Paper by the AASB was written in order to try to influence the IASB in relation to the accounting for internally generated intangibles as there seemed to be a disparity between the recognition of acquired and internally generated intangibles.

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Exercise 6.11 Research and development General Labs Ltd manufactures and distributes a wide range of general pharmaceutical products. Selected audited data for the reporting period ended 31 December 2022 are as follows. Gross profit

26 400 000

Profit before income tax Income tax expense

2 550 000 750 000

Profit for the period

1 800 000

Total assets: Current Non‐current

10 950 000 171 250 000

The company uses a standard mark-up on cost. From your audit files, you ascertain that total research and development expenditure for the year amounted to $7 050 000. This amount is substantially higher than in previous years and has eroded the profitability of the company. Mr Birkdale, the company’s finance director, has asked for your firm’s advice on whether it is acceptable accounting practice for the company to carry forward any of this expenditure to a future accounting period. Your audit files disclose that the main reason for the significant increase in research and development costs was the introduction of a planned 5-year laboratory program to attempt to find an antidote for the common cold. Salaries and identifiable equipment costs associated with this program amounted to $3 525 000 for the current year. The following additional items were included in research and development costs for the year: (a) Costs to test a new tamper-proof dispenser pack for the company’s major selling line (20% of sales) of antibiotic capsules — $1 140 000. The new packs are to be introduced in the 2023 financial year. (b) Experimental costs to convert a line of headache powders to liquid form — $885 000. The company hopes to phase out the powder form if the tests to convert to the stronger and better-handling liquid form prove successful. (c) Quality control required by stringent company policy and by law on all items of production for the year — $1 125 000. (d) Costs of a time and motion study aimed at improving production efficiency by redesigning plant layout of existing equipment — $75 000. (e) Construction and testing of a new prototype machine for producing hypodermic needles — $300 000. Testing has been successful to date and is nearing completion. Hypodermic needles accounted for 1% of the company’s sales in the current year, but it is expected that the company’s market share will increase following introduction of © John Wiley and Sons Australia Ltd, 2020

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this new machine. Required Respond to Mr Birkdale’s question for each item above. (LO4) The outlays must be analysed using paragraph 57 of AASB 138/IAS 38: • Technical feasibility. • Intention to complete and sell. • Ability to use or sell. • Existence of a market. • Availability of resources. • Ability to measure costs reliably. (a) Dispenser pack: As the dispenser pack was a new product, costs incurred until the pack developed met the tests in paragraph 57 of AASB 138/IAS 38 are expensed. In this case, determining the technical feasibility of the pack and developing a cost effective product would have been two key issues. (b) Converting powders to liquid form: The tests have not yet proven successful, therefore the technical feasibility test would not be met and the $885 000 must be expensed. (c) Costs of quality control: These costs relate to products being produced and hence can be capitalised into the products produced. No separate intangible such as “Superior Quality” could be raised as such an asset is not identifiable. (d) Costs of time and motion study: As the equipment is being used in current production, the costs could be capitalised into the cost of the equipment. (e) New prototype machine: This is a difficult one to classify. The question hinges on the “nearing completion” statement. It is a question of what has yet to be done. Questions relating to the criteria in paragraph 57 of AASB 138/IAS 38 need to be asked. For example: has technical feasibility been established, and is it only minor adjustments that are being made? Do any minor adjustments have a material effect on the determination of the costs of the machine?

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Exercise 6.12 Recognition of copyright Marlene Ltd acquired two copyrights during 2022. One copyright related to a textbook that was developed internally at a cost of $12 500. This book is estimated to have a useful life of 5 years from 1 September 2022, the date it was published. The second copyright was purchased from the King George University Press on 1 December 2022 for $24 000. This book, which analyses Aboriginal history in Western Australia prior to 2000, is considered to have an indefinite useful life. Required Discuss how these two copyrights should be reported in the statement of financial position of Marlene Ltd at 30 June 2023. (LO4 and LO7) Internally developed copyright: • It is unlikely that any asset is recognised with this copyright. Being internally developed no costs can be capitalised until all the criteria in paragraph 57 of AASB 138/IAS 38 are met. Also under paragraph 63 of AASB 138/IAS 38, publishing titles can never be recognised as intangible assets. Acquired intangible: • This copyright will be recognised as an intangible asset. • In terms of recognition criteria, the probability recognition criterion is always met. Further the cost can usually be measured reliably. • Intangible assets are measured initially at cost. • In this case the asset will be measured at cost of $24,000. • Having an indefinite life there will be no amortisation charge per annum.

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Exercise 6.13 Recognition of intangible assets JK Ltd is unsure of how to obtain computer software. Four possibilities are: 1. employ its own programmers to write software that the company will use. 2. buy computer software to incorporate into a product that the company will develop. 3. purchase computer software externally, including packages for payroll and general ledger. 4. contract to independent programmers to develop specific software for the company’s own use. Required Discuss whether the accounting will differ depending on which method is chosen. (LO4) 1. Employ programmers: Until the software meets the criteria in paragraph 57 of AASB 138/IAS 38, the costs of the programmers would be expensed. 2. Buy software to include in internally developed project: Assuming the product is still in the research phase, the cost of the software would be expensed, unless the software has alternative uses or could be sold separately. 3. Purchase the software: Being an acquired intangible, the acquirer could recognise an asset, measuring it at the cost of the software. 4. Contract independent programmers: The amounts paid to the contractors would be capitalised as this represents the cost of the acquired software.

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Exercise 6.14 Research and development outlays A small manufacturing company, Ousmane Ltd, has significantly increased it expenditure on research and development over the past year. Required Advise Ousmane Ltd on how research and development expenditure should be accounted for under AASB 138/IAS 38 (disregard any discussion on amortisation of intangible assets). (LO4) Accounting for research and development expenditure will depend on whether the R&D is acquired as a separate asset, acquired as part of a business combination or whether the company has spent money on developing its own intangible assets. Separately acquired assets: • If the company acquired in-process research from another company it would be recognised as an asset if the cost could be reliably measured, which is usually the case – paragraph 26 of AASB 138/IAS 38. There is no need to apply any probability recognition test – paragraph 25 of AASB 138/IAS 38. • Assets meeting the recognition tests are measured at cost being the sum of purchase price and directly attributable costs. Assets acquired in a business combination: • If R&D assets are acquired as part of a business combination there are no recognition tests to be met. Provided the assets meet the definition of an asset they must be recognised as separate assets. • The initial measurement of the asset is at cost being its fair value at acquisition date – paragraph 33 of AASB 138/IAS 38. Expenditure on research activities is expensed when incurred: paragraph 54 of AASB 138/IAS 38. Expenditure on development is capitalised as an intangible asset if all the six criteria in paragraph 57 of AASB 138/IAS 38 are met. If the criteria are not met the expenditure is expensed as incurred. If the criteria are met, the amount to be capitalised is the expenditure incurred from the date when the intangible asset first meets the tests in paragraph 57 of AASB 138/IAS 38. There can be no reinstatement of amounts previously expensed. Paragraph 63 of AASB 138/IAS 38 provides an exclusion in relation to recognising some internally generated assets even if the tests in paragraph 57 of AASB 138/IAS 38 are met: Internally generated brands, mastheads, publishing titles, customer lists and item similar in substance shall not be recognised as intangible assets. Subsequent expenditure: • Paragraph 20 of AASB 138/IAS 38 discusses subsequent expenditure on intangible assets. In general it is expected that subsequent expenditure will be expensed rather than capitalised as it generally maintains currently recognised benefits rather than adds to them. Subsequent expenditure on assets addressed in paragraph 63 of AASB 138/IAS 38 is always expensed. © John Wiley and Sons Australia Ltd, 2020

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Note paragraph 42 of AASB 138/IAS 38 in relation to subsequent expenditures relating to acquired in-process research and development expenditure. Effectively the same criteria for initially recognising an asset and expensing are applied to account for subsequent expenditure, namely: • Research outlays are expensed. • Development outlays are only capitalised if the criteria in paragraph 57 of AASB 138/IAS 38 are all met, otherwise they are expensed.

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Exercise 6.15 Research and development outlays Rosalie Ltd has been involved in a project to develop an engine that runs on extracts from sugar cane. It started the project in February 2023. Between the starting date and 30 June 2023, the end of the reporting period for the company, Rosalie Ltd spent $508 000 on the project. At 30 June 2023, there was no indication that the project would be commercially feasible, although the company had made significant progress and was sufficiently sure of future success that it was prepared to outlay more funds on the project. After spending a further $240 000 during July and August, the company had built a prototype that appeared to be successful. The prototype was demonstrated to a number of engineering companies during September, and several of these companies expressed interest in the further development of the engine. Convinced that it now had a product that it would be able to sell, Rosalie Ltd spent a further $130 000 during October adjusting for the problems that the engineering firms had pointed out. On 1 November, Rosalie Ltd applied for a patent on the engine, incurring legal and administrative costs of $70 000. The patent had an expected useful life of 7 years, but was renewable for a further 7 years upon application. Between November and December 2023, Rosalie Ltd spent an additional amount of $164 000 on engineering and consulting costs to develop the project such that the engine was at manufacturing stage. This resulted in changes in the overall design of the engine, and costs of $10 000 were incurred to add minor changes to the patent authority. On 1 January 2024, Rosalie Ltd invited tenders for the manufacture of the engine for commercial sale. Required Discuss how Rosalie Ltd should account for these costs. Provide journal entries with an explanation of why these are the appropriate entries. (LO4) The outlays must be analysed using paragraph 57 of AASB 138: • Technical feasibility. • Intention to complete and sell. • Ability to use or sell. • Existence of a market. • Availability of resources. • Ability to measure costs reliably. At 30 June 2023: The project is not commercially feasible, therefore all cost to date must be expensed: Research costs Cash (Expensing research costs)

Dr Cr

508 000 508 000

At 31 August 2023: © John Wiley and Sons Australia Ltd, 2020

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These costs must be expensed as the company is not yet convinced it has a product that it can sell: Research costs Cash (Expensing research costs)

Dr Cr

240 000 240 000

At 31 October 2023: The company now has an intention to complete and sell. Potentially, due to the adjustments required by the engineering firms, the company is not yet able to measure the cost of the engine reliably. If that is the case, expenses during this period must be expensed: Research costs Cash (Expensing research costs)

Dr Cr

130 000 130 000

At 1 November 2023: The company now should be able to meet all the criteria in paragraph 57 of AASB 138/IAS 38 and all subsequent outlays should be capitalised: Patent Dr Cash Cr (Recognition of internally generated asset)

70 000 70 000

At 31 December 2023: The project is in the development stage and all outlays can be capitalised: Patent Cash (Capitalisation of development costs)

Dr Cr

174 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 6.16 Considering accounting theory Future Enterprises Ltd, a listed company, commenced a research and development (R&D) project in July 2022 to modify the method of recharging batteries used in its products. The project was successfully completed in June 2023 and the company applied for a patent for the design. Future Enterprises Ltd plans to modify all products in its consumer range over the next two years and has incorporated these plans into its financial budget. The entity expects to derive economic benefits from the new battery recharging technology over the next 10 years. The accountant was unsure how to account for the project so they used the New Project R&D account to accumulate the salaries of all engineers involved in the project during the year ended 30 June 2023. The following analysis of the salaries expenditure is based on the engineers’ time sheets. $ Cost of time spent searching for and evaluating alternative materials Cost of time designing models, and constructing and testing prototypes Cost of time spent on training maintenance workers for the new design

150 000 1 050 000 300 000

The value in use of the design, estimated using present value techniques, is $6 000 000. However, the fair value of the design is estimated to be only $4 500 000 because the only potential buyer would need to modify the design to adapt it to its own products. The following conversation took place between the chief executive officer (CEO) and the accountant (ACC). CEO: That ‘R&D asset’ should make our financial statements look great this year. We can show it is worth $6 000 000 in the balance sheet and add an extra $4 500 000 to profit because it cost only $1 500 000. ACC: I haven’t finalised accounting for it yet but I am quite sure the accounting standard requires us to measure it at historical cost, and some of it will probably have to be recognised as an expense. CEO: It isn’t fair. These conservative accounting rules make it impossible to show investors that our project was successful — and expensing any of it will cause our share price to go down because the investors will think it didn’t work. Required 1. How should the project be accounted for in the financial statements for the year ended 30 June 2023? Justify your answer with reference to relevant paragraphs of AASB 138/IAS 38. 2. To what extent might the rules or restrictions in AASB 138/IAS 38 reduce the comparability of financial statements?

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Chapter 6: Intangible assets

3. Write a response to the CEO, drawing on your understanding of AASB 138/IAS 38 and the efficient market hypothesis (refer to chapter 2 of this text). Include a recommendation as to how the company might mitigate their concerns about investors’ interpretation of the information reported in the financial statements. (LO1, LO2, LO3, LO4 and LO7) 1. The internally generated intangible asset satisfied the recognition criteria because: • it was successfully completed (thus technically feasible — paragraph 57(a) of AASB 138/IAS 38) • they have the intention and ability of using it on their own products (paragraph 57(b) and (c) of AASB 138/IAS 38) • there is a market for its output, through its use in their own products (paragraph 57(d) of AASB 138/IAS 38) • they have the resources to use it evidenced by the budget, (paragraph 57(e) of AASB 138/IAS 38) • and they can measure it reliably (paragraph 57(e) of AASB 138/IAS 38), as discussed below. Costs that are directly attributable to the development phase are included in the cost of the asset until its completion (paragraphs 65 and 66 of AASB 138/IAS 38). This includes the engineers’ salaries for time spent designing models and constructing and testing prototypes (paragraph 66(b) of AASB 138/IAS 38). Costs incurred during the research phase, such as searching for materials, are expensed in the period in which they are incurred (paragraph 54 AASB 138/IAS 38). Costs subsequent to completion and staff training costs are also expensed (paragraph 67(c) of AASB 138/IAS 38). Thus the engineers’ salaries for time spent in the research phase, $300 000, and on staff training, $300 000, should be recognised as an expense in the year ended 30 June 2023. The development of the new battery recharging process should be recognised as an internally generated intangible asset and measured at cost, which is $1 500 000. The intangible asset should be amortised on a straight-line basis over 10 years from the time of completion, when the asset is ready to be used. The internally generated intangible asset should not be revalued because fair value, for the purposes of revaluation under AASB 138/IAS 38, must be made with reference to an active market (paragraph 75 of AASB 138/IAS 38). An active market does not exist for this asset because there is only one potential buyer. 2. The prohibition on the capitalisation of costs incurred in the research phase does not allow entities to distinguish between successful and unsuccessful research. AASB 138/IAS 38 makes an assumption that future economic benefits would be too uncertain during the research phase but this imposes a rule, rather than applying consistent definition and recognition criteria irrespective of the stage of the project in which the costs are incurred. This reduces comparability, because all costs incurred in the research phase are treated as expenses, thus failing to distinguish between successful and unsuccessful projects in the research phase. The omission of costs incurred in the research phase from the carrying amount of the internally generated intangible asset also reduces comparability with purchased intangible assets.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. A market is efficient in the semi-strong form if the security prices in that market rapidly adjust to publicly available information, in an unbiased manner, such that the price reflects all publicly available information. Information about costs incurred in the research phase and those incurred in the development phase, if disclosed, becomes part of the publicly available information set. Thus the efficient market hypothesis implies that the share price would react to both the disclosure of research expenses and the information that the project was successful, conveyed by the recognition of the internally generated intangible asset. However, the financial statements are effectively restricted to the use of cost-based measurement for this type of asset. Accordingly, if Future Enterprises Ltd prefers to signal the greater expected benefits of the new design, supplementary disclosure in the notes or other publicly available sources, such the company’s ‘operating and financial review’ is recommended.

6.33

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 6: Intangible assets Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 6: Intangible assets Multiple Choice Questions 1. Which of the following assets meets the identifiability criteria for recognition as an identifiable intangible asset that can be recorded as acquired in a business combination? *a. b. c. d.

Royalty agreements. Customer base. Continuing development programs. Strong and favourable supplier relations.

Answer: a Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

2. AASB 138 Intangibles requires that an asset meet which of the following criteria to be classified as an identifiable intangible? I. II. III. IV.

It arises from a contractual or legal right. It is separable from the entity. Its cost must be reliably measurable. Its fair value must be able to be reliably measured.

a. I or IV only. *b. I or II only. c. II or III only. d. I or III only. Answer: b Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

3. Items such as market knowledge, effective advertising programs, fundraising capabilities and trained staff are NOT regarded as assets because they: a. are monetary items. *b. are not controlled by the entity. c. cannot be reliably measured. d. are too difficult to manage. Answer: b Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

6.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. A key characteristic that separates intangible assets from assets such as property, plant and equipment is: a. length of useful life. b. separability. c. reliability. *d. lack of physical substance. Answer: d Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

5. Which of the following assets is regarded as meeting the identifiability criteria for recognition as an identifiable intangible asset that may be acquired in a business combination? *a. b. c. d.

Newspaper mastheads. Customer service capability. Outstanding credit ratings. Presence in geographic locations.

Answer: a Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

6. The three key characteristics of intangible assets are: I II III IV V

a. b. c. *d.

Expected future economic benefit Lack of physical substance Identifiable Physical substance Non-monetary in nature

I, II and III I, III, and IV III, IV, and V II, III, and V

Answer: d Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

6.2

Chapter 6: Intangible assets Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Goodwill is distinguished from other intangible assets due to which of the following characteristic? a. monetary nature. b. physical substance. *c. identifiability. d. separability. Answer: c Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

8. AASB 138 Intangibles, requires goodwill to only be recognised as an asset if it: a. is internally generated. *b. is acquired as part of a business combination. c. does not exceed its internally recorded cost. d. arises as a result of creating new assets within the normal business operations. Answer: b Learning objective 5.2: outline the recognition criteria for initial recognition of property, plant and equipment.

9. The recognition criteria that an asset must meet before it may be recognised and presented in the financial statements includes: *a. b. c. d.

results from a past event. having physical substance. relevant to management decision making. verifiability.

Answer: a Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition. 10. AASB 138 Intangibles, defines the ‘research’ phase of the generation of an asset as: a. the use of research findings to create a substantially improved product. b. using knowledge to materially improve a manufacturing device. c. the application of knowledge to a design for new production processes. *d. original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge or understanding. Answer: d Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

6.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. The original and planned investigation undertaken with the prospect of gaining new knowledge is described as: *a. b. c. d.

research. exploration. development. investigation.

Answer: a Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

12. Jameson Limited was involved in a mining exploration business. It commenced a project to design more efficient opal detecting equipment. The following expenditures occurred during the financial year ended 30 June 2022: researcher’s salary $50 000; research consumables $30 000; re-development of the detecting equipment $40 000; final adjustments to the detecting equipment $12 500. The amount to be capitalised by this company as an intangible asset, for the 2022 financial year, is: a. b. c. *d.

$80 000 $90 000 $12 500 $52 500

Answer: d Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

13. Bankstown Limited was involved in a highly successful plastics manufacturing business. It commenced a project to design a more efficient extrusion system for its plastic pipes. The following outlays occurred: September: researcher salaries $30 000; October: research materials $40 000; November: re-development of the extrusion plant $250 000; December: final adjustments to the extrusion plant $25 000. The amount to be expensed by Bankstown Limited at the end of the financial year, 31 December, is: a. *b. c. d.

$30 000 $70 000 $250 000 $275 000

Answer: b Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

6.4

Chapter 6: Intangible assets Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Paragraph 63 of AASB 138 Intangibles, prohibits the recognition of the following internally generated identifiable intangibles:

Brands Mastheads Publishing titles Customer lists

I No

II No

III Yes

IV No

No No

Yes No

Yes Yes

Yes

a. I. b. II. *c. III. d. IV. Answer: c Learning objective 5.3: explain how to measure property, plant and equipment on initial recognition.

15. Unless acquired under a business combination, intangible assets must be initially measured using which of the following measurement approaches? a. *b. c. d.

Net present value. Cost. Diminishing value. Fair value.

Answer: b Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

16. The cost of an intangible asset is comprised of the fair value of the consideration: a. b. *c. d.

plus indirect costs. less directly attributable costs. plus directly attributable costs. less legal costs incurred in the purchase.

Answer: c Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

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Testbank to accompany Financial reporting 3e by Loftus et al.

17. The measurement of fair value is determined in accordance with AASB 13 Fair Value Measurement. AASB 13 defines fair value as one that has all of the following conditions:

The price that would be received to sell an asset or paid to transfer a liability Is an orderly transaction between market participants Based on the measurement date.

I Yes

II Yes

III No

IV Yes

No Yes

Yes Yes

No Yes

Yes No

a. I. *b. II. c. III. d. IV. Answer: b Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

18. When an intangible asset is acquired by an exchange of assets, which of the following measures will need to be considered in the determination of cost? a. The initial cost of the asset given up. *b. The fair value of the asset given up. c. The replacement value of the asset received. d. The carrying amount of the asset received. Answer: b Learning objective 5.4: explain the alternative ways in which property, plant and equipment can be measured subsequent to initial recognition.

19. Under the revaluation method of measuring an intangible, the asset is carried at fair value and subject to charges for: a. b. c. *d.

interest. inflation. improvements. amortisation and impairment.

Answer: d Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

6.6

Chapter 6: Intangible assets Not for distribution in full. Instructors may assign selected questions in their LMS.

20. Cost incurred on intangible assets subsequent to initial expenditure are: a. b. *c. d.

recognised directly in the revaluation reserve account. transferred to the retained earnings account. expensed immediately. capitalised.

Answer: c Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

21. AASB 138 Intangibles, requires that an intangible asset with an indefinite life: a. be amortised across its useful life. b. be amortised across a period of no greater than 10 years. c. not be amortised in periods when it has been properly maintained. *d. not be subject to amortisation charges. Answer: d Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

22. Under AASB 138 Intangibles, an intangible asset with an finite useful life is: a. not able to be recognised by an entity as an asset. b. not subject to annual amortisation charges. c. amortised using the straight-line method over a period of no more than 20 years. *d. amortised systematically over its useful life. Answer: d Learning objective 5.5: explain the cost model of measurement and understand the nature and calculation of depreciation.

23. AASB 138 Intangibles requires which of the following items to be disclosed in relation to intangibles? a. b. c. *d.

Whether the life of the intangible is finite or indefinite. The amortisation method used for intangibles with a finite life. A reconciliation of the beginning and ending carrying amounts for the reporting period. All of the options are required disclosures.

Answer: d Learning objective 5.7: account for derecognition.

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Testbank to accompany Financial reporting 3e by Loftus et al.

24. Which of the following statements is correct? *a. b. c. d.

Separate disclosures are required for internally generated intangibles. AASB 138 requires disclosures about an entity’s intangible assets to be made on an asset by asset basis. Disclosures about the useful lives of intangibles are required with explanations being required where assets are assessed to have finite useful lives. Where the cost model is used, specific disclosures are required including assumptions made on estimating fair values.

Answer: a Learning objective 5.7: account for derecognition.

6.8

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Noel Boys

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 7: Impairment of assets

Chapter 7: Impairment of assets Comprehension questions 1. What is an impairment test? An impairment test is a test to determine if an entity’s assets are overstated, that is, whether the carrying amount of the assets is greater than their recoverable amount.

2. Why is an impairment test considered necessary? An impairment test is considered necessary to ensure that the reporting entity’s assets are not overstated. That is, entity’s assets are carried at no more than their recoverable amount. An entity’s balance sheet may overstate the assets, either because the assets’ fair values are lower than the carrying amounts, or because the accountant’s estimates have resulted in an understatement of accumulated depreciation e.g. estimates of residual value, useful life, pattern of benefits.

3. When should an entity conduct an impairment test? According to paragraph 9 of AASB 136/IAS 36, at each reporting date, an entity must assess whether there is any indication of impairment. If such an indication exists, the entity shall estimate the recoverable amount of the asset.

4. What are some external indicators of impairment? According to paragraph 12 of AASB 136/IAS 36, some examples of external indicators of impairment are: (a) significant decline in market value (b) significant changes in the technological, market, economic or legal environment in which the entity operates (c) increases in market interest rates (d) the carrying amount of the entity’s assets exceeds the entity’s market capitalisation.

5. What are some internal indicators of impairment? According to paragraph 12 of AASB 136/IAS 36, some examples of internal indicators of impairment are: (a) evidence of obsolescence or physical damage (b) assets becoming idle, plans to discontinue operations, plans to dispose of assets (c) economic performance is worse than expected.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

6. What is meant by recoverable amount? Recoverable amount is the higher of an asset’s or a cash generating unit (CGU)’s fair value less costs of disposal and its value in use.

7. How is an impairment loss calculated in relation to a single asset accounted for? According to paragraph 60 of AASB 136/IAS 36, the impairment loss in relation to a single asset is accounted for as follows: • Under the cost model: o Recognise the impairment loss immediately in profit or loss. o Write down the asset to its recoverable amount – if the asset is depreciable, increase accumulated depreciation. • Under the revaluation model: the impairment loss is treated the same as for a revaluation decrease, taking into account any past revaluation increases.

8. What are the limits to which an asset can be written down in relation to impairment losses? With respect to impairment, an asset cannot be written down beyond its recoverable amount. Note that this concept is relevant when applying impairment losses to assets in a cash-generating unit.

9. What is a cash-generating unit (CGU)? A cash generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows largely independent of the cash flows from other assets or groups of assets.

10. How are impairment losses accounted for in relation to cash-generating units? According to paragraph 104 of AASB 136/IAS 36, the following steps need to be taken in order to account for the impairment losses in relation to cash generating units: • Reduce the carrying amount of any goodwill allocated to the CGU. • Allocate any balance of impairment loss to the other assets of the CGU pro rata on the basis of their carrying amounts. 11. Are there limits in adjusting assets within a cash generating unit when impairment losses occur? According to paragraph 105 of AASB 136/IAS 36: • An entity shall not reduce the carrying amount of the asset in a CGU below the highest of: - Its fair value less costs of disposal; - Its value in use; and - Zero.

7.3

Chapter 7: Impairment of assets

12. How is goodwill tested for impairment? According to paragraph 80 of AASB 136/IAS 36, the goodwill is tested for impairment as follows: • At the acquisition date, allocate the goodwill to each of the acquirer’s CGUs • If goodwill cannot be allocated, treat it as a corporate asset • Test goodwill annually for impairment, but note paragraph 99 of AASB 136/IAS 36 may allow use of a preceding period’s information.

13. What is a corporate asset? AASB 138 defines a corporate asset as an asset other than goodwill that contributes to the future cash flows of both the CGU under review and other CGUs. Examples of corporate assets include headquarters, IT equipment or a research centre. The distinctive characteristic of a corporate asset is that it does not generate cash inflows independently of other assets or groups of assets, and its carrying amount cannot be fully attributed to a single CGU.

14. How are corporate assets tested for impairment? According to paragraph 102 of AASB 136/IAS 36: • A corporate asset is one that cannot be fully attributable to a single CGU but, where possible, a portion of its carrying amount should be allocated to one or more CGUs. • If it cannot be allocated on a reasonable and consistent basis, after testing the separate CGUs, identify the smallest group of CGUs that includes the CGU under review and to which the corporate asset can be allocated and test the group of CGUs for impairment.

15. When can an entity reverse past impairment losses? According to paragraph 110 of AASB 136/IAS 36, at each reporting date, an entity shall assess whether there is any indication that past impairment losses – other than for goodwill – may no longer exist or have decreased. If such an indication exists, the recoverable amount is determined. If the recoverable amount exceeds the carrying amount, reversal may occur, subject to the paragraph 117 limitation i.e. the increased carrying amount attributable to the reversal shall not exceed the carrying amount that would have been determined had no impairment loss been recognised.

16. What are the steps involved in reversing an impairment loss? The following steps are involved in reversing an impairment loss: 1. Test for indication that past losses may no longer exist or have decreased. Testing involves analysing external and internal sources of information as per paragraph 111 of AASB 136/IAS 36.

7.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. If test is positive, determine the recoverable amount of the asset or cash generating unit (CGU). 3. If the recoverable amount is greater than the carrying amount, determine the carrying amount that would have been determined had no impairment loss been recognised in prior years. 4. Subject to the limit in step 3 above, if testing an individual asset, write the asset up to its recoverable amount. If the asset is carried under the cost model, the reversal should be recognised as income in profit or loss. If the asset is carried under the revaluation model, the reversal should be treated as a revaluation increase. 5. If testing a CGU, allocate the reversal amount to the assets of the CGU – except goodwill – pro rata to carrying amounts, but ensuring that the carrying amounts of the CGU’s assets are not increased above the lower of: - Recoverable amount; and - Carrying amount had no impairment occurred (paragraph 123 of AASB 136/IAS 36) 6. Adjust subsequent depreciation/amortisation charges of assets (paragraph 121 of AASB 136/IAS 36).

7.5

Chapter 7: Impairment of assets

Case studies Case study 7.1 Indications and determination of impairment losses BHP Billiton released the following announcement to investors and media on 15 January 2016.

Required 1. Describe the process undertaken by BHP Billiton in determining: (a) its assets may have been impaired (b) the value of the impairment losses. 2. In percentage terms, what was the extent of BHP Billiton’s impairment charge against its Onshore US assets?

7.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. Explain the impact of an impairment loss on a company’s gearing ratio. 1(a). BHP Billiton identified significant volatility and much weaker prices in the oil and gas industry. 1(b). In determining the recoverable amount of its onshore US assets, BHP Billiton: • Decreased its medium to long-term gas and short to medium-term oil price assumptions which would decrease their future cash flow forecasts. • Increased its discount rate which would decrease the discounted future cash flows. • Decreased its output projections based on decreasing the number of operational rigs from 7 to 5. 2. The impairment loss of $7.2 billion decreased onshore US assets to $16 billion. Therefore, the pre-impairment carrying amount of these assets was $23.2 billion ($16b + $7.2b). The impairment loss was approximately 31% ($7.2b / $23.2b). A write down of this magnitude would be considered significant. 3. An impairment loss decreases total assets and equity (either through profit or loss or other comprehensive income) while total liabilities are unchanged. Accordingly, gearing measured by either total liabilities to total assets or total liabilities to total equity increases, therefore indicating a deterioration.

7.7

Chapter 7: Impairment of assets

Case study 7.2 Determination of CGUs The Scenic City Council contracts out the bus routes in Scenic City to various subcontractors based on a tender arrangement. Some routes, such as the Express to City routes, are profitable, while others, such as those collecting schoolchildren from remote areas, are unprofitable. As a result, the council requires tenderers to take a package of routes, some profitable, some less so. The Saferide Bus Company has won the contract to operate its buses with a package of five separate routes, one of which operates at a significant loss. Specific buses are allocated by the Saferide Bus Company to each route, and cash flows can be isolated to each route because drivers and takings are specific to each route. Required Write a report to the accountant of Saferide Bus Company which includes the following information. 1. An explanation of why impairment testing may require the use of CGUs, rather than being based on a single asset. 2. An explanation of the factors that should be considered in determining a CGU for Saferide Bus Company. 3. Your determination as to the identification of CGUs for Saferide Bus Company. A cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash flows that are largely independent of the cash inflows from other assets or groups of assets. The impairment test requires a comparison of the recoverable amount of an asset with the higher of the asset’s value in use and fair value less costs of disposal. Value in use requires: • An estimate of the future cash flows the entity expects to derive from the asset. • Expectations about variety in timing of cash flows. • The price for bearing the uncertainty inherent in the asset. These cash flows are based upon data such as financial budgets and forecasts. For some assets, there are no cash flows that are generated independently from those of other assets. The eventual cash flows come from operating the bus routes. The assets, such as the buses, could be sold separately, giving a fair value less costs of disposal. However, as management have decided to operate the bus routes, management’s view, presumably, is that their value in use is greater than their fair value through sale. It is possible to determine the profitability of each route as costs and revenues can be isolated to each route. However, as the council contracts for a package of routes, it is not possible to stop operating a single route in the package. Hence, the tender for the package is based on the group of routes as a package.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The lowest level of identifiable cash flows that are largely independent of the cash flows from other assets is the cash flows of the package of routes. The cash-generating unit is then the package of routes.

7.9

Chapter 7: Impairment of assets

Case study 7.3 Goodwill write-offs Gu and Lev (2011) argue that the root cause of many goodwill write-offs is that the shares of the buyer are overpriced at the acquisition date. Figure 7.8 presents eBay’s cumulative stock return against the S&P 500 index from 2003. In mid-September 2005, eBay acquired the internet phone company Skype for $2.6 billion. On 1 October 2007, it announced a massive goodwill write-off of $1.43 billion (55% of the acquisition price) related to the Skype acquisition. Gu and Lev argue that the root cause of this behaviour is the incentives of managers of overvalued firms to acquire businesses, whether to exploit the overpricing for shareholders’ benefit or to justify and prolong the overpricing to maintain a facade of growth. Goodwill write-offs are accordingly an important business event signalling a flawed investment strategy.

Required 1. Explain the circumstances under which goodwill is recognised and how any subsequent write-off occurs. 2. Explain why a significant goodwill write-off may signal a ‘flawed investment strategy’. Goodwill arises upon acquisition of a business combination. It is determined by the excess of consideration over the fair value of net assets acquired. Goodwill is then allocated to each of the

7.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

cash generating units (CGUs) or groups of CGUs, expected to benefit from the synergies of the business combination. If a CGU is subsequently identified as impaired, the impairment loss is first allocated to the goodwill before being allocated to any of the other assets in the CGU. Once goodwill has been written off as impaired, it can never be reversed. Goodwill represents a premium paid by the acquirer over and above the fair value of the net assets of a business. The more the acquirer pays, the greater the value placed on the goodwill acquired. Goodwill impairment is recognised when the recoverable amount of the business (i.e. the CGU) falls below the carrying amount. A significant goodwill write-off may indicate that the acquirer has overestimated the future earning capacity of the business and that the acquirer paid too much when acquiring the business, hence a flawed investment strategy.

7.11

Chapter 7: Impairment of assets

Case study 7.4 Impairment under the revaluation model ‘Impairment is only relevant to assets carried under the cost model. For assets carried under the revaluation model, such as our land and buildings, increases and decreases in fair value dictate whether carrying amounts are adjusted up or down. We don’t bother testing land and buildings for impairment.’ Required Critically evaluate the above statement. The objective of impairment testing is to ensure that assets are not carried at an amount that exceeds their recoverable amount. The revaluation model increases and decreases the carrying amounts of assets in line with changes in fair value. While there is a link between fair value and recoverable amount, they are different. To ignore a revalued asset’s recoverable amount exposes the entity to the risk that an asset’s fair value could exceed its recoverable amount. This could occur whenever an asset’s recoverable amount is its fair value less costs of disposal. If the asset is revalued to fair value, its carrying amount is overstated by the amount of the disposal costs. Another point to consider is that impairment testing is done annually whereas revaluations may be done less frequently (say, every 3 to 5 years). Ignoring potential impairment losses during the revaluation cycle increases the risk of potential overstatement. In summary, impairment is relevant to assets carried under the revaluation model and such assets should be tested for impairment.

7.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 7.5 Impact of impairment losses On 28 August 2014, Qantas announced an annual statutory loss after tax of $2.8 billion for the 12 months ended 30 June. This result included a massive $2.6 billion write-down of its international aircraft fleet. These losses were the largest in the airline’s history and were seen to represent ‘one of the biggest clearing of the decks in corporate history’ (Bartholomeusz 2014). In the media release announcing the loss, Qantas CEO Alan Joyce was quoted: ‘There is no doubt today’s numbers are confronting’, yet he remained remarkably optimistic about the future, going on to say ‘We expect a rapid improvement in the Group’s financial performance — and a return to Underlying PBT profit in the first half of FY15’ (Qantas Group 2014). Required 1. Explain how such a massive impairment loss could be linked to any improved future performance. 2. Review the 2015 and 2016 annual reports of Qantas to determine if Alan Joyce’s optimism was justified. 1. The recognition of an impairment loss decreases the carrying amount of assets which, in turn, will decrease the depreciation charge in future periods. In combination, the absence of the impairment loss and the lower depreciation expense in 2015 will result in significantly less expense recognised in profit or loss compared to 2014. Also, consider that the impairment losses decrease total assets and total equity in 2014. Profitability measured by ROE (profit / equity) and ROA (EBIT / total assets) are likely to improve due to potentially higher numerators and lower denominators. 2. A review of the annual reports reveals the following line items from the income statement (note all figures are in $ millions):

Revenue Depreciation and amortisation Impairment of CGU Fuel Profit or (loss)

2016 16 200 1 224 3 250 1 029

2015 15 816 1 096 3 937 560

2014 15 352 1 422 2 560 4 461 (2 843)

In its 2015 Annual Report, Qantas boasted a $1.6b turnaround in its underlying profit up from a loss of $646m the previous year to $975m (source: Note 4, p59 Qantas Annual Report 2015).

7.13

Chapter 7: Impairment of assets

While this change in underlying profit does not include the impact of the $2.56b impairment loss in 2014, the figures above confirm the decrease in depreciation from 2014 to 2015 arising from the impairment loss reducing carrying amounts of depreciable assets. This decrease in expenses alone accounts for around 20% of the turnaround. The line item disclosing the decreasing trend in fuel costs (in spite of the increase in revenue) is of interest given that one of Qantas’ assumptions in determining the 2014 impairment loss was anticipating future increases in fuel costs.

7.14

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Application and analysis exercises Exercise 7.1 Determining recoverable amount and impairment adjustments Consider the following information relating to five different items of plant and equipment at the reporting date.

Required 1. Calculate the recoverable amount for each of the five items of plant and equipment. 2. Assuming plant and equipment is carried under the cost model, determine the amount of any impairment adjustment necessary. 3. Assuming plant and equipment is carried under the revaluation model, determine the amount of any revaluation adjustment necessary. (LO3 and LO4) 1. Recoverable amount (RA) = higher of FV less costs of disposal and value in use. Asset A: $220 000 (higher of $204 000 and $220 000) Asset B: $96 000 (higher of $88 000 and $96 000) Asset C: $166 000 (higher of $166 000 and $164 000) Asset D: $440 000 (higher of $370 000 and $440 000) Asset E: $234 000 (higher of $234 000 and $230 000) 2. Impairment adjustment is necessary when RA < CA. Asset A: No impairment (RA of $220 000 > CA of $200 000) Asset B: Impairment adjustment of $4 000 (RA of $96 000 < CA of $100 000) Asset C: No impairment (RA of $166 000 > CA of $160 000) Asset D: No impairment (RA of $440 000 > CA of $400 000) Asset E: Impairment adjustment of $6 000 (RA of $234 000 < CA of $240 000) 3. Under revaluation model revalue to lower of FV and RA. Asset A: Revaluation increase of $10 000 (CA $200 000; FV $210 000; RA $220 000) Asset B: Revaluation decrease of $10 000 (CA $100 000; FV $90 000; RA $96 000) Asset C: Revaluation increase of $6 000 (CA $160 000; FV $170 000; RA $166 000) Asset D: Revaluation decrease of $20 000 (CA $400 000; FV $380 000; RA $440 000) Asset E: Revaluation decrease of $6 000 (CA $240 000; FV $240 000; RA $234 000)

7.15

Chapter 7: Impairment of assets

Exercise 7.2 Impairment of an individual asset On 1 April 2021 the construction of a fixed oil platform is completed and ready for use at a total cost of $500 million. The useful life of the rig is linked to the 25-year exploration rights granted to the company. Due to the specific nature of the platform it is deemed to have no realisable value (other than minimal scrap value) at any stage throughout its life. All impairment tests are therefore based on value-in-use estimations. On 30 June 2023 a rapid and significant decline in world oil prices has provided an indication that the asset may be impaired. On this date, the rig’s value in use is estimated to be $414 million. On 30 June 2024 a major contract was cancelled after one of the company’s customers was declared bankrupt. This led directors to believe the value in use of the rig was now $374 million. Required Prepare the necessary journal entries to record adjustments for impairment on 30 June 2023 and 30 June 2024. (LO3 and LO4) 30 June 2023 Impairment loss – Oil rig Dr 41 000 000 Accum. deprec. & impairment losses – Oil rig Cr 41 000 000 [Cost of $500 000 000 with 25 years life; Depreciation of $20 000 000 p.a.; Accum. depreciation after 2¼ years = $45 000 000; CA = $455 000 000, RA = $414 000 000, so impairment of $41 000 000] 30 June 2024 Impairment loss – Oil rig Dr 21 802 198 Accum. deprec. & impairment losses – Oil rig Cr 21 802 198 [CA at 30/6/2023 of $414 000 000 with 22¾ years life, Depreciation for year of $18 197 802 and CA of $395 802 198; RA of $374 000 000 so impairment of $21 802 198]

7.16

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Exercise 7.3 Impairment of an individual asset, calculating value-in-use Flash Ltd acquired a machine for $125 000 on 1 July 2022. It depreciated the asset at 10% p.a. on a straight-line basis. On 30 June 2024, Flash Ltd conducted an impairment test on the asset. It determined that the asset could be sold to other entities for $77 000 with costs of disposal of $1000. Management expect to use the machine for the next four years with expected cash flows from use of the machine being: 2024 2025 2026 2027

$40 000 30 000 25 000 20 000

The rate of return expected by the market on this machine is 8%. Required Assess whether the machine is impaired. If necessary, provide the appropriate journal entry to recognise any impairment loss. (LO3 and LO4) CA of machine at 30 June 2024 = $100 000 [$125 000 less ($125 000 x 10% x 2 years)] FV less costs of disposal = $76 000 [$77 000 less $1 000] Value in use = $97 300 calculated as follows: [($40 000 x 0.9259) + ($30 000 x 0.8573) + ($25 000 x 0.7938) + ($20 000 x 0.7350)] RA = $97 300 [higher of these two] RA < CA so asset is impaired by $2 700 Depreciation expense Accum. deprec. & impairment losses

Dr Cr

2 700 2 700

7.17

Chapter 7: Impairment of assets

Exercise 7.4 Impairment of an individual asset On 1 July 2023 an item of equipment is acquired at a cost of $3 million. The asset is to be depreciated using the straight-line method on the basis of an estimated useful life of 15 years and a negligible residual value. On 30 June 2026 it is determined that the asset has a value in use of $2 million and a fair value of $1.8 million before costs of disposal of $50 000. The remaining useful life of the asset is reassessed to be 8 years. On 30 June 2028 it is determined that the asset has a value in use of $1.2 million and a fair value of $1.1 million before costs of disposal of $50 000. The remaining useful life of the asset is reassessed to be 5 years. Required Prepare the journal entries for any depreciation and impairment adjustments on the following dates. 1. 30 June 2026 2. 30 June 2028 3. 30 June 2029 (LO3 and LO4) 1. 30 June 2026 Depreciation expense Accum. deprec. & impairment losses [$3 000 000 / 15 years] Impairment loss Accum. deprec. & impairment losses [CA of $2 400 000 less RA of $2 000 000] 2. 30 June 2028 Depreciation expense Accum. deprec. & impairment losses [$2 000 000 / 8 years] Impairment loss Accum. deprec. & impairment losses [CA of $1 500 000 less RA of $1 200 000] 3. 30 June 2029 Depreciation expense Accum. deprec. & impairment losses [$1 200 000 / 5 years]

Dr Cr

200 000

Dr Cr

400 000

Dr Cr

250 000

Dr Cr

300 000

Dr Cr

240 000

200 000

400 000

250 000

300 000

240 000

7.18

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Exercise 7.5 Impairment loss of an individual asset incorporating revaluation model At 30 June 2023, Harrod Ltd holds a block of land from which it generates revenue by leasing it to agricultural enterprises. The land has a carrying amount of $2.5 million. An independent market appraisal has valued the land at $2.36 million but costs to dispose of the land are estimated at $100 000. The value in use of land is determined to be $2.33 million. Required 1. Determine the recoverable amount of the land. 2. Prepare the appropriate journal entry to record any impairment loss that should be recognised. Suppose now that this same block of land was carried under the revaluation model. 3. Prepare the journal entry to record any necessary adjustment assuming there had been no prior revaluations. 4. Prepare the journal entry to record any necessary adjustment assuming there had been a prior revaluation increase of $200 000. 5. Prepare the journal entry to record any necessary adjustment assuming there had been a prior revaluation increase of $120 000. (LO3 and LO4) 1. FV less cost of disposal = $2 360 000 less $100 000 = $2 260 000, Value in use = $2 330 000 => RA = $2 330 000 2. Impairment loss – Land Accum. impairment losses – Land

Dr Cr

170 000

3. Loss on revaluation – Land Land

Dr Cr

170 000

4. Asset revaluation surplus – Land Land

Dr Cr

170 000

5. Asset revaluation surplus – Land Loss on revaluation – Land Land

Dr Dr Cr

120 000 50 000

170 000

7.19

Chapter 7: Impairment of assets

Exercise 7.6 Impairment of a CGU Robin Ltd reported the following information in its statement of financial position at 30 June 2022.

At 30 June 2022, Robin Ltd analysed the internal and external sources of information that would indicate deterioration in the worth of its assets. It determined that there were indications of impairment. Robin Ltd calculated the recoverable amount of the assets to be $490 000.

Required Provide the journal entry for any impairment loss at 30 June 2022. (LO5) Carrying amount of assets = $615 000 Recoverable amount = $490 000 Impairment loss = $125 000 Assuming the inventory is carried at the lower of cost and net realisable value, the allocation of the impairment loss will not involve either cash or inventory. The allocation of the impairment loss is as follows.

Plant Intangibles Land

Carrying amount $ 250 000 100 000 150 000 500 000

Proportion

25/50 10/50 15/50

Allocation of loss $ 62 500 25 000 37 500 125 000

Net carrying amount $ 132 500 75 000 112 500

The journal entry to record the impairment loss is:

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Impairment loss Land Accum. deprec. and impairment – plant Accum. amortis. and impairment – intangibles (Allocation of impairment loss)

Dr Cr Cr Cr

125 000 37 500 62 500 75 000

7.21

Chapter 7: Impairment of assets

Exercise 7.7 Impairment of a CGU Rainier Ltd reported the following assets in its statement of financial position at 30 June 2022.

The recoverable amount of the entity was calculated to be $1 660 000. The fair value less costs of disposal of the land was $280 913. Required Prepare the journal entry for any impairment loss at 30 June 2022. (LO5) Carrying amount of assets Recoverable amount Impairment loss

= = =

$1 780 000 $1 660 000 $120 000

Assuming the inventory is carried at the lower of cost and net realisable value, the allocation of the impairment loss will not involve both cash and inventory. The allocation of the impairment loss is as follows. Carrying amount $ Plant 560 000 Land 300 000 Patent 240 000 Office equipment 280 000 1 380 000

Proportion

56/138 30/138 24/138 28/138

Allocation of loss $ 48 696 26 087 20 870 24 347 120 000

Net carrying amount $ 511 304 273 913 219 130 255 653

If the fair value less costs of disposal of the land is $280 913, then the land cannot be written down to an amount below that figure. Hence the maximum impairment loss allocable to land is $19 087. The extra $7000 must be allocated to the other assets.

7.22

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Carrying amount $ Plant 511 304 Patent 219 130 Office equipment 255 653 986 087

Proportion

Allocation of loss $ 511 304/986 087 3 630 219 130/986 087 1 555 255 653/986 087 1 815 7 000

Net carrying amount $ 507 674 217 575 253 838

The journal entry to record the impairment loss is: Impairment loss Land Accum. deprec. and impairment – plant Accum. amortis. and impairment – patent Accum. deprec. and impairment – office equipment (Allocation of impairment loss)

Dr Cr Cr Cr Cr

120 000 19 087 52 326 22 425 26 162

7.23

Chapter 7: Impairment of assets

Exercise 7.8 Impairment of CGU, goodwill Crossbow Ltd is an entity that specialises in the manufacture of leather footwear for women. It has aggressively undertaken a strategy of buying out other companies that had competing products. These companies were liquidated and the assets and liabilities brought into Crossbow Ltd. At 30 June 2022, Crossbow Ltd reported the following assets in its statement of financial position.

In response to competition from overseas, as customers increasingly buy online rather than visit Crossbow Ltd’s stores, Crossbow Ltd assessed its impairment position at 30 June 2022. The indicators suggested that an impairment loss was probable. Crossbow Ltd calculated a recoverable amount of its company of $2 840 000. Required Prepare the journal entry(ies) for any impairment loss occurring at 30 June 2022. (LO5) Carrying amount of assets Recoverable amount Impairment loss

= = =

$3 000 000 $2 840 000 $160 000

The impairment loss is firstly used to write off the goodwill of $80 000. The balance of the loss, $80 000, is allocated across the other assets, except for cash and inventory, assuming the latter is recorded at the lower of cost and net realisable value:

Brand Factory Machinery

Carrying amount $ 320 000 1 400 000 800 000 2 520 000

Proportion

32/252 140/252 80/252

Allocation of loss $ 10 158 44 444 25 398 80 000

Net carrying amount $ 309 842 1 355 556 774 602

The journal entry to record the impairment loss is:

7.24

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Impairment loss Goodwill Accum. amortis. and impairment losses – brand Accum. deprec. and impairment losses – factory Accum. deprec. and impairment losses – machinery (Allocation of impairment loss)

Dr Cr Cr Cr Cr

160 000 80 000 10 158 44 444 25 398

7.25

Chapter 7: Impairment of assets

Exercise 7.9 Reversal of impairment losses At 30 June 2022, Boxes Ltd reported the following assets.

All assets are measured using the cost model. At 30 June 2022, the recoverable amount of the entity, considered to be a single CGU, was $272 000. For the period ending 30 June 2023, the depreciation charge on plant was $18 400. If the plant had not been impaired the charge would have been $25 000. At 30 June 2023, the recoverable amount of the entity was calculated to be $13 000 greater than the carrying amount of the assets of the entity. As a result, Boxes Ltd recognised a reversal of the previous year’s impairment loss. Required Prepare the journal entries relating to impairment at 30 June 2022 and 2023. (LO5) Impairment loss is $28 000 i.e. $300 000 less $272 000. The goodwill of $8 000 is written off. The remaining $20 000 impairment loss is allocated as follows:

Land Plant

Carrying amount $ 50 000 200 000 250 000

Allocation $ 4 000 16 000 20 000

Net amount $ 46 000 184 000 230 000

At 30 June 2022, the journal entries to record the impairment are: Impairment loss Accum. impairment losses – Goodwill Accum. impairment losses – Land Accum. deprec. & impairment losses – Plant

Dr Cr Cr Cr

28 000 8 000 4 000 16 000

At 30 June 2023, in relation to the assets previously adjusted for impairment:

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Land Accum. impairment losses Plant Accum. deprec. & impairment

CA at 30/6/23 50 000 (4 000) 250 000 (84 400)*

CA – if no impairment 50 000 0 250 000 (75 000)

Difference 0 4 000 0 9 400 13 400

* 50 000 + 16 000 + 18 400 The $13 000 reversal is allocated as follows:

Land Plant

CA at 30/6/23 46 000 165 600 211 600

Allocation 2 826 10 174 13 000

However, the plant can only be revalued upwards by $9 400. The balance of $774 is allocated to the land which increases its allocation to $3 600 which is still less than $4 000. The reversal is then accounted for as follows: Accum. impairment losses – Land Accum. deprec. & impairment losses – Plant Income – reversal of impairment loss

Dr Dr Cr

3 600 9 400 13 000

7.27

Chapter 7: Impairment of assets

Exercise 7.10 Impairment of a CGU Mitch Ltd has determined that its fine china division is a CGU. The carrying amounts of the assets at 30 June 2022 are as follows.

Mitch Ltd calculated the recoverable amount of the division to be $510 000. Required Provide the necessary journal entries for the impairment loss. (LO5) If recoverable amount is $510 000, then there is an impairment loss of $30 000. Assuming the inventory is carried at the lower of costs and net realisable value, the allocation of the impairment loss is as follows.

Factory Land Equipment

Carrying amount $ $210 000 150 000 120 000 $480 000

Proportion

21/48 15/48 12/48

Allocation of loss $ 13 125 9 375 7 500 30 000

Impairment loss Accum. deprec. and impairment losses – Factory Accum. impairment losses – Land Accum. deprec. and impairment losses – Equipment (Allocation of impairment loss)

Dr Cr Cr Cr

Net carrying amount $ 196 875 140 625 112 500

30 000 13 125 9 375 7 500

7.28

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Exercise 7.11 Impairment loss, goodwill On 1 January 2021, Ted Ltd acquired all the assets and liabilities of Mosby Ltd. Mosby Ltd has a number of operating divisions, including one whose major industry is the manufacture of toy trains, particularly models of trains of historical significance. The toy trains division is regarded as a CGU. In paying $2 million for the net assets of Mosby Ltd, Ted Ltd calculated that it had acquired goodwill of $360 000. The goodwill was allocated to each of the divisions, and the assets and liabilities acquired measured at fair value at acquisition date. At 31 December 2023, the carrying amounts of the assets of the toy train division were:

There is a declining interest in toy trains because of the aggressive marketing of computerbased toys, so the management of Ted Ltd measured the value in use of the toy train division at 31 December 2023, determining it to be $712 500.

Required 1. Prepare the journal entries to account for the impairment loss at 31 December 2023. 2. Prepare the journal entries as above but now assuming the value in use of the train division at 31 December 2023 was determined to be $634 500. (LO5) 1. CA of toy train division is $750 000, RA (given by the value in use) is $712 500 => Impairment loss of $37 500 The loss is allocated to goodwill as follows: Impairment losses Accum. impairment losses – Goodwill

Dr Cr

37 500 37 500

2. The carrying amount of the assets of the toy train division is $750 000. If the recoverable amount (given by the value in use) is $634 500, then there is an impairment loss of $115 500. The impairment loss is firstly used to write off the goodwill - $75 000. The balance of the loss $40 500 – is allocated across the other assets, except for inventory assuming it is recorded at the lower of cost and net realisable value. Carrying amount $

Proportion

Allocation of loss $

Net carrying amount $

7.29

Chapter 7: Impairment of assets

Factory Brand

375 000 75 000 450 000

375/400 75/400

33 750 6 750 40 500

341 250 68 250

The journal entry to record the impairment loss is: Impairment loss Accum. impairment losses - Goodwill Accum. deprec. and impairment losses – Factory Accum. amortis. and impairment losses – Brand (Allocation of impairment loss)

Dr Cr Cr Cr

115 500 75 000 33 750 6 750

7.30

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Exercise 7.12 Impairment loss and reversal of an individual asset On 30 June 2023, an item of machinery had a carrying amount of $525 000. The machinery’s cost at acquisition was $750 000 at which time its estimated useful life was 10 years with no residual value. On 30 June 2023, the same item of machinery was assessed as having a recoverable amount of $455 000 and a remaining useful life of 7 years. On 30 June 2026, the machinery was assessed as having a recoverable amount of $315 000 and a remaining useful life of 3 years. All machinery is carried under the cost model. Required Show the journal entries for depreciation and any adjustments relating to impairment on each of the following dates. 1. 30 June 2023 2. 30 June 2026 3. 30 June 2027 (LO4 and LO6) 1. 30 June 2023 Depreciation expense – Machinery Accum. deprec. & impairment losses – Machinery [$750 000 / 10 years]

Dr Cr

75 000

Impairment loss – Machinery Accum. deprec. & impairment losses – Machinery [CA of $525 000 less RA of $455 000]

Dr Cr

70 000

2. 30 June 2026 Depreciation expense – Machinery Accum. deprec. & impairment losses – Machinery [$455 000 / 7 years]

Dr Cr

65 000

75 000

70 000

65 000

Accum. deprec. & impairment losses – Machinery Dr 40 000 Impairment reversal income Cr 40 000 [CA of $260 000 ($455 000 less $65 000 x 3 years), RA of $315 000. However, new CA cannot exceed what CA would have been if no prior impairment. If no prior impairment, CA of $300 000 ($525 000 less $75 000 x 3 years). Therefore, maximum impairment reversal of $40 000] 3. 30 June 2027 Depreciation expense – Machinery Accum. deprec. & impairment losses – Machinery [$300 000 / 3 years]

Dr Cr

100 000 100 000

7.31

Chapter 7: Impairment of assets

Exercise 7.13 Impairment loss for a CGU, reversal of impairment loss One of the CGUs of Canal Ltd is associated with the manufacture of wine barrels. At 30 June 2022, Canal Ltd believed, based on an analysis of economic indicators, that the assets of the unit were impaired. The carrying amounts of the assets and liabilities of the unit at 30 June 2022 were: Buildings Accumulated depreciation — buildings* Factory machinery Accumulated depreciation — machinery** Goodwill Inventories Receivables Allowance for doubtful debts Cash Accounts payable Loans *Depreciated at $60 000 p.a. **Depreciated at $45 000 p.a.

$ 420 000 (180 000) 220 000 (40 000) 15 000 80 000 40 000 (5 000) 20 000 30 000 20 000

Canal Ltd determined the recoverable amount of the unit to be $535 000. The receivables were considered to be collectable, except those considered doubtful. The company allocated the impairment loss in accordance with AASB 136/IAS 36. During the 2022–23 period, Canal Ltd increased the depreciation charge on buildings to $65 000 p.a., and to $50 000 p.a. for factory machinery. The inventories on hand at 1 July 2022 were sold by the end of the year. At 30 June 2023, Canal Ltd, because of a return in the market to the use of traditional barrels for wines and an increase in wine production, assessed the recoverable amount of the CGU to be $30 000 greater than the carrying amount of the unit. As a result, Canal Ltd recognised a reversal of the impairment loss. Required 1. Prepare the journal entries for Canal Ltd at 30 June 2022 and 2023. (LO5 and LO6) 2. What differences would arise in relation to the answer in requirement 1 if the recoverable amount at 30 June 2023 was $20 000 greater than the carrying amount of the unit? (LO5 and LO6) 3. If the recoverable amount of the buildings at 30 June 2023 was $175 000, how would this change the answer to requirement 2? (LO5 and LO6) 1. Carrying amount of assets: Buildings Factory machinery

$240 000 180 000

7.32

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Goodwill Inventory Receivables Cash Value in use Impairment loss

15 000 80 000 35 000 20 000 570 000 535 000 $35 000

Goodwill is written down by $15 000, and the balance of the impairment loss, namely $20 000 is written off across the other relevant assets. Carrying Proportion Allocation Net carrying amount of loss amount $ $ $ Buildings 240 000 24/42 11 429 228 571 Machinery 180 000 18/42 8 571 171 429 420 000 20 000 The journal entry for the year ended 30 June 2022 is: Impairment loss Goodwill Accum. deprec. and impairment losses – buildings Accum. deprec. and impairment losses – machinery (Allocation of impairment loss)

Dr Cr Cr Cr

35 000 15 000 11 429 8 571

At 30 June 2023, the two assets are reported as follows. Buildings Accum. depreciation and impairment losses

$420 000

Factory machinery Accum. depreciation and impairment losses

$220 000

256 429 [180 000 + 11 429 + 65 000] $163 571

98 571 $121 429

[40 000 + 8 571 + 50 000]

The carrying amounts of these assets if no impairment loss had occurred would have been: Buildings Accum. depreciation and impairment losses

$420 000

Factory machinery Accum. depreciation and impairment losses

$220 000

240 000 $180 000

85 000

[180 000 + 60 000]

[40 000 + 45 000]

7.33

Chapter 7: Impairment of assets

$135 000 The differences between the carrying amounts recorded at 30 June 2023 and the carrying amounts if no impairment losses had been recorded are: Buildings Factory machinery

[180 000 – 163 571] [135 000 – 121 429]

$16 429 13 571 $30 000

As the recoverable amount at 30 June 2023 exceeds the carrying amount by $30 000, then the total amount can be recognised. Accum. deprec. and impairment losses – buildings Dr Accum. deprec. and impairment losses – factory machinery Dr Income: reversal of impairment loss Cr (Reversal of impairment loss)

16 429 13 571 30 000

2. If the excess of the recoverable amount over carrying amounts at 30 June 2023 was only $20 000, then the reversal would be based on a pro rata allocation based on carrying amounts at time of reversal.

Buildings Machinery

Carrying amount $ 163 571 121 429 285 000

Proportion

0.57 0.43

Allocation of excess $ 11 479 8 521 20 000

The entry would be: Accum. deprec. and impairment losses – buildings Dr Accum. deprec. and impairment losses – factory machinery Dr Income: reversal of impairment loss Cr (Reversal of impairment loss)

Net carrying amount $ 175 050 129 950

11 479 8 521 20 000

3. If the recoverable amount of the buildings at 30 June 2023 was only $175 000, then the reversal of the impairment for buildings could only be $11 429 (i.e. $175 000 less $163 571). Hence the balance of $50 (i.e. $11 479 - $11 429) could be allocated to factory machinery. The entry is: Accum. deprec. and impairment losses – buildings Dr Accum. deprec. and impairment losses – factory machinery Dr Income: reversal of impairment loss Cr (Reversal of impairment loss)

11 429 8 571 20 000

The $8 571 allocated to factory machinery still does not exceed the carrying amount if the asset had never been impaired. The factory machinery will now be shown as:

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Factory machinery Accum. depreciation and impairment losses

$220 000 90 000 [40 000 + 8 571 +50 000 – 8 571] $130 000

7.35

Chapter 7: Impairment of assets

Exercise 7.14 Impairment, two CGUs Honey Ltd has two divisions, Time and Leisure. Each of these is regarded as a separate CGU. At 31 December 2022, the carrying amounts of the assets of the two divisions were as follows.

The receivables were regarded as collectable, and the inventories’ fair value less costs of disposal was equal to its carrying amount. The patent had a fair value less costs of disposal of $440. The plant at Time was depreciated at $600 p.a., and that at Leisure was depreciated at $500 p.a. Honey Ltd undertook impairment testing at 31 December 2022 and determined the recoverable amounts of the two divisions to be as follows.

As a result, management increased the depreciation of the Time plant from $300 to $350 p.a. for the year 2023. By 31 December 2023, the performance in both divisions had improved, and the carrying amounts of the assets of both divisions and their recoverable amounts were as follows.

Required Determine how Honey Ltd should account for the results of the impairment tests at both 31 December 2022 and 31 December 2023. (LO5)

Plant Patent Inventory Receivables Goodwill Recoverable amount

Time $1 700 480 108 150 50 $2 488 $2 088

Leisure $1 650 0 150 164 40 $2 004 $1 980

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Impairment loss ($400) At 31 December 2022: In relation to Leisure, write goodwill down by $24:

($24)

Impairment loss Accum. impairment losses – goodwill

Dr Cr

24 24

In relation to Time, reduce goodwill by $50 and allocate the remaining $350 impairment loss to applicable assets: Carrying Proportion Allocation Net carrying amount of excess amount $ $ $ Plant 1 700 170/218 272 1 428 Patent 480 48/218 78 402 2 180 350 As the patent has a fair value less costs of disposal of $440, only $40 of the impairment loss can be allocated to it, so the plant must be reduced by a further $38, to $1 390. The journal entry to record the impairment loss at 31 December 2022 is: Impairment loss Goodwill Accum. deprec. and impairment losses – plant Accum. impairment losses – patent (Allocation of impairment loss)

Dr Cr Cr Cr

400 50 310 40

At 31 December 2023, the plant and patent are recorded as follows: Plant Accumulated depreciation and impairment losses

Patent Accumulated impairment losses

$3 000 (2 310) $690

[1 300 + 310 + 700]

$480 (40) $440

At 31 December 2023: In relation to Leisure, there can be no reversal of the prior goodwill impairment. In relation to Time, the plant would have had the following carrying amount if the impairment loss had not occurred: Plant Accumulated depreciation and impairment losses

$ 3000 1 900

[1 300 + 600]

7.37

Chapter 7: Impairment of assets

$1 100 Hence, the maximum reversal of impairment in relation to plant is $410 (i.e. $1 100 - $690). The maximum reversal for the patent is $40. As the recoverable amount for the unit’s assets exceed the carrying amount by $180, the whole of this amount can be allocated on a pro rata basis as a reversal of impairment losses: Carrying amount

Plant Patent

$ 690 440 1 130

Proportion

69/113 44/113

Allocation of impairment reversal $ 220 140 360

Net carrying amount $ 910 580

As the patent can only be reversed to the extent of $40, then $320 can be allocated to plant, this being less than the maximum of $410. The entry for the reversal of the impairment loss is: Accum. deprec. and impairment losses – plant Accum. impairment losses – patent Income: reversal of impairment loss (Reversal of impairment loss)

Dr Dr Cr

320 40 360

7.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 7.15 Corporate assets Barney Ltd has two divisions, each regarded as a separate CGU. The carrying amounts of the net assets within each division at the most recent reporting date were:

Barney Ltd also recorded goodwill of $14 000 (net of accumulated impairment losses of $12 000) and had corporate assets consisting of a head office building carried at $150 000 (net of depreciation of $50 000) and furniture and fittings of $80 000 (net of depreciation of $20 000). Barney Ltd determined that the recoverable amount of the entity’s assets was $950 000. The management of Barney Ltd then completed the accounting for impairment losses. The receivables in both divisions were considered to be collectable. Required 1. Prepare the journal entry to record the impairment loss at the reporting date. 2. Prepare a table of the assets and liabilities of Barney Ltd, using the headings ‘Division One’, ‘Division Two’ and ‘Corporate’, after the completion of accounting for impairment losses. (LO5) 1. Assets: Division One Assets: Division Two Corporate Goodwill Recoverable amount Impairment loss Goodwill written off Amount to be allocated

$430 000 346 000 230 000 14 000 $1 020 000 $950 000 $70 000 $14 000 $56 000

7.39

Chapter 7: Impairment of assets

Allocation: Division One: Plant Land Buildings Furniture & fittings Division Two: Plant Land Buildings Furniture & fittings Corporate: Building Furniture & fittings

Carrying amount

Allocation

Balance

$200 000 80 000 70 000 25 000

$12 514 5 006 4 380 1 564

$187 486 74 994 65 620 23 436

180 000 50 000 40 000 20 000

11 263 3 128 2 503 1 251

168 737 46 872 37 497 18 749

150 000 80 000 $895 000

9 385 5 006 $56 000

140 615 74 994 $839 000

Impairment loss Goodwill Accum. deprec. and impairment – Plant DIV 1 Accum. impairment – Land DIV 1 Accum. deprec. and impairment – Buildings DIV 1 Accum. deprec. and impairment – F&F DIV 1 Accum. deprec. and impairment – Plant DIV 2 Accum. impairment – Land DIV 2 Accum. deprec. and impairment – Buildings DIV 2 Accum. deprec. and impairment – F&F DIV 2 Accum. deprec. and impairment – Buildings CORP Accum. deprec. and impairment – F&F CORP (Allocation of impairment loss)

Dr Cr Cr Cr Cr Cr Cr Cr Cr Cr Cr Cr

70 000

Division 1 $5 000 30 000 20 000 320 000 (132 514) 74 994 110 000 (44 380) 40 000 (16 564) 406 536 20 000 30 000 50 000 $356 536

Division 2 $8 000 40 000 8 000 300 000 (131 263) 46 872 100 000 (62 503) 30 000 (11 251) 327 855 40 000 66 000 106 000 221 855

14 000 12 514 5 006 4 380 1 564 11 263 3 128 2 503 1 251 9 385 5 006

Table of assets and liabilities: Cash Inventory Receivables Plant Accum. deprec. & impairment losses - Plant Land Buildings Accum. deprec. & impairment losses - Buildings Furniture & fittings Accum. deprec. & impairment losses – Furniture & fittings Total assets Provisions Borrowings Total liabilities Net assets

Corporate -

$200 000 (59 385) 100 000 (25 006) 215 609 $215 609

7.40

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Exercise 7.16 Allocation of corporate assets and goodwill Lily Ltd acquired all the assets and liabilities of Marshall Ltd on 1 January 2023. Marshall Ltd’s activities were run through three separate businesses, namely the Alpha Unit, the Beta Unit and the Gamma Unit. These units are separate CGUs. Lily Ltd allowed unit managers to effectively operate each of the units, but certain central activities were run through the corporate office. Each unit was allocated a share of the goodwill acquired, as well as a share of the corporate office. At 31 December 2023, the assets allocated to each unit were as follows.

Lily Ltd determined the recoverable amounts of each of the business units at 31 December 2023.

Required Determine how Lily Ltd should allocate any impairment loss at 31 December 2023. (LO5) Alpha $100 50 60 30 10 50 300 290 (10)

Factory Land Equipment Inventories Goodwill Corporate property Recoverable amount Impairment loss

Beta $95 75 25 20 15 40 270 225 (45)

Gamma $30 40 60 25 10 30 195 205 0

Alpha Unit Write down the goodwill by $10: © John Wiley and Sons Australia Ltd, 2020

7.41

Chapter 7: Impairment of assets

Impairment loss Accum. impairment losses - goodwill (Allocation of impairment loss)

Dr Cr

10 10

Beta Unit Write off goodwill of $15 and allocate the $30 balance of impairment loss: Carrying amount $ Factory 95 Land 75 Equipment 25 Corporate property 40 235

Proportion

95/235 75/235 25/235 40/235

Allocation of excess $ 12 10 3 5 30

Impairment loss Goodwill Accum. deprec. and impairment – factory Land Accum. deprec. and impairment – equipment Accum. deprec. and impairment – corporate property (Allocation of impairment loss)

Dr Cr Cr Cr Cr Cr

Net carrying amount $ 83 65 22 35

45 15 12 10 3 5

7.42

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Exercise 7.17 Reversal of impairment losses Saxon Ltd conducted an impairment test at 30 June 2021. As a part of that exercise, it measured the recoverable amount of the entity, considered to be a single CGU, to be $217 600. The carrying amounts of the assets of the entity at 30 June 2021 were:

The receivables held by Saxon Ltd were all considered to be collectable. The inventories were measured in accordance with AASB 102/IAS 2 Inventories. For the period ending 30 June 2022, the depreciation charge on equipment was $14 720. If the plant had not been impaired the charge would have been $20 000. At 30 June 2022, the recoverable amount of the entity was calculated to be $10 400 greater than the carrying amount of the assets of the entity. As a result, Saxon Ltd recognised a reversal of the previous year’s impairment loss. Required Prepare the journal entry(ies) accounting for the impairment loss at 30 June 2021 and the reversal of the impairment loss at 30 June 2022 (LO5 and LO6) Impairment loss is $22 400 i.e. $240 000 less $217 600. The goodwill of $6 400 is written off. The remaining $16 000 impairment loss is allocated as follows: CA $ 40 000 160 000 200 000

Patent Equipment

Allocation $ 3 200 12 800 16 000

Net amount $ 36 800 147 200 184 000

At 30 June 2021, the journal entry to record the impairment is: Impairment loss Goodwill Accum. impairment losses – patent Accum. deprec. & impairment losses – equipment

Dr Cr Cr Cr

22 400 6 400 3 200 12 800

At 30 June 2022, in relation to the assets previously adjusted for impairment:

Patent Accum. impairment losses

CA at 30/6/21 $40 000 3 200

CA – if no impairment Difference $40 000 0 $3 200

7.43

Chapter 7: Impairment of assets

Equipment 200 000 Accum. depreciation & impairment losses - Equipment ($67 520)*

200 000 ($60 000)

7 520 $10 720 *Accum. depreciation & impairment losses – Equipment: $40 000 + $12 800 + $14 720 As the recoverable amount at 30 June 2022 is only $10 400 greater than the carrying amount of the entity, this amount can be reversed. The $10 400 reversal is allocated as follows.

Patent Equipment

CA at 30/6/21 $36 800 132 480 $169 280

Allocation $2 261 8 139 $10 400

However, the equipment can only be revalued upwards by $7 520. The balance of $619 is allocated to the patent which increases its allocation to $2 880 which is still less than $3 200. The reversal is then accounted for as follows. Accum. amortis. and impairment losses – patent Accum. deprec. and impairment losses – equipment Income – reversal of impairment loss

Dr Dr Cr

2 880 7 520 10 400

7.44

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Exercise 7.18 CGUs, reversal of impairment losses The two CGUs of Dark Forest Ltd are referred to as the Lady CGU and the Lake CGU. At 31 July 2021, the carrying amounts of the assets of the two divisions were:

The receivables were regarded as collectable, and the inventories were measured according to AASB 102/IAS 2 Inventories. The brand had a fair value less costs of disposal of $2 640. The equipment held by the Lady CGU was depreciated at $3 600 p.a., and the equipment of Lake CGU was depreciated at $3 000 p.a. Dark Forest Ltd undertook impairment testing in July 2021, and determined the recoverable amounts of the two CGUs at 31 July 2021 to be:

The relevant assets were written down as a result of the impairment testing affecting the financial statements of Dark Forest Ltd at 31 July 2021. As a result of the impairment testing management reassessed the factors affecting the depreciation of its non-current asset. The depreciation of the equipment held by the Lady CGU was increased from $3 600 p.a. to $4 200 p.a. for the year 2021–22. By 31 July 2022, the performance in both divisions had improved, and the carrying amounts of the assets of both divisions and their recoverable amounts were:

Required Determine how Dark Forest Ltd should account for the results of the impairment tests at both 31 July 2021 and 31 July 2022. (LO5 and LO6)

Equipment Brand Inventory Receivables

Lady CGU 10 200 2 880 648 900

Lake CGU 9 900 0 900 984

7.45

Chapter 7: Impairment of assets

Goodwill

300 14 928 12 528 (2 400)

Recoverable amount Impairment loss

240 12 024 11 880 (144)

In relation to the Lake CGU, write goodwill down by $144: Impairment loss Accum. impairment losses - Goodwill

Dr Cr

144 144

In relation to the Lady CGU, reduce goodwill by $300 and allocate the remaining $2 100 impairment loss to applicable assets:

Equipment Brand

Carrying amount 10 200 2 880 13 080

Proportion 1 020/1 308 288/1 308

Allocation of excess 1 638 462 2 100

Net carrying amount 8 562 2 418

As the brand has a fair value less costs of disposal of $2 640, only $240 of the impairment loss can be allocated to it, so the equipment must be reduced by a further $222, to $8 340. The journal entry to record the impairment loss at 31 July 2021 is: Impairment loss Accum. impairment losses - Goodwill Accum. deprec. and impairment losses – Equipment Accum. impairment losses – Brand (Allocation of impairment loss)

Dr Cr Cr Cr

2 400 300 1 860 240

At 31 July 2022, the equipment and brand are recorded as follows: Equipment Accumulated depreciation and impairment losses

Brand Accumulated impairment losses

$18 000 (13 860) [7 800 + 1 860 + 4 200] $4 140 $2 880 (240) $2 640

At 31 July 2022: In relation to the Lake CGU, there can be no reversal of the prior goodwill impairment.

7.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In relation to the Lady CGU, the equipment would have had the following carrying amount if the impairment loss had not occurred. Equipment Accumulated depreciation and impairment losses

$18 000 (11 400) $6 600

[7 800 + 3 600]

Hence, the maximum reversal of impairment in relation to equipment is $2 460 (i.e. $6 600 - $4 140). The maximum reversal for the brand is $240. As the recoverable amount for the Lady CGU’s assets exceed the carrying amount by $2 160 [i.e. $18 024 – $15 864], the whole of this amount can be allocated on a pro rata basis as a reversal of impairment losses. Carrying Proportion Allocation Net carrying amount of excess amount $ $ $ Equipment 4 140 414/678 1 318 2 822 Brand 2 640 264/678 842 1 798 6 780 2 160 As the brand can only be reversed to the extent of $240, then $602 can be allocated to equipment. The adjusted allocation for equipment is now $1 920 which is less than the maximum adjustment amount of $2 460. The entry for the reversal of the impairment loss is: Accum. deprec. and impairment losses – Equipment Accum. impairment losses – Brand Income: reversal of impairment loss (Reversal of impairment loss)

Dr Dr Cr

1 920 240 2 160

7.47

Chapter 7: Impairment of assets

Exercise 7.19 CGUs, corporate assets, goodwill Charleston Ltd is in the business of manufacturing children’s toys. Its operations are carried out through three operating divisions, namely the Merlin Division, the Hollow Division and the Hills Division. These divisions are separate CGUs. In accounting for any impairment losses, all central management assets are allocated to each of these divisions. At 31 July 2022, the assets allocated to each division were as follows.

In relation to land values, the land relating to the Merlin and Hills Divisions have carrying amounts less than their fair values as stand-alone assets. The land held by the Hollow Division has a fair value less costs of disposal of $234. Charleston Ltd determined the recoverable amount of each of the CGUs at 31 July 2022 as follows.

Required Prepare the journal entry(ies) for Charleston Ltd to record any impairment loss at 31 July 2022. (LO5)

Buildings Land Machinery Inventory Goodwill Head office assets

Merlin $320 160 192 96 32 160 960

Hollow $296 240 72 64 40 120 832

Hills $96 120 200 80 24 96 616

7.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Recoverable amount Impairment loss

936 ($24)

720 ($112)

640 $0

Merlin CGU Write down the goodwill by $24: Impairment loss Accum. impairment losses - goodwill (Allocation of impairment loss)

Dr Cr

24 24

Hollow CGU Write off goodwill of $40 and allocate the $72 balance of impairment loss: Carrying Amount $ Buildings 296 Land 240 Machinery 72 Head Office assets 120 728

Proportion

296/728 240/728 72/728 120/728

Allocation of Excess $ 29 24 7 12 72

Net Carrying Amount $ 267 216 65 108

As the land has a fair value less costs of disposal of $234, only $6 of the impairment loss can be allocated to it. Hence, the remaining $18 must be allocated to the other assets: Carrying Amount $ Buildings 267 Machinery 65 Head Office assets 108 440 The entry is:

Proportion

267/440 65/440 108/440

Allocation of Excess $ 11 3 _4 18

Impairment loss Goodwill Accum. deprec. and impairment – buildings Land Accum. deprec. and impairment – machinery Accum. deprec. and impairment – head office assets (Allocation of impairment loss)

Dr Cr Cr Cr Cr Cr

Net Carrying Amount $ 256 62 104

112 40 40 6 10 16

7.49

Chapter 7: Impairment of assets

Exercise 7.20 Goodwill, corporate assets A large manufacturing company, Dalby Ltd, has its operations in Newcastle. It has two CGUs, Red Unit and Dragon Unit. At 30 June 2022, the management of the company decided to conduct impairment testing. It calculated that the recoverable amounts of the two divisions were $1 245 000 (Red Unit) and $930 000 (Dragon Unit). In considering the assets of the CGUs the company allocated the assets of the corporate area equally to the units. The carrying amounts of the assets and liabilities of the two CGUs and the corporate assets at 30 June 2022 were as follows.

In relation to these assets: • the receivables of both units were considered to be collectable • the land held by the Dragon Unit had a fair value less costs of disposal of $405 000. Required Prepare the journal entry(ies) required at 30 June 2022 to account for any impairment losses. (LO5) Red Unit: Total assets = $1 266 000 + $21 000 goodwill + $240 000 building = $1 527 000 Recoverable amount = $1 245 000 Impairment loss = $282 000 Dragon Unit: Total assets = $918 000 + $21 000 goodwill + $240 000 buildings = $1 179 000 Recoverable amount = $930 000 Impairment loss = $249 000 RED UNIT: ALLOCATION OF IMPAIRMENT LOSS

7.50

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Write-off goodwill of $21 000. Allocate $261 000 to all assets except cash, inventory and receivables. CA Impairment loss Equipment $600 000 $118 636 Land 270 000 53 386 Buildings 210 000 41 523 Corporate Building 240 000 47 455 $1 320 000 $261 000 DRAGON UNIT: ALLOCATION OF IMPAIRMENT LOSS Write off goodwill of $21 000. Allocate $228 000 to relevant assets.

Land Buildings Furniture Corporate Building

CA $450 000 240 000 60 000 240 000 $990 000

Impairment loss $103 636 55 273 13 818 55 273 $228 000

Net CA $184 727 46 182 184 727

Land can only be written down by $45 000, hence need to allocate $58 636 to other assets.

Buildings Furniture Corporate Building

CA $184 727 46 182 184 727 $415 636

Impairment loss $26 060 6 515 26 061 $58 636

Impairment loss Accum. impairment - goodwill

Dr Cr

42 000

Impairment loss Accum. deprec. and impairment - corporate building ($47 455 + $55 273 + $26 061) Impairment loss (Red Unit) Accum. Impairment – land Accum. deprec. and impairment – equipment Accum. deprec. and impairment – buildings

Dr Cr

128 789

Dr Cr Cr Cr

213 545

Impairment loss (Dragon Unit) Land Accum. deprec. and impairment – buildings* Accum. deprec. and impairment – furniture** * $55 273 + $26 060 ** $13 818 + $6 515

Dr Cr Cr Cr

146 666

42 000

128 789

53 386 118 636 41 523

45 000 81 333 20 333

7.51

Chapter 7: Impairment of assets

Exercise 7.21 Impairment loss Excalibur Ltd operates in the Swan Valley in Western Australia where it is involved in the growing of grapes and the production of wine. In June 2022, it anticipated that its assets may be impaired due to a glut on the market for grapes and an impending tax from the Australian government seeking to reduce binge drinking of alcohol by teenage Australians. Land is measured by Excalibur Ltd at fair value. At 30 June 2022, the entity revalued the land to its fair value of $480 000. The land had previously been revalued upwards by $80 000. As a result of its impairment testing, Excalibur Ltd calculated that the recoverable amount of the entity’s assets was $5 824 000. The carrying amounts of the assets of Excalibur Ltd prior to adjusting for the impairment test and the revaluation of the land were as follows. Non-current assets Buildings Accumulated depreciation Land (at fair value 1/7/21) Plant and equipment Accumulated depreciation Goodwill Accumulated impairment losses Trademarks — wine labels

3 400 000 (776 000) 512 000 5 816 000 (3 000 000) 240 000 (176 000) 320 000

Current assets Cash Receivables

28 000 36 000

Required 1. Prepare the journal entries required on 30 June 2022 in relation to the measurement of the assets of Excalibur Ltd. 2. Assume that, as the result of the allocation of the impairment loss, the plant and equipment was written down to $2 560 000. If the fair value less costs of disposal of the plant and equipment was determined to be $2 400 000, outline the adjustments, if any, that would need to be made to the journal entries you prepared in part 1 of this question, and explain why adjustments are or are not required. (LO5) 1. Assets Recoverable amount Impairment loss

$6 368 000 5 824 000 $544 000

($6 400 000 - $32 000 write-down of land)

7.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

$64 000 $480 000

($240 000 – $176 000)

CA $ 2 624 000 2 816 000 320 000 5 760 000

Impairment loss $ 218 667 234 667 26 667 480 000

Net CA $ 2 405 333 2 581 333 293 333

Asset revaluation surplus Deferred tax liability Land

Dr Dr Cr

22 400 9 600

Accum. impairment losses Impairment loss Goodwill

Dr Dr Cr

176 000 64 000

Impairment loss Accum. deprec. and impairment losses – buildings Accum. deprec. and impairment losses – P & E Accum. amortis. and impairment losses – trademarks

Dr Cr Cr Cr

480 000

Goodwill written off Balance to be allocated

Buildings Plant and equipment Trademarks

32 000

240 000

218 667 234 667 26 667

2. P&E written down to $2 560 000. FV less costs of disposal $2 400 000. No adjustment required cannot write down below fair value but can be carried at an amount greater than fair value. The impairment is calculated on the CGU not on individual assets. As P&E are included in the CGU, they do not independently generate cash flows. Therefore, it is impossible to determine value in use for P&E and cannot determine the recoverable amount. So, cannot conduct an impairment test on P&E as an individual asset. Hence use a CGU in relation to the P&E.

7.53

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 7: Impairment of assets Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 7: Impairment of assets Multiple choice questions 1. If an entity does not expect to recover the carrying amount of an asset, the entity has incurred a/an: a. b. c. *d.

depreciation expense. amortisation cost. loss on disposal. impairment loss.

Answer: d Learning objective 7.1: explain the nature and purpose of an impairment test.

2. How often must an impairment test be applied to tangible assets? a. b. *c. d.

every two years. at the end of each financial year. only when there is an indication that the asset may be impaired. at each reporting date including interim reporting dates such as half-year.

Answer: c Learning objective 7.2: explain when an impairment test should be undertaken.

3. Which of the following assets need to be tested for impairment every year? I II III IV

intangible assets with indefinite useful lives intangible assets not yet available for use intangible assets accounted for under the revaluation method goodwill acquired in a business combination

a. b. c. *d.

I, II and III only. II, III and IV only. I, III and IV only. I, II and IV only.

Answer: d Learning objective 7.2: explain when an impairment test should be undertaken.

7.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Goodwill acquired under a business combination is subject to an impairment test every: *a. year. b. two years. c. three years. d. five years. Answer: a Learning objective 7.2: explain when an impairment test should be undertaken.

5. An impairment loss occurs when: a. the asset has a residual value of zero. b. the recoverable amount of an asset exceeds the carrying amount. *c. the carrying amount of an asset exceeds the recoverable amount. d. the recoverable amount of an asset exceeds its initial cost. Answer: c Learning objective 7.3: outline the components of the impairment test.

6. As per AASB 136 Impairment of Assets, the recoverable amount test requires an entity to compare the fair value of an asset less costs to sell, with: a. its disposal value. *b. its value in use. c. the amount obtainable from the sale of the asset. d. the costs directly attributable to the liquidation of the asset. Answer: b Learning objective 7.3: outline the components of the impairment test.

7.2

Chapter 7: Impairment of assets Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following identifies an impairment of an asset and describes the appropriate accounting treatment using the cost model as per AASB 136 Impairment of Assets?

a. b. *c. d.

Impairment identified when: Carrying amount of an asset is less than its recoverable amount Carrying amount of an asset is less than its recoverable amount Carrying amount of an asset is greater than its recoverable amount Carrying amount of an asset is greater than its recoverable amount

Appropriate accounting treatment Asset is written up to its recoverable amount No change to the asset value Asset is written down to its recoverable amount No change to the asset value

Answer: c Learning objective 7.3: outline the components of the impairment test.

8. Noble Limited estimated that it would receive future cash flows from the use of equipment as follows: End of Year 1 $20 000 End of Year 2 $70 000 End of Year 3 $40 000 End of Year 4 $30 000 The discount rate was determined as 5%. The ‘value in use’ of the equipment is: *a. b. c. d.

$141 774 $160 000 $142 727 unable to determine from the information provided.

Answer: a Learning objective 7.3: outline the components of the impairment test.

9. When evaluating whether an asset has been impaired, the carrying amount of the asset must be compared to its recoverable amount. Recoverable amount is the higher of: a. b. c. *d.

initial cost: and, fair value. original cost: and, net present value. value in use: and, original cost. fair value less costs to sell: and, value in use.

Answer: d Learning objective 7.3: outline the components of the impairment test.

7.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. AASB 136 defines value in use as the: a. b. c. *d.

amount obtainable from the disposal of an asset, excluding any selling costs. initial cost of an asset less any expected disposal costs. incremental costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and income tax expense. present value of the future cash flows expected to be derived from an asset or cashgenerating unit.

Answer: d Learning objective 7.3: outline the components of the impairment test.

11. Lacey Limited expected future cash flows from the use of plant as follows: End of Year 1 $14 000; End of Year 2 $15 000; End of Year 3 $12 000. The discount rate was determined as 9%. The value in use of the plant is: a. *b. c. d.

$41 000 $34 735 $37 862 $Nil.

Answer: b Learning objective 7.3: outline the components of the impairment test.

12. When an asset is measured using the cost model, an impairment loss is: a. b. c. *d.

set off against the balance of revenue. recognised directly in equity. accumulated in a separate ‘accumulated impairment losses’ account. included in the balance of the accumulated depreciation and impairment losses account for that asset.

Answer: d Learning objective 7.4: describe how to account for an impairment loss for a single asset.

7.4

Chapter 7: Impairment of assets Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Under the cost model, an impairment loss would be recorded as: a. *b. c. d.

DR Sales, CR Impairment loss. DR Impairment loss, CR Accumulated depreciation and impairment losses. DR Accumulated impairment losses, CR Impairment loss. DR Accumulated impairment losses, CR Asset revaluation (equity).

Answer: b Learning objective 7.4: describe how to account for an impairment loss for a single asset.

14. When an asset is measured using the revaluation model, any impairment loss is treated as: *a. b. c. d.

a revaluation decrement. a revaluation increment. an off-set against depreciation expense. an addition to depreciation expense.

Answer: a Learning objective 7.4: describe how to account for an impairment loss for a single asset.

15. Parkes Limited recognised an impairment loss of $20 000 against a cash-generating unit containing the following assets: buildings $50 000; roads $110 000; equipment $40 000. The net carrying amount of the roads after allocation of the impairment loss is: a. b. *c. d.

$ 90 000 $ 45 000 $ 99 000 $ 36 000

Answer: c Learning objective 7.5: describe how to account for an impairment loss for a cash‐generating unit.

7.5

Testbank to accompany Financial reporting 3e by Loftus et al.

16. At reporting date Guzzle Limited estimated an impairment loss of $50 000 against its single cash-generating unit. The company had the following assets: headquarters building $200 000; plant $120 000; equipment $40 000. The net carrying amount of the headquarters building after allocation of the impairment loss is: a. b. c. *d.

$103 333 $150 000 $160 000 $172 222

Answer: d Learning objective 7.5: describe how to account for an impairment loss for a cash‐generating unit.

17. Berry Pty Ltd has two cash generating units. CGU A had a carrying amount of $1700 and value in use of $1750. CGU B has a carrying amount of $1900 and a value in use of $1800. The carrying amount of the head office assets is $1400. CGU A and B utilise the head office services equally. The impairment loss for CGU A is: a. *b. c. d.

$0. $650. $800. $1350.

Answer: b Learning objective 7.5: describe how to account for an impairment loss for a cash‐generating unit.

18. Compose Limited estimated an impairment loss of $2 500 000 against its single cashgenerating unit. The company had the following assets: headquarters building $3 000 000; plant $1 600 000; equipment $1 400 000. The net carrying amount of the plant after allocation of the impairment loss is: a. b. *c. d.

$Nil $933 $817 $1750

Answer: c Learning objective 7.5: describe how to account for an impairment loss for a cash‐generating unit.

7.6

Chapter 7: Impairment of assets Not for distribution in full. Instructors may assign selected questions in their LMS.

19. In relation to the reversal of an impairment loss of an individual asset, which of the following is incorrect? a. When reversing an impairment loss, the carrying amount cannot be increased to an amount in excess of the carrying amount that would have been determined had no impairment loss been recognised. *b. Where the recoverable amount is less than the carrying amount of an individual asset, the reversal of a previous impairment loss requires adjusting the carrying amount of the asset to recoverable amount. c. For a depreciable asset, there needs to be a calculation of carrying amount using the depreciation variables applied before the impairment loss to determine what the carrying amount would have been if there had been no impairment loss. d. If the individual asset is recorded under the cost model, then the increase in the carrying amount is recognised immediately in profit or loss. Answer: b Learning objective 7.6: explain when an impairment loss can be reversed and how to account for it.

20. When assessing the recoverable amount of assets that have previously been subject to an impairment loss, which of the following indicators assist in providing external evidence that an impairment loss has reversed: *a. a decrease in market interest rates during the period. b. a significant decrease in the asset’s market value during the period. c. an adverse effect on the entity from significant changes that have taken place. d. internal reporting sources indicate that the economic performance of the asset will not be as good as expected. Answer: a Learning objective 7.6: explain when an impairment loss can be reversed and how to account for it.

7.7

Testbank to accompany Financial reporting 3e by Loftus et al.

21. During 2021, Simpson Limited estimated that the carrying amount of goodwill was impaired by $20 000. In 2022, the company reassessed goodwill and determined that the goodwill initially acquired still existed. The appropriate accounting treatment in 2022 is: a. b. c. *d.

reverse the previous goodwill impairment loss. recognise the revalued amount of goodwill by an adjustment against the asset revaluation surplus account. increase goodwill by an adjustment to retained earnings. ignore the reversal as it is prohibited by AASB 136 Impairment of Assets.

Answer: d Learning objective 7.6: explain when an impairment loss can be reversed and how to account for it.

22. AASB 136 Impairment of Assets requires which of the following disclosures for each class of assets: I II III IV

The line item(s) of the statement of profit or loss and other comprehensive income in which impairment losses are included. The amount of reversals of impairment losses during the period. The amount of impairment losses recognised directly in other comprehensive income. The beginning and ending balances of any accumulated impairment account.

*a. b. c. d.

I, II and III only. I, II, III and IV. II and IV only. IV only.

Answer: a Learning objective 7.7: identify the disclosures required in relation to impairment of assets.

7.8

Chapter 7: Impairment of assets Not for distribution in full. Instructors may assign selected questions in their LMS.

23. Which of the following is required to be disclosed for each class of assets? I II III IV

a. b. *c. d.

the amount of impairment losses recognised in profit or loss during the period. the amount of reversals of impairment losses recognised in profit or loss during the period. the amount of impairment losses on revalued assets recognised in other comprehensive income during the period. the amount of reversals of impairment losses on revalued assets recognised directly in other comprehensive income during the period. III and IV only. I, II and III only. I, II, III and IV I and II only.

Answer: c Learning objective 7.7: identify the disclosures required in relation to impairment of assets.

7.9

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Hong Nee Ang

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 8: Provisions, contingent liabilities and contingent assets

Chapter 8: Provisions, contingent liabilities and contingent assets Comprehension questions 1. How is present value related to the concept of a liability? AASB 137/IAS 37 (paragraph 42) requires that the risks and uncertainties surrounding the events and circumstances should be taken into account in reaching the best estimate of a provision. AASB 137/IAS 37 requires provisions to be discounted to present value where the effect of discounting is material (paragraph 45). The discount rate used must be a pre-tax rate that reflects the time value of money and the risks specific to the liability. To avoid doublecounting, where the estimates of future cash flows have been adjusted for risk then the discount rate should not also reflect the particular risk (paragraph 47). In practical terms it is often difficult to determine reliably a liability-specific discount rate. Usually entities use a rate available for a liability with similar terms and conditions or, if a similar liability is not available, a risk-free rate for a liability with the same term (for example a government bond1 with a five-year term may be used as the basis for a company’s specific liability with a fiveyear term) and this rate is then adjusted for the risks pertaining to the liability in question.

2. Define (a) a contingency and (b) a contingent liability. A “contingency” is not defined in AASB 137/IAS 37. In plain English, a contingency is an unforeseen event that may or may not happen. AASB 137/IAS 37 defines a “contingent liability” at paragraph 10. It has two limbs to the definition: (a) a possible obligation that arises from past events; or (b) a present obligation (liability) that fails the recognition criteria. The definition at paragraph 10 is: “(a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability.” Refer to section 8.3 of the text for discussion about why part (a) of the definition is potentially misleading.

3. What are the characteristics of a provision? The characteristics of a provision are that it is a liability where there is uncertainty as to either the timing of settlement or the amount to be settled. When measuring a provision, the amount to be recognised should be the best estimate of the consideration required to settle the present obligation at the end of the reporting period. The fact that it is difficult to measure a provision and that estimates have to be used does not mean that the provision is not reliably measurable. 1

Assumed to be risk-free, although this may not always be the case.

8.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. Define a constructive obligation. One of the essential characteristics of a liability is that there must be a present obligation arising from past events. A present obligation exists only where the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation. A present obligation includes a constructive obligation. A constructive obligation is defined in AASB 137/IAS 37 as “an obligation that derives from an entity’s actions where: (a) By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.”

5. What is the key characteristic of a present obligation? The key characteristic of a present obligation is if the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation. This may be the case for example, if an entity makes a public announcement that it will match dollar for dollar the financial assistance provided by other entities to bushfire victims, and because of custom and moral obligations, there is no realistic alternative but to provide the financial assistance. In rare cases it may not be clear whether there is a present obligation. In such cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the reporting date (AASB 137/IAS 37, paragraph 15)

6. What are the recognition criteria for provisions? The recognition criteria for provisions are contained in AASB 137/IAS 37 (paragraph 14). A provision should be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation.

7. At what point would a contingent liability become a provision? Contingent liabilities need to be continually assessed to determine whether or not they have become actual liabilities. This is done by considering whether the recognition criteria for liabilities have been met. If it becomes probable that an outflow of economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognised in the financial statements in the period in which the change in probability occurs.

8.3

Chapter 8: Provisions, contingent liabilities and contingent assets

8. Compare and contrast the requirements of AASB 3/IFRS 3 and AASB 137/IAS 37 in respect of restructuring provisions and contingent liabilities. See Table 8.1 in the text, which summarises the similarities and differences between AASB 3/IFRS 3 and AASB 137/IAS 37.

8.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 8.1 Distinguish between provisions and contingent liabilities Provisions are recognised as a liability in the statement of financial position whereas contingent liabilities are not recognised in the financial statements but disclosed in the notes to financial statements. Paragraph 12 of AASB 137/IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that ‘in a general sense, all provisions are contingent because they are uncertain in timing or amount’. Required What are some of the possible reasons that provisions are recognised in the financial statements but contingent liabilities are not. For an item to be recognised in the financial statements, paragraph 82 of the Framework requires the item to meet the definition of an element and satisfy the recognition criteria. Provisions are recognised as liabilities because they are present obligations and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations. Contingent liabilities are not recognised as liabilities because they do not meet either the definition or the recognition criteria of a liability. They are either: • possible obligations, as it has yet to be confirmed whether the entity has a present obligation that could lead to an outflow of resources embodying economic benefits; or • it is not probable that an outflow of economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made. Case study 8.2 Management judgements Moolie Ltd is a manufacturer of surfboards. Pursuant to the sales terms, it gives warranties at the time of sales to purchasers of the surfboards for manufacturing defects that become apparent within two years from the date of sale. Based on past experience, Moolie is predicted to have 5% of the sales returned on manufacturing defects. Required Figure 8.2 provides a useful decision tree to help management make judgements on classifying a liability. Using this decision tree, determine how the case should be recorded. Present obligation as a result of a past event – The obligating event is the sale of surfboards with a warranty which gives rise to a legal obligation. An outflow of resources embodying economic benefits in settlement – Probable for the warranties as a whole.

8.5

Chapter 8: Provisions, contingent liabilities and contingent assets

Reliable estimate of the amount of the obligation – The amount can be reliably estimated based on past experience. Conclusion – A provision is recognised for the best estimate of the costs of making good under the warranty products sold before the end of the reporting period.

Case study 8.3 Lack of symmetry between a contingent asset and a contingent liability Jackshire Ltd filed a lawsuit against Bormire Ltd for compensation of $23 million as a result of failure to deliver goods on time. At the end of the financial year the outcome of the hearing is unknown. The lawyer is of the opinion that there is a 40% chance that Bormire Ltd will be found liable for the damages. Required Discuss how this court case should be recorded by Bormire Ltd and Jackshire Ltd. There is a low possibility that Bormire Ltd will be found guilty on the lawsuit. Hence it is not probable that there is an outflow of economic benefits from the entity. Nevertheless, the possibility of outflow is higher than remote. A note on contingent liability shall be provided in the financial report. Unlike contingent liabilities, contingent assets do not include assets that fail the recognition criteria. As the receipt of damages is not probable no contingent asset shall be recorded.

8.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 8.1 Distinguishing between liabilities, provisions and contingent liabilities Kasey Ltd’s financial statements are authorised for issue on 24 August 2022. Required Identify whether each of the following would be a liability, a provision or a contingent liability, or none of the above, in the financial statements of Kasey Ltd as at the end of its reporting period of 30 June 2022. 1. An amount of $42 000 owing to Pigz Ltd for services rendered during May 2022. 2. Long service leave, estimated to be $350 000, owing to employees in respect of past services. 3. Costs of $12 000 estimated to be incurred for relocating an employee from Kasey Ltd’s head office location to another city. The staff member will physically relocate during July 2022. 4. Provision of $40 000 for the overhaul of a machine. The overhaul is needed every 5 years and the machine was 5 years old as at 30 June 2022. 5. Damages awarded against Kasey Ltd resulting from a court case decided on 26 June 2022. The judge has announced that the amount of damages will be set at a future date, expected to be in September 2022. Katz Ltd has received advice from its lawyers that the amount of the damages could be anything between $50 000 and $2 million. (LO2, LO3, LO4 and LO6) 1. Liability: this event falls within the reporting period and the amount and timing are certain. 2. Provision: the amount and timing are uncertain: it is unclear how long employees will continue to serve in Kasey Ltd and this affects whether or not they become eligible for long service leave. 3. No provision or liability: the amount is a future cost. 4. No provision or liability: no present obligation to overhaul the machine – Kasey Ltd could decide to sell the machine or not repair it. 5. This is a present obligation and the obligating event has occurred, therefore it is a liability; however the amount cannot be reliably measured as the estimated range is too great. Therefore, this should be disclosed as a contingent liability, being a liability that fails the recognition criterion of reliable measurement.

8.7

Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.2 Recognising a provision When should liabilities for each of the following items be recorded in the accounts of the business entity? 1. Acquisition of goods by purchase on credit 2. Salaries 3. Annual bonus paid to management 4. Dividends (LO4) 1. When the goods are delivered (the obligating event for the purchaser is the receipt of the goods). 2. When the services are rendered (the obligating event for the employer is when the employees deliver their services). 3. When the conditions for receiving the bonus are met and the amount can be reliably measured. See also AASB 119/IAS 19 paragraphs 19-24. 4. When the dividends are declared (appropriately authorised and no longer at the discretion of the entity). See also AASB 110/IAS 10 paragraphs 12 and 13.

8.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.3 Recognising a provision The government introduces a number of changes to the goods and services (valueadded) tax system. As a result of these changes, Welles Ltd, a manufacturing company, will need to retrain a large proportion of its administrative and sales workforce to ensure compliance with the new tax regulations. At the end of the reporting period, no retraining of staff has taken place. Required Should Welles Ltd provide for the costs of the staff training at the end of the reporting period? (LO4) The question here is whether a present obligation as a result of a past obligating event exists. There is no obligation because no obligating event (retraining) has taken place. Therefore, no provision is recognised.

8.9

Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.4 Recognising a provision Tray Ltd is a listed company that provides food to function centres that host events such as weddings and engagement parties. After an engagement party held by one of Tray Ltd’s customers in June 2023, 100 people became seriously ill, possibly as a result of food poisoning from products sold by Tray Ltd. Legal proceedings were commenced seeking damages from Tray Ltd. Tray Ltd disputed liability by claiming that the function centre was at fault for handling the food incorrectly. Up to the date of authorisation for issue of the financial statements for the year to 30 June 2023, Tray Ltd’s lawyers advised that it was probable that Tray Ltd would not be found liable. However, two weeks after the financial statements were published, Tray Ltd’s lawyers advised that, owing to developments in the case, it was probable that Tray Ltd would be found liable and the estimated damages would be material to the company’s reported profits. Required Should Tray Ltd recognise a liability for damages in its financial statements at 30 June 2023? How should it deal with the information it receives 2 weeks after the financial statements are published? (LO4) At 30 June 2023: Present obligation as a result of a past obligating event: on the basis of the evidence available when the financial statements were approved, there is no obligation as a result of past events because, according to legal advice, Tray Ltd does not have a present obligation. Even if Tray Ltd did have a present obligation, the recognition criterion of probability of outflow of resources is not met. Conclusion: no provision is recognised. The matter is disclosed as a contingent liability (either a possible liability or a present obligation that fails the recognition criteria) unless the probability of any outflow is regarded as remote. Once Tray Ltd becomes aware of the new information: Present obligation as a result of a past obligating event: on the basis of the evidence available, there is a present obligation. An outflow of resources embodying economic benefits in settlement: probable. Conclusion: a provision should be recognised for the best estimate of the amount to settle the obligation. However, Tray Ltd has already issued its financial statements. The fact that the expected damages are material to the reported profit means that Tray Ltd, being a listed company, will be most likely to have a continuous disclosure obligation to disclose the new information. Depending on the laws of its jurisdiction it may have to rescind the financial statements and issue new ones, updating the disclosures about the contingent liability and recognising the provision as required by paragraphs 19 and 20 of AASB 110/IAS 10 Events After the Reporting Period.

8.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.5 Recognising a provision In each of the following scenarios, explain whether or not Margot Ltd would be required to recognise a provision. 1. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is no legal requirement to clean up the land, and Margot Ltd has no record of cleaning up land that it has contaminated. 2. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is a legal requirement to clean up the land. 3. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is no legal requirement to clean up the land, but Margot Ltd has a long record of cleaning up land that it has contaminated. (LO4) 1. No present obligation: no provision. 2. Present obligation exists; contamination of the land is the past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and assume that a reliable estimation of the cleaning costs can be made. Therefore a provision should be recognised. 3. There is a constructive obligation, which is construed from Margot Ltd’s past actions; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and assume that a reliable estimation of the cleaning costs can be made. Therefore a provision should be recognised.

8.11

Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.6 Risk and present value of cash flows Using examples, explain how a liability-specific discount rate could cause the amount calculated for a provision to be lower when the risk associated with that provision is high. How could this problem be averted in practice? (LO5) The higher the discount rate used, the lower the present value of cash flows will be. Therefore using a higher discount rate to reflect higher risk creates a lower provision – a counterintuitive outcome. Consider $100 to be paid in five years’ time. If the risk associated with this anticipated cash flow is considered to be high, a discount rate of (say) 10% p.a. might be used; if the risk associated with the cash flow is lower, a lower discount rate (say 5% p.a.) might be chosen. $100 in 5 years discounted at 10% p.a. $100 in 5 years discounted at 5% p.a.

PV (0.62092) PV (0.78352)

$62.09 $78.35

However, when adjusting a discount rate for a provision, the risk-adjusted rate should actually be LOWER than the risk-free rate. This outcome may seem surprising, because the experience of most borrowers is that lenders will charge a higher rate of interest on loans that are assessed to be a higher risk to the lender. However, in the case of a provision, a lower rate reflects the elimination of the possibility of the actual cost being higher (i.e. the cost is capped at a certain amount above which it will not go) whereas in the case of a loan the lender requires a premium to compensate it for the risk of not recovering the full value of the loan (i.e. the lender’s asset is set at a floor below which it will not go). In other words, the discount rate for the asset (in this case the loan held by the lender) is increased to reflect the risk of recovering less and the discount rate for a provision is reduced to reflect the risk of paying more. A simpler way to factor in risk would be to use it in assessing the probability of outcomes for purposes of calculating expected future cash outflows, and use the risk-free rate to discount the cash flows.

8.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.7 Restructuring costs A division of an acquired entity will be closed and activities discontinued. The division will operate for 6 months after the date of acquisition. At the end of the 6 months, a few divisional employees will be retained to finalise closure of the division, but the rest will be retrenched. Required Which of the following costs, if any, are restructuring costs? 1. The costs of employees (salaries and benefits) to be incurred after operations cease and that are associated with the closing of the division. 2. The costs of leasing the factory space occupied by the division for the year after the date of acquisition. 3. The costs of modifying the division’s purchasing system to make it consistent with that of the acquirer’s. (LO6) 1. Yes: they are directly attributable to the restructuring and are not associated with the ongoing activities of the entity. 2. No: they relate to the ongoing activities of the entity. 3. No: they relate to the ongoing activities of the entity.

8.13

Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.8 Restructuring costs Groucho Ltd acquires Harpo Ltd. The restructuring plan, which satisfies the criteria for the existence of a present obligation under AASB 137/IAS 37 and AASB 3/IFRS 3, includes an advertising program to promote the new company image. The restructuring plan also includes costs to retrain and relocate existing employees of the acquired entity. Required Are these costs restructuring costs? (LO6) These employees will be part of Groucho Ltd’s ongoing activities. The costs of retraining and relocating those employees are not restructuring costs because they are costs associated with the ongoing activities of the entity. The costs of the advertising program to promote the new company image are not restructuring costs because they relate to the ongoing activities of the entity. In addition, they are costs that the acquirer will incur and thus are not permitted to be recognised as part of the acquisition accounting under AASB 137/IAS 37 or AASB 3/IFRS 3.

8.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.9 Recognising a provision — measurement Explain how a borrowing cost could arise as part of the measurement of a provision. Illustrate your explanation with a simple example. (LO5 and LO6) Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as borrowing cost. This is similar to the way finance lease liabilities are accounted for under AASB 117/IAS 17 Leases. Refer to Illustrative Example 8.3 in the text, which shows how the interest (borrowing cost) is calculated and provides the journal entries.

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Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.10 Contingent liabilities - disclosure A customer filed a lawsuit against Beta Ltd in December 2023 for costs and damages allegedly incurred as a result of the failure of one of Beta Ltd’s electrical products. The amount claimed was $2 million. Beta Ltd’s lawyers have advised that the amount claimed is extortionate and that Beta Ltd has a good chance of winning the case. However, the lawyers have also advised that if Beta Ltd loses the case its expected costs and damages would be about $400 000. Required How should Beta Ltd disclose this event in its financial statements as at 31 December 2023? (LO3, LO6 and LO8) A customer filed a lawsuit against the company in December 2023, for costs and damages allegedly incurred as a result of the failure of an electrical product. The company is confident that it will successfully defend the case, however the company’s lawyers have advised that expected costs and damages would be about $500 000 in the event that the company is unsuccessful in defending the case. (Paragraph 86 of AASB 137/IAS 37 requires disclosure of each class of contingent liability unless the possibility of an outflow in settlement is remote, which is not the case here. However, paragraph 86 also requires that the estimate of the financial effect be measured under paragraphs 36 – 52: that is, the amount is a ‘best estimate’ of the expenditure required to settle the obligation, rather than the amount claimed by the customer).

8.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.11 Calculation of a provision In May 2022, Savoir Ltd relocated an employee from head office to an office in another city. As at 30 June 2022, the end of Savoir Ltd’s reporting period, the costs were estimated to be $44 000. Analysis of the costs is as follows. Costs for shipping goods $ 4 000 Airfare 8 000 Temporary accommodation costs (May and June) 6 000 Temporary accommodation costs (July and August) 8 000 Reimbursement for lease break costs (paid in July; lease was terminated in May) 3 000 Reimbursement for cost of living increases (for the period 15 May 2022 – 15 May 15 000 2023) Required Calculate the provision for relocation costs for Savoir Ltd’s financial statements as at 30 June 2022. Assume that AASB 137/IAS 37 applies to this provision and that the effect of discounting is immaterial. (LO5 and LO6) Savoir Ltd relocated an employee from Savoir Ltd head office location to another city. The employee moved to the other city during May 2022. As at 30 June 2022 (Savoir Ltd’s reporting date) the costs were estimated to be $44 000. An analysis of the costs and the amounts to be included as part of a provision, is as follows: Note that the obligating event is the relocation of the employee, which occurred before 30 June 2022. Costs for shipping goods $4 000 Include (assume goods shipped before 30 June 2022) Airfare 6 000 Include (assume employee flew in May 2022) Temporary accommodation costs (May and June) 8 000 Include Temporary accommodation costs (July and August) 9 000 Exclude - Future costs Reimbursement for lease break costs (paid in July; 2 000 Include; obligating event lease was terminated in May) occurred in May 2022 Reimbursement for cost of living increases 12 000 Include $1 500 ($1 000 x 1.5 (for the period 15 May 2022-18 May 2023) months) for May and June 2022; remainder are future costs Total amount provided should therefore be $20 500 ($3 000 + $6 000 + $8 000 + $2 000 + $1 500).

8.17

Chapter 8: Provisions, contingent liabilities and contingent assets

Exercise 8.12 Restructuring provisions on acquisition Steel Ltd acquires Nail Ltd, effective 1 March 2023. At the date of acquisition, Steel Ltd intends to close a division of Nail Ltd. As at the date of acquisition, management has developed and the board has approved the main features of the restructuring plan and, based on available information, best estimates of the costs have been made. As at the date of acquisition, a public announcement of Steel Ltd’s intentions has been made and relevant parties have been informed of the planned closure. Within a week of the acquisition being effected, management commences the process of informing unions, lessors, institutional investors and other key shareholders of the broad characteristics of its restructuring program. A detailed plan for the restructuring is developed within 3 months and implemented soon thereafter. Required Should Steel Ltd create a provision for restructuring as part of its acquisition accounting entries? Explain your answer. How would your answer change if all the circumstances are the same as those above except that Steel Ltd decided that, instead of closing a division of Nail Ltd, it would close down one of its own facilities? (LO4 and LO6) Steel Ltd should not create a provision for restructuring as part of its acquisition accounting entries. Under both AASB 137/IAS 37 and AASB 3/IFRS 3 the acquirer cannot recognise the provision if it is not already recognised as a liability of the acquiree. If Steel Ltd decided to close down one of its own facilities instead of closing a division of Nail Ltd, although the closing of the facility only arises because of the proposed acquisition, whether or not a present obligation exists would need to be considered in accordance with the requirements for an internal restructuring under AASB 137/IAS 37 as opposed to a restructuring recognised as part of an acquisition. This is because the AASB 3/IFRS 3 requirements relating to restructuring provisions recognised as part of an acquisition, relate only to assets and liabilities of the acquiree. Since the intended closure relates to an operation of the acquirer, a restructuring provision cannot be raised in the books of the acquiree and cannot be considered as part of a restructuring cost recognised as part of an acquisition.

8.18

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Exercise 8.13 Measuring a restructuring provision Technic Ltd’s directors decided on 3 May 2023 to restructure the company’s operations as follows. • Factory Z would be closed down and put on the market for sale. • 200 employees working in Factory Z would be retrenched on 31 May 2023, and would be paid their accumulated entitlements plus 3 months wages. • The remaining 40 employees working in Factory Z would be transferred to Factory X, which would continue operating. • Five head-office staff would be retrenched on 30 June 2023, and would be paid their accumulated entitlements plus 3 months wages. As at the end of Technic Ltd’s reporting period, 30 June 2023, the following transactions and events had occurred. • Factory Z was shut down on 31 May 2023. An offer of $6 million had been received for Factory Z but there was no binding sales agreement. • The 200 retrenched employees had left and their accumulated entitlements had been paid. However, an amount of $34 000, representing a portion of the 3 months wages for the retrenched employees, had still not been paid. • Costs of $35 000 were expected to be incurred in transferring the 40 employees to their new work in Factory X. The transfer is planned for 14 July 2023. • Five of the six head-office staff who have been retrenched have had their accumulated entitlements paid, including the 3 months wages. However, one employee, Jerry Perry, remains in order to complete administrative tasks relating to the closure of Factory Z and the transfer of staff to Factory X. Jerry is expected to stay until 31 July 2023. His salary for July will be $6000 and his retrenchment package will be $15 000, all of which will be paid on the day he leaves. He estimates that he would spend 60% of his time administering the closure of Factory Z, 30% on administering the transfer of staff to Factory X, and the remaining 10% on general administration. Required Calculate the amount of the restructuring provision recognised in Technic Ltd’s financial statements as at 30 June 2023, in accordance with AASB 137/IAS 37 (LO6). Factory Z was shut down on 31 May 2023. An offer of $6 million has been received for Factory Z, however there was no binding sales agreement: this is not relevant – the binding sale agreement test in paragraph 78 of AASB 137/IAS 37 applies to the sale of an operation. In this case the factory has already been shut down and thus the implementation of the restructuring has virtually been completed. The 200 employees who have been retrenched have left and their accumulated entitlements have been paid, however an amount of $34 000, representing a portion of the three months’ wages for the retrenched employees, has still not been paid. This amount is included in the restructuring provision as the implementation of the restructuring has commenced and the amount represents a present obligation.

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Chapter 8: Provisions, contingent liabilities and contingent assets

Costs of $35 000 are expected to be incurred in transferring the 40 employees to their new work in Factory X. The transfer will occur on 14 July 2023. This item is not included as the costs relate to ongoing operations. Four of the five head-office staff have been retrenched; they have left and their accumulated entitlements, including the three months’ wages, have been paid. However one employee, Jerry Perry, remains on to complete administrative tasks relating to the closure of Factory Z and the transfer of staff to Factory X. Jerry is expected to stay until 31 July 2023. Jerry’s salary for July will be $6000 and his retrenchment package will be $53 000, all of which will be paid on the day he leaves. Jerry estimated that he will spend 60% of his time administering the closure of Factory Z, 30% of his time administering the transfer of staff to Factory X and the remaining 10% on general administration. The amount to be recognised as a provision is (60% x $6000) + $15 000 = $18 600. The 30% of his salary that relates to ongoing operations and the 10% that relates to general administration cannot be included. The company has a present obligation for the retrenchment pay so that amount is included. Therefore the total provision is = $34 000 + $18 600 = $52 600.

8.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 8.14 Comprehensive problem Wizards Ltd, a listed company, is a manufacturer of confectionery and biscuits. The end of its reporting period is 30 June. Relevant extracts from its financial statements at 30 June 2023 are shown. Current liabilities Provisions Provision for warranties

$ 540 000

Non‐current liabilities Provisions Provision for warranties

320 000

Non‐current assets Plant and equipment At cost Accumulated depreciation

$ 2 000 000 600 000

Carrying amount

1 400 000

Plant and equipment has a useful life of 10 years and is depreciated on a straight‐line basis. Note 36 — contingent liabilities Wizards is engaged in litigation with various parties in relation to allergic reactions to traces of peanuts alleged to have been found in packets of fruit gums. Wizards strenuously denies the allegations and, as at the date of authorising the financial statements for issue, is unable to estimate the financial effect, if any, of any costs or damages that may be payable to the plaintiffs. The provision for warranties at 30 June 2023 was calculated using the following assumptions (there was no balance carried forward from the prior year). Estimated cost of repairs — products with minor defects Estimated cost of repairs — products with major defects Expected % of products sold during FY 2023 having no defects in FY 2024 Expected % of products sold during FY 2023 having minor defects in FY 2024 Expected % of products sold during FY 2023 having major defects in FY 2024 Expected timing of settlement of warranty payments — those with minor defects Expected timing of settlement of warranty payments — those © John Wiley and Sons Australia Ltd, 2020

$3 000 000 $9 000 000 80% 15% 5% All in FY 2024 40% in FY 2024, 60% in FY 8.21

Chapter 8: Provisions, contingent liabilities and contingent assets

with major defects Discount rate

2025 6%. The effect of discounting for FY 2024 is considered to be immaterial.

During the year ended 30 June 2024, the following occurred. (a) In relation to the warranty provision of $860 000 at 30 June 2023, $350 000 was paid out of the provision. Of the amount paid, $250 000 was for products with minor defects and $100 000 was for products with major defects, all of which related to amounts that had been expected to be paid in the 2024 financial year. (b) In calculating its warranty provision for 30 June 2024, Wizards made the following adjustments to the assumptions used for the prior year. Estimated cost of repairs — products with minor defects Estimated cost of repairs — products with major defects Expected % of products sold during FY 2024 having no defects in FY 2025 Expected % of products sold during FY 2024 having minor defects in FY 2025 Expected % of products sold during FY 2024 having major defects in FY 2025 Expected timing of settlement of warranty payments — those with minor defects Expected timing of settlement of warranty payments — those with major defects Discount rate

No change $6 000 000 80% 15% 5% All in FY 2025 25% in FY 2025, 75% in FY 2026 No change. The effect of discounting for FY 2024 is considered to be immaterial.

(c) Wizards determined that part of its plant and equipment needed an overhaul — the conveyor belt on one of its machines would need to be replaced in about May 2025 at an estimated cost of $250 000. The carrying amount of the conveyor belt at 30 June 2023 was $140 000. Its original cost was $200 000. (d) Wizards was unsuccessful in its defence of the peanut allergy case and was ordered to pay $1 500 000 to the plaintiffs. As at 30 June 2024, Wizards had paid $800 000. (e) Wizards commenced litigation against one of its advisers for negligent advice given on the original installation of the conveyor belt referred to in (c) above. In April 2024 the court found in favour of Wizards. The hearing for damages had not been scheduled as at the date the financial statements for 2024 were authorised for issue. Wizards estimated that it would receive about $425 000. (f) Wizards signed an agreement with BankSweet to the effect that Wizards would guarantee a loan made by BankSweet to Wizards’ subsidiary, CCC Ltd. CCC’s loan with BankSweet was $3 200 000 as at 30 June 2024. CCC was in a strong financial position at 30 June 2024.

8.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required Prepare the relevant extracts from the financial statements (including the notes) of Wizards Ltd as at 30 June 2024, in compliance with AASB 137/IAS 37 and related accounting standards. Include comparative figures where required. Show all workings separately. Perform your workings in the following order. 1. Calculate the warranty provision as at 30 June 2023. This should agree with the financial statements provided in the question. 2. Calculate the warranty provision as at 30 June 2024. 3. Calculate the movement in the warranty provision for the year. 4. Calculate the prospective change in depreciation required as a result of the shortened useful life of the conveyor belt. 5. Determine whether the unpaid amount owing as a result of the peanut allergy case is a liability or a provision. 6. Determine whether the receipt of damages for the negligent advice meets the definition of an asset or a contingent asset. 7. Determine whether the bank guarantee meets the definition of a provision or a contingent liability (ignore AASB 139/IAS 39 in this regard). 8. Prepare the financial statement disclosures. (LO2, LO3, LO5, LO6, LO7 and LO8) 1. (80% x $0) + (15% x $3 000 000) + (5% x $9 000 000)

= = =

$0 $450 000 $450 000 $900 000

Timing: FY 2024: $450 000 + (40% x $450 000)

= =

$450 000 $180 000 $630 000 (current portion)

FY 2025: + (60% x $450 000 discounted at 6% [for 2 years]) = $270 000/1.1236* $240 300 (non-current portion) * rounded to 4 decimal places (1 + 0.06)2 = 1.1236 (the PV discount factor is therefore calculated as 1/1.1236 = 0.8900) Therefore total provision = $630 000 + $240 300 = $870 300 2. (85% x 0) + (15% x 3 000 000) + ( 5% x 6 000 000) Timing: FY 2025: $450 000 + (25% x $300 000)

$0 $450 000 $300 000 $750 000

$450 000 $ 75 000 $525 000 (current portion)

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Chapter 8: Provisions, contingent liabilities and contingent assets

FY 2026: + (75% X $300 000 discounted at 6% [for 2 years]) = $225 000/1.1236 $200 250 (non-current portion) Total new provision for FY 2024 = $525 000 + $200 250 = $725 250 Balance of provision from FY 2023 payable in FY 2025

*$240 300 (current portion) $995 250

*$270 000 = 60% of $450 000 (major defects) Current portion = $795 000 ($525 000 + $270 000) Non-current portion = $200 250 3. Opening balance $870 300 Plus: Increase in the provision $725 250 Less: Amounts used during the year ($350 000) Less: Unused amounts reversed during the year ($280 000)

Plus: Increase in discounted amount arising from the passage of time Closing balance

$29 700 $995 250

[$630 000 expected to be paid in FY2024, $350 000 was actually paid] [$270 000 – $240 300]

4. Conveyer belt overhaul: The expected overhaul is not a provision as Wizards has no present obligation to conduct the overhaul. Rather, it is evidence that the conveyer belt’s useful life has been shortened. The change in the depreciation rate must be accounted for prospectively in accordance with AASB 116/IAS 16 paragraph 61 as follows: Conveyer Original cost Accumulated depreciation Carrying amount

As at 30 June 2023 $200 000 60 000 $140 000

As at 30 June 2024 $200 000 130 000 $70 000

The following adjustment should be made for the year ending 30/06/2024: Original expected life 10 years Expired life at 30 June 2023 3 years New expected life 5 years (3 years old at 30 June 2023, approx. 2 year left) Therefore, remaining life at 30 June 2023 2 years Therefore, new depreciation amount for 2024 $70 000 per annum should be i.e. CA at 30/06/2020 of $140 000 / 2 years Therefore, accumulated depreciation as at 30 June $130 000 ($60 000 + $70 000) 2024 Calculations for disclosure of plant & equipment: Excluding conveyer (10 yr life)

Conveyer (5 yr life)

Total

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cost Accumulated depreciation to 30 June 2024 Carrying amount

$1 800 000 720 000 *

$200 000 130 000

$2 000 000 850 000

$1 080 000

$70 000

$1 150 000

*Accumulated depreciation as at 30/06/23 Less Accumulated depreciation at 30/06/23 re: Conveyor Belt Add Accumulated depreciation for year ending 30/06/24 ($1 800 000/10)

$600,000 (60 000) 180 000 $720 000

5. The unpaid amount of $700 000 ($1 500 000 - $800 000 already paid) owing as a result of the peanut allergy case, should be included as part of trade and other payables as there is no uncertainty regarding timing or amount of settlement and hence it is not a provision. 6. The receipt of damages for the negligent advice about the conveyer belt meets the definition of a contingent asset because the case has been found in favour of Wizards as at the end of the reporting period (thus it is a possible asset) and the amount to be received is dependent on the outcome of future events not wholly within the control of Wizards (the hearing for damages). The contingent asset should be disclosed because the receipt of damages is probable. Note that the receipt of damages is not a reimbursement relating to a provision – the overhaul of the conveyer belt is not accounted for as a provision. 7. Wizards’ guarantee of the loan made by BankSweet to CCC Ltd would be disclosed as a contingent liability rather than recorded as a provision because CCC was in a strong financial position at 30 June 2024 and therefore whilst Wizards has a present obligation under the guarantee, it is not probable that an outflow of economic benefits will be required to settle the obligation. 8. Extracts from Financial Statements of Wizards Limited as at 30 June 2024. 30 June 2024 $

30 June 2023 $

CURRENT LIABILITIES Trade & other payables

700 000

Provisions Provision for warranties (Note x)

795 000

NON-CURRENT LIABILITIES Provision for warranties (Note x)

200 250

NON-CURRENT ASSETS

Reference

AASB 101/IAS 1 para. 60 - AASB 101/IAS 1 para. 54 630 000 AASB 101/IAS 1 para. 54 AASB 101/IAS 1 para. 60 240 300 AASB 101/IAS 1 para. 54 AASB 101/IAS 1 para. 60

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Chapter 8: Provisions, contingent liabilities and contingent assets

Plant and equipment (Note y)

1 150 000

1 400 000 AASB 101/IAS 1 para. 54

Note x: Provision for warranties Wizards provides for expected amounts payable under warranties for AASB 137/IAS 37 products sold during the financial year. The portion of the warranty para. 85 provision that is expected to be settled more than 1 year after the end of the reporting period is classified as a non-current provision. Assumptions used in calculating the warranty are based on past history and experience and include the percentage of products having minor defects vs. those having major defects, the expected costs of rectifying those defects and the expected timing of settlement. Reconciliation of warranty provision:

Opening balance Plus: Additional provision made in the current year Less: Amounts used during the year Less: Unused amounts reversed during the year Plus: Increase in discounted amount arising from the passage of time Closing balance

AASB 137/IAS 37 para. 84. No comparatives required. $870 300 725 250 (350 000) (280 000)

29 700 $995 250

Note y: Plant and equipment AASB 116/IAS 16 Plant and equipment is measured at cost. Depreciation is calculated para. 73 on a straight line basis. Useful lives of the assets vary from 5 years to 10 years. Plant and equipment At cost Accumulated depreciation Carrying amount

$ 2 000 000 850 000 1 150 000

$ AASB 116/IAS 16 2 000 000 para. 73 600 000 1 400 000

Note z: Contingent liabilities and contingent assets During the year Wizards signed an agreement with BankSweet to the effect that Wizards would guarantee a loan made by BankSweet to Wizards’ subsidiary, CCC Ltd. CCC’s loan with BankSweet was $3 200 000 as at 30 June 2024 (2023: Nil). CCC was in a strong financial position at 30 June 2024 and accordingly Wizards believes that it is not probable that the guarantee will be called. Wizards commenced litigation against one of its advisers for negligent advice in relation to the installation of certain plant and equipment. In April 2024 the court found in favour of Wizards. The hearing for damages had not been scheduled as at the date these financial statements were authorised for issue. Wizards estimates that it will receive approximately $425 000, based on advice from their

AASB 137/IAS 37 para. 86

AASB 137/IAS 37 para. 89

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

lawyers.

Exercise 8.15 Applying accounting theory In June 2021 Great Southern Ltd built a submarine under a contract with the Australian Navy. The contract required Great Southern Ltd to provide a one-year warranty. The accountant was unsure how to measure the warranty because the design of the submarine differed from those previously built by Great Southern Ltd. The trainee accountant was asked to obtain more information, so she asked some engineers for their advice on the expected cost of servicing the warranty. The trainee’s report is summarised below. Engineers’ estimates and accompanying explanations Worst-case scenario Best-case scenario Most probable scenario Quote from a Japanese company to take on the warranty

$ 1 000 000 $ 200 000 $ 500 000 $ 700 000

Recommendation: The provision for warranty should not be recognised because it is too difficult to measure. The accountant needs to decide whether to recognise a provision for warranty and, if so, how to measure it. Required 1. Describe two principles from AASB 137/IAS 37 that are relevant to the accountant’s decision. 2. Use the principles identified in 1, above, to evaluate the trainee accountant’s recommendation. 3. Describe an accounting policy to account for the provision for warranty. 4. Explain how the policy that you proposed in 3, above, is consistent with AASB 137/IAS 37. 5. Identify assumptions made in the exercise of judgement in proposing an accounting policy for the warranty. (LO1, LO4, LO5 and LO6) This question builds on discussion in chapter 2 of the role of professional judgement in applying principles-based accounting standards, in the context of measuring provisions. 1. Any of the following. •

Definition of a liability AASB 137, paragraph 10: a present obligation arising from a past event, settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

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Chapter 8: Provisions, contingent liabilities and contingent assets

• • •

Recognition criteria of provision AASB137, paragraph 14 (a-c) – present obligation as a result of a past event, the outflow or resources if probable and a reliable estimate can be made of the amount of the obligation. A provision should be measured as the best estimate of the expenditure required to settle the obligation at the end of the reporting period (AASB 137, paragraph 36). The best estimate of a provision is the amount that an entity would rationally pay to settle an obligation or transfer it to another party (AASB 137, paragraph 37).

Some student may draw on AASB 137, paragraph 40 which states that the most likely outcome may be the best estimate where a single obligation is being measured, but it is necessary to consider other possible outcomes. However this is more of a statement of what might be, rather than a principle that provided guidance. 2. The trainee’s policy fails to recognise a liability for the warranty, thus understating expenses and liabilities. The policy does not correctly apply the recognition criteria because an estimate is available. The trainee has taken the view that there is too much measurement uncertainty so that nonrecognition is justified by AASB 137. i.e., it fails the recognition criteria and meets the second limb of the definition of a contingent liability, and should thus not be recognised. However, it is not necessary that the amount be known with certainty. The issue is whether it can be measured reliably. 3. Recognise a provision for warranty when the submarine is sold and measure it at the best estimate of the expenditure required to settle it, which is the most probable estimate. (An alternative answer is to measure it at the best estimate of the amount the entity would need to pay to transfer it to another party.) 4. The warranty satisfies the definition of a liability because a present obligation to service a warranty has arisen from the sale of a submarine. Settlement of the warranty is expected to result in an outflow of at least $200 000. The recognition criteria are satisfied because there is a present obligation, as stated above, an outflow is probable, based on all available evidence or advice from engineers, and it can be measured reliably. The justification of reliable measurement depends on which measurement is adopted and the assumptions made. For example, if measuring at the $700 000, the reliability is ascertained from the existence of a quote. If measuring at $500 000, the reliability is only as good as the engineers’ estimates. 5. Answers will vary with the policy. If proposing measurement at $700 000, there is an assumption that Great Southern Ltd would reasonably pay the Japanese company $700 000 to transfer the obligation. If proposing to measure the provision at $500 000, the assumption would be that Great Southern Ltd would not pay the Japanese company $700 000 to transfer the obligation. It further assumes that the engineers’ estimate of the most probable amount is sufficiently reliable and in accordance with AASB 137, paragraph 38 with respect to having considered the range of other possible outcomes.

8.28

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 8: Provisions, contingent liabilities and contingent assets Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 8: Provisions, contingent liabilities and contingent assets Multiple choice questions 1. Which of the following is an example of a provision falling within the scope of AASB 137? a. *b. c. d.

Accruals. Onerous contracts. Insurance contracts. Employee benefits.

Answer: b Learning objective 8.1: describe the purpose of AASB 137/IAS 37.

2. AASB 137 prescribes the accounting and disclosure for all provisions, contingent liabilities and contingent assets except for: a. b. c. *d.

those arising for insurance entities from contracts with policyholders. those relating to employee benefits. those relating to leases. none. All of these are exceptions to AASB 137.

Answer: d Learning objective 8.1: describe the purpose of AASB 137/IAS 37.

3. An example of where an entity has a present obligation is: *a. b. c. d.

a public announcement made by an entity’s management to undertake restructuring. a recommendation from the HR manager to the Board of Directors as to the level of bonuses to be paid at the end of the financial period. a historical pattern of performing a major overhaul of plant and machinery every three years. the declaration of a dividend by directors which is yet to be approved at a meeting of shareholders.

Answer: a Learning objective 8.2: outline the concept of a provision and how it is distinguished from other liabilities.

8.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following statements is correct? a. *b. c. d.

A constructive obligation is an example of an equitable obligation. An equitable obligation is an example of a present obligation. A present obligation is an example of a legal obligation. A legal obligation is an example of a constructive obligation

Answer: b Learning objective 8.2: outline the concept of a provision and how it is distinguished from other liabilities.

5. Which of the following statements is correct? a. b. *c. d.

A contingent liability is a class of liabilities. A provision is a class of contingent liabilities. A provision is a class of liabilities. Contingent liabilities and provisions are classes of liabilities.

Answer: c Learning objective 8.2: outline the concept of a provision and how it is distinguished from other liabilities.

6. The uncertainty that exists in relation to provisions is one of: a. timing. b. amount. *c. timing or amount. d. timing and amount. Answer: c Learning objective 8.2: outline the concept of a provision and how it is distinguished from other liabilities.

8.2

Chapter 8: Provisions, contingent liabilities and contingent assets Not for distribution in full. Instructors may assign selected questions in their LMS.

7. An event that gives rise to a present obligation, but which cannot be measured with sufficient reliability is an example of a: a. b. c. *d.

accrual. provision. liability. contingent liability.

Answer: d Learning objective 8.3: outline the concept of a contingent liability and how it is distinguished from other liabilities.

8. A contingent liability is defined as a:

possible obligation that arises from past events. possible obligation whose existence will be confirmed by the occurrence of an uncertain future event. present obligation not recognised because the outflow of economic benefits to settle the obligation is not probable. present obligation that is measured reliably. *a. b. c. d.

I Yes Yes

II Yes No

III No Yes

IV No No

Yes

I. II. III. IV.

Answer: a Learning objective 8.3: outline the concept of a contingent liability and how it is distinguished from other liabilities.

8.3

Testbank to accompany Financial reporting 3e by Loftus et al.

9. Contingent liabilities are: a. b. *c. d.

recognised in the financial statements unless the possibility of an outflow in settlement is remote. recognised in the notes to the financial statements because the possibility of an outflow in settlement is remote. recognised in the notes to the financial statements unless the possibility of an outflow in settlement is remote. not recognised in the notes to the financial statements because the possibility of an outflow in settlement is remote.

Answer: c Learning objective 8.3: outline the concept of a contingent liability and how it is distinguished from other liabilities.

10. AASB 137 requires provisions to be recognised when: I II III IV

there has been a past event. an entity has a present obligation. the amount of the obligation can be reliably estimated. it is possible that an outflow of resources will be required to settle the obligation.

*a. b. c. d.

I, II and III. II, III and IV. I, III and IV. I, II and IV.

Answer: a Learning objective 8.4: explain when a provision should be recognised.

11. Liabilities which do not meet the recognition criteria and where the possibility of an outflow of economic resources is remote should: a. b. c. *d.

be recognised as an accrual. be recognised as a provision. be recognised as a contingent liability. not be recognised in the financial statement at all.

Answer: d Learning objective 8.4: explain when a provision should be recognised.

8.4

Chapter 8: Provisions, contingent liabilities and contingent assets Not for distribution in full. Instructors may assign selected questions in their LMS.

12. Collins Limited estimated the future cash outflows over the next three years relating to settlement of warranty obligations would be as follows: 1 year from now: 2 years from now: 3 years from now:

$20 000 $38 000 $45 000

Collins Limited calculates that the present value of the total expected future cash outflow, using a discount rate of 8%, is: *a. b. c. d.

$ 86 820 $ 88 301 $ 95 370 $103 000

Answer: a Learning objective 8.5: explain how a provision, once recognised, should be measured.

13. Under AASB 137 Provisions, Contingent Liabilities and Contingent Assets, when providing for a future event such as the clean-up of a construction site at the end of a long-term project, gains and other cash inflows that are expected to arise on the sale of assets related to the clean-up, must be: a. b. *c. d.

set-off against the provision for the clean-up. recognised as a deferred asset. measured separately of the provision. recognised directly in equity in the period in which the cash inflows arise.

Answer: c Learning objective 8.5: explain how a provision, once recognised, should be measured. 14. Percy Limited is a manufacturer of playground equipment. Percy provides its customers with five-year warranties from the date of sale. Past experience shows that there will be some claims under the warranties. The appropriate treatment of this item under AASB 137 Provisions, Contingent Liabilities and Contingent Assets is to: *a. b. c. d.

recognise the best estimate of costs as a provision. disclose in the notes, but do not recognise in the financial statements. charge the costs directly to profit or loss in the period in which the economic outflows occur. transfer the expected amount of the warranty from retained earnings to a special reserve account in equity.

8.5

Testbank to accompany Financial reporting 3e by Loftus et al.

Answer: a Learning objective 8.5: explain how a provision, once recognised, should be measured.

15. Accountants are required to use professional judgement in determining the best estimate of provisions. Which of the following is an example of when judgement is required? a. b. c. *d.

Assessing the likely consideration that will be required to settle the obligation. Determining if various scenarios may arise. Determining when the consideration is likely to be settled. All of these options.

Answer: d Learning objective 8.5: explain how a provision, once recognised, should be measured.

16. An entity sells goods under warranty and past experience shows that minor defects account for 10% of sales and major defects account for 2% of sales. If minor defects were detected in all goods sold the repair costs would be $260 000, and if major defects were detected in all goods sold the repair costs would be $990 000. The expected value of the warranty costs is: a. b. *c. d.

$ 0. $ 19 800. $ 45 800. $ 99 000.

Answer: c Learning objective 8.5: explain how a provision, once recognised, should be measured.

8.6

Chapter 8: Provisions, contingent liabilities and contingent assets Not for distribution in full. Instructors may assign selected questions in their LMS.

17. The costs under an onerous contract are measured as: a. b. c. *d.

the lower of cost or net market value. the present value method using a risk-free discount rate. the unavoidable costs of meeting the obligations discounted by reference to market yields at reporting date. the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil the contract.

Answer: d Learning objective 8.6: apply the definitions, recognition and measurement criteria for provisions and contingent liabilities to practical situations.

18. Angus Ltd has provided a bank guarantee to a bank in relation to a loan provided to Brown Ltd. Brown Ltd is solvent and shows no signs of defaulting on the loan. The treatment of the bank guarantee in the records of Angus Ltd is to: a. *b. c. d.

do nothing. recognise a contingent liability. recognise a liability. recognise a provision.

Answer: b Learning objective 8.6: apply the definitions, recognition and measurement criteria for provisions and contingent liabilities to practical situations.

19. AASB 137 Provisions, Contingent Liabilities and Contingent Assets provides the definition of a/an as: ‘a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it’. a. b. *c. d.

future operating loss. deferred liability. onerous contract. present obligation.

Answer: c Learning objective 8.6: apply the definitions, recognition and measurement criteria for provisions and contingent liabilities to practical situations.

8.7

Testbank to accompany Financial reporting 3e by Loftus et al.

20. McAllister Limited announced its plans for a major restructuring of its operations. Under AASB 137 Provisions, Contingent Liabilities and Contingent Assets, the entity is able to: a. b. c. *d.

capitalise all direct and indirect restructuring costs. set up a provision for the best estimate of all restructuring costs. provide for restructuring costs that are associated with the ongoing activities of the entity. provide only for restructuring costs that are directly and necessarily caused by the restructuring.

Answer: d Learning objective 8.6: apply the definitions, recognition and measurement criteria for provisions and contingent liabilities to practical situations.

21. Under AASB 137 Provisions, Contingent Liabilities and Contingent Assets, the appropriate accounting treatment for future operating losses is to: a. b. *c. d.

determine a reasonable estimate of the future losses and recognise as a provision. determine the future losses and charge them directly against retained earnings. not recognise such items in the financial statements. determine the future losses and discount them to present value.

Answer: c Learning objective 8.6: apply the definitions, recognition and measurement criteria for provisions and contingent liabilities to practical situations.

22. AASB 137 Provisions, Contingent Liabilities and Contingent Assets, defines a as: ‘a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity’ a. *b. c. d.

deferred liability. contingent asset. deferred asset. contingent liability.

Answer: b Learning objective 8.7: outline the concept of a contingent asset.

8.8

Chapter 8: Provisions, contingent liabilities and contingent assets Not for distribution in full. Instructors may assign selected questions in their LMS.

23. At the end of the financial period, Rosella Limited was awaiting the final details of a court case for damages awarded in its favour. The amount and possible receipt of damages is unknown and will not be decided until the court sits again in approximately three months’ time. How should Rosella Limited recognise this situation when preparing the financial statements? *a. b. c. d.

Disclose in the notes to the financial statements as it is possible that the entity will receive the damages and the court decision is out of its control. Do not recognise or disclose in the financial statements as the possibility of receiving damages is remote. Recognise as an asset in the financial statements as the receipt of damages is probable. Recognise as a deferred asset in the statement of financial position and re-classify as a noncurrent asset when the court decision is known.

Answer: a Learning objective 8.7: outline the concept of a contingent asset.

24. As per AASB 137 Provisions, Contingent Liabilities and Contingent Assets, the appropriate treatment for a contingent asset in the financial statements of an entity is: a. b. c. *d.

recognition in the financial statements, and note disclosure. recognition in the financial statements, but no further disclosure in the notes. do not recognise in the financial statements, and do not disclose in the notes. disclosure of information in the notes, but do not recognise in the financial statements.

Answer: d Learning objective 8.7: outline the concept of a contingent asset.

25. In respect to a contingent liability, AASB 137 Provisions, Contingent Liabilities and Contingent Assets, requires disclosure of: *a. b. c. d.

an estimate of its financial effect. any increase in the contingent liability during the period. the carrying amount at the beginning and end of the period. an indication of the uncertainties about the amount and timing of expected outflows.

Answer: a Learning objective 8.8: describe the disclosure requirements for provisions, contingent liabilities and contingent assets.

8.9

Testbank to accompany Financial reporting 3e by Loftus et al.

26. For each class of provision, AASB 137 Provisions, Contingent Liabilities and Contingent Assets requires an entity to disclose the following information: I II III IV V a. *b. c. d.

Comparative information. Unused amounts reversed during the period. Additional provisions made during the period. The carrying amount at the beginning and end of the period. A brief description of the nature of the obligation and the expected timing.

I, II, and III only. II, III, IV and V only. II, III and IV only. I, III, IV and V only.

Answer: b Learning objective 8.8: describe the disclosure requirements for provisions, contingent liabilities and contingent assets.

27. Entities are not required to disclose which of the following in relation to provisions? *a. b. c. d.

Comparatives. Amounts used during the period. The effect of any change in the discount rate used. Carrying amounts of provisions at the beginning of the period.

Answer: a Learning objective 8.8: describe the disclosure requirements for provisions, contingent liabilities and contingent assets.

8.10

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Belinda Luke

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 9: Employee benefits

Chapter 9: Employee benefits Comprehension questions 1. What is a paid absence? Provide an example. Refer to section 9.2. Paid absence refers to an employee entitlement to be paid during certain absences. Examples include sick leave and annual leave.

2. What is the difference between accumulating and non-accumulating sick leave? How does the recognition of accumulating sick leave differ from the recognition of nonaccumulating sick leave? Refer to section 9.2.4. Accumulating sick leave may be carried forward to a future period if the employee has not taken the leave in the current period. Non-accumulating sick leave may not be carried forward to a future period. A liability must be recognised for accumulating sick leave when the employee renders services that increase the entitlement. The liability is measured as the amount that the entity expects to pay. If the leave is non-vesting, the amount recognised is affected by the probability that the leave will be taken.

3. What is the difference between vesting and non-vesting sick leave? How does the recognition of vesting sick leave differ from the recognition of non-vesting sick leave? Refer to section 9.2.4. If sick leave is vesting, the employee is entitled to cash settlement for unused leave. If sick leave is non-vesting, the employee has no entitlement to cash settlement of unused leave. The employer recognises a liability for accumulating sick leave, measured as the undiscounted amount expected to be paid. The entity will have good reason to expect that all vested accumulating sick leave will be paid. However, if sick leave is not vesting, a liability is recognised for proportion of accumulated sick leave that the entity expects to be taken by its employees.

4. Explain how a defined contribution superannuation plan differs from a defined benefit superannuation plan. Refer to sections 9.4 and 9.5. Under a defined contribution superannuation plan the employer pays fixed contributions into a fund. Employees’ benefits are a function of the level of contributions paid and the return achieved by the fund on the investment of plan assets. The employer has no obligation to make further payments if the fund is unable to pay all the benefits accruing to members for past service. In a defined-benefit superannuation plan, the benefits received by members on retirement are determined by a formula reflecting their years of service and level of remuneration, rather than

9.2

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the performance of the fund. The employer has an obligation to pay further contributions if the fund is unable to pay members’ benefits.

5. During October 2008 there was a sudden global decline in the price of equity securities and credit securities. Many superannuation funds made negative returns on investments during this period. How would this event affect the wealth of employees and employers? Consider both defined benefit and defined contribution superannuation funds in your answer to this question. Refer to sections 9.4 and 9.5. In a defined contribution fund the employees bear the risk of low or negative returns on the investment of plan assets because the benefits paid on retirement are a function of the level of contributions and the return achieved on plan assets. Thus, the employer is not directly affected by the poor performance of the defined contribution fund because it has no obligation for additional contributions if the fund is unable to pay benefits to members on retirement. Members of defined benefit plans would not be affected by the negative returns achieved by the fund. Their benefits are defined in terms of their years of service and level of remuneration, rather than by the performance of the fund. The employer has an obligation for the excess of the defined benefit over the plan assets. Thus a decline in the value of investments held by the fund may increase the employer’s obligation to the fund.

6. Explain how an entity should account for its contribution to a defined contribution superannuation plan in accordance with AASB 119/IAS 19. Refer to section 9.4. Contributions payable to defined contribution funds are recognised as expenses in the period that the employee renders services, unless another standard permits the cost of employment benefits to be allocated to the carrying amount of an asset, such as inventory. If the amount paid to the defined contribution fund by the entity during the year is less than the amount payable in relation to services rendered by employees, a liability for unpaid contributions must be recognised. The liability is measured at the undiscounted amount payable unless it is due more than 12 months after the end of the period, in which case it is discounted.

7. Compare the off-balance sheet approach to accounting for a defined benefit postemployment plan with the net capitalisation approach adopted by AASB 119/IAS 19. Can these approaches be explained by different underlying views as to whether a deficit or surplus in the fund meets the definition of a liability or asset of the sponsoring employer? The off-balance sheet approach ignores any surplus or deficit in the defined benefit postemployment plan. Under this approach, the accounting is similar to accounting for a defined contribution fund, for which contributions are recognised as expenses in the period in which the employee renders services. This approach can be justified conceptually if adopting the view that

9.3

Chapter 9: Employee benefits

a surplus in the fund is not an asset of the employer, who cannot direct a surplus to be used as a resource to pursue its own objectives; and a deficit is not a liability of the employer in the absence of a legal obligation to pay for any shortfall in the fund. However, this argument is premised on a narrow view assets and liabilities. Adopting a broader view, the expected cost savings, in the form of lower contributions, constitute future economic benefits that are expected to be derived from the surplus. Similarly, the deficit gives rise to a constructive obligation because the employer may find it difficult to attract and retain staff, or face opposition from unions, if it did not make additional contributions to enable the fund to pay benefits to members. This broader view is reflected in the net capitalisation approach because the surplus (deficit) of the plan assets is recognised as an asset (liability) by the employer.

8. In relation to defined benefit post-employment plans, paragraph 56 of AASB 119/IAS 19 states, “… the entity is, in substance, underwriting the actuarial and investment risks associated with the plan”. Evaluate whether the requirements for the recognition and measurement of the net defined benefit liability reflect the underlying assumptions about the entity’s risks. The standard reflects the view that a deficit in the post-employment fund represents a constructive obligation because the entity (the employer) effectively underwrites the actuarial and investment risks associated with the plan. Similarly, a surplus represents an asset in the form of future savings in contributions. The recognition of a liability to the extent that the present value of the accrued benefits exceed the fair value of plan assets is consistent with this view; it provides a present value measure of the risk to the entity of having to pay additional contributions in future to enable the fund to pay accrued benefits to members for services that have already been rendered. While the question focuses on the requirements for a defined benefit liability, some further comments are offered in relation to the accounting requirements for a net defined benefit asset. Conversely, a surplus in the fund represents potential savings in the form of reduced contributions resulting from past actuarial and investment gains. However, assets are resources controlled by the entity form which future economic benefits are expected to flow to the entity. Accordingly, AASB 119/IAS 19 limits the carrying amount of the net superannuation asset to the greater of the surplus and ‘the present value of any economic benefits available in the form of refunds from the plan or reductions in future contributions of the plan’.

9. Identify and discuss the assumptions involved in the measurement of a provision for long service leave. Assess the consistency of these requirements with the fundamental qualitative characteristics of financial information prescribed by the conceptual framework. Refer to section 9.6. Accounting for long service leave requires estimation of when the leave will be taken, projected salary levels and the proportion of employees who will continue in the entity’s employment long enough to become entitled to long service leave. It is necessary to make assumptions about when employees will take long service leave, which may be any time

9.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

after they become entitled. The estimation of the timing of when leave will be taken affects estimates of projected salaries and wages and the discounting of the defined benefit. The estimation of projected salary levels may be affected by assumptions about the rate of inflation as well as promotion. The likelihood of promotion may differ among different categories of employees, such as engineers, graduate trainees and unskilled workers. The proportion of employees who will become entitled to long service leave may vary from one location to another, and is usually considered to be increasing with the period of past employment. Employees who are approaching entitlement are assumed to be less likely to leave before their long service leave vests, because the loss of long service leave entitlement would be viewed as a cost of changing employment. The fundamental qualitative characteristics of financial information prescribed by the Conceptual Framework are relevance and faithful representation. The liability for long service leave is required to be measured as the present value of the amount expected to be paid to settle the obligation. The focus on future cash flows required to settle the obligation reflects the fundamental characteristic of relevance because users of financial statements need information with which to assess the entity’s prospects for future not cash inflows (Conceptual Framework, paragraph OB4). However, the estimation of future cash flows introduces measurement uncertainty that can detract from faithful representation. The use of historical patterns of employee retention and actuarial estimates can enhance the faithful representation of liabilities for long service leave.

10. Explain the projected unit credit method of measuring and recognising an obligation for long-term employee benefits? Illustrate your answer with an example. Refer to section 9.6. Under the projected unit credit method the obligation for long-term employee benefits is measured by calculating the present value of the expected future payments that will result from employee services provided to date. For example, if employees will be entitled to 13 weeks of long service leave after 10 years of employment, 30% of the amount expected to be paid in the future is recognised for employees who have provided three years of service.

9.5

Chapter 9: Employee benefits

Case studies Case study 9.1 Termination benefits The board of directors of Launceston Ltd met in June 2022 and decided to close down a branch of the company’s operations when the lease expired in the following February. The chief financial officer advised that termination benefits of $2 million are likely to be paid. Required Advise the company’s accountant whether the company should recognise a liability for termination benefits in its financial statements for the year ended June 2022. Explain your advice with reference to the requirements of AASB 119/IAS 19. Given the timeframe for the expected payments is within 12 months after the end of the reporting period, the amount should be recorded as a current liability (paragraph 8, AASB 119/IAS 9).

Case study 9.2 Vesting entitlements Monash Ltd is a newly formed company and is formulating its policies in terms of employee benefits. The company would like to offer employees payment for any accumulated unused sick leave if they resign from the company. Required Explain to the CEO the effect on the financial statements if sick leave entitlements are vesting versus non-vesting. Where payment is made for any accumulated unused sick leave, such leave is referred to as vesting. In this case, records of accumulated unused leave must be kept and the associated liability recorded in the company’s financial statements. If there is no entitlement to payment for unused sick leave on resignation/termination, such leave is referred to as non-vesting and only amounts due and payable within the next 12 months would be recorded as a current liability in the company’s financial statements.

Case study 9.3 Long service leave The accountant of Oxford Ltd believes that long service leave should not be considered as a liability in the accounts until employees have commenced their tenth year of service, given this leave entitlement only applies to Oxford Ltd employees after 10 years of continuous service.

9.6

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Required Advise the accountant on whether this approach is acceptable, and what requirements exist under AASB 119/IAS 19. Under AASB119/IAS 9, long service leave accrues to employees as they provide services to the entity, even though there may be no legal entitlement to the leave until after 10 years. Hence, net present value calculations of the expected future obligation are required. This is normally done using the projected unit credit method, which involves estimating when the leave will be taken, projected salary levels at that time, and the proportion of employees who will remain in employment to qualify for the leave.

Case study 9.4 Bonuses Bond Ltd pays bonuses to its staff 3 months after year-end, provided profit targets are met and staff remain employed with the company at the time the bonuses are paid. At 30 June 2022 the company determines it has exceeded its profit target for the year, but prefers not to record a liability for bonuses payable until it confirms how many staff continue to be employed with the company in September, given there has been significant variation in turnover rates in recent years. Required Advise whether the proposed approach is acceptable. The proposed approach is not acceptable under AASB 119/IAS 19 if the company has a present legal or constructive obligation to make such payments as a result of past events (meeting their profit target), and a reliable estimate of the obligation can be made. While Bond has experienced significant variation in staff turnover rates in recent years, it should be possible to make a reasonable estimate of the liability for bonus payments.

9.7

Application and analysis exercises Exercise 9.1 Accounting for the payroll Kingfisher Ltd pays its employees on a monthly basis. The payroll is processed on the 6th day of the month and payable on the 7th day of the month. Gross salaries for July were $600 000, from which $150 000 was deducted in tax. All of Kingfisher Ltd’s salaries are accounted for as expenses. Deductions for health insurance were $12 000. Payments for health insurance and employee income taxes withheld are due on the 15th day of the following month. Required 1. Prepare all journal entries to record the July payroll, the payment of July salaries and the remittance of deductions. 2. Calculate the balance of the Accrued Payroll account at the end of July. (LO2) 1. 6 July

7 July

15 August

Wages and salaries expense Accrued payroll (Payroll for July)

Dr Cr

600 000

Accrued payroll Cash (Payment of net salaries for July)

Dr Cr

438 000

Accrued payroll Dr Cash Cr (Payment of health insurance payroll deductions)

600 000

438 000

12 000

Accrued payroll Dr 150 000 Cash Cr (Payment of payroll deductions for withheld income tax)

12 000

150 000

2. $162 000 credit ($600 000 - $438 000), as all June payroll deductions would have been remitted during July.

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 9.2 Accrual of wages and salaries Zhang Ltd has a weekly payroll of $140 000. The last payroll processed before the end of the annual reporting period was for the week ended Friday 24 June. Employees do not work during weekends. Required Prepare a journal entry to accrue the weekly payroll as at 30 June. (LO2) Wages and salaries must be accrued for four business days after Friday 24 June. that is, Monday 27 June – Thursday 30 June. 30 June

Wages and salaries expense Dr 112 000 Accrued wages and salaries Cr 112 000 (Accrual of payroll for business days 27-30 June: 4/5 x $140 000 = $112 000)

9.9

Chapter 9: Employee benefits

Exercise 9.3 Accounting for the payroll Malee Ltd pays management on a monthly basis and staff on a fortnightly basis. Payroll is processed and paid on the 1st of each month for management, and the 1st and 15th of each month for staff. Gross management salaries per month are $360 000 (less $162 000 tax). Gross staff wages per month are $540 000 (less $175 500 tax), and paid in equal instalments on the 1st and 15th of each month. Tax is remitted on the 15th of the following month. Required Prepare journal entries for January payroll. (LO2) 1 Jan

Wages expense Dr 270 000 Salaries expense Dr 360 000 Accrued payroll Cr 249 750 Cash Cr 380 250 (Payroll for first half of January, net salary and wages $198 000 + $182 250)

15 Jan

Wages expense Accrued payroll Cash (Payroll for second half of January)

15 Feb

Dr Cr Cr

Accrued payroll Dr Cash Cr (Payment of payroll deductions for income tax withheld)

270 000 87 750 182 250

337 500 337 500

9.10

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Exercise 9.4 Accounting for sick leave Magpie Ltd has 80 employees who each earn a gross wage of $120 per day. In an attempt to reduce absenteeism, Magpie Ltd introduced a new workplace agreement providing all employees with entitlement to 5 days of non-vesting, accumulating sick leave per annum, effective from 1 July 2021. Under the previous workplace agreement, all sick leave was non-cumulative. During the year ended 30 June 2022, 240 days of paid sick leave were taken by employees. It is estimated that 70% of unused sick leave will be taken during the year ended 30 June 2023 and that 30% will not be taken at all. Required Prepare a journal entry to recognised Magpie Ltd’s liability, if any, for sick leave at 30 June 2022. (LO2) 30 June

Wages and salaries expense Dr 13 440 Provision for sick leave Cr (Accrual of sick leave: 70% x (80 x 5 – 240) x $120 = $13 440)

13 440

9.11

Chapter 9: Employee benefits

Exercise 9.5 Accounting for sick leave Omu Ltd has 220 employees who each earn a gross wage of $145 per day. Omu Ltd provides 5 days of paid non-accumulating sick leave for each employee per annum. During the year, 160 days of paid sick leave and 20 days of unpaid sick leave were taken. Staff turnover is negligible. Required Calculate the employee benefits expense for sick leave during the year and the amount that should be recognised as a liability, if any, for sick leave at the end of the year. (LO2) Employee benefits for sick leave during the year: 160 days x $145 per day = $23 200. Omu Ltd should not recognise a liability for sick leave because it is non-cumulative.

9.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 9.6 Accounting for annual leave Burung Ltd provides employees with 4 weeks (20 days) of annual leave for each year of service. The annual leave is accumulating and vesting up to a maximum of 6 weeks. Thus, all employees take their annual leave within 6 months after the end of each reporting period so that it does not lapse. Burung Ltd pays a loading of 17.5% on annual leave; that is, employees are paid an additional 17.5% of their regular wage while taking annual leave. Refer to the following extract from Burung Ltd’s payroll records for the year ended 30 June 2019.

Employee Chand Kettle Sander Zhou

Wage/day

AL 1 July 2021 (days)

Increase in entitlement (days)

AL taken (days)

$150 $115 $140 $100

8 5 4 6

20 20 20 20

15 12 10 15

Required Calculate the amount of annual leave that should be accrued for each employee. (LO2) Employee Chand Kettle Sander Zhou

Wage, per day $150 $115 $140 $100

Change in AL entitlement 8+20-15 5+20-12 4+20-10 6+20-15

AL 30/6/22 in days 13 13 14 11

AL accrual (col. 2 x col. 4 x 117.5%) 2 291 1 757 2 303 1 293

9.13

Chapter 9: Employee benefits

Exercise 9.7 Accounting for profit-sharing arrangements Ren Ltd has a profit-sharing arrangement in which 1% of profit for the period is payable to employees, paid 3 months after the end of the reporting period. Employees’ entitlements under the profit-sharing arrangement are subject to their continued employment at the time the payment is made. Based on past staff turnover levels, it is expected that 95% of the share of profit will be paid. Ren Ltd’s profit for the period was $70 million. Required Prepare a journal entry to record Ren Ltd’s liability for employee benefits arising from the profit-sharing arrangement at the end of the reporting period. (LO2) 30 June

Wages and salaries expense Dr 665 000 Provision for employee benefits Cr 665 000 (Accrual of employee benefits for profit-sharing arrangements: 95% x 1% x $70 000 000 = $665 000)

9.14

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Exercise 9.8 Accounting for the payroll and accrual of wages and salaries Lyrebird Ltd pays its employees on a fortnightly basis. All employee benefits are recognised as expenses. The following information is provided for its July and August payrolls: July $ Fortnightly payroll Gross payroll for the month Deductions payable to: Taxation authority Health fund Community charity Union fees

August $

Net wages and salaries paid 14 July, 11 August 28 July, 25 August

800 000 700 000

1 500 000

1 500 000 255 000 20 000 4 000 6 500

290 500 553 775 655 725

680 000 820 000

260 000 20 000 4 000 6 500

Total deductions for the month

285 500

648 230 1 209 500 566 270

1 214 500

1 500 000

The two fortnightly payrolls in August were for the fortnight ended Friday 7 August and Friday 21 August. The payrolls were processed and paid on the following Monday and Tuesday respectively. Payroll deductions are remitted as follows. Health fund deductions Union fees Taxation authority Community charity

7th day of the following month 7th day of the following month 14th day of the following month 21st day of the following month

Required 1. Prepare all journal entries to account for the August payroll and all payments relating to employee benefits during August.

9.15

Chapter 9: Employee benefits

2. Prepare a journal entry to accrue wages for the remaining days in August not included in the final August payroll. Use the same level of remuneration as per the final payroll for August. (LO2) 1. 7 August

10 August

11 August

1 August

21 August

24 August

25 August

2. 31 August

Accrued payroll Dr Cash Cr (Payment of July health insurance payroll deductions) Accrued payroll Dr Cash Cr (Payment of July payroll deductions for union fees)

20 000

Wages and salaries expense Accrued payroll (Payroll for fortnight ended 7/8)

Dr Cr

800 000

Accrued payroll Cash (Payment of net wages & salaries)

Dr Cr

648 230

Accrued payroll Dr Cash Cr (Payment of employee income tax withheld in July) Accrued payroll Dr Cash Cr (Payment of July payroll deductions for charity donations)

20 000 6 500 6 500

800 000

648 230

260 000 260 000

4 000 4 000

Wages and salaries expense Accrued payroll (Payroll for fortnight ended 21/8)

Dr Cr

700 000

Accrued payroll Cash (Payment of net wages & salaries)

Dr Cr

566 270

700 000

566 270

Wages and salaries expense Dr 420 000 Accrued wages and salaries Cr 420 000 (Accrual of wages and salaries for 6 business days Mon 24-28/8, 31/8; Daily wages $700 000/10 days = $70 000; 6 days x $70 000 per day = $420 000)

9.16

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Exercise 9.9 Accounting for annual leave Niao Ltd provides 4 weeks (20 days) of accumulating vested annual leave for each year of service. The company policy is that annual leave must be taken within 6 months of the end of the period in which it accrues. Annual leave is paid at the base salary rate (which excludes commissions, bonuses and overtime). A 17.5% loading is applied to annual leave payments. The following summary data is derived from Niao Ltd’s payroll records for the year ended 30 June 2022. Base pay rates have increased during the year. The amounts shown are applicable at 30 June 2022.

Additional information After leave taken during the year had been recorded, Niao Ltd’s trial balance revealed that the provision for annual leave had a debit balance of $262 460 at 30 June 2022. Required Prepare journal entries to account for the liability for annual leave at 30 June 2022. (LO2) Category Managers Sales staff Office workers Other Liability 30 June Bal. of provision Accrual

Pay/day $ 440 220 110 100

Op bal Increase AL taken Clos bal. Days Days Days Days 100 200 260 40 150 600 630 120 120 400 387 133 60 200 240 20

Loading Liability $ 0.175 20 680 0.175 31 020 0.175 17 190 0.175 2 350 71 240 Cr 262 460 Dr 333 700

Closing balance of annual leave accumulation (in days) = Opening balance + accumulation during the year – Annual leave taken; e.g. Managers: 100 + 200 – 260 = 40 days Accrual = Days accumulated at the end of the period x basic pay rate x (1 + 0.175); e.g. Managers: 40 days x $440 per day x (1 + 0.175) = $20 680 30/6/2022

Wages and salaries expense

333 700

9.17

Chapter 9: Employee benefits

Provision for annual leave Cr 333 700 (Accrual of employee benefits arising from profit-sharing arrangements)

9.18

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Exercise 9.10 Accounting for annual leave Assume the same details as in exercise 9.9, except that Niao Ltd’s trial balance showed the provision for annual leave had a credit balance of $62 640. Required 1. Prepare journal entries to account for the annual leave liability at 30 June 2022. 2. Prepare journal entries to account for the annual leave liability at 30 June 2022 if the provision for annual leave had a credit balance of $62 640, but there was no loading applied to annual leave payments. (LO2) 1. 30/6/2022

Wages and salaries expense Provision for annual leave ($71 240 – $62 640 = $8 600)

Dr Cr

8 600 8 600

2. Category Managers Sales staff Office workers Other Liability 30/6 Bal of provision Accrual

Pay/day $ 440 220 110 100

Op bal Increase AL taken Clos bal. Loading Liability Days Days Days Days $ 100 200 260 40 0 17 600 150 600 630 120 0 26 400 120 400 387 133 0 14 630 60 200 240 20 0 2 000 60 630 Cr 62 640 Cr 2 010 Dr

Closing balance of annual leave accumulation (in days) = Opening balance + accumulation during the year – Annual leave taken; e.g. Managers: 100 + 200 – 260 = 40 days Accrual = Days accumulated at the end of the period x basic pay rate x (1); e.g. Managers: 40 days x $440 per day x (1) = $17 600 30/6/2022

Provision for annual leave Wages and salaries expense

Dr Cr

2 010 2 010

9.19

Chapter 9: Employee benefits

Exercise 9.11 Accounting for sick leave Drake Ltd opened a call centre on 1 July 2021. The company provides 1 week (5 days) of sick leave entitlement for the employees working at the call centre. The following information has been obtained from Drake Ltd’s payroll records and actuarial assessments for the year ended 30 June 2022. The column headed ‘Term. in 2019’ indicates the leave entitlement pertaining to service of employees whose employment was terminated during the year. The actuary has estimated the percentage of unused leave that would be taken within 12 months if Drake Ltd allowed leave to accumulate. Due to high staff turnover, the remaining leave would lapse (or be settled in cash, if vesting) within 1 year after the end of the reporting period.

Employee category

Base pay/day $

Current service (days)

Leave taken in 2022 (days)

Term. in 2022 (days)

Estimated leave used 2022 %

Estimated termination 2022 %

Supervisors Operators

150 90

30 500

20 400

3 60

90 70

10 30

Required Calculate the employee benefits expense for sick leave for the year and the amount that should be recognised as a liability for sick leave at 30 June 2022, assuming that sick leave entitlements are: 1. non-accumulating 2. accumulating and non-vesting 3. accumulating and vesting. (LO2) There is no opening balance of sick leave, even if accumulating, because all employees commenced in the current year. Provision for sick leave:

category

day

in 2022

Supervisors Operators

$ 150 90

Days 20 400

benefits expense $ 3 000 36 000 $39 000

$ Nil Nil Nil

Explanation: there is no obligation for unused sick leave at the end of the period because it is non-accumulating. Therefore, Drake Ltd would not recognise a provision for non-accumulating sick leave. Accumulating sick leave is recognised when the employee provides a service and the liability is measured as the nominal amount (if short-term) that is expected to be paid for sick leave arising from services already provided. 2. Employee benefits expense = leave taken during the period + increase in the provision for sick leave = $39 000 + $3 465 = $42 465 Amount of liability = $3 465 3. If the accumulating sick leave is vesting, all unused entitlement is expected to be paid. Employee benefits expense = leave taken during the period + increase in the provision for sick leave = $39 000 + $4 650 = $43 650 Amount of liability = $4 650.

9.21

Chapter 9: Employee benefits

Exercise 9.12 Accounting for defined contribution superannuation plans Bachstelze Ltd provides a defined contribution superannuation fund for its employees. The company pays contributions equivalent to 10% of annual wages and salaries. Contributions of $60 000 per month were paid for the year ended 30 June 2022. Actual wages and salaries were $8 million. Three months after the reporting period, there is a settlement of the difference between the amount paid and the annual amount payable determined with reference to Bachstelze Ltd’s audited payroll information. The settlement at 30 September involves either an additional contribution payment by Bachstelze Ltd or a refund of excess contributions paid. Required Prepare all journal entries required during June 2022 for Bachstelze Ltd’s payment of, and liability for, superannuation contributions. (LO4) Superannuation payable Contributions paid Superannuation liability 30/06/22

$800 000 $720 000 ($60 000 x 12) $80 000

Superannuation expense Cash (Superannuation contribution for June)

Dr Cr

60 000

Superannuation expense Dr 80 000 Superannuation liability Cr (Liability for unpaid superannuation contribution for the year)

60 000

80 000

9.22

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Exercise 9.13 Accounting for defined benefit superannuation plans Lily Ltd provides a defined benefit superannuation plan for its managers. The following information is available in relation to the plan. 2022 $ Present value of the defined benefit obligation 1 July 2021 Fair value of plan assets 1 July 2021 Current service cost Contributions paid by Lily Ltd to the fund during the year Benefits paid by the fund during the year Present value of the defined benefit obligation 30 June 2022 Fair value of plan assets at 30 June 2022

5 000 000 4 750 000 575 000 500 000 600 000 5 375 000 5 023 750

Additional information • No past service costs were incurred during the year ended 30 June 2022. • The interest rate used to measure the present value of defined benefits at 30 June 2021 was 9%. • The interest rate used to measure the present value of defined benefits at 30 June 2022 was 10%. • There was an actuarial gain pertaining to the present value of the defined benefit obligation as a result of an increase in the interest rate. • The only remeasurement affecting the fair value of plan assets is the return on plan assets. • The asset ceiling was nil at 30 June 2021 and 30 June 2022. • All contributions received by the funds were paid by Lily Ltd. Employees make no contributions. Required 1. Determine the surplus or deficit of Lily Ltd’s defined benefit plan at 30 June 2022. 2. Determine the net defined benefit asset or liability that should be recognised by Lily Ltd at 30 June 2022. 3. Calculate the net interest for the year ended 30 June 2022. 4. Calculate the actuarial gain or loss for the defined benefit obligation for the year ended 30 June 2022. 5. Calculate the return on plan assets, excluding any amount recognised in net interest, for the year ended 30 June 2022. 6. Present a reconciliation of the opening balance to the closing balance of the net defined benefit liability (asset), showing separate reconciliations for plan assets and the present value of the defined benefit obligation.

9.23

Chapter 9: Employee benefits

Prepare a summary journal entry to account for the defined benefit superannuation plan in the books of Lily Ltd for the year ended 30 June 2022. (LO5) 1. Deficit of the fund = $351 250 Present value of the defined benefit obligation 30 June 2022 Fair value of plan assets 30 June 2022 Deficit of the fund at 30 June 2022

$5 375 000 55 023 750 $ 351 250

2. The net defined benefit liability at 30 June 2022 is $351 250, being the deficit of the fund. 3. Net interest = $22 500 Interest expense component of the defined benefit obligation = $5 000 000 x 9% =$450 000. Interest income component of the change in fair value of plan assets = $4 750 000 x 9% = $427 500 4. Actuarial gain on remeasurement of the defined benefit obligation = $50 000 Closing present value of defined benefit obligation (DBO) = Opening DBO + interest cost + current service costs- benefits paid +/(-) actuarial loss (gain) $5 375 000 = $5 000 000 + $450 000 + $575 000 - $600 000 +/(-) actuarial loss (gain) Solving for actuarial gain arising on remeasurement of DBO: $5 375 000 - $5 000 000 - $450 000 - $575 000 + $600 000 = - $50 000 actuarial gain 5. Return on plan assets (excluding amount recognised in net interest) = $53 750 Fair value of plan assets at 1 July 2021 + Interest income + Contributions received by the fund - Benefits paid to members Loss on plan assets excluding interest Fair value of plan assets at 30 June 2022

$ 4 750 000 427 500 500 000 ($600 000) 5 077 500 (53 750) $5 023 750

6. Reconciliation:

Balance 1 July 2022 Interest @ 9% Current service cost Contributions received by fund Benefits paid by fund Loss on plan assets excluding interest

Net defined benefit liability $ 250 000

Defined benefit obligation $ 5 000 000 450 000 575 000 (600 000)

Plan assets $

4 750 000 427 500 500 000 (600 000) (53 750) 9.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

recognised Actuarial gain on remeasurement of DBO Balance 30 June 2022

351 250

(50 000) 5 375 000

5 023 750

7. Summary journal entry: 30/6/2022

Superannuation expense (P&L) Dr Superannuation expense (OCI) Dr Cash Cr Superannuation liability Cr (Superannuation expense and contributions for the year) Profit or Loss $

Balance 1 July 2021 Net interest Service cost Contributions paid to the fund Loss on plan assets (ex. interest) Actuarial gain on DBO Journal entry Balance 30 June 2022

Other comprehensive income $

597 500 3 750 500 000 101 250

Cash

Net DBL(A)

$ 250 000 Cr

22 500 Dr 575 000 Dr 500 000 Cr

597 500 Dr

53 750 Dr 50 000 Cr 3 750 Dr

500 000 Cr

101 250 Cr 351 250 Cr

9.25

Chapter 9: Employee benefits

Exercise 9.14 Accounting for defined benefit superannuation plans Some years ago, Bidulgi Ltd established a defined benefit superannuation plan for its employees. The company has since introduced a defined contribution plan, which all new staff join when commencing employment with Bidulgi Ltd. Although the defined benefit plan is now closed to new recruits, the fund continues to provide for employees who have been with the company for a long time. The following actuarial report has been received for the defined benefit plan. 2022 $ Present value of the defined benefit obligation 1 Jan. Past service cost Net interest Current service cost Benefits paid Actuarial loss on DBO Present value of the defined benefit obligation 31 Dec. Fair value of plan assets at 1 Jan. Return on plan assets Contributions paid to the fund during the year Benefits paid by the fund during the year Fair value of plan assets at 30 June 2022

20 000 000 2 000 000 ? 800 000 2 100 000 100 000 23 000 000 19 000 000 ? 1 000 000 2 100 000 20 130 000

Additional information • All contributions received by the funds were paid by Bidulgi Ltd. Employees make no contributions. • The interest rate used to measure the present value of the defined benefit obligation was 10% at 31 December 2021 and 31 December 2022. • The asset ceiling was nil at 31 December 2021 and 31 December 2022. Required 1. Determine the surplus or deficit of Bidulgi Ltd’s defined benefit plan at 31 December 2022. 2. Determine the net defined benefit asset or liability that should be recognised by Bidulgi Ltd at 31 December 2022. 3. Calculate the net interest and the return on plan assets for the year ended 31 December 2022.

9.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. Present a reconciliation of the opening balance to the closing balance of the net defined benefit liability (asset), showing separate reconciliations for plan assets and the present value of the defined benefit obligation. 5. Prepare a summary journal entry to account for the defined benefit superannuation plan in the books of Bidulgi Ltd for the year ended 31 December 2022. (LO5) 1. Present value of the defined benefit obligation 31 December 2022 Fair value of plan assets 31 December 2022 Deficit of the fund at 31 December 2022

$23 000 000 20 130 000 $ 2 870 000

2. The net defined benefit liability at 31 December 2022 is $2 870 000, being the deficit of the fund. 3. Net interest = $300 000 Interest expense component of the defined benefit obligation: Defined benefit obligation brought forward $20 000 000 Past service cost 2 000 000 $23 000 000 Interest income component: $19 000 000 x 10% = $1 900 000

4. Reconciliation:

Balance 1 January 2022 Past service cost Revised balance Interest @ 10% Current service cost Contributions received by fund Benefits paid by fund Return on plan assets excluding interest recognised * Actuarial loss on remeasurement of DBO Balance 31 December 2022

Net defined benefit liability $ 1 000 000

2 870 000

Defined benefit obligation $

Plan assets $

20 000 000 2 000 000 22 000 000 2 200 000 800 000

19 000 000

1 900 000

1 000 000 (2 100 000) (2 100 000) 330 000 100 000 23 000 000 20 130 000

* Workings for return on plan assets: Fair value of plan assets 31 December 2022 $20 130 000 Less: Opening balance $19 000 000 Interest income 1 900 000 Contributions received 1 000 000 Benefits paid (2 100 000) $19 800 000

9.27

Chapter 9: Employee benefits

Return on plan assets ex. interest income

330 000

5. Summary journal entry: 31/12/2022

Superannuation expense (P&L) Dr 3 100 000 Superannuation income (OCI) Cr Cash Cr Superannuation liability Cr (Superannuation expense and contributions for the year) P&L $

Balance 1 January 2022 Past service cost Net interest Service cost Contributions paid to the fund Gain on plan assets (ex. interest) Actuarial loss on DBO Journal entry Balance 31 December 2022

OCI $

Cash $

230 000 1 000 000 1 870 000

Net DBL(A) $ 1 000 000 Cr

2 000 000 Dr 300 000 Dr 800 000 Dr 1 000 000 Cr

3 100 000 Dr

330 000 Cr 100 000 Dr 230 000 Cr

1 000 000 Cr

1 870 000 Cr 2 870 000 Cr

9.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 9.15 Accounting for defined benefit superannuation plans Pigeon Ltd provides a defined benefit superannuation plan for its managers. The assistant accountant has completed some sections of the defined benefit worksheet based on information provided in an actuary’s report on the Pigeon DB Superannuation Fund for the year ended 30 June 2023. PIGEON DB SUPERANNUATION FUND Defined benefit worksheet for the year ended 30 June 2023

P&L $’000 Balance 30/6/22 Net interest at 10% Current service cost Contributions to the fund Benefits paid by the fund Actuarial loss: DBO Journal entry

OCI $’000

Bank $’000

Pigeon Ltd

Pigeon DB Superannuation Fund

Net DBL(A) $’000

DBO $’000

Plan assets $’000

1 500 Cr

9 000 Cr

7 500 Dr

600 Cr 900 Cr

Balance 30/6/23 Adjustment for asset ceiling if < deficit Balance 30/6/23

150 Dr 450 Cr 10 800 Cr

900 Dr 150 Cr

9 000 Dr

Additional information The asset ceiling was $900 000 at 30 June 2023. Required 1. Determine the surplus or deficit of the fund at 30 June 2023. 2. Determine the net defined benefit asset or liability at 30 June 2023. 3. Calculate the net interest and distinguish between the interest expense component of the defined benefit obligation and the interest income component of the change in the fair value of plan assets for the year ended 30 June 2023. 4. Determine the amount to be recognised in profit or loss in relation to the defined benefit superannuation plan for the year ended 30 June 2023. 5. Determine the amount to be recognised in other comprehensive income in relation to the defined benefit superannuation plan for the year ended 30 June 2023. (LO5) © John Wiley and Sons Australia Ltd, 2020

9.29

Chapter 9: Employee benefits

1. $1 800 000 deficit. Present value of the defined benefit obligation 30 June 2023 Fair value of plan assets 30 June 2023 Deficit of the fund at 30 June 2023

$10 800 000 9 000 000 $1 800 000

2. The net defined benefit liability at 30 June 2023 is $1 800 000, being the deficit of the fund. 3. Net interest = $150 000 Interest expense component of the defined benefit obligation

= $9 000 000 x 10% = $900 000

Interest income component of the change in fair value of plan assets

= $7 500 000 x 10% = $750 000

4. $750 000. Net interest Service cost Superannuation expense

$150 000 600 000 $750 000

5. The actuarial loss of $450 000 is recognised in other comprehensive income.

9.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 9.16 Accounting for defined benefit superannuation plans Which of the following items in relation to a defined benefit fund are recognised in (i) profit or loss and (ii) other comprehensive income in accordance with AASB 119/IAS 19? (LO5) 1. Current service cost 2. Past service cost incurred during the period 3. Net interest 4. Return on plan assets excluding amounts recognised in net interest 5. Benefits paid to members 6. Current period actuarial gains in relation to the defined benefit obligation 7. Current period actuarial losses in relation to the defined benefit obligation 8. Current period actuarial gains in relation to the assets of the plan 9. Current period actuarial losses in relation to the assets of the plan 10. Contributions paid i) Recognised in profit or loss: 1. Current service cost 2. Past service cost incurred during the period 3. Net interest ii) Recognised in other comprehensive income: 4. Return on plan assets excluding amounts recognised in net interest 6. Current period actuarial gains in relation to the defined benefit obligation 7. Current period actuarial losses in relation to the defined benefit obligation

9.31

Chapter 9: Employee benefits

Exercise 9.17 Accounting for defined benefit superannuation plans For each of the following scenarios, determine (i) the surplus or deficit in the defined benefit superannuation fund and (ii) the net defined benefit liability or asset that should be recognised by the sponsoring employer in accordance with AASB 119/IAS 19. (LO5) Present value of DBO

Fair value of plan assets

$2 600 000 $3 100 000 $4 000 000 $4 800 000

$2 000 000 $2 400 000 $4 400 000 $5 000 000

1. 2. 3. 4. Present value of DBO (a) (b) (c) (d)

$2 600 000 $3 100 000 $4 000 000 $4 800 000

Fair value of plan assets $2 000 000 $2 400 000 $4 400 000 $5 000 000

Asset ceiling

(i) Deficit or surplus

$Nil $Nil $200 000 $500 000

$600 000 Deficit $700 000 Deficit $400 000 Surplus $200 000 Surplus

Asset ceiling $Nil $Nil $200 000 $500 000 (ii) Net defined benefit asset / liability $600 000 liability $700 000 liability $200 000 asset $200 000 asset

9.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 9.18 Accounting for long service leave Victoria Ltd provides long service leave entitlement of 13 weeks of paid leave after 10 years of continuous employment. The provision for long service leave had a credit balance of $180 000 at 30 June 2022. During the year ended 30 June 2023, long service leave of $45 000 was paid. At the end of the year, the present value of the defined benefit obligation for long service leave was $160 000. Required Prepare all journal entries in relation to long service leave for the year ended 30 June 2023. (LO6)

$ Defined obligation 30/6/23 Obligation brought forward Less LSL paid Required increase/LSL expense

180 000 (45 000)

$ 160 000 135 000 25 000

During 2023

Provision for long service leave Cash (Long service leave paid)

Dr Cr

45 000

30/06/23

Long service leave expense Provision for long service leave (Increase in liability for LSL)

Dr Cr

25 000

45 000

25 000

9.33

Chapter 9: Employee benefits

Exercise 9.19 Accounting for sick leave Finch Ltd provides 1 week (5 days) of accumulating non-vesting sick leave for each year of service. Sick leave is paid at the base pay rate, which does not include commissions, bonuses and overtime. The proportion of accumulated sick leave that will be taken is estimated for each category of employee due to differences in staff turnover rates. The following summary data is derived from Finch Ltd’s payroll records for the year ended 30 June 2022. % of unused leave expected to be taken

Sick leave Balance b/d Increase in 1 July leave for 2021 current (days) service (days)

Leave taken or lapsed (days)

Within 12 months

Employee category

Base pay/day $

Managers

450

120

Consultants

300

110

100

Clerical staff

100

1 year 2 years later later

Additional information The yield on high-quality corporate bonds at 30 June 2022 is 7% for one-year bonds and 8% for two-year bonds. After leave taken during the year had been recorded Finch Ltd’s trial balance at 30 June 2022 revealed the provision for sick leave had a credit balance of $13 000. Required 1. Prepare journal entries to account for the liability for sick leave at 30 June 2022. 2. State how much of the provision should be classified as a non-current liability. (LO2 and LO6) 1. Category Managers Consultants Clerical staff

Daily wage $ 450 300

Open. bal Days 120 110

Current service 50 100

Taken or Lapsed 10 90

100

Clos. bal Accumulated days Benefit $ 160 72 000 120 36 000 110

11 000

Closing balance of sick leave accumulation (in days): = Opening balance + entitlement for service during the year – sick leave taken/lapsed

9.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

e.g. Managers: 120 + 50 – 10 = 160 days

Managers Consultants Clerks

Accum. Benefit 72 000 36 000 11 000

Amount of Sick Leave Expected to be Taken Within 1 Year 1 Year Later 2 Years Later % $ % $ % $ 20 14 400 10 7 200 5 3 600 75 27 000 10 3 600 0 0 65 7 150 9 990 0 0 48 550 11 790 3 600

Provision for sick leave: Current - due within one year after balance date – undiscounted $48 550 Non-current Due one year later, discounted at 7% = $11 790 = $11 019 (1 + .07) Due 2 years later, discounted at 8% = $3 600 = $3 086 (1 + 0.08)2 Total provision for sick leave at 30 June 2019 $62 655 Cr Amount per trial balance 13 000 Cr Accrual $49 655 The amount that is expected to be paid more than one year after the end of the reporting period is not a short-term benefit (refer to paragraph 5 of AASB 119/IAS 19). Accordingly, it is measured at present value, consistent with other long-term employee benefits (refer to paragraphs 55 and 57(a) (ii) of AASB 119/IAS 19). 30/6/2022

Wages and salaries expense Dr 49 655 Provision for sick leave Cr (Accrual of employee benefits for profit-sharing arrangements)

49 655

2. Non-current component of Provision for Sick Leave = $11 019 + $3 086 = $14 105

9.35

Chapter 9: Employee benefits

Exercise 9.20 Accounting for long service leave Oca Ltd provides long service leave for its retail staff. Long service leave entitlement is determined as 13 weeks of paid leave for 10 years of continued service. The following information is obtained from Oca Ltd’s payroll records and actuarial reports for its retail staff at 30 June 2022. Unit credit (years)

No. of employees

% expected to become entitled

Annual salary per employee

No. of years until vesting

Yield on HQ corporate bonds

1 2 3 4

80 70 50 30

20 30 50 60

$45 000 $45 000 $45 000 $45 000

9 8 7 6

10% 9% 9% 9%

Additional information • The estimated annual increase in retail wages is 1% p.a. for the next 10 years, reflecting expected inflation. • The provision for long service leave for retail staff at 30 June 2021 was $22 000. • No employees were eligible to take long service leave during the year ended 30 June 2022. Required Prepare the journal entry to account for Oca Ltd’s provision for long service leave at 30 June 2022. (LO6) Step 1: Estimate the number of employees who are expected to become eligible for long service leave. Years of service 1 2 3 4

% expected to become entitled 20% 30% 50% 60%

Total employees 80 70 50 30

Eligible employees 16 21 25 18

Step 2: Estimate projected salaries = Current salary x Eligible employees x (1 + inflation rate)n Years of service

Eligible employees

1 2 3 4

16 21 25 18

Current salary $ 45 000 45 000 45 000 45 000

Inflation rate

Period until LSL vests (years)

0.01 0.01 0.01 0.01

9 8 7 6

Projected salaries $ 787 453 1 023 300 1 206 152 859 831

9.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Step 3: Determine the accumulated benefit =

Years of service Years required for LSL

Years of service

1 2 3 4

LSL weeks x projected salaries 52

Projected salaries $ 787 453 1 023 300 1 206 152 859 831

Years of service/Years required for LSL

LSL weeks / 52

0.1 0.2 0.3 0.4

0.25 0.25 0.25 0.25

Accumulated benefit $ 19 686 51 165 90 461 85 983

Step 4: Measure the present value of the accumulated benefit. = Accumulated benefit (1 + i)n Years of service 1 2 3 4

Accumulated benefit $ 19 686 51 165 90 461 85 983

Discount factor*

Present value $ 8 349 25 678 49 485 51 269 134 781

0.424098 0.501866 0.547034 0.596267

*The discount factors are calculated based on the respective % yields on HQ corporate bonds as 1 / (1 + yield)n, where n is the respective period until LSL vests in years. The increase in the provision for long service leave can be calculated as $134 781 less the opening balance, $22 000, because there have been no long service leave payments during the year. Thus, the long service leave expense for the year ended 30 June 2022 is $112 781. 30/6/2022

Long service leave expense Provision for long service leave (Increase in provision for long service leave)

Dr Cr

112 781 112 781

9.37

Chapter 9: Employee benefits

Exercise 9.21 Accounting for long service leave Bluebird Ltd provides credit services. Bluebird Ltd provides its employees with long service leave entitlements of 13 weeks of paid leave for every 10 years of continuous service. As the company has been operating for only 5 years, no employees have become entitled to long service leave. However, the company recognises a provision for long service leave using the projected unit credit approach required by AASB 119/IAS 19. The following information is obtained from Bluebird Ltd’s payroll records and actuarial reports for the non-managerial staff of its debt collection business at 30 June 2022. Unit credit (years)

No. of employees

% expected to become entitled

1 2 3 4 5

100 85 40 32 25

20 26 35 50 65

Average annual No. of years salary until vesting $46 000 $48 000 $50 000 $52 500 $55 600

9 8 7 6 5

Yield on goverment corporate bonds 6% 6% 5% 5% 5%

Additional information • The estimated annual increase in retail wages is 5% p.a. for the next 10 years, reflecting Bluebird Ltd’s policy of increasing salaries of its debt collection staff for each year of additional experience. • At 30 June 2021, the provision for long service leave for non-managerial debt collection staff was $132 000. Required Prepare the journal entry to account for Bluebird Ltd’s provision for long service leave at 30 June 2022 in relation to the non-managerial employees of the company’s debt collection business. (LO6) Step 1: Estimate the number of employees who are expected to become eligible for long service leave. Years of service % expected to become entitled 1 20% 2 26% 3 35% 4 50% 5 65%

Total employees 100 85 40 32 25

Eligible employees 20 22 14 16 16

9.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Step 2: Estimate projected salaries = Current salary x Eligible employees x (1 + inflation rate)n, with n being the respective period until LSL vests in years. Years of service

Eligible Period until employees Current salary Inflation rate LSL vests Projected salaries $ $ 1 20 46 000 0.05 9 1 427 222 2 22 48 000 0.05 8 1 560 193 3 14 50 000 0.05 7 984 970 4 16 52 500 0.05 6 1 125 680 5 16 55 600 0.05 5 1 135 380 Step 3: Determine the accumulated benefit. = Years of service Years required for LSL Years of service 1 2 3 4 5

x LSL weeks x projected salaries 52

Projected Years of service/Years salaries required for LSL $ 1 427 222 0.1 1 560 193 0.2 984 970 0.3 1 125 680 0.4 1 135 380 0.5

LSL weeks /52 0.25 0.25 0.25 0.25 0.25

Accumulated benefit $ 35 681 78 010 73 873 112 568 141 923

Step 4: Measure the present value of the accumulated benefit. = Accumulated benefit (1 + i)n Years of service

Accumulated benefit $ 35 681 78 010 73 873 112 568 141 923

Discount factor*

Present value $ 1 0.591898 21 119 2 0.627412 48 944 3 0.710681 52 500 4 0.746215 84 000 5 0.783526 111 200 317 763 *The discount factors are calculated based on the respective % yields on HQ corporate bonds as 1 / (1 + yield)n, where n is the respective period until LSL vests in years. The amount by which the provision for long service should be increased can be calculated as the present value of the accumulated benefit at 30 June 2022 less the opening balance of the provision for long service leave because there have been no long service leave payments during the year: $317 763 - $132 000 = $185 763. 30/6/2022

Long service leave expense

185 763

9.39

Chapter 9: Employee benefits

Provision for long service leave (Increase in provision for long service leave)

185 763

9.40

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 9: Employee benefits Multiple choice questions 1. Which of the following types of employee benefits are not covered by AASB 119/IAS 19? a. Long service leave. b. Wages. *c. Share-based payments. d. Annual leave. Answer: c Learning objective 9.1: outline the scope, purpose and principles of accounting for employee benefits under AASB 119/IAS 19.

2. An enterprise bargaining agreement results from an entity entering into an agreement with: a. the government. b. its employees. c. the relevant industry body. *d. the relevant employee union. Answer: d Learning objective 9.1: outline the scope, purpose and principles of accounting for employee benefits under AASB 119/IAS 19.

3. Employee benefits can arise from which of the following? I. II. III. IV.

government legislation. specific industry arrangements. workplace agreements between an entity and its employees. enterprise bargaining agreements between an entity and the relevant employee union.

a. I and II only . b. I, II and IV only. c. I, II and III only. *d. I, II, III and IV. Answer: d Learning objective 9.1: outline the scope, purpose and principles of accounting for employee benefits under AASB 119/IAS 19.

9.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following types of employee benefits may be conditional upon the continuation of employment? a. Annual leave. b. Maternity leave. *c. Long service leave. d. Accumulating non-vesting sick leave. Answer: c Learning objective 9.1: outline the scope, purpose and principles of accounting for employee benefits under AASB 119/IAS 19.

5. Which of the following is not an example of a short-term employee benefit? *a. Termination payments. b. Wages and salaries. c. Sick leave and annual leave. d. Bonuses and profit-sharing arrangements. Answer: a Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

6. Salary sacrificing refers to: a. an employer withholding a portion of an employee’s salary or wages for sub-standard performance. *b. an employee electing to forego some of their salary or wages in return for other non-cash benefits. c. an employee not receiving a portion of their salary and wages due to the fact that predetermined performance targets have not been met. d. an employee foregoing some of their wages because leave entitlements such as sick leave have been overdrawn. Answer: b Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

9.2

Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

7. An entity is required to recognise a liability for short-term compensated absences that are: a. non-vesting only. *b. accumulating and vesting. c. non-accumulating and vesting. d. non-accumulating and non-vesting . Answer: b Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

8. Under AASB 119, leave entitlements that may be carried forward to a future financial period if unused are referred to as: a. b. *c. d.

non-accumulating paid absences accumulating unpaid absences accumulating paid absences non-accumulating unpaid absences

Answer: c Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

9.3

Testbank to accompany Financial reporting 3e by Loftus et al.

9. Primrose Ltd employs 5 staff. Each staff member is entitled to 20 days annual leave per annum. Leave loading of 17.5% is paid when the leave is taken. At 1 July 2022 the balance in the provision for annual leave account was $14 028. Details of each employee’s leave entitlement at 30 June 2023 are as follows: Employee

Salary

John Adams Wendy Carter Ken Murphy Susan O’Leary Marcus Thomson

$60 000 $52 000 $70 000 $58 000 $80 000

Days owing @ 1/7/22 15 4 20 2 6

Days taken during year 22 20 25 12 15

There are 260 work days in a year. On 1 July each year all employees receive a 5% wage rise. There are no other wage rises given during the year. The closing balance in the provision for annual leave account at 30 June 2023 is: a. $13 454. b. $14 127. c. $15 808. *d. $16 599. Answer: d Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

9.4

Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

10. Primrose Ltd employs 5 staff. Each staff member is entitled to 20 days annual leave per annum. Leave loading of 17.5% is paid when the leave is taken. At 1 July 2022 the balance in the provision for annual leave account was $14 028. Details of each employee’s leave entitlement at 30 June 2023 are as follows: Employee

Salary

John Adams Wendy Carter Ken Murphy Susan O’Leary Marcus Thomson

$60 000 $52 000 $70 000 $58 000 $80 000

Days owing @ 1/7/22 15 4 20 2 6

Days taken during year 22 20 25 12 15

There are 260 work days in a year. On 1 July each year all employees receive a 5% wage rise. There are no other wage rises given during the year. Annual leave payments made during the year were debited against the provision account. The total debit against the annual leave account during the year in relation to leave taken was: *a. $28 500 b. $19 334 c. $27 143 d. $20 301 Answer: a Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

9.5

Testbank to accompany Financial reporting 3e by Loftus et al.

11. North Quay Ltd employs 8 staff. Each staff member is entitled to 20 days annual leave per annum. Leave loading of 17.5% is paid when the leave is taken. On 31 December 20229 Margie Winton left the company and was paid out her untaken leave entitlements. Margie had 14 days leave owing at 1 July 2022 and took 6 days leave between 1 July and 31 December 2022. Her salary at the time of her departure was $80 000. There are 260 work days in a year. On 1 July each year all employees receive a 2% wage rise. There are no other wage rises given during the year. The gross entitlement owing to Margie Winton on 31 December 2022 was: a. b. c. *d.

$5 538 $5 649 $6 638 $6 508

Answer: d Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

12. Treloar Ltd has 10 employees, who are each paid $750 per week for a 5 day working week. Each employee is entitled to 8 days accumulating non-vesting sick leave per year. At 1 July 2022 the accumulated untaken leave was 16 days in total. During the year ended 30 June 2023 a total of 50 days sick leave was taken, of which 8 days were unpaid leave. Of the accumulated untaken leave at 30 June 2023 it is estimated that 75% of it will be taken during the following year. The balance of the provision for sick leave at 30 June 2023 is: a. $6 300 b. $8 100 *c. $6 075 d. Nil, as the leave is non-vesting. Answer: c Learning objective 9.2: prepare journal entries to account for short‐term liabilities for employee benefits, such as wages and salaries, sick leave and annual leave.

9.6

Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

13. The key difference between defined benefit and defined contributions post-employment plans is that: a. the employee bears the risk in a defined benefit plan, whereas the employer bears the risk in a defined contribution plan. *b. the employer bears the risk in a defined benefit plan, whereas the employee bears the risk in a defined contribution plan. c. the fund bears the risk in a defined benefit plan, whereas the employee bears the risk in a defined contribution plan. d. the employer bears the risk in a defined benefit plan, whereas the fund bears the risk in a defined contribution plan. Answer: b Learning objective 9.3: compare defined benefit and defined contribution post‐employment benefit plans.

14. Which of the following statements regarding defined contribution plans is incorrect? a. b. c. *d.

They include fixed contributions paid by the employer to an employee’s superannuation fund. The amount of the contribution is normally based on a percentage of the employee’s wages. The amount received by employees upon their retirement is dependent on the level of contributions made and the return earned by the fund on its investment. The employer has a legal obligation to pay further contributions if the fund does not hold sufficient assets to pay it members.

Answer: d Learning objective 9.3: compare defined benefit and defined contribution post‐employment benefit plans.

9.7

Testbank to accompany Financial reporting 3e by Loftus et al.

15. In the event that an employer pays an amount to the defined contribution fund that is less than the amount payable: a. b. *c. d.

an asset is to be recognised at the end of the reporting period for the unpaid contributions. an asset is to be recognised to the extent that the entity is entitled to a refund or a reduction in future contributions. a liability is to be recognised at the end of the reporting period for the unpaid contributions. a liability is to be recognised to the extent that the entity is entitled to a refund or a reduction in future contributions.

Answer: c Learning objective 9.4: prepare entries to account for expenses, assets and liabilities arising from defined contribution post‐employment plans.

16. An increase in the present value of a defined benefit obligation resulting from employee service in the current period is referred to as: a. the past service cost. b. the asset ceiling. *c. the current service cost. d. an actuarial gain or loss. Answer: c Learning objective 9.5: prepare entries to record expenses, assets and liabilities arising from defined benefit post‐employment plans.

17. If the amount paid to the defined contribution fund by an entity during the year is less than the amount payable in relation to service provided by employees, the entity must recognise: a. an asset for the unpaid contributions. b. an expense for the unpaid contributions. *c. a liability for the unpaid contributions. d. a gain for the unpaid contributions. Answer: c Learning objective 9.5: prepare entries to record expenses, assets and liabilities arising from defined benefit post‐employment plans.

9.8

Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

18. Benefits paid to members of a defined benefit post-employment fund are based on: I. II. III. IV.

investment returns generated by the fund. remuneration levels while employed. number of years of service. the level of employer contributions made to the fund.

a. I and II only. b. II and IV only. *c. II and III only. d. III and IV only. Answer: c Learning objective 9.5: prepare entries to record expenses, assets and liabilities arising from defined benefit post‐employment plans.

19. Actuarial gains or losses can arise from: I. II. III. IV.

Experience adjustments. Employee services provided in future periods. The withdrawal of changes to a defined benefit plan. Changes to actuarial assumptions.

a. I and II. *b. I and IV. c. II and III. d. III and IV. Answer: b Learning objective 9.5: prepare entries to record expenses, assets and liabilities arising from defined benefit post‐employment plans.

20. AASB 119 requires an entity to record a liability for long service leave: a. b. c. *d.

when the leave is taken by the employee. in a consistent manner from year to year. when the employee becomes legally entitled to the leave. as the employee provides service to the entity even though they may have no legal entitlement to the leave.

Answer: d Learning objective 9.6: explain how to measure and record other long‐term liabilities for employment benefits, such as long service leave.

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Testbank to accompany Financial reporting 3e by Loftus et al.

21. AASB 119 adopts the projected unit credit method for the measurement of long service leave obligations. This method requires the entity to: a. calculate the future value of the expected payments that will result from employee services provided in the future. *b. calculate the present value of the expected future payments that will result from employee services provided to date. c. provide for the amount of long service leave that is planned to be taken by employees within the next 12 months. d. commence providing for long service leave once employees have completed 10 years of service. Answer: b Learning objective 9.6: explain how to measure and record other long‐term liabilities for employment benefits, such as long service leave.

22. An entity is required to make several estimates when measuring the liability for long service leave. These estimates include: a. the number of employees expected to become eligible for long service leave. b. the projected wages and salaries at the time the long service leave is expected to be paid. c. when the leave will be taken by eligible employees. *d. all of the above. Answer: d Learning objective 9.6: explain how to measure and record other long‐term liabilities for employment benefits, such as long service leave.

23. Which of the following does not fall within the definition of a termination benefit? *a. Employee resignation. b. Voluntary redundancy accepted by an employee. c. An entity’s decision to termination employment before an employee’s normal retirement date. d. An entity’s decision to undertake a redundancy program due to restructuring. Answer: a Learning objective 9.7: explain when a liability should be recognised for termination benefits and how it should be measured.

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Chapter 9: Employee benefits Not for distribution in full. Instructors may assign selected questions in their LMS.

24. When an entity decides to terminate an employee’s employment, the offer to pay termination benefits can no longer be withdrawn when the entity has communicated to affected employees a plan of termination that meets which of the following criteria? a. The plan identifies the location, function or job classification, the number of employees whose services are to be terminated, and the expected completion date. b. Actions required to complete the plan indicate that significant changes to the plan are unlikely. c. The plan establishes the termination benefits payable in sufficient detail to enable employees to determine the type and amount of benefits they will receive. *d. All of the above. Answer: d Learning objective 9.7: explain when a liability should be recognised for termination benefits and how it should be measured.

25. The key steps involved in accounting by the employer for a defined benefit post-employment fund in accordance with AASB 119 include: I. II. III. IV. a. b. c. *d.

Determining the deficit or surplus of the fund Determining the amount of the net defined benefit liability (asset) Determining the amounts to be recognised in profit or loss Determining the remeasurements of the net defined benefit liability (asset) to be recognised in other comprehensive income I, II and III only I, III and IV only II, III and IV only I, II, III and IV

Answer: d Learning objective 9.5: prepare entries to record expenses, assets and liabilities arising from defined benefit post‐employment plans.

26. The nominal value of an accumulated benefit for long service leave is calculated as (Years of employment/Years required for LSL) x (weeks of paid leave/52) x _____ __. a. current salaries *b. projected salaries c. current salaries / (1+inflation rate)n d. projected salaries x (1+inflation rate)n Answer: b Learning objective 9.6: explain how to measure and record other long‐term liabilities for employment benefits, such as long service leave.

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Testbank to accompany Financial reporting 3e by Loftus et al.

27. Which of the following obligations do not arise from past services provided by an employee? *a. Termination benefits. b. Post-employment benefits. c. Short-term compensated absences. d. Other long-term employee benefits. Answer: a Learning objective 9.7: explain when a liability should be recognised for termination benefits and how it should be measured.

28. An entity is able to record a provision for termination benefits when it: a. has developed a formal plan for redundancies. b. has decided to undertake a termination program. *c. can no longer withdraw the offer of the benefits. d. has received Board approval for the termination benefits. Answer: c Learning objective 9.7: explain when a liability should be recognised for termination benefits and how it should be measured.

9.12

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 10: Leases

Chapter 10: Leases Comprehension questions 1. What characteristics should a contract have to be considered a lease? Appendix A of AASB 16/IFRS 16 defines a lease as follows. A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Paragraphs B9–B31 provides detailed guidance to help in assessing whether a contract is, or contains, a lease. The transfer of the right to use is essential in the definition and therefore the guidance focuses on clarifying the concept of the right to use. According to paragraph B9, that includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30). 2. Explain the ‘right to use’ of an identified asset. According to paragraph B9 of AASB 16/IFRS 16, the right to use an identified asset includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30). The customer’s ability to derive benefits from use of the underlying asset refers to substantially the whole of the potential economic benefits throughout the lease term. The customer can obtain the benefits either directly (e.g. by holding and using the asset itself) or indirectly (e.g. by subleasing the asset to another entity). A customer does not have the ability to derive benefits from the underlying asset if the benefits can only be derived by using the asset in conjunction with other goods and services provided by the supplier (and not available for separate purchase from the supplier or alternative suppliers). The customer’s ability to direct the use of an asset is determined by its ability to make the decisions that are most significant to the derivation of the economic benefits from the underlying asset during the lease term. The customer’s ability to direct the use of the underlying asset would normally be evident in whether it can determine: • how and for what purpose the asset is employed • how the asset is operated • the operator of the asset. Note that if the lessor has a substantive right to substitute the asset, the contract cannot be recognised as a lease as the right to use the asset cannot be considered to have been transferred. A substantive right to substitute the asset would exist if the lessor has the practical ability to substitute the asset at any time without needing the lessee’s approval and can benefit from substituting the asset. Note that a substantive right does not exist if the underlying asset can be substituted only when the asset is not operating properly or when a technical upgrade is available — therefore, in those cases, the contract can be recognised as a lease.

10.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. What are ‘lease payments’? Lease payments are defined in Appendix A of AASB 16/IFRS 16 as payments for the right to use the underlying asset made during the lease term and include: • fixed payments, less any lease incentives • variable lease payments, calculated based on an index or a rate • the purchase option, if it is reasonably expected to be exercised by the lessee • penalties for terminating the lease, if the lease payments are calculated on early termination • residual value guarantees expected to be payable by the lessee. If any of the payments are made at commencement date, they are still considered lease payments, but they are not included in the initial amount recognised for the lease liability (as the obligation to pay the amount was already settled). If any of the payments above include a payment for executory costs (i.e. insurance, maintenance, consumable supplies, replacement parts and rates) reimbursed by the lessee after being paid by the lessor on behalf of the lessee, those costs should be deducted before calculating the lease payments. That is because those costs are related to additional services provided by the lessor that are not related to the right to use the underlying asset and therefore are not considered lease components. Fixed payments include payments by the lessee for the right to use the asset that do not change throughout the lease term and are adjusted for payments made or reimbursements by the lessor to the lessee (i.e. lease incentives). Variable lease payments may be increased or decreased during the lease term because of changes in facts and circumstances occurring after the asset is made available to the lessee to use, other than the passage of time. To be included in the lease payments, the purchase option should allow the lessee to purchase the asset at the end of the lease for a pre-set amount, significantly less than the expected residual value at the end of the lease term (as such, it is normally referred to as a bargain purchase option). The residual value guarantee, in general, is that part of the residual value of the underlying asset guaranteed by the lessee, a party related to the lessee or a third party unrelated to the lessor. The lessor will estimate the residual value of the underlying asset at the end of the lease term based on market conditions at the inception of the lease, and the lessee, a party related to the lessee or a third party unrelated to the lessor will guarantee that, when the asset is returned to the lessor, it will realise at least that amount. The guarantee may range from 1% to 100% of the residual value and is a matter for negotiation between lessor and lessee or a third party unrelated to the lessor. Where a lessee guarantees some or all of the residual value of the asset, the lessor has transferred risks associated with movements in the residual value to the lessee. The lessee will recognise as part of the lease payments only the residual value guarantees expected to be payable by them. The part of the residual value that the lessor is not assured that will be realised or that is guaranteed solely by a party related to the lessor is identified as the unguaranteed residual value.

10.3

Chapter 10: Leases

4. If a lease agreement states that ‘the lessee guarantees a residual value, at the end of the lease term, of $20 000’, what does this mean? The residual value guarantee is that part of the residual value of the leased asset guaranteed by the lessee, a party related to the lessee or a third party unrelated to the lessor (AASB 16/IFRS 16, Appendix A). The lessor will estimate the residual value of the leased asset at the end of the lease term based on market conditions at the inception of the lease and the lessee may guarantee that, when the asset is returned to the lessor, it will realise at least a part of that amount. If the lessee guarantees a residual value, at the end of the lease term, of $20 000, the lessee has to make sure that the value of the leased asset at the end of the lease is at least $20 000 – if the value is less, the lessee may need to make up the difference in cash for example. The guarantee may range from 1% to 100% of the residual value estimated by the lessor and is a matter for negotiation between lessor and lessee. Where a lessee guarantees some or all of the residual value of the asset, the lessor has transferred risks associated with movements in the residual value to the lessee. 5. What is meant by ‘the interest rate implicit in a lease’ and ‘the lessee’s incremental borrowing rate’? The interest rate implicit in a lease is defined in AASB 16/IFRS 16, Appendix A as the rate of interest that causes the present value of: (a) the lease payments; and (b) the unguaranteed residual value To equal the sum of: (i) the fair value of the underlying asset, and (ii) any initial direct costs of the lessor. This interest rate is used to discount the lease payments to their present value for recognition purposes. This discount rate is implicit in the lease because it is the terms of the lease (number, timing and quantum of repayments, residual value guarantee or purchase option) that determine its value. The lessee’s incremental borrowing rate is defined in AASB 16/IFRS 16, Appendix A as the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

6. Where a lessor incurs initial direct costs in establishing a lease agreement, how are these costs to be accounted for? Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors in connection with a finance lease (AASB 16/IFRS 16, Appendix A). Examples include commission, legal fees and internal costs, but exclude general overheads such as those incurred by a sale and marketing team.

10.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs of the lessor are included automatically in the net investment in the lease; there is no need to add them separately. The accounting treatment for initial direct costs differs depending on whether the lease is classified as operating or finance, and if finance, whether the lessor is a manufacturer/dealer. Finance lease: • Non-manufacturer/dealer lessor: initial direct costs are included in the finance lease receivable and are recovered via payments received over the lease term. • Manufacturer/dealer lessor: initial direct costs are recognised as an expense at the commencement of the lease when the profit or loss on ‘sale’ of the leased asset is recognised. Operating lease: • Any initial direct costs incurred by lessors in negotiating operating leases are added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease income (paragraph 83).

7. Where a lessee incurs initial direct costs in establishing a lease agreement, how a are these costs to be accounted for? The initial direct costs incurred by the lessee are conceptually similar to the initial direct costs of the lessor — they are incremental costs that are directly attributable to negotiating and arranging a lease, but they are incurred by the lessee. The lessee needs to recognise those costs as directly attributable costs to the right-to-use asset. As such, the right-to-use asset will be recognised at cost and that will include: • the amount recognised as the lease liability (i.e. the present value of the lease payments that are not paid at that date) • any lease payments made before or at the commencement date, less any lease incentives received • any initial direct costs incurred by the lessee • an estimate of the costs to dismantle and remove the underlying asset, to restore the site on which it is located and to restore the asset to the conditions required by the lease contract.

8. How are leases to be accounted for by lessees according to AASB 16/IFRS 16? AASB 16/IFRS 16 adopts a single lessee accounting model for all leases with a term of more than 12 months and requires the lessee to recognise an asset and a related liability for all their leases, unless the underlying asset is of low value. Paragraphs 23 and 26 of AASB 16/IFRS 16 require the lessee, at the commencement date of the lease, to recognise a right-of-use asset and a related liability. According to the Preface of AASB 16/IFRS 16:

10.5

Chapter 10: Leases

A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligations to make lease payments. The commencement of the lease is the date from which the lessee is entitled to exercise its right to use the underlying asset. The liability is to be measured at the present value of the lease payments that are not paid at the commencement date of the lease. The present value is calculated based on the interest rate implicit in the lease, or, if the implicit rate is not readily determined, the lessee’s incremental borrowing rate. The initial measurement of the right-of-use asset is very similar to the initial measurement of an item of property, plant and equipment prescribed by AASB 116/IAS 16 Property, Plant and Equipment. The right-to-use asset should be measured as cost and that will include: • the amount recognised as the lease liability (i.e. the present value of the lease payments that are not paid at that date) • any lease payments made before or at the commencement date, less any lease incentives received • any initial direct costs incurred by the lessee • an estimate of the costs to dismantle and remove the underlying asset, to restore the site on which it is located and to restore the asset to the conditions required by the lease contract. After initial recognition: • the right-of-use asset is depreciated over its useful life – generally the lease term – in a pattern reflecting the consumption or loss of the rewards embodied in the asset. • the lease liability is reduced as the lessee makes lease payments. Interest expense is determined by applying the interest rate implicit in the lease to the lease liability at the beginning of the period. The lease payment is divided into interest expense and reduction in lease liability.

9. What are operating and finance leases? Paragraph 61 of AASB 16/IFRS 16 requires lessors to classify each lease as either a finance lease or an operating lease. A finance lease is defined in Appendix A of AASB 16/IFRS 16 as lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Appendix A defines an operating lease as a lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

10. How are finance leases to be accounted for by lessors? In accounting for a finance lease, the lessor derecognises the leased asset and records a lease receivable. The initial measurement of the lease receivable is at fair value of the leased asset plus initial direct costs incurred by the lessor. On receipt of lease payments from the lessee, the lessor records lease rental revenue and reduces the lease receivable, based on an application of the interest rate implicit in the lease. © John Wiley and Sons Australia Ltd, 2020

10.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

It is important to note that finance leases need to further be classified into (a) finance leases involving a financier lessor and (b) leases involving manufacturers or dealers, as the accounting standard prescribes different accounting requirements for those two types of finance leases. With financier lessors, the lessor acquires the asset at fair value and then enters into a lease arrangement with the lessee and will only recognise income periodically throughout the lease term. With manufacturer/dealer lessors, the assets are normally being carried in the records of the lessor at an amount (cost) different from fair value. At the beginning of the lease, manufacturer/dealer lessors will recognise a selling profit.

11. How does the accounting treatment for a finance lease change if the lessor is a manufacturer/dealer lessor? If the lessor is a manufacturer/dealer, the lessor in a finance lease makes two profits, namely gross profit on sale and interest on the receivable over time. Accounting for the lease is identical to that required by financier lessors except for an initial entry to recognise profit or loss and the fact that initial direct costs are not included in the lease receivable amount (and not used in the calculation of the implicit rate in the lease). The manufacturer dealer lessor recognises sales revenue at the commencement of the lease equal to the present value of the lease payments, (which equals fair value minus the present value of any unguaranteed residual value). Cost of sales is recorded as the cost minus the present value of any unguaranteed residual value, which the lessor may have to recover by a future sale after the end of the lease agreement. Initial costs to establish a lease agreement do not satisfy the definition of initial direct costs in the standard. Instead, these initial establishment costs must be treated as an expense when the selling profit is recorded. As a consequence of the definition of the interest rate implicit in the lease, these costs are not included in the formula, unlike the initial direct costs incurred by a lessor as financier. Hence, the calculation of the interest rate implicit in the lease for a manufacturer/dealer lessor is different from the calculation for a financier lessor. The establishment costs of a manufacturer/dealer lessor are to be treated as an expense.

12. How are operating leases to be accounted for by lessors? Paragraph 81 of AASB 16/IFRS 16 requires lessors to account for receipts from operating leases as income on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern in which the benefit derived from the underlying asset is diminished. According to paragraph 83 of AASB 16/IFRS 16, any initial direct costs incurred by lessors in negotiating operating leases are to be added to the carrying amount of the underlying asset and recognised as an expense over the lease term on the same basis as the lease income. Given that the underlying asset is to be depreciated over the useful life (which in operating leases is normally longer that the lease term), while the initial direct costs are to be recognised as an expense over the lease term, the initial direct costs are capitalised into a separate deferred costs account; however, the balance of that account is nevertheless included in the calculation of the carrying amount of the underlying asset, just like the balance of the accumulated depreciation is taken into consideration when calculating that carrying amount. © John Wiley and Sons Australia Ltd, 2020

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Chapter 10: Leases

According to paragraph 84 of AASB 16/IFRS 16, depreciation of underlying assets provided under operating leases should be consistent with the lessor’s normal depreciation policy for similar assets, and should be calculated in accordance with AASB 116/IAS 16 Property, Plant and Equipment and AASB 138/IAS 38 Intangible Assets. 13. Identify three possible adverse effects on an entity’s financial statements arising from recognition of a lease arrangement on the statement of financial position. • • • •

The lessee has to recognise an asset at the inception of the lease. The lessee has to recognise a liability at the inception of the lease. Depreciation expenses on the leased asset affect annual profit. Interest expense reduces annual profit.

Leases may have the following adverse impacts on a lessee entity’s financial statements: • The capitalisation of the right-of-use asset increases the value of reported non-current assets and reduces the return on assets ratio. • Recognition of the present value of future lease payments as a liability increases reported current and non-current liabilities. This adversely affects debt–equity ratios and liquidity–solvency ratios, such as the current ratio (current assets/current liabilities). Reporting increased liabilities may result in entities breaching debt covenants, thereby causing debts to become due and payable immediately. • Subsequent depreciation and interest expenses may exceed rental payments and result in lower profits being reported in the early years of the lease. • Depreciation and interest expenses are not deductible for tax purposes, so additional liabilities may have to be recognised under AASB 112/IAS 12 Income Taxes when these expenses are less than the deduction for rental payments.

10.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 10.1 Accounting for leases by lessee Farm Ltd leases some parcels of land from their owner for a period of 10 years at a time. The lease agreement can be cancelled, but a significant penalty will be incurred by Farm Ltd. The lease payments required include a payment up-front of $300 000, followed by another 9 payments of equal value at the end of every year up to the end of the ninth year. The implicit rate in the lease is 10%. Required Prepare the journal entries for Farm Ltd to recognise the lease under AASB 16/IFRS 16. The journal entry to recognise right-of-use asset and lease liability at the commencement of the lease, plus the upfront payment in cash (at 1 July 20X1), is as follows: Right-of-use asset Lease liability Cash

Dr Cr Cr

2 027 700 1 727 700* 300 000

*The lease liability recognised at the commencement of the lease is the present value of the 9 yearly payments of $300 000 each, discounted by the implicit rate in the lease of 10% (assuming no residual value guarantee and unguaranteed residual value equal to $0): PV of LP = $300 000 x 5.7590 [T2 10% 9yrs] = $1 727 700 The journal entry to recognise interest expense (at 30 June 20X2, and every year after than until the end of lease term – the amounts are taken from the lease payments schedule below) is as follows: Interest expense Lease liability Cash

Dr Dr Cr

172 770 127 230 300 000

The lease payments schedule for Farm Ltd can be prepared as follows:

Date $ 1 July 20X1 30 June 20X2 30 June 20X3 30 June 20X4 30 June 20X5 30 June 20X6 30 June 20X7

FARM LTD Lease payments schedule Lease Interest expense Reduction in payments (10%) liability $ $ $ 300 000 300 000 300 000 300 000 300 000 300 000

172 770 160 047 146 052 130 657 113 723 95 095

127 230 139 953 153 948 169 343 186 277 204 905

Balance of liability $ 1 727 700 1 600 470 1 460 517 1 306 569 1 137 226 950 949 746 044 10.9

Chapter 10: Leases

30 June 20X8 30 June 20X9 30 June 20X0

300 000 300 000 300 000 2 700 000

74 604 52 065 27 288 972 300

225 396 247 935 272 712 1 727 700

520 648 272 713 —

The journal entry to recognise depreciation expense on the right-of-use asset (at 30 June 20X2, and every year after than until the end of lease term) is as follows: Depreciation expense Dr 202 770 Accumulated depreciation Cr 202 770 (Depreciation of the leased asset for the year = $202 770 = $2 027 700 / 10 years) Case study 10.2 Identification of leases For the following arrangements, discuss whether they are lease transactions, and thus fall under the ambit of AASB 16/IFRS 16. 1. Entity A enters into a contract with Entity B, whereby Entity B will provide 5 SUV vehicles for Entity A to use over the next 3 years. The vehicles have been selected by Entity A from a large pool of similar vehicles and are explicitly identified in the contract. Entity B is only allowed to substitute the vehicles if, and only for the period when, the vehicles are being repaired. 2. Entity C enters into a contract with Entity D, whereby Entity D will provide 2 aeroplanes for Entity C to use over the next 5 years. The aeroplanes have been selected by Entity C from a large pool of similar aircraft, but remain in the airport hangar owned by Entity D when not in use and can be substituted at any time by Entity C. 3. Entity E enters into a contract with Entity F, a shopping centre operator, whereby Entity E will be offered a space for a pop-up shop in one of the centres managed by Entity F. The contract specifies the size of the space to be provided, not the actual location. Appendix A of AASB 16/IFRS 16 defines a lease as follows. A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Paragraphs B9–B31 provide detailed guidance to help in assessing whether a contract is, or contains, a lease. The transfer of the right to use is essential in the definition and therefore the guidance focuses on clarifying the concept of the right to use. According to paragraph B9, that includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30). The concept of underlying asset and identified asset are used interchangeably. Nevertheless, paragraph B13 provides the following explanation about what constitutes an identified asset:

10.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

An asset is typically identified by being explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer. Note that if the lessor has a substantive right to substitute the asset, the contract cannot be recognised as a lease as the right to use the asset cannot be considered to have been transferred. A substantive right to substitute the asset would exist if the lessor has the practical ability to substitute the asset at any time without needing the lessee’s approval and can benefit from substituting the asset. Note that a substantive right does not exist if the underlying asset can be substituted only when the asset is not operating properly or when a technical upgrade is available — therefore, in those cases, the contract can be recognised as a lease. In example 1 above, Entity B can substitute the underlying asset only when the asset is not operating properly— therefore, the contract can be recognised as a lease. In example 2 above, Entity D has the practical ability to substitute the asset at any time without needing the lessee’s approval and therefore the contract cannot be recognised as a lease as the right to use the asset cannot be considered to have been transferred— therefore, the contract cannot be recognised as a lease. In example 3 above, Entity F provides by contract an asset that is being implicitly specified at the time that the asset is made available for use by the customer — therefore, the contract can be recognised as a lease.

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Chapter 10: Leases

Application and analysis exercises Exercise 10.1 Determination of interest rates On 1 July 2021, Pretty Ltd leases a machine with a fair value of $109 445 to Cool Ltd for 5 years at an annual rental (payable in advance) of $25 000, and Cool Ltd guarantees in full the estimated residual value of $15 000 on return of the asset. What would be the interest rate implicit in the lease? (LO3) (a) 9% (b) 10% (c) 12% (d) 14% The correct answer is (c). That is because 12% is the discount rate that makes the present value of the lease payments (including the payment in advance and the residual value guarantee) equal to the fair value of the asset. PV of LP = $25 000 + $25 000 x 3.0373 [T2 12% 4yrs] + $15 000 x 0.5674 [T1 12% 5yrs] = $25 000 + $75 932.50 + $8 511.00 = $109 443.50 $109 443.50 is approximately equal to the fair value, so 12% is the implicit interest rate. The other rates provided do not result in a present value of lease payments equal to the fair value.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.2 Accounting by lessee Mitch Ltd prepares the following lease payments schedule for the lease of a machine from Stark Ltd. The machine has an economic life of 6 years. The lease agreement requires four annual payments of $33 000, and the machine will be returned to Stark Ltd at the end of the lease term.

Date $ 1 July 2021 1 July 2022 1 July 2023 1 July 2024 1 July 2025

MITCH LTD Lease payments schedule Lease Interest expense Reduction in payments (10%) liability $ $ $ 30 000 30 000 30 000 35 000 125 000

9 851 7 836 5 620 3 181 26 488

20 149 22 164 24 380 31 819 98 512

Balance of liability $ 98 512 78 363 56 199 31 819 —

Required The following three multiple-choice questions relate to the information provided above. Select the correct answer and show any workings required. 1. For the year ended 30 June 2022, what would Mitch Ltd record in relation to the lease? (a) An interest payable of $26 488 (b) An interest payable of $nil (c) An interest payable of $9 851 (d) An interest payable of $7 836 2. How much annual depreciation expense would Mitch Ltd record? (a) $24 628 (b) $16 419 (c) $15 585 (d) $23 378 3. If Stark Ltd (the lessor) records a lease receivable of $102 327, the variance between this receivable and the liability of $98 512 recorded by Mitch Ltd could be due to what? (a) Initial direct costs paid by Stark Ltd (b) An unguaranteed residual value (c) Both of the above (d) Neither of the above (LO3) 1. The correct answer is (c). For the year ended 30 June 2022, the interest payable (to be paid on 1 July 2022) is equal to the interest expense recognised for the year which is $9 851 (calculated as the interest rate of 10% multiplied by the balance of the lease liability at the beginning of the year, i.e. on 1 July 2021, of $98 512.

10.13

Chapter 10: Leases

2. The correct answer is (d). The annual depreciation expense is calculated on a straight-line basis over the duration of the lease term of 4 years (as the asset is going to be returned to the lessor at the end of the lease). The depreciable amount is equal to the cost of the right-of-use asset minus the residual value guarantee. The lease payments appear to be $30 000 per year excluding the payment of $35 000 on 1 July 2025 (the end of the lease). The difference between the normal lease payment and the last payment is given by the residual value guarantee – which in this case seems to be $5 000. The cost of the right-of-use asset is equal to the present value of the four annual payments of $30 000 ($33 000 seems to include $3 000 executory costs), plus the present value of the residual value guarantee. These present values are calculated based on the implicit rate in the lease which seems to be 10%. It should be noted that in this case the cost of right-of-use asset recognised in equal to the beginning balance of the lease liability as there are no payments made at the commencement of the lease and no initial direct costs by the lessee or any other directly attributable costs. PV of LP = $30 000 x 3.1699 [T2 10% 4yrs] + $5 000 x 0.6830 [T1 10% 4yrs] = $95 097 + $3 415 = $98 512 Depreciation expense = ($98 512 - $5 000) / 4 years = $23 378. 3. The correct answer is (b). The lease receivable recognised by the lessor at the commencement of the lease is equal to the fair value of the asset plus the initial direct costs to the lessor and at the same time equal to the present value of the lease payments plus the present value of the unguaranteed residual. As the liability of $98 512 recorded by Mitch Ltd recognises the present value of the lease payments, the difference between the lease receivable recorded by the lessor and this liability seems to be explained by the existence of an unguaranteed residual value. The existence of initial direct costs to the lessor won’t necessarily explain the difference if the interest rates for both the lessee and the lessor are the same.

10.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.3 Accounting by lessee On 1 July 2022, Monkey Ltd leased a plastic-moulding machine from Wise Ltd. The machine cost Wise Ltd $65 000 to manufacture and had a fair value of $77 055 on 1 July 2022. The lease agreement contained the following provisions. Lease term Annual rental payment, in advance on 1 July each year Residual value at end of the lease term Residual guaranteed by lessee Interest rate implicit in lease The lease is cancellable only with the permission of the lessor.

4 years $20 750 $7 500 nil 8%

The expected useful life of the machine is 5 years. Monkey Ltd intends to return the machine to the Wise Ltd at the end of the lease term. Included in the annual rental payment is an amount of $750 to cover the costs of maintenance and insurance paid for by the lessor. Required 1. Prepare the lease payments schedule for the Monkey Ltd (show all workings). 2. Prepare the journal entries in the books of Monkey Ltd for the year ended 30 June 2023. (LO3) 1. PV of LP = $20 000 + $20 000 x 2.5771 [T2 8% 3yrs] = $20 000 + $51 542 = $71 542

Date $ 1 July 2022 1 July 2022 1 July 2023 1 July 2024 1 July 2025

MONKEY LTD Lease payments schedule Lease Interest expense Reduction in payments (8%) liability $ $ $

Balance of liability $ 71 542 51 542 35 665 18 519 —

20 000 — 20 000 20 000 4 123 15 877 20 000 2 853 17 147 20 000 1 481 18 519 80 000 8 458 71 542 2. The journal entry to recognise right-of-use asset and lease liability at the commencement of the lease, plus the upfront payment in cash (at 1 July 2022) is as follows: Right-of use asset Lease liability Cash

Dr Cr Cr

71 542

51 542 20 000

10.15

Chapter 10: Leases

The lease liability recognised at the commencement of the lease is the present value of the 3 yearly payments of $20 000 each, discounted by the implicit rate in the lease of 8% (the first payment is made on the commencement date, so it is not included in the liability). The journal entry to recognise the upfront payment of executory costs of $750 in cash (at 1 July 2022) is as follows: Prepaid executory costs Cash

Dr Cr

750 750

The journal entry to recognise the prepayment expired for executory costs of $750 (at 30 June 2023, and every year after than until the end of lease term) is as follows: Executory costs expense Prepaid executory costs

Dr Cr

750 750

The journal entry to recognise interest expense (at 30 June 2023, and every year after than until the end of lease term – the amounts are taken from the lease payments schedule above) is as follows: Interest expense Interest payable

Dr Cr

4 123 4 123

The journal entry to recognise depreciation expense on the right-of-use asset (at 30 June 2023, and every year after than until the end of lease term) is as follows: Depreciation expense Accumulated depreciation

Dr Cr

17 886 17 886

The annual depreciation expense is calculated on a straight-line basis over the duration of the lease term of 4 years (as the asset is going to be returned to the lessor at the end of the lease). The depreciable amount is equal to the cost of the right-of-use asset as there is no residual value guarantee.

10.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.4 Finance lease If a lease has been capitalised as a finance lease by the lessor, identify circumstances in which the lease receivable raised by the lessor will differ from the right-of-use asset raised by the lessee. (LO3 and LO5) The lessee will value the right-of-use asset at the present value of the lease payments plus any directly attributable costs (including the initial direct costs incurred by the lessee), whereas the lease receivable will be valued at the net investment in the lease by the lessor, which is the present value of the lease payments plus the present value of the unguaranteed residual value, all discounted at the interest rate implicit in the lease. One circumstance is where there is an unguaranteed residual value in the lease contract. A second circumstance is where the lessee has incurred initial direct costs or may incur any other directly attributable costs.

10.17

Chapter 10: Leases

Exercise 10.5 Accounting by lessee and lessor On 1 July 2023, Sherlock Ltd leased a processing plant to Holmes Ltd. The plant was purchased by Sherlock Ltd on 1 July 2023 for its fair value of $348 942. The lease agreement contained the following provisions: Lease term Economic life of plant Annual rental payment, in arrears (commencing 30/6/24) Residual value at end of the lease term Residual guaranteed by lessee Interest rate implicit in lease The lease is cancellable only with the permission of the lessor.

3 years 5 years $120 000 $50 000 $30 000 8%

Holmes Ltd intends to return the processing plant to Sherlock Ltd at the end of the lease term. The lease has been classified as a finance lease by Sherlock Ltd. Required 1. Prepare: (a) the lease payments schedule for Holmes Ltd (show all workings) (b) the journal entries in the records of Holmes Ltd for the year ended 30 June 2025. 2. Prepare: (a) the lease receipts schedule for Sherlock Ltd (show all workings) (b) the journal entries in the records of Sherlock Ltd for the year ended 30 June 2025. (LO3 and LO5)

1. (a) Lease payments schedule.

Date $ 1 July 2023 30 June 2024 30 June 2025

HOLMES LTD Lease payments schedule Lease Interest expense Reduction in payments (8%) liability $ $ $ 120 000 120 000

26 645 19 177

93 355 100 823

Balance of liability $ 333 066* 239 711 138 888 10.18

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30 June 2026

*PV of LP

150 000 390 000

11 111 56 934

—

138 888 333 066

= $120 000 x 2.5771 [T2 8% 3yrs] + $30 000 x 0.7938 [T1 8% 3yrs] = $309 252 + $23 814 = $333 066

1. (b) Journal entries for the year ended 30 June 2025. 30 June 2025 Lease liability Interest expense Cash (Second lease payment)

Dr Dr Cr

100 823 19 177 120 000

Depreciation expense Dr 101 022 Accumulated depreciation Cr 101 022 (Depreciation of the leased asset for the year = ($333 066 – $30 000) / 3 years) 2. (a) Lease receipts schedule.

Date $ 1 July 2023 30 June 2024 30 June 2025 30 June 2026

SHERLOCK LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable $ $ $ 120 000 120 000 170 000 410 000

27 915 20 549 12 592 61 057

92 085 99 451 157 406 348 942

Balance of receivable $ 348 942* 256 857 157 406 —

*PV of LP

= $120 000 x 2.5771 [T2 8% 3yrs] + $30 000 x 0.7938 [T1 8% 3yrs] = $309 252 + $23 814 = $333 066 PV of UGRV = $20 000 x 0.7938 [T1 8% 3yrs] = $15 876 Lease receivable at 1 July 2023 = PV of LP + PV of UGRV = $348 942 2. (b) Journal entries for the year ended 30 June 2025. 30 June 2025 Cash Interest revenue Lease receivable (Second lease receipt)

Dr Cr Cr

120 000

20 549 99 451

10.19

Chapter 10: Leases

Exercise 10.6 Finance lease — lessor On 1 July 2022, Jane Plum decided she needed a new car. She went to the local car yard, North Ltd, run by Fred Peach. Jane discussed the price of a new Roadster Special with Fred, and they agreed on a price of $37 000. As North Ltd had acquired the vehicle from the manufacturer for $30 000, Fred was pleased with the deal. On learning that Jane wanted to lease the vehicle, Fred agreed to arrange for South Ltd, a local finance company, to set up the lease agreement. North Ltd then sold the car to South Ltd for $37 000. South Ltd wrote a lease agreement, incurring initial direct costs of $1 410 as a result. The lease agreement contained the following provisions: Initial payment on 1 July 2022 Payments on 1 July 2023 and 1 July 2024 Guaranteed residual value at 30 June 2025 Implicit interest rate in the lease

$13 000 $13 000 $10 000 6%

South Ltd agreed to pay for the insurance and maintenance of the vehicle, the latter to be carried out by North Ltd at regular intervals. The cost of these services is valued at $3 000 p.a. The vehicle had an expected useful life of 4 years. The expected residual value of the vehicle at 30 June 2025 was $12 000. Costs of maintenance and insurance incurred by South Ltd over the years ended 30 June 2023 to 30 June 2025 were $2 810, $3 020 and $2 750 respectively. At 30 June 2025, Jane returned the vehicle to South Ltd. Assume that the lease is classified as a finance lease by South Ltd. Required 1. Prepare the lease receipts schedule for South Ltd. 2. Prepare the journal entries in the books of South Ltd from 1 July 2022 to 30 June 2025. (LO3 and LO5)

Date $ 1 July 2022 1 July 2022

SOUTH LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (6%) receivable $ $ $ 10 000

—

10 000

Balance of receivable $ 38 410 28 410 10.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1 July 2023 1 July 2024 30 June 2025

10 000 10 000 12 000 42 000

2. 1 July 2022 Vehicle Cash (Purchase of vehicle)

1 705 1 207 678 3 590

Dr Cr

8 295 8 793 11 322 38 410

37 000 37 000

Lease receivable Dr 38 410 Cash Cr Vehicle Cr (Lease of vehicle and payment of initial direct costs) Cash

Dr Cr Cr

13 000

1 July 2022 – 30 June 2023 Insurance and maintenance expense Cash

Dr Cr

2 810

30 June 2023 Interest receivable Interest revenue

Dr Cr

1 705

Dr Cr Cr Cr

13 000

Dr Cr

3 020

Dr Cr

1 207

Dr Cr Cr Cr

13 000

Dr Cr

2 750

Reimbursement revenue Lease receivable

1 July 2023 Cash Reimbursement revenue Interest receivable Lease receivable 1 July 2023 – 30 June 2024 Insurance and maintenance expense Cash 30 June 2024 Interest receivable Interest revenue 1 July 2024 Cash Reimbursement revenue Interest receivable Lease receivable 1 July 2024 – 30 June 2025 Insurance and maintenance expense Cash

20 115 11 322 —

1 410 37 000

3 000 10 000

2 810

1 705

3 000 1 705 8 295

3 020

1 207

3 000 1 207 8 793

2 750 10.21

Chapter 10: Leases

30 June 2025 Vehicle Interest revenue Lease receivable

Dr Cr Cr

12 000

678 11 322

10.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.7 Lease classification; accounting by lessor Use the information contained in exercise 10.3 to complete the following: 1. Classify the lease for Wise Ltd. Justify your answer. 2. Prepare (a) the lease receipts schedule for Wise Ltd (show all workings) and (b) the journal entries in its books for the year ended 30 June 2023. (LO4 and LO5) 1. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Wise Ltd is a manufacturer lessor. Accordingly, the initial direct costs are treated as part of expenses and are not included in calculating the interest rate implicit in the lease (they are not considered as part of the lessor’s investment in the lease). (b) Determine whether substantially all of the risks and rewards associated with ownership of the machine have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee. (ii) Transfer of ownership test: The machine will be returned to the lessor at the end of the lease term. Moreover, the lessee does not guarantee any part of the residual value at the end of the lease, which may imply that the lease did not transfer some risks and rewards to the lessee. (iii) Lease term test: The lease term at 4 years is 66% of the machine’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 92.85% of the fair value of the machine (i.e. substantially all of that fair value). PV of LP = $20 000 + $20 000 x 2.5771 [T2 8% 3yrs] = $20 000 + $51 542 = $71 542 PV of LP/FV = $71 542/$77 055 = 92.85% Given the above evidence, the lessor will classify the transaction as a finance lease by a manufacturer lessor. 2. (a) Lease receipts schedule.

Date

WISE LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable © John Wiley and Sons Australia Ltd, 2020

Balance of receivable 10.23

Chapter 10: Leases

$ 1 July 2022 1 July 2022 1 July 2023 1 July 2024 1 July 2025 30 June 2026

20 000 20 000 20 000 20 000 7 500 87 500

— 4 564 3 330 1 996 555 10 445

20 000 15 436 16 670 18 004 6 945 77 055

$ 77 055 57 055 41 619 24 949 6 945 —

2. (b) Journal entries for the lessor prepared for the year ended 30 June 2030. 1 July 2022 Lease receivable Dr 77 055 Inventory Cr Cost of sales Dr 59 487* Sales revenue Cr (Inception of lease) (* Cost less PV of UGRV [$7 500 x 0.7350 [T1 8% 4yrs]]) (** PV of LP) Cash

Dr Cr Cr

20 750

Dr Cr

750

Interest receivable Dr Interest revenue Cr (Interest revenue accrued at balance date)

4 564

Reimbursement revenue Lease receivable (First lease receipt) 30 June 2023 Insurance and maintenance expense Cash (Payment of executory costs)

65 000 71 542**

750 20 000

750

4 564

10.24

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Exercise 10.8 Lease classification, accounting by lessor Oceans Ltd manufactures specialised moulding machinery for both sale and lease. On 1 July 2020, Oceans Ltd leased a machine to Thirteen Ltd. The machine being leased cost Oceans Ltd $205 000 to make and its fair value at 1 July 2023 is considered to be $239 997. The terms of the lease are as follows. The lease term is for 5 years, starting on Annual lease payment, payable on 30 June each year Estimated useful life of machine (scrap value $15 000) Estimated residual value of machine at end of lease term Residual value guarantee by Thirteen Ltd Interest rate implicit in the lease The annual lease payment includes an amount of $2 000 to cover annual maintenance and insurance costs. Thirteen Ltd may cancel the lease but only with the permission of the lessor. Thirteen Ltd intends to lease another machine from Oceans at the end of the lease term.

1 July 2023 $64 000 8 years $8 000 $5 000 10%

Required 1. Classify the lease for Oceans Ltd. Justify your answer. 2. Prepare (a) the lease receipts schedule for Oceans Ltd (show all workings) and (b) the journal entries in its books for the year ended 30 June 2024. 3. Assuming that Thirteen Ltd can cancel the lease without incurring any penalties, prepare the journal entries in the books of Oceans Ltd for the year ended 30 June 2024. (LO4, LO 6 and LO7) 1. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease Oceans Ltd is a manufacturer lessor. Accordingly, the initial direct costs are treated as part of expenses and are not included in calculating the interest rate implicit in the lease (they are not considered as part of the lessor’s investment in the lease). (b) Determine whether substantially all of the risks and rewards associated with ownership of the machinery have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee.

10.25

Chapter 10: Leases

(ii) Transfer of ownership test: The machine will be returned to the lessor at the end of the lease term, but the lessee is planning to lease another machine from the lessor at the end of this lease. Moreover, the lessee guarantees a part of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee. (iii) Lease term test: The lease term at 5 years is 62.5% of the machine’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 99.2% of the fair value of the machine (i.e. substantially all of that fair value). PV of LP = $62 000 x 3.7908 [T2 10% 5yrs] + $5 000 x 0.6209 [T1 10% 5yrs] = $235 030 + $3 105 = $238 135 PV of LP/FV = $238 135/$239 997 = 99.2%. Given the above evidence, the lessor will classify the transaction as a finance lease by a manufacturer lessor. 2. (a) Lease receipts schedule.

Date $ 1 July 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027 30 June 2028

OCEANS LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (10%) receivable $ $ $ 62 000 62 000 62 000 62 000 70 000 318 000

24 000 20 200 16 020 11 422 6 364 78 004

Balance of receivable $ 239 997 201 997 160 196 114 216 63 638 —

38 000 41 800 45 980 50 578 63 638 239 997

2. (b) Journal entries for the lessor prepared for the year ended 30 June 2024. 1 July 2023 Lease receivable Dr 239 997 Inventory Cr Cost of sales Dr 203 137* Sales revenue Cr (Inception of lease) (* Cost less PV of UGRV [$3 000 x 0.6209 [T1 10% 5yrs]]) (** PV of LP)

205 000 238 134**

10.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30 June 2024 Cash Reimbursement revenue Lease receivable Interest revenue (First lease receipt) Insurance and maintenance expense Cash (Payment of executory costs)

Dr Cr Cr Cr

64 000

Dr Cr

2 000

2 000 38 000 24 000

2 000

3. If Thirteen Ltd can cancel the lease without incurring any penalties, all the other terms and conditions of the lease agreement do not matter and the lease should be classified by Oceans Ltd as an operating lease. The journal entries for the year ended 30 June 2024 for Oceans Ltd would then be as follows: 30 June 2024 Cash Reimbursement revenue Lease income (First lease receipt) Insurance and maintenance expense Cash (Payment of executory costs)

Dr Cr Cr

64 000

Dr Cr

2 000

2 000 62 000

2 000

10.27

Chapter 10: Leases

Exercise 10.9 Accounting by lessee and lessor Eliza Ltd decided to lease from Ford Ltd a car that had a fair value at 30 June 2022 of $38 960. The lease agreement contained the following provisions. Lease term Annual rental payments (commencing 30/6/22) Guaranteed residual value (expected fair value at end of lease term)

3 years $11 200 $12 000

The expected useful life of the vehicle is 5 years. At the end of the 3-year lease term, the car was returned to Ford Ltd, which sold it for $10 000. The annual rental payments include an amount of $1200 to cover the cost of maintenance and insurance arranged and paid for by Ford Ltd. Required 1. Prepare the journal entries for Eliza Ltd from 30 June 2022 to 30 June 2023. 2. Assuming that the lease is a finance lease from the perspective of Ford Ltd, prepare the journal entries for Ford Ltd from 30 June 2022 to 30 June 2023. 3. Assuming that the lease is an operating lease from the perspective of Ford Ltd, prepare the journal entries for Ford Ltd from 30 June 2022 to 30 June 2023. (LO3, LO6 and LO7) 1. By trial and error, or a financial calculator, determine the implicit rate in the lease of 5% that makes the present value of the lease payments (after $1 200 was deducted from annual payments as executory costs, but including the guaranteed residual value of $12 000) equal to the fair value of the leased asset (assume no initial direct costs to the lessor): $10 000 payable now $10 000 x 1.85941 (annuity for 2 years at 5%) $12 000 x 0.86384 (PV of guaranteed residual in 3 years at 5%) Total

Date $ 30 June 2022 30 June 2022 30 June 2023 30 June 2024 30 June 2025

= = = =

$10 000 $18 594 $10 366 $38 960

ELIZA LTD Lease payments schedule Lease Interest expense Reduction in payments (5%) liability $ $ $

30 June 2022 Right-of-use vehicle Lease liability

10 000 10 000 10 000 12 000 42 000

— 1 448 1 020 572 3 040

Dr Cr

10 000 8 552 8 980 11 428 38 960

Balance of liability $ 38 960 28 960 20 408 11 428 —

38 960

38 960 10.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(Recognition of lease asset and liability) Lease liability Prepaid executory costs Cash (First lease payment)

Dr Dr Cr

1 July 2022 Executory costs expense Dr Prepaid executory costs Cr (Executory costs for the 2023 financial year) 30 June 2023 Lease liability Interest expense Prepaid executory costs Cash (Second lease payment)

Dr Dr Dr Cr

10 000 1 200 11 200

1 200 1 200

8 552 1 448 1 200 11 200

Depreciation expense Dr 8 987 Accumulated depreciation Cr 8 987 (Depreciation of the leased asset for the year = ($38 960 - $12 000) / 3 years) 1 July 2023 Executory costs expense Dr 1 200 Prepaid executory costs Cr 1 200 (Executory costs for the 2024 financial year) 30 June 2024 Lease liability Interest expense Prepaid executory costs Cash (Third lease payment)

Dr Dr Dr Cr

8 980 1 020 1 200 11 200

Depreciation expense Dr 8 987 Accumulated depreciation Cr 8 987 (Depreciation of the leased asset for the year = ($38 960 - $12 000) / 3 years) 1 July 2024 Executory costs expense Dr Prepaid executory costs Cr (Executory costs for the 2025 financial year)

1 200 1 200

30 June 2025 Depreciation expense Accumulated depreciation

Dr Cr

8 986

Lease liability Interest expense Accumulated depreciation

Dr Dr Dr

11 428 572 26 960

8 986

10.29

Chapter 10: Leases

Right-of-use vehicle (Return of vehicle to lessor)

Loss on guaranteed residual value Cash (Payment required under guarantee)

Dr Cr

38 960

2 000 2 000

2. Journal entries for the lessor.

Date $ 30 June 2022 30 June 2022 30 June 2023 30 June 2024 30 June 2025

FORD LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (5%) receivable $ $ $ 10 000 10 000 10 000 12 000 42 000

30 June 2022 Lease receivable Motor vehicle (Recognition of lease receivable)

10 000 8 552 8 980 11 428 38 960

1 448 1 020 572 3 040

Dr Cr

38 960

Dr Executory costs reimbursement in advance Cr Lease receivable Cr (First lease receipt)

11 200

Cash

38 960

1 200 10 000

1 July 2022 Executory costs reimbursement in advance Dr 1 200 Reimbursement revenue Cr (Executory costs reimbursement for the 2023 financial year) 30 June 2023 Cash Lease receivable Interest revenue Executory costs reimbursement in advance (Second lease receipt)

Dr Cr Cr

1 200

11 200 8 552 1 448

Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

Balance of receivable $ 38 960 28 960 20 408 11 428 —

1 200 1 200 1 200

1 July 2023 © John Wiley and Sons Australia Ltd, 2020

10.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Executory costs reimbursement in advance Dr 1 200 Reimbursement revenue Cr (Executory costs reimbursement for the 2024 financial year) 30 June 2024 Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2024 financial year) Cash

Dr Lease receivable Cr Interest revenue Cr Executory costs reimbursement in advance Cr (Third lease receipt)

1 200 1 200 11 200 8 980 1 020 1 200

1 July 2024 Executory costs reimbursement in advance Dr 1 200 Reimbursement revenue Cr (Executory costs reimbursement for the 2025 financial year) 30 June 2025 Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2025 financial year)

1 200

Dr Cr Cr

12 000

Loss of sale of motor vehicle Cash Motor vehicle (Sale of vehicle)

Dr Dr Cr

2 000 10 000

Cash

Dr Cr

2 000

3. 30 June 2022 Cash Dr Lease income Cr Executory costs reimbursement in advance Cr (First lease receipt) 1 July 2022 Executory costs reimbursement in advance

1 200

Motor vehicle Lease receivable Interest revenue (Return of vehicle to lessor)

Other income (Payment received under guarantee)

1 200

11 428 572

12 000

2 000

11 200 10 000 1 200

1 200

10.31

Chapter 10: Leases

Reimbursement revenue Cr (Executory costs reimbursement for the 2023 financial year) 30 June 2023 Depreciation expense Dr 7 792 Accumulated depreciation Cr (Depreciation of the motor vehicle for the year = $38 960 / 5 years) Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

1 200

Cash

11 200

Dr Cr

10 000 1 200

1 July 2023 Executory costs reimbursement in advance Dr 1 200 Reimbursement revenue Cr (Executory costs reimbursement for the 2024 financial year) 30 June 2024 Depreciation expense Dr 7 792 Accumulated depreciation Cr (Depreciation of the motor vehicle for the year = $38 960 / 5 years) Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2024 financial year)

1 200

Cash

11 200

1 200

7 792

1 200

Lease income Executory costs reimbursement in advance Cr

10 000 1 200

1 July 2024 Executory costs reimbursement in advance Dr 1 200 Reimbursement revenue Cr (Executory costs reimbursement for the 2025 financial year) 30 June 2023 Depreciation expense Dr 7 792 Accumulated depreciation Cr (Depreciation of the motor vehicle for the year = $38 960 / 5 years) Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2025 financial year)

7 792

1 200

Lease income Executory costs reimbursement in advance Cr (Second lease receipt)

Dr Cr

1 200

7 792

1 200

10.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Loss of sale of motor vehicle Cash Accumulated depreciation Motor vehicle (Sale of vehicle)

Dr Dr Dr Cr

5 584 10 000 23 376

Cash

Dr Cr

2 000

Other income (Payment received under guarantee)

38 960

2 000

10.33

Chapter 10: Leases

Exercise 10.10 Lease schedules and accounting by lessee and lessor On 1 July 2023, Hermione Ltd leased a crane from Grainger Ltd. The crane cost Grainger Ltd $120 307, considered to be its fair value on that same day. The finance lease agreement contained the following provisions:

The lease term is for 3 years, starting on

1 July 2023

The lease is cancellable, but only with the permission from the lessor. Annual lease payment, payable on 30 June each year

$39 000

Estimated useful life of crane

4 years

Estimated residual value of crane at end of lease term

$22 000

Residual value guarantee by Hermione Ltd

$16 000

Interest rate implicit in the lease

Required 1. Prepare the lease schedules for Hermione Ltd and Grainger Ltd. 2. Prepare the journal entries in the records of Hermione Ltd only for the year ended 30 June 2024. (LO3 and LO7) 1.

Date $ 1 July 2023 30 June 2024 30 June 2025 30 June 2026

*PV of LP

HERMIONE LTD Lease payments schedule Lease Interest expense Reduction in payments (7%) liability $ $ $ 39 000 39 000 55 000 133 000

8 079 5 914 3 598 17 591

30 921 33 086 51 402 115 409

Balance of liability $ 115 409* 84 488 51 402 —

= ($39 000 x 2.6243 [T2 7% 3yrs]) + ($16 000 x 0.8163 [T1 7% 3yrs]) = $102 348 + $13 061 = $115 409

Date $ 1 July 2023 30 June 2024 30 June 2025

GRAINGER LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (7%) receivable $ $ $ 39 000 39 000

8 421 6 281

30 579 32 719

Balance of receivable $ 120 307* 89 728 58 009 10.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30 June 2026

61 000 139 000

3 991 18 693

—

57 009 120 307

*PV of LP

= ($39 000 x 2.6243 [T2 7% 3yrs]) + ($16 000 x 0.8163 [T1 7% 3yrs]) = $102 348 + $13 061 = $115 409 PV of UGRV= $6 000 x 0.8163 [T1 7% 3yrs] = $4 898 PV = $120 307 = FV 2. Journal entries for the year ended 30 June 2024. 1 July 2023 Right-of-use crane Dr 115 409 Lease liability Cr 115 409 (Recognition of right-of-use asset and lease liability at the inception of the lease) 30 June 2024 Lease liability Interest expense Cash (First lease payment)

Dr Dr Cr

30 921 8 079 39 000

Depreciation expense Dr 33 136 Accumulated depreciation Cr 33 136 (Depreciation of the leased asset for the year = $33 136 = ($115 409 - $16 000) / 3 years)

10.35

Chapter 10: Leases

Exercise 10.11 Accounting by lessee and lessor Albert Ltd entered into an agreement on 1 July 2022 to lease a processing plant with a fair value of $569 230 to Einstein Ltd. The terms of the lease agreement were: Lease term

3 years

Economic life of plant

5 years

Annual rental payment, in arrears (commencing 30/6/23)

$225 000

Residual value of plant at end of lease term

$50 000

Residual value guarantee by Einstein Ltd

$20 000

Interest rate implicit in the lease

The lease is cancellable, but only with the permission of the lessor. At the end of the lease term, the plant is to be returned to Albert Ltd. In setting up the lease agreement Albert Ltd incurred $7350 in legal fees and stamp duty costs. The annual rental payment includes $25 000 to reimburse Albert Ltd for maintenance costs incurred on behalf of Einstein Ltd. Required 1. Prepare a lease payments schedule and the journal entries in the records of Einstein Ltd for the year ended 30 June 2023. Show all workings. 2. Classify the lease from Albert Ltd perspective. 3. Prepare a lease receipts schedule and the journal entries in the records of Albert Ltd for the year ending 30 June 2023. Show all workings. 4. Explain how and why your answers to requirements 1 and 2 would change if the lease agreement could be cancelled at any time without penalty. (LO3, LO4 and LO7) 1.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025

EINSTEIN LTD Lease payments schedule Lease Interest expense Reduction in payments (6%) liability $ $ $ 200 000 200 000 220 000 620 000

1 July 2022 Right-of-use plant Lease liability (Recognition of lease agreement)

33 084 23 069 12 453 68 605

Dr Cr

166 916 176 931 207 544 551 392

Balance of liability $ 551 392 384 476 207 544 —

551 392

10.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30 June 2023 Lease liability Interest expense Executory costs expense Cash (First lease payment)

Dr Dr Dr Cr

166 916 33 084 25 000 225 000

Depreciation expense Dr 177 131 Accumulated depreciation Cr 177 131 (Depreciation of the leased asset for the year = ($551 392 – $20 000) / 3 years) 2. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Albert Ltd is a financier lessor. Accordingly, the initial direct costs are treated as part of the lessor’s investment in the lease). (b) Determine whether substantially all of the risks and rewards associated with ownership of the processing plant have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee. (ii) Transfer of ownership test: The processing plant will be returned to the lessor at the end of the lease term. Moreover, the lessee guarantees a part of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee. (iii) Lease term test: The lease term at 3 years is 60% of the plant’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 96.87% of the fair value of the processing plant (i.e. substantially all of that fair value). PV of LP = $200 000 x 2.6730 [T2 6% 3yrs] + $20 000 x 0.8396 [T1 6% 3yrs] = $534 600 + $16 792 = $551 392 PV of LP/FV = $551 392/$569 230 = 96.87%. Given the above evidence, the lessor will classify the transaction as a finance lease by a financier lessor. 3. Accounting for the lease in the books of Albert Ltd.

Date

ALBERT LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (6%) receivable © John Wiley and Sons Australia Ltd, 2020

Balance of receivable 10.37

Chapter 10: Leases

$ 1 July 2023 30 June 2024 30 June 2025 30 June 2026

200 000 200 000 250 000 650 000

34 595 24 670 14 151 73 416

165 405 175 330 235 845 576 580

1 July 2022 Lease receivable Processing plant (Recognition of lease agreement) Lease receivable Cash (Payment of initial direct costs) 30 June 2023 Cash Lease receivable Interest revenue Reimbursement revenue (First lease receipt) Maintenance expense Cash (Payment of maintenance costs)

Dr Cr

569 230

Dr Cr

7 350

Dr Cr Cr Cr

225 000

Dr Cr

25 000

$ 576 580 411 175 235 845 —

569 230

7 350

165 405 34 595 25 000

25 000

4. As the lease is now cancellable without penalty it could be argued that the lease can no longer be classified by the lessor as a finance lease and thus should be treated as an operating lease. There are no consequences from Einstein Ltd’s perspective.

10.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.12 Lease classification, lease accounting On 30 June 2022, Harper Ltd purchased machinery for its fair value of $42 500 and then leased it to Lee Ltd. Lee Ltd incurred $349 in costs to negotiate the lease agreement. The machine is expected to have an economic life of 5 years, after which time it will have a residual value of $2500. The lease agreement details are as follows. Length of lease Commencement date Annual lease payment, payable 30 June each year commencing 30 June 2022 Residual value at the end of the lease term Residual value guarantee by Lee Ltd Interest rate implicit in the lease The lease is cancellable, but only with the permission of Harper Ltd.

4 years 30 June 2022 $12 000 $10 000 $8 000 8%

All insurance and maintenance costs are paid by Harper Ltd and amount to $2 000 per year and will be reimbursed by Lee Ltd by being included in the annual lease payment of $12 000. The machinery will be depreciated on a straight-line basis. It is expected that Lee Ltd will return the machinery at the end of the lease to Harper Ltd. Required 1. Calculate the initial direct costs incurred by Harper Ltd to negotiate the lease agreement. 2. Describe why the lease can be considered as a finance lease by Harper Ltd, giving at least three reasons for your answer. 3. Prepare the journal entries to account for the lease in the books of Lee Ltd for the years ended 30 June 2019 and 30 June 2023. 4. Prepare the journal entries to account for the lease in the books of Harper Ltd for the year ended 30 June 2023. (LO3, LO4 and LO5) 1. PV of LP = ($12 000 - $2 000) + ($12 000 - $2 000) x 2.5771 [T2 8% 3yrs] + $8 000 x 0.7350 [T1 8% 4yrs] = $10 000 + $25 771 + $5 880 = $41 651 PV of UGRV = $2 000 x 0.7350 [T1 8% 4yrs] = $1 470 Initial direct costs = PV of LP + PV of UGRV – FV = $41 651 + $1 470 - $42 500 = $621. 2. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Harper Ltd is a financier lessor. Accordingly, the initial direct costs are treated as part of the lessor’s investment in the lease.

10.39

Chapter 10: Leases

(b) Determine whether substantially all of the risks and rewards associated with ownership of the machinery have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but only with the permission of the lessor. Arguably, this condition implies that the lease transferred some risks, but probably not the rewards to the lessee. (ii) Transfer of ownership test: The machinery will be returned to the lessor at the end of the lease term. Moreover, the lessee guarantees a part of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee. (iii) Lease term test: The lease term at 4 years is 80% of the machine’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 98% of the fair value of the processing plant (i.e. substantially all of that fair value). PV of LP = ($12 000 - $2 000) + ($12 000 - $2 000) x 2.5771 [T2 8% 3yrs] + $8 000 x 0.7350 [T1 8% 4yrs] = $10 000 + $25 771 + $5 880 = $41 651 PV of LP/FV = $41 651/$42 500 = 98%. Given the above evidence, the lessor will classify the transaction as a finance lease by a financier lessor. 3. Journal entries for the lessee.

Date $ 30 June 2022 30 June 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026

LEE LTD Lease payments schedule Lease Interest expense Reduction in payments (8%) liability $ $ $ 10 000 10 000 10 000 10 000 8 000 48 000

— 2 532 1 935 1 289 593 6 349

10 000 7 468 8 065 8 711 7 407 41 651

30 June 2022 Right-of-use vehicle Dr 42 000 Prepaid executory costs Dr 2 000 Lease liability Cr Cash Cr (Recognition of lease asset and liability and first lease payment) © John Wiley and Sons Australia Ltd, 2020

Balance of liability $ 41 651 31 651 24 183 16 118 7 407 —

31 651 12 349

10.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dr Dr Dr Cr

2 000 2 000

7 468 2 532 2 000 12 000

Depreciation expense Dr 8 500 Accumulated depreciation Cr 8 500 (Depreciation of the leased asset for the year = ($42 000 - $8 000) / 4 years) 5. Journal entries for the lessor.

Date $ 30 June 2022 30 June 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026

HARPER LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable $ $ $ — 2 650 2 062 1 427 740 6 879

10 000 10 000 10 000 10 000 10 000 50 000

30 June 2022 Machinery Cash (Purchase of machine)

10 000 7 350 7 938 8 573 9 260 43 121

Dr Cr

42 500

Dr Cr Cr

43 121

Dr Executory costs reimbursement in advance Cr Lease receivable Cr (First lease receipt)

12 000

Lease receivable Machinery Cash (Recognition of lease receivable) Cash

Balance of receivable $ 43 121 33 121 25 771 17 833 9 260 —

42 500

42 500 621

1 July 2022 Executory costs reimbursement in advance Dr 2 000 Reimbursement revenue Cr (Executory costs reimbursement for the 2023 financial year) © John Wiley and Sons Australia Ltd, 2020

2 000 10 000

2 000

10.41

Chapter 10: Leases

30 June 2023 Cash Lease receivable Interest revenue Executory costs reimbursement in advance (Second lease receipt)

Dr Cr Cr

12 000 7 350 2 650

Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

2 000

10.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.13 Finance lease — financier lessor On 1 July 2022, Safe Ltd acquired a new car. The manager of Safe Ltd, Jack Safe, went to the local car yard, House Autos, and discussed the price of a new Racer Special with Denzel House. Jack and Denzel agreed on a price of $37 876. As House Autos had acquired the vehicle from the manufacturer for $32 000, Denzel was pleased with the deal. On discussing the financial arrangements in relation to the car, Jack decided that a lease arrangement was the most suitable. Denzel agreed to arrange for Washington Ltd, a local finance company, to set up the lease agreement. House Autos then sold the car to Washington Ltd for $37 876. Washington Ltd wrote a lease agreement, incurring initial direct costs of $534 in the process. The lease agreement contained the following clauses: Initial payment on 1 July 2022 Payments on 1 July 2023 and 1 July 2024 Interest rate implicit in the lease

$13 000 $13 000 6%

The lease agreement also specified for Washington Ltd to pay for the insurance and maintenance of the vehicle, the latter to be carried out by House Autos at regular intervals. A cost of $3000 per annum was included in the lease payments to cover these services. Jack was concerned that the lease be considered an operating lease for accounting purposes. To achieve this, the lease agreement included the following: • The lease was cancellable by Safe Ltd at any stage. However, if the lease was cancelled, Safe Ltd agreed to lease, on similar terms, another car from Washington Ltd. • Safe Ltd was not required to guarantee the payment of any residual value. At the end of the lease term, 30 June 2025, or if cancelled earlier, the car would automatically revert to the lessor with no payments being required from Safe Ltd. The vehicle had an expected economic life of 6 years. The expected fair value of the vehicle at 30 June 2025 was $12 000. Because of concern over the residual value, Washington Ltd required Jack to sign another contractual arrangement separate from the lease agreement which gave Washington Ltd the right to sell the car to Safe Ltd if the fair value of the car at the end of the lease term was less than $10 000. Costs of maintenance and insurance paid by Washington Ltd to House Autos over the years ended 30 June 2023 to 30 June 2025 were $2810, $3020 and $2750. At 30 June 2025, Jack returned the vehicle to Washington Ltd. The fair value of the car was determined by to be $9000. Washington Ltd invoked the second agreement. With the consent of Safe, Washington Ltd sold the car to House Autos for a price of $9000 on 5 July 2025, and invoiced Safe Ltd for $1000. Safe Ltd subsequently paid this amount on 13 July 2025. Required © John Wiley and Sons Australia Ltd, 2020

10.43

Chapter 10: Leases

Assuming the lease is classified as a finance lease for the perspective of Washington Ltd, prepare: 1. a schedule of lease payments for Safe Ltd 2. journal entries in the records of Safe Ltd for the years ended 30 June 2023, 30 June 2024 and 30 June 2025 3. a schedule of lease receipts for Washington Ltd 4. journal entries in the records of Washington Ltd for the years ended 30 June 2023, 30 June 2024 and 30 June 2025. (LO3 and LO5) 1. Schedule of lease payments for lessee, Safe Ltd.

Date $ 1 July 2022 1 July 2022 1 July 2023 1 July 2024 30 June 2025

SAFE LTD Lease payments schedule Lease Interest expense Reduction in payments (6%) liability $ $ $ — 1 604 1 100 566 3 270

10 000 10 000 10 000 10 000 40 000

10 000 8 396 8 900 9 434 36 730

Balance of liability $ 36 730* 26 730 18 334 9 434 —

*PV of LP = $10 000 + ($10 000 x 1.8334 [T2 6% 2yrs]) + ($10 000 x 0.8396 [T2 6% 3yrs]) = $36 730 2. Journal entries for lessee, Safe Ltd. 1 July 2022 Right-of-use vehicle Executory costs expense Lease liability Cash

Dr Dr Cr Cr

36 730 3 000

30 June 2023 Interest expense Interest payable

Dr Cr

1 604

26 730 13 000

1 604

Depreciation expense Dr 8 910 Accumulated depreciation Cr 8 910 (Depreciation of the leased asset for the year = ($36 730 - $10 000) / 3 years) 1 July 2023 Lease liability Interest payable Executory costs expense Cash

Dr Dr Dr Cr

8 396 1 604 3 000

13 000

10.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30 June 2024 Interest expense Interest payable

Dr Cr

1 100 1 100

Depreciation expense Dr 8 910 Accumulated depreciation Cr 8 910 (Depreciation of the leased asset for the year = ($36 730 - $10 000) / 3 years) 1 July 2024 Lease liability Interest payable Executory costs expense Cash

Dr Dr Dr Cr

8 900 1 100 3 000 13 000

30 June 2025 Depreciation expense Dr 8 910 Accumulated depreciation Cr 8 910 (Depreciation of the leased asset for the year = ($36 730 - $10 000) / 3 years) Lease liability Interest expense Accumulated depreciation Right-of-use vehicle

Dr Dr Dr Cr

9 434 566 26 730

5 July 2025 Loss on lease Payable to lessor

Dr Cr

1 000

13 July 2025 Payable to lessor Cash

Dr Cr

1 000

36 730

1 000

3. Schedule of lease receipts for lessor, Washington Ltd.

Date $ 1 July 2022 1 July 2022 1 July 2023 1 July 2024 30 June 2025

WASHINGTON LTD Lease receipts schedule Lease Interest expense Reduction in receipts (6%) liability $ $ $ 10 000 10 000 10 000 12 000 42 000

— 1 705 1 207 678 3 590

10 000 8 295 8 793 11 322 38 410

Balance of liability $ 38 410 28 410 20 115 11 322 —

10.45

Chapter 10: Leases

4. Journal entries for lessor, Washington Ltd. 1 July 2022 Vehicle Cash

Dr Cr

37 876

Lease receivable Cash Vehicle

Dr Cr Cr

38 410

Cash

Dr Cr Cr

13 000

1 July 2022 – 30 June 2023 Insurance and maintenance expense Cash

Dr Cr

2 810

30 June 2023 Interest receivable Interest revenue

Dr Cr

1 705

Dr Cr Cr Cr

13 000

1 July 2023 – 30 June 2024 Insurance and maintenance expense Cash

Dr Cr

3 020

30 June 2024 Interest receivable Interest revenue

Dr Cr

1 207

Dr Cr Cr Cr

13 000

1 July 2024 – 30 June 2025 Insurance and maintenance expense Cash

Dr Cr

2 750

30 June 2025 Vehicle Interest revenue Lease receivable

Dr Cr Cr

12 000

Reimbursement revenue Lease receivable

1 July 2023 Cash Reimbursement revenue Interest receivable Lease receivable

1 July 2024 Cash Reimbursement revenue Interest receivable Lease receivable

37 876

534 37 876

3 000 10 000

2 810

1 705

3 000 1 705 10 000

3 020

1 207

3 000 1 207 8 793

2 750

678 11 322 10.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

5 July 2025 Cash Receivable from lessee Loss on vehicle sold Vehicle

Dr Dr Dr Cr

9 000 1 000 2 000

13 July 2025 Cash Receivable from lessee

Dr Cr

1 000

12 000

1 000

10.47

Chapter 10: Leases

Exercise 10.14 Lease classification, lease accounting As of 1 July 2022, Scarlett Ltd leases a building from Rhett Ltd. The building has a fair value at 1 July 2022 of $1 972 000. The lease agreement details are as follows. Length of lease Commencement date Annual lease payment, payable 30 June each year commencing 30 June 2023 Estimated economic life of the building Residual value at the end of the lease term Residual value guarantee by Scarlett Ltd Interest rate implicit in the lease

10 years 1 July 2022 $350 000 10 years $20 000 $14 000 10%

The lease is cancellable, but a penalty equal to 50% of the remaining lease payments is applicable on cancellation. Scarlett Ltd incurred $1 331 to negotiate and execute the lease agreement. All insurance and maintenance costs are paid by Rhett Ltd and are expected to amount to $30 000 per year and will be reimbursed by Scarlett Ltd by being included in the annual lease payment of $350 000. The building is to be depreciated on a straightline basis. Required 1. Calculate the initial direct costs incurred by Rhett Ltd to negotiate and execute the lease agreement. 2. Indicate the amounts recorded as right-of-use asset and lease liability by Scarlett Ltd and the amount recorded as lease receivable by Rhett Ltd at the beginning of the lease in their respective books. 3. Prepare the journal entries to account for the lease in the books of Scarlett Ltd for the year ended 30 June 2023. 4. Calculate the current and non-current lease liability as of 30 June 2023 relating to the lease. 5. Prepare the journal entries to account for the lease in the books of Rhett Ltd for the year ended 30 June 2023. (LO3, LO4 and LO5) 1. PV of LP

= ($350 000 - $30 000) x 6.1446 [T2 10% 10yrs] + $14 000 x 0.3855 [T1 10% 10yrs] = $1 966 272 + $5 397 = $1 971 669 PV of UGRV = $6 000 x 0.3855 [T1 10% 10yrs] = $2 313 Initial direct costs = PV of LP + PV of UGRV – FV = $1 971 669 + $2 313 - $1 972 000 = $1 982 2. Right-of-use asset = PV of LP + Initial direct costs to the lessee = $1 971 669 + $1 331 = $1 973 000 Lease liability = PV of LP = $1 971 669 Lease receivable = PV of LP + PV of UGRV = FV + Initial direct costs to the lessor © John Wiley and Sons Australia Ltd, 2020

10.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

= $1 971 669 + $2 313 = $1 972 000 + $1 982 = $1 973 982 3.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027 30 June 2028 30 June 2029 30 June 2030 30 June 2031 30 June 2032

SCARLETT LTD Lease payments schedule Lease Interest expense Reduction in payments (10%) liability $ $ $ 320 000 320 000 320 000 320 000 320 000 320 000 320 000 320 000 320 000 334 000 3 214 000

197 167 184 884 171 372 156 509 140 160 122 176 102 394 80 633 56 696 30 340 1 242 331

1 July 2022 Right-of-use building Dr Lease liability Cr Cash Cr (Recognition of lease asset and liability) 30 June 2023 Lease liability Interest expense Executory costs expense Cash (First lease payment)

Dr Dr Dr Cr

122 833 135 116 148 628 163 491 179 840 197 824 217 606 239 367 263 304 303 660 1 971 669

Balance of liability $ 1 971 669 1 848 836 1 713 720 1 565 092 1 401 601 1 221 761 1 023 937 806 331 566 964 303 660 —

1 973 000 1 971 669 1 331

122 833 197 167 30 000 350 000

Depreciation expense Dr 195 900 Accumulated depreciation Cr 195 900 (Depreciation of the leased asset for the year = ($1 973 000 - $14 000) / 10 years) 4. Current lease liability at 30 June 2023 is the part of the lease liability balance (i.e. $1 848 836) that is payable in the year ended 30 June 2024 – that is $135 116. The non-current lease liability at 30 June 2023 is the remaining lease liability to be paid after – that is $1 713 720. 5.

Date $ 1 July 2022

RHETT LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (10%) receivable $ $ $

Balance of receivable $ 1 973 982 10.49

Chapter 10: Leases

30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027 30 June 2028 30 June 2029 30 June 2030 30 June 2031 30 June 2032

320 000 320 000 320 000 320 000 320 000 320 000 320 000 320 000 320 000 340 000 3 220 000

1 July 2022 Lease receivable Machinery Cash (Recognition of lease receivable)

197 398 185 138 171 652 156 817 140 499 122 549 102 804 81 084 57 192 30 885 1 246 018 Dr Cr Cr

30 June 2023 Cash Dr Lease receivable Cr Interest revenue Cr Reimbursement revenue Cr (First lease receipt) Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

122 602 134 862 148 348 163 183 179 501 197 451 217 196 238 916 262 808 309 115 1 973 982

1 851 380 1 716 518 1 568 170 1 404 987 1 225 486 1 028 035 810 839 571 923 309 115 —

1 973 982 1 972 000 1 982

350 000 122 602 197 398 30 000 30 000

30 000

10.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.15 Lease classification, lease accounting On 1 July 2022, Connor Ltd purchased equipment for its fair value and then leased it to Violet Ltd, incurring $2 548 in costs to prepare and execute the lease document. Violet Ltd incurred $1 935 in costs to negotiate the agreement. The equipment is expected to have an economic life of 6 years, after which time it will have a residual value of $6 000. The lease agreement details are as follows. Length of lease Commencement date Annual lease payment, payable 1 July each year commencing 1 July 2022 Residual value at the end of the lease term, of which 50% is guaranteed by Violet Ltd Interest rate implicit in the lease

5 years 1 July 2022 $15 000 $12 000 6%

All insurance and maintenance costs are paid by Connor Ltd and amount to $3000 per year and will be reimbursed by Violet Ltd by being included in the annual lease payment of $15 000. The equipment will be depreciated on a straight-line basis. It is expected that Violet Ltd will return the equipment to Connor Ltd at the end of the lease. Required 1. Calculate the fair value of the leased equipment at 1 July 2022. 2. Prepare the journal entries to account for the lease in the books of Violet Ltd for the year ended 30 June 2023. 3. Prepare the journal entries to account for the lease in the books of Connor Ltd for the year ended 30 June 2023. (LO3, LO4 and LO7) 1. PV of LP

= ($15 000 - $3 000) + ($15 000 - $3 000) x 3.4651 [T2 6% 4yrs] + $6 000 x 0.7473 [T1 6% 5yrs] = $12 000 + $41 581 + $4 484 = $58 085

PV of UGRV

= $6 000 x 0.7473 [T1 6% 5yrs] = $4 484

= PV of LP + PV of UGRV – Initial direct costs to the lessor = $58 085 + $4 484 - $2 548 = $60 001

2. VIOLET LTD Lease payments schedule

10.51

Chapter 10: Leases

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

Lease payments $

Interest expense (6%) $

Reduction in liability $

12 000 12 000 12 000 12 000 6 000 54 000

2 765 2 211 1 624 1 001 314 7 915

9 235 9 789 10 376 10 999 5 686 46 085

1 July 2022 Right-of-use equipment Dr Executory costs expense Dr Lease liability Cr Cash Cr (Recognition of lease asset and liability) 30 June 2023 Interest expense Interest payable (First lease interest)

Balance of liability $ 46 085 36 850 27 061 16 685 5 686 —

58 020 2 000 46 085 13 935

Dr Cr

2 765 2 765

Depreciation expense Dr 10 404 Accumulated depreciation Cr 10 404 (Depreciation of the leased asset for the year = ($58 020 - $6 000) / 5 years) 4. Journal entries for the lessor.

Date $ 1 July 2022 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

CONNOR LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (6%) receivable $ $ $ — 3 033 2 495 1 925 1 320 678 9 451

12 000 12 000 12 000 12 000 12 000 12 000 72 000

1 July 2022 Machinery Cash Lease receivable Machinery Cash (Recognition of lease receivable)

Cr Cr Dr Cr Cr

12 000 8 967 9 505 10 075 10 680 11 322 62 549

Balance of receivable $ 62 549 50 549 41 582 32 077 22 002 11 322 —

60 001 60 001 62 549

60 001 2 548

10.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cash

Dr Cr Cr

15 000

Dr Cr

3 033

Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

3 000

Lease receivable Reimbursement revenue (First lease receipt) 30 June 2023 Interest receivable Interest revenue (Interest for the 2023 financial year)

12 000 3 000

3 033

3 000

10.53

Chapter 10: Leases

Exercise 10.16 Lease classification, lease accounting Pacific Ltd has entered into an agreement to lease a crane to Masters Ltd. The lease agreement details are as follows: Length of lease Commencement date Annual lease payment, payable 30 June each year commencing 30 June 2023 Fair value of the crane at 1 July 2022 Estimated economic life of the crane Estimated residual value of the crane at the end of its economic life Residual value at the end of the lease term, of which 50% is guaranteed by Masters Ltd Interest rate implicit in the lease

5 years 1 July 2022 $12 000 $48 776 8 years $2 000 $6 000 9%

The lease is cancellable, but a penalty equal to 50% of the total lease payments is payable on cancellation. Masters Ltd does not intend to buy the crane at the end of the lease term. Pacific Ltd incurred $1 800 to negotiate and execute the lease agreement. Pacific Ltd purchased the crane for $48 776 just before the inception of the lease. Required 1. Prepare a schedule of lease payments for Masters Ltd. 2. Prepare journal entries to record the lease transactions for the year ended 30 June 2023 in the records of Masters Ltd. 3. State how Pacific Ltd should classify the lease. Give reasons for your answer. 4. Prepare a schedule of lease receipts for Pacific Ltd. 5. Prepare journal entries to record the lease transactions for the year ended 30 June 2023 in the records of Pacific Ltd. (LO3, LO4, LO6) 1.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

MASTERS LTD Lease payments schedule Lease Interest expense Reduction in payments (9%) liability $ $ $ 12 000 12 000 12 000 12 000 15 000 63 000

4 376 3 690 2 942 2 127 1 239 14 375

7 624 8 310 9 058 9 873 13 762 48 626

Balance of liability $ 48 626 41 002 32 693 23 635 13 762 —

10.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. Journal entries for Masters Ltd. 1 July 2022 Right-of-use crane Dr 48 626 Lease liability Cr 48 626 (Recognition of right-of-use asset and lease liability at the inception of the lease). 30 June 2023 Lease liability Interest expense Cash (First lease payment)

Dr Dr Cr

7 624 4 376 12 000

Depreciation expense Dr 9 125 Accumulated depreciation Cr 9 125 (Depreciation of the leased asset for the year = $9 125 = ($48 626 - $3 000) / 5 years) 3. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Pacific Ltd is a financier lessor. Accordingly, the initial direct costs are treated as part of the lessor’s investment in the lease. (b) Determine whether substantially all of the risks and rewards associated with ownership of the crane have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Cancellability test: The lease is cancellable, but a penalty equal to 50% of the total lease payments is payable on cancellation. Arguably, this condition implies that the lease transferred some risks and rewards to the lessee as the lessee may not want to cancel the lease considering the penalties payable. (ii) Transfer of ownership test: The crane will be returned to the lessor at the end of the lease term. Moreover, the lessee guarantees a part of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee. (iii) Lease term test: The lease term at 5 years is 62.5% of the crane’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee. (iv) Present value test: Applying the provided implicit rate in the lease to the lease payments, we find the present value of those payments to be 99.69% of the fair value of the crane (i.e. substantially all of that fair value). PV of LP = $12 000 x 3.8897 [T2 9% 5yrs] + $3 000 x 0.6499 [T1 9% 5yrs] = $46 676 + $1 950 = $48 626 PV of LP/FV = $48 626/$48 776 = 99.69%. Given the above evidence, the lessor will classify the transaction as a finance lease. 4. © John Wiley and Sons Australia Ltd, 2020

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Chapter 10: Leases

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

PACIFIC LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (9%) receivable $ $ $ 12 000 12 000 12 000 12 000 18 000 66 000

4 552 3 882 3 151 2 354 1 486 15 424

7 448 8 118 8 849 9 646 16 515 50 576

Balance of receivable $ 50 576 43 128 35 009 26 160 16 515 —

5. Journal entries for Pacific Ltd (lessor). 1 July 2022 Crane

Dr Cr

Cash (Purchase of crane)

48 776 48 776

Lease receivable Dr 50 576 Crane Cr Cash Cr (Recognition of lease receivable and payment of initial direct costs) 30 June 2023 Cash Lease receivable Interest revenue (First lease receipt)

Dr Cr Cr

48 776 1 800

12 000

7 448 4 552

10.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.17 Finance lease – manufacturer lessor Stella Ltd manufactures specialised equipment for both sale and lease. On 1 July 2022, Stella Ltd leased one of these equipment to Freddy Ltd, incurring $1200 in costs to prepare and execute the lease document. Freddy Ltd incurred $650 in costs to negotiate the agreement. The equipment being leased cost Stella Ltd $55 072 to manufacture. The equipment is expected to have an economic life of 6 years, after which time it will have a residual value of $950. The lease agreement details are as follows. Length of lease Commencement date Annual lease payment, payable 30 June each year commencing 30 June 2023 Residual value at the end of the lease term, fully guaranteed by Freddy Ltd Interest rate implicit in the lease

5 years 1 July 2022 $16 000 $8 000 8%

All insurance and maintenance costs are paid by Stella Ltd and amount to $3 000 per year and will be reimbursed by Freddy Ltd by being included in the annual lease payment of $16 000. The equipment will be depreciated on a straight-line basis. It is expected that Freddy Ltd will purchase the equipment from Stella Ltd at the end of the lease. Required 1. State how Stella Ltd should classify the lease. Give reasons for your answer. 2. Calculate the fair value of the leased equipment at 1 July 2022. 3. Prepare the journal entries to account for the lease in the books of Freddy Ltd for the year ended 30 June 2023. 4. Prepare a schedule of lease receipts for Stella Ltd. 5. Prepare the journal entries to account for the lease in the books of Stella Ltd for the year ended 30 June 2023. (LO3, LO4 and LO7) 1. (a) Determine whether the lessor is a financier or a manufacturer/dealer. This is essential as it changes the accounting treatment for initial direct costs paid by the lessor and the impacts on the determination of the interest rate implicit in the lease. Stella Ltd is a manufacturer lessor. Accordingly, the initial direct costs are not treated as part of the lessor’s investment in the lease. (b) Determine whether substantially all of the risks and rewards associated with ownership of the processing plant have been transferred to the lessee; that is, whether the lease is a finance lease or an operating lease. (i) Transfer of ownership test: The specialised equipment will be purchased by the lessee at the end of the lease term. Moreover, the lessee guarantees all of the residual value at the end of the lease, which may imply that the lease transferred some risks and rewards to the lessee. (ii) Lease term test: The lease term at 5 years is 83.33% of the equipment’s economic life. Arguably, this represents a major part of that economic life, which may imply that the lease transferred some risks and rewards to the lessee.

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Chapter 10: Leases

(iii) Present value test: Applying the formula to prove the implicit rate in the lease for a manufacturer lessor (initial direct costs to the lessor are no considered and there is no unguaranteed residual, we find the present value of the lease payments to be 100% of the fair value of the processing plant (i.e. all of that fair value). Given the above evidence, the lessor will classify the transaction as a finance lease by a manufacturer lessor. 2. PV of LP = ($16 000 - $3 000) x 3.9927 [T2 8% 5yrs] + $8 000 x 0.6806 [T1 8% 5yrs] = $51 905 + $5 445 = $57 350 FV

= PV of LP = $57 350.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

FREDDY LTD Lease payments schedule Lease Interest expense Reduction in payments (8%) liability $ $ $ 13 000 13 000 13 000 13 000 21 000 73 000

4 588 3 915 3 188 2 403 1 556 15 650

8 412 9 085 9 812 10 597 19 444 57 350

Balance of liability $ 57 350 48 938 39 853 30 041 19 444 —

1 July 2022 Right-of-use equipment Dr 58 000 Lease liability Cr 57 350 Cash Cr 650 (Recognition of right-of-use asset and lease liability at the inception of the lease) 30 June 2023 Lease liability Interest expense Executory expense Cash (First lease payment)

Dr Dr Dr Cr

8 412 4 588 3 000 16 000

Depreciation expense Dr 9 508 Accumulated depreciation Cr 9 508 (Depreciation of the leased asset for the year = $5 971 = ($58 000 - $950) / 6 years)

10.58

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

STELLA LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (8%) receivable $ $ $ 13 000 13 000 13 000 13 000 21 000 73 000

4 588 3 915 3 188 2 403 1 556 15 650

8 412 9 085 9 812 10 597 19 444 57 350

Balance of receivable $ 57 350 48 938 39 853 30 041 19 444 —

5. Journal entries for Stella Ltd (lessor). 1 July 2022 Lease receivable Cost of sales Inventories Sales revenue (Recognition of lease receivable) Lease costs Cash (Payment of initial direct costs) 30 June 2023 Cash Lease receivable Interest revenue Reimbursement revenue (First lease receipt) Insurance and maintenance expense Cash (Payment of executory costs)

Dr Dr Cr Cr

57 350 55 072

Cr Cr

1 200

Dr Cr Cr Cr

16 000

Dr Cr

3 000

55 072 57 350

1 200

8 412 4 588 3 000

3 000

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Chapter 10: Leases

Exercise 10.18 Finance lease — manufacturer lessor Gold Ltd manufactures specialised moulding machinery for both sale and lease. On 1 July 2022, Gold Ltd leased a machine to Silver Ltd, incurring $2 200 in costs to prepare and execute the lease document. The machine being leased cost Gold Ltd $220 000 to make and its fair value at 1 July 2022 is considered to be $251 990. The terms of the lease agreement are as follows: Lease term commencing on 1 July 2022 Annual lease payment commencing on 1 July 2023 Estimated useful life of machine (scrap value $0) Estimated residual value of machine at end of lease term Residual value guarantee by Silver Ltd Interest rate implicit in the lease The lease is classified as a finance lease by Gold Ltd.

5 years $72 000 8 years $9 000 $5 000 10%

The annual lease payment includes an amount of $7000 to cover annual maintenance and insurance costs. Actual executory costs for each of the 5 years were: 2022–23 2023–24 2024–25 2025–26 2026–27

$7 400 7 900 7 700 7 300 7 200

Silver Ltd may cancel the lease but will incur a penalty equivalent to 2 years’ payments if it does so. Silver Ltd intends to lease a new machine at the end of the lease term. The end of the reporting period for both companies is 30 June. Required 1. Prepare a schedule of lease payments for Silver Ltd. 2. Prepare the general journal entries to record the lease transactions for the year ended 30 June 2023 in the records of Silver Ltd. 3. Prepare a schedule of lease receipts for Gold Ltd. 4. Prepare the general journal entries to record the lease transactions for the year ended 30 June 2023 in the records of Gold Ltd. (LO3 and LO7) 1. PV of LP = $65 000 x 3.7908 [T2 10% 5yrs] + $5 000 x 0.62092 [T1 10% 5yrs] = $246 402 + $3 105 = $249 507 SILVER LTD Lease payments schedule © John Wiley and Sons Australia Ltd, 2020

10.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Date $ 1 July 2021 1 July 2022 1 July 2023 1 July 2024 1 July 2025 1 July 2026

Lease payments $

Interest expense (10%) $

Reduction in liability $

65 000 65 000 65 000 65 000 70 000 330 000

24 951 20 946 16 540 11 694 6 364 80 495

40 049 44 054 48 460 53 306 63 636 249 506

2. 1 July 2022 Right-of-use machinery Lease liability (Recognition of lease agreement)

Dr Cr

249 507

Dr Cr

24 951

Executory costs expense Dr Executory costs payable Cr (Recognition of executory costs payable)

7 500

30 June 2023 Interest expense Interest payable (Recognition of interest payable)

Balance of liability $ 249 507 209 457 165 403 116 943 63 638 —

249 507

24 951

7 500

Depreciation expense Dr 48 901 Accumulated depreciation Cr 48 901 (Depreciation of the leased asset for the year = ($249 507 – $5 000) / 5 years) 3.

Date $ 1 July 2021 1 July 2022 1 July 2023 1 July 2024 1 July 2025 1 July 2026 4. 1 July 2022 Lease receivable Cost of sales Inventories Sales revenue

GOLD LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (10%) receivable $ $ $ 65 000 65 000 65 000 65 000 74 000 334 000

25 199 21 219 16 841 12 025 6 727 82 011

Dr Dr Cr Cr

39 801 43 781 48 159 52 975 67 275 251 992

Balance of receivable $ 251 990 212 189 168 408 120 249 67 274 —

251 990 217 516*

220 000 249 506** 10.61

Chapter 10: Leases

(* Cost less PV of UGRV [$4 000 x 0.62092 [T1 10% 5yrs]]) (** PV of LP) Lease arrangement expense Cash

Dr Cr

2 200

1 July 2022 – 30 June 2023 Insurance and maintenance expense Cash

Dr Cr

7 400

30 June 2023 Interest receivable Interest revenue

Dr Cr

25 199

Dr Cr

7 000

Reimbursement receivable Reimbursement revenue

2 200

7 400

25 199

7 000

10.62

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 10.19 Lease classification, lease accounting Ascot Ltd enters into a 5-year agreement to lease an item of machinery from Eton Ltd on 1 July 2022. Ascot Ltd incurred costs of $3928 in setting up the lease agreement. The machinery has a fair value of $492 000 at the inception of the lease and it is expected to have an economic life of 6 years, after which time it will have a residual value of $45 000. The lease agreement details are as follows. Length of lease Commencement date Annual lease payment, payable 30 June each year commencing 30 June 2023 Residual value at the end of the lease term Residual value guarantee by Ascot Ltd Interest rate implicit in the lease The lease is cancellable without any penalties.

5 years 1 July 2022 $110 000 $100 000 $60 000 6%

All insurance and maintenance costs are paid by Eton Ltd and are expected to amount to $10 000 per year and will be reimbursed by Ascot Ltd by being included in the annual lease payment of $110 000. The machinery will be depreciated on a straight-line basis. It is expected that Ascot Ltd will return the machinery to Eton Ltd at the end of the lease. Required 1. Calculate the initial direct costs incurred by Ascot Ltd to negotiate the lease agreement. 2. Prepare the journal entries to account for the lease in the books of Ascot Ltd for the year ending 30 June 2023. 3. Prepare a schedule of lease receipts for Eton Ltd. 4. Prepare the journal entries to account for the lease in the books of Eton Ltd for the year ending 30 June 2023. (LO3 and LO7) 1. PV of LP = ($110 000 - $10 000) x 4.2124 [T2 6% 5yrs] + $60 000 x 0.7473 [T1 6% 5yrs] = $421 240 + $44 838 = $466 078 PV of UGRV

= $40 000 x 0.7473 [T1 6% 5yrs] = $29 892

Initial direct costs = PV of LP + PV of UGRV – FV = $3 970. 2. ASCOT LTD Lease payments schedule

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Chapter 10: Leases

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

Lease payments $

Interest expense (6%) $

Reduction in liability $

100 000 100 000 100 000 100 000 160 000 560 000

197 167 184 884 171 372 156 509 30 340 94 874

72 035 76 357 80 939 85 795 150 952 466 078

1 July 2022 Right-of-use machinery Dr Lease liability Cr Cash Cr (Recognition of lease asset and liability) 30 June 2023 Lease liability Interest expense Executory costs expense Cash (Second lease payment)

Dr Dr Dr Cr

Balance of liability $ 466 078 394 043 317 686 236 747 150 952 —

470 006 466 078 3 928

72 035 27 965 10 000 110 000

Depreciation expense Dr 82 001 Accumulated depreciation Cr 82 001 (Depreciation of the leased asset for the year = ($470 006 - $60 000) / 5 years) 3.

Date $ 1 July 2022 30 June 2023 30 June 2024 30 June 2025 30 June 2026 30 June 2027

ETON LTD Lease receipts schedule Lease Interest revenue Reduction in receipts (6%) receivable $ $ $ 100 000 100 000 100 000 100 000 200 000 600 000

4. 1 July 2022 Lease receivable Machinery Cash (Recognition of lease receivable)

29 758 25 544 21 076 16 341 11 311 92 719

Dr Cr Cr

70 242 74 456 78 924 83 659 188 689 495 970

Balance of receivable $ 495 970 425 728 351 272 272 348 188 689 —

495 970 492 000 3 970

30 June 2023 © John Wiley and Sons Australia Ltd, 2020

10.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cash

Dr Cr Cr Cr

110 000

Insurance and maintenance expense Dr Cash Cr (Executory costs for the 2023 financial year)

10 000

Lease receivable Interest revenue Reimbursement revenue (First lease receipt)

70 242 29 758 10 000

10 000

10.65

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 10: Leases Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 10: Leases Multiple choice questions 1. The new accounting standard for leases, AASB 16/IFRS 16, has introduced: *a. a single lessee accounting model for all leases with a term of more than 12 months. b. a multi lessee accounting model for all leases with a term of more than 12 months. c. a single lessee accounting model for all leases with a term of less than 12 months. d. a multi lessee accounting model for all leases with a term of less than 12 months. Answer: a Learning objective 10.1: explain the need for an accounting standard on leases.

2. The preface to AASB 16/IFRS 16 Leases states that the new standard will: a. enhance disclosures required of entities. b. provide a greater transparency of a lessee’s financial leverage and capital employed. c. result in a more faithful representation of a lessee’s assets and liabilities. *d. all of the above options. Answer: d Learning objective 10.1: explain the need for an accounting standard on leases.

3. Which of the following is included within the scope of AASB 16/IFRS 16? a. Lease agreements for motion picture films. b. Lease agreements to explore for minerals. *c. Lease agreement for an oil refinery. d. Lease agreements for biological assets. Answer: c Learning objective 10.2: discuss the characteristics of a lease.

4. AASB 16/IFRS 16 defines a lease as: a. a contract, or part of a contract, that conveys the right to transfer ownership of an asset (the underlying asset) for a period of time in exchange for consideration. *b. a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. c. a contract that conveys the right for the lessor to obtain substantially all of the economic benefits of the identified asset. d. a contract, or part of a contract, that conveys the right to transfer a liability for a period of time in exchange for an asset. Answer: b Learning objective 10.2: discuss the characteristics of a lease.

10.1

Testbank to accompany Financial reporting 3e by Loftus et al.

5. The rewards of ownership of an asset include the possibilities of gains related to: I. II. III.

Realisation of a residual value. Benefits obtained from profitable operation over the underlying asset’s economic life. Appreciation in the asset’s value.

a. I only. b. I and II only. *c. I, II and III. d. III only. Answer: c Learning objective 10.3: classify lease arrangements as operating leases or finance leases.

6. At the commencement of the lease agreement the lessor recognises the balance of the lease receivable as the: a. the nominal value of the lease payments receivable from the lessee. b. the present value of the lease payments receivable from the lessee. c. the present value of the residual value of the asset. *d. the present value of the lease payments receivable from the lessee and the present value of the unguaranteed residual value. Answer: d Learning objective 10.3: account for leases from the perspective of the lessee.

7. Which of the following is not an example of a risk of ownership of an asset? *a. Gains on the future sale of the asset. b. Changing economic conditions. c. Idle capacity. d. Technical obsolescence. Answer: a Learning objective 10.4: classify lease arrangements from the perspective of the lessor.

8. Which of the following is not one of the steps in the classification process of a finance lease? a. Analyse the lease to determine what risks and rewards are transferred from the lessor to the lessee. b. Identify the potential risks and rewards associated with the ownership of the asset. c. Assess whether the risks and rewards have been substantially passed to the lessee. *d. Determine what risks and rewards stay with the owner of the asset. Answer: d Learning objective 10. 4: classify lease arrangements from the perspective of the lessor.

10.2

Chapter 10: Leases Not for distribution in full. Instructors may assign selected questions in their LMS.

9. According to AASB 16/IFRS 16 Leases, because lease payments are received from the lessee over the lease term, the receipts need to be divided into the following components:

Reduction of the lease receivable Interest revenue earned Lease receipts Cost of sale expense

I Yes Yes Yes No

II Yes No Yes No

III No Yes Yes Yes

IV Yes No No Yes

*a) I. b) II. c) III. d) IV. Answer: a Learning objective 10.5: account for finance leases from the perspective of a financier lessor.

10. Barry Limited and Allen Limited enter into a finance lease agreement with the following terms: • • • • •

lease term is 4 years estimated economic life of the leased asset is 5 years 4 × annual rental payments of $15 000 each payable in advance residual value at the end of the lease term is not guaranteed by the lessee interest rate implicit in the lease is 8%.

On inception date, the present value of the lease payments is: *a. $53 656. b. $38 656. c. $49 682. d. $60 000. Answer: a Learning objective 10.5: account for finance leases from the perspective of a financier lessor.

10.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. Barry Limited and Allen Limited enter into a finance lease agreement with the following terms: • • • • •

The journal entry recorded by the lessor when the first lease payment is received would be: *a.

DR Cash 15 000 CR Lease receivable

15 000

DR Lease receivable CR Asset

15 000

15000

DR Cash 15 000 CR Interest revenue CR Lease receivable

5 175 9 825

DR Cash 15 000 CR Reimbursement revenue

15 000

Answer: a Learning objective 10.5: account for finance leases from the perspective of a financier lessor.

12. On 30 June 2021, Monty Ltd leased a motor vehicle to Taylor Ltd. Monty Ltd had purchased the motor vehicle on that day for its fair value of $68 346. The lease agreement cost Monty $1659 to have drawn up and requires Taylor to reimburse Monty for annual insurance costs of $1500. The amount recorded as a lease receivable by Monty Ltd at the inception of the lease is: a. $66 846. b. $69 849. *c. $70 005. d. $71 505. Answer: c Learning objective 10.5: account for finance leases from the perspective of a financier lessor.

10.4

Chapter 10: Leases Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Nichols Ltd manufactures specialised machinery for both sale and lease. On 1 July 2021, Nichols leased a machine to Pontine Ltd. The costs incurred by Nichols to set up the lease agreement were $1690. The machine cost Nichols Ltd $210 000 to manufacture, and its fair value at the inception of the lease was $232 890. The interest rate implicit in the lease is 10%, which is in line with current market rates. Under the terms of the lease, Pontine Ltd has guaranteed $22 000 of the asset’s expected residual value of $40 000 at the end of the 5-year lease term. Pontine Ltd agreed to pay an annual lease payment of $55 000 with the first payment due at the end of the first year. The debit to the sales revenue account in Nichols’ books is: a. $198 823. b. $210 000. *c. $222 154. d. $232 890. Answer: c Learning objective 10.6: account for finance leases from the perspective of a manufacturer/dealer lessor.

14. A finance lease is defined in AASB 16/IFRS 16 as: a. a lease that is not classified as an operating lease. b. a lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset. c. a rental agreement of less than 12 months’ duration. *d. a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Answer: d Learning objective 10.4: classify lease arrangements from the perspective of the lessor.

15. At the inception date of the lease, the fair value of the asset measures: a. the present value of the total benefits remaining with the lessor. *b. the present value of the total benefits associated with the asset. c. the total of the lease payments over the term of the lease. d. none of these options. Answer: b Learning objective 10.4: classify lease arrangements from the perspective of the lessor.

10.5

Testbank to accompany Financial reporting 3e by Loftus et al.

16. Which of the following is an appropriate journal entry for the initial recognition by a financier lessor of a finance lease arrangement? a. *b. c. d.

DR DR DR DR

Leased asset: CR Cash Lease receivable: CR Asset Lease receivable: CR Lease liability Leased asset: CR Cash/accounts payable

Answer: b Learning objective 10.5: account for finance leases from the perspective of a financier lessor.

17. AASB 16/IFRS 16 requires manufacturer and dealer lessors to recognise selling profit or loss: *a. at the commencement of the lease. b. at the end of the lease. c. systematically over the lease term. d. 50% at commencement of the lease and 50% at the end of the lease. Answer: a Learning objective 10.6: account for finance leases from the perspective of a manufacturer/dealer lessor.

18. Which of the following is an appropriate journal entry for the initial recognition by a manufacturer/dealer lessor? a. b. c. *d.

DR DR DR DR

Leased asset: Cash: Lease liability: Leased receivable:

CR CR CR CR

Cash Sales revenue Leased asset Sales revenue

Answer: d Learning objective 10.6: account for finance leases from the perspective of a manufacturer/dealer lessor.

19. Which of the following is an appropriate journal entry for the recognition by a lessor of the first payment received under an operating lease arrangement? a. b. *c. d.

DR DR DR DR

Lease expense: CR Cash Leased liability: CR Lease income Cash: CR Lease income Lease expense: CR Deferred initial direct costs

Answer: c Learning objective 10.7: account for operating leases from the perspective of a lessor.

10.6

Chapter 10: Leases Not for distribution in full. Instructors may assign selected questions in their LMS.

10.7

Testbank to accompany Financial reporting 3e by Loftus et al.

20. When negotiating operating leases, any initial direct costs incurred by lessors are to be: a. recognised as an expense over the lease term. b. initially capitalised into a separate deferred costs account. c. added to the carrying amount of the underlying asset. *d. all of the above. Answer: d Learning objective 10.7: account for operating leases from the perspective of a lessor.

21. On 1 July 2021, One Ltd leased a network server from Short Ltd. The server had cost Short Ltd $32 000 on the same day. The lease agreement cost Short Ltd $1390 to set up and included the following: Lease term 5 years Estimated economic life of the network server 10 years The lease is cancellable Annual rental payment (in arrears) $6500 Residual value at end of lease term $24 000 Residual guarantee by One Ltd $0 Interest rate implicit in the lease 8% The journal entry recorded by the lessor to recognise the initial direct costs incurred would be: a.

DR Lease expense CR Cash

$1390 $1390

*b.

DR Deferred initial direct costs - equipment $1390 CR Cash $1390

DR Lease expense $1390 CR Deferred initial direct costs - equipment $1390

DR Cash $1390 CR Deferred initial direct costs - equipment $1390

Answer: b Learning objective 10.7: account for operating leases from the perspective of a lessor.

10.8

Chapter 10: Leases Not for distribution in full. Instructors may assign selected questions in their LMS.

22. On 1 July 2021, One Ltd leased a network server from Short Ltd. The server had cost Short Ltd $32 000 on the same day. The lease agreement cost Short Ltd $1390 to set up and included the following: Lease term 5 years Estimated economic life of the network server 10 years The lease is cancellable Annual rental payment (in arrears) $6500 Residual value at end of lease term $24 000 Residual guarantee by One Ltd $0 Interest rate implicit in the lease 8% The journal entry recorded by the lessor for the annual recognition of the initial direct costs would be: a.

DR Deferred initial direct costs – equipment $278 CR Lease expense $278

DR Lease expense CR Cash

$278 $278

DR Cash $278 CR Deferred initial direct costs – equipment $278

*d.

DR Lease expense $278 CR Deferred initial direct costs – equipment $278

Answer: d Learning objective 10.7: account for operating leases from the perspective of a lessor.

23. AASB 16/IFRS 16 Leases requires lessors to account for lease receipts from operating leases as: *a. income, on a straight-line basis over the lease term. b. revenue, on a reducing balance basis over the lease term. c. income, on inception date of the lease. d. revenue, at the end of the lease term. Answer: a Learning objective 10.7: account for operating leases from the perspective of a lessor.

10.9

Testbank to accompany Financial reporting 3e by Loftus et al.

24. Under AASB 16/IFRS 16 Leases, lessees are required to disclose which of the following? I. II. III. IV.

Interest expense on lease liabilities Income from subleasing right-of-use assets Gains or losses arising from sale and leaseback transaction Expenses relating to short-term leases

a. I, II and III only. b. I, III and IV only. c. II, III and IV only. *d. I, II, III and IV only. Answer: d Learning objective 10.8: summarise the disclosure requirements regarding leases.

25. In relation to finance leases, the following information must be disclosed separately in the financial statements of lessors: I. II. III. IV.

The undiscounted lease payments to be received on an annual basis. A reconciliation of the undiscounted lease payments to the net investment in the lease. A reconciliation of the discounted unguaranteed residual value. The depreciation charge for each class of right-of-use asset.

*a. I, II and III only. b. I, III and IV only. c. II, III and IV only. d. II and IV only. Answer: a Learning objective 10.8: summarise the disclosure requirements regarding leases.

10.10

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Janice Loftus

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 11: Financial instruments

Chapter 11: Financial instruments Comprehension questions 1. Define a financial instrument and identify transactions that give rise to financial instruments and those that do not. Paragraph 11 of AASB 132/IAS 32 defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Transactions that do give rise to financial instruments: • Sale or purchase of goods or services on credit terms. • Deposit of cash with a financial institution. • Taking out a bank loan. • Buying or selling derivatives such as options. • Issue or purchase of ordinary shares. • Issue or purchase of debt securities. • Issue or purchase of convertible notes. Transactions that do NOT give rise to financial instruments: • Sale or purchase of goods or services for cash. • Prepayments. • Unearned revenue. • Commodity contracts. • Employee benefits. • Leases. • Warranty. • Insurance. 2. Define a financial asset and list some common examples. A financial asset is defined in paragraph 11 of AASB 132/IAS 32 as any asset that is: (a) cash (b) an equity instrument of another entity (c) a contractual right: (i) to receive cash or another financial asset from another entity or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity (d) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs © John Wiley and Sons Australia Ltd, 2020

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16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. Examples of financial assets (from figure 11.2): Definition Examples Paragraph 11(a) Cash on hand Deposit of cash with a bank or similar financial institution Paragraph 11(b) Shares held in another entity Paragraph Trade receivables 11(c)(i) Loans or advances to other entities Bills of exchange held Promissory notes held Secured, unsecured or convertible notes held Debentures held Bonds held Right to cash from a guarantor Paragraph Purchased call or put options for shares in another entity 11(c)(ii) Interest rate or currency rate swap agreements Forward exchange contracts Forward rate agreements Futures contracts Paragraph A contract to receive at a future date as many of the entity’s own equity 11(d)(i) instruments equal in value to $100 million Paragraph A contract to receive at a future date a variable number of the entity’s 11(d)(ii) own equity instruments equal in value to 100 ounces of gold at that date 3. Define a financial liability and list some common examples. A financial liability is defined in paragraph 11 of AASB 132/IAS 32 as any liability that is: (a) a contractual obligation: (i) to deliver cash or another financial asset to another entity or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (b) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. © John Wiley and Sons Australia Ltd, 2020 11.3

Chapter 11: Financial instruments

Examples of financial liabilities (from Figure 11.3): Definition Examples Paragraph Bank overdraft 11(a)(i) Trade payables Loans or advances from other entities Bills of exchange issued Promissory notes issued Secured, unsecured or convertible notes issued Debentures issued Redeemable preference shares issued Obligation to pay cash as a guarantor Paragraph Sold call or put options for shares in another entity 11(a)(ii) Interest rate or currency rate swap agreements Forward exchange contracts Forward rate agreements Exchange traded futures contracts Paragraph A contract to deliver at a future date as many of the entity’s own equity 11(b)(i) instruments as are equal in value to $100 million Paragraph A contract to deliver at a future date as many of the entity’s own equity 11(b)(ii) instruments as are equal in value to 100 ounces of gold at that date

4. Define a derivative and explain how a hybrid contract can have an embedded derivative. List some common examples of derivatives and embedded derivatives. Appendix A of AASB 9/IFRS 9 defines a derivative as a contract with three characteristics: (I) the value of the contract changes in response to an underlying — that is, a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable that is not specific to a party to the contract. (II) no initial net investment is required or it is smaller than for other types of contracts expected to have a similar response to changes in market factors. (III) settlement is at a future date. Paragraph 4.3.1 of AASB 9/IFRS 9 describes an embedded derivative as “a component of a hybrid contract that also includes a non-derivative host – with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative”. The embedded derivative causes some or all of the cash flows that would otherwise be required by the host contract to be modified, based on changes in an underlying price or index, such as a specified interest rate, exchange rate or commodity price. Examples of derivatives: • Futures contract: a standardized contract written by an exchange clearing house that can be traded and where settlement occurs at a specific time in the future based on a predetermined price without physical delivery. • Forward contract: a non-standardized contract written between two parties where settlement occurs at a specific time in the future based on a pre-determined price. • Option contract: a contract that gives the holder the right but not the obligation to buy or sell an underlying asset at a pre-determined price on or before a specific date. Exchange traded options do not require physical delivery. © John Wiley and Sons Australia Ltd, 2020

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•

Warrants: these are a form of option contracts that are exchange traded. Some warrants, such as investment warrants, give the holder the right to buy (or sell) the underlying instrument from (to) the issuer at a predetermined price. Some warrants, such as index warrants, give the holder the right to receive cash for the value of the option at a particular time. Swap contract: a contract to exchange cash on or before a specified time based on an underlying that is usually interest rates or exchange rates for currencies.

Examples of embedded derivatives: • Convertible notes: a security that has a face value and coupon rate but that entitles the holder to convert the note into a fixed number of ordinary shares. • Debt instrument with embedded option: there is an option to extend the term to maturity of a debt instrument without a concurrent interest rate adjustment. • Debt instrument with embedded futures: debt contract that pays interest based on the price of gold.

5. Define an equity instrument and explain how it differs to a financial liability. An equity instrument is defined in paragraph 11 of AASB 132/IAS 32 as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. An equity instrument is effectively the default category for an instrument that does not meet the definition of either financial asset or financial liability. Ordinary shares issued that cannot be put back to the company – non-puttable ordinary shares – are the most common example of an equity instrument. In accordance with paragraph 16 of AASB 132/IAS 32, the key difference between an equity instrument and a financial liability is that for an equity instrument there are: • no contractual obligations to deliver cash or another financial asset to another entity • no contractual obligations to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable • no contractual obligations to deliver a variable number of the entity’s own equity instruments. AASB 132/IAS 32 does not contain a clear hierarchy to be used in determining whether a financial instrument is a financial liability or an equity instrument of the issuer. Paragraph 15 of AASB 132/IAS 32 sets out the general principle: • The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. Interpreting the substance of contractual arrangements is the key. Consider the case of preference shares that have escalating ‘dividend’ payments if certain events occur, such that one would always expect the issuer to pay the dividend even if it is not strictly legally required to do so. Other guidance that assists in the classification for the issuer is below. © John Wiley and Sons Australia Ltd, 2020 11.5

Chapter 11: Financial instruments

Paragraph AG25 of AASB 132/IAS 32 explains that the classification of preference shares issued depends on the various rights that attach to the issue. Paragraphs 21-24 of AASB 132/IAS 32 deals with contracts that involve settlement in the entity’s own equity instruments – if the contract allows for net cash settlement or net share settlement, then the instrument is a financial asset or financial liability – if the contract requires gross physical settlement in a fixed number of shares, then there is an equity instrument only Paragraph 25 of AASB 132/IAS 32 deals with contingent settlement provisions – if the contractual arrangements require an entity to deliver cash or another financial asset based on uncertain future events, then the instrument is regarded as a financial liability except in limited circumstances Paragraph 26 of AASB 132 deals with settlement options for derivative financial instruments –the instrument is a financial asset or financial liability unless all settlement alternatives would result in it being classified as equity.

6. Explain why some preference shares are recognised as financial liabilities by the issuer while others are recognised as equity instruments. The substance of contractual arrangements must govern whether preference share issues are treated as equity instruments or equity issues. Preference shares take the legal form of an equity issue but may in substance be financial liabilities to the issuer. Consider the example of an issue of 10% redeemable preference shares that must be mandatorily redeemed after three years. In substance, the issue of these preference shares achieves the same result as agreeing to a three year bank loan at the fixed interest rate of 10%. Financial Liability v Equity Classification (from Illustrative example 11.2): From the perspective of the issuer Equity Financial liability 1. Ordinary shares √ 2. Preference Shares √ • Non-redeemable • Discretionary distributions 3. Preference Shares √ • Mandatorily redeemable • Non-discretionary distributions 4. Preference shares √ • Redeemable at option of holder • Conditional distributions 5. Preference shares √ • Redeemable at option of issuer • Conditional distributions

7. What is a convertible note? How does the issuer of convertible notes initially recognise the notes in its financial statements? A convertible note is a debt security with an embedded conversion option that makes the security convertible into ordinary shares of the issuer. © John Wiley and Sons Australia Ltd, 2020

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A convertible note is an example of a compound financial instrument that contains both a liability and an equity component Paragraph 28 of AASB 132/IAS 32 requires the issuer of a convertible note to present the liability component and the equity component separately in the statement of financial position. The liability component reflects the issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. The equity instrument is an embedded option to convert the liability into equity of the issuer. This option has value on initial recognition even when it is out of the money. The equity component is measured as the residual after allocating the proceeds of the issue to the liability component. Accounting for the issue of convertible notes is explained and illustrated in section 11.7 of the textbook. Convertible notes with a face value of $2 million pay interest annually in arrears at 6% p.a. The fair value of these obligations is the financial liability component and is calculated as $1 848 156 based on a discount rate of 9% p.a. The difference between the face value of the notes and the fair value of the debt obligations is $151 844. This difference is attributable to the conversion option and is the equity component.

8. Should the dividends on preference shares be recognised directly in equity or as an expense in profit or loss? Paragraph 35 of AASB 132/IAS 32 states that: • Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be debited by the entity directly to equity. Accordingly, if preference shares are classified as a financial liability, then the dividend distributions on the shares must be recognised as an expense in the profit or loss. In effect, the dividends are treated as if interest. In contrast, if preference shares are classified as an equity instrument, then the dividend distributions on the shares must be debited directly in equity. The debit will usually be against retained profits. It is also worth noting that in the calculation of basic earnings per share – a summary financial performance measure widely used by financial analysts when evaluating a company – preference share distributions are deducted in the calculation of earnings (i.e. profit) irrespective of whether the preference shares are classified as financial liabilities or equity instruments.

Chapter 11: Financial instruments

Examples: (a) Dividends paid on non-redeemable preference shares: - Dividends paid on non-redeemable preference shares – preference shares will be classified as equity instruments therefore dividends will be classified as a distribution to equity holders and included in the statement of changes in equity. (b) Dividends paid on preference shares redeemable at the holder’s option: - Dividends paid on preference shares redeemable at the holder’s option – preference shares will be classified as financial liabilities therefore the “dividends” will be classified as interest expense and included in the determination of profit or loss. 9. The initial recognition of a financial asset or financial liability is based on a ‘rights and obligations approach’. Discuss. The principle for initial recognition of a financial asset or financial liability is set out at paragraph 3.1.1 of AASB 9/IFRS 9: • An entity shall recognise a financial asset or financial liability in its statement of financial position when, and only when, the entity becomes a party to the contractual provisions of the instrument When an entity becomes subject to contractual rights and obligations, then it must recognise any financial asset or financial liability that arises from those rights and obligations. Examples at paragraph B3.1.2 of AASB 9/IFRS 9: • Unconditional receivables and payables are recognised as financial assets or liabilities when the entity becomes a party to the contract and, as a consequence, has a legal right to receive or a legal obligation to pay cash. Normal trade accounts receivable and trade accounts payable would fall into this category. • Assets to be acquired and liabilities to be incurred under a firm commitment to purchase or sell goods or services are generally not recognised until at least one of the parties has performed under the agreement, establishing a right and giving rise to an obligation of the counterparty. An entity that receives a firm order for the supply of goods does not recognise a financial asset at the date of the commitment but delays recognition until the ordered goods have been shipped or delivered. • Forward contracts within the scope of the standard are recognised as a financial asset or liability on the commitment date rather than on the date that settlement takes place. • Option contracts within the scope of the standard are recognised as financial assets or liabilities when the holder or writer becomes a party to the contract. • Planned future transaction, no matter how likely to occur, are not recognised as financial assets or financial liabilities because the entity is not party to a contract.

10. What is a regular way purchase or sale of a financial asset and what is the difference between trade date accounting and settlement date accounting? Appendix A of AASB 9/IFRS 9 states that a regular way purchase or sale is: • A purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. © John Wiley and Sons Australia Ltd, 2020

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The trade date is when the entity commits to purchase or sell the asset. A purchaser applying trade date accounting recognises the asset and corresponding liability on the trade date. A seller applying trade date accounting derecognises the asset and recognises a receivable and any associated gain or loss on disposal on the trade date. The settlement date is when the asset is delivered to or by an entity. A purchaser applying settlement date accounting recognises the asset and corresponding liability on the settlement date. A seller applying settlement date accounting derecognises the asset and recognises a receivable and any associated gain or loss on disposal on the trade date. Refer to Illustrative Example 11.5 for an example of trade date and settlement date accounting. 11. When does an entity set off a financial asset and financial liability for presentation in its statement of financial position? According to paragraph 42 of AASB 132/IAS 32: • A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an entity: (a) currently has a legally enforceable right to set off the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. Paragraph 49 of AASB 132/IAS 32 sets out examples where the conditions for set off are NOT met as follows: (a) Several different financial instruments are used to emulate the features of a single financial instrument, for example, a group of option contracts that is used to create a synthetic futures position. (b) Financial assets and financial liabilities that arise from financial instruments having the same primary risk exposure but that involve different counterparties (e.g. a portfolio of derivatives). (c) Financial or other assets pledged as collateral for non-recourse financial liabilities. (d) Financial assets set aside in a trust by a debtor for the purpose of discharging an obligation where those assets have not been accepted by the creditor in settlement of the obligation (a sinking fund arrangement). (e) Losses expected to be recovered from a third party by virtue of a claim under and insurance contract.

12. When does an entity derecognise a financial asset or financial liability? Derecognition of a financial liability is required when it is extinguished; that is, when the contractual obligation is settled, cancelled or has otherwise expired (AASB 9/IFRS 9 paragraph 3.3.1), or if there are substantial modifications to the terms of a loan contract such that the borrowing entity has effectively exchanged its original financial liability for a new financial liability (AASB 9/IFRS 9 paragraph 3.3.3). Paragraph 3.2.2 of AASB 9/IFRS 9 requires the derecognition of a financial asset if: (a) the contractual rights to cash flows from the financial asset have expired; (b) the entity has transferred the financial asset in such a way that it is no longer subject to the risks and rewards of ownership of the financial asset; or (c) the entity has transferred the financial asset so that it no longer has control of the asset. The factors to consider in deciding whether to derecognise a financial liability are illustrated in Figure 11.5, reproduced below. © John Wiley and Sons Australia Ltd, 2020 11.9

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13. How is the initial measurement of a financial asset determined? Explain how a gain or loss can arise on initial measurement of a financial asset. The general principle, prescribed by paragraph 5.1.1 of AASB 9/IFRS 9, is that on initial recognition, financial assets should be measured at fair value. Plus, transaction costs that are directly attributable to the acquisition of the financial asset, except if the financial asset is classified as fair value through profit or loss. Paragraph B5.1.2A of AASB 9/IFRS 9: • The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received) Difference between initial measurement at fair value and transaction price: if an entity determines that the fair value of a financial asset at initial recognition differs from the transaction price, the accounting treatment of the difference depends on how the fair value of the financial asset has been determined. The difference between the transaction price and fair value is recorded as a gain or loss if the fair value determined by: • a quoted price in an active market for identical asset (Level 1 input) • a valuation technique that uses only data from observable markets (Level 2 input). However, if the fair value is determined by other means (Level 3 input), the difference between fair value and transaction price is deferred and included in the initial measurement of the financial asset.

14. How is the initial measurement of a financial liability determined and how does it differ to the initial measurement of a financial asset? Based on paragraph 5.1.1 of AASB 9/IFRS 9, at initial recognition, an entity shall measure a financial liability at fair value. Less: (a) transaction costs that are directly attributable to the acquisition or issue of the financial liability except if the financial liability is classified as fair value through profit or loss. In effect there is no difference between the initial measurement of a financial liability and a financial asset. It should be noted that transaction costs are deducted instead of added in the measurement of a financial liability. The transactions costs incurred are by nature a debit, which means they are added in the initial measurement of a financial asset but deducted in the initial measurement of a financial liability.

15. Describe the various approaches to subsequent measurement of financial assets permitted by AASB 9 and the circumstances in which each approach may be applied. Paragraph 4.1.1 of AASB 9/IFRS 9 requires that an entity must classify financial assets as either subsequently measured at amortised cost or subsequently measured at fair value.

Chapter 11: Financial instruments

Amortised cost Paragraph 4.1.2 states that a financial asset can only be subsequently measured at amortised cost if it meets both of the following conditions: (a) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows; and (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Purchased debt securities or purchased and originated loans are examples of financial assets that may meet these two conditions. In accordance with Appendix A of AASB 9/IFRS 9, the amortised cost of a financial asset is the amount recognised at initial recognition less principal repayments add/less cumulative amortisation using the effective interest method, less any loss allowance. Fair value Paragraph 4.1.1 of AASB 9/IFRS 9 makes it clear that a financial asset is subsequently measured at fair value if subsequent measurement at amortised cost does not apply. Trading portfolios of equity instruments, debt securities held short term and derivatives are examples of financial assets that are subsequently measured at fair value. In accordance with Appendix A of AASB 9/IFRS 9, fair value of a financial asset is the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date (refer AASB 13/IFRS 13 Fair Value Measurement requirements covered at chapter 3 of the textbook) Subsequent measurement at fair value through other comprehensive income is allowed in two circumstances: • An entity can make an irrevocable election at initial recognition to use fair value through other comprehensive income for investments in equity instruments not held for trading (paragraphs 4.1.4 and 5.7.5 of AASB 9/IFRS 9). • If a financial asset that satisfies the cash flow test is held within a business model with the objective of generating returns by both collecting contractual cash flows and selling the financial asset (paragraph 4.1.2A of AASB 9/IFRS 9). The default classification Subsequent measurement at fair value is the default classification because paragraph 4.1.4 states that a financial asset shall be subsequently measured at fair value through profit or loss unless it is measured at amortised cost or at fair value through other comprehensive income. Further, for financial assets that qualify for subsequent measurement at amortised cost, paragraph 4.1.5 of AASB 9/IFRS 9 allows an entity at initial recognition to irrevocable designate a financial asset as measured at fair value through profit or loss if doing so eliminates or significantly reduces an accounting mismatch – that is inconsistency between measurement approach and how gains and losses on the asset are treated. Paragraph 4.4.1 of AASB 9/IFRS 9 explains how an entity may change its business model and this, and only this, can result in reclassifications of financial assets between the categories of subsequent measurement at amortised cost and subsequent measurement at fair value.

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16. Explain how financial assets that are debt instruments, equity instruments or derivatives may subsequently be measured. Debt instruments may be measured subsequent to initial recognition: • at amortised cost if both the cash flow test and are held within a business model whose objective is to hold assets in order to collect contractual cash flows • at fair value through other comprehensive income if the cash flow test is satisfied and it is held within a business model with the objective of generating returns by both collecting contractual cash flows • otherwise, at fair value through profit or loss. Equity instruments may be measured subsequent to initial recognition: • at fair value through profit or loss or • at fair value through other comprehensive income if the entity has made an irrevocable election to do so. Derivative instruments are measured subsequent to initial recognition at fair value through profit or loss.

17. Describe the subsequent measurement of financial liabilities. What is the default category for subsequent measurement of a financial liability? Paragraph 4.2.1 of AASB 9/IFRS 9 requires an entity to classify all financial liabilities as subsequently measured at amortised cost using the effective interest rate except: (a) financial liabilities subsequently measured at fair value through the profit or loss including derivatives (b) financial liabilities that arise when the transfer of a financial assets does not qualify for derecognition or when the continuing involvement in a financial asset approach applies (c) financial guarantee contracts as defined in Appendix A (d) commitments to provide a loan at a below-market interest rate. In accordance with Appendix A of AASB 9/IFRS 9, the amortised cost of a financial liability is the amount recognised at initial recognition less principal repayments add/less cumulative amortisation using the effective interest method. The effective interest method uses the effective interest rate to allocate interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments through the expected life of the financial liability to the net carrying amount of the liability. The default classification Subsequent measurement at amortised cost is the default classification because it applies in the absence of any other measurement being applicable. In contrast to financial assets, paragraph 4.4.2 of AASB 9/IFRS 9 prohibits financial liabilities from being reclassified for subsequent measurement.

Chapter 11: Financial instruments

18. Disclosures are required in respect of the nature and extent of risks arising from financial instruments. What are the usual risks and what details must be included in the disclosures. From Figure 11.10: Type of risk Description Market risk • Currency risk: the risk that the value of a financial instrument will fluctuate because of changes in foreign exchange rates. • Interest rate risk: the risk that the value of a financial instrument will fluctuate because of changes in market interest rates. For example, the issuer of a financial liability that carries a fixed rate of interest is exposed to decreases in market interest rates, such that the issuer of the liability is paying a higher rate of interest than the market rate. • Other price risk: the risk that the value of a financial instrument will fluctuate as a result of changes in market prices (other than those arising from interest rate risk or currency risk). Market risk embodies the potential for both loss and gain. Credit risk The risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. Liquidity The risk that an entity will encounter difficulty in meeting obligations risk associated with financial liabilities. This is also known as funding risk. For example, as a financial liability approaches its redemption date, the issuer may experience liquidity risk if its available financial assets are insufficient to meet its obligations. The required disclosures include: • Qualitative disclosures for each type of risk, such as how the risk arises and the entity’s objectives, policies and processes for managing the risk; • Quantitative disclosures for each type of risk, such as quantitative data about the exposure at the end of the reporting period based on information provided to key management personnel; • Credit risk - extensive disclosures about financial instruments subject to impairment provisions; • General credit risk information – for financial instruments not subject to impairment provisions, such as the amount of the maximum exposure, collateral held and information about the credit quality of financial assets that are neither overdue or impaired; • Credit risk collateral – details where the entity has taken possession of collateral; • Liquidity risk – maturity analyses distinguishing between derivative and non-derivative financial assets, and a description of how liquidity risk is managed; and

• Market risk – sensitivity analyses for each type of market risk (e.g., currency, interest rate), methods employed, assumptions and explanations of any change from previous periods.

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Case studies Case study 11.1 Financial instruments in the global financial crisis The global financial crisis (GFC) that began in 2007 gave rise to criticism of financial reporting, particularly in relation to the accounting treatment of financial instruments. The Financial Crisis Advisory Group (FCAG) identified four primary weaknesses: 1. difficulties in the application of fair value in illiquid markets 2. the delayed recognition of impairment losses resulting from the incurred loss approach adopted by IAS 39 Financial Instruments: Recognition and Measurement 3. the use of off-balance sheet financing, particularly in the US 4. the complexity of accounting standards for financial instruments. AASB 13/IFRS 13 Fair Value was issued in response to concerns about the application of fair value, along with additional disclosures introduced in AASB 7/IFRS 7 when level 3 inputs are used to measure fair value. Critics of fair value argued that it had a pro-cyclical effect and thus worsened the effects of the GFC on the financial system. They argued that falling financial asset prices during the GFC resulted in asset write-downs by financial institutions. Consequently, financial institutions were forced to sell financial assets in order to maintain capital adequacy prices. The forced asset sales arguably fuelled further reduction in prices, which exacerbated the effects of the GFC. Proponents of fair value countered the arguments of its critics by pointing out that, in most countries, the majority of financial assets held by financial institutions were measured using amortised cost. Further, where used, fair value provided more timely recognition of problems, thus facilitating resolution of problems and mitigating the effects of the GFC. In relation to financial assets carried at amortised cost by financial institutions, the FCAG (2009) concluded that: . . . the overall value of these assets has not been understated — but overstated. The incurred loss model for loan loss provisioning and difficulties in applying the model — in particular, identifying appropriate trigger points for loss recognition — in many instances has delayed the recognition of losses on loan portfolios.

Required Discuss the concerns about the accounting treatment of financial instruments raised in response to the global financial crisis. To what extent have these concerns been addressed by AASB 9/IFRS 9 and other changes in accounting standards? The Financial Crisis Advisory Group suggests that weaknesses in accounting for financial instruments contributed to the general loss of confidence during the Global Financial Crisis (GFC). The weaknesses identified are: © John Wiley and Sons Australia Ltd, 2020 11.15

Chapter 11: Financial instruments

1. The difficulty of applying fair value (‘mark to market’) accounting in illiquid markets. 2. The delayed recognition of losses associated with loans, structured credit products, and other financial instruments by banks, insurance companies and other financial institutions. 3. Issues surrounding off-balance sheet financing. 4. The complexity of the accounting standards for financial instruments. The difficulty of applying fair value accounting Fair value accounting overstated gains in a rising market and then losses when the market headed downwards. Falling asset prices necessitated write-downs that led to forced sales and then more falling prices. The recognition of losses affected capital adequacy requirements and led to fire sales and more losses with earnings numbers affected and market confidence drained. AASB 13/IFRS 13 Fair Value Measurement defines fair value as the amount that would be expected to be paid or received to transfer a liability or an asset in an orderly transaction between market participants. The preferred estimate of fair value is the observed price of an identical item in an active market. An illiquid market is not an active market. Observed prices from forced sales should not be used as a measure of fair value because a forced sale is not an orderly transaction. The delayed recognition of losses The majority of bank assets – for example, loan portfolios – were still valued on an amortised cost basis. Recognition of impairment was based on an incurred loss model under AASB 139/IAS 39. The recognition of losses on these assets was not timely. The market did not have timely information on the true financial position of various significant financial institutions and panic and a flight to cash was the result. The delayed recognition of losses is addressed by the implementation of the expected loss model to account for impairment under AASB 9/IFRS 9. Off balance sheet financing Again the issue is that obscurity of financial affairs can mean panic and confusion if events occur that are likely to cause financial stress to a financial institution. The problem of offbalance sheet financing through special purpose vehicles was primarily under US generally accepted accounting principles (US GAAP). Complexity There is complexity in the range and nature of financial instruments but also in the accounting standards that describe how these instruments should be recognised and measured. Different categorisation of financial assets can have significant effects on their measurement, which increases the complexity of accounting for financial instruments. Attempts have been made to simplify accounting for financial instruments. However, the classification scheme adopted by AASB 9/IFRS 9 underpins a mixed measurement model. Similar assets may be accounted for differently, due to differences in business models under which they are held or, in some cases, as a result of irrevocable designations or elections. If you read AASB 9, then you will find that it is very challenging document and not easily translated into simple descriptions about what accounting is required. The standard is full of cross-referencing and long worded paragraphs. It also raises fair value accounting as one of the issues.

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Case study 11.2 Financial instruments and performance reporting Find and read the following article: Horton, J & Macve, R 2008, ‘“Fair value” for financial instruments: how erasing theory is leading to unworkable global accounting standards for performance reporting’, Australian Accounting Review, vol. 10, no. 21, May, pp. 26–39. Required Provide a brief summary of the authors’ main criticisms. The article by Horton and Macve raises criticisms of the approach to accounting for financial instruments advocated by the IASC, the Joint Working Group and the FASB. The concerns focus on accounting for the implications of changes in interest rates (which include the effects of inflation), changes in creditworthiness and hedging activities, particularly where the hedged item is not yet recognised. Changes in interest rates The authors disagree with recognition of gains or losses in financial performance arising from financial liabilities being remeasured because of changes in interest rates. The authors reject the notion of maintaining a capital value in this case. The authors argue that when interest rates change the relevant concept for capital maintenance is the capacity to maintain the level of cash flows in the future to meet interest commitments. The fall in value of fixed interest investments does not reduce a company’s ability to continue to meet its interest obligations on its issued debentures and to pay dividends to shareholders out of the unchanged cash flows it is still receiving Changes in creditworthiness The authors point to the classic case of a downgrade in a company’s creditworthiness leading to the recognition of a gain because its borrowings have a lower value. The authors argue that there is a fundamental inconsistency in the accounting treatment for loan capital and equity capital because the equity ownership interest is not measured at current value. They argue that recognition of changes in the creditworthiness of liabilities would accentuate this inconsistency. The authors argue that changing valuation should take account of the changing valuation of all expected future cash flows: • But there would be an equal if not greater “loss” to equity from the downgrading of the expected value, first of any “goodwill”, then of the value of assets, and finally of any expectation of receiving a residual payout given the priority of debtholders. Hedges The authors point to the mismatch that arises when financial instruments are hedging operating assets and activities that are not reported at current value or are hedging transactions that are yet to occur.

Chapter 11: Financial instruments

Application and analysis exercises Exercise 11.1 Identification of financial assets, financial liabilities and equity instruments Which of the following items qualify as a financial asset, financial liability or equity instrument within the scope of AASB 9/IFRS 9? Give reasons for your answers. 1. Cash held 2. Investment in a debt security 3. Investment in a subsidiary 4. Provision for restoration of a mine site 5. Buildings owned by the reporting entity 6. Income tax payable 7. Provision for employee benefits 8. Deferred revenue 9. Prepayments 10. Forward exchange contract 11. Investment in 3% of the ordinary shares of a private company 12. A percentage interest in an unincorporated joint venture 13. A non-controlling interest in a partnership 14. A non-controlling interest in a discretionary trust 15. An investment in an associate 16. A forward purchase contract for delivery of a commodity, e.g. wheat that is settled only by physical delivery 17. Forward contract entered into by a gold producer to sell gold that is settled net in cash 18. Leases 19. Trade receivables 20. Loan receivables 21. Debentures issued 22. Bank borrowings 23. Ordinary shares issued 24. Call options held for shares in Telstra Corporation Limited 25. Call options written for shares in Telstra Corporation Limited 26. Convertible notes issued (LO2, LO3, LO5 and LO6) This solution is based on AASB 132/IAS 32 Financial Instruments: Presentation, taking into consideration scope exclusion of AASB 9/IFRS 9 Financial Instruments. Refer to paragraph 4 for the scope of the Standard. Refer to paragraph 11 of AASB 132/IAS 32 for the definitions of financial asset, financial liability and equity instrument. Item

Financial Asset Definition 1. Cash held Paragraph 11(a) 2. Investment in debt security Paragraph 11(c)(i) 10. Forward exchange contract Gaining: Paragraph 11(c)(ii)

Financial Liability Equity Definition Instrument Definition

Losing: Paragraph 11(a)(ii)

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11. Investment in private company 18. Finance leases

Paragraph 11(b)

19. Trade receivables 20. Loan receivables 21. Debentures issued 22. Bank borrowings 23. Ordinary shares issued 24. Call options held 25. Call options written 26. Convertible notes issued

Item 1. Investment in subsidiary 2. 3. 4. 5.

Provision for restoration Buildings owned Income tax payable Provision for emp. benefits

6. Deferred revenue 7. Prepayments 10. Interest in joint venture 11. Interest in a partnership 12. Interest in a disc. trust 13. Investment in associate 14. Forward contract for wheat 15. Forward contract for gold 16. Leases

Excluded by AASB 9, paragraph 2.1(b)(i) Paragraph 11(c)(i) Paragraph 11(c)(i)

Excluded by AASB 9, paragraph 2.1(b)(ii)

Paragraph 11(a)(i) Paragraph 11(a)(i) Paragraph 11 Paragraph 11(c)(ii) Paragraph 11(a)(ii) Debt component Paragraph 11(a)(i)

Option component Paragraph 11

Does not meet definitions or excluded Excluded by AASB 132/IAS 32 paragraph 4(a) and AASB 9/IFRS 9, paragraph 2.1(a) Does not relate to exchange with another entity Physical asset Income taxes are levied not contractual AASB 132/IAS 32 paragraph 4(b) and AASB 9/IFRS 9, paragraph 2.1(c) Obligation to provide goods or services Right to goods or services Excluded by AASB 132/IAS 32 paragraph 4(a) and AASB 9/IFRS 9, paragraph 2.1(a) Excluded by AASB 132/IAS 32 paragraph 4(a) A discretionary trust does not give rise to a contractual right Excluded by AASB 132/IAS 32 paragraph 4(a) and AASB 9/IFRS 9, paragraph 2.1(a) Contract for the exchange of physical commodity Contract for the exchange of physical commodity Excluded by AASB 9, paragraph 2.1(b)(i) and (ii)

Chapter 11: Financial instruments

Exercise 11.2 Subsequent measurement of financial assets and financial liabilities The trainee accountant at Daffodil Ltd is unsure how to measure a number of items included in its financial records and has asked for your advice. Identify whether each of the following is a financial asset or financial liability and explain on what basis it must be subsequently measured. 1. 2. 3. 4. 5. 6. 7.

Trade receivables Primary borrowings of $2 million carrying a variable interest rate 4-year government bonds held paying interest of 5% p.a. Investment in a long-term portfolio of shares listed on the ASX Investment in a trading portfolio of shares listed on the ASX Purchased loans held for short periods before being on-sold Mandatorily converting notes held, paying coupon interest of 8% p.a. — the notes must convert to a variable number of ordinary shares at the expiration of their term 8. Mandatorily redeemable preference shares with a cumulative dividend rate of 4% p.a. — the preference shares must be redeemed for cash at their expiration in five years, held within a business model with the objective of collecting contractual cash flows 9. Call or put options held on shares in Solar Corporation Ltd 10. Call or put options written on shares in Solar Corporation Ltd 11. ASX SPI 200 Futures contract with a negative fair value 12. ASX SPI 200 Futures contract with a positive fair value (LO2, LO3, LO13 and LO15) Item

Classification

1. Trade receivables 2. Primary borrowings 3. Government bonds held

4. 5. 6. 7.

Subsequent Measurement Financial Asset Amortised cost Financial Liability Amortised cost Financial Asset Amortised cost or fair value, depending on the business model under which they are held Financial Asset FVTPL or FVOCI Financial Asset FVTPL Financial Asset FVTPL Financial Asset FVTPL or FVOCI

Investment in long-term share portfolio Investment in trading portfolio Purchased loans held for on-sale Convertible notes held having mandatory conversion option 8. Preference shares held having mandatory Financial Asset redemption 9. Call/Put options held in Solar Corp Financial Asset 10. Call/Put options written inn Solar Corp Financial Liability 11. Futures contract ASX Index (negative) Financial Liability 12. Futures contract ASX Index (positive) Financial Asset Index FVTPL = Fair value through profit or loss FVOCI = Fair value through other comprehensive income © John Wiley and Sons Australia Ltd, 2020

FVTPL or FVOCI FVTPL FVTPL FVTPL FVTPL

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Exercise 11.3 Forward to buy shares Wallace Ltd enters a forward contract to buy its own ordinary shares after 12 months at a fixed forward price. Wallace Ltd has a contractual obligation based on the forward price and it has a contractual right based on the market price at the maturity date. Wallace Ltd is considering a range of different alternatives for the settlement of the contract. Details of the contract are: Contract date Maturity date Market price per share on 1 February 2023 Market price per share on 31 December 2023 Market price per share on 31 January 2024 Fixed forward price per share on 31 January 2024 Present value of forward price on 1 February 2023 Number of shares under the forward contract Fair value of forward contract on 1 February 2023 Fair value of forward contract on 31 December 2023 Fair value of forward contract on 31 January 2024

1 February 2023 31 January 2024 $5.00 $5.10 $5.05 $5.03 $5.00 2 000 000 Nil $540 000 $180 000

Required Prepare the entries of Wallace Ltd for the forward purchase contract on its own shares assuming the company has a year end of 31 December and that the contract will be settled: 1. Cash for cash (net cash settlement) 2. Shares for shares (net share settlement) 3. Cash for shares (gross physical settlement) (LO5) 1. Cash for cash (net cash settlement): In this case the contract gives rise to either a financial asset or financial liability because there is: • a contractual right to receive cash from another entity (financial asset) • a contractual obligation to deliver cash to another entity (financial liability). 1 February 2023 No entry, fair value = $0 31 December 2023 Forward contract Dr Gain on forward contract (P&L) Cr

540 000 540 000

Chapter 11: Financial instruments

(Subsequent measurement at fair value, $540 000 - $0) 31 January 2024 Loss on forward contract (P&L) Dr 360 000 Forward contract Cr (Subsequent measurement at fair value, $180 000 - $540 000)

360 000

31 January 2024 Cash Dr 180 000 Forward contract Cr 180 000 (Settlement of contract, realised gain of $180 000) The question and solution assume that Wallace Ltd has an annual reporting date of 31 December. If Wallace Ltd has a half year reporting date of 30 June, then the contract would also have to be remeasured to fair value on that date. 2. Shares for shares (net share settlement): Net share settlement means the contract is settled by a variable number of the entity’s own equity instruments dependent on the price at settlement date. In this case the contract gives rise to either a financial asset or financial liability because there is: • a contract that will be settled in the entity’s own equity instruments • a derivative that will be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. Paragraph AG36 of AASB 132: • An entity’s own equity instruments are not recognised as a financial asset regardless of the reason for which they are reacquired. Paragraph 33 requires an entity that reacquires its own equity instruments to deduct those equity instruments from equity. 1 February 2023 No entry, fair value = $0 31 December 2023 Forward contract Dr 540 000 Gain on forward contract (P&L) Cr (Subsequent measurement at fair value, $540 000 - $0) 31 January 2024 Loss on forward contract (P&L) Dr 360 000 Forward contract Cr (Subsequent measurement at fair value, $180 000 - $540 000) 31 January 2024 Share capital Dr 180 000 Forward contract Cr (Settlement of contract, realised gain of $180 000)

540 000

360 000

180 000

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The final entry must be debited against equity. Share capital is the equity account shown in the solution but another equity account could be used, for example, ‘Share Repurchase Reserve’. Section 259A of the Corporations Act, 2001 generally prohibits a company from acquiring shares in itself unless for the purpose of an authorised buy back, employee share scheme or financing arrangement of a financial institution. If a company acquires shares in itself, then subsequently the company should cancel the shares or transfer the shares to a third party. 3. Shares for cash (gross physical settlement): Gross physical settlement means the contract is settled by the exchange of a fixed amount of cash for a fixed number of shares. In this case the contract gives rise to an equity instrument because there is: • a contract that will be settled in the entity’s own equity instruments • a derivative that will be settled only by the issuer exchanging a fixed amount of cash for a fixed number of its own equity instruments. 1 February 2023 No entry as an equity instrument 31 December 2023 No entry as an equity instrument 31 January 2024 Share capital Dr Cash Cr (Settlement of contract, 2 000 000 x $5.03)

10 060 000 10 060 000

The final entry must be debited against equity. Share capital is the equity account shown in the solution but another equity account could be used, for example, ‘Share Repurchase Reserve’.

Chapter 11: Financial instruments

Exercise 11.4 Distinguishing financial liabilities from equity instruments Determine whether Aster Ltd has a financial liability or equity instrument resulting from the issue of securities in each situation below. Give reasons for your answer. 1. Aster Ltd issues 100 000 $1 convertible notes. The notes pay interest at 7% p.a. The market rate for similar debt without the conversion option is 9%. Each note is not redeemable, but it converts at the option of the holder into however many shares that will have a value of exactly $1. 2. Aster Ltd issues 100 000 $1 redeemable convertible notes. The notes pay interest at 5% p.a. Each note converts at any time at the option of the holder into one ordinary share. The notes are redeemable at the option of the holders for cash after 5 years. Market rates for similar notes without the conversion option are 7% p.a. 3. Aster Ltd issues 100 000 $1 redeemable convertible notes. The notes pay interest at 5% p.a. Each note converts at any time at the option of the holder into one ordinary share. The notes are redeemable at the option of the issuer for cash after 5 years. If after 5 years the notes have not been redeemed or converted, they cease to carry interest. Market rates for similar notes without the conversion option are 7% p.a. 4. Aster Ltd issues 100 000 $1 redeemable convertible notes. The notes pay interest at 5% p.a. The notes are redeemable after 5 years at the option of the issuer for cash or for a variable number of shares (calculated according to a formula). If after 5 years the notes have not been redeemed or converted, they continue to carry interest at a new market rate to be determined at the expiration of the 5 years. 5. Aster Ltd issues redeemable preference. The shares are redeemable at the expiration of five years at the option of the holder. The shares carry a cumulative 6% dividend. 6. Aster Ltd issues redeemable preference shares. The shares carry a cumulative 6% dividend. The shares are redeemable for cash if the company makes an accounting loss in any year. Aster Ltd is highly profitable and has a history of profits and paying ordinary dividends at a yield of about 4% annually without fail for the past 25 years. The market interest rate for long-term debt at the time the preference shares were issued was 7% p.a. (LO6) Paragraph 16 of AASB 132: When an issuer applies the definitions in paragraph 11 to determine whether a financial instrument is an equity instrument rather than a financial liability, the instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met. (a) The instrument includes no contractual obligation: (i) to deliver cash or another financial asset to another entity or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the issuer. (b) If the instrument will or may be settled in the issuer’s own equity instruments, it is: (i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments or (ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. © John Wiley and Sons Australia Ltd, 2020

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1. 100 000, $1, 7% convertible notes – non-redeemable, convertible at the option of holder,

convertible into variable number of ordinary shares: Equity Instrument

Financial Liability Contractual obligation to deliver variable number of own equity instruments means there is no equity risk. A financial liability in full: refer to paragraph 16(b)

2. 100 000, $1, 5% convertible notes – redeemable for cash at the option of the holder after 5

years, convertible at the option of the holder at any time, convertible for a fixed number of ordinary shares: Equity Instrument Equity component for the conversion option as it relates to a fixed number of own equity instruments: refer para 16(b). The equity component is initially measured as the difference between issue proceeds and financial liability component.

Financial Liability Contractual obligation to pay annual interest and principal at the end of 5 years. Financial liability component is initially measured as the present value of the interest and principal discounted at equivalent rate of 7% p.a. for pure play debt security.

Option to convert = $100 000 – $91 801 = $8 PV = $100 000 x 0.7130 [T1 7% 5yrs] + $5 199 000 x 4.1002 [T2 7% 5yrs] = $91 801 3. 100 000, $1, 5% convertible notes – redeemable for cash at the option of the issuer after 5

years, convertible at the option of the holder, convertible for a fixed number of ordinary shares, interest ceases after 5 years if redemption or conversion not completed: Equity Instrument Equity component for the conversion option as it relates to a fixed number of own equity instruments: refer paragraph 16(b). The equity component is initially measured as the difference between issue proceeds and financial liability component

Financial Liability Contractual obligation for annual interest only. The issuer does not have a contractual obligation to repay principal at redemption since redemption is at the issuer’s option. Financial liability component is initially measured as the present value of the interest discounted at equivalent rate of 7% p.a. for Option to convert = $100 000 – $20 501 = pure play debt security. $79 499 PV = $5 000 x 4.1002 [T2 7% 5yrs] = $20 501 4. 100 000, $1, 5% convertible notes – redeemable for cash or a variable number of own

equity instruments at the option of the issuer after 5 years, interest adjusted to new market rate after 5 years: Equity Instrument

Financial Liability Contractual obligation for annual interest only. The issuer does not have a contractual obligation to repay principal because any © John Wiley and Sons Australia Ltd, 2020 11.25

Chapter 11: Financial instruments

redemption is at the issuer’s option. Variable number of own equity instruments means there is no equity risk. In substance, a perpetuity to annual interest at market rate. 5. 6% preference shares – redeemable for cash on maturity date at the option of the holder,

cumulative dividend distributions: Equity Instrument

Financial Liability Contractual obligation for annual dividends and to repay principal if demanded by the holder at maturity. A financial liability classification is appropriate here.

6. 6% preference shares – not redeemable as right to redeem is conditional. Cumulative dividend distributions; the contractual obligation is limited to the dividends Equity Instrument Financial Liability Classification as equity is appropriate here; The obligation is limited to the dividends. refer AASB 132/IAS 32, paragraph AG26 The intention to make distributions of dividends does not affect the classification of the shares.

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Exercise 11.5 Convertible notes issue including financial liability at amortised cost On 1 July 2021 Scarecrow Ltd issues convertible notes with a face value of $6 million. The convertible notes have a 20-year term and mature on 30 June 2041. Interest is payable semiannually in arrears, i.e. on 31 December and 30 June each year, and the coupon rate of interest is 7.5% p.a., At around the same point in time, companies with a similar credit rating issue debt securities without a conversion option with a coupon rate of 10% p.a., payable semiannually. Required 1. Explain why the coupon rate to holders of the convertible notes is less than the rate of return offered to investors in the debt securities of other similar companies. 2. Determine the debt and equity components of the convertible notes issued using the residual valuation method. 3. Prepare the entries of Scarecrow Ltd to account for the convertible notes over the period 1 July 2021 to 30 June 2024. (LO7) 1. The issuer of the convertible notes has contractual obligations to make semi-annual interest payments and return principal at the end of the 20 year term. The issuer is also giving the holder of the notes an option to acquire ordinary shares at some point in the future. If the option is for a fixed number of ordinary shares, then the attached option has the character of a valuable call option. In exchange for giving the holder of the convertible note a valuable option, the issuer requires the holder to accept a lower interest rate than would be the case for a pure debt security. 2. In the residual method, an amount is assigned to the financial liability component of the compound financial instrument. The amount assigned to the equity component is the residual, that is, the difference between the proceeds of the issue and the amount assigned to the financial liability component. The advantage of the residual method is the simplicity with which the equity component is determined using the implied value from the issue price for the security. Financial liability component = $852 276 + $3 860 798 = $4 713 074 Equity component = $6 000 000 – $4 713 074 = $1 286 926 The discount rate is 10% p.a. paid semi-annually or 5% per half year whilst the interest coupon is 7.5% p.a. paid semi-annually or 3.75% per half year Present value of principal = $6 000 000 x 0.142046 = $852 276. Working for present value factor: Solve for rate paid annually equivalent to 10% p.a. paid semi-annually (1+r)^1 = (1.05)^2 r = (1.05)^2 – 1 = 0.1025 PV factor = 1/(1.1025)^20 = 0.142046 Present value of interest stream = $6 000 000 x 0.0375 x 17.1591 = $3 860 798. Working for annuity factor: Annuity factor = [1 – (1+r)^-n]/r = 1 – (1.05)^-40 = 17.1591

Chapter 11: Financial instruments

3. Period # 1 2 3 4 5 6

Opening Balance 4 713 074 4 723 728 4 734 914 4 746 660 4 758 993 4 771 942

Interest Rate 0.05 0.05 0.05 0.05 0.05 0.05

Interest Expense 235 654 236 186 236 746 237 333 237 950 238 597

Payment Amortisation 3.75% 225 000 10 654 225 000 11 186 225 000 11 746 225 000 12 333 225 000 12 950 225 000 13 597

Closing Balance 4 723 728 4 734 914 4 746 660 4 758 993 4 771 942 4 785 540

Dr Cr Cr

6 000 000 4 713 074 1 286 926

31 December 2021 Interest expense Convertible notes liability Cash (First interest payment)

Dr Cr Cr

235 654

30 June 2022 Interest expense Convertible notes liability Cash (Second interest payment)

Dr Cr Cr

236 186

31 December 2022 Interest expense Convertible notes liability Cash (Third interest payment)

Dr Cr Cr

236 746

30 June 2023 Interest expense Convertible notes liability Cash (Fourth interest payment)

Dr Cr Cr

237 333

31 December 2023 Interest expense Convertible notes liability Cash (Fifth interest payment)

Dr Cr Cr

237 950

1 July 2021 Cash Convertible notes liability Option to convert notes (Issue of convertible notes)

Period End Dec-21 Jun-22 Dec-22 Jun-23 Dec-23 Jun-24

10 654 225 000

11 186 225 000

11 746 225 000

12 333 225 000

12 950 225 000

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30 June 2024 Interest expense Convertible notes liability Cash (Sixth interest payment)

Dr Cr Cr

238 597 13 597 225 000

Chapter 11: Financial instruments

Exercise 11.6 Convertible notes issue including financial liability at amortised cost On 1 July 2024, Parade Ltd issues 2000 convertible notes. The notes have a three-year term and are issued at par with a face value of $1000 per note, giving total proceeds at the date of issue of $2 million. The notes pay interest at 4% p.a. annually in arrears. The holder of each note is entitled to convert the note into 250 ordinary shares of Parade Ltd at contract maturity. When the notes are issued, the prevailing market interest rate for similar debt (similar term, similar credit status of issuer and similar cash flows) without conversion options is 8% p.a. Hence at the date of issue:

Required Prepare the journal entries of Parade Ltd to account for the convertible notes for each year ending 30 June under the following circumstances. 1. The holders do not exercise their option and the note is repaid at the end of its term. 2. The holders exercise their conversion option at the expiration of the contract term. (LO7)

Date

1 July 2024 30 June 2025 30 June 2026 30 June 2027

Amortised cost of convertible note liability Interest Interest Difference paid Expense (8%) $ $ $ 80 000 80 000 80 000 240 000

143 507 148 587 154 074 446 168

Liability $ 1 793 832 1 857 339 1 925 926 2 000 000

63 507 68 587 74 074 206 168

1. 1 July 2024 Cash

Dr 2 000 000 Convertible notes liability Cr 1 793 832 Option to convert notes* Cr 206 168 (Issue of 2 000 convertible notes for cash) * Option to convert notes is an equity account. It is initially measured as the difference between the proceeds from the note issue ($2 000 000) and the present value of the note liability based on the market rate for equivalent debt ($1 793 832). 30 June 2025 Interest expense Convertible notes liability Cash (First interest payment)

Dr Cr Cr

143 507

63 507 80 000

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30 June 2026 Interest expense Convertible notes liability Cash (Second interest payment)

Dr Cr Cr

148 587

30 June 2027 Interest expense Convertible notes liability Cash (Third interest payment)

Dr Cr Cr

154 074

68 587 80 000

74 074 80 000

Convertible notes liability Dr 2 000 000 Cash Cr (Redemption of 2 000 convertible notes for cash) 2. 1 July 2024 Cash

Dr Convertible notes liability Cr Option to convert notes* Cr (Issue of 2 000 convertible notes for cash)

2 000 000

2 000 000 1 793 832 206 168

* Option to Convert Notes is an equity account. It is initially measured as the difference between the proceeds from the note issue ($2 000 000) and the present value of the note liability based on the market rate for equivalent debt ($1 793 832). 30 June 2025 Interest expense Convertible notes liability Cash (First interest payment)

Dr Cr Cr

143 507

30 June 2026 Interest expense Convertible notes liability Cash (Second interest payment)

Dr Cr Cr

148 587

30 June 2027 Interest expense Convertible notes liability Cash (Third interest payment)

Dr Cr Cr

154 074

63 507 80 000

68 587 80 000

Convertible notes liability Dr 2 000 000 Share capital Cr (Conversion of 2 000 convertible notes into ordinary shares)

74 074 80 000

2 000 000

Chapter 11: Financial instruments

Exercise 11.7 Trading shares Asha Ltd is an investment company that trades in shares on the Australian Securities Exchange. Asha Ltd measures the shares at fair value through the profit or loss. Asha Ltd makes the following trades in Telco Ltd. Trade date

Quantity

Price

Buy/Sell

Brokerage

8 June 2022 15 June 2022 30 June 2022

20 000 80 000 40 000

$6.00 $6.20 $5.50

Buy Buy Sell

$1 000 $1 600 $800

Settlement date is T+2 meaning that settlement of trades occurs two business days after trade date. The closing market price for shares in Telco at 30 June 2019 is $5.60. Required Prepare the entries of Asha Ltd on the basis of: 1. trade date accounting 2. settlement date accounting. (LO9) Extract from the accounting policy note of an Australian investment company: Valuation of Trading Portfolio Securities, including listed and unlisted shares and options, are initially brought to account at market value, which is the cost of acquisition, or proceeds in the case of options written, and are revalued to market values continuously. ‘Continuously’ means revalue every time there is a sale and also at the end of the period. The result is the net gain/loss on trading. 1. Trade date accounting for shares classified as a financial asset at fair value through profit or loss. 8 June 2022 Shares in Telco Ltd Dr 120 000 Brokerage expense Dr 1 000 Payable to broker Cr (Acquisition of shares in Telco Ltd) 10 June 2022 Payable to broker Dr 121 000 Cash Cr (Settlement of the share acquisition from 8 June) 15 June 2022 Shares in Telco Ltd Brokerage expense Payable to broker (Acquisition of shares in Telco Ltd)

Dr Dr Cr

121 000

496 000 1 600

497 600

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17 June 2022 Payable to broker Dr 497 600 Cash Cr (Settlement of the share acquisition from 15 June) 30 June 2022 Loss on shares in Telco Ltd Dr 66 000 Shares in Telco Ltd Cr (Loss on shares in Telco Ltd = 100 000 x $5.50 - $616 000) 30 June 2022 Receivable from broker Brokerage expense Shares in Telco Ltd (Sale of shares in Telco Ltd)

Dr Dr Cr

497 600

66 000

219 200 800 220 000

30 June 2022 Shares in Telco Ltd Dr 6 000 Gain on shares in Telco Ltd Cr (Gain on shares in Telco Ltd = 60 000 x ($5.60 - $5.50))

6 000

Check for 30 June 2022: • Shares on hand = 60 000 x $5.60 = $336 000 • Shares (journals) = $120 000 + $496 000 – $66 000 – $220 000 + $6 000 = $336 000 • Net loss on shares = $66 000 – $6 000 = $60 000 2 July 2022 Cash

Dr Receivable from broker Cr (Settlement of the share sale from 30 June)

219 200 219 200

2. Settlement date accounting for shares classified as a financial asset at fair value through profit or loss. 10 June 2022 Shares in Telco Ltd Brokerage expense Cash (Acquisition of shares in Telco Ltd)

Dr Dr Cr

120 000 1 000

17 June 2022 Shares in Telco Ltd Brokerage expense Cash (Acquisition of shares in Telco Ltd)

Dr Dr Cr

496 000 1 600

121 000

30 June 2022 Loss on shares in Telco Ltd Dr 56 000 Shares in Telco Ltd Cr (Loss on shares in Telco Ltd = 100 000 x $5.60 - $616 000)

497 600

56 000

Chapter 11: Financial instruments

Check for 30 June 2022: • Shares on hand = 100 000 x $5.60 = $560 000 • Shares (journals) = $120 000 + $496 000 – $56 000 = $560 000 • Loss on shares = $56 000 In contrast to the solution for trade date accounting, the sell trade on 30 June 2022 is not brought to account at year end because the settlement date occurs on 2 July 2022. This solution assumes no change in fair value of the Telco shares between the trade date, 30 June 2022, and the settlement date, 2 July 2022.

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Exercise 11.8 Accounting for loan assets at amortised cost Finale Ltd is a manufacturing company that makes loans to other parties from time to time. The loan assets are classified by Finale Ltd as subsequently measured at amortised cost. Finale Ltd does not apply the simplified approach to impairment of loans receivable. In accounting for impairment losses, Finale Ltd classifies all loans as remaining at stage 1 from inception to maturity. On 1 July 2022, Finale Ltd made the following loans: (a) A 3-year loan of $1 million to Grate Ltd at an interest rate of 15% p.a. due annually in arrears on 30 June each year. Grate Ltd incurred transaction costs of $97 749 in respect of this loan to arrange charges for security. Finale Ltd estimates 12-months expected credit loss as $20 000. (b) A 3-year loan of $1 million to American Ltd at an interest rate of 10% p.a. with interest due only on settlement at 30 June 2022. Finale Led estimates 12-months expected credit loss as $10 000. (c) A 3-year loan of $1 million to an employee, Mr Whale. The loan is interest free in recognition of his loyalty to the company. Finale Led estimates 12-months expected credit loss as $30 000. Required Prepare the entries of Finale Ltd to account for the three loans from initial recognition on 1 July 2022 to derecognition on 30 June 2022, assuming loans are fully paid on maturity. (LO14) (a) Loan to Grate Ltd, $1 000 000, 3 years, interest due each year 15% p.a. Initial measurement = fair value + transaction costs = $1 000 000 + $97 749 = $1 097 749. Annual interest received = 15% x $1 000 000 = $150 000. Effective interest rate: solve equation by trial and error. 1 097 749 = $150 000/(1+r) + $150 000/(1+r)^2 + $150 000/(1+r)^3 + $1 000 000/(1+r)^3 r = 11% Amortised cost of loan receivable Period # 1 2 3

Opening Balance 1 097 749 1 068 501 1 036 036

Interest Rate 0.11 0.11 0.11

Interest Income 120 752 117 535 113 964

Interest Received 150 000 150 000 150 000

1 July 2022 Loan receivable – Grate Ltd Dr Cash Cr (Initial measurement of loan receivable) 30 June 2023 Cash Loan receivable – Grate Ltd

Dr Cr

Amortisation 29 248 32 465 36 036

Closing Balance 1 068 501 1 036 036 1 000 000

Period End Jun-23 Jun-24 Jun-25

1 097 749 1 097 749

150 000 29 248

Chapter 11: Financial instruments

Interest income (First interest receipt)

120 752

Impairment loss Dr 20 000 Loss allowance Cr (Recognition of 12 months expected credit losses) 30 June 2024 Cash Loan receivable – Grate Ltd Interest income (Second interest receipt)

Dr Cr Cr

150 000

30 June 2025 Cash Loan receivable – Grate Ltd Interest income (Third interest receipt)

Dr Cr Cr

150 000

Dr Cr

1 000 000

Dr Cr

20 000

Cash Loan receivable – Grate Ltd (Receipt of the loan principal) Loss allowance Impairment loss reversal (Reversal of excess loss allowance)

20 000

32 465 117 535

36 036 113 964

1 000 000

20 000

(b) Loan to American Ltd, $1 000 000, 3 years, interest due on settlement 10% p.a. Initial measurement = fair value = $1 000 000. Interest received on settlement = 10% x $1 000 000 x 3 = $300 000. Effective interest rate: solve equation by trial and error. $1 000 000 = $1 300 000/(1+r)^3 r = 9.1393% Or by using tables: Present value factor = 1 000 000/1 300 000 = 0.769231, n = 3. Amortised cost of loan receivable Period Opening Interest Interest Interest AmortisClosing Period # Balance Rate Income Received ation Balance End 1 1 000 000 0.091393 91 393 0 91 393 1 091 393 Jun-23 2 1 091 393 0.091393 99 746 0 99 746 1 191 139 Jun-24 3 1 191 139 0.091393 108 861 300 000 (191 139) 1 000 000 Jun-25 Rounding the effective interest rate to say 9.14% would result in a rounding difference of $25 in the final period but this would still give an acceptable answer to the question. 1 July 2022 © John Wiley and Sons Australia Ltd, 2020

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Loan receivable – American Ltd Dr Cash Cr (Initial measurement of loan receivable)

1 000 000 1 000 000

30 June 2023 Loan receivable – American Ltd Dr 91 393 Interest income Cr (Accrual of the interest for the 2023 financial year)

91 393

Impairment loss Dr 10 000 Loss allowance Cr (Recognition of 12 months expected credit losses)

10 000

30 June 2024 Loan receivable – American Ltd Dr 99 746 Interest income Cr (Accrual of the interest for the 2024 financial year) 30 June 2025 Cash Dr Loan receivable – American Ltd Cr Interest income Cr (Interest receipt on settlement) Cash

Dr Loan receivable – American Ltd Cr (Receipt of the loan principal) Loss allowance Dr Impairment loss reversal Cr (Reversal of excess loss allowance)

99 746

300 000 191 139 108 861

1 000 000 1 000 000 10 000 10 000

(c) Loan to Mr Whale, $1 000 000, 3 years, interest-free. Initial measurement = fair value = $1 000 000 / (1+r)^3. Where: r is the market rate of interest for a similar loan. Assume r = 10% p.a. for zero coupon debt instruments with 3 year term. Fair value = $1 000 000 / (1.10)^3 = $751 315 Paragraph B5.1.1 of AASB 9: • The fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received). However, if part of the consideration given is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument. For example, the fair value of a longterm loan or receivable that carries no interest can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a

Chapter 11: Financial instruments

similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset. In this case, the extra amount lent is to reward Mr Whale for his employee loyalty. Consideration given for loan = $1 000 000. Fair value of loan receivable = $751 315. Employee Expense = $248 685. Amortised cost of loan receivable Period # 1 2 3

Opening Balance 751 315 826 446 909 091

Interest Rate 0.10 0.10 0.10

Interest Income 75 131 82 645 90 909

Interest Received 0 0 0

1 July 2022 Loan receivable – Mr Whale Dr Employee expense Dr Cash Cr (Initial measurement of loan receivable)

Amortisation 75 131 82 645 90 909

1 000 000

30 June 2024 Loan receivable – Mr Whale Dr 82 645 Interest income Cr (Accrual of the interest for the 2024 financial year) 30 June 2025 Loan receivable – Mr Whale Dr 90 909 Interest income Cr (Accrual of the interest for the 2025 financial year) Loan receivable – Mr Whale (Receipt of the loan principal) Loss allowance Impairment loss reversal (Reversal of excess loss allowance)

Period End Jun-23 Jun-24 Jun-25

751 315 248 685

30 June 2023 Loan receivable – Mr Whale Dr 75 131 Interest income Cr (Accrual of the interest for the 2023 financial year) Impairment loss Dr 30 000 Loss allowance Cr (Recognition of 12 months expected credit losses)

Cash

Closing Balance 826 446 909 091 1 000 000

Dr Cr

1 000 000

Dr Cr

30 000

75 131

30 000

82 645

90 909

1 000 000

30 000

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Exercise 11.9 Various financial assets and financial liabilities Santiago Adventures Ltd has entered into a number of contracts that are financial instruments as follows: (a) On 1 July 2021, the company acquired 100 000 shares in Telex Corporation Ltd as a long-term investment at a cost of $500 000. The year-end market prices of Telex shares were $6.50 on 30 June 2022 and $5.50 on 30 June 2020. (b) On 1 April 2022, the company acquired 100 000 exchange traded call options in Westside Banking Corporation Ltd at a cost of $3.00 per option. The options have an exercise price of $38.00 and mature on 22 November 2022. The options have a fair value to the holder of $4.00 each on 30 June 2022 and $5.20 each on 22 November 2022 when the options are exercised. (c) On 1 October 2021, the company wrote 100 000 exchange traded call options in FoodCo Ltd at a premium of $2.50 per option. The options have an exercise price of $40.00 and mature on 20 July 2022. FoodCo share price is $39.00 on 20 July 2016. The options have a fair value to the holder of $1.50 each on 30 June 2022 and nil each on 20 July 2022. (d) On 1 March 2022, the company takes a sell position on 50 units of ASX SPI 200 Futures. Each contract unit is valued at $25 per index point. The ASX SPI Futures Index is 5800 on 1 March 2022, 6500 on 30 June 2022 and 5500 on 22 September 2022 when the company closes out its position. Required Prepare the entries of Santiago Adventures Ltd for any financial assets or financial liabilities that arise in each case. (LO12 and LO13) (a) Shares in Telex Corporation Ltd as long term investor – investment in equity instrument. Paragraph 5.7.5 of AASB 9 permits an entity, on initial recognition, to make an irrevocable election to account for an equity instrument at fair value through other comprehensive income, if it is not held for trading. If the election is made – gains and losses recognised in other comprehensive income: 1 July 2021 Shares in Telex Corporation Ltd Dr 500 000 Cash Cr (Acquisition of shares in Telex Corporation Ltd)

500 000

30 June 2022 Shares in Telex Corporation Ltd Dr 150 000 Gain on shares in Telex (OCI) Cr 150 000 (Gain on shares in Telex Corporation Ltd = 100 000 x ($6.50 - $5.00)) 30 June 2023 Loss on shares in Telex (OCI) Dr 100 000 Shares in Telex Corporation Ltd Cr 100 000 (Loss on shares in Telco Corporation Ltd = 100 000 x ($5.50 - $6.50)) © John Wiley and Sons Australia Ltd, 2020 11.39

Chapter 11: Financial instruments

If the election is NOT made – gains and losses recognised in profit or loss: 1 July 2021 Shares in Telex Corporation Ltd Dr 500 000 Cash Cr (Acquisition of shares in Telex Corporation Ltd)

500 000

30 June 2022 Shares in Telex Corporation Ltd Dr 150 000 Gain on shares in Telex (P&L) Cr 150 000 (Gain on shares in Telex Corporation Ltd = 100 000 x ($6.50 - $5.00)) 30 June 2023 Loss on shares in Telex (P&L) Dr 100 000 Shares in Telex Corporation Ltd Cr 100 000 (Loss on shares in Telco Corporation Ltd = 100 000 x ($5.50 - $6.50)) (b) Bought call options in Westside Banking Corporation Ltd are a financial asset that is a derivative. Financial assets that are derivatives are accounted for at fair value through profit or loss unless certain hedging rules apply: 1 April 2022 Bought call options - Westside Dr 300 000 Cash Cr 300 000 (Acquisition of call options in Westside Banking Corporation Ltd) 30 June 2022 Bought call options - Westside Dr 100 000 Gain on call options (P&L) Cr 100 000 (Gain on call options in Westside Banking Corporation Ltd = 100 000 x ($4 - $3)) 22 November 2022 Bought call options - Westside Dr 120 000 Gain on call options (P&L) Cr 120 000 (Gain on call options in Westside Banking Corporation Ltd = 100 000 x ($5.20 - $4)) Shares in Westside Dr 4 320 000 Bought call options - Westside Cr Cash Cr (Exercise of options = 100 000 x ($38 + $5.20))

520 000 3 800 000

(c) Written call options in FoodCo Ltd are a financial liability that is a derivative. Financial liabilities for written call options are derivatives and accounted for at fair value through the profit or loss unless certain hedging rules apply: 1 October 2021 Cash Written call options – FoodCo

Dr Cr

250 000

250 000 11.40

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(Written call options in FoodCo Ltd) 30 June 2022 Written call options - FoodCo Dr 100 000 Gain on call options (P&L) Cr (Gain on call options in FoodCo Ltd = 100 000 x ($2.5 - $1.5))

100 000

20 July 2022 Written call options - FoodCo Dr 150 000 Gain on call options (P&L) Cr 150 000 (Settlement of call options in FoodCo Ltd = 100 000 x ($1.50 - $0)) (d) Sold 50 units of ASX SPI Futures is a derivative that may be a financial asset or financial liability. Futures contracts are accounted for at fair value through the profit or loss unless certain hedging rules apply: Date ASX SPI 200 Fair value of Gain/(Loss) on Futures Index contract Sell Contract (50  $25  Index) 1 March 2022 5 800 $7 250 000 30 June 2022 6 500 $8 125 000 ($875 000) 22 September 2022 5 500 $6 875 000 $1 250 000 Realised gain 375 000 1 March 2022 No entry 30 June 2022 Loss on futures contract (P&L) SPI futures contract liability (Measurement at reporting date)

Dr Cr

875 000

22 September 2022 SPI futures contract asset Dr 375 000 SPI futures contract liability Dr 875 000 Gain on futures contract (P&L) Cr (Remeasurement of futures contract at settlement) Dr 375 000 SPI futures contract asset Cr (Settlement of futures contract = 50 x $25 x (5 800 – 5 500))

875 000

1 250 000

Cash

375 000

Chapter 11: Financial instruments

Exercise 11.10 Netting off a financial asset and financial liability In each of the situations below, state whether the financial asset and financial liability must be offset in the books of Company A as at 30 June 2022, and explain why. 1. Company X owes Company B $750 000, due on 30 June 2025. Company Y owes Company X $450 000, due on 30 June 2025. A legal right of set-off between the two companies is documented in writing, and the parties have indicated their intent to settle the amounts on a net basis. 2. Company X owes Company Y $750 000, due on 30 June 2023. Company Y owes Company X $450 000, due on 31 March 2023. A legal right of set-off between the two companies is documented in writing, and the parties have indicated their intent to settle amounts owing between the two parties on a net basis whenever possible. 3. Company X owes Company Y $750 000, due on 30 June 2023. Company Z owes Company X $450 000, due on 30 June 2023. 4. Company X owes Company Y $750 000, due on 30 June 2023. Company Z owes Company X $750 000, due on 30 June 2023. A legal right of set-off between the three companies is documented in writing, and the parties have indicated their intent to settle the amounts on a net basis. 5. Company X owes Company Y $750 000, due on 30 June 2024. Company X has plant and equipment with a fair value of $500 000 that it pledges to Company Y as collateral for the debt. (LO10) Paragraph 42 of AASB 132/IAS 32: A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when and only when, an entity: (a) currently has a legally enforceable right to set off the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Scenario

Paragraph Paragraph 42(a) 42(b)

1. X owes Y $750 000 due on 30 June 2025. Y owes X $450 000 due on 30 June 2026. Although a legal right of set-off exists, settlement on a net basis is unlikely because the amounts are not due on the same dates. 2. X owes Y $750 000 due on 30 June 2023. Y owes X $450 000 due on 31 March 2023. Although a legal right of set-off exists and parties intend to settle net, the amounts cannot be settled net as they are not due on the same dates. 3. X owes Y $750 000 due on 30 June 2023. Z owes X $450 000 due on 30 June 2023. The amounts relate to different counterparties and there is no

Offset

√

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indication of any agreement between them – refer paragraph 49(b) of AASB 132/IAS 32. 4. X owes Y $750 000 due on 30 June 2023. Z owes X $750 000 due on 30 June 2023. Legal right of set-off exists between the three parties, amounts due on the same dates, intent and ability to settle on a net basis. 5. X owes Y $750 000 due on 30 June 2024. X has plant and equipment with a fair value of $750 000 that it pledges to Y as collateral for the debt. Conditions in paragraph 42 generally not satisfied and offsetting usually inappropriate when Plant and equipment pledged as collateral for a non-recourse liability – refer paragraph 49(c) of AASB 132/IAS 32.

√

Yes

Chapter 11: Financial instruments

Exercise 11.11 Purchases debt instrument with impairment On 1 January 2025, Biz Banking Ltd purchases a debt instrument with a 5-year term for its fair value of $1 000 million (including transaction costs). The instrument has a principal amount of $1250 million (the amount payable on redemption) and carries fixed interest of 4.7% paid annually in arrears on 31 December. The annual cash interest income is thus $59 million ($1 250 million  0.047 rounded to nearest million). Using a financial calculator, the effective interest rate is calculated as 10%. The debt instrument is classified as subsequently measured at amortised cost. At 31 December 2025 Biz Banking Ltd assesses that the credit risk of the debt instrument has not changed significant since initial recognition and that 12-months expected credit loss is $1 million. There is no significant change in credit risk until 2024. During that year, the issuer of the debt instrument faces financial difficulties. By 31 December 2024 it becomes likely that the issuer and it becomes probable that the issuer will of the debt instrument will be placed into receivership. The lifetime expected credit loss of the debt instrument is estimated to be $500 million on 31 December 2024, calculated by discounting the expected future cash flows at 10%. No cash flows are received during 2024. At the end of 2025, Biz Banking Ltd receives a letter stating that the issuer will be able to meet all of its remaining obligations, including interest and repayment of principal. Required Prepare the entries of Biz Banking Ltd for all years from initial recognition to derecognition of the financial asset. (LO9, LO11, LO13 and LO14) Amortised cost of purchased debt instrument (no impairment) A. Year 2022 2023 2024 2025 2026

B. Amortised cost at beginning of year $m 1 000 1 041 1 086 1 136 1 190

C. Interest (B  10%) $m 100 104 109 113 119

D. Interest cash flows $m 59 59 59 59 1 309

E. Amortised cost at end (B+C-D) $m 1 041 1 086 1 136 1 190 -

Amortised cost of purchased debt instrument (with impairment) A. Year

2022 2023 2024 2025 2026

B. Amortised cost at beginning of year $m 1 000 1 041 1 086 695 1 190

C. Interest (B x 10%) $m 100 104 109 70 119

D. Interest cash flows $m 59 59

E. Impairment Loss/(Reversal) $m

59 1 309

500 (485)

F. Amortised cost at end (B+C-D-E) $m 1 041 1 086 695 1190 -

The lifetime expected loss is $500 million at the end of 31 December 2024. The amortised cost, excluding the loss allowance, would have been $1 195 million. Thus the asset carrying amount must be $695 million after recognising the lifetime expected loss of $500 million. This is achieved through an impairment loss of $499 million, which increasing the loss allowance from $1 million to $500 million. The full amount of the loss allowance is shown in the table above because when the financial asset enters stage 2 of impairment, the carrying amount, net of the © John Wiley and Sons Australia Ltd, 2020

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impairment allowance, forms the basis of subsequent amortisation. At the end of 31 December 2025, the asset carrying amount must be adjusted to $1 190 million through an impairment reversal of $484 million, which reduces the expected loss allowance to $15 million. The impairment loss is not fully reversed for two reasons: 1. the impairment loss includes the effect of the non-payment of interest in 2024 ($59 million) 2. the recognition of the life-time expected loss in 2024 reduced subsequent amortisation in 2025 by $45 million ($11 million instead of $55 million). 1 January 2022 Investment in debt security Cash (Acquisition of debt instrument)

Dr Cr

1 000 1 000

31 December 2022 Cash Dr 59 Investment in debt security Dr 41 Interest income Cr (Interest and cash received for the 2022 financial year) Impairment loss Dr 1 Loss allowance Cr (12 months expected loss) 31 December 2023 Cash Dr 59 Investment in debt security Dr 45 Interest income Cr (Interest and cash received for the 2023 financial year) 31 December 2024 Investment in debt security Interest income (Interest for the 2024 financial year)

Dr Cr

109

Impairment loss Dr Loss allowance Cr (Impairment loss for 2024 financial year)

499

31 December 2026 Cash Loss allowance Investment in debt security Interest income

104

109

499

31 December 2025 Cash Dr 59 Investment in debt security Dr 11 Interest income Cr (Interest and cash received for the 2025 financial year) Loss allowance Impairment loss reversal (12 months expected loss)

100

Dr Cr

484

Dr Dr Cr Cr

1 309 15

484

1 205 119

Chapter 11: Financial instruments

(Interest and cash received for the 2025 financial year) Exercise 11.12 Applying accounting theory Northern Tours Ltd needs to raise $500 000 to finance the acquisition of a new tour bus. It approached an investment bank that proposed the following alternatives: (a) the issue of 8%, cumulative preference shares for $500 000 with a fixed redemption date 5 years from the date of issue (8% cumulative preference shares) (b) the issue of 10%, non-cumulative, preference shares for $500 000, redeemable at the option of the issuer (10% non-cumulative preference shares). The preference share issue is planned for 2022. The accountant prepared an abridged projected statement of financial position for Northern Tours Ltd s at 30 June 2021, based on the company’s master budget. The projected statement of financial position excludes the effects of the proposed preference share issue or the investment in the new tour bus.

Additional information • Northern Tours Ltd estimates profit before interest and tax (EBIT) as $420 000. This estimate is based on prior years’ performance, adjusted for the effects of the additional tour bus. • Interest expense in relation to a bank loan included in ‘Liabilities’ = $100 000 • Northern Tours Ltd’s bank loan includes a debt covenant which specifies a maximum leverage ratio (total liabilities/total assets) of 60%. • The company has investigated alternative sources of funding and found that most lenders require it to have maintained interest coverage (EBIT/Interest expense) greater than 3.0. • Management receives a bonus of 2% of profit before tax, provided the return on investment (EBIT/total assets) exceeds 12%. Required 1. Calculate Northern Tours Ltd’s leverage ratio at 30 June 2021 based on the projected statement of financial position. 2. How should the 8% cumulative preference shares be classified in accordance with AASB 132/IAS 32? Justify your classification. 3. Prepare a journal entry to record the annual dividend payable on the 8% cumulative preference shares. 4. Using the projected figures and estimates provided, calculate Northern Tours Ltd’s leverage ratio and interest coverage assuming the company issues the 8% cumulative preference shares. 5. How should the 10% non-cumulative preference shares be classified in accordance with AASB 132/IAS 32? Justify your classification. © John Wiley and Sons Australia Ltd, 2020

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6. Prepare a journal entry to record the annual dividend payable on the 10% noncumulative preference shares. 7. Using the projected figures and estimates provided, calculate Northern Tours Ltd’s leverage ratio and interest coverage assuming the company issues the 10% noncumulative preference shares. 8. Compare Northern Tours Ltd’s profit before tax for each financing alternative. 9. Drawing on agency theory (refer chapter 2), explain which financing arrangement would be preferred by management. Where relevant, refer to your analysis of financial statement implications in parts 2 to 8. (LO6, LO6, LO13 and LO14) 1. Leverage ratio = 60% ($1 500 000/$2 500 000). 2. Although the 8% cumulative preference shares are in the legal form of equity the preference share issue would be classified as a liability in accordance with AASB 132, paragraph 11, 15, 16, AG25. This occurs because the fixed redemption at maturity gives rise to an obligation. 3. 8% x $500 000 = $40 000 Interest expense (P&L) Preference dividend payable

Dr Cr

40 000 40 000

4. Liabilities and assets would increase by $500 000 as a result of the issue of the 8% cumulative preference shares. Leverage ratio = 66.7% [($1 500 000 + $500 000)/($2 500 000 + $500 000)]. Interest coverage = Profit before interest and taxes / Interest expense. The dividend is accounted for as an interest expense (refer to the answer to question 3). Interest coverage = 3 times [$420 000 / ($100 000 + $40 000)]. 5. The 10% non-cumulative preference shares would be classified as equity in accordance with AASB 132, paragraphs 11, 15, 16, AG25. This occurs because Northern Tours Ltd has no obligation to redeem the preference shares. 6. 10% x $500 000 = $50 000 Dividend declared (retained earnings) Preference dividend payable

Dr Cr

50 000 50 000

7. Assets increase by $500 000 as a result of the non-cumulative preference share issue. Leverage ratio = 50% [$1 500 000 / ($2 500 000 + $500 000)]. Interest coverage = Profit before interest and taxes /Interest expense. Interest coverage = 4.2 times [$420 000/$100 000]

Chapter 11: Financial instruments

8. The profit before tax will be lower with the 8% cumulative preference share issue because the dividend would be accounted for an expense in profit or loss, consistent with the classification of the preference shares as a liability. Northern Tours Ltd’s profit before tax with the 8% cumulative preference shares would be $380 000 ($420 000 – 8% x $500 000), compared with $420 000 if the company raises the finance through the issue of 10% non-cumulative preference shares. 9. According to agency theory, management is more likely to prefer the 10% non-cumulative preference share issue because it is classified as equity. This would reduce the company’s leverage from 60% to 50%, which is below the maximum permitted in the debt covenant in the bank loan. In contrast, the classification of the 8% non-cumulative preference share issue as a liability would increase reported leverage to 66.7%, which will put Northern Tours Ltd in breach of its loan contract with the bank. Further, classification of the 10% non-cumulative preference shares as equity would keep interest coverage greater than 3.0, which would make it easier to refinance or obtain additional finance if required. The application of agency theory also suggests that management would prefer the 10% noncumulative preference share issue because it results in a higher profit before tax. Although the ROI is 14% [$420 000 / ($2 500 000 + $500 000)] under both alternatives, the 10% cumulative preference issue results in higher profit before tax ($420 000 compared with $380 000) than the 8% non-cumulative preference share issue. Thus managers would receive additional bonuses of $800 (2% x $40 000). Some students might raise concerns about the different cash flow consequences of the financing alternatives. Although from the perspective of Northern Tours Ltd, the 8% cumulative preference share issue has more favourable annual cash flows (assuming the dividend is paid), the 10% non-cumulate provides more flexibility in cash flow management. In particular, Northern Tours Ltd is under no obligation to redeem the 10% non-cumulative preference shares, compared with the mandatory redemption of the 8% cumulative preference shares.

11.48

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 11: Financial instruments Multiple choice questions 1. Financial instruments are separated into two categories. They are: a. b. c. *d

financial and non-financial derivative and non-derivative primary and secondary primary and derivative

Answer: d Learning objective 11.1: define a financial instrument.

2. Which of the following are regarded as financial instruments? I. Deposits held by a financial institution. II. Ordinary shares. III. Raw materials inventories. IV. Property, plant and equipment. V. Accounts receivable and accounts payable. a. I, II, IV and V only. b. II, III and IV only. *c. I, II and V only. d. I, IV and V only. Answer: c Learning objective 11.1: define a financial instrument.

3. Which of the following statements relating to financial instruments is not correct? a. *b. c. d.

They may relate to singular instruments or a combination of instruments. A convertible note with the conversion option to issue shares is a financial liability. Primary instruments include receivables and payables. Derivative instruments include forward exchange contracts.

Answer: b Learning objective 11.1: define a financial instrument.

11.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following would not be regarded as a financial instrument? a. cash. b. bank overdraft. c. notes payable. *d. equipment. Answer: d Learning objective 11.1: define a financial instrument.

5. Which of the following items is classified as a financial asset? a. *b. c. d.

promissory notes accounts receivable inventory forward exchange contracts

Answer: b Learning objective 11.2: define a financial asset

6. The AASB 132 Financial Instruments: Presentation definition of a financial asset does not include any asset that is: a. b. c. *d.

an equity instrument of another entity. a contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity. a contract that will be settled in the entity’s own equity instruments. a contractual obligation to deliver cash or another financial asset to another entity.

Answer: d Learning objective 11.2: define a financial asset

11.2

Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

7. According to AASB 132 Financial Instruments: Presentation, which of the following items would be regarded as a financial liability? a. Ordinary shares held in another entity. b. A contractual right to exchange under potentially favourable conditions, an option to purchase shares below the market price. c. The right of a depositor to obtain cash from a financial institution with which it has deposited cash. *d. A contract that is a non-derivative for which the entity is obliged to deliver a variable number of its own equity instruments. Answer: d Learning objective 11.3: define a financial liability

8. Examples of financial liabilities include: a. b. c. *d.

bank overdraft unsecured convertible notes debentures issued all of these are examples of financial liabilities.

Answer: d Learning objective 11.3: define a financial liability

9. The definition of a derivative requires which of the following characteristics to be met? I.

III. IV.

Its value must change in response to a change in an underlying variable such as a specified interest rate, foreign exchange rate, credit rating or commodity price. It must require no initial net investment or an additional net investment that is smaller than would be required for other types of contracts with similar responses to changes in market factors. It is to be settled at a future date. It must be settled on a net basis.

a. *b. c. d.

I, III and IV. I, II and III I, II and IV. II, III and IV.

II.

Answer: b Learning objective 11.4: explain what is meant by a derivative and an embedded derivative.

11.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. Which of the following is not an example of a derivative financial instrument? a. b. c. *d.

A forward exchange contract. A futures contract. An option contract. A commercial bill contract.

Answer: d Learning objective 11.4: explain what is meant by a derivative and an embedded derivative.

11. Dickson Corporation Limited buys an option that entitles it to purchase 4000 shares in Moody Limited at $8 per share at any time in the next 6 months. The derivative financial instrument in this transaction is the: *a. b. c. d.

option priced at $8. shares in Moody Limited. shares in Dickson Corporation Limited. price of the shares in Moody Limited after 6 months have elapsed.

Answer: a Learning objective 11.4: explain what is meant by a derivative and an embedded derivative.

12. Company C issues preference shares to Company D, the terms of which entitle Company D to redeem the preference shares for cash if Company C’s revenues fall below a specified level. From Company C’s perspective, the preference shares are: *b. c. d.

a financial liability. an equity instrument. a compound financial instrument.

Answer: b Learning objective 11.5: define an equity instrument

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Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

13. A contract with a residual interest in the assets of an entity after deducting all of its liabilities is referred to as a (an): *a. b. c. d.

equity instrument. derivative instrument. primary instrument. secondary instrument.

Answer: a Learning objective 11.5: define an equity instrument

14. The classification of a financial instrument on the statement of financial position of an entity is governed by the principle of: a. b. c. *d.

legal form. forfeiture. net present value. substance over form.

Answer: d Learning objective 11.6: distinguish between financial liabilities and equity instruments

15. Which of the following is an example of an adverse effect of financial liabilities? a. b. c. *d.

Periodic payments on the financial instruments, such as dividends, may be recognised as a borrowing cost and therefore reduce the entity’s profits. A financial institution breaching regulations imposed on it to maintain a minimum level of capital. An entity breaching their obligations under a debt covenant relating to its solvency. All of the above options.

Answer: d Learning objective 11.6: distinguish between financial liabilities and equity instruments

16. Company A issued convertible notes 3 years ago and accounted for them as a compound financial instrument. Complete the following sentence.

11.5

Testbank to accompany Financial reporting 3e by Loftus et al.

At the end of the three year period the portion of the the notes which have been converted a. *b. c. d.

component that relates to .

liability, remains as a liability. liability, is transferred to equity. equity, is transferred to profit and loss. liability, is transferred to profit or loss.

Answer: b Learning objective 11.7: explain the concept of a compound financial instrument

17. Company A has convertible notes on issue. These notes are convertible to ordinary shares of the Company after 3 years. The distributions made to the note holders by Company A are classified by Company A as follows: a. b. c. *d.

interest expense. dividends distributed. indeterminable based on the information provided. a portion representing interest expense and a portion representing dividends distributed.

Answer: d Learning objective 11.7: explain the concept of a compound financial instrument

18. The appropriate accounting treatment for incremental costs directly attributable to an equity transaction that would otherwise have been avoided is to: *a. deduct from equity, net of tax. b. add to equity, net of tax. c. expense in the period incurred. d. defer as a contingent asset. Answer: a Learning objective 11.8: explain the consequential effects of financial instrument classifications for dividends, interest and gains and losses.

19. Which of the following statements is incorrect? a. b.

Trade debtors and trade creditors are treated as unconditional financial assets and financial liabilities. Forward contracts covered by AASB 9 are recognised as financial assets or financial liabilities at the commitment date.

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Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

c. *d.

Option contracts covered by AASB 9 are recognised as financial assets or financial liabilities when the holder or writer becomes a party to the contract. Planned future transactions are to be recognised as asset or liabilities at the date the plan is finalised.

Answer: d Learning objective 11.9: describe the criteria for the recognition of a financial asset or financial liability

20. A contract that requires delivery of a financial asset within a time frame generally established by regulation or convention in the marketplace is what type of purchase? a. *b. c. d.

normal purchase. regular way purchase. abnormal purchase. irregular way purchase.

Answer: b Learning objective 11.9: describe the criteria for the recognition of a financial asset or financial liability.

21. When an entity has a legally enforceable right to set off the recognised amounts of a financial asset and financial liability and it intends to settle on a net basis, it: a. b. *c. d.

can write off both the asset and the liability. is not entitled to offset the asset and liability. may offset the financial asset and liability. need not present the asset, the liability or the net amount in its financial statements.

Answer: c Learning objective 11.10: describe the conditions under which a financial asset and a financial liability must be offset.

22. Which of the following are examples where the conditions for offsetting a financial asset and a financial liability are generally not satisfied? I. II.

Financial assets pledged as collateral for non-recourse financial liabilities. The combination of a number of different financial instruments to emulate the features of a single financial instrument. © John Wiley and Sons Australia, Ltd 2020

11.7

Testbank to accompany Financial reporting 3e by Loftus et al.

III.

a. b. c. *d.

Financial liabilities for obligations expected to be recovered from a third party such as an insurance company.

I and III only II and III only I and II only. I, II and III.

Answer: d Learning objective 11.10: describe the conditions under which a financial asset and a financial liability must be offset.

23. Company A and Company B regularly trade between each other. They have agreed to offset their accounts receivable and accounts payable and settle them on a net basis. At 30 June Company A has accounts receivable of $40 000 owing from Company B but also has accounts payable of $10 000 owing to Company B. Which of the following statements is correct? a. b. *c. d.

The net payable from Company A is $30 000. The net receivable from Company B is $40 000. Company A offsets the account payable of $10 000 against the account receivable and presents the net amount of $30 000 in their financial statements as accounts receivable. Company B offsets the account payable of $10 000 against the account receivable and presents the net amount of $30 000 in their financial statements as accounts receivable.

Answer: c Learning objective 11.10: describe the conditions under which a financial asset and a financial liability must be offset.

24. An example of the derecognition of a financial asset is: a. b. c. *d.

the entity no longer has control of the asset. the expiration of the contractual rights to cash flows. the asset no longer qualifies for recognition in the statement of financial position. All of the above.

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Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

Answer: d Learning objective 11.11: describe the requirements for the derecognition of a financial asset or a financial liability.

25. Derecognition of a financial liability occurs when: *a. b. c. d.

the contractual obligation has been settled due to the transfer of a cash consideration. there is an extension to the terms of the contractual obligation. the contractual rights to cash flows has expired. the entity obtains control of the financial instrument.

Answer: a Learning objective 11.11: describe the requirements for the derecognition of a financial asset or a financial liability.

26. AASB 9 requires financial assets to be initially measured at: a. *b. c. d.

fair value fair value plus directly attributable costs historical cost historical cost plus directly attributable costs

Answer: b Learning objective 11.13: outline the requirements for the subsequent measurement of a financial asset

27. AASB 9 requires subsequent measurement of a financial asset at amortised cost when two tests have been satisfied. Those two tests are: a. b. c. *d.

fair value test; impairment test fair value test; business model test fair value test; cash flows characteristics test business model test; cash flows characteristics test

Answer: d Learning objective 11.13: outline the requirements for the subsequent measurement of a financial asset 28. Which of the following events provide objective evidence that a financial asset has been impaired: I. II. III.

A default in interest payments. The borrower enters into bankruptcy. The downgrade of an entity’s credit rating.

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Testbank to accompany Financial reporting 3e by Loftus et al.

IV. *a. b. c. d.

Significant financial difficulty of the issuer.

I, II and IV only. II, III and IV only. I, III and IV only. II and IV only.

Answer: a Learning objective 11.14: describe the expected loss model for impairment of financial assets.

29. AASB 9 provides examples of financial liabilities which are not required to be subsequently measured at amortised costs. These examples include: a. b. c. *d.

financial guarantees contracts. commitments to provide loans below market interest rates. holdings of derivatives. all of the above

Answer: d Learning objective 11.15: outline the requirements for the subsequent measurement of a financial liability

30. The default subsequent measurement base for financial liabilities is: a. *b. c. d.

fair value using the effective interest rate. amortised cost using the effective interest rate. fair value through profit or loss. amortised cost through profit or loss.

Answer: b Learning objective 11.15: outline the requirements for the subsequent measurement of a financial liability

31. The disclosure requirements for financial assets that have been reclassified at amortised cost include:

The interest income or expense recognised The effective interest rate on the reclassification

I No No

II No Yes

III Yes Yes

IV Yes No

11.10

Chapter 11: Financial instruments Not for distribution in full. Instructors may assign selected questions in their LMS.

date The fair value of the financial assets at the end of the reporting period after reclassification The fair value gain or loss that would have been recognised in the financial year if no reclassification had occurred.

Yes

a. I. b. II. *c. III. d. IV. Answer: c Learning objective 11.16: summarise the disclosures required for financial instruments.

32. The risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss is referred to as: a. *b. c. d.

market risk. credit risk. liquidity risk. interest rate risk.

Answer: b Learning objective 11.16: summarise the disclosures required for financial instruments.

11.11

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 12: Income taxes

Chapter 12: Income taxes Comprehension questions 1. What is the main principle of tax-effect accounting as outlined in AASB 112/IAS 12? As the objective paragraph of AASB 112/IAS 12 points out, the principal issue in accounting for income taxes is how to account for the current and future tax consequences of: (a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in a company’s statement of financial position; and (b) transactions and other events of the current period that are recognised in a company’s financial statements. AASB 112/IAS 12 adopts the philosophy that, as a general rule, the tax consequences of transactions that occur during a period should be ‘recognised as income or an expense in the net profit or loss for the period’ irrespective of when those tax effects will occur. A transaction may have two tax ‘effects’: 1. Tax payable on the current profit earned for the year may be reduced or increased because the transaction is not taxable or deductible in the current year. 2. Future tax payable may be increased or reduced when that transaction becomes taxable or deductible. If only current tax payable is recorded as an expense, the accounting profit after tax for the current year is overstated (understated) by the amount of tax (benefit) to be paid (received) in future years. Similarly, in the years that the tax (benefit) on these transactions is paid (received), income tax expense will include amounts relating to prior periods and therefore be overstated (understated). To illustrate, consider an entity with accrued interest of $12 000 at end of reporting period. Assuming accrued interest is deductible only when paid, taxable profit will be $12 000 greater than accounting profit, resulting in $3 600 extra tax being paid (assuming a 30% tax rate). In the next accounting period, the tax deduction for interest paid results in a taxable profit that is $12 000 lower than the accounting profit. This tax benefit reduces the current tax expense by $3 600 although the transaction occurred in the prior year. If only current tax payable calculated based on the taxable profit is recorded as an expense, the accounting profit after tax for the current year is overstated by the amount of benefit to be received in future years. Similarly, in the years that the benefit on this transaction is received, income tax expense will include benefits relating to prior periods and therefore be understated. To ensure that the tax effect (expense or benefit) of a transaction is recorded in the appropriate period, AASB 112/IAS 12 requires income tax expense to reflect all tax effects of transactions entered into during the year regardless of when the effects occur. 2. Explain how accounting profit and taxable profit differ and how each is treated when accounting for income taxes. Accounting profit is defined in AASB 112/IAS 12, paragraph 5, as ‘net profit or loss for a period before deducting tax expense’, with net profit or loss being the excess (or deficiency) of revenues over expenses for that period. The revenues and expenses would be determined

12.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

and recognised in accordance with accounting standards and the conceptual Framework, normally based on accrual accounting rules: • revenues are recognised when earned, not when received in cash • expenses are recognised when incurred, not when paid in cash. Taxable profit is defined in the same paragraph AASB 112/IAS 12 as ‘the profit for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable’. Taxable profit is the excess of taxable income over taxation deductions allowable against that income, normally based on cash accounting rules: • income is taxed received in cash • deductions are claimed when paid in cash. Thus, accounting profit and taxable profit, as they are determined by different principles and rules, are unlikely to be equal in any one period. Income tax expense cannot be determined by simply multiplying the accounting profit by the applicable tax rate. Instead, accounting for income taxes involves identifying and accounting for the differences between accounting profit and taxable profit. These differences arise from a number of common transactions and may be either permanent or temporary in nature. Normally: • the income tax expense is calculated as the accounting profit adjusted for permanent differences and then multiplied by the tax rate • the current tax liability is calculated as the taxable profit multiplied by the tax rate • the difference between the income tax expense recognised based on the adjusted accounting profit and the current tax liability is the deferred tax. 3. How are the current and future tax consequences of transactions accounted for? Accounting for income tax takes into account both current and future tax consequences of transactions. In essence, AASB 112/IAS 12: • Prescribes the accounting treatment of the current tax consequences of transactions. This will give rise to current tax liabilities or current tax assets. The task is to determine an entity’s liability for taxation in the current period based on an assessment of the entity’s current taxable profit or tax loss determined in accordance with the tax legislation. The liability for taxation in the current period is recognised by a journal entry of the following form. Income tax expense (current) Current tax liability (Recognition of the current tax liability)

Dr Cr

xxx xxx

Accounting for current tax is covered in section 12.4. •

Prescribes the accounting treatment of the future tax consequences of transactions. This involves an analysis of whether more tax or less tax will need to be paid in the future as a result of those transactions. From this analysis, the future tax consequences are accounted for by the recognition of deferred tax assets and deferred tax liabilities. The deferred or future tax assets and liabilities are recognised by a journal entry of the following form. © John Wiley and Sons Australia Ltd, 2020

12.3

Chapter 12: Income taxes

Income tax expense (deferred) Deferred tax asset Deferred tax liability (Recognition of movement in deferred tax accounts)

Dr Dr Cr

xxx xxx xxx

Accounting for deferred tax is covered in section 12.5.NING CHECK 4. How is the taxable profit and the related current tax calculated? The calculation of taxable profit and the related current tax involve the following steps: 1. Identify accounting profit for the period — as accounting profit contains the accounting revenues and accounting expenses, it is used as the starting point. 2. Determine the expenses and revenues where there are differences between the accounting numbers used to determine accounting profit and the tax numbers used to calculate taxable profit. 3. Adjust for these differences. This is done by: • adding the accounting expenses and subtracting the tax deductions for each expense, both where an accounting expense is not deductible for tax and where an accounting expense differs from the deductible amount • subtracting the accounting revenues and adding the taxable revenues for each revenue, both where an accounting revenue is not taxable and where an accounting revenue differs from the taxable amount. The result of adjusting accounting profit for these differences is the taxable profit for the period. Accounting profit + accounting expenses or losses where the amounts differ from deductible amounts + taxable revenues where the amounts differ from accounting revenues or gains − deductible amounts where the amounts differ from accounting expenses or losses − accounting revenues or gains where the amounts differ from taxable revenues = Taxable profit 4. Multiply the taxable profit by the current tax rate (30%) to determine the current tax liability. This process can be performed in a worksheet — referred to as the current tax worksheet. 5. What is a ‘tax loss’ and how is it accounted for? Tax losses occur when allowable deductions exceed taxable revenues. In Australia, tax losses can be carried forward and deducted against future taxable profits. This means that an entity that incurs a tax loss has a future tax benefit: provided it earns taxable profit in the future, it will be able to use the carried forward balances of tax losses to reduce the tax it needs to pay on that taxable profit. This tax benefit will be recognised as an asset referred to as ‘a deferred tax asset’.

12.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In dealing with tax losses it is necessary to distinguish between two events occurring at two different points of time. 1. The creation of carry forward tax losses. • In the year in which a tax loss occurs, there is no liability to pay tax as there is no taxable profit. Instead a deferred tax asset is recorded to recognise the future deductibility of the tax loss. The form of the journal entry is: Deferred tax asset Income tax expense (Recognition of current period tax loss)

Dr Cr

xxx xxx

2. Recoupment of carry forward tax loss. • In a period subsequent to that in which the tax loss was incurred, an entity may earn taxable profit. The amount of tax to be paid on that period’s taxable profit may then be reduced by claiming a deduction for past tax losses. In this period, the form of the journal entry for the current period tax liability is: Income tax expense (current) Deferred tax asset Current tax liability (Recognition of current tax)

Dr Cr Cr

xxx xxx xxx

6. What is an ‘exempt income’ and how does it affect the calculation or recovery of carry‐forward tax losses? Exempt income is recognised as accounting income by the company but not recognised as taxable by the tax authorities; for example, certain government grants are tax exempt. The existence of exempt income has an effect both on the creation of a tax loss and the recoupment of a tax loss. 1. Exempt income and the creation of tax loss. • If a tax loss occurs in a period, prior to determining any deferred tax asset arising from it, exempt income must be added back to the tax loss to calculate the tax loss after exempt income. It is this number on which the deferred tax asset is calculated. Exempt income loses its exempt status under these circumstances. 2. Exempt income and the recoupment of a tax loss. • If a company has earned exempt income in the current period, the deduction for past tax losses must be made firstly from the exempt income, and only after that from the taxable profit for the current period. In other words, a tax loss must first be set off against the entity’s exempt income before any reduction can be made in relation to the current period’s liability for tax. 7. In determining whether deferred tax assets relating to tax losses are to be recognised, what factors should be taken into consideration? Under paragraph 28 of AASB 112/IAS 12, deferred tax assets can be recognised only to the extent that it is probable that taxable profit (or taxable temporary differences) will be available © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

against which the deductible temporary differences can be utilised. A future tax deduction is a benefit only if an entity earns sufficient taxable profit in the future against which the deductions can be used. If an entity makes only tax losses in the future then tax deductions are of no benefit. Hence the recognition criterion for deferred tax assets is based on the probability of an entity earning sufficient taxable profit in the future. For deferred tax assets arising from tax losses, the same principle applies. The criterion is still that it must be probable that an entity earns sufficient taxable profit against which the past tax loss can be offset. However, when there is a tax loss in the current period, this is in itself strong evidence that an entity may not be able to earn taxable profit in the future. Where an entity has a history of recent tax losses, there must be convincing evidence that circumstances are going to improve for the entity in the future. Paragraph 36 of AASB 112/IAS 12 specifies a number of factors that can be used in the assessment of possible changes in the future: • whether the entity has sufficient taxable temporary differences that will result in taxable amounts in the future against which the tax loss can be utilised • whether the unused tax losses result from identifiable causes which are unlikely to recur • whether tax planning opportunities are available to the entity that will create future taxable profit. An analysis of the following areas could provide evidence that there is a change expected in the profits of the entity in the future. Future budgets: • If an entity has a 5 year budget setting out future sales and expenses, this may indicate better prospects for profits for the entity in the future. Causes of past/current losses: • An analysis of what caused past/current tax losses to occur may provide indications that these were one off events (e.g. natural disasters). If these same events are not expected in the future, then this increases the probability of future profitability for the entity. The entity may have a strong history of earnings other than those giving rise to the current loss, indicating that the loss was an aberration and not a continuing condition. Analysis of existing contracts and sales agreements: • If an entity has recently signed significant new contracts that will benefit the company’s returns, then this may be evidence of a change in the fortunes of the company. New developments and favourable opportunities are likely to give rise to future taxable amounts. 8. What are the steps in the calculation of deferred tax? The process of accounting for deferred tax involves the following steps. 1. Determine the carrying amounts of the assets and liabilities in the statement of financial position (see section 12.5.1). 2. Determine the tax bases of these assets and liabilities (see section 12.5.2).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. Determine the differences between the carrying amounts and the tax bases, and classify the differences into taxable and deductible temporary differences (see section 12.5.3). 4. (a) Determine the ending balances of the deferred tax asset and deferred tax liability accounts by multiplying the temporary differences by the tax rate (see section 12.5.4). (b) Determine the adjustments to the deferred tax asset and liability accounts necessary to arrive at their ending balances, using the opening balances and the movements during the current period in these accounts (see section 12.5.5) (c) Prepare a journal entry recognising the adjustments to the deferred tax asset and deferred tax liability accounts, the net being the deferred income tax expense/revenue for the current period (see section 12.5.6)

9. What is a tax base and how are the tax bases for assets and liabilities calculated? Tax base is the amount that would be shown for an asset or a liability in the statement of financial position if prepared by the tax authorities. Paragraph 5 of AASB 112/IAS 12 simply states that the tax base of an asset is the amount attributed to that asset for tax purposes. Paragraph 7 notes two ways in which the tax base of an asset can be calculated, dependent on whether the asset generates economic benefits that are taxable: • Economic benefits are taxable: tax base future deductible amount for tax purposes. • Economic benefits are not taxable: tax base carrying amount of asset. In general, the tax base of an asset can be calculated based on the following formula: • Tax base of an asset – Future deductible amount carrying amount − Future taxable amount. This equation for calculating the tax base of an asset is derived from the formula in paragraph 5.1 of the now superseded AASB 1020 Income taxes. It is used in this text to demonstrate that the difference between the carrying amount and tax base for an asset is given by the difference between the amount of taxable amounts and the amount of tax deductions that can be claimed in the future as follows: • Carrying amount − Tax base of an asset – Future taxable amount − Future deductible amount. The future taxable amount for an asset is normally equal to its carrying amount unless the economic benefits are not taxable, in which case the future taxable amount is zero. The future deductible amount is the total deductions that can be claimed in the future against the asset. Unlike assets which by their nature are expected to generate income, liabilities are outflows of funds and do not generate future taxable amounts. Paragraph 8 of AASB 112/IAS 12 describes two calculations for the tax base of a liability: • all liabilities other than revenue received in advance; and • revenue received in advance. All liabilities other than revenue received in advance: • The tax base of such a liability equals the carrying amount less any amount that will be deductible for tax purposes in respect of that liability in future periods. The formula is: - Tax base of a liability – Carrying amount − Future deductible amount. © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

•

Even though the future taxable amount for a liability is $0, the equation above can be written is a similar way to the equation used to determine the tax base for an asset: - Tax base of a liability – Future taxable amount – Carrying amount − Future deductible amount. As such, the difference between the tax base of a liability other than revenue received in advance and its carrying amount can be written as follows: - Carrying amount − Tax base of a liability – Future deductible amount − Future taxable amount. Therefore: - where the carrying amount equals the future deductible amount, the tax base is zero - where there is no future deductible amount, the tax base equals the carrying amount.

Revenue received in advance: • The tax base of such a liability is equal its carrying amount less the revenue received in advance not taxable in future periods (AASB 112/IAS 12 paragraph 8). The formula is: - Tax base – Carrying amount − Revenue received in advance not taxable in the future. • The reason for the difference in the formula is that in the case of revenue received in advance the tax is always paid on receipt of the revenue. The tax base is then always equal to $0. 10. Explain the meaning of a temporary difference as it relates to deferred tax calculations and give three examples. Paragraph 5 of AASB 112/IAS 12 defines temporary differences as differences between the carrying amount of an asset or liability in the statement of financial position and the asset’s or liability’s tax base. Temporary differences effectively represent the expected net future taxable or deductible amounts arising from recovery of assets and the settlement of liabilities at their carrying amounts. Temporary differences cannot exist where there are no future tax consequences from the realisation or settlement of an asset or liability at its carrying amount; for example, with the liability loan payable, there are no future tax consequences (i.e. no future tax deduction or assessable income). With this liability, as shown in figure 12.5, the tax base equals the carrying amount and no temporary difference occurs. As can be seen in figures 12.4 and 12.5, having determined both the carrying amounts and the tax bases of an entity’s assets and liabilities, it is a simple task to determine the temporary differences between these amounts. Note that differences between carrying amounts and the tax bases are equal to differences between future taxable amounts and future deductible amounts. Temporary differences can be calculated without the need to identify the tax base. They can simply be seen as the differences between the future taxable amounts and future deductible amounts recognised for each asset and liability: • •

If future taxable amount > future deductible amount: taxable temporary difference. If future taxable amount < future deductible amount: deductible temporary difference.

12.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Carrying amount

Equipment

$ 60 000

Future taxable amount $ 60 000

Future deductible amount $ 50 000

Tax base

Taxable temporary differences $ $ 50 000 10 000

Deductible temporary differences $

Accrued expenses

3 700

Revenue in advance

15 000

Equipment: • The carrying amount of the asset is greater than the tax base. Hence a taxable temporary difference arises. This is because the asset is being depreciated faster for tax purposes than accounting purposes. In a future period there will still be a recovery of the economic benefits from the asset as evidenced by a carrying amount of the asset for accounting purposes, but there will be no tax deduction for depreciation. This results in a future taxable amount greater than the future deductible amount and therefore a taxable temporary difference exists. Accrued expenses: • The accrued expenses is greater than the zero tax base, giving rise to a deductible temporary difference. In future periods as the entity pays the accrued expenses a tax deduction will be received, but there is no taxable amount. Revenue in advance: • The $15 000 liability is greater than the zero tax base, giving rise to a deductible temporary difference. In future periods revenue will be recognised, but it is subject to tax in the current period. The tax on the future revenue is effectively prepaid this period. In future periods the revenue will be recognised for accounting purposes but no tax will be paid in the year of recognition. As such, the amount of revenue received in advance is virtually a future deductible amount and there is no future taxable amount.

11. Are all differences that exist at the end of the reporting period between the carrying amounts and tax bases of assets and liabilities recognised as part of deferred tax assets or deferred tax liabilities? For deferred tax liabilities, under paragraph 16 of AASB 112/IAS 12 all deferred tax liabilities must be recognised; that is, there are no recognition criteria to be applied. Under paragraph 28 of AASB 112/IAS 12, deferred tax assets can be recognised only to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilised. A future tax deduction is a benefit only if an entity earns sufficient taxable profit in the future against which the deductions can be offset. If an entity makes only tax losses in the future then tax deductions are of no benefit. Hence the recognition criterion for deferred tax assets is based on the probability of an entity earning sufficient taxable profit in the future.

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Chapter 12: Income taxes

12. In tax-effect accounting, the temporary differences between the carrying amount and the tax base for assets and liabilities leads to the establishment of deferred tax assets and liabilities in the accounting records. List examples of temporary differences that create: (a) deferred tax assets (b) deferred tax liabilities. Consider the reasons for temporary differences as shown in section 12.2. Accounting treatment Taxation treatment Deferred development costs Sometimes recognised as Tax deduction on cash an asset and amortised payment Goodwill impairment Expense Not deductible Entertainment outlays Expense Not deductible Fines and penalties Expense Not deductible Interest revenue Recognised when Taxable on cash receivable receipt Interest expense Recognised as an expense Tax deduction on cash when payable payment Depreciation Expense Tax deduction – but depreciation rate may differ from accounting Receivables e.g. rent, interest Recognition of asset and Income taxable on revenue on accrual cash receipt Bad and doubtful debts Expense when debt is Tax deduction when doubtful debt is written off as bad Revenue received in advance Recognised as a liability, Income taxable on with revenue recognised receipt of cash when earned Accrued expenses e.g. provisions for Recognised as an expense Tax deduction on cash long service leave, warranties etc. on accrual payment (liability reduced) Prepaid expenses e.g. interest, rent Recognised as an asset, Tax deduction on cash then expensed in a later payment period as benefits received As it can be seen above, some transactions will be treated differently for accounting and taxation and that will sometimes result in assets and liabilities generated by those transactions to be recognised for accounting based on their carrying amount, while for taxation they will be recognised based on a different amount, called tax base. The difference between the carrying amount and the tax base for those assets and liabilities are normally temporary differences that reverse time and classified into: • Taxable temporary differences (TTD) that will result in more tax to be paid in the future – for those, a deferred tax liability will be recognised. • Deductible temporary differences (DTD) that will result in less tax to be paid in the future – for those, a deferred tax asset will be recognised. Examples of items that may generate these differences that result in the recognition of deferred tax assets or liabilities include the below.

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DTD - Deferred tax assets Provisions Accrued expenses Prepaid revenue Accounting depreciation rate > Taxation depreciation rate Tax losses

TTD - Deferred tax liabilities Accrued revenue Prepaid expenses Expenses capitalised and amortised Accounting depreciation rate < Taxation depreciation rate

13. In AASB 112/IAS 12, criteria are established for the recognition of a deferred tax asset and a deferred tax liability. Identify these criteria, and discuss any differences between those criteria for assets and liabilities. Deferred tax liabilities must be recognised for all taxable temporary differences. According to the Conceptual Framework, paragraph 91A, a liability is recognised when, and only when, it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. However, there is no need to explicitly consider this recognition criteria for a deferred tax liability, as it is always probable that resources will flow from the entity to pay the tax associated with taxable temporary difference. Deferred tax assets must be recognised for all deductible temporary differences and from tax losses carried forward but only to the extent that is it probable that future taxable profits will be available against which these deductible temporary differences or tax losses can be utilised. According to the Conceptual Framework, paragraph 89, an asset is recognised when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably. The Conceptual Framework, paragraph 85, states that the concept of probability refers to the degree of uncertainty that the future economic benefits associated the asset will flow to the entity. This probability must be assessed using the best evidence available when the financial statements are prepared. Deductible temporary differences result in deductions against taxable profits of future periods. However, economic benefits in the form of reductions in tax payments will flow to the enterprise only if it earns sufficient taxable profits against which the deductions can be offset. Therefore, an enterprise recognises deferred tax assets only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised (AASB 112/IAS 12, paragraph 27). 14. ‘Despite the fact that deferred tax liabilities and assets are recognised in respect of certain assets and liabilities, the income tax expense (or benefit) of such items is always recognised in the current year’. Is this statement true? Discuss. This statement is true. Tax effect accounting as mandated in AASB 112/IAS 12 has two main purposes: 1. To calculate and account for the current tax liabilities of the company.

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Chapter 12: Income taxes

2. To calculate and account for the future tax consequences for those items where taxation and accounting treatments differ. Future tax consequences arise when the carrying amount of items recognised in the company’s statement of financial position differ from their tax figure, i.e. tax base. An item’s tax base equals the amount that would be shown as an asset or liability in a statement of financial position prepared for taxation purposes. These future tax consequences may involve either the payment of additional tax (temporary taxable differences) or future tax savings (temporary deductible differences and tax losses). Such future liabilities or savings are recognised as deferred tax liabilities or deferred tax assets. The standard requires that both current and deferred amounts be reported as income tax expense (income) for the reporting period. Thus, if an expense is prepaid creating a deferred tax asset (future deduction) the current year’s income tax expense will record this deduction against the current year’s profit even though the deduction will not affect taxable profit until next year. Effectively, tax-effect accounting ensures that the tax-effect of each transaction or event recognised during a financial year will be reflected in the income tax expense of that year irrespective of when that tax-effect will occur.

15. What action should be taken when a tax rate changes? Why? When a new tax rate is enacted or substantively enacted, not only should the new rate be applied in calculating the current tax liability and adjustments to deferred tax accounts during the year, but they should also be applied to the deferred amounts recognised in prior years. A journal adjustment must be passed to increase or reduce the carrying amounts of deferred tax assets and liabilities to reflect the new value of future taxable or deductible amounts. AASB 112/IAS 12, paragraph 60, requires that the net amount arising from the restatement of deferred tax balances be recognised in the income statement except to the extent that the deferred tax amounts relate to items previously charged or credited to equity. Failing to adjust for the changes will result in deferred tax assets and liabilities being overstated or understated with respect to the reversal of tax-effects.

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Chapter 12: Income taxes

Case studies Case study 12.1 Tax-effect accounting Every year companies in Australia generally expect to have to pay some of their earnings to the Australian government in the form of income tax. However, the amount paid to the government is rarely the amount reported as income tax expense in the statement of profit or loss and other comprehensive income. Required 1. Explain the objectives of accounting for income tax in general purpose financial statements. 2. Explain the basic principles that are applied in accounting for income tax to meet these objectives. 3. List the steps in the calculation of deferred tax assets and liabilities. 1. As the objective paragraph of AASB 112/IAS 12 points out: • ‘the principal issue in accounting for income taxes is how to account for the current and future tax consequences of: (a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in an enterprise’s statement of financial position; and (b) transactions and other events of the current period that are recognised in an enterprise’s financial statements.’ AASB 112/IAS 12 adopts the philosophy that, as a general rule, the tax consequences of transactions that occur during a period should be ‘recognised as income or an expense in the net profit or loss for the period’ irrespective of when those tax effects will occur. 2. AASB 112/IAS 12 recognises the current and future tax consequences of the following: • the transactions and events of the current period included in the financial statements • the recovery of assets and settlement of liabilities based on the carrying amounts shown in the financial statements. A transaction may have two tax ‘effects’: 1. Tax payable on profit earned for the year may be reduced or increased because the transaction is not taxable or deductible in the current year. Current tax is the amount of income tax payable (recoverable) in respect of the taxable profit (tax loss) for a period (AASB 112/IAS 12, paragraph 5) 2. Future tax payable may be reduced or increased when that transaction becomes deductible or taxable. Deferred tax is the amount of income tax estimated to be payable (recoverable) in respect of the future tax consequences from the recovery of assets and settlement of liabilities in the statement of financial position. The existence of deferred tax may be recognised in deferred tax assets or deferred tax liabilities. If only current tax payable is recorded as an expense, the accounting profit after tax for the current year is understated (overstated) by the amount of tax (benefit) to be paid (received) in future years. Similarly, in the years that the tax (benefit) on these transactions is paid (received), income tax expense will include amounts relating to prior periods and therefore be understated (overstated).

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Chapter 12: Income taxes

To illustrate, consider an entity with accrued interest of $12 000 at end of reporting period. Assuming accrued interest is deductible only when paid, taxable profit will be $12 000 greater than accounting profit, resulting in $3 600 extra tax being paid (assuming a 30% tax rate). In the next accounting period, the tax deduction for interest paid results in a taxable profit that is $12 000 lower than the accounting profit. This tax benefit reduces the current tax expense by $3 600 although the transaction occurred in the prior year. If only current tax payable calculated based on the taxable profit is recorded as an expense, the accounting profit after tax for the current year is overstated by the amount of benefit to be received in future years. Similarly, in the years that the benefit on this transaction is received, income tax expense will include benefits relating to prior periods and therefore be understated. To ensure that the tax effect (expense or benefit) of a transaction is recorded in the appropriate period, AASB 112/IAS 12 requires income tax expense to reflect all tax effects of transactions entered into during the year regardless of when the effects occur. 3. The steps in the calculation of deferred tax assets and liabilities are: i. Determine the carrying amounts of the assets and liabilities in the statement of financial position (see section 12.5.1). ii. Determine the tax bases of these assets and liabilities (see section 12.5.2). iii. Determine the differences between the carrying amounts and the tax bases, and classify the differences into taxable and deductible temporary differences (see section 12.5.3). iv. (a) Determine the ending balances of the deferred tax asset and deferred tax liability accounts by multiplying the temporary differences by the tax rate (see section 12.5.4). (b) Determine the adjustments to the deferred tax asset and liability accounts necessary to arrive at their ending balances, using the opening balances and the movements during the current period in these accounts (see section 12.5.5). (c) Prepare a journal entry recognising the adjustments to the deferred tax asset and deferred tax liability accounts, the net being the deferred income tax expense/revenue for the current period (see section 12.5.6). Case study 12.2 Recognition of tax loss Whale Ltd is engaged primarily in agricultural pursuits as well as in forestry products, including the management of its own forest reserves. Unfortunately, in the current year an eruption of a volcano in the mountain range bordering the company’s operations resulted in the destruction of 40 000 hectares of standing timber, harvested logs, forestry buildings and equipment. As a result, the company recognised a $80 million tax loss in the current period. The management of Whale Ltd are debating whether it can raise a deferred tax asset in relation to this loss in the financial statements for the current period. Required Prepare a report to management providing advice on the recognition of a deferred tax asset and specifying the conditions, if any, under which the asset could be recognised. Under paragraph 28 of AASB 112/IAS 12, deferred tax assets can be recognised only to the extent that it is probable that taxable profit will be available against which the deductible

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temporary differences can be utilised. A future tax deduction is a benefit only if an entity earns sufficient taxable income in the future against which the deductions can be offset. If an entity makes only tax losses in the future then tax deductions are of no benefit. Hence the recognition criterion for deferred tax assets is based on the probability of an entity earning sufficient taxable income in the future. For deferred tax assets arising from tax losses, the same principle applies. The criterion is still that it must be probable that an entity earns sufficient taxable income against which the past tax loss can be offset. However, when there is a tax loss in the current period, this is in itself strong evidence that an entity may not be able to earn taxable income in the future. Where an entity has a history of recent tax losses, there must be convincing evidence that circumstances are going to improve for the entity in the future. Paragraph 36 of AASB 112/IAS 12 specifies a number of factors that can be used in the assessment of possible changes in the future: • whether the entity has sufficient taxable temporary differences that will result in taxable amounts in the future against which the tax loss can be utilised • whether the unused tax losses result from identifiable causes which are unlikely to recur • whether tax planning opportunities are available to the entity that will create future taxable profit. An analysis of the following areas could provide evidence that there is a change expected in the profits of the entity in the future: • Future budgets: - If an entity has a 5-year budget setting out future sales and expenses, this may indicate better prospects exist for the entity in the future. • Causes of past/current losses: - An analysis of what caused current/past tax losses to occur may provide indications that these were one-off events (e.g. natural disasters). If these same events are not expected in the future, then this increases the probability of future profitability for the entity. The entity may have a strong history of earnings other than those giving rise to the current loss, indicating that the loss was an aberration and not a continuing condition. • Analysis of existing contracts and sales agreements: - If an entity has recently signed significant new contracts that will benefit the company’s returns, then this may be evidence of a change in the fortunes of the company. New developments and favourable opportunities are likely to give rise to future taxable amounts. In the case of the volcano, the effects of this natural disaster would have to be analysed in terms of the above factors – such as considering the likelihood of another eruption. If it were determined that the deferred tax asset raised did not meet the recognition criteria, then the following journal entry is passed: Income tax expense (deferred) Dr xx Deferred tax asset Cr xx (De-recognition of deferred tax asset as recovery is no longer probable)

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Chapter 12: Income taxes

Case study 12.3 Deferred tax asset of a loss making company Isa Ltd is a gold exploration company. Isa Ltd has recognised a deferred tax asset balance for tax losses in its statement of financial position for each of the past four years as follows.

At 30 June 2026, Isa Ltd is in financial distress due to a cash shortage and bank restrictions on providing any further funds. Required The auditors of Isa Ltd have asked for your advice on whether a deferred tax asset should be recognised for carried forward tax losses at 30 June 2026. Discuss with reference to AASB 112/IAS 12. Isa Ltd is in financial distress at 30 June 2026 and the recognition of a deferred tax asset for tax losses is inappropriate in these circumstances because it is not probable that future taxable profit will be available against which the tax losses can be utilised. Paragraph 56 of AASB 112/IAS 12 requires that a deferred tax asset be reviewed each year and reduced if it is no longer probable that it will be utilised. A deferred tax asset should not be recognised for tax losses if a company is on the verge of liquidation and it is likely the tax losses will not be utilised. Moreover, paragraph 25 of AASB 101/IAS 1 indicates that if going concern assumption is not appropriate, then the financial statements should not be prepared on a going concern basis. In Isa Ltd’s case, the recognition of the tax losses as a deferred tax asset in previous years (20232025) should also be called into question. The fact that the company has consistently made a tax loss over the three years indicates that a future taxable profit was not around the corner. Based on the year-on-year balances of the deferred tax asset, the tax loss for each year is the following. • • • •

2023: $24 200 000 / 30% = $80 666 667 2024: ($133 000 000 - $24 200 000) / 30% = $363 333 333 2025: ($197 000 000 - $133 200 000) / 30% = $212 666 667 2026: ($300 800 000 - $197 000 000) / 30% = $346 000 000

The tax loss for 2024 and 2026 in particular appears to have increased significantly relative to the applicable prior year. One reason that the management of Isa Ltd may have recognised the tax losses as a deferred tax asset is to reduce the loss for the year shown in the statements of profit or loss. As an example, the calculation of the accounting loss the year to 30 June 2026, could be as follows:

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Accounting loss before tax Add: Income tax income Accounting loss for the year

($200 000 000) 103 800 000 ($96 200 000)

All available evidence, both positive and negative, must be evaluated before determining whether to recognise a deferred tax asset for a tax loss. Paragraph 35 of AASB 112/IAS 12 notes that the existence of unused tax losses provides strong evidence that future taxable profit may not be available. This evidence has great weight in Isa Ltd’s case because there is no other evidence that would suggest a future taxable profit is probable. Isa Ltd could be a company with high risk such as a junior mining company that spends large amounts of cash on exploration and development activities, which are treated as an asset in the accounting records, but are claimable immediately as tax deductions. These companies often have no or small revenues because they have not reached the stage of having a mine with economic production. In light of the risk associated with taxable profits in future, a deferred tax asset for tax losses should not be recognised. Case study 12.4 Deferred tax balances and discounting A fellow student said, ‘Deferred tax liabilities and assets should be measured using a discounted cash flow model. The deferred tax is paid or refunded in the future — that could be years away — so the time value of money should be taken into account.’ Required Refer to AASB 112/IAS 12 and comment on your fellow student’s argument. Identify other assets and liabilities where discounting is required in the measurement approach. Paragraph 53 of AASB 112/IAS 12 states that deferred tax assets and liabilities shall not be discounted. The expected increase (decrease) in tax to be paid in future periods is recognised on a gross basis. Land revalued from its cost of $100 000 to its fair value of $1 100 000 gives rise to a taxable temporary difference of $1 000 000 and a deferred tax liability of $300 000. The tax will not be paid until the land is actually sold for $1 100 000 and such a sale may not happen for 5 or 10 years. The statement of financial position may show a deferred tax liability of $300 000 for tax that is not due for 10 years. Based on a discount rate of 5%, the present value of the liability would be $300 000 / (1.05)^10 equal to $184 174. It is clear that there is a material difference between the gross amount of the liability and its present value. There is a good argument that the disclosure of the gross amount for deferred tax assets and liabilities may be misleading. Other liabilities and assets subject to measurement using a present value approach include the following: © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

AASB 137 Provisions, Contingent Liabilities and Contingent Assets: • Liabilities such as the provision for employee benefits and provision for warranty are measured using discounting. • Paragraph 45 of AASB 137 states that “where the effect of the time value of money is material, the provision shall be the present value of the expenditures expected to be required to settle the obligation”. AASB 16/IFRS 16 Leases: • Lessees initially recognise leases as assets and liabilities using the present value of the lease payments. Lessors initially recognise lease receivable under finance leases based on the present value of the lease receipts. AASB 1023 General Insurance Contracts: • Paragraph 5.1 of AASB 1023 requires that the liability of outstanding claims for a general insurance company is measured using estimates discounted to present value. AASB 1038 Life Insurance Contracts: • In AASB 1038, life insurance contracts are measured on a “net present value” basis. AASB 13/IFRS 13 Fair Value Measurement: • AASB 13/IFRS 13 includes the valuation technique of “the income approach” where future amounts (e.g. cash flows or income or expenses) are converted to a single discounted amount. • Fair values based on the income approach may be used in the subsequent measurement of assets in AASB 116/IAS 16 Property, Plant and Equipment, AASB 138/IAS 38 Intangible Assets, AASB 139/IAS 39 Financial Instruments, AASB 140/IAS 40 Investment Property and AASB 141/IAS 41 Agriculture.

Case study 12.5 Recognition of deferred tax assets All Sheds Ltd manufactures prefabricated sheds, ranging from industrial sheds and garden sheds down to small items such as dog kennels. In recent years, All Sheds Ltd has recorded accounting losses. The company has retrenched several of its staff after struggling to find new markets for its products. In the prior year, the company recognised expenses and liabilities for long-service leave and potential redundancy payouts. Redundancy costs and long-service leave are not deductible for income tax until paid. The company recognised deferred tax assets as a result of these liabilities. With the long-service leave and redundancy entitlements being paid out to the retrenched employees in the current year, the company has now been able to claim large tax deductions for the cash payments made. The effect of these deductions is that the company has recorded a significant tax loss in the current year. Required 1. Outline the requirements of AASB 112/IAS 12 in relation to the recognition of deferred © John Wiley and Sons Australia Ltd 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

tax assets from long-service leave and retrenchment liabilities. How do these requirements differ (if at all) from the recognition requirements for deferred tax assets from tax losses? 2. Discuss whether the deferred tax asset from the employee benefits liabilities in the prior year should have been recognised. Should the tax loss in the current year be recognised as a deferred tax asset? 1. Long service leave liabilities and retrenchment liabilities provide tax deductions on the payment of cash to employees. For accounting purposes, an expense is recognised on an accrual basis. Hence, there is a difference between the carrying amount of the liability for accounting purposes and the tax base of zero, caused by the existence of a future deductible amount when cash is paid. The resulting deductible temporary difference leads to the existence of a deferred tax asset. Paragraph 24 of AASB 112/IAS 12 specifies that a deferred tax asset can be recognised ‘to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised’. Paragraph 28 of AASB 112/IAS 12 states: It is probable that taxable profit will be available against which a deductible temporary difference can be utilised when there are sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity which are expected to reverse: (a) in the same period as the expected reversal of the deductible temporary difference; or (b) in periods into which a tax loss arising from the deferred tax asset can be carried back or forward. When there are insufficient taxable temporary differences for the entity to use against the deductible temporary differences, a deferred tax asset can be recognised only to the extent that it is probable that the entity will have enough taxable income in the same period as the reversal of the deductible temporary difference or recovery of a tax loss, or tax planning opportunities are available to the entity that will create taxable income in appropriate periods (paragraph 29). All available evidence, both positive and negative, must be evaluated before determining whether to recognise a deferred tax asset. In evaluating whether the entity will have sufficient taxable income in future periods, paragraph 29 of AASB 112/IAS 12 states that the entity must ignore the taxable amounts arising from deductible temporary differences expected to originate in future periods, because the deferred tax asset from future deductible temporary differences will itself require future taxable income in order to be used. In relation to tax losses, the recognition criteria are discussed in paragraph 34. A deferred tax asset arising from the carry forward of an unused tax loss must be recognised to the extent that it is probable that future taxable profits will be available against which the unused tax loss can be used. It appears, therefore, that the recognition criteria for deferred tax assets from tax losses are the same as the recognition criteria for other deferred tax assets, described above. AASB 112/IAS 12 also points out, however, that the mere existence of a tax loss provides strong evidence that future taxable income may not be available to ensure that the deferred tax asset from the tax loss is recognisable.

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Paragraph 35 of AASB 112/IAS 12 states that when an entity has a history of recent losses, it can recognise a deferred tax asset from tax losses only to the extent that it has sufficient taxable temporary differences, or there is other convincing evidence that sufficient taxable profits will be available in the future against which the unused tax losses can be used. Paragraph 36 of AASB 112/IAS 12 specifies a number of factors which the entity must consider in assessing the probability that a deferred tax asset from a tax loss can be recognised: • whether the entity has sufficient taxable temporary differences which will result in taxable amounts in future so that the tax losses can be used • whether it is probable that the entity will have future taxable profits before the tax losses expire (this is not an issue in Australia as tax losses can be carried forward indefinitely) • whether the unused tax losses result from identifiable causes which are unlikely to recur • whether tax planning opportunities are available to the entity that will create sufficient future taxable profits to recover the tax losses. If, based on an assessment of the evidence, it is not probable that sufficient future taxable income will exist, then a deferred tax asset can be recognised only to the extent that it can be recovered against the future taxable income available. 2. Looking at the requirements of AASB 112/IAS 12 concerning the recognition of deferred tax assets from temporary differences and tax losses, there is little evidence in All Sheds Ltd to support the recognition of any deferred tax assets. All Sheds Ltd is struggling after losing market share and has recorded accounting losses over an extended period of time. To convince the auditors, All Sheds Ltd will have to show clearly the basis for the expectation of returning to profitability and future taxable profits so that it can claim the benefits of the tax loss and of the deferred tax assets from long service leave and retrenchments. Relevant evidence would be: • recent operating performance in markets including in any significant new markets • budgets for operating performance in markets in the next 12 months and any other evidence that supports the reliability of the budgets. Case study 12.6 Income tax disclosures of top Australian companies Select three companies listed on the ASX from different industries (e.g. Telstra, Woolworths and Fortescue Metals Group). Go to www.asx.com.au and find the most recent annual financial report of each of the three companies. Compare the information relating to income tax in the financial statements and report your findings to class. Your presentation should address:  the income tax expense included in the profit or loss for the year  any income tax included in other comprehensive income  the current and deferred tax components of income tax expense  whether a deferred tax asset or deferred tax liability or both is disclosed in the statement of financial position and the magnitude of their balances. This is an open-ended case for student presentation. Students should use the ASX website by clicking on “Prices and Research” and then use the drop down menu for “Company

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Information” and follow the link for “View all companies” in the “Company Directory” (http://www.asx.com.au/asx/research/listedCompanies.do). You will find the companies in each industry as per the “GICS Industry Group”. Select three companies from three different industries and go from there to the annual reports of each company in the announcements section to view the income tax disclosures in the financial statements and notes. Alternatively students can use a search engine, such as Google, to find the financial statements and notes of three appropriate companies. The presentation should consider if deferred tax liabilities or deferred tax assets are expected based on what the company’s operations are. For example, Telstra has large capital expenditure commitments that involving property, plant and equipment at accelerated tax depreciation rates and should be expected to have a large deferred tax liability.

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Application and analysis exercises Exercise 12.1 Tax effects of a temporary difference The following information was extracted from the records of Bowen Ltd for the year ended 30 June 2022 in relation to equipment that had cost $120 000 on 1 July 2019.

Assets Equipment

Carrying amount $

Future taxable amount $

Future deductible amount $

Tax base $

30 000

48 000

Taxable temporary differences $

Deductible temporary differences $ 18 000

Equipment is depreciated at 25% p.a. straight-line for accounting purposes, but the allowable rate for taxation is 20% p.a. Required Assuming that no equipment is purchased or sold during the years ended 30 June 2022 to 30 June 2024, calculate the: 1. accounting expense and tax deduction for each year 2. impact of depreciation on the calculation of current tax expense for each year 3. effect on the deferred tax asset account each year. (LO4 and LO5) The tax rate for the solution provided below is 30%. Year ended 30 June 2022 1. Accounting depreciation expense: $30 000 ($120 000 x 25%). Taxation depreciation deduction: $24 000 ($120 000 x 20%). 2. The accounting depreciation expense of $30 000 is added back to accounting profit before tax and then the tax deduction for depreciation of $24 000 is subtracted to determine taxable profit on which the current tax expense is calculated. 3. Deferred tax effect . Carrying amount Tax base Deductible temporary difference

$30 000 48 000 $18 000

A deferred tax asset of $5 400 (being 30% x $18 000) exists in relation to this asset at 30 June 2022. This reflects 3 years of $6 000 difference between the accounting and tax depreciation amounts.

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Year ended 30 June 2023 Current tax effect 1. Accounting depreciation expense: $30 000 ($120 000 x 25%). Taxation depreciation deduction: $24 000 ($120 000 x 20%). 2. The accounting depreciation expense of $30 000 is added back to accounting profit before tax and then the tax deduction for depreciation of $24 000 is subtracted to determine taxable profit on which the current tax expense is calculated. 3. Deferred tax effect Carrying amount Tax base Deductible temporary difference

$0 24 000 $24 000

There would be a balance in the deferred tax asset account of $7 200, being 30% x $24 000. This reflects 4 years of $6 000 difference between the accounting and tax depreciation amounts. Year ended 30 June 2024 1. Accounting depreciation expense: $0. Taxation depreciation deduction: $24 000 ($120 000 x 20%). 2. The tax deduction for depreciation of $24 000 is subtracted to determine taxable profit on which the current tax expense is calculated. 3. Deferred tax effect Carrying amount Tax base

$0 $0

There would be a zero balance in the deferred tax account, caused by a $7 200 credit adjustment to the account, being 30% x $24 000 – the opening balance of the deferred tax asset account was $7 200.

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Exercise 12.2 Applying tax‐effect accounting Orca Ltd applies the principles of tax‐effect accounting as per AASB 112/IAS 12 in accounting for company income tax. Orca Ltd calculates depreciation expense on its plant using the straight‐line method, but applies an accelerated method for tax purposes. Tax depreciation in the current year is then larger than the related accounting depreciation expense. Orca Ltd has also recognised rent received in advance from buildings that it owns. These revenues are included in the current year’s taxable profit but shown in the financial statements as a liability.

Required 1. Explain the principles underlying tax‐effect accounting. 2. Determine how Orca Ltd should account for the above differences for accounting and tax. 3. Analyse under what circumstances Orca Ltd should raise deferred tax accounts and how they should be classified in the statement of financial position. (LO1, LO2, LO3 and LO5) 1. The main principles of tax-effect accounting can be found in paragraphs 12, 15 and 24 of AASB 112/IAS 12. The principles consider not only the current tax consequences, but place special emphasis on the future tax consequences arising as a result of differences between the carrying amounts of an entity’s net assets determined under accounting standards and the tax bases of those net assets, determined under the Tax Act. As the objective paragraph of AASB 112/IAS 12 points out, the principal issue in accounting for income taxes is how to account for the current and future tax consequences of: (a) the future recovery (settlement) of the carrying amount of assets (liabilities) that are recognised in a company’s statement of financial position; and (b) transactions and other events of the current period that are recognised in a company’s financial statements. AASB 112/IAS 12 adopts the philosophy that, as a general rule, the tax consequences of transactions that occur during a period should be ‘recognised as income or an expense in the net profit or loss for the period’ irrespective of when those tax effects will occur. A transaction may have two tax ‘effects’: i. Tax payable on the current profit earned for the year may be reduced or increased because the transaction is not taxable or deductible in the current year. ii. Future tax payable may be increased or reduced when that transaction becomes taxable or deductible. If only current tax payable is recorded as an expense, the accounting profit after tax for the current year is overstated (understated) by the amount of tax (benefit) to be paid (received) in future years. Similarly, in the years that the tax (benefit) on these transactions is paid (received), income tax expense will include amounts relating to prior periods and therefore be overstated (understated). To illustrate, consider an entity with accrued interest of $12 000 at end of reporting period. Assuming accrued interest is deductible only when paid, taxable profit will be $12 000 greater

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than accounting profit, resulting in $3 600 extra tax being paid (assuming a 30% tax rate). In the next accounting period, the tax deduction for interest paid results in a taxable profit that is $12 000 lower than the accounting profit. This tax benefit reduces the current tax expense by $3 600 although the transaction occurred in the prior year. If only current tax payable calculated based on the taxable profit is recorded as an expense, the accounting profit after tax for the current year is overstated by the amount of benefit to be received in future years. Similarly, in the years that the benefit on this transaction is received, income tax expense will include benefits relating to prior periods and therefore be understated. 2. Plant: • In any year the carrying amount of the plant for accounting purposes will be higher than that for tax purposes. In other words, the tax base, being the future deductible amount, will be lower than the carrying amount. As the carrying amount is greater than the tax base (in other words, future taxable amount is greater than future deductible amount), a taxable temporary difference arises giving rise to a deferred tax liability. Revenue received in advance: • The tax base for such a liability is equal to the carrying amount of the liability less the revenue received in advance which will not be taxable in future periods: The tax base for such a liability is always equal to zero. This gives rise to a deductible temporary difference, causing a deferred tax asset to be raised. The tax has already been paid on the revenue, being paid on receipt of the revenue paid in advance. 3. Deferred tax liabilities must be recognised for all taxable temporary differences under any circumstances. Therefore, Orca Ltd will recognise the deferred tax liability generated by the revenue received in advance. Deferred tax assets must be recognised for all deductible temporary differences and from tax losses carried forward but only to the extent that is it probable that future taxable profits will be available against which these deductible temporary differences or tax losses can be utilised. According to the Conceptual Framework, paragraph 89, an asset is recognised when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably. The Conceptual Framework, paragraph 85, states that the concept of probability refers to the degree of uncertainty that the future economic benefits associated the asset will flow to the entity. This probability must be assessed using the best evidence available when the financial statements are prepared. Deductible temporary differences result in deductions against taxable profits of future periods. However, economic benefits in the form of reductions in tax payments will flow to the enterprise only if it earns sufficient taxable profits against which the deductions can be offset. Therefore, Orca Ltd will recognise a deferred tax asset for plant only when it is probable that taxable profits will be available against which the deductible temporary difference for plant can be utilised.

12.25

Chapter 12: Income taxes

Exercise 12.3 Calculation of current tax Mandiri Ltd made an accounting profit before tax of $80 000 for the year ended 30 June 2024. Included in the accounting profit were the following items of revenue and expense. Donations to political parties (non‐deductible)

7 000

Depreciation expense — machinery (20% p.a., straight‐line)

18 000

Annual leave expense Rent revenue

6 400 12 000

For tax purposes the following applied. Depreciation rate — machinery Annual leave paid Rent received Income tax rate

$ $

25% 7 800 10 000 30%

Required 1. Calculate the current tax liability for the year ended 30 June 2024, and prepare the adjusting journal entry. 2. Explain your treatment of rent items in your answer to requirement 1. (LO3 and LO4) 1. MANDIRI LTD Current tax worksheet for year ended 30 June 2024 Accounting profit Add: Donations to political parties (non-deductible) Depreciation expense – machinery Annual leave expense Rent received Deduct: Depreciation – machinery (tax) Annual leave paid Rent revenue Taxable profit Current tax liability @ 30%

$80 000 7 000 18 000 6 400 10 000

22 500 7 800 12 000

41 400 121 400

(42 300) 79 100 $23 730

Adjusting journal entry 30 June 2024 Income tax expense (current)

23 730

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Current tax liability Cr (Being recognition of current tax liability)

23 730

2. Rent is recognised as income by Mandiri Ltd as it is earned, but will not be taxable income until the cash is received. In the current year only $10 000 of the $12 000 rental income earned has been received and thus, an adjustment is required to remove $2 000 from the accounting profit when calculating the company’s tax liability for the current year. In the worksheet this is accomplished by adding all rent received in cash to accounting profit and deducting all rent income recognised. This difference will create a deferred tax liability of $600 ($2 000 x 30%) which will be recognised via the deferred tax worksheet. When the cash is received next year the company will add $2 000 rent to the accounting profit, pay the $600 tax and reverse the tax liability.

12.27

Chapter 12: Income taxes

Exercise 12.4 Calculation of current tax Magpalitan Ltd recorded an accounting profit before tax of $100 000 for the year ended 30 June 2025. Included in the accounting profit were the following items of revenue and expense.

For tax purposes the following applied.

Required 1. Use a current tax worksheet to calculate the current tax liability for the year ended 30 June 2025. Prepare the journal entry to record current tax. 2. Explain the future tax effect of the adjustment made in requirement 1 for rent revenue/received. (LO3 and LO4) 1. MAGPALITAN LTD Current tax worksheet for year ended 30 June 2025 $ Accounting profit Add: Entertainment expense (non-deductible) Depreciation expense – furniture Rent received

2 000 17 000 3 000

Deduct: Depreciation – furniture (tax) Rent revenue Taxable profit Current tax liability @ 30%

25 500 2 500

$ 100 000

22 000 122 000

28 000 94 000 28 200

The entry to recognise current tax is: Income tax expense (current) Current tax liability

Dr Cr

28 200 28 200

2. In part 1, an additional $500 ($3 000 – $2 500) was added to accounting profit to determine taxable profit for the year resulting in an increase in current tax liability of $150 ($500 x 30%). This adjustment creates a deductible temporary difference which will reverse next year when accounting profit will be $500 greater than taxable profit but no additional tax will be payable.

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Exercise 12.5 Calculation of deferred tax The following information was extracted from the records of Sol Ltd for the year ended 30 June 2024. SOL LTD Statement of financial position (extract) as at 30 June 2024 Assets Accounts receivable Allowance for doubtful debts

50 000 (4 000) 200 000 (50 000)

Motor vehicles Accumulated depreciation — motor vehicles Liabilities Interest payable

46 000 150 000 2 000

Additional information • The accumulated tax depreciation for motor vehicles at 30 June 2024 was $100 000. • The tax rate is 30%. Required Prepare a deferred tax worksheet to identify the temporary differences arising in respect of the assets and liabilities in the statement of financial position, and to calculate the balance of the deferred tax liability and deferred tax asset accounts at 30 June 2024. Assume the opening balances of the deferred tax accounts were $0. (LO5)

Carrying Amount $ Assets Accounts receivable Motor vehicles Liabilities Interest payable TTD Excluded TD Net TD DTL DTA

SOL LTD Deferred tax worksheet as at 30 June 2024 Future Future Tax Taxable Deductible Base Amount Amount $ $ $

46 000

4 000

50 000

150 000

100 000

2 000

Taxable Temporary Differences $

Deductible Temporary Differences $ 4 000

50 000

50 000 50 000 15 000

2 000 6 000 6 000 1 800

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Chapter 12: Income taxes

Beginning balances Movement during year Adjustment

(0)

15 000 Cr

1 800 Dr

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Exercise 12.6 Current and future tax consequences Explain which of the following have current or future tax consequences. 1. Estimated warranty costs covering a 3-year warranty period are expensed for financial reporting purposes over a 3-year period but are treated as a tax deduction in the year in which a claim is made by a customer. 2. The company has recognised entertainment expenses in the current period for financial reporting purposes but these outlays are never deductible for tax purposes. 3. Insurance is paid 2 years in advance and a prepaid asset is recognised for accounting purposes. A tax deduction is claimed when the cash is paid. (LO3) 1. Warranty costs For accounting purposes, there is an accounting expense in the year of sale of inventory. For tax purposes, a tax deduction is available in the year a claim is made. Hence, there are current and future tax consequences – evidenced by the accrual of the liability. In relation to current tax, in the years where no warranty claims are received and paid, there is an accounting expense but no tax deduction. In relation to deferred tax, warranty is a liability for which the tax base equal 0 as the future deductible amount equals carrying amount. As the carrying amount would then be greater than the tax base, a deductible temporary difference arises. A deferred tax asset would be raised to reflect potential future consequences, namely the receipt of a tax deduction in the event of a claim on the warranty by a customer. 2. Entertainment costs For accounting purposes, there is an expense in the year of outlay. For tax purposes, there is never a tax deduction. Hence, this item only has current period tax consequences – note there is no accrual of an asset or a liability. In calculating current tax, the accounting expense would have to be added back to accounting profit and no tax deduction being allowed. 3. Prepaid insurance For accounting purposes an expense and a prepaid asset are recognised in the first year. In the second year, a further expense is recognised and the prepaid asset is de-recognised. For tax purposes, a tax deduction is received in the first year when the insurance was paid. Hence, for this item there are both current and future consequences – evidenced by the accrual of the asset. In calculating current tax, the accounting expense would be added back to accounting profit and the amount paid – 2 years of insurance – would be deducted to determine taxable profit. In calculating deferred tax, as there are taxable economic benefits, tax base is equal to future deductible amount. However, for the prepaid insurance, the future deductible amount is zero, hence the tax base is zero. As the carrying amount is greater than the tax base, there is a taxable temporary difference. The company expects to earn benefits in the second year and the tax deduction has already been received.

12.31

Chapter 12: Income taxes

Exercise 12.7 Change in tax rates At 30 June 2023, Blue Heeler Ltd recognised a deferred tax asset of $12 000 and a deferred tax liability of $15 000. This has resulted by applying a tax rate of 30%. The Australian government has determined to raise more revenue from companies by way of taxation. It announced that it will increase the tax rate as of 1 July 2023 to 35%. In its deferred tax worksheet for the year ending 30 June 2024, Blue Heeler Ltd calculated that its taxable temporary differences were $6000 and its deductible temporary differences were $12 000. Required Prepare a report for the chief accountant on how the increase in the tax rate will affect the application of tax-effect accounting for the year ended 30 June 2024. (LO6) The change in the tax rates affects the opening balances of the deferred tax asset and the deferred tax liability at 30 June 2024. Each deferred tax account at 1 July 2023 will be increased by (35-30)/30. Hence, the deferred tax asset will increase by (35-30)/30 x $12 000 = $2 000 (or $12 000/30% x 35% - $12 000). The deferred tax liability will increase by (35-30)/30 x $15 000 = $2 500 (or $15 000/30% x 35% - $15 000). The journal entry at 1 July 2023 to recognise the effect of the change in tax rate on the opening balances of deferred tax asset and deferred tax liability is: Income tax expense Deferred tax asset Deferred tax liability

Dr Dr Cr

500 2 000 2 500

These effects on deferred tax asset and deferred tax liability are shown as movements in the deferred tax worksheet at 30 June 2024. The temporary differences in the period ended 30 June 2024 will result in the ending balances of the deferred tax asset and deferred tax liability based on the 35% tax rate.

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Exercise 12.8 Recognition of deferred tax assets Orbost Ltd manufactures its products in Australia. In the past, Orbost Ltd has relied heavily on the export of its products to the United States. In 2022 the company’s profits have declined as sales both in Australia and overseas have fallen. As a result, the company has had to retrench some of its employees as it has endeavoured to streamline its business and search for new markets. The company has always had a generous employee scheme whereby employees were entitled to good long service leave payments as well as payments in the event of redundancy. These expenses were recognised for financial reporting purposes on an annual basis but no tax deductions were allowed until cash payments were made. The company has raised deferred tax assets in relation to these items in its financial statements. On retrenching its employees, the company has been able to claim tax deductions for the long service leave and retrenchment payouts. This has resulted in the company recording a tax loss in 2022. Required Write a report to the group accountant of Orbost Ltd, covering your assessment of the company: 1. continuing to raise deferred tax assets in relation to long service leave and redundancy payouts 2. raising a deferred tax asset in relation to the current period tax loss 3. raising any deferred tax liabilities such as for depreciation of the manufacturing machinery. (LO5) 1. Long service leave liabilities and redundancy payouts provide tax deductions on the payment of cash to employees. For accounting purposes, an expense is recognised gradually as the long service leave accrues. Hence, there is a difference between the carrying amount of the liability for accounting purposes and the tax base of zero, caused by the existence of a future deductible amount for tax when cash is paid. The resulting deductible temporary difference leads to the existence of a deferred tax asset. Paragraph 24 of AASB 112/IAS 12 specifies that a deferred tax asset can be recognised ‘to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised’. Paragraph 28 of AASB 112/IAS 12 states: It is probable that taxable profit will be available against which a deductible temporary difference can be utilised when there are sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity which are expected to reverse: i. in the same period as the expected reversal of the deductible temporary difference; or ii. in periods into which a tax loss arising from the deferred tax asset can be carried © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

back or forward. When there are insufficient taxable temporary differences for the entity to use against the deductible temporary differences, a deferred tax asset can be recognised only to the extent that it is probable that the entity will have enough taxable income in the same period as the reversal of the deductible temporary difference or recovery of a tax loss, or tax planning opportunities are available to the entity that will create taxable income in appropriate periods (paragraph 29 of AASB 112/IAS 12). All available evidence, both positive and negative, must be evaluated before determining whether to recognise a deferred tax asset. In evaluating whether the entity will have sufficient taxable income in future periods, paragraph 29 of AASB 112/IAS 12 states that the entity must ignore the taxable amounts arising from deductible temporary differences expected to originate in future periods, because the deferred tax asset from future deductible temporary differences will itself require future taxable income in order to be used. Based on these requirements, there are doubts about the legitimacy of the deferred tax assets recognised by Orbost Ltd. 2. In relation to tax losses, the recognition criteria are discussed in paragraph 34 of AASB 112/IAS 12. A deferred tax asset arising from the carry forward of an unused tax loss must be recognised to the extent that it is probable that future taxable profits will be available against which the unused tax loss can be used. It appears, therefore, that the recognition criteria for deferred tax assets from tax losses are the same as the recognition criteria for other deferred tax assets, described above in item (a). AASB 112/IAS 12 also points out, however, that the mere existence of a tax loss provides strong evidence that future taxable income may not be available to ensure that the deferred tax asset from the tax loss is recognisable. Paragraph 35 of AASB 112/IAS 12 states that when an entity has a history of recent losses, it can recognise a deferred tax asset from tax losses only to the extent that it has sufficient taxable temporary differences, or there is other convincing evidence that sufficient taxable profits will be available in the future against which the unused tax losses can be used. Paragraph 36 of AASB 112/IAS 12 specifies a number of factors which the entity must consider in assessing the probability that a deferred tax asset from a tax loss can be recognised: • whether the entity has sufficient taxable temporary differences which will result in taxable amounts in future so that the tax losses can be used • whether it is probable that the entity will have future taxable profits before the tax losses expire (this is not an issue in Australia as tax losses can be carried forward indefinitely) • whether the unused tax losses result from identifiable causes which are unlikely to recur • whether tax planning opportunities are available to the entity that will create sufficient future taxable profits to recover the tax losses. If, based on an assessment of the evidence, it is not probable that sufficient future taxable income will exist, then a deferred tax asset can be recognised only to the extent that it can be recovered against the future taxable income available. Orbost Ltd will need to generate evidence about its ability to generate taxable income in the future. There may need to be evidence of continuing contracts with, say, the US police force, and evidence of new markets in Australia, or information of a movement in the Australian dollar to the benefit of the company.

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There is no evidence in the question to suggest a deferred tax asset should be raised in relation to the tax loss. 3. There are no recognition criteria in relation to deferred tax liabilities. All deferred tax liabilities must be raised. Hence is depreciation is being charged at a higher rate for tax than accounting, a deferred tax liability must be raised.

12.35

Chapter 12: Income taxes

Exercise 12.9 Creation and reversal of temporary differences The following are all independent situations. Prepare the journal entries for deferred tax on the creation or reversal of any temporary differences. Explain in each case the nature of the temporary difference. Assume a tax rate of 30%. 1. The entity has an allowance for doubtful debts of $10 000 at the end of the reporting period relating to accounts receivable of $125 000. The prior period balances for these accounts were $8500 and $97 500 respectively. During the current period, debts worth $9250 were written off as uncollectable. 2. The entity sold a vehicle at the end of the reporting period for $15 000. The vehicle cost $100 000 when purchased 4 years ago, and had a carrying amount of $20 000 when sold. The tax depreciation rate for vehicle of this type is 25% p.a. 3. The entity has recognised an interest receivable asset with an opening balance of $17 000 and an ending balance of $19 500 for the current year. During the year, interest of $127 000 was received in cash. 4. At the end of the reporting period, the entity has recognised a liability of $4 000 in respect of outstanding fines for non-compliance with safety legislation. Such fines are not tax-deductible. (LO5) 1. Doubtful debts are recognised as an accounting expense when the likelihood of receiving a debt is doubtful, whereas for tax purposes the deduction will only be allowed when the debt is written out of the books as bad. The differential accounting treatment creates a temporary deductible difference when the allowance for doubtful debts is raised. The difference is reversed when the debts are written off as bad. Therefore, in this situation, the current year doubtful debts expense of $10 000 will not be an allowable deduction against taxable income and must be added back to accounting profit when income tax expense is being determined. On the other hand, the debts of $9 250 written off during the current year will be deductible. $8 500 of these debts were expensed in the prior year. Last year, the carrying amount of accounts receivable would have been $8 500 lower than the tax base giving rise to a deferred tax asset of $2 550 ($8 500 x 30%). The deferred tax asset will reverse this year, but a new deferred tax asset of $3 000 will be created due to allowance for doubtful debts of $10 000 raised in the current period giving rise to a net increase to the deferred tax asset of $450 ($3 000 - $2 550). The adjusting journal entry required will be: Deferred tax asset Income tax expense

Dr Cr

450 450

2. The accounting treatment for depreciation as per AASB 116/IAS 16 is to allocate the depreciable amount on a systematic basis over the asset’s useful life. The tax treatment is normally based on a standard set of rates supplied by the taxation authority and often different to the accounting depreciation rates. On sale of the vehicle, AASB 116/IAS 16 requires the entity to measure and report the difference between the proceeds on sale and the carrying amount of the asset at the date of sale as a gain/loss on sale. In this case, the accounting loss is $10 000 ($15 000 - $25 000). For taxation purposes, the difference between the proceeds and the carrying amount determined

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using tax depreciation rates will be taxable/deductible. The tax gain is $15 000 ($15 000 – $0) as the asset is fully depreciated for tax purposes. The net difference of $25 000 must be added to accounting profit to derive taxable profit resulting in $7 500 more tax being paid in the current year. This payment represents the reversal of a taxable temporary difference of $25 000 which has accumulated over the past three years when the carrying amount of the asset exceeded its tax base due to the depreciation rate differentials between accounting and taxation. A total deferred tax liability of $7 500 would have been recorded and must now be removed via the following journal entry: Deferred tax liability Dr 7 500 Income tax expense Cr 7 500 3. Interest income is recognised for accounting purposes when earned but is taxed when it is received in cash. In the current year, $127 000 cash was received representing $17 000 owing from last year and $110 000 earned this year. Accounting income for the current year is $129 500 ($110 000 received and $19 500 receivable). In the prior year, a taxable temporary difference of $19 000 was created by the recognition of the interest receivable (tax base $0). A deferred tax liability of $5 100 ($17 000 x 30%) would have been recognised. This tax difference has reversed with the receipt of the cash. The additional tax will be paid this year. However, a new temporary difference has been created by the recognition of this year’s interest receivable requiring a deferred tax liability of $5 850 ($19 500 x 30%) to be recognised. A net adjustment of $750 ($5 850 - $5 100) is required as follows: Income tax expense Deferred tax liability

Dr Cr

750 750

4. As the fines are non-deductible for taxation purposes no temporary difference can exist with respect to the liability. The fines expense recorded in the current year will be added back to accounting profit; taxable profit will exceed accounting profit by $4 000; and tax of $1 200 will be paid.

12.37

Chapter 12: Income taxes

Exercise 12.10 Creation and reversal of a temporary difference Injune Ltd purchased machinery on 1 July 2020 at a cost of $75 000. The machinery had an expected useful life of 5 years and was to be depreciated on a straight-line basis. The tax depreciation rate for machinery of this type is 15% p.a., straight-line. On 30 June 2022, Injune Ltd reassessed the remaining useful life of the machinery from 3 years to 2 years, and the accounting depreciation charge was adjusted accordingly. The machinery was sold on 30 June 2023 for $45 000. The company tax rate is 30%. Required For each of the years ended 30 June 2021, 30 June 2022 and 30 June 2023, calculate the carrying amount and the tax base of the asset and determine the appropriate deferred tax entry. Explain your answer. (LO5)

Cost Depreciation (2020-2021) Carrying amount (30/6/2021) Depreciation (2021-2022) Carrying amount (30/6/2022) Depreciation (2022-2023) Carrying amount (30/6/2023) Proceeds on sale Gain on sale

Accounting 75 000 (15 000) 60 000 (15 000) 45 000 (22 500) 22 500 (45 000) 22 500

Taxation 75 000 (11 250) 63 750 (11 250) 52 500 (1 250) 41 250 (45 000) 3 750

Injune Ltd Calculation of deferred tax (extract) as at 30 June 2021 Carrying Future Future Tax Taxable Amount Taxable Deductible Base Temporary Amount Amount Differences $ $ $ $ $ Machinery

60 000

63 750

Deductible Temporary Differences $ 3 750

The differential in depreciation rates has created a deductible temporary difference of $3 750. Injune Ltd will receive these deductions at the end of the asset’s useful life when taxation deductions exist but the equipment is fully depreciated for accounting purposes. A deferred tax asset must be created as follows: Deferred tax asset Income tax expense

Dr Cr

1 125 1 125

Injune Ltd Calculation of deferred tax (extract) as at 30 June 2022

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Carrying Amount

Machinery

Future Taxable Amount $

Future Deductible Amount $

45 000

52 500

Tax Base $

Taxable Temporary Differences $

52 500

Deductible Temporary Differences $ 7 500

The deductible temporary difference has increased to $7 500 (representing two year’s depreciation differentials). A deferred tax asset for $1 125 already exists so this year’s adjustment will add a further $1 125 as follows: Deferred tax asset Income tax expense

Dr Cr

1 125 1 125

Injune Ltd Calculation of deferred tax (extract) as at 30 June 2023 Carrying Future Future Tax Taxable Amount Taxable Deductible Base Temporary Amount Amount Differences $ $ $ $ $ Machinery

Deductible Temporary Differences $ 0

As the asset has been sold the temporary difference will reverse. In the current tax worksheet there will be two differences impacting on taxable profit: • difference between the accounting gain on sale $22 500 and the taxable gain $3 750 will reduce taxable profit by $18 750 • difference between accounting depreciation expense $22 500 and tax deductible depreciation $11 250 will increase taxable profit by $11 250. The net decrease of $7 500 will result in $2 250 less tax being paid in the current year. This benefit represents the reversal of the deferred tax asset. The adjusting journal entry is: Income tax expense Deferred tax asset

Dr Cr

2 250

12.39

Chapter 12: Income taxes

Exercise 12.11 Calculation of deferred tax, and adjustment entry The following information was extracted from the records of Jondaryan Ltd as at 30 June 2023.

The depreciation rates for accounting and taxation are 15% p.a. and 25% p.a. respectively. Deposits are taxable when received, and warranty costs are deductible when paid. An allowance for doubtful debts of $25 000 has been raised against accounts receivable for accounting purposes, but such debts are deductible only when written off as uncollectable. Required 1. Calculate the temporary differences for Jondaryan Ltd as at 30 June 2023. Justify your classification of each difference as either a deductible temporary difference or a taxable temporary difference. 2. Prepare a deferred tax worksheet and the journal entry to record deferred tax for the year ended 30 June 2023 assuming no deferred items had been raised in prior years. (LO5) 1. Accounts receivable: • The carrying amount is $25 000 less than the tax base due to the allowance for doubtful debts. This reduction will only occur for taxation purposes when the debts actually go bad and are written off in the books. Thus, a deductible temporary difference exists for which a deferred tax asset will be raised. Motor vehicles: • The tax base for motor vehicles is less than the carrying amount because the asset is being depreciated faster for taxation purposes than for accounting. Thus, the company will be paying less tax in the early years of the asset’s useful life due to the extra deduction for depreciation. When the asset is written off for tax purposes the accounting expense will not be deductible and more tax will be payable. Thus, a deferred tax liability is created. Provision for warranty: • The carrying amount of the liability is $12 000 greater than the tax base of zero. Expenditure on warranty claims will only be deductible when they are paid. Hence the carrying amount represents future deductions for which a deferred tax asset should be raised. Deposits received in advance: • The deposits have been deferred for accounting purposes and will be recognised as income when the goods or services relating to the deposit have been provided in a future accounting period(s). For tax purposes, the money is taxable on receipt. As the money has been received and the tax paid then when the income is recorded as accounting profit no tax will be payable. The prepayment of tax creates a deductible temporary difference and a deferred tax asset.

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Carrying Amount $ Assets Accounts receivable Motor vehicles Liabilities Provision for warranty Deposits in advance TTD Excluded TD Net TD DTL DTA Beginning balances Movement during year Adjustment

JONDARYAN LTD Deferred tax worksheet as at 30 June 2023 Future Future Tax Taxable Deductible Base Amount Amount $ $

Taxable Temporary Differences $

Deductible Temporary Differences $

150 000

175 000

25 000

165 000

125 000

12 000

15 000

40 000

40 000 40 000 12 000

52 000 52 000

(0)

15 600 (0)

12 000 Cr

15 600 Dr

The journal entry to record deferred tax is: Deferred tax asset Deferred tax liability Income tax expense (deferred)

Dr Cr Cr

15 600

12 000 3 600

12.41

Chapter 12: Income taxes

Exercise 12.12 Calculation of current and deferred tax, and adjustment Shengli Ltd commences operations on 1 July 2023. One year later, on 30 June 2024, the entity prepares its first statement of comprehensive income and its first statement of financial position. The statements are prepared before considering taxation. The following information is available. Statement of comprehensive income for the year ended 30 June 2024 Gross profit Wages expense Annual leave expense Bad debts expense Rent expense Depreciation expense — furniture and fittings

$ 250 000 (100 000) (25 000) (10 000) (25 000) (15 000) 75 000

Accounting profit before tax Assets and liabilities as disclosed in the statement of financial position as at 30 June 2024 Assets Cash Inventories Accounts receivable (net) Prepaid rent Furniture and fittings Accumulated depreciation — furniture and fittings

$ 75 000 100 000 90 000 25 000 75 000) (15 000 350 000

Liabilities Accounts payable Revenue received in advance Loan payable Provision for annual leave

50 000 25 000 100 000 25 000 200 000

Additional information • The company tax rate is assumed to be 30%. • All salaries have been paid as at year end and are deductible for tax purposes. • None of the annual leave expense has actually been paid. It is not deductible for tax purposes until it is actually paid. • Rent was paid in advance on 1 July 2023. Actual amounts paid are allowed as a tax deduction.

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• Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. No bad debts were written off. • The revenue received in advance is included in the taxable income. • The furniture and fittings is depreciated on a straight-line basis over 5 years for accounting purposes, but over 3 years for taxation purposes. The furniture and fittings is not expected to have any residual value. Required 1. Prepare the current tax worksheet and the journal entry to recognise current tax at 30 June 2024. 2. Prepare the deferred tax worksheet and journal entries to adjust deferred tax accounts. (LO4 and LO5) 1. SHENGLI LTD Current tax worksheet for year ended 30 June 2024 $ Accounting profit Add: Wages expense Annual leave expense Bad debts expense Rent expense Depreciation expense – furniture and fittings Revenue received in advance Deduct: Wages paid Annual leave paid Bad debts written off Rent paid Depreciation – furniture and fittings (tax) Taxable profit Tax payable @ 30%

100 000 25 000 10 000 25 000 15 000 25 000

100 000 0 0 50 000 25 000

$ 75 000

200 000 275 000

175 000 100 000 30 000

Rent paid: rent expense for the year ended 30 June 2024 ($25 000) + prepaid rent at 30 June 2024 ($25 000) = $50 000. Depreciation of furniture and fittings for tax purposes: $75 000 / 3 = $25 000. Note that revenue received in advance is not recognised as part of the revenues earned in the calculation of the accounting profit, but it is a taxable income in the calculation of the taxable profit. The entry to recognise current tax is: Income tax expense (current) Current tax liability

Dr Cr

30 000 30 000

2. © John Wiley and Sons Australia Ltd, 2020

12.43

Chapter 12: Income taxes

Carrying Amount $ Relevant Assets Accounts receivable Prepaid rent Furniture and fittings Relevant Liabilities Revenue received in advance Provision for annual leave Total Temporary Differences Excluded differences Temporary Differences DTL DTA Beginning balances Movements during year Adjustment

SHENGLI LTD Deferred tax worksheet as at 30 June 2024 Future Future Tax Base Taxable Deductible Amount Amount $ $ $

Taxable Temporary Differences $

Deductible Temporary Differences $

90 000

10 000

100 000

10 000

25 000 60 000

0 50 000

25 000

25 000 10 000

35 000

60 000

35 000

60 000

10 500 (0)

18 000 (0)

10 500 Cr

18 000 Dr

The entry to adjust deferred tax accounts is: Deferred tax asset Deferred tax liability Income tax expense (deferred)

Dr Cr Cr

18 000 10 500 7 500

Please note that the income tax expense is equal to $22 500 (the debit of $30 000 from the current tax entry is adjusted by the credit of $7 500 from the deferred tax entry) – that is equal to the accounting profit before tax of $7 500 multiplied by the tax rate (as there are no permanent differences).

12.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.13 Calculation of current and deferred tax, and adjustment entry Bondi Ltd’s accounting profit before tax for the year ended 30 June 2024 was $150 000. At 30 June 2023 and 30 June 2024, the company’s draft statements of financial position showed the following balances. 2023 Assets Cash Inventories Accounts receivable Allowance for doubtful debts Prepaid insurance Equipment Accumulated depreciation — equipment Buildings Accumulated depreciation — buildings Goodwill Deferred tax asset Liabilities Accounts payable Accrued expenses Mortgage loan Warranty payable Current tax liability Deferred tax liability

40 000 150 000 300 000 (15 000) 20 000 200 000 (100 000) 400 000 (140 000) 40 000 45 000

255 000 120 000 210 000 70 000 9 000 12 000

2024 $

50 000 160 000 420 000 (21 500) 15 000 260 000 (146 000) 400 000 (160 000) 40 000 ?

270 000 90 000 210 000 50 000 ? ?

Additional information • The company tax rate is assumed to be 30%. • During the year ended 30 June 2024, Bondi Ltd received a non-taxable royalty revenue of $20 000. • Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. Bondi Ltd recognised $20 000 in bad debts expense during the year ended 30 June 2024. • Insurance expense incurred during the year ended 30 June 2024 was $20 000. The amounts paid in cash for insurance are allowed to be claimed as deductions for tax purposes. • The equipment is depreciated on a straight-line basis over 5 years for accounting purposes and over 4 years for taxation purposes. The equipment is not expected to have any residual value. The only movement in the equipment account during the year ended 30 June 2024 was a result of Bondi Ltd acquiring a new equipment on 1 January 2024. © John Wiley and Sons Australia Ltd, 2020

12.45

Chapter 12: Income taxes

• The buildings are depreciated on a straight line basis over 20 years for accounting purposes and are not expected to have any residual value. Depreciation of buildings is not allowed to be claimed as a deduction for tax purposes. There is no movement in the Buildings account during the year ended 30 June 2024. • During the year ended 30 June 2024, Bondi Ltd paid accrued expenses of $210 000 and recognised $45 000 in warranty expense. These expenses are not deductible for tax purposes until they are actually paid. • There are no other items that cause differences between accounting and taxable profit. • During the year ended 30 June 2024, Bondi Ltd paid the Australian Taxation Office the following instalments for income tax: 1. 2. 3. 4.

28 July 2023: $9 000 28 October 2023: $7 000 28 February 2024: $7 500 28 April 2024: $8 000.

Required 1. Prepare the current tax worksheet and the journal entry to recognise current tax at 30 June 2024. 2. Prepare the deferred tax worksheet and journal entries to adjust deferred tax accounts. (LO4 and LO5) 1. BONDI LTD Current tax worksheet for year ended 30 June 2024 $ Accounting profit Add: Bad debts expense Insurance expense Depreciation expense – equipment Depreciation expense – buildings (non-deductible) Accrued expense Warranty expense Deduct: Royalty revenue (tax exempt) Bad debts written off Insurance paid Depreciation – equipment (tax) Accrued expenses paid Warranty paid Taxable profit Tax payable @ 30% Less quarterly tax paid (from October 2023 to April 2024) Current tax liability

20 000 20 000 46 000 20 000 180 000 45 000

20 000 13 500 15 000 57 500 210 000 65 000

$ 150 000

331 000 481 000

(381 000) 100 000 30 000 (22 500) 7 500

12.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Workings: Bad debts written off: opening balance of allowance for doubtful debts ($15 000) + bad debts expense ($20 000) – ending balance of allowance for doubtful debts ($21 500) = $13 500. Insurance paid: ending balance of prepaid insurance ($15 000) + insurance expense ($20 000) – opening balance of prepaid insurance ($20 000) = $15 000. Depreciation of equipment for tax purposes: depreciation of old equipment ($200 000 / 4) + depreciation of new equipment acquired on 1 January 2024 ([$260 000 - $200 000] / 4 / 2) = $57 500. Accrued expenses: ending balance of accrued expenses ($90 000) + accrued expenses paid ($210 000) – opening balance of accrued expenses ($120 000) = $180 000. Warranty paid: opening balance of warranty payable ($70 000) + warranty expense ($45 000) – ending balance of warranty payable ($50 000) = $65 000. Those amounts (excluding the depreciation of equipment for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows: Allowance for doubtful debts $ Bad debts written off 13 500 Opening balance Ending balance 21 500 Expense 35 000

$ 15 000 20 000 35 000

Prepaid insurance $ 20 000 15 000 35 000

$ 20 000 15 000 35 000

Opening balance Insurance paid

Expense Ending balance

Accrued expenses payable $ 210 000 Opening balance 90 000 Accrued expense 300 000

Expenses paid Ending balance

Warranty paid Ending balance

Warranty payable $ 65 000 50 000 115 000

Opening balance Warranty expense

$ 120 000 180 000 300 000

$ 70 000 45 000 115 000

Please note that quarterly tax paid for the current year’s tax includes only the last three instalments shown in the question (from 28 October 2023 to 28 April 2024). The first instalment given on 28 July 2023 refers to the previous year’s tax. The entry to recognise current tax is: Income tax expense (current) Current tax liability

Dr Cr

7 500 7 500

This current tax liability for the year ended 20 June 2024 will be paid around 28 July 2024. © John Wiley and Sons Australia Ltd, 2020

12.47

Chapter 12: Income taxes

Carrying Amount

BONDI LTD Deferred tax worksheet as at 30 June 2024 Future Future Tax Base Taxable Deductible Amount Amount $ $ $

Taxable Temporary Differences $

$ Relevant Assets Accounts 398 500 0 21 500 420 000 receivable Prepaid 15 000 15 000 0 0 15 000 insurance Equipment 114 000 114 000 77 500 77 500 36 500 Goodwill 40 000 40 000 0 0 40 000 Relevant Liabilities Accrued 90 000 0 90 000 0 expenses Warranty 50 000 0 50 000 0 payable TTD 91 500 Excluded TD (40 000) Net TD 51 500 DTL 15 450 DTA Beginning (12 000) balances Movements during the year Adjustment 3 450 Cr Note that the future deductible amount for equipment is calculated as follows:

Deductible Temporary Differences $

21 500

90 000 50 000 161 500 161 500 48 450 (45 000) 3 450 Dr

Future deductible amount for equipment = Historical cost of total equipment ($260 000) – Accumulated tax depreciation of equipment ($182 500) Accumulated tax depreciation of equipment = Accumulated tax depreciation of old equipment + Accumulated tax depreciation of new equipment Accumulated tax depreciation of old equipment = Accumulated accounting depreciation of old equipment ($140 000) / accounting depreciation rate (20%) x tax depreciation rate (25%) = $175 000 Accumulated tax depreciation of new equipment = Historical cost of new equipment ($60 000) x tax depreciation rate (25%) / 2 = $7 500 (equal to the depreciation for tax of the new equipment during the current year)

12.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The entry to adjust the deferred tax accounts is: Deferred tax asset Deferred tax liability

Dr Cr

3 450

12.49

Chapter 12: Income taxes

Exercise 12.14 Calculation of current and deferred tax, and adjustment entry The profit before tax, as reported in the statement of profit and loss for Albury Ltd for the year ended 30 June 2024, amounted to $400 000, including the following revenue and expense items. Sales revenue Interest revenue Government grant (non‐taxable)

2 600 000 200 000 200 000 1 600 000 40 000 40 000 80 000 240 000 480 000 80 000

Cost of sales Bad debts expense Depreciation expense — equipment Depreciation expense — plant Research and development expense Wages expense Long service leave expense

The statement of profit and loss for Albury Ltd for the year ended 30 June 2024 also included a gain on sale of equipment of $40 000. According to AASB 116/IAS 16, this gain is not classified as revenue, but it is nevertheless part of the accounting profit before tax for the year. The draft statements of financial position of Albury Ltd at 30 June 2023 and 30 June 2024 showed the following assets and liabilities.

Assets Cash Inventories Accounts receivable Allowance for doubtful debts Interest receivable Equipment Accumulated depreciation — equipment Plant Accumulated depreciation — plant Goodwill Deferred tax asset Liabilities Accounts payable

2023

2024

120 000 400 000 200 000 (20 000) 100 000 120 000 (60 000) 800 000 (160 000) 60 000 132 000

$ 120 000 600 000 280 000 (40 000) 80 000 — — 800 000 (240 000) 60 000 ?

240 000

160 000

12.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Wages payable Revenue received in advance Loan payable Provision for long service leave Deferred tax liability

2023

2024

200 000 — 800 000 160 000 96 000

320 000 80 000 400 000 120 000 ?

Additional information • In the year ended 30 June 2023, Albury Ltd had a tax loss of $260 000 that it carried over in the deferred tax asset. In June 2024, the company received an amended assessment for the year ended 30 June 2023 from the ATO, indicating that an amount of $20 000 claimed as a deduction has been disallowed. Albury Ltd has not yet adjusted its accounts to reflect the amendment. • Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. All other general taxation rules apply. • The movement in the equipment account is caused by the sale of the equipment on 1 March 2024 for which a gain on sale of $40 000 was recognised as part of the profit before tax (see above). Albury Ltd had purchased the equipment on 1 July 2022 (with an estimated useful life of 2 years and no residual value) and for taxation purposes it claimed its full cost as a deduction at 30 June 2023. • The plant is depreciated on a straight-line basis over 10 years for accounting purposes, but over 5 years for taxation purposes. The plant is not expected to have any residual value. • All research and development expenses were paid in cash during the year ended 30 June 2024. • The company tax rate is assumed to be 30% for the year ended 30 June 2023 and 28% for the year ended 30 June 2024. The balances of the deferred tax accounts at 30 June 2023 are still reflecting the 30% tax rate. Required 1. Prepare the current tax worksheet and the journal entry to recognise current tax at 30 June 2024. 2. Prepare the deferred tax worksheet and journal entries to adjust deferred tax accounts. (LO4 and LO5)

ALBURY LTD Current tax worksheet for year ended 30 June 2024 $ Accounting profit Add: © John Wiley and Sons Australia Ltd, 2020

$ 400 000

12.51

Chapter 12: Income taxes

Interest received Bad debts expense Depreciation expense – equipment Depreciation expense – plant Research and development expense Wages expense Long service leave expense Revenue received in advance Gain on equipment sold (tax) Deduct: Interest revenue Government grant (tax exempt) Bad debts written off Depreciation – plant (tax) Research and development expense Wages paid Long service leave paid Gain on equipment sold (accounting) Taxable profit Add back exempt income

220 000 40 000 40 000 80 000 320 000 480 000 80 000 80 000 60 000

200 000 200 000 20 000 160 000 320 000 360 000 120 000 40 000

Tax loss recouped Taxable profit Tax payable @ 28%

1 400 000 1 800 000

(1 420 000) 380 000 200 000 580 000 (240 000) 340 000 95 200

Workings: Interest received: opening balance of interest receivable ($100 000) + interest revenue ($200 000) – ending balance of interest receivable ($80 000) = $220 000. Bad debts written off: opening balance of allowance for doubtful debts ($20 000) + bad debts expense ($40 000) – ending balance of allowance for doubtful debts ($40 000) = $20 000. Depreciation of plant for tax purposes: $800 000 / 5 = $160 000. Wages paid: opening balance of wages payable ($200 000) + wages expense ($480 000) – ending balance of wages payable ($320 000) = $360 000. Long service leave paid: opening balance of provision for long service leave ($160 000) + long service leave expense ($80 000) – ending balance of provision for long service leave ($120 000) = $120 000. Gain on equipment sold for tax purposes: as there are no further tax deductions available, the gain for tax purposes is equal to proceeds from sale = carrying amount of equipment sold ($120 000 - $60 000 - $40 000) + gain on sale for accounting purposes ($40 000) = $60 000. Those amounts (excluding the depreciation of plant and gain on equipment sold for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows: Interest receivable

12.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

$ 100 000 200 000 300 000

Opening balance Interest revenue

Interest received Ending balance

$ 220 000 80 000 300 000

Allowance for doubtful debts $ Bad debts written off 20 000 Opening balance Ending balance 40 000 Bad debts expense 60 000

$ 20 000 40 000 60 000

Wages payable $ 360 000 320 000 680 000

$ 200 000 480 000 680 000

Wages paid Ending balance

Opening balance Wages expense

Provision for long service leave $ Long service leave 120 000 Opening balance paid Ending balance 120 000 Long service leave expense 240 000

$ 160 000 80 000 240 000

Please note that the tax loss recouped is adjusted for the amount of $20 000 claimed as a deduction that has been disallowed by ATO. The entry to recognise current tax is: Income tax expense (current) Current tax liability Deferred tax asset

Dr Cr Cr

162 400 95 200 67 200

The entry affecting the deferred tax asset is recognised as part of the movement during the year in the deferred tax worksheet at 30 June 2024.

Carrying Amount $

ALBURY LTD Deferred tax worksheet As at 30 June 2024 Future Future Tax Base Taxable Deductible Amount Amount $ $ $ © John Wiley and Sons Australia Ltd, 2020

Taxable Temporary Differences $

Deductible Temporary Differences $ 12.53

Chapter 12: Income taxes

Relevant Assets Accounts receivable Interest receivable Plant Goodwill Relevant Liabilities Wages payable Revenue received in advance Provision for long service leave Total Temporary Differences Excluded differences Temporary Differences Deferred tax liability (28%) Deferred tax asset (28%) Beginning balances Movements during the year Adjustment

240 000

40 000

280 000

40 000

80 000

560 000 60 000

320 000 0

320 000 60 000

240 000 60 000

320 000

80 000

120 000

380 000

560 000

(60 000) 320 000

560 000

89 600 156 800 (96 000)

(132 000) 81 600 Cr

(6 400) Dr

106 400 Dr

Note that the future deductible amount for plant is calculated as follows: Future deductible amount for plant = Historical cost of total plant ($800 000) – Accumulated tax depreciation of equipment ($480 000). Accumulated tax depreciation of plant = Accumulated accounting depreciation of plant ($240 000) / accounting depreciation rate (10%) x tax depreciation rate (20%) = $480 000. Note that the movement in the deferred tax accounts during the year include (in order): 1. Adjustment to deferred tax asset due to the amended tax assessment for the year ended 30 June 2023. 2. Adjustment to deferred tax asset and deferred tax liability due to the change in tax rate. 3. Adjustment to deferred tax asset due to the use of the adjusted carry forward tax losses from the year ended 30 June 2023. © John Wiley and Sons Australia Ltd 2020

12.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

As a result of the amended tax assessment for the year ended 30 June 2023, the carry forward tax losses for the year ended 30 June 2024 becomes $240 000 (decreased by $20 000) and the opening balance of the deferred tax asset needs to be adjusted as follows (consider the tax rate of 30% applicable before the change in tax rate) – this is considered a part of the movement during the year before the use of the losses: Income tax expense Deferred tax asset

Dr Cr

6 000 6 000

As a result of the change in tax rate from 30% for the year ended 30 June 2023 to 28% for the year ended 30 June 2024, the adjusted opening balances of the deferred tax accounts need to be further adjusted as follows (before the use of tax losses). Deferred tax asset: ($132 000 - $6 000) / 30% x (30% – 28%) = $8 400 decrease Deferred tax liability: $96 000 / 30% x (30% – 28%) = $6 400 decrease The entry to adjust deferred tax accounts for the change in tax rate (recognised as part of the movement during the year) is: Income tax expense Deferred tax liability Deferred tax asset

Dr Dr Cr

2 000 6 400 8 400

Therefore, the total movements in the deferred tax asset and liability during the year is as follows. • Deferred tax asset decreases by $67 200 + $6 000 + $8 400 = $81 600 (recognised in the deferred tax worksheet as a credit) to $50 400. • Deferred tax liability decreases by $6 400 (recognised in the deferred tax worksheet as a debit) to $89 600. Considering the effect of these movements on the opening balances of deferred tax asset and deferred tax liability, the adjustment at the end of the period needed to bring those balances to the ending balances calculated based on the net temporary differences are (included in the deferred tax worksheet) as: • Deferred tax asset needs to be adjusted from $50 400 to $156 800 by increasing it with $106 400 (recognised in the deferred tax worksheet as a debit). • Deferred tax liability does not need to be adjusted from $89 600.

12.55

Chapter 12: Income taxes

Exercise 12.15 Current and deferred tax Konpayi Ltd has determined its accounting profit before tax for the year ended 30 June 2023 to be $256 700. Included in this profit are the items of revenue and expense shown below.

The accounting profit for Konpayi Ltd for the year ended 30 June 2023 also included a gain on sale of buildings of $5 000. The company’s draft statement of financial position at 30 June 2023 showed the following assets and liabilities.

Additional information • Quarterly income tax instalments paid during the year were as follows. $18 000 17 500 18 000

28 October 2022 28 January 2023 28 April 2023 • •

The final balance of tax payable was due on 28 July 2023. The tax depreciation rate for plant (which cost $150 000, 3 years before) is 20%. Depreciation on buildings is not deductible for taxation purposes. The gain on sale of buildings of $5 000 (see above) was recognised on buildings sold on 1 January 2023 that had cost $100 000 when acquired on 1 January 2017. The company depreciates buildings for accounting purposes at 5% p.a., straight-line. Any gain (loss) on sale of buildings is not taxable (not deductible).

12.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

During the year, the following cash amounts were paid.

•

Bad debts of $3500 were written off against the allowance for doubtful debts during the year. The $15 000 spent (and expensed) on development during the year is not deductible for tax purposes until 30 June 2024. Konpayi Ltd has tax losses amounting to $12 500 carried forward from prior years. The company tax rate is 30%.

• • •

Required 1. Prepare the current tax worksheet and the journal entry to recognise current tax at 30 June 2023. 2. Prepare the deferred tax worksheet and journal entries to adjust deferred tax accounts. (LO4 and LO5)

1. KONPAYI LTD Current tax worksheet for year ended 30 June 2023 $ Accounting profit Add: Entertainment expense (non-deductible) Depreciation expense – buildings (non-deductible) Depreciation expense – plant Doubtful debts expense Annual leave expense Insurance expense Development expenditure Deduct: Royalty revenue (tax exempt) Depreciation – plant (tax) Bad debts written off Annual leave paid Insurance paid Gain on sale of buildings (non-assessable) Taxable profit Add back exempt income

1 700 7 600 22 500 4 100 46 000 4 200 15 000

8 000 30 000 3 500 52 000 3 700 5 000

Tax loss recouped Taxable profit Tax payable @ 30% Less quarterly tax paid Current tax liability

$ 256 700

101 100 357 800

(102 200) 255 600 8 000 263 600 (12 500) 251 100 75 330 (53 500) 21 830

12.57

Chapter 12: Income taxes

Working: Depreciation of plant for tax purposes: $150 000 x 20% = $30 000. The entry to recognise current tax is: Income tax expense (current) Current tax liability Deferred tax asset

Dr Cr Cr

25 580 21 830 3 750

Carrying Amount $ Relevant Assets Accounts receivable Prepaid insurance Buildings Plant Development expenditure Relevant Liabilities Provision for annual leave TTD Excluded TD Net TD DTL DTA Beginning balances Movements during the year Adjustment

KONPAYI LTD Deferred tax worksheet as at 30 June 2023 Future Future Tax Base Taxable Deductible Amount Amount $ $ $

Taxable Temporary Differences $

17 400

4 100

21 500

4 500

110 500 82 500 0

0 82 500 0

0 60 000 15 000

110 500 22 500

10 000

Deductible Temporary Differences $

4 100

15 000

10 000 137 500 (110 500) 27 000 8 100

29 100 29 100

(6 000)

8 730 (9 600)

3 750

2 100 Cr

2 880 Dr

The entry to adjust deferred tax accounts is: Deferred tax asset Deferred tax liability Income tax expense (deferred)

Dr Cr Cr

2 880

2 100 780

12.58

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.16 Calculation of movements in deferred tax accounts The statement of financial position of Labrador Ltd at 30 June 2024 showed the following assets and liabilities. 2024

2023

Assets Cash Inventories Accounts receivable Allowance for doubtful debts Plant Accumulated depreciation — plant Deferred tax asset

$ 40 000 85 000 250 000 (27 500) 250 000 (130 000) ?

$ 42 500 77 500 240 000 (20 000) 250 000 (105 000) 20 250

Liabilities Accounts payable Provision for long service leave Rent received in advance Deferred tax liability

145 000 30 000 12 500 ?

130 000 22 500 10 000 19 050

Additional information • Accumulated depreciation of plant for tax purposes was $157 500 at 30 June 2023, and depreciation for tax purposes for the year ended 30 June 2024 amounted to $37 500. • The tax rate is 30%. Required Prepare a deferred tax worksheet to calculate the end of reporting period adjustment to deferred tax asset and liability accounts as at 30 June 2024, and show the necessary journal entry. (LO5)

12.59

Chapter 12: Income taxes

Carrying Amount $ Relevant Assets Accounts receivable Plant Relevant Liabilities Provision for long service leave Rent received in advance Total Temporary Differences Excluded differences Temporary Differences Deferred tax liability Deferred tax asset Beginning balances Movements during the year Adjustment

LABRADOR LTD Deferred tax worksheet as at 30 June 2024 Future Future Tax Taxable Deductible Base Amount Amount $ $ $

Taxable Temporary Differences $

Deductible Temporary Differences $

222 500

27 500

250 000

27 500

120 000

55 000

30 000

12 500

65 000

70 000

65 000

70 000

19 500 21 000 19 050

20 250

450 Cr

750 Dr

Note that the future deductible amount for plant is calculated as the historical cost of $250 000 minus the accumulated tax depreciation at 30 June 2023 of $157 500 and the extra tax depreciation for the year ended 30 June 2024 of $37 500. The entry to adjust deferred tax accounts is: Deferred tax asset Deferred tax liability Income tax expense

Dr Cr Cr

750

450 300

12.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.17 Calculation of current tax liability and adjusting journal entry The profit before tax, as reported in the statement of profit or loss and other comprehensive income of Miami Ltd for the year ended 30 June 2024, amounted to $60 000, including the following revenue and expense items.

The statement of financial position of the company at 30 June 2024 showed the following assets and liabilities. 2024 Assets Cash Inventories Accounts receivable Allowance for doubtful debts Office supplies Plant Accumulated depreciation — plant Buildings Accumulated depreciation — buildings Goodwill (net) Deferred tax asset

Liabilities Accounts payable Provision for long service leave Provision for annual leave Rent received in advance Deferred tax liability

8 000 17 000 50 000 (5 500) 2 500 50 000 (26 000) 30 000 (14 800) 7 000 ? 29 000 6 000 4 000 2 500 ?

2023 $

8 500 15 500 48 000 (4 000) 2 200 50 000 (21 000) 30 000 (14 000) 7 000 4 050 26 000 4 500 3 000 2 000 3 150

Additional information • Accumulated depreciation of plant for tax purposes was $31 500 at 30 June 2023, and depreciation for tax purposes for the year ended 30 June 2024 amounted to $7500. • The tax rate is 30%. © John Wiley and Sons Australia Ltd, 2020

12.61

Chapter 12: Income taxes

Required Prepare a current tax worksheet and the journal entry to recognise the company’s current tax liability as at 30 June 2024. (LO4) MIAMI LTD Current tax worksheet for year ended 30 June 2024 $ Accounting profit Add: Rent received Bad debts expense Depreciation expense – plant Annual leave expense Entertainment costs (non-deductible) Depreciation expense – buildings (non-deductible) Long service leave expense Deduct: Rent revenue Bad debts written off Depreciation – plant (tax) Annual leave paid Taxable profit Current tax liability (30%)

3 500 6 000 5 000 3 000 1 800 800 1 500

3 000 4 500 7 500 2 000

$ 60 000

21 600 80 100

(17 000) 64 600 19 380

Workings Rent received: ending balance of rent received in advance ($2 500) + rent revenue ($3 000) – opening balance of rent received in advance ($2 000) = $3 500. Bad debts written off: opening balance of allowance for doubtful debts ($4 000) + bad debts expense ($6 000) – ending balance of allowance for doubtful debts ($5 500) = $4 500. Annual leave paid: opening balance of provision for annual leave ($3 000) + annual leave expense ($3 000) – ending balance of provision for annual leave ($4 000) = $2 000. Long service leave paid: opening balance of provision for long service leave ($4 500) + long service leave expense ($1 500) – ending balance of provision for long service leave ($6 000) = $0. Those amounts can also be calculated by recreating the ledgers for the affected accounts as follows:

Rent revenue Ending balance

Rent received in advance $ 3 000 2 500 5 500

Opening balance Rent received

$ 2 000 3 500 5 500

12.62

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Allowance for doubtful debts $ Bad debts written off 4 500 Opening balance Ending balance 5 500 Expense 10 000

$ 4 000 6 000 10 000

Provision for annual leave $ 2 000 Opening balance 4 000 Expense 6 000

$ 3 000 3 000 6 000

Provision for long service leave $ Long service leave paid 0 Opening balance Ending balance 6 000 Expense 6 000

$ 4 500 1 500 6 000

Annual leave paid Ending balance

The entry to recognise current tax is: Income tax expense (current) Current tax liability

Dr Cr

19 380

12.63

Chapter 12: Income taxes

Exercise 12.18 Calculation of current and deferred tax, and prior year amendment The accounting profit before tax of Narrabri Ltd for the year ended 30 June 2023 was $66 720. It included the following revenue and expense items. Government grant (non‐taxable)

5 500

Entertainment expense (non‐deductible)

8 200

Doubtful debts expense Depreciation expense — plant Insurance expense Annual leave expense

8 100 24 000 12 900 15 400

The accounting profit before tax for Nebo Ltd for the year ended 30 June 2023 also included a gain on sale of plant of $3000. The draft statement of financial position as at 30 June 2023 included the following assets and liabilities. 2023 Accounts receivable Allowance for doubtful debts Prepaid insurance Plant Accumulated depreciation — plant Deferred tax asset Provision for annual leave Deferred tax liability

156 000 (6 800) 3 400 240 000 (134 400) ? 14 100 ?

2022 $

147 500 (5 200) 5 600 290 000 (130 400) 9 990 9 700 9 504

Additional information • In November 2022, the company received an amended assessment for the year ended 30 June 2022 from the tax authority. The amendment notice indicated that an amount of $4500 claimed as a deduction had been disallowed. Narrabri Ltd has not yet adjusted its accounts to reflect the amendment. • For tax purposes, the carrying amount of plant sold was $26 000. This sale was the only movement in plant for the year. • The tax deduction for plant depreciation was $28 800. Accumulated depreciation at 30 June 2022 for taxation purposes was $156 480. • In the previous year, Narrabri Ltd had made a tax loss of $18 400. Narrabri Ltd recognised a deferred tax asset in respect of this loss. • The tax rate is 30%. Required 1. Prepare the journal entry necessary to record the amendment to the prior year’s taxation return.

12.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. Prepare the current tax worksheet and journal entry/entries to calculate and record the current tax for the year ended 30 June 2023. 3. Justify your treatment of annual leave expense in the current tax worksheet. 4. Calculate the temporary difference as at 30 June 2023 for each of the following assets. Explain how these differences arise and why you have classified them as either deductible temporary differences or taxable temporary differences: (a) plant (b) accounts receivable. (LO3, LO4 and LO5) 1. Journal entry to record the tax assessment amendment for the year ended 30 June 2022: 30 June 2023 Income tax expense Deferred tax asset (30% x $4 500)

Dr Cr

1 350 1 350

The disallowed deduction reduces the carried forward tax losses from $18 400 to $13 900 so the deferred tax asset relating to the losses must be adjusted.

2. NARRABRI LTD Current tax worksheet for year ended 30 June 2023 Accounting profit Add: Entertainment expense (non-deductible) Doubtful debts expense Depreciation expense – plant Insurance expense Annual leave expense Gain on sale of plant (tax) Deduct: Government grant (exempt) Bad debts written off Depreciation – plant (tax) Insurance paid Annual leave paid Gain on sale of plant (accounting) Taxable profit Add back exempt income

$66 7200 $8 200 8 100 24 000 12 900 15 400 7 000 5 500 6 500 28 800 10 700 11 000 3 000

Less recoupment of tax loss Taxable profit Current tax liability @ 30%

75 600 142 320

(65 500) 76 820 3 600 80 420 (13 900) 66 520 $19 956

12.65

Chapter 12: Income taxes

Workings: Bad debts written off: opening balance of allowance for doubtful debts ($5 200) + doubtful debts expense ($8 100) – ending balance of allowance for doubtful debts ($6 800) = $6 500. Insurance paid: ending balance of prepaid insurance ($3 400) + insurance expense ($12 900) – opening balance of prepaid insurance ($5 600) = $10 700. Annual leave paid: opening balance of provision for annual leave ($9 700) + annual leave expense ($15 400) – ending balance of provision for annual leave ($14 100) = $11 000. Gain on plant sold for tax purposes: the gain for tax purposes is equal to proceeds from sale minus the carrying amount of plant sold for tax purposes ($26 000). The proceeds on sale are equal to the accounting carrying amount of plant sold + gain on sale for accounting purposes ($3 000). The accounting carrying amount of plant sold is equal to the difference between the historical cost of plant sold ($290 000 - $240 000) and its accumulated depreciation ($130 400 + $24 000 - $134 400). Therefore, the accounting carrying amount of plant sold is $30 000, making the proceeds on sale equal to $33 000 and the gain on sale for tax purposes $7 000. Those amounts (excluding the gain on plant sold for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows: Allowance for doubtful debts $ Bad debts written off 6 500 Opening balance Ending balance 6 800 Doubtful debts expense 13 300

13 300

Prepaid insurance $ 5 600 10 700 16 300

$ 3 400 12 900 16 300

Opening balance Insurance paid

$ 5 200 8 100

Ending balance Insurance expense

Provision for annual leave $ Annual leave paid 11 000 Opening balance Ending balance 14 100 Annual leave expense 25 100

$ 9 700 15 400 25 100

Note that the tax loss recouped is adjusted for the amount of $4 500 claimed as a deduction that has been disallowed by ATO. The journal entry to recognise current tax is: Income tax expense (current) Deferred tax asset

Dr Cr

24 126

4 170

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Current tax liability

19 956

The entry affecting the deferred tax asset is recognised as part of the movement during the year in the deferred tax worksheet at 30 June 2023. 3. Annual leave expense: Both the taxation authority and the accountant regard annual leave expenditure as an expense but in different periods. In the current year, the company recorded an expense of $15 400 relating to leave accrued but not yet taken by employees. As no cash has yet been paid in respect to this leave no deduction will be allowed against the current year’s taxable income. Accordingly, this amount has been added back against accounting profit. During the year leave accrued in past years was taken by employees and cash payments amounting to $11 000 were made. The company is allowed to deduct this amount and so an amount of $11 000 has been taken from accounting profit. The net effect of these adjustments results in the taxable profit being $4 400 less than the accounting profit for the year ended 30 June 2023.

Carrying Amount

Accounts receivable Plant

$ 149 200

NARRABRI LTD Deferred tax worksheet (extract) as at 30 June 2023 Future Future Tax Base Taxable Taxable Deductible Temporary Amount Amount Differences $ $ $ $ 0 6 800 156 000

105 600

*78 720

78 720

Deductible Temporary Differences $ 6 800

26 880

*Cost of plant $240 000 ** Accumulated depreciation of plant ($156 480 + $28 800 – $24 000 ) 161 280 Carrying amount (accounting) of plant $78 720 **Cost of plant sold ($290 000 - $240 000) Carrying amount (tax) of plant sold Accumulated depreciation (tax) of plant sold

$50 000 (26 000) $24 000

Explanation of classification: • Accounts receivable: - At the end of the current year, the company recognises an amount of $6800 for doubtful debts. This amount was not deductible in the current year, but will be deductible when the debts go bad and are actually written off against the allowance for doubtful debts. Therefore a deductible temporary difference exists in respect to this amount. © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

•

Plant: - Plant is being depreciated faster for taxation purposes than for accounting purposes. Accordingly, in past years, the deduction for depreciation has been greater than the accounting expense. In some future period(s) the plant will be fully depreciated for taxation purposes but not for accounting. In these years the accounting expense will not be deductible and the company’s taxable profit will be greater (not smaller as has been the case) than its accounting profit and more income tax will be paid. Therefore a taxable temporary difference exists in relation to plant.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.19 Current and deferred tax with tax rate change You have been asked by the accountant of Charlton Ltd to prepare the tax-effect accounting adjustments for the year ended 30 June 2023. Investigations revealed the following information. (a) In September 2021, the Australian government reduced the company tax rate from 40 cents to 30 cents in the dollar, effective from 1 July 2022. (b) The profit for the year ended 30 June 2023 was $1 350 000. (c) The assets and liabilities at 30 June 2022 and 30 June 2023 were:

(d) The company is entitled to claim a tax deduction of 125% for development expenditure in the year of expenditure. The company has adopted the accounting policy of capitalising and then amortising the expenditure over five years. (e) Revenue for the year included:

(f) Expenses brought to account included:

(g) Accumulated depreciation on equipment for tax purposes was $180 000 on 30 June 2022, and $285 000 on 30 June 2023. © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

(h) Bad debts of $14 000 were written off during the year, and warranty repairs to the value of $22 000 were carried out. There was no tax deduction for long service leave in the current year. (i) Buildings are depreciated in the accounting records but no deduction is allowed for tax purposes. Required 1. Prepare the journal entry to account for the change in the income tax rate announced by the Australian Government in September 2021. 2. Prepare the worksheets and journal entries to calculate and record the current tax liability, and any movements in deferred tax assets and liabilities for the year ended 30 June 2023. (LO4, LO5 and LO6) 1. Change in tax rate Deferred tax liability Deferred tax asset Income tax expense (Recognition of change of tax rate)

Dr Cr Cr

18 000 7 400 10 600 DTA $29 600 (7 400) $22 200

Opening balance Adjustment for change in tax rate: (40% - 30%) / 40%

DTL $72 000 (18 000) $54 000

2. OAKEY LTD Current tax worksheet for year ended 30 June 2023 Accounting profit Add: Depreciation expense – buildings Depreciation expense – equipment Impairment expense – goodwill Amortisation expense – development expenditure Doubtful debts expense Warranty expense Long service leave expense Deduct: Non-taxable income Depreciation – equipment (tax) Development costs paid Development costs – additional deduction Bad debts written off Warranty paid Taxable profit Current tax liability @ 30%

$1 350 000 $29 000 70 000 30 000 64 000 15 000 20 000 8 000

138 000 105 000 120 000 30 000 14 000 22 000

236 000 1 586 000

(429 000) 1 157 000 $347 100

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The depreciation for equipment for tax purposes can be calculated as the difference between the accumulated tax depreciation for plant at 30 June 2023 ($285 000) and that at 30 June 2022 ($180 000). Research and development costs paid can be found by reconstructing the development expenditure account: Development expenditure – at cost $ $ 1/07/22 Opening balance 200 000 R&D costs paid 120 000 30/06/23 Ending balance 320 000 320 000 320 000 Additional tax deduction for development costs is 25% of $120 000 = $30 000 Doubtful debts expense can be found by reconstructing the allowance for doubtful debts account, given that the balance of the account increased by $1 000 over the year: Allowance for doubtful debts $ 30/06/23 Bad debts written off 14 000 1/07/22 Opening balance 30/06/23 Ending balance 13 000 30/06/23 Doubtful debts expense 27 000

$ 12 000 15 000 27 000

Warranty expense can be found by reconstructing the provision for warranty claims account: Provision for warranty claims $ 30/06/23 Warranty paid 22 000 1/07/22 Opening balance 30/06/23 Ending balance 32 000 30/06/23 Warranty expense 54 000

Carrying Amount $ Relevant Assets Accounts receivable Buildings Equipment Development costs Relevant Liabilities

CHARLTON LTD Deferred tax worksheet as at 30 June 2023 Future Future Tax Base Taxable Deductible Amount Amount $ $

222 000

13 000

235 000

701 000 410 000 176 000

0 410 000 0

0 315 000 0

Taxable Temporary Differences $

$ 34 000 20 000 54 000

Deductible Temporary Differences $

13 000 701 000 95 000 176 000

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Chapter 12: Income taxes

Provision for 36 000 36 000 LSL Provision for 32 000 32 000 warranty TTD Excluded TD Net TD DTL DTA Beginning balances Movement during year Adjustment The entries for income tax, current and deferred, are:

36 000

32 000 972 000 (701 000) 271 000 81 300

Income tax expense (current) Current tax liability

Dr Cr

347 100

Income tax expense (deferred) Deferred tax asset Deferred tax liability

Dr Dr Cr

25 200 2 100

81 000 81 000

72 000

24 300 29 600

(18 000)

(7 400)

27 300 Cr

2 100 Dr

347 100

27 300

12.72

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.20 Recognition of deferred tax assets Paddington Ltd incurred an accounting loss of $15 120 for the year ended 30 June 2023. The current tax calculation determined that the company had incurred a tax loss of $25 000. Taxation legislation allows such losses to be carried forward and offset against future taxable profits. The company had the following temporary differences. 30 June 2023 Deductible temporary differences: Accounts receivable Plant and equipment Taxable temporary differences: Interest receivable Prepaid insurance

30 June 2022

Expected period of reversal

$24 000 10 000

$20 000 15 000

2024 2024/2025 equally

3 000 20 000

5 000 40 000

2024 2024

At 30 June 2022, Paddington Ltd had recognised a deferred tax liability of $13 500 and a deferred tax asset of $10 500 with respect to temporary differences existing at that date. No adjustment has yet been made for temporary differences existing at 30 June 2023. Required 1. Discuss the factors that Paddington Ltd should consider in determining the amount (if any) to be recognised for deferred tax assets at 30 June 2023. 2. Calculate the amount (if any) to be recognised for deferred tax assets at 30 June 2023. Justify your answer. (LO5) 1. and 2. AASB 112/IAS 12, paragraph 24 states that deferred tax assets shall be recognised for all deductible temporary differences (DTD) ‘to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilised’. The same recognition criteria apply to deferred tax assets arising from carry forward tax losses (paragraph 34). In determining whether it can recognise deferred tax assets with respect to tax losses of $25 000 and deductible temporary differences of $34 000, Paddington Ltd will need to consider the following factors. (a)

(b)

(c)

Taxable profit against which tax losses and DTDs can be utilised will be available if taxable temporary differences (TTD) reverse in the same period as the deductions are available. Thus, the extent and period of reversal of TTDs will need to be considered. If insufficient TTDs exist to recoup the DTDs and tax losses Paddington Ltd will need to consider if the company will earn sufficient taxable profit in the period of reversal against which the deductions can be made. AASB 112/IAS 12, paragraph 35 states that the existence of unused tax losses is strong evidence that future taxable profit may not be available. Paddington Ltd will need to

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Chapter 12: Income taxes

examine the cause of the loss to determine whether it is due to factors which are unlikely to recur. As Paddington Ltd has incurred a tax loss in the current year deferred tax assets can only be recognised to the extent that TTDs exist and will reverse in the same period as the DTDs and tax losses, and to the extent that convincing evidence exists that future taxable profits will be made. An analysis of the temporary differences at 30 June 2023 reveals: Existing 2023 Deductible temporary differences $34 000 Taxable temporary differences $23 000

Reversal 2024 $29 000 $23 000

As there is no indication that the losses incurred in the year ended 30 June 2023 are a ‘one-off’, Paddington Ltd can only recognise a DTA of $6 900 ($23 000 x 30%) representing the deductions which can be made against taxable profit arising in the year ended 30 June 2024 from the reversal of taxable temporary differences.

12.74

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.21 Current and deferred tax The accounting profit before tax for the year ended 30 June 2022 for Quamby Ltd amounted to $28 500 and included:

The draft statement of financial position at 30 June 2022 contained the following assets and liabilities. 2022 Assets Cash Accounts receivable Allowance for doubtful debts Inventories Rent receivable Motor vehicle Accumulated depreciation — motor vehicle Equipment Accumulated depreciation — equipment Deferred tax asset

Liabilities Accounts payable Provision for annual leave Current tax liability Deferred tax liability

13 200 12 000 (3 000) 19 000 2 800 18 000 (15 750) 100 000 (60 000) ?

15 655 4 500 ? ?

2021 $

9 800 14 000 (2 500) 21 500 2 400 18 000 (11 250) 130 000 (52 000) 6 450

21 500 6 000 8 200 3 445

Additional information • The motor vehicle is fully depreciated for tax purposes. • The company claims tax depreciation on equipment at the rate of 15% p.a. The sale of equipment on which a gain was recognised (see above) was the only movement in the equipment account during the year and took place on 1 July 2021. • The company tax rate is 30%. Required © John Wiley and Sons Australia Ltd, 2020

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Chapter 12: Income taxes

1. Prepare the current tax worksheet and the journal entry to recognise the current tax as at 30 June 2022. 2. Prepare the deferred tax worksheet and any necessary journal entries to adjust deferred tax accounts. (LO4 and LO5) 1. QUAMBY LTD Current tax worksheet for year ended 30 June 2022 Accounting profit Add: Depreciation expense – motor vehicle Depreciation expense – equipment Rent received Doubtful debts expense Entertainment expense (non-deductible) Annual leave expense Deduct: Depreciation – equipment (tax) Rent revenue Royalty revenue (non-assessable) Bad debts written off Gain on sale of equipment (accounting) Loss on sale of equipment (tax) Annual leave paid Taxable profit Current tax liability @ 30%

$28 500 $4 500 20 000 15 600 2 300 1 500 5 000 15 000 16 000 5 000 1 800 1 000 2 000 6 500

48 900

(47 300) 30 100 $9 030

Depreciation of equipment for tax purposes: depreciation expense for equipment ($20 000) / 20% x 15% = $15 000 Rent received: opening balance of rent receivable ($2 400) + rent revenue ($16 000) – ending balance of rent receivable ($2 800) = $15 600. Bad debts written off: opening balance of allowance for doubtful debts ($2 500) + doubtful debts expense ($2 300) – ending balance of allowance for doubtful debts ($3 000) = $1 800. Annual leave paid: opening balance of provision for annual leave ($6 000) + annual leave expense ($5 000) – ending balance of provision for annual leave ($4 500) = $6 500. Gain/loss on equipment sold for tax purposes: the gain for tax purposes is equal to proceeds from sale minus the carrying amount of equipment sold for tax purposes. The proceeds on sale are equal to the accounting carrying amount of equipment sold + gain on sale for accounting purposes ($1 000). The accounting carrying amount of equipment sold is equal to the difference between the historical cost of equipment sold ($130 000 - $100 000) and its accumulated depreciation ($52 000 + $20 000 - $60 000). The carrying amount of equipment sold for tax purposes is equal to the difference between the historical cost of equipment sold ($130 000 $100 000) and its accumulated tax depreciation ($52 000 + $20 000 - $60 000) / 20% x 15%.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Therefore, the accounting carrying amount of equipment sold is $18 000, making the proceeds on sale equal to $19 000, the carrying amount for tax purposes $21 000 and the loss on sale for tax purposes $2 000. Those amounts (excluding the depreciation of equipment and gain/loss on equipment sold for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows: Rent receivable $ $ 1/07/21 Opening balance 2 400 30/06/22 Rent received 15 600 30/06/22 Rent revenue 16 000 30/06/22 Ending balance 2 800 18 400 18 400 Allowance for doubtful debts $ 30/06/22 Bad debts written off 1 800 1/07/21 Opening balance 30/06/22 Ending balance 3 000 30/06/22 Expense 4 800

$ 2 500 2 300 4 800

Provision for annual leave $ 30/06/22 Annual leave paid 6 500 1/07/21 Opening balance 30/06/22 Ending balance 4 500 30/06/22 Expense 11 000

$ 6 000 5 000 11 000

Carrying Amount $ Relevant Assets Accounts receivable Rent receivable Motor vehicle Equipment Relevant Liabilities Provision for annual leave TTD Excluded TD Net TD

QUAMBY LTD Deferred tax worksheet as at 30 June 2022 Future Future Tax Taxable Deductible Base Amount Amount $ $ $

Taxable Temporary Differences $

Deductible Temporary Differences $

3 000

9 000

3 000

12 000

2 800

2 250

40 000

55 000

15 000

4 500

5 050 5 050

22 500 22 500

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Chapter 12: Income taxes

DTL DTA Beginning balances Movement during year Adjustment

1 515 3 445

6 750 6 450

(1 930) Dr

300 Dr

The future deductible amount for equipment is calculated as: • Accumulated tax depreciation: $100 000 (cost) x 15% x ($60 000 / [20% x $100 000]) = $45 000 • Future deductible amount is then $100 000 – $45 000 = $55 000 The entries for income tax, current and deferred, are: Income tax expense (current) Current tax liability

Dr Cr

9 030

Deferred tax liability Deferred tax asset Income tax expense (deferred)

Dr Dr Cr

1 930 300

9 030

2 230

12.78

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 12.22 Current and deferred tax with prior year losses The accounting profit before tax of Charleville Ltd for the year ended 30 June 2023 was $175 900. It included the following revenue and expense items: Government grant (non‐taxable)

5 800

Interest revenue Long service leave expense Doubtful debts expense Depreciation expense — plant (15% p.a., straight‐line)

14 000 7 000 4 200 33 000

Rent expense Entertainment expense (non‐deductible)

22 800 3 900

The draft statement of financial position as at 30 June 2023 included the following assets and liabilities. 2023 Cash Accounts receivable Allowance for doubtful debts Inventories Interest receivable Prepaid rent Plant Accumulated depreciation — plant Deferred tax asset Accounts payable Provision for long service leave Deferred tax liability

9 000 83 000 (5 000) 67 100 2 000 2 800 220 000 (99 000) ? 71 200 64 000 ?

2022 $

7 500 76 800 (3 200) 58 300 — 2 400 220 000 (66 000) 32 480 73 600 61 000 950

Additional information • The tax depreciation rate for plant is 10% p.a., straight-line. • The tax rate is 30%. • The company has $15 000 in tax losses carried forward from the previous year. A deferred tax asset was recognised for these losses. Taxation legislation allows such losses to be offset against future taxable profit. Required 1. Prepare the worksheets and journal entries to calculate and record the current tax liability and the movements in deferred tax accounts for the year ended 30 June 2023. 2. Justify your treatment of the interest revenue in the current tax worksheet. Explain how and why this leads to the deferred tax consequence shown in the deferred tax worksheet. (LO4 and LO5) © John Wiley and Sons Australia Ltd, 2020

12.79

Chapter 12: Income taxes

1. CHARLEVILLE LTD Current tax worksheet for year ended 30 June 2023 Accounting profit Add: Interest received (assessable for tax) Long service leave expense Doubtful debts expense Depreciation expense – plant Rent expense Entertainment expense (non-deductible) Deduct: Government grant (exempt) Interest revenue Long service leave paid Bad debts written off Depreciation – plant (tax) Rent paid Taxable profit Add back exempt income

$175 900 10 000 7 000 4 200 33 000 22 800 $3 900

5 800 14 000 4 000 2 400 22 000 23 200

Less recoupment of tax loss Taxable profit Current tax liability @ 30%

80 900 256 800

(71 400) 185 400 3 600 189 000 (15 000) 174 000 $52 200

Workings: Interest received: opening balance of interest receivable ($0) + interest revenue ($11 000) – ending balance of interest receivable ($1 000) = $10 000. Long service leave paid: opening balance of provision for long service leave ($61 000) + long service leave expense ($7 000) – ending balance of provision for long service leave ($64 000) = $4 000. Bad debts written off: opening balance of allowance for doubtful debts ($3 200) + doubtful debts expense ($4 200) – ending balance of allowance for doubtful debts ($5 000) = $2 400. Depreciation of plant for tax purposes: depreciation expense for plant ($33 000) / 15% x 10% = $22 000 Rent paid: ending balance of prepaid rent ($2 800) + rent expense ($22 800) – opening balance of prepaid rent ($2 400) = $23 200. Those amounts (excluding the depreciation of plant for tax purposes) can also be calculated by recreating the ledgers for the affected accounts as follows:

01/07/22 Opening balance 30/06/23 Interest revenue

Interest receivable $ $ 0 30/06/23 Ending balance 1 000 11 000 30/06/23 Interest received 10 000 11 000 11 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Provision for long service leave $ 30/06/23 LSL paid 4 000 01/07/22 Opening balance 30/06/23 Ending balance 64 000 30/06/23 Expense 68 000

$ 61 000 7 000 68 000

Allowance for doubtful debts $ 30/06/23 Ending balance 5 000 01/07/22 Opening balance 30/06/23 Bad debts written off 2 400 30/06/23 Expense 7 400

$ 3 200 4 200 7 400

Prepaid rent $ 2 400 30/06/22 Rent expense 23 200 30/06/23 Ending balance 25 600

$ 22 800 2 800 25 600

01/07/22 Opening balance 30/06/23 Rent paid

Carrying Amount $ Relevant Assets Accounts receivable Interest receivable Prepaid rent Plant Relevant Liabilities Provision for long service leave Temporary differences Deferred tax liability Deferred tax asset Beginning balances Movement during year Adjustment

CHARLEVILLE LTD Deferred tax worksheet as at 30 June 2023 Future Future Tax Taxable Deductible Base Amount Amount $ $ $

Taxable Temporary Differences $

78 000

5 000

83 000

1 000

2 800 121 000

0 154 000

2 800

64 000

Deductible Temporary Differences $

5 000

33 000

64 000

3 800 1 140

102 000

30 600 950

32 480 *(4 500)

190 Cr © John Wiley and Sons Australia Ltd, 2020

2 620 Dr 12.81

Chapter 12: Income taxes

The future deductible amount for plant is calculated as follows: Cost Accumulated tax depreciation Future deductible amount

$220 000 66 000* $154 000

*The accumulated depreciation for accounting purposes is $99 000 which at $33 000 per annum (15% x $220 000) is 3 years’ worth of depreciation and therefore the accumulated depreciation for tax purposes is 3 x $200 000 x 10%. The entries for income tax, current and deferred, are: Income tax expense (current) Current tax liability Deferred tax asset

Dr Cr Cr

56 700

Deferred tax asset Deferred tax liability Income tax expense (deferred)

Dr Cr Cr

2 620

52 200 4 500

190 2 430

2. Interest is recorded as revenue for accounting purposes as it is earned but is only taxable when the cash is received. In this situation, $1 000 of interest revenue has not been received and has been recognised as a receivable at end of reporting period. In calculating the current tax liability this $1 000 was deducted from accounting profit as not taxable by deducting the whole interest revenue recognised for accounting purposes of $11 000 and only adding to taxable profit the interest received of $10 000. Accordingly, the current tax liability for the year does not include tax of $300 with respect to this interest receivable. This tax will be paid in the next financial year when the cash is received. A deferred tax liability of $300 has been raised to reflect this future tax payment.

12.82

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS

Chapter 12: Income taxes Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 12: Income taxes Multiple choice questions 1. In general, the differences between the accounting treatment and the income tax treatment of a particular item if that the accounting treatment is based on: a. the income tax legislation. b. cash flows. c. cash flows adjusted for depreciation charges. *d. accrual accounting and is subject to the requirements of accounting standards. Answer: d Learning objective 12.1: discuss the need for an accounting standard on income taxes.

2. Current tax consequences of business operations are recognised as: *a. b. c. d.

a current liability for income tax payable. a non-current liability for taxes payable. a contingent liability for taxes payable. a deferred liability for income tax payable.

Answer: a Learning objective 12.2: discuss differences in accounting treatments and taxation treatments for a range of transactions and events.

3. If a company has not yet paid their existing tax payable they will recognise a in the statement of financial position. a. b. *c. d.

current tax asset. non-current asset. current tax liability. non-current liability.

Answer: c Learning objective 12.2: discuss differences in accounting treatments and taxation treatments for a range of transactions and events

12.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The assumption made for the tax effect method of accounting for a company’s income tax is: a. *b. c. d.

income tax expense is equal to income tax payable. income tax expense is not equal to current tax liability. an accounting balance sheet and a tax balance sheet are the same. a tax balance sheet is prepared according to accounting standards.

Answer: b Learning objective 12.3: explain that some transactions and events have both current and future tax consequences.

5. The following information relates to Jefferson Limited for the year ended 30 June 2022. Accounting profit before income tax (after all expenses have been included) Entertainment expenses (not tax deductible) Depreciation of machinery (accounting) Depreciation of machinery (tax) Annual leave expense (not a tax deduction until the leave is paid) Income tax rate

$200 000 10 000 20 000 50 000 4 000 30%

On the basis of this information the current tax liability is: *a. b. c. d.

$55 200. $64 800. $45 000. $51 000.

Answer: a Learning objective 12.4: calculate and account for current income tax.

6. Omega Limited has an accounting profit before tax of $400 000. All of the following items have been included in the accounting profit: depreciation of plant $70 000 (tax deductible depreciation is $50 000); entertainment expenses $10 000 (non-deductible for tax purposes); Long service leave expense provided $12 000 (no employee took long service leave during the year). The tax rate is 30%. The amount of current tax liability is: a. *b. c. d.

$147 600 $132 600 $107 400 $120 000

Answer: b Learning objective 12.4: calculate and account for current income tax.

12.2

Chapter 12: Income taxes Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Amigos Limited has an asset with a carrying value of $60 000. The tax base of this asset is $40 000. The tax rate is 30%. The deferred tax item to be recognised by Amigos Limited is: a. b. *c. d.

Deferred tax liability of $20 000. Deferred tax asset of $20 000. Deferred tax liability of $6000. Deferred tax asset of $6000.

Answer: c Learning objective 12.5: calculate and account for deferred income tax. 8. Differences between the carrying amounts of an entity’s net assets determined under accounting standards and accrual accounting, and the tax bases of those net assets determined under the Income Tax Assessment Act, are known as: a. *b. c. d.

tax losses. temporary differences. permanent differences. the current income tax liability.

Answer: b Learning objective 12.5: calculate and account for deferred income tax.

9. A taxable temporary difference leads to the payment of: a. b. c. *d.

more tax in the future and gives rise to a deferred tax asset. less tax in the future and gives rise to a deferred tax asset. less tax in the future and gives rise to a deferred tax liability. more tax in the future and gives rise to a deferred tax liability.

Answer: d Learning objective 12.5: calculate and account for deferred income tax.

10. A deductible temporary difference leads to the payment of: *a. b. c. d.

less tax in the future and gives rise to a deferred tax asset. more tax in the future and gives rise to a deferred tax asset. more tax in the future and gives rise to a deferred tax liability. less tax in the future and gives rise to a deferred tax liability.

Answer: a Learning objective 12.5: calculate and account for deferred income tax.

12.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. Colonial Limited has a machine which cost $300 000 and has been depreciated by $100 000 to date. The accumulated depreciation for tax purposes is $180 000 and the company tax rate is 30%. The tax base of this asset is: a. b. *c. d.

$54 000 $60 000 $120 000 $200 000

Answer: c Learning objective 12.5: calculate and account for deferred income tax.

12. At which time are deferred tax accounting adjustments to be recorded? *a. b. c. d.

At balance date. At the end of each month. When each transaction arises. When the cash flows from each transaction occur.

Answer: a Learning objective 12.5: calculate and account for deferred income tax.

13. AASB 112 Incomes Taxes requires deferred tax assets and liabilities to be measured at the tax rates that: a. b. c. *d.

prevail at the reporting date. applied at the end of the reporting period. applied at the beginning of the reporting period. are expected to apply when the asset is realised or the liability is settled.

Answer: d Learning objective 12.5: calculate and account for deferred income tax.

14. Mangrove Limited has a product warranty liability valued at $12 000. The product warranty costs are not tax deductible until paid out to customers. The company tax rate is 30%. The company has: *a. b. c. d.

a deductible temporary difference of $12 000. a taxable temporary difference of $12 000. a deferred tax asset of $12 000. a future deductible amount of $0.

Answer: a Learning objective 12.5: calculate and account for deferred income tax.

12.4

Chapter 12: Income taxes Not for distribution in full. Instructors may assign selected questions in their LMS.

15. The following information was extracted from the financial records of Pineapple Limited: Equipment purchased on 1 July 2021 for $200 000 (accounting depreciation 10% straight line; tax depreciation 15% straight line). If the company tax rate is 30%, the deferred tax item that will be recorded by Pineapple Limited at 30 June 2022 is: a. b. *c. d.

CR Deferred tax asset $3000. DR Deferred tax asset $3000. CR Deferred tax liability $3000. DR Deferred tax liability $3000.

Answer: c Learning objective 12.5: calculate and account for deferred income tax. 16. Maleny Limited accrued $40 000 for employees’ long service leave in the year ended 30 June 2021. This item will not be tax deductible until it is paid in approximately 5 years’ time. Assuming the company tax rate is 30%, Maleny Limited must record the following tax effect as a balance date adjustment: *a. b. c. d.

DR Deferred tax asset $12 000. DR Deferred tax liability $12 000. CR Deferred tax asset $12 000. CR Deferred tax liability $12 000.

Answer: a Learning objective 12.5: calculate and account for deferred income tax.

12.5

Testbank to accompany Financial reporting 3e by Loftus et al.

17. A company commenced business on 1 July 2022. On 30 June 2023, an extract of the statement of financial position prepared for internal purposes, but excluding the effect of income tax, disclosed the following information: Assets Cash Inventories Plant Accumulated depreciation

$20 000 60 000 200 000 (20 000)

Liabilities Accounts payable Provision for annual leave

$50 000 8 000

Additional information: The plant was acquired on 1 July 2022. Depreciation for accounting purposes was 10% (straight-line method), while 20% (straight-line) was used for tax purposes. The tax rate is 30%. Using the following worksheet, determine the deferred tax asset and deferred tax liability. Carrying amount

Future taxable amount

Future deductible amount

Tax base

Taxable temporary differences

Deductible temporary differences

Assets Cash Inventories Plant Liabilities Accounts payable Prov’n annual leave

Deferred tax liability Deferred tax asset The deferred tax liability is: a. *b. c. d.

$2 400. $6 000. $8 000. $20 000.

Answer: b Learning objective 12.5: calculate and account for deferred income tax.

12.6

Chapter 12: Income taxes Not for distribution in full. Instructors may assign selected questions in their LMS.

18. A company commenced business on 1 July 2022. On 30 June 2023, an extract of the statement of financial position prepared for internal purposes, but excluding the effect of income tax, disclosed the following information: Assets Cash Inventories Plant Accumulated depreciation

$20 000 60 000 200 000 (20 000)

Liabilities Accounts payable Provision for annual leave

$50 000 8 000

Future taxable amount

Future deductible amount

Tax base

Taxable temporary differences

Deductible temporary differences

Assets Cash Inventories Plant Liabilities Accounts payable Prov’n annual leave

Deferred tax liability Deferred tax asset The deferred tax asset is: *a. b. c. d.

$2 400. $6 000. $8 000. $20 000.

Answer: a Learning objective 12.5: calculate and account for deferred income tax.

12.7

Testbank to accompany Financial reporting 3e by Loftus et al.

19. In jurisdictions where the impairment of goodwill is not tax deductible, AASB 112 Income Taxes: a. allows the recognition of a deferred tax item in relation to goodwill. *b. does not permit the application of deferred tax accounting to goodwill. c. requires that any deferred tax items in relation to goodwill be recognised directly in equity. d. requires that any deferred tax items for goodwill be deducted from the carrying amount of goodwill. Answer: b Learning objective 12.5: calculate and account for deferred income tax.

20. On 1 November 2021, the company rate of income tax was changed from 35% to 30%. At the previous reporting date (30 June 2021) Montgomery Limited had the following tax balances: Deferred tax assets $33 500 Deferred tax liabilities $18 000 What is the impact of the tax rate change on income tax expense? a. b. *c. d.

Increase Decrease Increase Decrease

$2 583. $2 583. $2 214. $2 214.

Answer: c Learning objective 12.6: account for changes in income tax rates.

21. Jenson Limited had the following deferred tax balances at reporting date: Deferred tax assets $32 000 Deferred tax liabilities $55 000 Effective from the first day of the next financial period, the company rate of income tax was reduced from 40% to 35%. The adjustment to income tax expense to recognise the impact of the tax rate change is: a. b. c. *d.

DR CR DR CR

$3 286. $3 286. $2 875. $2 875.

Answer: d Learning objective 12.6: account for changes in income tax rates.

12.8

Chapter 12: Income taxes Not for distribution in full. Instructors may assign selected questions in their LMS.

22. Which of the following disclosures are ‘optional’ under AASB 112? a. *b. c. d.

The major components of income tax expense. A numerical reconciliation between the average effective tax rate and the applicable tax rate, disclosing also the basis of calculating the applicable tax rate. The aggregate current tax or deferred tax that arises relating to items that are charged directly to equity. The amount of deductible temporary differences and unused tax losses, for which no deferred tax asset is recognised in the statement of financial position.

Answer: b Learning objective 12.7: explain the disclosure requirements of AASB 112/IAS 12.

12.9

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 13: Share capital and reserves

Chapter 13: Share capital and reserves Comprehension questions 1. Explain the nature of a reserve. How do reserves differ from the other main components of equity? Under Australian accounting standards there are 2 forms of equity: • Contributed capital: inflows from equity contributors. • Reserves: the generic term for all equity accounts other than contributed equity. Reserves arise as a result of increases in equity other than from contributions from equity participants. They may arise from various actions: • earnings of profits [retained earnings] • increases in the fair value of assets [asset revaluation surplus]. Unlike share capital, reserves are not created via cash flows into the entity. Dividends may be paid out of reserves, but not out of capital.

2. The telecommunications industry in a particular country has been a part of the public sector. As a part of its privatisation agenda, the government decided to establish a limited liability company called Telecom Plus, with the issue of 10 million $3 shares. These shares were to be offered to the citizens of the country. The terms of issue were such that investors had to pay $2 on application and the other $1 per share would be called at a later time. Discuss: (a) The nature of the limited liability company, and in particular the financial obligations of acquirers of shares in the company. (b) The journal entries that would be required if applications were received for 11 million shares. The nature of a limited liability company is such that shareholders’ liability is limited to the issue price of a share. If the shares are issued at par value, the liability is limited to payment of that par value per share. If shares are issued at a given price, the limitation is to that price. The journal entries are – assuming that applications were received for 10 million shares: Cash trust Application (Receipt of application money)

Dr Cr

20 000 000

Application Share capital (Issue of shares)

Dr Cr

20 000 000

Cash

Dr Cr

20 000 000

Cash trust (Transfer from cash trust on issue of shares)

20 000 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. Explain when an options reserve would be raised. When options are issued, the holder of the option has a choice on whether to exercise the option or not. If an option to acquire ordinary shares is exercised then any monies paid for the option are capitalised into share capital. If the option is not exercised then any monies paid for the option are transferred to an options reserve.

4. Explain the difference between a renounceable and a non-renounceable rights issue. A rights issue is an issue of shares with the terms of issue giving existing shareholders the right to an additional number of shares in proportion to their current shareholding, i.e. the shares are offered on a pro rata basis. For example, each shareholder may be entitled to one share for every two currently held. Renounceable rights issue: • Existing shareholders may: - accept the offer i.e. exercise the rights; or - sell all or part of their rights to the new shares to another party; or - do nothing i.e. reject the offer. Non-renounceable rights issue: • Existing shareholders may: - do nothing i.e. reject the offer; or - accept the offer.

5. A company has a share capital consisting of 100 000 shares issued at $2 per share, and 50 000 shares issued at $3 per share. Discuss the effects on the accounts if: (a) The company buys back 20 000 shares at $4 per share (b) The company buys back 20 000 shares at $2.50 per share. At date of buyback, the company has issued 150 000 shares and has a total share capital of $350 000. Having issued the shares, the issue price is irrelevant. (a) If the company buys back 20 000 shares at $4 per share, the company will record a cash receipt of $80 000. Which equity accounts it adjusts is the decision of management. There is no requirement that share capital be reduced. (b) The answer is the same if the shares are bought back at $2.50 per share.

6. When is a cash trust raised? A cash trust is raised whenever investors make an offer to a company to acquire equity instruments. This may occur when a company issues a prospectus outlining the details of a proposed share issue. It may also occur in relation to a proposed issue of options, if investors have to make an offer to the company to acquire the options. In such cases it is the investor who makes the offer to acquire the equity instrument and it is up to the company to accept/reject that offer. Until the company makes the decision to accept/reject the offer, any monies received © John Wiley and Sons Australia Ltd, 2020

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Chapter 13: Share capital and reserves

by the company hare held in trust as no contract has as yet been formed between the offeror and the company. Where the company makes an offer inviting investors to invest, there is no need to raise a cash trust as on receipt of the cash the contract between the company and the investor is complete.

7. Discuss the nature of a rights issue, distinguishing between a renounceable and a nonrenounceable issue. A rights issue is an issue of shares with the terms of issue giving existing shareholders the right to an additional number of shares in proportion to their current shareholding, i.e. the shares are offered on a pro rata basis. For example, each shareholder may be entitled to one share for every two currently held. Renounceable: • Existing shareholders may: - accept the offer i.e. exercise the rights. - sell all or part of their rights to the new shares to another party. - do nothing i.e. reject the offer. Non-renounceable: • Existing shareholders may: - do nothing i.e. reject the offer. - accept the offer.

8. What is a private placement of shares? What are the advantages and disadvantages of such a placement? A private placement is where a company places the shares with specific investors rather than invite applications for the new issue of shares. Advantages [see text]: • speed • price • direction • prospectus. Disadvantages: • dilution of current shareholders’ interests • where shares are placed at a discount.

9. Discuss whether it is necessary to distinguish between the different components of equity rather than just having a single number for shareholders’ equity. The question is whether an investor would prefer to invest in Company A or Company B assuming the net assets of the company are the same:

13.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Share capital General reserve Retained earnings

Company A

Company B

$100 000 30 000 40 000 $170 000

$20 000 60 000 90 000 $170 000

In general, the composition of equity is irrelevant. Composition may be relevant where local laws place restrictions on what can be done with particular equity accounts e.g. if dividends may be paid only out of profits.

10. For what reasons may a company make an appropriation of its retained earnings? Appropriations from retained earnings are made for: • dividends, cash or shares • transfer to other reserves. May also like to consider how increases in retained earnings occur: • earning of profit • transfers from reserves • recognition of actuarial gains and losses under IFRS 4 [note here that in all other cases amounts recognised directly in equity are taken to reserve accounts rather than to retained earnings].

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Chapter 13: Share capital and reserves

Case studies Case study 13.1 Private placement Mining company Aeon Metals Ltd announced plans to raise $1 150 000 through a placement of 5 227 273 ordinary fully paid shares at $0.22 per share to institutional investors to fund new surveys and drilling campaigns for its copper project. Prior to this announcement the shares of Aeon Metals Ltd were trading at around $0.26. Required 1. Distinguish between a public share float and a private placement. 2. Assuming that the placement above proceeded, what journal entries would be required to account for it? 1. With a public share float the company asks investors – the general public – to apply for shares in the company. Investors will complete application forms, pay any requested application fees and wait for the company to accept or reject the offers. On acceptance of the offers the company will issue shares to the general public. With a private placement, the company places the shares with specific investors such as insurance companies and superannuation funds. Neither the general public nor current shareholders are invited to be a part of the share placement. As a result current shareholders suffer a dilution of their shareholdings. The advantages to the company of a placement are speed, price, direction and no need to issue a prospectus. Because of the effects on current shareholders, the Corporations Act places restrictions of the number of shares that may be placed by a company in a particular year. 2. Cash

Dr Share capital Cr (Placement of 5 227 273 shares at $0.22 per share)

1 150 000

13.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 13.2 Right issues The following is an extract from a letter sent on 22 February 2020 by Oz Outback Ltd to its shareholders in relation to a rights issue by the company.

Required A client who holds shares in Oz Outback Ltd has approached you in relation to this letter. She requires you to explain the nature of a renounceable rights issue and who will receive shares in Oz Outback Ltd under the proposed rights issue. Write a report to your client providing the requested advice. A rights issue is an offer of shares to existing shareholders to acquire additional shares in a company in proportion to their current shareholdings – that is, the shares are offered on a pro rata basis. The shares are generally offered at a discount price. Current shareholders may accept the offer in whole or in part. Under a renounceable rights offer existing shareholders may sell their rights to the new shares to another party during the offer period. © John Wiley and Sons Australia Ltd, 2020

13.7

Chapter 13: Share capital and reserves

With the Oz Outback offer: • The share offer is for current shareholders to acquire 3 shares for every one held • It is underwritten by convertible noteholders who will acquire shares if current shareholders do not accept the rights offer or are unable to find other parties who are willing to buy the rights to the shares and who then accept the offer. • If the rights issue is not fully subscribed, the company can offer “eligible shareholders” the right to apply for the new shares. There is a limit on the number of shares that can be allocated to eligible shareholders. The offering of shares to an eligible shareholder is in effect a placement as the issue is to a selected group of shareholders.

13.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 13.3 Reserves In its consolidated balance sheet, Qantas Airways Ltd (2018, p. 82) provided the following information.

(O) CAPITAL AND RESERVES iv. Employee Compensation Reserve The fair value of equity plans granted is recognised in the employee compensation reserve over the vesting period. This reserve will be reversed against treasury shares when the underlying shares vest and transfer to the employee at the fair value. The difference between the fair value at grant date and the cost of treasury shares used is recognised in retained earnings (net of tax). v. Hedge Reserve The hedge reserve comprises the effective portion of the cumulative net change in the fair value of cash flow hedging instruments and the cumulative change in fair value arising from the time value of options related to future forecast transactions. vi. Foreign Currency Translation Reserve The Foreign Currency Translation Reserve comprises all foreign exchange differences arising from the translation of the Financial Statements of foreign controlled entities and investments accounted for under the equity method. vii. Other Reserves Other reserves includes the defined benefit reserve comprising the remeasurements of the net defined benefit asset/(liability) which are recognised in other comprehensive income in accordance with AASB 119 Employee Benefits and the fair value reserve comprising of the fair value gains/(losses) on investments at fair value through Other Comprehensive Income. Source: Qantas Airways Ltd (2018, pp. 82, 94). Required Explain the nature of a reserve, and evaluate whether a company should retain reserve accounts other than retained earnings — provide examples to illustrate your analysis. “Reserves” is the generic term used for all equity accounts other than contributed equity. Contributed equity is equity directly contributed by owners. Hence with reserves they arise from events other than by contribution from owners such as: • earning profit and loss from trading • revaluation of assets © John Wiley and Sons Australia Ltd, 2020

13.9

Chapter 13: Share capital and reserves

•

transfers from other equity accounts.

For each reserve created there should be some reason for establishing the reserve. Shareholders should receive information about the operation of the company from viewing the reserves, for example: • asset revaluation reserve: some assets are measured at fair value and not at cost • foreign currency translation reserve: the company has a subsidiary whose accounts are kept in currency other than $A.

13.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis questions Exercise 13.1 Cash trust accounts In accounting for the funds received by the company in the process of raising capital, it is sometimes necessary to raise a cash trust account. However, the cash trust account is not always an appropriate account to use. Required Compare the various ways in which a company may increase its share capital and analyse when a cash trust should be used in the accounting process. (LO5 and LO6) A cash trust is raised whenever investors make an offer to a company to acquire equity instruments. This may occur when a company issues a prospectus outlining the details of a proposed share issue. It may also occur in relation to a proposed issue of options, if investors have to make an offer to the company to acquire the options. In such cases it is the investor who makes the offer to acquire the equity instrument and it is up to the company to accept/reject that offer. Until the company makes the decision to accept/reject the offer, any monies received by the company hare held in trust as no contract has as yet been formed between the offeror and the company. Where the company makes an offer inviting investors to invest, there is no need to raise a cash trust as on receipt of the cash the contract between the company and the investor is complete.

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Chapter 13: Share capital and reserves

Exercise 13.2 Application accounts Lootera Ltd has announced a renounceable rights issue of one-for-four based on shares held at 2 July 2022. The shareholders have to exercise their rights by 31 August 2022, and pay $2 per share on application. At the end of the company’s reporting period, 30 June 2022, half of the company’s shareholders have applied for the new shares, and the company has received $3.5 million. The monies received have been recorded in an ‘Application Account’. The accountant of Lootera Ltd plans to report the Application Account as a liability in the statement of financial position prepared at 30 June 2022, arguing that this is consistent with the accounting used for new issues of shares by the company. Required Write a report to the accountant of Lootera Ltd, critiquing the accountant’s decision. (LO5 and LO6) With the rights issue the company made an offer to existing shareholders to acquire new shares. By paying the application fee the shareholders are exercising their rights and accepting the offer made by the company. The application account is therefore not a liability as the company has entered into a contract with the shareholders and has no obligation to return the money to the shareholders. The application account is an equity account.

13.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.3 Repurchase of shares The directors of Sand Ltd are considering spending $8 million in a repurchase of the company’s shares. Some directors argue that this outlay requires the company to use a large amount of its capital that could be better put to alternative uses. They also argue that current shareholders may prefer to reward a company that grows its own business rather than artificially inflate the share price by a repurchase of shares. There is a fear among some directors that the repurchase could be a sign that the company cannot find anything better to do with its cash. Required Analyse these arguments and set out the main arguments in favour of a share buyback for the company in the form of a report to management of Sand Ltd. (LO7) Some of the reasons a company may consider buying back its own shares are: • to increase the worth per share of the remaining shares: this will depend on whether the funds used to buy back the shares were not being used effectively in the company; • to manage the capital structure by reducing equity; • to provide price support for issued shares: by acquiring its own shares a company demonstrates confidence in the future of the company; • to most efficiently manage surplus funds held by the company: rather than pay a dividend or reinvest in other ventures the company reduces the number of shares on issue and hopefully increases earnings per share. Should the money spent on buying back shares could be better spent on other uses? Perhaps if there are no suitable investments around then it is in the best interests of shareholders for the company to use excess cash to buy back shares. This allows the shareholders to choose where to invest their money. Are prices “artificially” raised by buybacks? If the market sees the buyback as a good deal for remaining shareholders, the prices will rise and shareholders will be better off. The price rise is not artificial.

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Chapter 13: Share capital and reserves

Exercise 13.4 Placement of shares Fuyu Ltd is in need of an injection of capital. The directors are considering whether to raise capital via a public issue or by placing new shares with a selected group of new investors. Required Examine the factors that would motivate the directors to choose a placement of shares over an issue of shares to existing shareholders. (LO6) The advantages to the company of a placement of shares are: • Speed: - A placement can be effected in a short period of time, 1-2 days; this lowers risks relating to movements in the market. • Price: - Because a placement is made to other than existing shareholders, and to a market that is potentially more informed and better funded, the issue price of the new shares may be closer to the market price at the date of issue. There are also lower underwriting costs. • Direction: - The shares may be placed with investors who approve of the directions of the company, or who will not interfere in the formation of company policies • Prospectus: - In some cases, a placement can occur without the need for a detailed prospectus to be prepared. There are potential disadvantages to the existing shareholders from private placements in that the current shareholders will have their interest in the company diluted as a result of the placement. As a result, there are limits placed on the amounts of placements of shares without the approval of existing shareholders, namely a 15% of issued capital limit in a 12-month period. Further disadvantages to current shareholders can occur if the company places the shares at a large discount. Again, securities laws are enacted to ensure that management cannot abuse the placement process and that current shareholders are protected.

13.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.5 Crabapple Ltd in its statement of financial position at 30 June 2022 reported the existence of two reserves: • an asset replacement reserve created to inform shareholders of the potential amounts of funds needed to replace critical manufacturing assets in the next few years • an assets revaluation surplus created because of the application of the revaluation model to property held by the company. Required Write an information release to shareholders informing them how movements in these accounts will be accounted for and the potential effects on profit or loss and other comprehensive income. (LO8) Reserves Asset replacement reserve This reserve is created by a transfer from other reserve accounts e.g. a transfer from the retained earnings account. The general form of the entry to create or recognise increments in the account is: Transfer to asset replacement reserve (RE) Asset replacement reserve

Dr Cr

10 000 10 000

The account will never have an effect on profit or loss or other comprehensive income.

Asset revaluation surplus This account is created when there is an upward revaluation of an item of property, plant and equipment or an intangible asset under the revaluation model. Under this model such assets are measured at fair value. Increments are recognised in other comprehensive income and accumulated in equity. Hence comprehensive income increases when a revaluation increment occurs (assuming no prior revaluation decrement). The general form of the entries, using land as the asset being revalued upwards, is: Land

Dr Cr

20 000

Dr Cr

6 000

Gain on revaluation of land (OCI) Dr Income tax expense (OCI) Cr Asset revaluation surplus Cr (Accumulation of net revaluation gain in equity)

20 000

Gain on revaluation of land (OCI) (Recognition of revaluation increment) Income tax expense (OCI) Deferred tax liability (Tax effect of revaluation increment)

20 000

6 000

6 000 14 000

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Chapter 13: Share capital and reserves

Exercise 13.6 Dividends The directors of Beach Ltd are preparing the annual report for the company at 30 June 2022. The directors anticipate that the company will pay a dividend of $0 per share subsequent to the annual general meeting scheduled for 13 August 2022. This information will be included in the directors’ report as well as in a release to the public concerning the annual performance of the company. The group accountant of Beach Ltd is unsure as to whether or not the dividend should be shown as a liability in the statement of financial position at 30 June 2022. Required Provide a recommendation to the group accountant on what action should be undertaken in relation to accounting for the dividend. (LO8 and LO9) Where a dividend is declared at 30 June 2022, whether or not a liability is raised is dependent on whether a liability exists at that date i.e. whether the company has an obligation to outflow funds at that date. If the company requires shareholder approval at the next AGM before paying the dividend then the company does not have an obligation until that approval is given. Hence no liability would be raised at 30 June 2022. If the company does not need shareholder approval to pay a dividend, then a liability would be raised at 30 June 2022.

13.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.7 Placement of shares, right issues The directors of Yugii Ltd are considering increasing its share capital. However they are unsure as to whether they should pursue a placement of shares or an accelerated rights issue. Some of the directors believe that this will target the same audience, namely institutional investors, and so are indifferent on which approach to take. Required Write a report to the directors assessing the differences between these two forms of capital raising. (LO6) Placement A placement is an issue of shares to specific investors, usually institutional investors such as life insurance companies and superannuation funds. Accelerated rights issue A rights issue is an offer to existing shareholders to acquire additional shares in a company in proportion to their current holding, that is, the shares are offered pro rata. For example, an offer could be made to each shareholder to buy two new shares on the basis of every 10 shares currently held. The ASX (2010, p. 24) made a distinction between “traditional rights” issues and “accelerated rights” issues. With traditional rights issues, these are conducted according to a detailed timetable prescribed in the ASX listing rules. However, industry has adapted these traditional issues to allow mostly larger companies to raise funds more quickly and to give boards more certainty about the funds that will be in place at a point of time (ASX, 2010, p. 26). These accelerated rights issues are structured as a two-stage process with an initial or accelerated institutional component and a secondary or non-accelerated component. The advantage of the accelerated rights issues is that an entity can obtain funds from the institutional investors quickly; reducing the risk of an overall shortfall in funding, but still allow non-institutional investors time to consider whether they should participate in the rights offer. Both forms of capital raising involve institutional investors. However the difference is that an accelerated rights issue can only be made to institutional investors who already own shares in the company whereas a placement can be made with institutional investors who do not currently own shares. Also with a rights issue, the offer must be in proportion to current holdings whereas, with a placement, the total placement could be to a single entity. However there are legal limits on the amount of equity that can be raised in a placement.

13.17

Chapter 13: Share capital and reserves

Exercise 13.8 Rights issue West Ltd needs to raise funds for mining projects in Northern Territory. It currently has share capital of $3 million and has issued 1.5 million shares. The directors have decided to make a non-renounceable rights issue to existing shareholders of 300 000 new shares at an issue price of $15 per share. Rainy Day Ltd, a firm of finance brokers has agreed to fully underwrite the rights issue. West Ltd issued a prospectus on 1 April 2022 and applications closed on 3 May 2022. Costs associated with the rights issue and the eventual issue of the shares were $30 000. Required 1. Prepare the journal entries for the rights issue and the subsequent share issue made by West Ltd, assuming that 80% of the rights were exercised by the due date. 2. Prepare the journal entries assuming that the rights issue was not underwritten and that any unexercised rights lapsed. (LO6) 1. 1 April 2022 to 3 May 2022 Cash Dr 3 600 000 Application – rights issue Cr 3 600 000 (Money received on applications for rights issue) 3 May 2022 Application – rights issue Receivable from underwriter Share capital (Issue of shares) Share capital Cash (Costs of share issue)

Dr 3 600 000 Dr 900 000 Cr 4 500 000 Dr Cr

30 000 30 000

2. 1 April 2022 to 3 May 2022 Cash Dr 3 600 000 Application – rights issue Cr 3 600 000 (Money received on applications for rights issue) 3 May 2022 Application – rights issue Share capital (Issue of shares) Share capital Cash (Costs of share issue)

Dr 3 600 000 Cr 3 600 000 Dr Cr

30 000

13.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.9 Issues of shares and options White Ltd has been investigating the expansion of the company into new areas of development. In order to fund these new investments the company needs an increase in equity. On 1 April 2022 the company decided to make a public issue to raise $1 800 000 for new capital development. The company issued a prospectus inviting applications for 600 000 $3 shares, payable in full on application. There was an additional incentive offered by White Ltd to investors, as those shareholders who acquired more than 30 000 shares were allowed to acquire options at 50 cents each. These options allowed the investors to acquire shares in White Ltd at $3.20 each, the acquisition having to occur before 30 November 2022. White Foam Ltd had received applications for 750 000 shares and 60 000 options by 10 May. On 28 May the shares and options were allotted and money returned to unsuccessful applicants. All applicants who acquired options also received shares. By 30 November 2022 the price of each of White Foam’s shares was $3.35. Holders of 54 000 options exercised their options in November, with the remaining options lapsing. Required Prepare the journal entries in the records of White Foam Ltd in relation to the above events. (LO6) 10 May 2022 Cash trust – shares Application – shares (Applications for shares) Cash trust – options Application – options (Applications for options) 28 May 2022 Cash Cash trust – shares Cash trust – options (Transfer on issue of shares and options)

Dr 2 250 000 Cr 2 250 000

Dr Cr

30 000 30 000

Dr 1 830 000 Cr 1 800 000 Cr 30 000

Application – shares Share capital (Issue of shares)

Dr 1 800 000 Cr 1 800 000

Application – shares Cash trust (Refund to unsuccessful applicants)

Dr Cr

450 000

Application – options Options (Issue of options)

Dr Cr

30 000

450 000

30 000

30 November 2022 © John Wiley and Sons Australia Ltd, 2020

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Chapter 13: Share capital and reserves

Options Cash Share capital (Issue of shares on exercising the options)

Dr Dr Cr

27 000 172 800

Options Options lapsed reserve (Transfer of lapsed options)

Dr Cr

3 000

199 800

3 000

Note: the $3 000 amount for lapsed options could have been included in share capital.

13.20

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Exercise 13.10 Rights issues and placement of shares At 1 July 2022 City Cat Ltd reported that it had a share capital of $800 000 resulting from the issue of 400 000 shares. The following transactions occurred during the year ended 30 June 2023. 1. On 10 August 2022, a renounceable one-for-two rights issue was made to existing shareholders. The issue price was $2 per share, payable in full on application. The issue was underwritten for a commission of $6500. The issue closed fully subscribed on 31 August, the holders of 80 000 shares having transferred their rights. The underwriting commission was paid on 4 September. 2. On 10 February 2023, 20 000 shares were privately placed with Sandy Dog Finance and Superannuation Ltd at $2 per share. Required Prepare the general journal entries to record the above transactions. (LO6) 10 August 2022 Cash Dr 400 000 Application Cr (Applications for shares on rights issue: ½ x 400 000 x $2) Application Share capital (Issue of shares)

Dr Cr

400 000

4 September 2022 Share capital Cash (Share issue costs)

Dr Cr

6 500

10 February 2023 Cash Share capital (Placement of 20 000 shares at $2 per share)

Dr Cr

40 000

400 000

6 500

40 000

13.21

Chapter 13: Share capital and reserves

Exercise 13.11 Dividends, calls on shares and bonus issues The equity of Lootera Ltd at 1 January 2023 was as follows. Share capital 400 000 shares fully paid 300 000 shares issued for $1 and paid to 50c

$ 400 000 150 000

550 000 100 000 40 000 120 000

General reserve Plant maintenance reserve Retained earnings $

Total equity

810 000

The following events occurred during the year. June 25 July 10 July 31 Sept 15 Dec 31

Interim dividend of 20c per share paid, with partly paid shares receiving a proportionate dividend. Call of 50c per share on the partly paid shares. Collection of call money. Bonus share issue of one share for each 10 shares held, at $1 per share, allocated from general reserve. Directors announce that a dividend of 15c per share will be paid in September, subject to approval at the February annual general meeting. Transfer of plant maintenance reserve to general reserve. The company earned a profit of $80 000.

Required 1. Prepare the journal entries to give effect to the above events. 2. Prepare the equity section of the statement of financial position at 31 December 2023. (LO6, LO8 and LO9) 1. 25 June 2023 Dividend paid Dr 110 000 Cash Cr 110 000 (Interim dividend of 20c per share on 400 000 fully paid shares and 10c per share on 300 000 partly paid shares) 10 July 2023 Call Share capital (Final call on 300 000 shares at 50c) 31 July 2023 Cash Call

Dr Cr

150 000

Dr Cr

150 000

13.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(Cash received on call) 15 September 2023 General reserve Dr 70 000 Share capital Cr (1 for 10 bonus issue on 700 000 shares from general reserve) 31 December 2023 Plant maintenance reserve General reserve (Transfer between reserves)

Dr Cr

40 000

Profit and loss summary Retained earnings Dividend paid

Dr Dr Cr

80 000 30 000

70 000

40 000

110 000

2. LOOTERA LTD Statement of Financial Position [extract] as at 31 December 2023 Share capital: (770 000 shares fully paid) General reserve Retained earnings

$770 000 70 000 __90 000 $930 000

13.23

Chapter 13: Share capital and reserves

Exercise 13.12 Share issue, options On 30 June 2021, the equity accounts of Moray Ltd consisted of: 400 000 ‘A’ ordinary shares, issued at $2.50 each, fully paid 75 000 6% cumulative preference shares, issued at $3 and paid to $2 Options (20 000 at 65c each) Accumulated losses

$ 1 000 000 150 000 13 000 (12 750)

As the company had incurred a loss for the year ended 30 June 2021, no dividends were declared for that year. The options were exercisable between 1 March 2022 and 30 April 2022. Each option allowed the holder to buy one ‘A’ ordinary share for $4.50. The following transactions and events occurred during the year ended 30 June 2022. 2021 July 25 Aug 31 Sept 7

Nov 1

Nov 30 Dec 1

Dec 5 2022 April 30

The directors made the final call of $1 on the preference shares. All call monies were received except those owing on 5000 preference shares. The directors resolved to forfeit 5000 preference shares for non-payment of the call. The constitution of the company directs that forfeited amounts are not to be refunded to shareholders. The shares will not be reissued. The company issued a prospectus offering 40 000 ‘B’ ordinary shares payable in two instalments: $3 on application and $2 on 30 November 2022. The offer closed on 30 November. Applications for 50 000 ‘B’ ordinary shares were received. The directors resolved to allot the ‘B’ ordinary shares pro rata with all applicants receiving 80% of the shares applied for. Excess application monies were allowed to be held. The shares were duly allotted. Share issue costs of $8600 were paid. The holders of 16 000 options applied to purchase shares. All monies were sent with the applications. All remaining options lapsed. The shares were duly issued.

Required 1. Prepare general journal entries to record the above transactions. 2. If Moray Ltd buys back 25 000 preference shares for $3.50 per share, what factors would its accountant have to consider in determining how best to record the transaction in the accounts? (LO6 and LO7) 1. 25 July 2021 Call - preference Share capital - preference (75 000 shares x $1)

Dr Cr

75 000

13.24

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31 August 2021 Cash Call - preference ((75 000 - 5 000) shares x $1)

Dr Cr

70 000

Dr Cr Cr

15 000

30 November 2021 Cash trust Application (50 000 shares x $3)

Dr Cr

150 000

1 December 2021 Application Share capital – B ordinary (40 000 shares x $3)

Dr Cr

120 000

Application Calls in advance (10 000 shares x $3)

Dr Cr

30 000

Cash

Dr Cr

150 000

5 December 2021 Share capital – B Ordinary Cash (Share issue costs)

Dr Cr

8 600

30 April 2022 Cash Share capital – A ordinary (16 000 shares x $4.50)

Dr Cr

72 000

7 September 2021 Share capital - preference Call - preference Forfeited share reserve

Cash trust (50 000 shares x $3)

70 000

5 000 10 000

150 000

120 000

30 000

150 000

8 600

72 000

Options Dr 11 200 Share capital – A ordinary Cr 8 960 Options reserve Cr 2 240 2. The accountant should consider whether there are tax or dividend distribution issues associated with particular equity accounts before determining which accounts are to be affected by the buy-back. If there are no such issues the buy-back can be written off against any equity account or across all equity accounts.

13.25

Chapter 13: Share capital and reserves

Exercise 13.13 Issue of option and shares, forfeiture of shares Prepare ledger accounts to record the following transactions for Turtle Ltd. (LO6 and LO8) 2023 July 1

July 21 July 31 Aug 14 Dec 1

2024 June 1 June 10 June 15 June 25

Date 21/7/23 21/7/23

A prospectus was issued inviting applications for 100 000 ordinary shares at an issue price of $3, with $2 payable on application and the balance payable on 10 June 2024. The prospectus also offered 50 000 10% preference shares at $2, fully payable on application. The issue was underwritten at a commission of $6500, allocated equally between the classes of shares. Applications closed with the ordinary share issue oversubscribed by 20 000 and the preference shares undersubscribed by 15 000. All shares were allotted, and application money refunded to unsuccessful applicants for ordinary shares. The underwriter paid amounts less commission. The directors resolved to give each ordinary shareholder, free of charge, one option for every two shares held. The options are exercisable prior to 1 June 2024 and allow each holder to acquire one ordinary share at an exercise price of $2.70. Options not exercised prior to that date lapse. The holders of 40 000 options elected to exercise those options and 40 000 shares were issued. The balance payable on the ordinary shares was received from holders of 95 000 ordinary shares. The shares on which call money was not received were forfeited. The forfeited shares were placed with a financial institution, paid to $3 on payment of $2.80. The cash was received from the financial institution, and any balance in the forfeited shares account returned to the former shareholders. Reissue costs amounted to $550.

Item Application – ordinary Application – preference

Cash trust $ Date 240 000 31/7/23 70 000 31/7/23

Item Application – ordinary Cash

$ 40 000 270 000

310 000 Date 31/7/23 31/7/23

Item Cash trust Share capital – ordinary

Application – ordinary $ Date Item 40 000 21/7/23 Cash trust 200 000

310 000 $ 240 000

240 000

13.26

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Date 31/7/23

Application – preference $ Date Item 100 000 21/7/23 Cash Trust

Item Share capital – preference

31/7/23

$ 70 000

Receivable from underwriter

30 000

100 000

Date 14/08/23

Item Share issue costs

15/06/24

Forfeited shares account Balance c/d

30/06/24

Date 14/8/23

Item Share issue costs

30/6/24

Balance c/d

Date 10/6/24

100 000

Share capital – ordinary $ Date Item 3 250 31/7/23 Application – ordinary 15 000 1/06/24 Cash 404 750 10/06/24 25/06/24 423 000 1/07/24

Item Share capital – ordinary

15/06/24 100 000 Date 25/6/24

Cash (extract) $ Date 270 000 25/06/24

Date 31/7/23

Item Cash trust

14/8/23

Receivable from underwriter

23 500 25/06/24

108 000 100 000 15 000 423 000 404 750

Balance b/d

Item

$ 100 000

100 000 96 750 $

Cash

95 000

Share capital – ordinary

5 000 100 000

Forfeited shares account $ Date Item 1 000 15/06/24 Share capital – ordinary 550 8 450 10 000

Item Share capital – ordinary Cash Cash

200 000

Call Cash

Share capital – preference $ Date Item 3 250 31/7/23 Application – preference 96 750 100 000 1/07/24 Balance b/d Call – ordinary $ Date 100 000 10/06/24

Item Forfeited shares account Forfeited shares account

$ 10 000

$ 550 8 450

13.27

Chapter 13: Share capital and reserves

1/06/24 10/06/24 25/06/24

Share capital – ordinary Call – ordinary Share capital – ordinary

108 000 95 000 14 000

13.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.14 Share buybacks The group accountant of Cruise Ltd has been given the task of accounting for a repurchase of shares by the company. The company is repurchasing 5 million shares at a cost of $2 each, paying for this in cash. However, the accountant is unsure which accounts should be reduced by the share buyback. The current equity position of the company is as follows. $m Share capital General reserve Asset revaluation surplus Retained earnings

120 50 10 65

Required Write a report to the group accountant advising how to account for the buyback of shares. Provide justification for your advice. (LO7) There are no accounting standards specifying what accounts should be reduced when accounting for a share buyback. Any of the accounts could be used in any proportion required. The company should consider any implications for taxation and potential dividend payments arising in relation to specific equity accounts rather than the nature of the accounts themselves.

13.29

Chapter 13: Share capital and reserves

Exercise 13.15 Buyback of shares Budgial Ltd decided to repurchase 10% of its ordinary shares under a buyback scheme for $4.80 per share. At the date of the buyback, the equity of Budgial Ltd consisted of: Share capital — 4 million shares fully paid General reserve Retained earnings

4 000 000 600 000 1 100 000

The costs of the buyback scheme amounted to $9 500. Required 1. Prepare the journal entries to account for the buyback. Explain the reasons for the entries made. 2. Assume that the buyback price per share was equal to 60c per share. Prepare journal entries to record the buyback, and explain your answer. (LO7) 1. Any combination of equity accounts is correct. The following entry is purely illustrative. Unless there are taxation or legislative reasons, any equity account can be used. General reserve Dr 600 000 Retained earnings Dr 1 100 000 Share capital Dr 229 500 Cash Cr 1 929 500 (Repurchase of 400 000 ordinary shares under a buy-back scheme plus costs) 2.

Retained earnings Dr 20 000 Share capital Dr 229 500 Cash Cr 249 500 (Repurchase of 400 000 ordinary shares under a buy-back scheme plus costs)

As with (a) any combination of equity accounts is appropriate.

13.30

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Exercise 13.16 Movements in reserves and retained earnings Evergreen Ltd undertook the following transactions during the financial year ended 30 June 2022. (a) transferred $80 000 from the general reserve to retained earnings (b)paid an interim dividend of $45 000 (c) transferred $36 000 from the asset revaluation surplus to the general reserve subsequent to the sale of an item of plant that was measured using the revaluation model (d)used the general reserve to fund the payment of 350 000 bonus shares, these being issued at $1.50 per share. Required Prepare the journal entries in relation to these events. (LO8) (a)

(b)

(c)

(d)

General reserve Transfer from general reserve (Transfer between reserves)

Dr Cr

80 000

Dividend paid Cash (Payment of dividend) Asset revaluation surplus General reserve (Transfer between reserves)

Dr Cr

45 000

Dr Cr

36 000

General reserve Dr Share capital Cr (Bonus issue: 350 000 shares at $1.50 each)

525 000

80 000

45 000

36 000

525 000

13.31

Chapter 13: Share capital and reserves

Exercise 13.17 Share issues, options, statement of changes in equity On 30 June 2022, the equity accounts of Yabby Ltd consisted of: 180 000 ordinary shares, issued at $2.50 each, fully paid Options (80 000 at 75c each)* General reserve Forfeited shares reserve Retained earnings

450 000 60 000 50 000 4 000 95 000

*The options were exercisable between 1 May 2023 and 31 May 2023. Each option allowed the holder to buy one ordinary share for $3 each. Required 1. Prepare general journal entries, including any closing entries required, to record the following transactions that occurred during the year ended 30 June 2023. • The final 6c per share dividend for the year ended 30 June 2022 was paid on 27 September 2022. Shareholder approval to pay the dividend had been obtained at the annual general meeting on 20 September. • On 1 October, the directors issued a prospectus offering 60 000 ordinary shares at an issue price of $2.80, payable $2 on application and 80c as a future call. The closing date for application was 31 October 2022. The share issue was underwritten by Support Stockbrokers for a fee of $5000, payable on 15 November 2022. • By 31 October 2022, applications for 75 000 shares had been received. • On 5 November 2022, the directors allotted the shares pro rata, with applicants receiving 80% of their requested shares. The company’s constitution allows excess application monies to be retained and used to offset future calls payable. • On 15 November 2022, the underwriting fee was paid. • On 31 December 2022, the directors announced an interim dividend of 3c per share payable in cash on 1 February. • To raise funds for expansion, the directors sold a parcel of 65 000 ordinary shares to Iron Jays Finance on 28 April 2023 at an issue price of $2.80 per share. • By 31 May 2023, the holders of 65 000 options had indicated that they wished to purchase shares. On 2 June 2023, 65 000 ordinary shares were issued with monies being payable by 21 June. Options not exercised duly lapsed. • All outstanding monies were received with respect to shares issued to option holders. • Profit for the year was $152 380. On 30 June 2023, the directors decided to: - transfer $40 000 to the general reserve - declare a final 10c per share dividend. Shareholder approval for this dividend will be sought at the annual general meeting in September 2023. 2. Prepare a statement of changes in equity for the year ended 30 June 2023. 3. Yabby Ltd has recognised a ‘Forfeited Shares Reserve’ as part of equity. Explain how and why such a reserve would be created. (LO6, LO8 and LO9)

1. 20 September 2022

13.32

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Dividend declared Dividend payable (180 000 x $0.06 = $10 800)

Dr Cr

10 800

Dr Cr

10 800

31 October 2022 Cash trust Application (75 000 x $2 = $150 000)

Dr Cr

150 000

5 November 2022 Application Share capital (60 000 x $2 = $120 000)

Dr Cr

120 000

Application Calls in advance (15 000 x $2 = $30 000)

Dr Cr

30 000

Cash

Dr Cr

150 000

15 November 2022 Share capital Cash (Share issue costs)

Dr Cr

5 000

31 December 2022 Dividend declared Dividend payable ((180 000 + 60 000) x $0.03 = $7 200)

Dr Cr

7 200

Dr Cr

7 200

Dr Cr

182 000

Dr Cr

195 000

Dr Cr Cr

60 000

27 September 2022 Dividend payable Cash

Cash trust

1 February 2023 Dividend payable Cash 28 April 2023 Cash Share capital (65 000 x $2.80 = $182 000) 2 June 2023 Application Share capital (65 000 x $3 = $195 000) Options Share capital Lapsed options reserve

10 800

150 000

120 000

30 000

150 000

5 000

7 200

182 000

195 000

48 750 11 250

13.33

Chapter 13: Share capital and reserves

21 June 2023 Cash Application

Dr Cr

195 000

30 June 2023 Transfer to general reserve General reserve

Dr Cr

40 000

Dr Cr Cr Cr

152 380

Profit and loss summary Dividend declared Transfer to general reserve Retained earnings (Closing entry)

195 000

40 000

18 000 40 000 94 380

2. YABBY Ltd Statement of changes in equity for the year ended 30 June 2023 Comprehensive income for the period

$152 380

Movements of changes in equity during the period ending 30 June 2023 were: Share capital Balance at 1 July 2022 Issue of 60 000 ordinary shares, paid to $2.00 Share issue costs Issue of 65 000 ordinary shares @ $2.80 Issue of 65 000 ordinary shares @ $3.00 on exercise of options worth 75c Calls in advance Balance at 30 June 2023 Options Balance at 1 July 2022 Transfer to share capital on exercise Transfer to reserve on lapse Balance at 30 June 2023 General reserve Balance at 1 July 2022 Transfer from retained earnigs Balance at 30 June 2023 Forfeited shares reserve Balance at 1 July 2022 Balance at 30 June 2023 Lapsed options reserve Balance at 1 July 2022 Transfer of lapsed options Balance at 30 June 2023 Retained earnings Balance at 1 July 2022

$450 000 120 000 (5 000) 182 000 243 750 30 000 $1 020 750 $60 000 (48 750) (11 250) $0 $50 000 40 000 $90 000 $4 000 $4 000 $0 11 250 $11 250 $95 000

13.34

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Dividends declared and paid Transfer to general reserve Profit for the period Balance at 30 June 2023

(18 000) (40 000) 152 380 $189 380

3. The forfeited shares reserve can only have arisen if shareholders failed to pay a call made on their shares by the company. Corporate legislation or the company’s own rules must then allow the directors to forfeit those shares for non-payment of the call and to retain any monies already paid. Forfeiture will result in the cancellation of the shares, the elimination of the calls in arrears balance and the transfer of any monies by the shareholders to the reserve account titled ‘forfeited shares reserve’.

13.35

Chapter 13: Share capital and reserves

Exercise 13.18 Shares, options, dividends and reserve transfers The equity of Gugu Ltd at 30 June 2022 consisted of:

The options were exercisable before 28 February 2023. Each option entitled the holder to acquire two ordinary ‘C’ shares at $1.80 per share, the amount payable on notification to exercise the option. The following transactions occurred during the year ended 30 June 2023. 2022 Sept 15

Nov 1

Nov 30

Dec 10 2023 Jan 10 Feb 28 Apr 30 May 31 June 18 June 26

June 27 June 30

The preference dividend and the final ordinary dividend of 16c per fully paid share, both declared on 30 June 2022, were paid. The directors do not need any other party to authorise the payment of dividends. A 1-for-5 renounceable rights offer was made to ordinary ‘A’ shareholders at an issue price of $1.90 per share. The expiry date on the offer was 30 November 2022. The issue was underwritten at a commission of $3000. Holders of 320 000 shares accepted the rights offer, paying the required price per share, with the renounced rights being taken up by the underwriter. Ordinary ‘A’ shares were duly issued. Money due from the underwriter was received. The directors transferred $35 000 from retained earnings to a general reserve. As a result of options being exercised, 70 000 ordinary ‘C’ shares were issued. Unexercised options lapsed. The directors made a call on the ordinary ‘B’ shares for 80c per share. Call money was payable by 31 May. All call money was received except for that due on 15 000 shares. Shares on which the final call was unpaid were forfeited. Forfeited shares were reissued, credited as paid to $2, for $1.80 per share, the balance of the forfeited shares account being refundable to the former shareholders. Refund paid to former holders of forfeited shares. The directors declared a 20c per share final dividend to be paid on 15 September 2023.

Required 1. Prepare general journal entries to record the following transactions, which occurred during the year ended 30 June 2023. 2. Prepare the equity section of the statement of financial position as at 30 June 2023. (LO6, LO8 and LO9) © John Wiley and Sons Australia Ltd, 2020

13.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. 15 September 2022 Dividend payable – preference Cash (Payment of preference dividend)

Dr Cr

4 500 4 500

Dividend payable – Ordinary A Dr 64 000 Cash Cr (Payment of dividend of 16c per share on 400 000 shares)

64 000

Dividend payable – Ordinary B Dr 28 800 Cash Cr 28 800 (Payment of dividend of $1.20 / $2.00 x 16c per share on 300 000 shares) 30 November 2022 Cash Receivable – underwriter Share capital – Ordinary A (Issue of 80 000 shares at $1.90 each)

Dr Dr Cr

121 600 30 400

Share capital – Ordinary A Receivable – underwriter (Underwriting costs)

Dr Cr

3 000

Dr Cr

27 400

Dr Cr

35 000

10 December 2022 Cash Receivable – underwriter (Payment from underwriter net of costs) 10 January 2023 Transfer to general reserve General reserve (Transfer between reserves)

152 000

3 000

27 400

35 000

28 February 2023 Cash Dr 126 000 Options Dr 24 000 Lapsed options reserve* Cr 3 000 Share capital – Ordinary C Cr 147 000 (Issue of 70 000 ordinary C shares) * Note: the issue price of lapsed options may be taken to any equity account, or left in an options “reserve” account. Legal and taxation implications must be considered. 30 April 2023 Call – Ordinary B Dr Share capital – Ordinary B Cr (Call of 80c per share on 300 000 shares) 31 May 2023 Cash Call – Ordinary B

Dr Cr

240 000 240 000

228 000

228 000 13.37

Chapter 13: Share capital and reserves

(Receipt of 80c call on 285 000 shares) 18 June 2023 Share capital – Ordinary B Forfeited shares liability Call – Ordinary B (Forfeiture of 15 000 shares)

Dr Cr Cr

30 000

26 June 2023 Cash Forfeited shares liability Share capital – Ordinary B (Reissue of 15 000 Ordinary B shares)

Dr Dr Cr

27 000 3 000

27 June 2023 Forfeited shares liability Cash (Refund to holders of forfeited shares)

Dr Cr

15 000

30 June 2023 Dividend declared – Ordinary A Dividend declared – Ordinary B Dividend declared – Ordinary C Dividend payable – Ordinary A Dividend payable – Ordinary B Dividend payable – Ordinary C (Provision for 20c per share dividend)

Dr Dr Dr Cr Cr Cr

96 000 60 000 14 000

Retained earnings Dividend declared – Ordinary A Dividend declared – Ordinary B Dividend declared – Ordinary C Transfer to general reserve

Dr Cr Cr Cr Cr

205 000

18 000 12 000

30 000

15 000

96 000 60 000 14 000

96 000 60 000 14 000 35 000

2. GUGU LTD Statement of financial position (extract) as at 30 June 2023 Share capital: Ordinary A shares: 480 000 shares fully paid Ordinary B shares: 300 000 fully paid Ordinary C shares: 70 000 fully paid Preference shares: 50 000 fully paid General reserve Options reserve Retained earnings Total shareholders’ equity

$949 000 600 000 147 000 75 000 1 771 000 35 000 3 000 113 000 $1 922 000

13.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 13.19 Dividends, share issues, share buybacks, options and movements in reserves Chilli Crab Ltd, a company whose principal interests were in the manufacture of fine leather shoes and handbags, was formed on 1 January 2020. Prior to the 2023 period, Chilli Crab Ltd had issued 110 000 ordinary shares: • 95 000 $30 shares were issued for cash on 1 January 2020 • 5000 shares were exchanged on 1 February 2021 for a patent that had a fair value at date of exchange of $240 000 • 10 000 shares were issued on 13 November 2022 for $50 per share. At 1 January 2023, Chilli Crab Ltd had a balance in its retained earnings account of $750 000, while the general reserve and the asset revaluation surplus had balances of $240 000 and $180 000 respectively. The purpose of the general reserve is to reflect the need for the company to regularly replace certain of the shoe-making machinery to reflect technological changes. Share issue costs amount to 10% of the worth of any share issue. Required 1. Prepare the general journal entries to record the following transactions, which occurred during the 2023 financial year.

Feb 15

May 10

June 25 June 30 July 1

July 22

Nov 16

Chilli Crab Ltd paid a $25 000 dividend that had been declared in December 2022. Liabilities for dividends are recognised when they are declared by the company. 10 000 shares at $55 per share were offered to the general public. These were fully subscribed and issued on 20 June 2023. On the same date, another 15 000 shares were placed with major investors at $55 per share. The company paid a $20 000 interim dividend. The company revalued land by $30 000, increasing the asset revaluation surplus by $21 000 and the deferred tax liability by $9000. A change in the accounting standard related to insurance became effective, meaning the transitional liability was $55 000 more than the liability recognised under the previous version of the standard. This amount was recognised in other comprehensive income and accumulated in retained earnings. Chilli Crab Ltd repurchased 5000 shares on the open market for $56 per share. The repurchase was accounted for by writing down share capital and retained earnings by an equal amount. Chilli Crab Ltd declared a 1-for-10 bonus issue to shareholders on record at 1 October 2023. The whole of the general reserve was used to create this bonus issue.

13.39

Chapter 13: Share capital and reserves

The company issued 100 000 options at 20c each, each option entitling the holder to acquire an ordinary share in Chilli Crab Ltd at a price of $60 per share, the options to be exercised by 31 December 2024. No options had been exercised by 31 December 2023. Chilli Crab Ltd calculated that its profit for the 2023 year was $150 000. It declared a $30 000 final dividend, transferred $40 000 to the general reserve, and transferred $30 000 from the asset revaluation surplus to retained earnings.

Dec 1

Dec 31

2. Prepare the statement of changes in equity for Chilli Crab Ltd for the year ended 31 December 2023. (LO6, LO7, LO8 and LO9) 1. 15 February 2023 Dividend payable Cash (Payment of dividend)

Dr Cr

25 000 25 000

May – June 2023 Cash trust Dr 550 000 Application Cr (Application monies received during May-June 2008) 20 June 2023 Cash

Dr Cr

550 000

Application Share capital (Issue of shares: 10 000 x $55)

Dr Cr

550 000

Cash

Dr Cr

825 000

Cash trust (Transfer on issue of shares)

Share capital (Placement of shares: 15 000 x $55)

550 000

825 000

Share capital Dr 137 500 Cash Cr (Share issue costs: 10% x ($550 000 + $825 000)) 25 June 2023 Dividend paid Cash (Interim dividend paid) 30 June 2023 Land Deferred tax liability Asset revaluation surplus

550 000

Dr Cr

20 000

Dr Cr Cr

30 000

137 500

20 000

9 000 21 000

13.40

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(Revaluation of land) 1 July 2023 Accounting standard adjustment Dr 55 000 Provision for insurance Cr (Adjustment due to change in accounting standard) 22 July 2023 Share capital Dr Repurchase of shares Dr Cash Cr (Repurchase of 5 000 shares at $56 per share)

55 000

140 000 140 000 280 000

16 November 2023 General reserve Dr 240 000 Share capital Cr 240 000 (Bonus issue of 13 000 shares: No. of shares = 10% x (95 000 + 5 000 + 10 000 + 25 000 – 5 000)) Share capital Cash (Share issue costs: 10% x $240 000)

Dr Cr

24 000

1 December 2023 Cash Options (Issue of options)

Dr Cr

20 000

31 December 2023 Dividend declared Dividend payable (Final dividend)

Dr Cr

30 000

Transfer to general reserve General reserve (Transfer between reserves)

Dr Cr

40 000

Asset revaluation surplus Transfer from asset reval. surplus (Transfer between reserves)

30 000

24 000

20 000

30 000

40 000

Profit and loss summary Dr Transfer from asset reval. surplus Dr Retained earnings Dr Dividend paid Cr Accounting standard adjustment Cr Repurchase of shares Cr Dividend declared Cr Transfer to general reserve Cr

30 000

150 000 30 000 105 000

20 000 55 000 140 000 30 000 40 000 13.41

Chapter 13: Share capital and reserves

(Closing entry) 2. CHILLI CRAB LTD Statement of changes in equity for year ended 31 December 2023 Comprehensive income for the period

$171 000

Share capital Balance at 1 January 2023 Share issues: 25 000 shares Repurchase of shares: 5 000 shares Bonus issue: 13 000 shares Balance at 31 December 2023

$3 590 000 1 237 500 (140 000) 216 000 $4 903 500

Retained earnings Balance at 1 January 2023 Profit for the period Transfer from asset revaluation surplus Dividends paid and provided Accounting standard adjustment Repurchase of shares Transfer to general reserve Balance at 31 December 2023

$750 000 150 000 30 000 (50 000) (55 000) (140 000) (40 000) $645 000

Asset revaluation surplus Balance at 1 January 2023 Increase – revaluation of land Transfer to retained earnings Balance at 31 December 2023

$180 000 21 000 (30 000) $171 000

General reserve Balance at 1 January 2023 Bonus issue of shares Transfer from retained earnings Balance at 31 December 2023

$240 000 (240 000) 40 000 $40 000

Options Balance at 1 January 2023 Options issued Balance at 31 December 2023

$0 20 000 $20 000

CHILLI CRAB LTD Statement of financial position (extract) as at 31 December 2023 Share capital $4 903 500 Options 20 000 General reserve 40 000 Asset revaluation surplus 171 000

13.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings

645 000 $5 779 500

13.43

Chapter 13: Share capital and reserves

Exercise 13.20 Options, shares, dividends, reserves The statement of changes in equity for Aput Ltd for the year ended 30 June 2023 was as shown below. APUT LTD Statement of changes in equity for the year ended 30 June 2023 Profit for the year Other comprehensive income

164 370 0

Total comprehensive income for the year

164 370

400 000 40 000 (6 500) 350 000 170 000 25 000

978 500

38 000 (34 000)

Movements in equity for the year ended 30 June 2023 were: Share capital Balance at 1 July 2022 Issue of 20 000 ordinary shares @ $2.00 Share issue costs: public issue Issue of 100 000 ordinary shares @ $3.50 to public Issue of 50 000 ordinary shares @ $3.00 on exercise of options costing 40c Calls in advance on issue of 100 000 ordinary shares @ $3.50 to public Balance at 30 June 2023 Options Balance at 1 July 2022 Transfer to share capital on exercise

(4 000)

Transfer to reserve on lapse Balance at 30 June 2023

120 000 (80 000) 45 000

Balance at 30 June 2023

85 000

Options reserve Balance at 1 July 2022 Transfer of lapsed options

0 4 000

Balance at 30 June 2023

4 000

Retained earnings Balance at 1 July 2022 Dividends declared

82 000 (12 000)

General reserve Balance at 1 July 2022 Bonus issue of shares Transfer from retained earnings

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

APUT LTD Statement of changes in equity for the year ended 30 June 2023 (6 000) (45 000) 164 370

Dividends paid Transfer to general reserve Profit for the period Balance at 30 June 2023

183 370

Required Provide journal entries in relation to: 1. issue of shares on exercise of options, and related transfers to/from reserves 2. issue of shares to public 3. dividends 4. movements in general reserve. Note: None of the entries should contain the account Retained Earnings. (LO6 and LO8) 1. Cash Dr 150 000 Share capital Cr 150 000

Options Share capital Lapsed options reserve Cash trust Application

Dr Cr Cr Dr Cr

Application Share capital

Dr Cr

350 000

Application Calls in advance

Dr Cr

25 000

Cash

Dr Cr

375 000

Share capital Cash

Dr Cr

6 500

Dividend declared Dividend payable

Dr Cr

12 000

Dividend paid Cash

Dr Cr

6 000

Transfer to general reserve General reserve (Transfer between reserves)

Dr Cr

45 000

General reserve Share capital

Dr Cr

80 000

Cash trust

24 000 20 000 4 000 252 000 252 000

350 000

25 000

375 000

6 500

12 000

6 000

45 000

80 000 13.45

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS

Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 13: Share capital and reserves Multiple choice questions 1. For-profit companies may be: I II III IV *a. b. c. d.

Listed No-liability Unlimited Limited by guarantee

I, II, III and IV. II and III only. I, II and III only. II, III and IV only.

Answer: a Learning objective 13.2: identify the different forms of corporate entities.

2. Which of the following statements relating to shares is not correct? a. A share represents an ownership right in a company. b. Each share in a company carries a right to vote for directors of the company. *c. Each share in a company carries a right to share proportionately in all new share issues of a company. d. Each share in a company carries a right to share in the assets on the liquidation of the company. Answer: c Learning objective 13.3: outline the key features of the corporate structure. 3. In respect to a company’s issue of shares, an IPO is an: a. Instruments providing options to ordinary shareholders. b. Investment in preference and ordinary shares. c. Investment prospectus for an issue of options. *d. Initial public offering of shares. Answer: d Learning objective 13.5: account for the initial issue of shares.

13.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. When a public share issue is made, the offer comes from: *a. the applicant. b. the company issuing the shares. c. the broker handling the share issue for the company. d. the relevant oversight body once it has reviewed the prospectus documentation. Answer: a Learning objective 13.5: account for the initial issue of shares.

5. Contact Ltd was registered as a corporation on 1 July 2021. On 3 July 2021, Contact Ltd issued a prospectus offering 50 000 ordinary shares at an issue price of $5.00 each, payable $3.00 on application and $2.00 on allotment. Application closed on 1 August 2021 with the company having received applications for 60 000 shares. The shares were allotted on 15 August 2021, with the over-subscription amount being refunded to unsuccessful applicants. All allotment monies were received by 31 August 2021. Following the allotment, the balance in the Share Capital account would be: a. *b. c. d.

$50 000 CR. $150 000 CR. $180 000 DR. $300 000 DR.

Answer: b Learning objective 13.5: account for the initial issue of shares.

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Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

6. A company’s capital consists of 100 000 ordinary shares issued at $2 and paid to $1 per share. On 1 September, a first call of 50c was made on the ordinary shares. By 30 September, the call money received amounted to $45 000. No further payments were received, and on 31 October, the shares on which calls were outstanding were forfeited. On 15 November, the forfeited shares were reissued as paid to $1.50 for a payment of $1 per share. The appropriate cash amount from the reissue was received on 19 November. Costs of reissue amounted to $2 500. The company’s constitution provided for any surplus on resale, after satisfaction of unpaid calls, accrued interest and costs, to be returned to the shareholders whose shares were forfeited. The entry to record the forfeiture of shares is: *a. Share capital First call — ordinary shares Forfeited shares

Dr Cr Cr

15 000

Share capital First call — ordinary shares Forfeited shares

Dr Cr Cr

20 000

Share capital Forfeited shares

Dr Cr

10 000

Forfeited shares Share capital

Dr Cr

10 000

5 000 10 000

b. 5 000 15 000

c. 10 000

d. 10 000

Answer: a Learning objective 13.5: account for the initial issue of shares.

13.3

Testbank to accompany Financial reporting 3e by Loftus et al.

7. A company’s capital consists of 100 000 ordinary shares issued at $2 and paid to $1 per share. On 1 September, a first call of 50c was made on the ordinary shares. By 30 September, the call money received amounted to $45 000. No further payments were received, and on 31 October, the shares on which calls were outstanding were forfeited. On 15 November, the forfeited shares were reissued as paid to $1.50 for a payment of $1 per share. The appropriate cash amount from the reissue was received on 19 November. Costs of reissue amounted to $1 800. The company’s constitution provided for any surplus on resale, after satisfaction of unpaid calls, accrued interest and costs, to be returned to the shareholders whose shares were forfeited. The entry to record the reissue of forfeited shares is: *a. Cash Forfeited shares Share capital — ordinary

Dr Dr Cr

10 000 5 000

Cash Forfeited shares Share capital — ordinary

Dr Dr Cr

5 000 5 000

Cash Share capital — ordinary

Dr Cr

10 000

Share capital Forfeited shares

Dr Cr

15 000

10 000

c. 10 000

d. 15 000

Answer: a Learning objective 13.5: account for the initial issue of shares.

13.4

Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

8. A company’s capital consists of 100 000 ordinary shares issued at $2 and paid to $1 per share. On 1 September, a first call of 50c was made on the ordinary shares. By 30 September, the call money received amounted to $45 000. No further payments were received, and on 31 October, the shares on which calls were outstanding were forfeited. On 15 November, the forfeited shares were reissued as paid to $1.50 for a payment of $1 per share. The appropriate cash amount from the reissue was received on 19 November. Costs of reissue amounted to $1 800. The company’s constitution provided for any surplus on resale, after satisfaction of unpaid calls, accrued interest and costs, to be returned to the shareholders whose shares were forfeited. The amount of the surplus payable to the shareholders whose shares were forfeited is: *a. b. c. d.

$3 200 $5 000 $6 800 $10 000

Answer: c Learning objective 13.5: account for the initial issue of shares.

9. If the balance in a forfeited shares account is refundable to the owners of those shares, then the forfeited shares account is classified in the financial statements as: a. b. c. *d.

income. equity. expenses. liabilities

Answer: d Learning objective 13.5: account for the initial issue of shares.

10. Which account represents excess proceeds received and retained by a company from an oversubscription to a share offer application? *a. b. c. d.

Calls in advance account. Share issue costs account. Forfeited shares account. Share capital account.

Answer: a Learning objective 13.5: account for the initial issue of shares.

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Testbank to accompany Financial reporting 3e by Loftus et al.

11. The appropriate journal entry to recognise the accounting treatment for share issue costs is: a. *b. c. d.

DR Deferred asset: CR Cash. DR Share capital: CR: Cash. DR Cash: CR Deferred asset. DR Cash: CR Share capital.

Answer: b Learning objective 13.5: account for the initial issue of shares.

12. How does a bonus issue of shares impact the equity of a company? a. b. c. *d.

Total equity increases. Total equity decreases. Only the amount of issued share capital changes. One equity account increases and another equity account decreases by an equal amount.

Answer: d Learning objective 13.6: discuss the nature of, and account for, issues of shares subsequent to initial issues.

13. Sunshine Company issued 20 000 share options to subscribe for ordinary shares. The exercise price on the options was $2 per share. If all options were exercised on the due date, the journal entry that would be recorded is: a. Share capital — ordinary Cash

Dr Cr

60 000

Share options — ordinary Share capital — ordinary

Dr Cr

60 000

Share options reserve Cash

Dr Cr

60 000

Cash Share capital — ordinary

Dr Cr

60 000

b. 60 000

c. 60 000

*d. 60 000

Answer: d Learning objective 13.6: discuss the nature of, and account for, issues of shares subsequent to initial issues.

13.6

Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

14. A company issued share option is an instrument that gives the holder the right, but not the obligation, to: a. b. *c. d.

receive a certain dividend declared by the company by a specified date. receive a bonus issue of shares in a proportion as notified by the company. buy a certain number of shares in the company by a specified date at a stated price. sell a certain number of shares in the company by a specified date at a stated price.

Answer: c Learning objective 13.6: discuss the nature of, and account for, issues of shares subsequent to initial issues.

15. Which of the following is not a reason that companies may undertake a share buy-back? a. *b. c. d.

To manage the capital structure. As a defence against a hostile takeover. To efficiently manage surplus funds. To increase the value per share of the remaining shares.

Answer: b Learning objective 13.7: discuss the rationale behind and accounting treatment of share buybacks.

16. Which of the following statements relating to an asset revaluation surplus account is correct? *a. b. c. d.

An entity is able to use this surplus for the payment of future dividends. An entity is not able to transfer this surplus to any other reserve account. An entity is not able to use this surplus for the payment of future dividends. An entity can transfer the surplus to current period profit or loss when the asset is disposed of.

Answer: a Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

13.7

Testbank to accompany Financial reporting 3e by Loftus et al.

17. The balance in the retained earnings account is affected by: I. II. III. IV. a. b. c. *d.

Issued share capital Dividends paid or provided for Transfers to or from other reserve accounts Changes in accounting policies and errors

II and III only. I, II, III and IV. I, II and III only. II, III and IV only.

Answer: d Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

18. Dividends declared after the balance date but before the financial statements are authorised for issue: a. b. *c. d.

meet the recognition criteria for a liability. satisfy the recognition criteria for an expense. do not meet the AASB 137 criteria of a present obligation. are recognised in the statement of financial position as they meet the definition of equity.

Answer: c Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

19. AASB 101 Presentation of Financial Statements requires which of the following items to appear on the face of the statement of changes in equity? I. II. III. IV.

Profit or loss for the period The net amount of cash from the issue of any securities during the period The cumulative effect of changes in accounting policy and the correction of errors Each item of income or expenses that are required to be recognised directly in equity

*a. b. c. d.

I, III and IV only. II, III and IV only. II and IV only. I, II, III and IV.

Answer: a Learning objective 13.9: prepare a statement of changes in equity as well as note disclosures in relation to equity.

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Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

20. Accounting for share buy-backs is prescribed by: a. b. c. *d.

an IFRIC interpretation. an IFRS accounting standard. an IAS accounting standard. generally accepted accounting practices.

Answer: d Learning objective 13.7: discuss the rationale behind and accounting treatment of share buybacks.

21. Regulations for share buy-backs are primarily designed to protect the interests of a company’s: a. *b. c. d.

shareholders. creditors. directors. option holders.

Answer: b Learning objective 13.7: discuss the rationale behind and accounting treatment of share buybacks.

22. Which of the following is responsible for deciding whether a dividend is paid by a company? a. b. *c. d.

Creditors of the company. Auditors of the company. Directors of the company. International Accounting Standards Board.

Answer: c Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

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Testbank to accompany Financial reporting 3e by Loftus et al.

23. Retained earnings are a component of: *a. b. c. d.

reserves. contributed equity. other equity. comprehensive income.

Answer: a Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

24. Gains or losses resulting from the translating of foreign currency denominated operations into the reporting currency are recognised in income: a. b. c. *d.

only if they are material items. only when they are settled in cash. in the reporting period in which they arise. only when the interest in the foreign operation is sold.

Answer: d Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

25. Gains and losses on available-for-sale financial assets are recognised directly in equity until the financial asset is derecognised. Upon derecognition, the cumulative gain or loss previously recognised is: a. *b. c. d.

set-off against the relevant financial asset. recognised in profit or loss. transferred to a revaluation reserve account in equity. charged against a provision for gains and losses account.

Answer: b Learning objective 13.8: explain the nature of reserves and account for movements in reserves, including dividends.

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Chapter 13: Share capital and reserves Not for distribution in full. Instructors may assign selected questions in their LMS.

26. AASB 101 requires that a reconciliation between the carrying amount of each class of contributed equity capital and each reserve at the beginning and end of each period be disclosed in: a. b. c. *d.

the statement of changes in equity only. the notes to the financial statements only. Statement of profit or loss and other comprehensive income. either the statement of changes in equity or the notes to the financial statements.

Answer: d Learning objective 13.9: prepare a statement of changes in equity as well as note disclosures in relation to equity.

27. The following items appear in the statement of changes in equity except for: a. *b. c. d.

Appropriations from retained earnings. The non-controlling interest share of equity. Dividends declared but not yet paid at year end. The payment of a bonus dividend from a reserve.

Answer: b Learning objective 13.9: prepare a statement of changes in equity as well as note disclosures in relation to equity.

28. In relation to share capital, AASB 101 does not require disclosure in the financial statements of: a. b. c. *d.

the number of shares on issue at the end of the year. the total dollar value of share capital at the end of the year. restrictions on dividends payable to certain classes of shareholders. the amount of any over- or under-subscription of new share issues during the year.

Answer: d Learning objective 13.9: prepare a statement of changes in equity as well as note disclosures in relation to equity.

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Testbank to accompany Financial reporting 3e by Loftus et al.

29. AASB 101 requires that information in relation to dividends paid or declared during the year be disclosed in: *a. b. c. d.

either the statement of changes in equity or the notes to the financial statements. the statement of changes in equity only. the notes to the financial statements only. the statement of comprehensive income.

Answer: a Learning objective 13.9: prepare a statement of changes in equity as well as note disclosures in relation to equity.

13.12

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 14: Share-based payment

Chapter 14: Share-based payment Comprehension questions 1. Why do standard setters formulate rules on the measurement and recognition of sharebased payment transactions? Prior to the introduction of AASB 2/IFRS 2 share-based payment, there was no requirement to recognise the cost of compensation payments to employees and transactions for the acquisition of goods and services from others in the financial statement. This situation can be criticised as reducing the transparency and reliability of financial statements. Standard setters have argued that recognising the cost of share-based payments in the financial statements of entities improves the relevance, reliability and comparability of that financial information and helps users of financial information to understand better the economic transactions affecting an enterprise and supports resource allocation decisions.

2. What is the difference between equity-settled and cash-settled share-based payment transactions? Equity-settled share-based payment transactions arise when an entity receives goods or services as consideration for its own equity instruments (including shares and share options). Cash-settled share-based payment transactions arise when an entity acquires goods or receives services by incurring liabilities (debt) for amounts based on the value of its own equities. Other share-based payment transactions may arise in which the entity receives or acquires goods or services and either the entity or the supplier has the choice of whether the transaction is settled in cash or equity instruments.

3. What is the different accounting treatment for instruments classified as debt and those classified as equity? Instruments classified as debt (liabilities) are accounted for by recognising an increase in an expense (or asset) and a corresponding increase in debt (a liability). The fair value of such liabilities determines the measurement of the transaction. Additionally, the debt (liability) must be remeasured at each reporting date and at settlement date. Instruments classified as equity are accounted for by recognising an increase in an expense (or asset) and a corresponding increase in equity. The fair value of the goods or services received is measured at the grant date fair value of the goods or services received and it is not subsequently remeasured. If the fair value of the goods or services received cannot be measured reliably, the transaction amount is determined indirectly by reference to the fair value of the equity instruments granted.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. Outline the accounting treatment for the recognition of an equity-settled share-based payment transaction. Equity settled share-based payment transactions are recognised as an increase in the goods or services received and a corresponding increase in equity measured at the grant date at the fair value of the goods or services received, or it the fair value of the equity instruments granted. 5. Explain when a counterparty’s entitlement to receive equity instruments of an entity vests. A counterparty’s entitlement to receive equity instruments of an entity vest when the vesting conditions are met. These are typically service criteria i.e.: the employee remaining employed by the entity for a specified period of time and performance conditions such as the entity achieving a specified growth in profit or a specified increase in the entity’s share price.

6. What are the minimum factors required under AASB 2/IFRS 2 to be taken into account in option pricing models? Appendix B of AASB 2/IFRS 2 supplies a list of factors that all option pricing models take into account as a minimum. These include: (a) the exercise price of the option (b) the life of the option (c) the current price of the underlying shares (d) the expected volatility of the share price (e) the dividends expected on the shares (f) the risk-free interest rate for the life of the option. Appendix B also contains a discussion of the valuation issues in the context of applying options pricing models. The student should refer to the discussion in AASB 2/IFRS 2 Appendix B. In brief, the following important matters are discussed in Appendix B. Expected volatility is a measure of the amount by which a price is expected to fluctuate during a period. Volatility is typically expressed in annualised terms, for example, daily or monthly price observations. Often a range of reasonable expectations about future volatility can be determined, and if so, an expected value should be calculated by weighting each amount within the range by its associated probability of occurrence. Expectations about the future are generally based on experience, modified if the future is reasonably expected to differ from the past. There may be cases where historical patterns may not be the best indicator of reasonable expectations for the future, for instance where a significant business segment has been acquired or disposed of.

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Chapter 14: Share-based payment

Whether dividends should be taken into account depends on the counterparty’s entitlement to those dividends. Generally, assumptions about dividends are to be based on publicly available information. The risk-free interest rate is the implied yield currently available on zero-coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term of the option being valued.

7. Distinguish between vesting and non-vesting conditions. Vesting conditions comprise service and performance conditions only. Other features of sharebased payment transactions are not regarded as vesting conditions. Whether or not a condition is a vesting condition or a non-vesting condition is illustrated in the following flowchart. Does the condition determine whether the entity receives the services that entitle the counter-party to the share-based payment? NO Non-vesting condition

YES Does the condition require only a specified period of service to be completed? NO Performance condition

YES Service condition

8. Explain what the ‘repricing’ of share options means. Repricing of share options occurs when an entity chooses to modify the terms and conditions on which it granted equity instruments. For example, it might change (reprice/retest) the exercise price of share options previously granted to employees at prices that were higher than the current price of the entity’s shares. It might accelerate the vesting of share options to make the options more favourable to employees; or it might remove or alter a performance condition. If the exercise price of options is modified, the fair value of the options changes. A reduction in the exercise price would increase the fair value of share options. Irrespective of any modifications to the terms and conditions on which equity instruments are granted, paragraph 27 of AASB 2/IFRS 2 requires the services received, measured at the grant-date fair value of the equity instruments, to be recognised unless those equity instruments do not vest. Although some companies provide for retesting to allow for the potential volatility of earnings

14.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

and the cyclical nature of the market, many companies limit the retesting opportunities and others do not allow retesting at all.

9. Explain the measurement approach for cash-settled share-based payment transactions. If a share-based payment is settled in cash, the general principle employed in AASB 2/IFRS 2 is that the goods or services received and the liability incurred are measured at the fair value of the liability (AASB 2/IFRS 2 paragraph 10). The fair value of the liability must be remeasured at the end of each reporting period and at the date of settlement, and any changes in fair value are recognised in profit or loss (AASB 2/IFRS 2 paragraph 30).

10. Are the following statements true or false? (a) Goods or services received in a share-based payment transaction must be recognised when they are received. (b) Historical volatility provides the best basis for forming reasonable expectations of the future price of share options. (c) Share appreciation rights entitle the holder to a future equity instrument based on the profitability of the issuer. (a) True (b) False (c) False

14.5

Chapter 14: Share-based payment

Case studies Case study 14.1 Vesting conditions On 1 January 2020, Jarrod Ltd grants 2000 share options to its 10 sales staff. At this date the fair value of the share options is $50. The vesting conditions are: • the salesperson must remain with the company for a minimum of 3 years • the gross profit margin remains at a minimum of 40% over the next 3 years. At the end of year 1, Jarrod Ltd adjusts the target for gross profit margin from 40% to 50%. This target proves too difficult to maintain and by the end of year 3 the gross profit margin is at 42%. At 31 December 2022, there are 6 sales staff employed with Jarrod Ltd, 5 of these sales staff have been with the entity for the past 3 years. The other salesperson commenced employment with the entity on 1 December 2022. The fair value of the share options at the end of the vesting period is $55. Required With regards to the requirements of AASB 2/IFRS 2, discuss the implications of a share option grant whereby the vesting conditions are modified and subsequently not satisfied. We need to consider the two vesting conditions and their impact on the calculation of the equity instruments vested. AASB 2, Appendix A, defines vesting conditions as: The conditions that determine whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments…..Vesting conditions are either service conditions or performance conditions. Service conditions require the counterparty to complete a specified period of service. Performance conditions require the counterparty to complete a specified period of service and specified performance targets to be met (such as a specified increase in the entity’s profit over a specified period of time). A performance condition might include a market condition. A market condition is defined in Appendix A as: A condition upon which the exercise price, vesting or exercisability of an equity instrument depends that is related to the market price of the entity’s equity instruments, such as attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving a specified target that is based on the market price of the entity’s equity instruments relative to an index of market prices of equity instruments of other entities. The treatment of vesting conditions is discussed in paragraph 19 of AASB. Essentially, the vesting conditions, unless a market condition, are not taken into account when determining the fair value of the share options at the measurement date. That is, the fair value of the share options at the end of the vesting period is not to be included in the measurement of the transaction

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

amount. Instead, the standard requires the entity to adjust the number of equity instruments to be included in the measurement. The first condition is a service condition – the salespersons are required to remain employed with the entity for a minimum of 3 years from the grant date. In this case, only 5 of the original 10 salespersons have remained with the entity for the full 3-year period. If service was the only vesting condition to be satisfied the total amount of remuneration for the share options would be calculated as: •

5 salespersons x 2 000 share options x $50 FV per option = $500 000.

The requirement for a gross profit margin to be maintained at a minimum level of 40% is a performance condition. If the performance condition is not satisfied, and it is the only vesting condition, the share options do not vest and are subsequently forfeited. However, if the entity modifies the performance condition making it less likely that the share options will vest, which is not beneficial to the employee, the entity is not to take account of the modified performance condition when recognising the services rendered. (AASB 2, Paragraph B44(c) of Appendix B) With the entity changing the performance condition from a gross profit margin of 40% to 50% they have made it less likely that the share options will vest. This is not beneficial to the salesmen and therefore, cannot be taken into account when determining the services rendered. Jarrod Ltd is therefore required to recognise the services received based on the original vesting conditions. That is, the 5 salespersons remaining will be granted share options as per the above calculation of $500 000.

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Chapter 14: Share-based payment

Case study 14.2 Vesting conditions and share options Sebastian Ltd grants its manager a share option plan conditional on the manager contributing 10% of his fortnightly salary of $3000 for the next 2 years. The fortnightly payments will be automatically deducted from the manager’s salary and held until either: the end of the two-year period when the manager exercises their right to the share options; or earlier, within the two-year period, if the manager chooses to opt out of this arrangement and be refunded their contributions. Sebastian Ltd estimates the annual expense for this share-based payment plan to be $2000. Required Discuss the requirements of AASB 2/IFRS 2 if the manager chooses to discontinue his contributions and opts out of this share option plan after 12 months. This situation comprises a non-vesting condition: the requirement for the manager to contribute 10% of his fortnightly salary. Paragraph 21A of AASB 2 require an entity to “take into account all non-vesting conditions when estimating the fair value of the equity instruments granted…..irrespective of whether those non-vesting conditions are satisfied”. There are three components to be recognised by Sebastian Ltd for this share option plan. 1. Paid fortnightly salary (90% of $3 000 per fortnight). 2. Salary deduction held each fortnight (10% of $3 000 per fortnight). 3. Expenses of the share-based plan of $2 000 per year. Each fortnight the manager is paid 90% of his salary with Sebastian Ltd recognising an expense and payment of Cash each fortnight. The 10% of the salary that is deducted each fortnight is held by the entity in a savings plan for the 2-year vesting period. This is recognised as an expense and a liability (the obligation to refund it back to the manager if he opts out of the arrangement, or to be used as payment for the share options at the end of 2 years). An annual expense of $2 000 for the payment arrangement is also required to be recognised and is included as part of equity. At the end of 12 months the manager chooses to opt out of the arrangement and stops contributing 10% of his fortnightly salary, thus cancelling the grant. AASB 2, paragraph 28A states: If an entity or counterparty can choose whether to meet a non-vesting condition, the entity shall treat the entity’s or counterparty’s failure to meet the non-vesting condition during the vesting period as a cancellation. Paragraph 28 (b) of AASB 2 requires that, upon cancellation of a grant, any payment made to the employee in settlement of a liability is to be accounted for as “an extinguishment of the liability”.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The manager is entitled to a refund of his contributions made during the 12-month period. The total amount of the refund to the manager is $7 800 (10% of $3 000 x 26 fortnights in 12 months).

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Chapter 14: Share-based payment

Case study 14.3 Incentive plans Visit the websites of three Australian companies and access their latest annual reports. View the remuneration report within the director’s statutory report. Compare these remuneration reports and discuss your findings, especially in relation to short-term and/or long-term incentive structures. Student responses will obviously vary. They should be reporting to the class on the types of short-term and/or long-term incentives that are put in place by these companies and how they are aligned to the remuneration policy and employee performance.

14.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 14.1 Scope of AASB 2/IFRS 2 Which of the following is a share-based payment transaction within the scope of AASB 2/IFRS 2? Give reasons for your answer. (a) Goods acquired from a supplier by incurring a liability based on the market price of the goods (b) An invoiced amount for professional advice provided to an entity, charged at an hourly rate, and to be settled in cash (c) Services provided by an employee to be settled in equity instruments of the entity (d) Supply of goods in return for cash or equity instruments at the discretion of the supplier (e) Dividend payment to employees who are holders of an entity’s shares (LO2) (a) AASB 2/IFRS 2 does not include such transactions as share-based payment transactions within the scope as outlined in AASB 2/IFRS 2 paragraph 2: however, if the liability for the goods were based on the market price of the entity’s equity, the transaction would be considered a share-based payment transaction. (b) This is not a share-based payment transaction as the entity does not receive services as consideration by incurring liabilities for amounts based on the price of its own equity instruments. (c) This is a share-based payment transaction as specified by AASB 2/IFRS 2 paragraph 2(a), that is, it is a transaction in which the entity receives goods or services as consideration for equity instruments of the entity. (d) This is a share-based payment transaction as specified by AASB 2/IFRS 2 paragraph 2(c), that is, it is a transaction in which the entity receives goods and the terms of the arrangement provide the supplier with a choice of whether to settle in cash or equity instruments of the entity. (e) This is not a share-based payment transaction. Paragraph 4 of AASB 2/IFRS 2 excludes transactions with employees (or other parties) in the employees’ capacity as a holder of equity instruments of the entity.

14.11

Chapter 14: Share-based payment

Exercise 14.2 Categorising An entity grants 20 000 shares to a senior manager in return for services rendered. Required Should the entity recognise the cost of these services as a liability or a component of equity? Explain. (LO2 and LO3) This is share-based payment transaction. AASB 2/IFRS 2 paragraph 2 recognises the acquisition of goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the share price of the entity’s shares, as share-based payment transactions.

14.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.3 Recognition principles Mulgogi Ltd, a listed company, organises major sporting events. It acquires crowd control equipment in return for a liability for an amount based on the price of 1000 of its own shares. Required Is this a share-based payment transaction? Should Mulgogi Ltd recognise the acquisition cost as an asset or an expense? Explain. (LO2 and LO3) This is a share-based payment transaction. AASB 2/IFRS 2 paragraph 2 recognises the acquisition of goods by incurring liabilities to the supplier of those goods for amounts that are based on the share price of the entity’s shares as a share-based payment transaction. The crowd control equipment should be recognised as an asset and progressively recognised as an expense according to the pattern of usage of the economic benefits.

14.13

Chapter 14: Share-based payment

Exercise 14.4 Equity-settled share-based payment transactions On 1 January 2022, Colette Park Ltd announces a grant of 500 share options to each of its 20 senior executives. The grant is conditional on the employee continuing to work for Colette Park Ltd for the next 3 years. The fair value of each share option is estimated to be $20. On the basis of a weighted average probability, Colette Park Ltd estimates that 10% of its senior executives will leave during the vesting period. Required Prepare a schedule setting out the annual and cumulative remuneration expense to be recognised by Park Ltd for services rendered as consideration for the share options granted. (LO3 and LO4) Year

Calculation

1 2 3

(20 x 500 options x 90% x $20) x 1/3 years (20 x 500 options x 90% x $20) x 2/3 years) – $60 000 (20 x 500 options x 90% x $20) – $120 000

Remuneration expense for period $ 60 000 60 000 60 000

Cumulative remuneration expense $ 60 000 120 000 180 000

14.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.5 Share-based payment with a non-vesting condition An employee is offered the opportunity to contribute 10% of their annual salary of $3000 across the next 2 years to a plan under which they receive share options. The employee’s accumulated contributions to the plan may be used to exercise the options at the end of the 2-year period. The estimated annual expense for this share-based payment arrangement is $200. Required Prepare the necessary journal entry or entries to recognise this arrangement at the end of the first year. (LO3, LO4 and LO5)

Year 1 salary $3 000 x 1 x 0.90 (Contribution to plan) $3 000 x 1 x 0.10 (Share-based payment)

Expense $

Cash $

2 700

Cr (2 700)

Dr Dr

300 200

Liability $

Equity $

Cr (300) Cr (200)

14.15

Chapter 14: Share-based payment

Exercise 14.6 Cash-settled share-based payment transactions An entity receives inventories from a counterparty in exchange for a liability based on the price of 4000 of the entity’s own shares. At the date of receiving the inventories, the entity’s shares have a market value of $12 each. Required Measure the value of this transaction and prepare an appropriate journal entry to recognise it. (LO3 and LO8) Amount of the liability for inventory received, measured by direct reference to the entity’s own shares is $48 000 (4 000 shares x $12). An appropriate journal entry to recognise this share-based payment transaction is: Inventory Dr 48 000 Accounts payable Cr 48 000 (Recognition of a cash-settled share-based payment transaction in which the amount for the fair value of goods received is measured by reference to the entity’s own shares).

14.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.7 Modifications to equity-settled share based payment transactions At the beginning of year 1, James Ltd grants 100 share options to each of its 120 employees, conditional on the employee remaining in the employ of James Ltd over the next 2 years. The company estimates that the fair value of the options on grant date is $12. On the basis of a weighted average probability, James Ltd estimates that 15% of its employees will leave during the vesting period. At the end of year 1 ten employees have left, and James Ltd estimates that a further five will leave during year 2. By the end of year 1 the company’s share price has dropped, and it decides to reprice the share options. It estimates that the fair value of the original share options is $7 and the fair value of the repriced share options is $10. Five employees leave during year 2. Required Prepare a schedule setting out the remuneration expense to be recognised at the end of years 1 and 2. (LO4 and LO7) Eight employees left during year 1, and James Ltd estimates that a further five employees will depart during year 2. By the end of year 1, the company’s share price has dropped and it decides to reprice the share options. The repriced share options will vest at the end of year two. At the date of repricing James Ltd estimates the fair value of each of the original share options is $7 and the fair value of each repriced share option is $10. The incremental value is $3 per share option and this amount is recognised over the remaining one year of the vesting period along with the remuneration expense based on the original option value of $12. Year Calculation

1 2

Remuneration expense for period $ (120-15) employees x 100 options x $12 x 1/2 years 63 000 ([120-15] employees x 100 options) x ($12 + $3) – 94 500 $63 000

Cumulative remuneration expense $ 63 000 157 500

14.17

Chapter 14: Share-based payment

Exercise 14.8 Accounting for a grant where the number of equity instruments expected to vest varies Mitchell Ltd grants 60 share options to each of its 200 employees. Each grant is conditional on the employee working for the company for the 3 years following the grant date. On grant date, the fair value of each share option is estimated to be $18. On the basis of a weighted average probability, the company estimates that 15% of its employees will leave during the 3-year vesting period. During year 1, 12 employees leave and the company revises its estimate of total employee departures over the full 3-year period from 15% to 18%. Required Prepare a schedule setting out the annual and cumulative remuneration expense for year 1. (LO7) Year Calculation

Remuneration expense for period $ (60 options x 200 employees x 82%) x $18 x 1/3 59 040 years

Cumulative remuneration expense $ 59 040

14.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.9 Accounting for a grant of share options where the exercise price varies At the beginning of 2022, Brandon Ltd grants 4000 employee share options with an exercise price of $40 to its newly appointed chief executive officer, conditional on the executive remaining in the company’s employ for the next 3 years. The exercise price drops to $30 if Brandon Ltd’s earnings increase by an average of 10% per year over the 3-year period. On grant date, the estimated fair value of the employee share options with an exercise price of $30 is $22 per option. If the exercise price is $40, the options have an estimated fair value of $17 each. During 2022, Brandon Ltd’s earnings increased by 8% and are expected to continue to increase at this rate over the next 2 years. Required Prepare a schedule setting out the annual remuneration expense to be recognised by Brandon Ltd and the cumulative remuneration expense for 2022. (LO7) The earnings increase during 2022 of 8% is less than the 10% required to drop the exercise price from $40 to $30. This 8% earnings increase is expected to continue over the next 2 years. Therefore, the exercise price remains at $40 and the estimated fair value of the employee share options is $17 each. Year Calculation

2022

4 000 options x $17 x 1/3 years

Remuneration expense for period $ 22 667

Cumulative remuneration expense $ 22 667

14.19

Chapter 14: Share-based payment

Exercise 14.10 Accounting for a grant with a market condition At the beginning of 2022, Montose Bay Ltd grants 10 000 share options to a senior marketing executive, conditional on that executive remaining in the company’s employ until the end of 2024. The share options cannot be exercised unless the share price has increased from $20 at the beginning of 2022 to above $30 at the end of 2024. If the share price is above $30 at the end of 2022, the share options can be exercised at any time during the following 5 years. Montose Bay Ltd applies a binomial option-pricing model that takes into account the possibility that the share price will exceed $30 at the end of 2024 and the possibility that the share price will not exceed $30 at the end of 2024. The fair value of the share options with this market condition is estimated to be $14 per option. Required Calculate the annual and cumulative remuneration expense to be recognised by Montose Bay Ltd for 2022. (LO5 and LO7) Year Calculation

2022 10 000 options x $14 x 1/3 years Source: Adapted from AASB 2, IG13.

Remuneration expense for period $ 46 667

Cumulative remuneration expense $ 46 667

14.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.11 Application of the intrinsic value method At the beginning of 2022, Albion Ltd grants 2000 share options to each of its 40 most senior executives. The share options have a life of 5 years and will vest at the end of year 3 if the executives remain in service until then. The exercise price is $50 and Albion Ltd’s share price is also $50 at the grant date. As the company’s share options have characteristics significantly different from those of other traded share options, the use of option-pricing models will not provide a reliable measure of fair value at grant date. The company’s share price during years 1–3 is shown below.

Year

Share price at year end

Estimated number of executives departing in each year

1 2 3

$53 $55 $65

3 2 1

Number of executives remaining at year end

Number of share options exercised at year end

36 34 33

0 0 0

Required Calculate the annual and cumulative remuneration expense to be recognised by Albion Ltd for each of the 3 years. (LO6) At the end of year 1, 4 employees (i.e. 40 – 36) have left and the company estimated that a further three employees will leave during years 2 and 3. Hence, only 82.5% of the share options are expected to vest. Year Calculation

(40 x 2 000 options x 82.5%) x [$53-$50] x 1/3 years

Remuneration expense for period $

Cumulative remuneration expense $

66 000

Two employees left during year 2, and one further employee was expected to leave during year three hence the company estimated the number of share options expected to vest remained at 82.5%. Year Calculation

(40 x 2 000 options x 82.5% x [$55-$50] x 2/3 years) – $66 000

Remuneration expense for period $

Cumulative remuneration expense $

154 000

220 000

14.21

Chapter 14: Share-based payment

(40 x 2 000 options x 82.5% x [$65-$50]) – $220 000

770 000

990 000

14.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.12 Accounting for cash-settled share-based payment transactions Ashmore Ltd grants 1000 share appreciation rights (SARs) to 10 senior managers, to be taken in cash within 2 years of vesting date on condition that the managers do not leave in the next 3 years. The SARs vest at the end of year 3. Ashmore Ltd estimates the fair value of the SARs at the end of each year in which a liability exists as shown below. The intrinsic value of the SARs at the date of exercise at the end of year 3 is also shown.

Year

Fair value

Intrinsic value

Number of managers who exercised their SARs

1 2 3

$ 8.80 $ 11.00 $20.40

$18.00

During year 1, one employee leaves and Ashmore Ltd estimates that a further two will leave before the end of year 3. One employee leaves during year 2 and the corporation estimates that another employee will depart during year 3. One employee leaves during year 3. At the end of year 3, four employees exercise their SARs. Required Prepare a schedule setting out the expense and liability that Ashmore Ltd must recognise at the end of each of the first 3 years. (LO3 and LO8) At the end of year 1, one employee has left and another 2 are expected to leave during year 2. Therefore, the liability is recognised for the 7 employees expected to remain. At the end of year 2, another employee has left and one more is expected to leave during year 3. Again, the liability is recognised for the 7 employees expected to remain. Year Calculation 1 2

(10-3) employees x 1 000 SARs x $8.80 x 1/3 years (10-3) employees x 1 000 SARs x $11 x 2/3 years – $20 533

Expense $ 20 533

Liability $ 20 533

30 800

51 333

At the end of year 3, seven employees remain and four of these employees exercise their SARs. The SARs vest at the end of year 3 but the employees still have another two years to take them. Therefore, a liability must still be recognised for the remaining three employees who are yet to exercise their SARs. Year Calculation

Expense $

Liability $

14.23

Chapter 14: Share-based payment

(10-3-4) employees x 1 000 SARs x $20.40 – $51 333 4 employees x 1 000 SARs x $18.00

9 867 72 000

61 200

14.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 14.13 Disclosure Fernvale Ltd operates a share option plan for its officers, employees and consultants for up to 10% of its outstanding shares. Under this plan, the exercise price of each option equals the closing market price of the shares on the day before the grant. Each option has a term of 5 years and vests one-third on each of the 3 years following grant date. Before this financial period, Fernvale Ltd has accounted for its share option plan on settlement date and no expense has been recognised. Required Prepare an appropriate memorandum outlining the disclosures that will need to be made in Fernvale Ltd’s financial statement following the adoption of AASB 2/IFRS 2. (LO9) Memorandum to XXX According to the requirements of AASB 2/IFRS 2 Share-based Payment, the financial statements for the next reporting period must include sufficient disclosure in respect to the share option plan operated on behalf of employees to enable users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the year; to understand how the fair value of goods or services received or the fair value of share options granted during the year was determined; and to understand the effect of share-based payment transactions on the profit or loss for the period and on financial position. The additional disclosures Fernvale Ltd will need to make in order to satisfy the requirements of AASB 2/IFRS 2 are the following: AASB 2/IFRS 2 paragraph 45(a) A description of the share plan including the general terms and conditions, vesting requirements, maximum term of options granted and method of settlement. AASB 2/IFRS 2 paragraph 45(b) The number and weighted average exercise prices of share options for each of the following groups: (i) outstanding at the beginning of the period; (ii) granted during the period; (iii) forfeited during the period; (iv) exercised during the period; (v) expired during the period; (vi) outstanding at the end of the period; and (vii) exercisable at the end of the period. AASB 2/IFRS 2 paragraph 45(c) For share options exercised during the period, the weighted average share price at the date of exercise (or is exercised regularly throughout the period, the weighted average share price during the year).

14.25

Chapter 14: Share-based payment

AASB 2/IFRS 2 paragraph 45(d) For share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life. If the range of exercise prices is wide, these options will need to be divided into ranges that are meaningful for an assessment of the number and timing of additional shares that may be issued and the cash that may be received on the exercise of the options. AASB 2/IFRS 2 paragraph 47(a) For share options granted during the period, the weighted average fair value of those options at the measurement date and information on how that fair value was measured including: (i) the options pricing model used and the inputs to that model, including the weighted average share price, exercise price, expected volatility, option life, expected dividends, risk-free interest rate, and any other inputs; (ii) how expected volatility was determined, including the extent to which expected volatility was based on historical volatility; (iii) whether and how any other features of the option were incorporated into the measurement of fair value. AASB 2/IFRS 2 paragraph 47(c) For arrangements that were modified during the period: (i) an explanation of the modifications (ii) the incremental fair value granted as a result; and (iii) information on how the incremental fair value was measured. AASB 2/IFRS 2 paragraph 51 The total expense recognised for the period that did not qualify for recognition as assets. Although it does not appear that employees have a settlement choice under this plan, if they do, then separate disclosure of the portion of the expense accounted for as equity-settled share-based payments must be made, and for any liabilities arising the total carrying amount at the end of the period, and the total intrinsic value at the end of the period for which the employees’ right to cash had vested by the end of the period. AASB 2/IFRS 2 paragraph 52 Any such other information as is necessary to enable the users understand the nature and extent of share-based payments, how the fair value of equity instruments granted was determined, and the effect of the transactions on profit or loss and financial position.

14.26

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 14: Share-based payment Multiple choice questions 1. Which of the following is within the scope of AASB 2 Share-based Payment? *a. b.

Cancellation, replacement or modification of share-based payments arising because of a business combination or restructuring. Transactions in which the entity receives or acquires goods or services as part of the net assets acquired in a business combination to which IFRS 3 Business Combinations applies. Transaction in which the entity receives or acquired goods or services under a contract which is within the scope of AASB 139 Financial Instruments: Recognition & Measurement. Transactions with employees in the employee’s capacity as a holder of equity instruments of the entity.

Answer: a Learning objective 14.1: explain the objective and scope of AASB 2/IFRS 2.

2. Which of the following is not within the scope of AASB 2 Share-based Payment? a. b. c. *d.

Equity instruments granted to employees of the acquiree in a business combination in their capacity as an employee. Cancellation, replacement or other modification of share-based payment arrangements because of a business combination. Cancellation, replacement or other modification of share-based payment arrangements because of other equity restructuring. Transactions in which the entity receives or acquires goods or services as part of the net assets acquired in a business combination to which IFRS 3 Business Combinations applies.

Answer: d Learning objective 14.1: explain the objective and scope of AASB 2/IFRS 2.

14.1

Chapter 14: Share based payment

3. As per AASB 2 Share-based Payment, a/an share-based payment transaction is one in which the entity acquires goods or services by incurring liabilities to the supplier for amounts that are based on the value of the entity’s shares or other equity instruments of the entity. a. b. *c. d.

equity-settled liability-settled cash-settled “other”

Answer: c Learning objective 14.2: distinguish between cash-settled and equity-settled share-based payment transactions.

4. A share–based payment transaction in which the entity receives goods or services as consideration for equity instruments of the entity is classified, in AASB 2 Share-based Payment, as: *a. b. c. d.

an equity-settled share-based payment transaction. a liability-settled share-based payment transaction. a cash-settled share-based payment transaction. an ‘other’ share-based payment transaction.

Answer: a Learning objective 14.2: distinguish between cash-settled and equity-settled share-based payment transactions.

5. Bolder Limited grants 1000 share options to each of its 80 employees. Each grant is conditional on the employee working for the company for the next two years. The fair value of each option is estimated to be $10.00 at grant date and $12.50 at vesting date. The amount to be recognised as an expense by Bolder Limited in year 2 is: a. b. *c. d.

$400 000. $800 000. $200 000. $1 000 000.

Answer: c Learning objective 14.4: explain how equity-settled share-based payment transactions are measured.

14.2

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

6. Abbott Limited grants 500 share options to each of its 20 employees. Each grant is conditional on the employee working for the company for the next three years. The fair value of each option is estimated to be $6.00 at grant date and $8.00 at vesting date. The amount to be recognised as an expense by Abbott Limited in year 2 is: a. *b. c. d.

$40 000. $20 000. $60 000. $80 000.

Answer: b Learning objective 14.4: explain how equity-settled share-based payment transactions are measured.

7. In situations where an option-pricing model is required to be used to determine the fair value of equity instruments granted, the accounting standard, AASB 2 Share-based Payment: a. b. *c.

requires the use of a binominal option-pricing model. requires the use of the Black-Scholes-Merton formula. allows the entity to choose the option-pricing model it wishes to use, but contains a number of factors that the option-pricing model selected must take into account as a minimum. requires expected dividends to be taken into account when measuring the shares or options granted.

Answer: c Learning objective 14.4: explain how equity-settled share-based payment transactions are measured.

14.3

Chapter 14: Share based payment

On 1 July 2021 Salt & Pepper Limited granted 200 share options to each of its 50 employees. Each grant is conditional on the employee working for the company for the next two years. The fair value of each option is estimated to be $8.00. Salt & Pepper estimates that 6% of its employees will leave during the two year period and therefore forfeit their rights to the share options. During the year ended 30 June 2022 five employees left. At this time the company revised its estimate of total employee departures over the full two-year period to 10%. During the year ended 30 June 2023 a further 4 employees left. The amount to be recognised as an expense by Salt & Pepper for the year ended 30 June 2022 is:

*a. b. c. d.

$36 000. $72 000. $40 000. $80 000.

Answer: a Feedback: (200 x 50 x 90%) x $8 x 1/2 Learning objective 14.5: explain the concept of vesting through differentiating between vesting and non-vesting conditions.

14.4

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

9. On 1 July 2022, Geoffrey Limited granted 250 options to each of its 100 employees. The options are conditional on the employees remaining with the company for the 2 year vesting period. The options have a fair value of $15 at vesting date. In addition, the shares will vest as follows: On 30 June 2023 if the company’s earnings have increased by more than 15%. On 30 June 2024 if the company’s earnings have increased by more than 12% averaged across the 2 year period. At 30 June 2033 Geoffrey’s earnings have increased by 12% and 5 employees have left. The company expects that earnings will continue to increase at a similar rate during the year to 30 June 2024 and that the shares will vest at that time. It also expects that a further 7 employees will leave during the year. The remuneration expense for the year ended 30 June 2022 for Geoffrey is: a. b. c. *d.

$178 125 $330 000 $187 500 $165 000

Answer: d Feedback: (250 x [100-5-7]) x $15 x 1/2 Learning objective 14.5: explain the concept of vesting through differentiating between vesting and non-vesting conditions.

14.5

Chapter 14: Share based payment

10. On 1 July 2021, Denver Ltd granted 800 share options with an exercise price of $25 to the CFO, conditional on the CFO remaining in employment with the company until 30 June 2024. The exercise price will drop to $20 if Denver’s earnings increase by an average of 10% per year over the three year period. On 1 July 2021 the estimated fair value of the share options with an exercise price of $25 is $15 per option, and if the exercise price is $20, the estimated fair value of the options is $18 per option. During the year ended 30 June 2022 Denver’s earnings increased by 10% and they are expected to continue to increase at this rate over the next two years. During the year ended 30 June 2023 Denver’s earnings increased by 8% and Denver management expected that the earnings target would be achieved. During the year ended 30 June 2024 Denver’s earnings increased by 12%. When calculating the remuneration expense to be recognised for the year ended 30 June 2023 which of the following dollar values should be included in the calculation? *a. $15. b. $18. c. $20. d. $25. Answer: a Feedback: The average earnings for the 2 years is 9%, not the required 10%. Therefore, the exercise price of the share options stays at $25 and the calculation uses the fair value per option as $15. Learning objective 14.5: explain the concept of vesting through differentiating between vesting and non-vesting conditions.

14.6

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

11. On 1 July 2021, Norman Pty Ltd granted 100 options to each of its 50 employees. The options are conditional on the employees remaining with the company for the 3 year vesting period. The options have a fair value of $5.00 at vesting date. In addition, the shares will vest as follows: On 30 June 2022 if the company’s earnings have increased by more than 12%. On 30 June 2023 if the company’s earnings have increased by more than 10% averaged across the 2 year period. On 30 June 2024 if the company’s earnings have increased by more than 8% averaged across the 3 year period. At 30 June 2022 Norman Pty Ltd’s earnings have increased by 11% and 2 employees have left. The company expects that earnings will continue to increase at a similar rate during the year to 30 June 2023 and that the shares will vest at that time. It also expects that a further 3 employees will leave during the year. The remuneration expense for the year ended 30 June 2022 for Norman Pty Ltd is: a. b. *c. d.

$12 500 $25 000 $11 250 $22 500

Answer: c Feedback: (50-2-3)employees x 100 options x $5.00 x ½ Learning objective 14.5: explain the concept of vesting through differentiating between vesting and non-vesting conditions.

14.7

Chapter 14: Share based payment

12. On 1 July 2021 Pearl Pty Ltd granted 800 share options with an exercise price of $35 to the Finance Director, conditional on the Finance Director remaining in employment with the company until 30 June 2024. The fair value of Pearl’s shares at that time were assessed to be $40. The exercise price will drop to $30 if Pearl’s earnings increase by an average of 8% per year over the three year period. On 1 July 2021 the estimated fair value of the share options with an exercise price of $35 is $10 per option, and if the exercise price is $30, the estimated fair value of the options is $12 per option. During the year ended 30 June 2022 Pearl’s earnings increased by 10% and they are expected to continue to increase at this rate over the next two years. During the year ended 30 June 2023 Pearl’s earnings increased by 9% and Pearl management continued to expect that the earnings target would be achieved. During the year ended 30 June 2024 Pearl’s earnings increased by only 2%. At 30 June 2024 the share price is $23. The remuneration expense to be recognised for the year ended 30 June 2022 is: a. *b. c. d.

$2667. $3200. $8000. $9600.

Answer: b Feedback: 800 options x $12 x 1/3 Learning objective 14.5: explain the concept of vesting through differentiating between vesting and non-vesting conditions.

14.8

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

13. On 1 July 2021 Pearl Pty Ltd granted 800 share options with an exercise price of $35 to the Finance Director, conditional on the Finance Director remaining in employment with the company until 30 June 2024. The fair value of Pearl’s shares at that time were assessed to be $40. The exercise price will drop to $30 if Pearl’s earnings increase by an average of 8% per year over the three year period. On 1 July 2021 the estimated fair value of the share options with an exercise price of $35 is $10 per option, and if the exercise price is $30, the estimated fair value of the options is $12 per option. During the year ended 30 June 2022 Pearl’s earnings increased by 10% and they are expected to continue to increase at this rate over the next two years. During the year ended 30 June 2023 Pearl’s earnings increased by 9% and Pearl management continued to expect that the earnings target would be achieved. During the year ended 30 June 2024 Pearl’s earnings increased by only 2%. At 30 June 2024 the share price is $23. Assuming that the Finance Director decides not to exercise his options at 30 June 2024, the following entry would be recorded: a. b. c. *d.

DR DR DR DR

Wages expense; CR Options issued (equity) Options issued (equity); CR Lapsed options reserve Options issued (equity); CR Retained earnings Options issued (equity); CR Wages expense

Answer: d Learning objective 14.6: explain the concept of a share option reload feature.

14. How are reload features accounted for? a. *b. c. d.

As a market condition. Separately from the initial options granted. Included in the fair value of the initial options granted at measurement date. As a modification to the initial terms and conditions of the initial options granted.

Answer: b Learning objective 14.6: explain the concept of a share option reload feature.

14.9

Chapter 14: Share based payment

15. On 1 July 2019 Fraser Ltd granted 200 options to each of its 100 employees. The share options will vest on 30 June 2021 if the employees remain employed with the company on that date. The share options have a life of four years. The exercise price is $10, which is also Fraser’s share price at the grant date. Fraser is unable to reliably estimate the fair value of the share options at the grant date. Fraser’s share price and the number of options exercised are set out below. Share options may only be exercised at year end. Year ended 30 June 2020 30 June 2021 30 June 2022 30 June 2023

Share price at year end $11 $12 $13 $14

Number of options exercised at year end 8 200 10 000

The cumulative remuneration expense to be recognised by Fantasy as at 30 June 2021 is: a. b. *c. d.

$8 200 $18 200 $36 400 $182 000

Answer: c Feedback: 18 200 options x ($12-$10) Learning objective 14.6: explain the concept of a share option reload feature.

14.10

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

16. On 1 July 2019 Fraser Ltd granted 200 options to each of its 100 employees. The share options will vest on 30 June 2021 if the employees remain employed with the company on that date. The share options have a life of four years. The exercise price is $10, which is also Fraser’s share price at the grant date. Fraser is unable to reliably estimate the fair value of the share options at the grant date. Fraser’s share price and the number of options exercised are set out below. Share options may only be exercised at year end. Year ended 30 June 2020 30 June 2021 30 June 2022 30 June 2023

Share price at year end $11 $12 $13 $14

Number of options exercised at year end 8 200 10 000

The formula to calculate the remuneration expense for the year ended 30 June 2022 is: a. 8200 x ($13-$12) b. 8200 x $13 c. (8200 + 10 000) x ($13-$10) *d. (8200 + 10 000) x ($13-$12) Answer: d Learning objective 14.6: explain the concept of a share option reload feature.

17. In relation to modifications to the terms and conditions on which equity instruments were granted as part of an employee share scheme, which of the following statements is correct? a. b. c. *d.

A reduction in the exercise price of options will reduce the fair value of the share options. A reduction in a performance hurdle relating to profitability targets will reduce the fair value of the options. An increase in the number of equity instruments granted is not an example of a modification. A shortening of the vesting period will increase the fair value of the share options.

Answer: d Learning objective 14.7: explain how modifications to granted equity instruments are treated.

14.11

Chapter 14: Share based payment

18. On 1 July 2021 Lucas Ltd grants 100 options to each of its 40 employees conditional on the employee remaining in service over the next three years. The fair value of each option is estimated to be $12. Lucas also estimates that 10 employees will leave over the three year vesting period. By 30 June 2022 four employees have left and the entity estimates that a further eight employees will leave over the next two years. On 30 June 2022 Luca decided to reprice its share options, due to a fall in its share price over the last 12 months. At the date of repricing, Lucas estimates that the fair value of each original option is $3 and the fair value of each repriced option is $5. During the year ended 30 June 2023 a further four employees left and Lucas estimates that another four employees will leave during the next year. During the year ended 30 June 2024 only three employees left. The share options vested on 30 June 2024. The remuneration expense for the year ended 30 June 2022 is: *a. b. c. d.

$11 200 $12 000 $13 500 $14 000

Answer: a Feedback: (40-12*) employees x 100 options x $12 x 1/3 = $11 200 *4 employees left and another 8 are estimated to leave. Learning objective 14.7: explain how modifications to granted equity instruments are treated.

14.12

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

19. On 1 July 2021 Lucas Ltd grants 100 options to each of its 40 employees conditional on the employee remaining in service over the next three years. The fair value of each option is estimated to be $12. Lucas also estimates that 10 employees will leave over the three year vesting period. By 30 June 2022 four employees have left and the entity estimates that a further eight employees will leave over the next two years. On 30 June 2022 Luca decided to reprice its share options, due to a fall in its share price over the last 12 months. At the date of repricing, Lucas estimates that the fair value of each original option is $3 and the fair value of each repriced option is $5. During the year ended 30 June 2023 a further four employees left and Lucas estimates that another six employees will leave during the next year. During the year ended 30 June 2024 only three employees left. The share options vested on 30 June 2024. The cumulative remuneration expense for the year ended 30 June 2023 is: a. *b. c. d.

$21 200 $32 400 $45 600 $60 000

Answer: b Feedback: ([50-4-4-6*] employees x 100 options) x {($12 x 2/3)+($2** x ½)} = 36 employees x 100 options x $9 *4 employees left in Yr 1, another 4 left in Yr 2, and another 6 are estimated to leave in Yr 3. **fair value of repriced option $5 less original fair value of options $3 = incremental value of $2 per option. Learning objective 14.7: explain how modifications to granted equity instruments are treated.

14.13

Chapter 14: Share based payment

20. In relation to equity instruments granted by an entity where the entity makes modifications to the terms and conditions attaching to the grant: a. b. *c. d.

if the modification occurs during the vesting period, the incremental fair value is recognised immediately. terms or conditions may not be modified in a manner that is not beneficial to the employee. where the exercise price of options is modified, the fair value of the options changes. the incremental fair value is measured as the difference between the fair value of the modified instrument, estimated at the date of modification and that of the original equity instrument, estimated at the date of original granting.

Answer: c Learning objective 14.7: explain how modifications to granted equity instruments are treated.

21. On 1 July 2021 Polly Ltd grants 300 options to each of its 100 employees conditional on the employee remaining in service over the next three years. The fair value of each option is estimated to be $12. Polly estimates that 15 employees will leave over the three year vesting period. By 30 June 2022 four employees have left and the entity estimates that a further ten employees will leave over the next two years. On 30 June 2022 Polly decided to reprice its share options, due to a fall in its share price over the last 12 months. The repriced share options will vest on 30 June 2024. At the date of repricing, Polly estimates that the fair value of each original option is $3 and the fair value of each repriced option is $5. During the year ended 30 June 2023 a further 6 employees leave and Polly estimates that another 3 employees will leave during the year ended 30 June 2024. During the year ended 30 June 2024 four employees left. The entry at 30 June 2023 to account for the share based payment transaction is: a. *b. c. d.

DR DR DR DR

Wages expense; CR Cash Wages expense; CR Options issued (equity) Wages expense; CR Share capital Wages expense; CR Liability to employee

Answer: b Learning objective 14.7: explain how modifications to granted equity instruments are treated.

14.14

Testbank to accompany: Financial reporting 3e by Loftus et al. Not for distribution in full. Instructors may assign selected questions in their LMS.

22. In a share based payment transaction where the entity has settlement choice, which of the following statements is true? a. b. c. *d.

the entity must settle in equity unless there is no commercial substance to the transaction. if an entity elects to settle in cash the settlement is accounted for as an expense. where a present obligation does not exist the entity has a choice of classification as an equity or cash settled share based payment transaction. the entity has a present obligation to settle in cash where it has a past practice or stated policy of settling in cash.

Answer: d Learning objective 14.8: demonstrate how cash-settled share-based payment transactions are measured.

23. Which of the following disclosures is not required under AASB 2 Share-based Payment? *a. b. c. d.

For liabilities arising from share-based payment transactions: the total intrinsic value at the end of the period for liabilities where the counter party’s right had not yet vested. For arrangements that were modified during the year: the incremental fair value granted as a result. The weighted average price of share options at the date of exercise for options exercised during the period. A description of the share-based payment plan, including the general terms and conditions, vesting requirements, maximum term of options granted and method of settlement must be disclosed.

Answer: a Learning objective 14.9: describe and apply the disclosure requirements of AASB 2/IFRS 2.

24. Which of the following statements in relation to disclosures required under AASB 2 Sharebased Payment is not correct? a. b. c. *d.

Option pricing models used in valuing share options must be identified. The number and weighted average exercise price of share options outstanding at the beginning and end of each period must be disclosed. Information about share-based payment arrangements that are substantially the same may be aggregated. The total expense arising from share-based payment transactions in which the services qualified for recognition as an asset must be disclosed.

Answer: d Learning objective 14.9: describe and apply the disclosure requirements of AASB 2/IFRS 2.

14.15

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Hong Nee Ang

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 15: Revenue

Chapter 15: Revenue Comprehension questions 1. What are the key distinctions between ‘income’ and ‘revenue’? Why do you think the AASB/IASB made these distinctions? The AASB/IASB Conceptual Framework states that income encompasses both revenue and gains. The only distinguishing feature of revenue is the reference to ‘ordinary activities of an entity’. The distinction is essentially a classification issue within income, to distinguish revenue from an entity’s ordinary activities from its other activities. Because of this broad definition, income is further dissected into revenue and gains. The Conceptual Framework defines revenue as arising in the ordinary activities of an entity, and includes sales, fees, interest, dividends, royalties and rent. Gains, on the other hand, are described in the Conceptual Framework as other items that meet the definitions of income and may or may not arise in the course of the ordinary activities of an entity. Gains include, for example, the gain on disposal of non-current assets, and from upward revaluation of financial assets that are classified as ‘available for sale’. 2. What is the ‘asset/liability’ model for the definition and recognition of income under the Conceptual Framework? Does it give a different outcome from other models permitted under AASB 15/IFRS 15? The definition of income as encompassing both revenue and gains is very broad, being based in effect, on statement of financial position (balance sheet) movements. The elements of the statement of financial position (assets, liabilities and equity) are defined first in the Conceptual Framework, before the elements of the statement of comprehensive income. Therefore, the statement of comprehensive income is derived from the statement of financial position (according to a strict interpretation of the Conceptual Framework). This is known as the asset/liability model. Theoretically this means that once an asset is recognised or a liability reduced or derecognised, under the Framework’s asset/liability model, income is recognised simultaneously. AASB 15/IFRS 15 Revenue from Contracts with Customers gives similar definition of income as the Conceptual Framework and they should arrive at the same outcome.

3. What are the recognition criteria for income under the Conceptual Framework? How do these differ from the key stated purpose of AASB 15/IFRS 15? The recognition criteria for income under the Conceptual Framework (paragraph 5.4(a)) are: the recognition of income occurs at the same time as: (i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (jj) the derecognition of a liability, or a decrease in the carrying amount of a liability. This means that once an asset is recognised or a liability reduced or derecognised, under the Conceptual Framework’s asset/liability model, income is recognised simultaneously.

15.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The key purpose stated in AASB 15/IFRS 15 is to identify when revenue should be recognised. AASB 15/IFRS 15 paragraph 31 states that: An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. AASB 15/IFRS 15 then specifies the circumstances in which the recognition criteria will be met if an entity satisfies the performance obligation over time or at a point in time.

4. What is a multiple-element transaction? Give two examples of these and discuss how AASB 15/IFRS 15 applies to such transactions. A multiple-element transaction is one in which there are separately identifiable components to each of which the recognition criteria must be applied in order to reflect the substance of the transaction. The total consideration for the transaction is allocated between the elements. Examples include: the selling price of a product that includes an amount for subsequent servicing; and a telephone service provider who provides a free handset to a customer who subscribes for a service contract. Paragraph 73 of AASB 15/IFRS 15 requires an entity to allocate the transaction price to each performance allocation (or distinct good or service) identified in the contract on a relative stand-alone selling price basis that the entity expects to be entitled. In the first example, the amount for subsequent servicing shall be identified, deferred and recognised as revenue over the period during which the service is performed. As for the second example, the telephone service provider shall record the sale of handsets and the service subscription separately by proportionately allocating the consideration received.

5. Compare and contrast the revenue recognition criteria for the sale of goods with those for the rendering of services. Revenue from the sale of goods can be recognised when an entity satisfies performance obligations and transfer control of the goods to the customer. Paragraph 33 of AASB 15/IFRS 15 further provides that: Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, the asset. The benefits of an asset are the potential cash flows (inflows or saving in outflows) that can be obtained directly or indirectly in many ways, such as by: (a) using the asset to produce goods or provide services (including public services); (b) using the asset to enhance the value of other assets; (c) using the asset to settle liabilities or reduce expenses; (d) selling or exchanging the asset; (e) pledging the asset to secure a loan; and (f) holding the asset. The revenue from a service transaction can be recognised by reference to the performance obligations satisfied over time if at least one of the following criteria is met:

15.3

Chapter 15: Revenue

(a) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. (b) The entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced. (c) Or, the entity’s performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an enforceable right to payment for performance completed to date. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time. To determine the point in time at which the customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the requirements of control and the indicators such as whether the entity has a present right to payment for the asset and transfer physical possession of the asset to the customer or the customer has legal title to the asset.

15.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 15.1 Payment by instalments Robinson Ltd is entering into a contract to sell boat products to Harris Ltd for $50 000. The agreement allows Harris Ltd to pay for these goods by equal instalments, the first instalment being required on delivery and the remainder to be paid every 6 months for the next 2 years. The boat products are delivered to Harris Ltd on 1 January 2023. Robinson Ltd determine that an appropriate discount rate for interest on this transaction is 5% per annum. Required Advise Robinson Ltd on how the company is to account for the revenue from this transaction. To provide the journal entries for Robinson Ltd, we need to determine the interest component of the instalment payments. The easiest way to do this is to draw up a table, as shown below. Date

1 Jan 2023 1 Jul 2023 1 Jan 2024 1 Jul 2024

Opening balance

Cash receipt

$ 50 000 37 033 24 992 12 650

$ 12 967 12 967 12 967 12 967 51 868

Interest income (2.5%) $

Principal reduction

Outstanding balance

926 625 317 1 868

12 041 12 342 12 650 37 033

$ 37 033 24 992 12 650 0

To determine the instalment amount, we have to solve the following equation: $50 000 = Instalment + Instalment x 2.8560 [T2 2.5% 3pmts] Instalment x (1 + 2.8560) = $50 000 Instalment = $50 000 / 3.8560 = $12 967 For the year ended 31 December 2023, Robinson Ltd would record the following journal entries. 1 January 2023 Receivable Revenue Deferred interest Cash Receivable

Dr Cr Cr

51 868

Dr Cr

12 967

50 000 1 868

12 967

15.5

Chapter 15: Revenue

1 July 2023 Cash Receivable 31 December 2023 Deferred interest Interest income

Dr Cr

12 967

Dr Cr

926

12 967

926

For the year ended 31 December 2024, the following journal entries would be recorded: 1 January 2024 Cash Receivable 1 July 2024 Cash Receivable 31 December 2024 Deferred interest Interest income

Dr Cr

12 967

Dr Cr

12 967

Dr Cr

942

12 967

942

15.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 15.2 Payment in advance Sahara Ltd sells goods to Jackson Ltd. The agreement between the two parties states that Jackson Ltd pays for the goods in advance of delivery which will occur in 12 months’ time. Control of the goods passes to Jackson Ltd at the date of delivery. Jackson Ltd pays $40 000 to Sahara Ltd on 1 July 2022. Sahara Ltd delivers the goods to Jackson Ltd on 1 July 2023. Required Advise Sahara Ltd on how to appropriately recognise the revenue from this transaction. Sahara Ltd shall only recognise the revenue upon delivery of goods. Advance payment received does not meet the income recognition criteria and shall be recorded as a liability as follows. 1 July 2022 Cash Revenue received in advance 1 July 2023 Revenue received in advance Revenue

Dr Cr

40 000

Dr Cr

40 000

15.7

Chapter 15: Revenue

Case study 15.3 Revenue recognition and measurement Access the ASX website (www.asx.com.au) and search for companies within the Commercial and Professional Services industry. Choose three companies from this industry, access their most recent annual reports, and provide a comparison of their notes to the financial statements that discuss their recognition and measurement of revenue. Answers will vary depending on the companies and financial statements selected for the exercise. For purposes of illustration, the 2016 annual reports for the following three companies have been selected: • CML Group Limited • Cabcharge Australia Limited • Seek Limited. The three companies disclose their accounting policies in relation to both of the recognition criteria and measurement of revenue in accordance with AASB 118/IAS 18 Revenue (This standard is now superseded by AASB 15/IFRS 15 for annual reports beginning on or after 1 January 2018, unless early application is adopted). The disclosures are summarised as follows:

CML Group Limited

CabCharge Australia Limited

Recognition criteria Revenue is measured at a fair value of the consideration received or receivable. The group recognises revenue for the major business activity of payroll and franchise services to the recruitment industry when the amount of revenue can be reliably measured, it is probable that future economic benefits will flow to the entity and specific criteria have been met for each of the group's activities. The group recognises revenues for the finance revenue stream as revenue earned and generated within the financial year, irrespective of invoice date. To clarify, any requests from customers received post 30 June which relate to services performed prior to 30 June are recognised as transactions occurring within the financial year.

Measurement of revenue Amounts disclosed as revenue are net of returns, trade allowances, rebates and amounts collected on behalf of third parties. The group bases its estimates on historical results, taking into consideration the type of customers, the type of transaction and the specifics of each arrangement. Interest revenue is recognised using the effective interest rate method, which, for floating rate financial assets, is the rate inherent in the instrument. All revenue is stated net of the amount of goods and services tax (GST). Taxi service fee income is recognised at the Taxi service fee income is time the payment is processed and billed. derived from taxi payments Network subscription fee and taxi plate processed through the licence incomes were billed every 28 days in Cabcharge Payment System advance and changed to a calendar month and is disclosed net of Goods basis in advance commencing 1 May 2016. and Services Tax (GST) and Revenue is recognised on a straight-line third party credit card fees. © John Wiley and Sons Australia Ltd, 2020

15.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Seek Limited

basis over the period the services are provided. Operating revenue receipts relating to the period beyond the current financial year are shown in the Consolidated Statement of Financial Position as unearned revenue under the heading of Current liabilities – Trade and other payables. Interest earned on finance leases is recognised as vehicle financing and insurance lease income on a basis reflecting a constant periodic return based on the lessor’s net investment outstanding in respect of the finance lease. The Group recognises revenue when the amount of revenue can be reliably measured, it is probable that future economic benefits will flow to the entity and specific criteria have been met as described below: Class of Recognition criteria revenue Online employment marketplaces Job In the period over which advertisements the advertisements are placed. Banner In the period that the advertisements impressions occur. CV online Over the period during which the jobseeker can access the services. Education Commission When the student is registered with the education provider or when the student passes the relevant census date, depending on the arrangement. Other revenue Dividends When the right to receive payment is established. Interest On a time proportion basis using the effective interest method. Services sold to customers in advance, which are yet to be utilised, are recognised initially in the balance sheet as unearned income and released to revenue in line with the above recognition criteria.

As the Group acts in the capacity of an agent the revenue represents only the fee received on the transaction although the Group is exposed to credit risk on the full amount of the proceeds received from the ultimate customer.

Revenue is measured at the fair value of the consideration received or receivable and is shown net of sales taxes (such as GST and VAT) and amounts collected on behalf of third parties.

15.9

Chapter 15: Revenue

The three companies report the recognition criteria for income generally as well as specific criteria for each activity. The income amounts for each activity are also provided. Consistent with the AASB 118/IAS 18, the three companies report their revenue measurement basis follows the fair value of the consideration received or receivable. They report revenue amounts net of returns, trade allowances, rebates, third party credit card fees, and duties and amounts collected on behalf of third parties.

15.10

Application and analysis exercises Exercise 15.1 Definitions State which of the following meets the definition of ‘revenue’ under AASB 15/IFRS 15 for Toys2U Ltd, a retailer of toys. Give reasons for your answer. 1. Sales tax collected on behalf of the taxation authority. 2. Gain on the sale of an investment property. 3. Amounts receivable from customers who have purchased toys. 4. Gain on the sale of equity securities held as investments. 5. Revaluation increase on the revaluation of operating properties under AASB 116/IAS 16. (LO1, LO2 and LO4) 1. 2. 3. 4. 5.

No, this is an agency relationship. No, this is not ordinary operations. Yes, this falls within ordinary operations. No, this is outside of the scope of AASB 15/IFRS 15. No, this is not ordinary operations.

Chapter 15: Revenue

Exercise 15.2 Definitions, scope State whether each of the following is true or false. 1. ‘Income’ means the same as ‘revenue’.” 2. ‘Gains’ are always recognised net under IFRSs. 3. ‘Revenue’ must always be in respect of an entity’s ordinary operations 4. ‘Gains’ must always be outside of an entity’s ordinary operations. 5. Services provided under a construction contract are accounted for under AASB 15/IFRS 15. (LO1, LO2 and LO3) 1. 2. 3. 4. 5.

False False True False True.

15.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 15.3 Measurement State whether each of the following is true or false. 1. Revenue is measured at the fair value of the consideration given by the seller. 2. Revenue is measured at the transaction price that is allocated to that performance obligation. 3. If payment for the goods or services is deferred, the fair value of the consideration will be less than the nominal amount of the cash receivable. 4. A swap or exchange for goods or services of a similar nature and value generates revenue. 5. Collectability of amounts due from customers is a measurement issue, not a recognition issue. (LO3) 1. False. Revenue is measured at the fair value of the consideration received or receivable by the seller. 2. True. 3. True. 4. False. 5. True.

15.3

Chapter 15: Revenue

Exercise 15.4 Recognition What is an ‘executory contract’? How does this affect the dates on which revenue is recognised under the conceptual framework? (LO4) An executory contract (also known as an agreement equally proportionately unperformed) is one where neither party to the contract has performed their obligations. In the case of such agreements no asset or liability exists under the conceptual framework. Only when the seller performs its obligation under the contract (usually at the delivery date) is it entitled to receive payment. It has an asset and revenue under the conceptual framework at that date.

15.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 15.5 Measurement – dates for recognition SodaPop Ltd sells plastic bottles. Wholesale customers that purchase more than 10 000 bottles per month are entitled to a discount of 8% on their purchases. On 1 March 2022, Customer P ordered 20 crates of bottles from SodaPop Ltd. Each crate contains 1000 bottles. The normal selling price per crate is $450. SodaPop Ltd delivered the 20 crates on 15 March 2022. Customer P paid for the goods on 15 April 2022. The end of SodaPop Ltd’s reporting period is 30 June. Required Prepare the journal entries to record this transaction by SodaPop Ltd for the year ended 30 June 2022. (LO4) 20 crates x $450 per crate = $9 000 Customer P is entitled to the discount because total bottles purchased = 20 000 Discount = $9 000 x 8% = $720 Therefore, the amount net of the discount is $8 280. This is the amount to be recognised as revenue in accordance with AASB 15/IFRS 15. 1 March 2022 No entry (date of order) 15 March 2022 Receivable Dr 8 280 Revenue Cr (To record the receivable and revenue at the date of delivery) 15 April 2022 Cash Dr 8 280 Receivable Cr (To record the cash received and recovery of the receivable)

8 280

15.5

Chapter 15: Revenue

Exercise 15.6 Revenue recognition – rendering of services On 1 February 2023, FastNet Ltd entered into an agreement with Smith Ltd to develop a new database system (both hardware and software) for Smith Ltd. The agreement states that the total consideration to be paid for the system will be $430 000. FastNet Ltd expects that its total costs for the system will be $335 000. As the end of its reporting period, 30 June 2023, FastNet Ltd had incurred labour costs of $65 000 and materials costs of $180 000. Of the materials costs, $30 000 is in respect of materials that have not yet been used on the system. Of the labour costs, $12 500 is an advance payment to a subcontractor who had not performed their work on the project as at 30 June 2023. As at 30 June 2023, Smith Ltd had made progress payments to FastNet Ltd of $250 000. FastNet Ltd calculates the measurement of progress using input methods in accordance with paragraph B18 of AASB 15/IFRS 15. Required Calculate the revenue to be recognised by FastNet Ltd for the year ended 30 June 2023 and prepare the journal entries to record the transactions described. Assume all of FastNet Ltd’s costs are paid for in cash. (LO4) $ Total costs incurred to date: 245 000 ($180 000 + $65 000) Less: Costs in respect of services not yet performed: 42 500 ($30 000 + $12 500) Total 202 500 (a) Total estimated costs Progress

335 000 (b) 60.448% [(a) / (b)]

Total estimated revenue under the agreement

430 000 (c)

Revenue to be recognised at 30 June 2023

259 926 [60.448% x (c)]

Expenses Dr 245 000 Cash Cr (To record expenses for costs incurred up to 30 June 2023)

245 000

If FastNet Ltd could sustain an argument that the $42 500 costs incurred in respect of services yet to be delivered could be deferred until those services are delivered then it could capitalise those costs as follows: Deferred expenses Dr 42 500 Expenses Cr (To record deferral of expenses related to future revenue) Receivable from Smith Ltd Revenue

Dr Cr

42 500

259 926

15.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(To record revenue in accordance with the % completion method) Cash

Dr Receivable from Smith Ltd Cr (To record payments made by Smith Ltd)

250 000 250 000

Profit on the contract as at 30 June 2023 assuming expenses of $42 500 are deferred: Revenue $259 926 Less expenses $202 500 Profit $ 57 426

15.7

Chapter 15: Revenue

Exercise 15.7 Revenue recognition – sale of goods In each of the following situations, state at which date, if any, revenue will be recognised. 1.

A contract for the sale of goods is entered into on 1 May 2022. The goods are delivered on 15 May 2022. The buyer pays for the goods on 30 May 2022. The contract contains a clause that entitles the buyer to rescind the purchase at any time. This is in addition to normal warranty conditions. 2. A contract for the sale of goods is entered into on 1 May 2022. The goods are delivered on 15 May 2022. The buyer 7pays for the goods on 30 May 2022. The contract contains a clause that entitles the buyer to return the goods up until 30 June 2022 if the goods do not perform according to their specification. 3. A contract for the sale of goods is entered into on 1 May 2022. The goods are delivered on 15 May 2022. The contract contains a clause that states that the buyer shall pay only for those goods that it sells to a third party for the period ended 31 August 2022. Any goods not sold to a third party by that date will be returned to the seller. 4. Retail goods are sold with normal provisions allowing the customer to return the goods if the goods do not perform satisfactorily. The goods are invoiced on 1 May 2022 and the customer pays cash for them on that date. (LO4) 1. No revenue is recognised because the customer has the right to rescind the purchase at any time – beyond normal warranty conditions. The cash is recorded on receipt with the credit being recorded as a borrowing. 2. Revenue is recognised on 30 June 2022. This is the date at which the seller has no further performance obligations. 3. Revenue is recognised only at the dates the buyer on-sells the goods to a third party. 4. Revenue is recognised on 1 May 2022. The right of return is a normal warranty clause and is included in determining the measurement of the revenue.

15.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 15.8 Multiple-element arrangement All Star Ltd provides a bundled service offering to Bruce Ltd. It charges Bruce Ltd $28 000 for initial connection to its network and two ongoing services — access to the network for 1 year and ‘on-call troubleshooting’ advice for that year. Bruce Ltd pays the $28 000 upfront, on 1 July 2023. All Star Ltd determines that, if it were to charge a separate fee for each service if sold separately, the fee would be: Connection fee Access fee Troubleshooting

$ 5 000 9 000 18 000

The end of All Star Ltd’s reporting period is 30 June. Required Prepare the journal entries to record this transaction in accordance with AASB 15/IFRS 15 for the year ended 30 June 2024, assuming All Star Ltd applies the relative fair value approach. Show all workings. (LO3 and LO4)

Connection fee Access fee Troubleshooting Total

Fair value of each component if sold separately $ 5 000 9 000 18 000 32 000

Allocation of fair value to total consideration $ 5 000/32 000 x 28 000 9 000/32 000 x 28 000 18 000/32 000 x 28 000

Allocated amount

$ 4 375 7 875 15 750 28 000

At inception of the agreement (1/7/20): Cash Revenue – connection fee Liability – access fee Liability – troubleshooting

Dr Cr Cr Cr

28 000 4 375 7 875 15 750

The undelivered elements (i.e. the ongoing access and on-call troubleshooting) will be recognised when those services are delivered. Because these are available to Bruce Ltd continuously over the period of the agreement the revenue should be recognised in accordance with paragraph 35 of AASB 15/IFRS 15 (i.e. on a straight-line basis). Since this agreement is for 1 year All Star Ltd would record the following over the year ended 30 June 2024: Liability – access fee Liability – troubleshooting Revenue

Dr Dr Cr

7 875 15 750

23 625

15.9

Chapter 15: Revenue

Exercise 15.9 Revenue recognition – rendering of services In each of the following situations, state at which date(s), if any, revenue will be recognised. 1.

A contract for the rendering of services is entered into on 1 May 2023. The services are delivered on 15 May 2023. The buyer pays for the services on 30 May 2023. 2. A contract for the rendering of services is entered into on 1 May 2023. The services are delivered continuously over a 1-year period commencing on 15 May 2023. The buyer pays for all the services on 30 May 2023. 3. A contract for the rendering of services is entered into on 1 May 2023. The services are delivered continuously over a 1-year period commencing on 15 May 2023. The buyer pays for the services on a monthly basis, commencing on 15 May 2023. 4. Lemon Ltd is an insurance agent and provides insurance advisory services to Customer B. Lemon Ltd receives a commission from insurance company Ibis Ltd when Lemon Ltd places Customer B’s insurance policy with Ibis Ltd, on 1 April 2023. Lemon Ltd has no further obligation to provide services to Customer B. 5. Lemon Ltd is an insurance agent and provides insurance advisory services to Customer B. Lemon Ltd receives a commission from insurance company Ibis Ltd when Lemon Ltd places Customer B’s insurance policy with Ibis Ltd, on 1 April 2023. Lemon Ltd is required to provide ongoing services to Customer B until 1 April 2024. Additional amounts are charged for these services. All amounts are at market rates. 6. Citrus Ltd receives a non-refundable upfront fee from Customer B for investment advice, on 1 March 2023. Under the agreement with Customer B, Citrus Ltd must provide ongoing management services until 1 March 2024. An additional amount is charged for these services. The upfront fee is higher than the market rate for equivalent initial investment advice services. (LO3 and LO4) 1. Revenue is recognised on 15 May 2023. 2. Revenue is recognised on a straight-line basis over the year commencing 15 May 2023. The upfront payment is recognised as revenue over this period. 3. Revenue is recognised on a straight-line basis over the year commencing 15 May 2023. 4. Revenue is recognised on 1 April 2023. 5. Commission revenue is recognised on 1 April 2023. Revenue for the ongoing services is recognised as those services are provided over the year commencing 1 April 2023. 6. The upfront fee should be allocated between revenue for initial investment advice (based on the fair value of an equivalent fee for such advice) and ongoing management services. The part attributable to ongoing services should be recognised as revenue over the period 1 March 2023 – 1 March 2024. The part attributable to initial investment advice may or may not be recognised immediately depending on whether there is any link to the ongoing services.

15.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 15.10 Agent vs. principal Discuss how an entity would determine whether it acts as an agent or principal in sales transactions. In your answer, discuss the distinguishing features between an agency versus principal relationship and the consequences for revenue recognition. (LO5) In an agency relationship, amounts collected on behalf of the principal are not gross inflows flowing to the agent and thus do not meet the definition of revenue. Rather, the revenue is the amount of commission received or receivable by the agent. An entity is a principal if it controls a promised goods or service before the entity transfers the good or service to a customer. An entity that is a principal in a contract may satisfy a performance obligation by itself or it may engage another party, such as a contractor, to satisfy some of all of a performance obligation on its behalf. Paragraph B37 of AASB 15/IFRS 15 provides indicators that an entity is an agent include the following: (a) Another party is primarily responsible for fulfilling the contract. (b) The entity does not have inventory risk before or after the goods have been ordered by a customer, during shipping or on return. (c) The entity does not have discretion in establishing prices for the other party’s goods or services and, therefore, the benefit that the entity can receive from those goods or services is limited. (d) The entity’s consideration is in the form of a commission. (e) The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other party’s goods or services.

15.11

Chapter 15: Revenue

Exercise 15.11 Telecommunications multiple-element arrangement Network Ltd is a telecommunications company that offers a variety of services to its customers including fixed-line telephone services, mobile phone services and internet services. It uses numerous distributors to sell its mobile phone services. Customers purchase a phone handset from the distributor and at the same time can sign up to a contract with Network Ltd for a period of 12 months or 24 months for the provision of network access for a fixed fee. Calls are charged separately if they exceed a certain limit per month. If the customer enters into a 12-month contract, the handset is sold to them for 40% less than the quoted market price. If the customer enters into a 24-month contract, the handset is sold to them for 50% less than the quoted market price. The distributor earns a commission from Network Ltd based on a percentage of the consideration for each contract entered into — 12% for a 12-month contract and 15% for a 24-month contract. Network Ltd sells its handsets to its distributors at 50% less than market price on the basis that the distributor will use the handset to entice customers to enter into the contracts with Network Ltd. If the customer has any problems with the handset during or after the period of the contract (up to a maximum of 2 years), the customer has recourse to the distributor who must replace the handset at its own cost. In the case of a handset manufactured by Network Ltd, the distributor will source the handset from Network Ltd, which will sell it to the distributor at 50% less than market price. The distributor sells handsets to customers even if they do not sign up to any services agreement with Network Ltd. In such cases, the customers are charged the market price for the handsets. The distributor also sells other handsets (i.e. not only those of Network Ltd). Network Ltd has determined that the distributor is acting as its agent in respect of the service contracts but not in respect of its handsets. Additional information Handset cost to Network Ltd Handset market price 12-month contract, price charged to customers 24-month contract, price charged to customers

$200 $320 $80 per month, all paid upfront $60 per month, all paid upfront

Required Discuss the revenue recognition issues that arise out of the transactions described (a) for Network Ltd and (b) for the distributor. Ignore discounting. (LO5) (a) Network Ltd Handset cost Sale to distributor Loss on handset

$200 $160 $ 40

15.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

12-month contract $80 x 12 Less 12% commission Net amount

24-month contract $60 x 24 Less 15% commission Net amount

$960 $115 $845

$1 440 $216 $1 224

Network Ltd regards the handset sale to the distributor as a separate transaction as it does not regard the distributor as its agent for the handset. Therefore it must recognise the loss on the handset immediately and cannot defer the cost as part of either the 12-month or the 24-month contracts. Cash/Receivable Revenue

Dr Cr

160

Cost of sales Inventory

Dr Cr

200

160

200

The fact that the sale is for 50% less than fair value raises the question of the amount of revenue to be recorded. Even though the market price of the handset is $320, the amount receivable from the distributor is $160 – therefore this is the amount to be recognised as revenue. On the 12-month contract, Network Ltd records the gross amount received from the customer as revenue over the period of the contract (because the distributor is its agent) and records the commission as a cost of sale; i.e.: Cash/Receivable Deferred revenue

Dr Cr

960

Deferred revenue Revenue

Dr Cr

960

Commission expense Cash/Payable

Dr Cr

115

960

115

The revenue would be initially recorded as deferred revenue and released to income on a straight-line basis in accordance with paragraph 25 of AASB 118/IAS 18 because Network Ltd has an obligation to provide access to its network over the 12-month period. Over 12 months, this would equate to recognition of revenue of $80 per month. On the 24-month contract Network Ltd records the gross amount received from the customer as revenue over the period of the contract (because the distributor is its agent) and records the commission as a cost of sale; i.e.: Cash/Receivable Deferred revenue

Dr Cr

1 440

Deferred revenue Revenue

Dr Cr

1 440

15.13

Chapter 15: Revenue

Commission expense Cash/Payable

Dr Cr

216 216

The revenue would be initially recorded as deferred revenue and released to income on a straight-line basis in accordance with paragraph 35 of AASB 15/IFRS 15 because Network Ltd has an obligation to provide access to its network over the 24-month period. Over 24 months, this would equate to recognition of revenue of $60 per month.

(b) Distributor 12-month contract Commission Handset ($320 x 60%) Total amount Less: Cost of handset Profit

$115 $192 $307 $160 $147

No Contract Commission Handset Total amount Less: Cost of handset Profit

$320 $320 $160 $160

24-month contract Commission Handset ($320 x 50%) Total amount Less: Cost of handset Profit

$216 $160 $376 $160 $216

The distributor acts for Network Ltd as an agent for the service contract, and thus recognises as revenue its commission received. It acts as principal for the handset, and thus recognises as revenue the amount received from the customer, with the cost of the handset recognised as an expense. The commission is recognised immediately unless there is an actual or implicit performance obligation to the customer for the duration of the contract, and that obligation is linked to the service contract. The distributor has an obligation to replace the handset if it fails but this would generally be considered a normal warranty obligation. This obligation is linked to the handset, not to the service contract. Any customer problems with access to the network or calls, etc., would be met by Network Ltd who is the principal in respect of the service contract. Thus, the distributor should recognise all its commission upfront and include any warranty obligation in its measurement of the revenue from the handset. Example journal entries – 12-month contract Cash/Receivable Revenue (To record commission revenue)

Dr Cr

115

Cash/Receivable Revenue

Dr Cr

192

Cost of sales

160

115

192

15.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Inventory Cr (To record handset revenue and cost of sale)

160

Example journal entries – 24-month contract Cash/Receivable Revenue (To record commission revenue)

Dr Cr

216

Cash/Receivable Revenue

Dr Cr

160

Cost of sales Dr Inventory Cr (To record handset revenue and cost of sale)

160

216

160

Example journal entries – no contract Cash/Receivable Revenue

Dr Cr

320

Cost of sales Dr Inventory Cr (To record handset revenue and cost of sale)

160

320

160

15.15

Chapter 15: Revenue

Exercise 15.12 Considering accounting theory Logistics Ltd provides professional advisory services to develop internal and external reporting systems to facilitate the integration of various forms of capital (financial, mechanical, human, intellectual, natural and social) in the business models of their clients. The contracts take up to 18 months, culminating in the delivery of a report to clients outlining the design of integrated information systems, as well as specifications and procedures for implementation. Until recently, Logistics Ltd progressively recognised revenue from providing services in accordance with AASB 118/IAS 18 Revenue. It recognised revenue and expenses and hence, profit, based on the stage of completion of its contracts with customers. The managing director of Logistics Ltd recently attended a presentation on the implementation of AASB 15/IFRS 15 Revenue from Contracts with Customers, where she discovered that the company would need to change the way it accounted for revenue. It would not be permitted to recognise revenue under AASB 15/IFRS 15 until the report is delivered to the customer on completion of the contract. The financial accountant estimated that the change in accounting policy would result in a 30% reduction in revenue and a 50% reduction in profit in the year of adoption of the new standard. The managing director thought this would be misleading to investors because the amount of work and cash inflows was expected to remain stable. She complains, ‘Investors will think Logistics Ltd is performing poorly and the share price will decline’. Required Drawing on your understanding of the efficient markets hypothesis (refer to chapter 2), prepare a response to the managing director’s concern. Include in your response any recommended action that Logistics Ltd could take to reduce the likelihood of a negative impact on its share price. (LO5) The question asks students to prepare a response to the managing director. Accordingly, the suggested answer uses terminology consistent with communication to a non-accountant. The managing director comments may be correct with respect naïve investors potentially misunderstanding the financial statements. However, it does not follow that their misconception would result in the market price failing to reflect all publicly available information. The Company’s shares are traded in a market that is best described as efficient in the semistrong form. If a market for a security is efficient in the semi-strong form, prices of that security make a rapid and unbiased response to the release of new information. In other words, the price of Logistics Ltd’s shares rapidly impounds new information. Specifically, the information set referred to in the semi-strong form of market efficiency is all publicly available information. Thus, if the market is efficient in the semi-strong form, efficient market theory suggests that the Company’s share price reflects all publicly available information.

15.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The financial statements form part of a wider set of publicly available information. It is important to appreciate that this is not limited to the amounts, such as revenue and profit, reported in financial statements. Publicly available information also includes the disclosures in the notes, such as the description of accounting policies and disclosures about the effect changes in accounting policies on the financial statements. An implication of capital market efficiency is the importance of disclosure. Accordingly, it is recommended that Logistics Ltd provide specific and comprehensive disclosures about the effects of the change in accounting policy on it reported revenue and profit, so that this information can be impounded in its share price.

15.17

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 15: Revenue Multiple choice questions 1. Which of the following are included in the scope of AASB 15/IFRS 15 Revenue from Contracts with Customers? I. II. III. IV.

Insurance contracts. Subscriptions. Accounting for investments in associates. Accounting for share of joint venture revenue.

*a. II only. b. II and IV only. c. I and IV only. d. II and III only. Answer: a Learning objective 15.1: describe the scope of AASB 15/IFRS 15.

2. Which of the following are excluded from the scope of AASB 15/IFRS 15? I. II. III. IV.

Financial instruments within the scope of AASB 9/IFRS 9. Insurance contracts within the scope of AASB 4/IFRS 4. Arrangements between oil companies that agree to exchange oil to meet demands of customers in different locations. Lease agreements within the scope of AASB 16/IFRS 16.

a. I, II only. b. II, III and IV only. c. I, III and IV only. *d. I, II, III and IV. Answer: d Learning objective 15.1: describe the scope of AASB 15/IFRS 15.

15.1

Testbank to accompany Financial reporting 3e by Loftus et al.

3. The Conceptual Framework refers to two elements of performance. They are: a. liabilities and equity. b. revenue and expenses. *c. expenses and income. d. assets and liabilities. Answer: c Learning objective 15.2: explain the definition of ‘income’ under the conceptual framework and distinguish it from the definition of ‘revenue’.

4. Which of the following is not an example of an agency arrangement where the selling entity would recognise revenue on a net basis? a. A retailer selling goods to a customer for $88 and remitting $8 GST to the government. b. A travel agent selling a cruise ticket to a customer, charging the customer $2 000 and remitting $1 800 to the cruise liner company. c. A licensed hotel selling keno tickets to customers for $5.00 and remitting $4.50 per ticket to the state gaming authority. *d. A distributor receiving stock from its supplier on a sale-or-return basis. The sales price per unit is $100 and the cost per unit is $60. Answer: d Learning objective 15.2: explain the definition of ‘income’ under the conceptual framework and distinguish it from the definition of ‘revenue’.

5. The two categories of income, as specified in the Conceptual Framework, are: a. income and revenue. b. income and gains. *c. revenue and gains. d. revenue and profits. Answer: c Learning objective 15.2: explain the definition of ‘income’ under the conceptual framework and distinguish it from the definition of ‘revenue’.

15.2 10.2

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

6. Which of the following is not a step in the recognition of revenue? a. Recognise revenue when the entity satisfies a performance obligation. *b. Allocate the buying price to the goods or services. c. Identify the performance obligation. d. Determine the transaction price. Answer: b Learning objective 15.3: explain and apply the five steps in recognising revenue.

7. Which of the following are part of the criteria that must be met when accounting for a contract with a customer? I. II. III. IV.

Commercial substance. Approval of contract by all parties. Identification of the payment terms for the goods/services. The collection of the consideration from the customer is remote.

a. I, III and IV. b. II and III only. c. I, II and IV. *d. I, II and III. Answer: d Learning objective 15.3: explain and apply the five steps in recognising revenue.

8. The first step in the recognition of revenue is: a. determine the transaction price. b. identify the performance obligation in the contract. *c. identify the contract or contracts with the customer. d. allocate the transaction price to the performance obligation. Answer: c Learning objective 15.3: explain and apply the five steps in recognising revenue.

15.3

Testbank to accompany Financial reporting 3e by Loftus et al.

9. “The amount of consideration to which the entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties” is the definition of: a. the contract. b. the consideration. c. the performance obligation. *d. the transaction price. Answer: d Learning objective 15.3: explain and apply the five steps in recognising revenue.

10. Natural Designs sells furniture on 12 months’ interest free terms to qualifying customers. On 30 June 2022, Natural Designs sells $20 000 of furniture to T. Bailey, payable by 30 June 2023. The appropriate interest rate for this transaction is determined to be 6% per annum. The present value of the $20 000 to be received in one year’s time is $18 868. The journal entry to be recorded by Natural Designs at 30 June 2022 is: a. DR Bank $20 000; CR Receivable $20 000. b. DR Receivable $20 000; CR Sales revenue $20 000. c. DR Receivable $20 000; CR Sales revenue $18 868; CR Interest revenue $1 132. *d. DR Receivable $20 000; CR Sales revenue $18 868; CR Deferred interest $1 132. Answer: d Learning objective 15.3: explain and apply the five steps in recognising revenue.

11. Which of the following statements relating to the identification of the performance obligation is incorrect? *a. The good or service to be transferred to the customer is non-distinct. b. The entity promises to transfer a distinct, or a series of distinct, goods or services to the customer. c. The customer can benefit from the good or service on its own or in conjunction with other readily available resources. d. The entity’s promise to transfer the good or service to the customer is separately identifiable in the contract. Answer: a Learning objective 15.3: explain and apply the five steps in recognising revenue.

15.4 10.4

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

12. When allocating the transaction price for a contract with a customer, the ‘expected cost plus a margin approach’ requires the entity to: a. evaluate the market in which it purchases goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. *b. forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service. c. allocate the price for the goods or services on an ‘in-combination’ basis. d. evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. Answer: b Learning objective 15.3: explain and apply the five steps in recognising revenue.

13. Which of the following is not a condition to be satisfied when recognising revenue from the sale of goods or services? *a. The seller retains control over the goods. b. Reliable measurement of the transaction costs. c. The probability of future economic benefits flowing to the seller. d. Transfer of the significant risks and rewards of ownership of the goods from the seller to the buyer. Answer: a Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

14. Abbott Ltd sells goods to Costello Ltd and issues an invoice on 10 August. On that date, Costello Ltd requests that Abbott Ltd delay delivery of the goods until the 25 August when they expect to have finished preparing their site for the goods. The goods can then be delivered on 26 August. Costello Ltd pays for the goods on 12 August and accepts full responsibility for the goods from this payment date. Assuming all other revenue recognition criteria are met, on which date can Abbott Ltd recognise revenue for the sale of these goods? a. 25 August. *b. 10 August. c. 12 August. d. 26 August. Answer: b Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

15.5

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Lily Ltd sells and delivers goods to Rose Ltd on 13 March. Both parties agree that Rose Ltd will hold the goods on consignment to be sold to third parties. Rose Ltd is not required to pay Lily Ltd for the goods until they are sold to a third party. Which of the following statements is incorrect? a. Lily Ltd does not recognise any revenue until Rose Ltd has on-sold goods to a third party. b. Lily Ltd retains the risks and rewards of ownership of the goods after delivery to Rose Ltd. *c. Lily Ltd recognises revenue on 13 March for the sale of goods to Rose Ltd. d. At the time of delivery of the goods to Rose Ltd there is no probability that future economic benefits will flow to Lily Ltd. Answer: c Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

16. Wiseman Ltd is offering the following conditions to customers who purchase goods with a minimum total of $5 000 in the one transaction: • • • • •

Initial deposit of 25% of purchase price. Immediate delivery of goods purchased. Interest rate of 10% p.a. charged on the outstanding balance. Repayment of the balance (including the interest) over 36 equal monthly instalments. Wiseman Ltd retains legal title to the goods until the final monthly payment has been made.

Wiseman Ltd would recognise revenue as follows: a. recognise the whole amount of revenue at purchase date. b. recognise all revenue as it is received c. recognise interest as it is received (monthly) and recognise the revenue on the sale of the goods at purchase date. *d. recognise interest as it is received (monthly) and recognise the revenue on the sale of the goods once the final payment has been received. Answer: d Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

15.6 10.6

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

17. Which of the following is not a condition that needs to be satisfied prior to recognising revenue from the rendering of services using the ‘percentage of completion’ method? *a. The contract is non-cancellable. b. The amount of revenue can be measured reliably. c. The stage of completion of the transaction can be measured reliably. d. The costs of the transaction (including future costs) can be measured reliably. Answer: a Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

18. Which of the following is not an example of an entity retaining significant risks and rewards of ownership? a. The entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions. b. The goods are shipped subject to installation, and the installation is a significant part of the contract that has not yet been completed by the entity. *c. The buyer has the right to rescind the purchase for a reason specified in the sales contract. The entity is confident that this option will not be exercised. d. The receipt of revenue from a sale is contingent on the buyer reselling the goods. Answer: c Learning objective 15.4: explain and apply the recognition criteria for revenue, distinguishing between the sale of goods and the rendering of services.

19. In a principal/agent relationship for contracts with customers, the pre-determined fee or commission for services is earned by the: a. owner. *b. agent. c. principal. d. customer. Answer: b Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

15.7

Testbank to accompany Financial reporting 3e by Loftus et al.

20. The key issue with connection fees received for connecting a customer to a telecommunications network is: a. whether they were provided by the principal or an agent. b. whether the provision of the handset is a separate transaction. c. whether the distribution channels used by the telecommunications companies are acting as agents or acting in their own rights as principals. *d. whether the revenue is recognised in full upfront or over an actual or implied service period. Answer: d Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

21. Angel Limited develops and sells off-the-shelf accounting software packages. The retail price of each package is $550 (GST inclusive). Included with each package sold are ‘free’ upgrades for a period of 12 months from the date of sale. These upgrades can be purchased separately for $66 (GST inclusive). At the date of sale, Angel should record revenue of: *a. $440.00. b. $484.00. c. $550.00. d. $616.00. Answer: a Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

15.8 10.8

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

22. TopTel Co provides a bundled-service package to J. Willis for $2000 upfront. The service package includes: • • •

upfront advice ‘on-call’ advice database access for a 1-year period.

If each service was sold separately to J. Willis the fees would be: • • •

Up-front advice: On-call advice : Database access:

$400 $1800 $600

Using the relative fair value approach, the amount of revenue recognised in relation to the database access is (rounded to the nearest whole dollar): a. $286. *b. $429. c. $1286. d. indeterminable based on the facts provided. Answer: b Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

15.9

Testbank to accompany Financial reporting 3e by Loftus et al.

23. TopTel Co provides a bundled-service package to J. Willis for $2000 upfront. The service package includes: • • •

upfront advice ‘on-call’ advice database access for a 1-year period.

If each service was sold separately to J. Willis the fees would be: • • •

Up-front advice: On-call advice : Database access:

$400 $1800 $600

The revenue that would be recorded by TopTel Co at the commencement of the agreement is (rounded to the nearest whole dollar): a. $2000. b. $1000. c. $714. *d. $286. Answer: d Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

15.10 10.10

Chapter 15: Revenue Not for distribution in full. Instructors may assign selected questions in their LMS.

24. What impact did the introduction of IFRIC 13 Customer Loyalty Programmes have on revenue recognition policies for entities in the airline industry? a) *b) c) d)

No impact. Changed the timing of the recognition of revenue. Reduced the amount of revenue able to be recognised. Increased the amount of revenue able to be recognised.

Answer: b Learning objective 15.5: interpret and analyse the revenue recognition issues and disclosures arising in specific industries in practice.

25. Which of the following disclosures are required under AASB 15/IFRS15? I. II. III. IV.

The accounting policies adopted for revenue recognition. Total income, allocated between revenue and other gains. The amount of revenue arising from exchanges of goods and services. The amount of each significant category of revenue recognised during the period.

a. I and II only. b. I, II and III only. *c. I, III and IV only d. I, II, III and IV. Answer: c Learning objective 15.6: describe the disclosure requirements of AASB 15/IFRS 15.

26. Which of the following statements is correct in terms of revenue-related disclosures on the face of the statement of profit or loss and other comprehensive income? *a. AASB 101/IAS 1 Presentation of Financial Statements requires total revenue to be disclosed on the face of the statement of profit or loss and other comprehensive income. b. AASB 15/IFRS 15 Revenue from Contracts with Customers requires total revenue to be disclosed on the face of the statement of profit or loss and other comprehensive income. c. AASB 101/IAS 1 Presentation of Financial Statements requires revenue by category to be disclosed on the face of the statement of profit or loss and other comprehensive income. d. AASB 15/IFRS 15 Revenue from Contracts with Customers requires revenue by category to be disclosed on the face of the statement of profit or loss and other comprehensive income. Answer: a Learning objective 15.6: describe the disclosure requirements of AASB 15/IFRS 15.

15.11

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Hong Nee Ang

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter16: Presentation of financial statements

Chapter 16: Presentation of financial statements Comprehension questions 1. Discuss the eight overall considerations to be applied in the presentation of financial statements. Of these, which are more subjective? Explain your answer. The eight overall considerations are: i. Fair presentation and compliance with standards – that financial statements should be faithfully represent the transactions, events and conditions of the entity in accordance with the definitions and recognition criteria specified in the framework, and that compliance with accounting standards is presumed to result in fair presentation (AASB 101/IAS 1 paragraph 15). ii. Going concern – that financial statements should be prepared on a going concern basis, unless management intends to liquidate or cease trading, or has no realistic alternative but to do so. iii. Accrual basis of accounting – applied to financial statements other than the statement of cash flows, which is prepared on a cash basis. iv. Consistency of presentation – that the presentation and classification of financial statements items should be consistent from one period to the next, unless changes are required by accounting standards or in the interests of more reliable and relevant presentation of financial information as may arise when there is a significant change in the nature of the entity’s operations. v. Materiality and aggregation – that each material class of similar items should be presented separately in the financial statements, with material items being defined as those items for which omission or misstatement could individually or collectively influence the economic decisions of users. vi. Offsetting – of assets and liabilities, and income and expenses, shall not be offset unless required or permitted by an Australian accounting standard, but income and expenses are presented on a net basis, when this presentation reflects the substances of the transactions or events. vii. Frequency of reporting – that financial statements should be presented at least annually, with disclosure where the length of the reporting period is affected by the change of the end of the reporting period. viii. Comparative information – must be presented for all financial statement items unless an accounting standard or interpretation permits otherwise. The potential departure from compliance with the requirements of a Standard when management concludes that compliance would be misleading and inconsistent with the objectives of the framework introduces considerable subjectivity. The assessment of how misleading non-compliance might be involves subjective assessment of users’ hypothetical reactions. However, it should be noted that paragraph Aus19.1 of AASB 101/IAS 1 prohibits depart from Australian Accounting Standards by entities required to prepare financial reports under Part 2M.3 of the Corporations Act, private and public sector not-for-profit entities, and entities applying Australian Accounting Standards — reduced disclosure requirements. AASB 101 is not prescriptive about offsetting, which is another area in which the exercise of judgement may be significant. Similarly, professional judgement is required in the assessment of the validity of the going concern assumption.

16.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. Why is it important for entities to disclose the measurement bases used in preparing the financial statements? It is important for entities to disclose the measurement bases used in preparing the financial statements because accounting standards permit alternatives – such as cost or fair value for property, plant and equipment. Therefore, users need to know which alternatives the entity has chosen so as to understand how items are measured and for purposes of comparison with the financial statements of other entities.

3. What is the purpose of a statement of financial position? What comprises a complete set of financial statements in accordance with AASB 101/IAS 1? The purpose of a statement of financial position is to provide information about an entity’s financial position, by summarising the entity’s assets, liabilities and equity. It thus provides the basic information for evaluating an entity’s capital structure and analysing its liquidity, solvency and financial flexibility and also provides a basis for computing rates of return and measures of solvency and liquidity. A complete set of financial statements comprises (AASB 101/IAS 1 paragraph 10): (a) a statement of financial position as at the end of the period; (b) a statement of profit or loss and other comprehensive income for the period; (c) a statement of changes in equity for the period; (d) a statement of cash flows for the period; and (e) notes, comprising a summary of significant accounting policies and other explanatory information; and (f) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A (g) a statement of financial position as at the beginning of the preceding period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements in accordance with paragraphs 40A–40D.

4. What are the major limitations of a statement of financial position as a source of information for users of general purpose financial statements? The major limitations of a statement of financial position as a source of information about an entity’s financial position are: (a) The optional measurement of certain assets, such as property, plant and equipment at historical cost or depreciated historical cost (where the asset has a limited useful life) rather than at a current value. This can reduce comparability between the statements of financial position of different entities. Further, the use of cost/depreciated cost as the basis of measurement leads to the statement of financial position not giving a view of a current value of recognised assets. (b) Some intangible self-generated assets (such as brand names and mastheads) are omitted in accordance with AASB 138 Intangible Assets. (c) The omission of various rights and obligations (such as non-cancellable operating leases) from the statement of financial position results in off-balance sheet liabilities and assets that distort the reported leverage of the entity.

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Chapter16: Presentation of financial statements

As a consequence of these limitations, the statement of financial position of an entity does not purport to present a total picture of the real worth of the entity, nor does it purport to report all assets controlled by the entity and all the obligations of the entity. 5. Under what circumstances are assets and liabilities ordinarily classified broadly in order of liquidity rather than on a current/non-current classification? Refer to section 16.3.1. The presentation of the statement of financial position based on liquidity, rather than on a current/non-current basis, is adopted when a presentation based on liquidity is considered to provide more relevant and reliable information. This situation is largely confined to entities such as financial institutions, which do not have a clearly identifiable operating cycle, as does a manufacturer or a retailer. 6. Can an asset that is not realisable within 12 months be classified as a current asset? If so, under what circumstances? Refer to section 16.3.1. One of the criteria for classifying an asset as current under AASB 101/IAS 1 is that it is expected to be realised, or is intended for sale or consumption, in the entity’s normal operating cycle. Thus, if an entity’s operating cycle is longer than 12 months it is possible for an asset that is not realisable within 12 months to be classified as a current asset. Examples of operating cycles that may extend beyond 12 months include property development, construction, wine and cheese making. 7. Explain the difference between classification of expenses by nature and by function. Refer to section 16.4.3. Classification of expenses by nature is according to their type of expense (such as, materials used, transport costs, employee benefits, depreciation, electricity, advertising costs, finance costs). Classification by function is according to the activity involved (such as, cost of sales, selling and distribution costs, administration, and finance costs). 8. Does the separate identification of profit and items of other comprehensive income provide a meaningful distinction between the effects of different types of non-owner transactions and events? Whether an item of income or expense is included in profit or in other comprehensive income is determined by the treatment of various gains and losses and other items of income or expense prescribed by accounting standards. The distinction becomes blurred when similar items, such as the effects of an asset revaluation under AASB 116/IAS 16, are included in profit (if a loss on revaluation) and in other comprehensive income (if a gain on revaluation). 9. What is the objective of a statement of changes in equity? Refer to section 16.5. The main purpose of a statement of changes in equity is to report transactions with equity holders, such as new share issues and the payment of dividends, and any retrospective adjustments to components of equity.

10. Why is a summary of accounting policies important to ensuring the understandability

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of financial statements to users of general purpose financial statements? Refer to sections 16.6 and 16.6.2. A summary of accounting policies facilitates the understandability of financial statements to users of general purpose financial statements for the following reasons: • Various options exist in certain Australian accounting standards (such as the option to revalue property, plant and equipment as an alternative to using historical cost) and therefore it is essential that the summary of accounting policies identify which options have been adopted (where relevant). • Under Australian accounting standards various assets of an entity (such as internally generally brand names and self-generated goodwill) and rights and obligations (such as non-cancellable operating leases) are not recognised in an entity’s statement of financial position. The summary of accounting policies helps ensure users of financial statements are aware of these omissions. 11. Provide an example of a judgement made in preparing the financial statements that can lead to estimation uncertainty at the end of the reporting period. Describe the disclosures that would be required in the notes. Refer to section 16.6.2. Some of the more important judgements that can lead to uncertainty required in the preparation of financial statements include: • Useful life of plant and equipment for depreciation purposes; • Residual value of plant and equipment; • Useful life of intangible assets, including whether the assets have an indefinite life or a finite life; • Assessment as to whether there is any indication that a non-current asset is impaired and, if so, the measurement of the recoverable amount of the asset, including estimating future cash flows and the appropriate discount rate for value in use measures; • Estimation of the fair value of assets and liabilities acquired in a business combination; • Estimation of the fair value of the consideration given in a transaction, particularly where the consideration is in the form of non-current assets or equity instruments; • Estimation of the expected outcome of construction contracts; • Estimation of provisions such as provisions for long service leave and provisions for restructuring; • Estimation of the realisable value of inventory. Paragraph 125 of AASB 101/IAS 1 requires that the notes disclose information about the assumptions made concerning the future and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year (for example, assumptions used in performing significant asset impairment tests). The entity should disclose the nature and carrying amount of the assets and liabilities concerned. 12. What disclosures are required in the notes in regard to accounting policy judgements? Refer to section 16.6.2. An entity is required by paragraphs 122 and 123 of AASB 101/IAS 1 to disclose judgements that management has made in the process of applying accounting policies that have the most significant effect on the amounts recognised in the financial statements, for example: • Whether a lease is a finance or operating lease (refer to AASB 117/IAS 17);

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Chapter16: Presentation of financial statements

• • • •

Whether certain transactions are sales of goods or are in substance financing arrangements; Whether an active market exists for certain intangible assets to support the adoption of the fair value basis of measurement (refer to AASB 138/IAS 38); Determining the functional currency of net investments in foreign operations, as required by AASB 121/IAS 21; Whether the actions of management and the Board in relation to a restructuring have been such as to constitute a constructive obligation and therefore justify the recognition of a provision for the costs of the restructuring (refer to AASB 137/IAS 37).

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Case studies Case study 16.1 Analysis of expenses Review the published financial reports of the following companies and report on the information applicable to the statement of profit or loss and other comprehensive income. Determine whether the expenses are classified by nature or function. Give some possible reasons for the different methods of classification of expenses used. • Bayer Group • Qantas Airways Limited • Sigma Pharmaceuticals Ltd • Telstra Corporation Limited The statement of profit or loss and other comprehensive income of Bayer Group and Sigma Pharmaceuticals Ltd are classified by function of expense whereas Qantas Airways Limited and Telstra Corporation Limited are classified by nature. The nature of expense method is simple to apply but the function of expense method provides more information to users than the classification of expenses by nature.

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Chapter16: Presentation of financial statements

Case study 16.2 Measurement basis used A first-time shareholder has approached you requesting some advice. The shareholder has received the company’s annual report and noticed the following statement in the summary of significant accounting policies: The financial report has been prepared on the basis of historical cost, except for the revaluation of certain non-current assets which is explained in the notes. Required Explain to the shareholder why this statement is included in the accounting policy note. It is important for companies to disclose the measurement basis (or bases) used in preparing the financial statements because AASB standards permit alternatives, e.g. cost or revaluation basis for property, plant and equipment under AASB 116 Property, Plant and Equipment. Therefore, users of financial statements need to understand which basis (or bases) the company has chosen in order to facilitate comparisons with other companies as revaluations may have an impact on both financial performance (in the form of higher depreciation expense and thus lower profit) and financial position of the company (higher asset and equity values).

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Case study 16.3 Management judgements Any judgements made by management when applying the entity’s accounting policies that have significant effect on amounts recognised in the financial statements must also be disclosed. What judgements do you think are made by management? According to paragraph 122 of AASB 101, an entity must disclose in the notes the judgements, apart from those involving estimates, made by management when applying the entity’s accounting policies that have the most significant effect on the amounts recognised in the financial statements. These judgements (as outlined in AASB 101, paragraph 123) may include: (a) whether financial assets are held-to-maturity investments; (b) whether substantially all the risks and rewards of ownership of an asset are transferred (a finance lease) or whether the lease is an operating lease; and (c) whether, in substance, particular sales of goods are financing arrangements and therefore do not give rise to revenue.

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Chapter16: Presentation of financial statements

Case study 16.4 Formats for statement of profit or loss and other comprehensive income The accountant for Moonshine Ltd has heard that following recent changes to accounting standards, the income statement now has a new title and companies now have a choice regarding the presentation of income and expense items recognised in a period. However, the accountant is unsure of the exact requirements following changes to accounting standards. Required As you are a recent university accounting graduate, the accountant seeks your assistance and requests that you provide information to Moonshine Ltd about this apparent presentation choice and whether the income statement now has a new title. The statement of profit or loss and other comprehensive income provides information regarding the financial performance of the entity for the reporting period. Income, expenses and other comprehensive income (e.g. movements in asset revaluation reserve) are summarised in the statement of profit or loss and other comprehensive income to determine an entity’s total comprehensive income, the usual measure of an entity’s financial performance. According to paragraph 10A of AASB 101, an entity may present: • a single statement of profit or loss and other comprehensive income with profit or loss and other comprehensive income presented in two sections (the two sections are to be presented together with the profit or loss section presented first followed directly by the other comprehensive income section), or • a separate statement of profit or loss immediately followed by a statement of comprehensive income, which shall begin with profit or loss. There appears to be no clear principles as to why income and expenses can be separated into two statements. While the income statement is now referred to as the statement of profit or loss and other comprehensive income by AASB 101, according to paragraph 10 and entity may use another title for the statement of profit or loss and other comprehensive income, e.g. statement of comprehensive income.

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Application and analysis exercises Exercise 16.1 Fair presentation The directors of an Australian company that is required to prepare financial reports under the Corporations Act conclude that applying the requirements of AASB 136/IAS 36 Impairment of Assets would not provide a fair presentation because the resulting $120 000 impairment loss is temporary. Required Advise the directors how this problem should be addressed in the financial statements in accordance with AASB 101/IAS 1. (LO2) AASB 101/IAS 1 does not permit departure from accounting standards, even in circumstances where the managers form the view that compliance would be misleading and conflict with the objective of financial statements. Accordingly, the managers should provide additional disclosure to mitigate the perceived misleading aspects. Disclosures should include: the title of the relevant standard, which in this instance is AASB 136/IAS 36 Impairment of Assets; that it requires the recognition of an impairment loss to the extent that the carrying amount of an asset of group of assets exceeds the recoverable amount; that its application is perceived to be misleading because management believes the impairment is temporary; and the adjustment required, in the view of management, to achieve a fair presentation, that is, that expenses should be reduced and the carrying amount of the asset increased by $120 000. (For simplification, taxes have been ignored in this solution. However, assuming a tax rate of 30%, and that the impairment does not affect the tax base, the required adjustment would also increase tax expense and deferred tax liability by $36 000).

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Chapter16: Presentation of financial statements

Exercise 16.2 Materiality and aggregation Indicate whether each of the following statements is true or false. (LO2) (a) A material item is determined solely on the basis of its size. (b) A class of assets or liabilities is determined by reference to items of a similar nature or function. (c) Inventories and trade accounts receivable may be aggregated in the statement of financial position. (d) Cash and cash equivalents may be aggregated in the statement of financial position. (a) False – size or nature, or combination of both (AASB 101/IAS 1 paragraph 7). (b) True – AASB 101/IAS 1 paragraph 29. (c) False –AASB 101/IAS 1 paragraphs 29, 54. (d) True – AASB 101/IAS 1 paragraphs 29, 54.

16.12

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Exercise 16.3 Classification of items in the statement of financial position The general ledger trial balance of Thomas Ltd includes the following accounts that are reported in the statement of financial position.

Thomas Ltd classifies assets and liabilities into current and non-current categories and uses the minimum line items permitted under AASB 101/IAS 1. Required Assume you are the accountant responsible for preparing the statement of financial position of Thomas Ltd. In which caption and classification on the statement of financial position would you include each of the above accounts? If you need additional information to finalise your decision as to the appropriate classification or caption, indicate what information you require. (LO3) Account a) Trade receivables b) Work in progress c) Trade creditors d) Prepayments e) Property f) Goodwill g) Debentures payable

h) Preference share capital

i) Unearned revenue

j) Accrued salaries k) Trading securities held l) Share capital

Caption Trade and other receivables Inventories Trade and other payables Other current assets Property, plant and equipment of Investment property, as applicable Intangible assets or other (*) Financial liabilities

Issued capital and reserves or Financial liabilities depending on whether the instruments meet the definition of a liability or of equity Other liabilities or a separate caption if material

Trade and other payables Financial assets Issued capital and reserves

Classification Current assets Current assets Current liabilities Current assets Non-current assets Non-current assets Current or non-current liabilities depending on when payment is due Equity or if they constitute a liability, current or non-current liabilities depending on the period of redemption Current or non-current liabilities depending on the applicable date or period of the unearned revenue Current liabilities Current assets Equity

Explanation: * Although AASB 138/IAS 38 defines intangible assets as identifiable, the intangible assets caption in the statement of financial position typically includes any goodwill recognised.

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Chapter16: Presentation of financial statements

Exercise 16.4 Current asset and liability classification The general ledger trial balance of David Ltd at 30 June 2022 includes the following asset and liability accounts. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)

Interest payable Trade receivables Accounts payable Prepayments Inventories of finished goods Allowance for doubtful debts Cash Accrued wages and salaries Inventories of raw materials Loan (due 31 October 2022) Lease liability Current tax payable

4 000 200 000 170 000 24 000 240 000 16 000 20 000 40 000 120 000 200 000 150 000 60 000

Additional information • The lease liability (k) includes an amount of $26 000 for lease payments due before 30 June 2023. • The company classifies assets and liabilities using a current/non-current basis. Required Prepare the current assets and current liabilities sections of the statement of financial position of David Ltd as at 30 June 2022, using the minimum line items permitted under AASB 101/IAS 1. (LO3) Current Assets Cash and cash equivalents Trade and other receivables Inventories Other current assets

$’000 20 (g) 184 [(b) 200 000 – (f) 16 000] 360 [(e) 240 000 + (i) 120 000] 24 (d) 588

Current Liabilities Trade and other payables Financial liabilities Current tax liability

$’000 214 [(a) 4 000 + (c) 170 000 + (h) 40 000] 226 [(j) 200 000 + (k) 26 000] 60 (l) 500

16.14

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Exercise 16.5 Current asset classification The general ledger trial balance of Madeleine Ltd includes the following asset accounts at 30 June 2022. (a) (b) (c) (d) (e) (f) (g)

Inventories Trade receivables Prepaid insurance Listed investments held for trading purposes at fair value Investments in financial assets Cash Deferred tax asset

250 000 300 000 20 000 50 000 200 000 75 000 37 500

Additional information • Madeleine Ltd’s investments are part of a long-term investment strategy. • The company classifies assets and liabilities using a current/non-current basis. Required Prepare the current asset section of the statement of financial position of Madeleine Ltd as at 30 June 2022, using the minimum line items permitted under AASB 101/IAS 1. (LO3) Current assets Cash and cash equivalents Trade receivables Listed investments held for trading purposes Inventories Other current assets

$ 75 000 300 000 50 000 250 000 20 000 695 000

Explanations: • Paragraph 56 of AASB 101/IAS 1 precludes the classification of deferred tax assets, item (g), as a current asset under any circumstances.

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Chapter16: Presentation of financial statements

Exercise 16.6 Statement of profit or loss and other comprehensive income The general ledger trial balance of DEF Ltd includes the following accounts at 30 June 2022. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

Sales revenue Interest income Gain on sale of plant Valuation gain on trading securities Dividend revenue Cost of sales Finance expenses Selling and distribution expenses Administrative expenses Income tax expense

1 800 000 36 000 7 500 30 000 7 500 1 260 000 27 000 114 000 52 500 127 500

Additional information • DEF Ltd recognised a loss on valuation of $1500 net of tax for financial assets recognised at fair value through other comprehensive income. No financial assets were sold during the year. • A gain of $6000 net of tax was recognised on the revaluation of land. • DEF Ltd uses the single statement format for the statement of profit or loss and other comprehensive income. • DEF Ltd classifies expenses by function. Required Prepare the statement of profit or loss and other comprehensive income of DEF Ltd for the year ended 30 June 2022, showing the analysis of expenses in the statement. (LO4)

Revenue Cost of sales Gross profit Other income Selling and distributions expenses Administrative expenses Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: Items that will not be reclassified subsequently to profit or loss: Gain on valuation of land net of tax Loss on valuation of financial assets net of tax*

$’000 1 800 (1 260) 540 81 (114) (52.5) (27) 427.5 (127.5) 300

6 (1.5)

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Total comprehensive income for the year 304.5 * Assuming not a significant or prolonged decline in fair value, otherwise treated as an impairment loss and recorded in profit or loss (see AASB 139 paragraph 61). Calculations: Other income comprises: Gain on sale of plant Interest income Valuation gain on trading securities Dividend revenue

$’000 7.5 36.0 30.0 7.5 81.0

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Chapter16: Presentation of financial statements

Exercise 16.7 Statement of profit or loss and other comprehensive income The general ledger trial balance of Dion Ltd includes the following accounts at 30 June 2022. (a) (b) (c) (d) (e) (f) (g) (h)

Sales revenue Interest revenue Gain on sale of plant and equipment Cost of sales Finance expenses Selling and distribution costs Administrative expenses Income tax expense

750 000 25 000 10 000 400 000 15 000 50 000 30 000 50 000

Additional information • A revaluation gain of $14 000 net of tax was recognised for financial assets recognised at fair value through other comprehensive income held during 2022. • No financial assets recognised at fair value through other comprehensive income were sold during the year. • Dion Ltd uses the single statement format for the statement of profit or loss and other comprehensive income and classifies expenses by function. Required Prepare the statement of profit or loss and other comprehensive income of Dion Ltd for the year ended 30 June 2022, showing the analysis of expenses in the statement. (LO4)

Revenue Cost of sales Gross profit Other income Selling and distributions expenses Administrative expenses Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: Items that will not be reclassified subsequently to profit or loss: Gain on valuation of financial assets net of tax Total comprehensive income for the year

$’000 750 (400) 350 35 (50) (30) (15) 290 (50) 240

14 254

Explanation: Other income comprises interest revenue $25 000 and gain on sale of plant and equipment $10 000.

16.18

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Exercise 16.8 Statement of changes in equity The shareholders’ equity section of the statement of financial position of Ark Ltd at 30 June 2022 is as follows. 2022 Share capital General reserve Foreign currency translation reserve Retained earnings

2021

100 000 25 000 37 000 85 000

80 000 20 000 30 000 80 000

247 000

210 000

Additional information • Ark Ltd issued 8 000 shares at $2.50 each on 31 May 2022 for cash. • A transfer of $5 000 was made from retained earnings to the general reserve. • Comprehensive income for the year was $72 000, including a foreign currency translation gain of $7 000 recognised in other comprehensive income. • Dividends paid during 2022 comprised: final dividend for 2021, $25 000; interim dividend, $30 000. Required Prepare the statement of changes in equity of Ark Ltd for the year ended 30 June 2022 in accordance with AASB 101/IAS 1. (LO5) ARK LTD Statement of changes in equity for the year ended 30 June 2022 Share General capital reserve $ $ 80 000 20 000

Balance at 30 June 2021 Comprehensive income for the year ended 30 June 2022 Dividends Transfer to general reserve Issue of share capital 20 000 Balance at 30 June 2022 100 000

Foreign currency translation reserve $ 30 000

Retained Total earnings equity $ $ 80 000 210 000

7 000

65 000 72 000 (55 000) (55 000) (5 000) 20 000 85 000 247 000

5 000 25 000

37 000

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Chapter16: Presentation of financial statements

Exercise 16.9 Materiality, offsetting Fine Company Ltd is a retailer that imports about 30% of its goods. The following foreign exchange gains and losses were recognised in profit during the year.

Materiality has been determined as $5 million for items recognised in profit or loss. Required Identify which of the above gains and losses are permitted to be offset in Fine Company Ltd’s financial statements. (LO2)

Foreign currency borrowings with Bank L

Loss $50m

Forward exchange contracts used as hedging instruments Forward exchange contracts not used as hedges

Foreign currency borrowings with Bank S

Gain

$1m

$3m

$10m

Set-off? Could be set-off with foreign currency borrowings with Bank S on the basis of being similar in nature, however the amount is material so it must be presented separately. (AASB 101/IAS 1 paragraph 35) Not similar to other items so no set-off allowed, however the amount is not material and so is not required to be disclosed. (AASB 101/IAS 1 paragraphs 29 and 35) If they are not part of a hedging arrangement, the forward exchange contracts are held for trading (AASB 139/IAS 39, paragraph 9); This item is not similar to other items so no set-off allowed, however the amount is not material and so is not required to be presented separately. (AASB 101/IAS 1 paragraphs 29 and 35) Could be set-off with foreign currency borrowings with Bank L on the basis of being similar in nature, however the amount is material so it must be disclosed separately. (AASB 101/IAS 1 paragraph 35)

16.20

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Exercise 16.10 Preparation of a statement of financial position The summarised general ledger trial balance of Jayden Ltd, a manufacturing company, includes the following accounts at 30 June 2022.

Additional information • Bank loans and ‘other loans’ are all repayable beyond 1 year. • $300 000 of the debentures is repayable within 1 year. • Lease liabilities include $125 000 repayable within 1 year. • Investments in listed companies are long-term investments. • Provision for employment benefits includes $192 000 payable within 1 year. • The planned restructuring is intended to be completed within 1 year. • Provision for warranty includes $20 000 estimated to be incurred beyond 1 year.

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Chapter16: Presentation of financial statements

Required Prepare the statement of financial position of Jayden Ltd at 30 June 2022 in accordance with AASB 101/IAS 1, using the captions that a listed entity is likely to use. (LO3)

JAYDEN LTD Statement of financial position as at 30 June 2022 Assets Current assets Cash and cash equivalents Trade and other receivables Inventories Other current assets Non-current assets Investments in listed companies Property, plant and equipment Goodwill Other intangible assets Total assets Equity and liabilities Current liabilities Trade and other payables Current portion of long-term borrowings Current tax payable Short-term provisions Non-current liabilities Long-term borrowings Deferred tax liability Long-term provisions Total liabilities Equity Share capital Reserves Retained earnings Total equity Total equity and liabilities

$’000 211 1 984 1 683 141 4 019 52 6 174 2 530 110 8 866 12 885

2 457 425 152 626 3 660 3 615 420 103 4 138 7 798 3 500 106 1 481 5 087 12 885

Explanations: • Cash and cash equivalents comprise cash $175 000 + deposits at call $36 000 = $211 000.

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•

Trade and other receivables comprise trade debtors $1 744 000 – allowance for doubtful debts $80 000 + sundry debtors $320 000 = $1 984 000. Inventories comprise raw materials $490 000 + work in progress $151 000 + finished goods $1 042 000 = $1 683 000. Other current assets comprise prepayments.

•

Property, plant and equipment comprises:

•

Land Buildings Accumulated depreciation Plant and equipment Accumulated depreciation Leased assets Accumulated amortisation • • • • •

• •

$’000 250 1 030 (120) 8 275 (3 726) 775 (310) 6 174

Goodwill has been separately disclosed on the face of the statement of financial position given its materiality and comprises cost $3 200 000 – accumulated impairment $670 000 = $2 530 000. Trade and other payables comprise trade creditors $1 617 000 + sundry creditors and accruals $840 000 = $2 457 000. The current portion of long-term borrowings comprises the following items payable within 12 months: lease liabilities $125 000 + debentures $300 000 = $425 000. Short-term provisions comprise: current portion of the provision for employee benefits $192 000 + provision for restructuring $412 000 + current portion of the provision for warranty $22 000 ($42 000 - $20 000) = $626 000. Long-term borrowings (financial liabilities) comprise: $’000 Banks loans 2 215 Debentures 675 Repayable within 12 months (300) Other loans 800 Lease liabilities 350 Repayable within 12 months (125) 3 615 Long-term provisions comprise provision for employee benefits $275 000 – current portion $192 000 + provision for warranty to be incurred beyond one year $20 000 = $103 000. Reserves comprise Investment revaluation reserve $25 000 + Land revaluation reserve $81 000 = $106 000.

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Chapter16: Presentation of financial statements

Exercise 16.11 Preparation of a statement of financial position The summarised general ledger trial balance of Dominic Ltd, a manufacturing company, includes the following accounts at 30 June 2022. Dr Cash deposits

Trade debtors

234 000 1 163 000

Allowance for doubtful debts

Sundry debtors

270 000

Prepayments

94 000

Sundry loans (current)

20 000

Raw materials on hand

493 000

Finished goods

695 000

Investments in unlisted companies

30 000

Land (at cost)

234 000

Buildings (at cost)

687 000

Accumulated depreciation — buildings

50 000

80 000

Plant and equipment (at cost)

6 329 000

Accumulated depreciation — plant and equipment

3 036 000

Goodwill

1 850 000

Brand names

40 000

Patents

25 000

Deferred tax asset

189 000

Trade creditors

1 078 000

Sundry creditors and accruals

685 000

Bank overdraft

115 000

Bank loans

1 273 000

Other loans

646 000

Current tax payable

74 000

Provision for employee benefits

222 000

Dividends payable

100 000

Provision for warranty

20 000

Share capital

3 459 000

Retained earnings

1 515 000 $ 12 353 000

12 353 000

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Additional information • The bank overdraft is payable on demand and forms part of cash equivalents. • Bank loans include amounts repayable within 1 year $480 000. • Other loans outstanding are repayable within 1 year. • Provision for employee benefits includes $124 000 payable within 1 year. • Provision for warranty is in respect of a 6-month warranty given over certain goods sold. • The investments in unlisted companies are long-term investments. Required Prepare the statement of financial position of Dominic Ltd at 30 June 2022 in accordance with AASB 101/IAS 1, using the captions that a listed company is likely to use. (LO3) DOMINIC LTD Statement of financial position as at 30 June 2022 $’000 Assets Current assets Cash and cash equivalents 119 Trade and other receivables 1 383 Loans receivable 20 Inventories 1 188 Other current assets 94 2 804 Non-current assets Available-for-sale financial assets 30 Property, plant and equipment 4 134 Goodwill 1 850 Intangible assets 65 Deferred tax asset 189 6 268 Total assets 9 072 Equity and liabilities Current liabilities Trade and other payables Financial liabilities Current tax payable Short-term provisions Non-current liabilities Financial liabilities Long-term provisions Total liabilities Equity

1 863 1 126 74 144 3 207 793 98 891 4 098

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Chapter16: Presentation of financial statements

Share capital Retained earnings Total equity Total equity and liabilities

3 459 1 515 4 974 9 072

Explanations: • Listed companies may use various captions in describing the minimal disclosure items required by AASB 101/IAS 1. Refer to Figures 16.1 – 16.4. In some instances, these may be modified as appropriate, e.g., “trade and other receivables” instead of “trade receivables”. • Cash and cash equivalents is the net amount of the cash of $234 000 and the bank overdraft of $115 000. • Trade and other receivables comprise: $’000 Trade debtors 1 163 Allowance for doubtful debts (50) Sundry debtors 270 1 383 • •

• • • • • • •

Inventories comprise raw materials ($493 000) + finished goods ($695 000) = $1 188 000. Property, plant and equipment comprises: $’000 Land 234 Buildings 687 Accumulated depreciation (80) Plant and equipment 6 329 Accumulated depreciation (3 036) 4 134 Goodwill has been separately shown in the statement of financial position because of its materiality. Other intangibles comprise brand names $40 000 + patents $25 000 = $65 000. Trade and other payables comprise trade creditors $1 078 000 + sundry creditors and accruals $685 000 + dividends payable $100 000 = $1 863 000. Current financial liabilities comprise other loans $646 000 + bank loans payable within one year $480 000 = $1 126 000. Short-term provisions comprise provision for warranty $20 000 and employee benefits $124 000 = $144 000. Non-current financial liabilities comprise bank loans of $1 273 000 less loans repayable within one year $480 000 = $793 000. An alternative label is long-term borrowings. Long-term provisions comprise provision for employee benefits $222 000 – amount payable within 12 months $124 000 = $98 000.

16.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 16.12 Preparation of a statement of financial position The summarised general ledger trial balance of Daniel Ltd, an investment company, includes the following accounts at 30 June 2022.

Cash at bank Deposits (at call) Dividends receivable Interest receivable Settlements receivable Trading securities Investments in listed securities Deferred tax asset Settlements payable Interest payable Other payables Current tax payable Provision for employee benefits Deferred tax liability Share capital Revaluation surplus — investments Retained earnings

Dr $ 14 000 224 869 22 693 478 9 900 74 455 1 880 000 655

$ 2 227 050

14 805 280 83 242 752 56 414 1 500 000 376 090 278 384

$ 2 227 050

Additional information • Provision for employee benefits includes $280 payable within 1 year. • Investments in listed securities are held as long-term investments. Revaluation gains and losses will not be reclassified. • The deferred tax asset and deferred tax liability do not satisfy the criteria for offsetting in accordance with AASB 112/IAS 12. Required Prepare the statement of financial position of Daniel Ltd at 30 June 2022 in accordance with AASB 101/IAS 1, using the captions that a listed company is likely to use. (LO3) DANIEL LTD Statement of financial position as at 30 June 2022 Assets Current assets Cash and cash equivalents Trade and other receivables Financial assets held for trading © John Wiley and Sons Australia Ltd, 2020

$ 238 869 33 071 74 455 16.27

Chapter16: Presentation of financial statements

346 395 Non-current assets Investments in listed securities Deferred tax asset Total assets Equity and liabilities Current liabilities Trade and other payables Current tax payable Short-term provisions Non-current liabilities Deferred tax liability Long-term provisions Total liabilities Equity Share capital Reserves Retained earnings Total equity Total equity and liabilities

1 880 000 655 1 880 655 2 227 050

15 168 242 280 15 690 56 414 472 56 886 72 576 1 500 000 376 090 278 384 2 154 474 2 227 050

Explanations • Cash and cash equivalents: cash $14 000 + deposits at call $224 869 = $238 869. • Trade and other receivables comprise dividends receivable $22 693 + interest receivable $478 + settlements receivable $9 900 = $33 071. • Trade and other payables comprises settlements payable $14 805 + interest payable $280 + other payables $83 = $15 168. • Long-term provisions: provision for employee benefits $752 – $280 = $472.

16.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 16.13 Preparation of a statement of profit or loss and other comprehensive income The general ledger trial balance of Caitlin Ltd, an investment company, includes the following revenue and expense items for the year ended 30 June 2022.

Additional information • The revaluation gain for financial assets recognised at fair value through other comprehensive income held during the year ended 30 June 2022 was $70 000. The related tax was $21 000. Revaluation gains and losses will not be reclassified. • No financial assets were sold during the year ended 30 June 2022. • Caitlin Ltd uses the single statement format for the statement of profit or loss and other comprehensive income. • Caitlin Ltd presents an analysis of expenses by function in the statement of profit or loss and other comprehensive income. Required Prepare the statement of profit or loss and other comprehensive income of Caitlin Ltd for the year ended 30 June 2022, in accordance with AASB 101/IAS 1. (LO4) CAITLIN LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 $’000 Income from investments 980 Interest income 90 Other income 10 Net loss on financial instruments held for trading (20) Administrative expenses (75) Finance costs (15) Profit before tax 970 Income tax expense (280) Profit for year 690 Other comprehensive income: Items that will not be reclassified subsequently to profit or loss: Revaluation gain on financial assets 70 Income tax relating to revaluation gain (21)

16.29

Chapter16: Presentation of financial statements

Other comprehensive income Total comprehensive income for the year

49 739

Explanations • Income from investments comprises dividends from investments $920 000 + distributions from trusts $60 000 = $980 000. • Interest income comprises interest on deposits $80 000 + interest income from bank bills $10 000 = $90 000. • Net loss on financial assets held for trading comprises income from dealing in securities and derivatives $40 000 – loss on credit derivatives held for trading $60 000 = Loss $20 000. These items are presented on a net basis as permitted by paragraph 35 of AASB 101 (refer to section 16.2.5).

16.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 16.14 Preparation of a statement of profit or loss and other comprehensive income The general ledger trial balance of Medico Ltd, a medical manufacturing and research company, includes the following accounts at 30 June 2022. Dr

Cr 2 600 000 4 000 52 000 4 000 20 000 2 000

Sales revenue $ Interest income Gain on sale of plant Rental income Royalty income Other revenue Cost of sales $ 1 640 000 Interest on borrowings 66 000 Sundry borrowing costs 2 000 Research expense 102 000 Advertising expense 50 000 Sales staff salaries 194 000 Amortisation of patents 14 000 Freight out 64 000 Shipping supplies 32 000 Depreciation on sales equipment 10 000 Administrative salaries 144 000 Legal and professional fees 26 000 Office rent expense 60 000 Insurance expense 28 000 Depreciation of office equipment 32 000 Stationery and supplies 10 000 Miscellaneous expenses 4 000 Income tax expense 62 000 Additional information • Land was revalued upward by $200 000 during the year ended 30 June 2022. The related tax was $60 000. • Medico Ltd uses the single statement format for the statement of profit or loss and other comprehensive income. Required Prepare the statement of profit or loss and other comprehensive income of Medico Ltd for the year ended 30 June 2022 in accordance with AASB 101/IAS 1, showing the analysis of expenses by function in the statement. (LO4)

16.31

Chapter16: Presentation of financial statements

MEDICO LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022

Sales revenue Cost of sales Gross profit Other income Selling and distribution expenses Administrative expenses Research costs Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: Items that will not be reclassified to profit or loss: Asset revaluation Income tax relating to asset revaluation Other comprehensive income for the year Total comprehensive income for the year

$'000 2 600 (1 640) 960 82 (350) (304) (116) (68) 204 (62) 142

200 (60) 140 282

Explanations • Other income $82 000 comprises: Gain on sale of plant Interest income Rental income Royalties Other revenue

$’000 52 4 4 20 2 82

•

Selling and distribution expenses comprise:

•

$’000 50 194 64 32 10 350 Finance costs comprise interest on borrowings $66 000 + sundry borrowing costs $2 000 = $68 000. Administrative expenses comprise: $’000 Administrative expenses 144 Legal and professional fees 1326 Office rent expense 60 Insurance expense 28 Advertising costs Sales staff salaries Freight-out Shipping supplies expense Depreciation on sales equipment

•

16.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Depreciation of office equipment Stationery and supplies Miscellaneous expenses

•

32 10 4 304 Alternatively, the asset revaluation may have been shown in the statement of comprehensive income net of tax, with the tax effect reported in the notes.

16.33

Chapter16: Presentation of financial statements

Exercise 16.15 Statement of profit or loss and other comprehensive income The general ledger trial balance of Anastasia Ltd includes the following accounts at 30 June 2022.

Additional information • The financial assets are bonds that are measured at fair value, with changes in fair value recognised through the statement of profit or loss. When held-for-sale financial assets from this category are sold, the accumulated amount recognised in equity for the asset is reclassified to profit or loss. Movements in the financial assets revaluation reserve during the year ended 30 June 2022 comprised: - gross revaluation increases recognised $44 000 (related deferred income tax $14 000) - gross reclassifications on sale of the financial assets $10 000 gain (related income tax $3000). • Anastasia Ltd uses the single statement format for the statement of profit or loss and other comprehensive income. • Anastasia Ltd presents an analysis of expenses by nature in the statement of profit or loss and other comprehensive income. Required Prepare the statement of profit or loss and other comprehensive income of Anastasia Ltd for the year ended 30 June 2022. (LO4) ANASTASIA LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 Revenue Share of profit of associates Other income Change in inventories of finished goods Raw materials and consumables used Employee benefit expenses Depreciation of property, plant and equipment Impairment loss on property Finance costs Other expenses © John Wiley and Sons Australia Ltd, 2020

$’000 975 15 30 (25) (350) (150) (45) (80) (35) (45)

16.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Profit before tax Income tax expense Profit for the year Other comprehensive income: Items that may be reclassified subsequently to profit or loss: Loss on translation of foreign operations Other comprehensive income for the year Total comprehensive income for the year

290 (75) 215

(30) (30) 185

Explanations • Other income comprises (b) interest income $20 000 and (d) gain on sale of financial assets $10 000. • The loss on translation of foreign operations under the current rate method is recognised directly in equity in accordance with AASB 121/IAS 21. This solution assumes application of the current-rate method to translate the net investment in a foreign operation.

16.35

Chapter16: Presentation of financial statements

Exercise 16.16 Presentation of items in the financial statements Consider the following items for Xavier Ltd at 30 June 2022. (a) loss on revaluation of financial assets recognised at fair value through other comprehensive income (b) finance expenses (c) aggregate amount of dividends declared and paid during the year (d) revaluation loss on building (not reversing any previous revaluation) (e) allowance for doubtful debts (f) transfer from retained earnings to general reserve (g) contractual commitments under an operating lease (h) deferred tax liability. Required State whether each item is reported: 1. in the statement of financial position 2. in profit or loss in the statement of profit or loss and other comprehensive income 3. in other comprehensive income in the statement of profit or loss and other comprehensive income 4. in the statement of changes in equity 5. in the notes to the financial statements. (LO2, LO3, LO4, LO5 and LO6) (a) (b) (c) (d) (e) (f) (g) (h)

loss on revaluation of financial assets recognised at fair value through OCI finance expenses aggregate dividends declared and paid during the year revaluation loss on building (not reversing any previous revaluation) allowance for doubtful debts transfer from retained earnings to general reserve contractual commitments under an operating lease deferred tax liability

3. other comprehensive income in statement of profit or loss and OCI 2. profit or loss in the statement of profit or loss and OCI 4. statement of changes in equity 2. profit or loss in the statement of profit or loss and OCI 5. notes 4. statement of changes in equity 5. notes 1. statement of financial position

16.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 16.17 Presentation of items in the financial statements Consider the following items for Kateri Ltd at 30 June 2022: (a) contingent liabilities (b) dividends paid (c) cash and cash equivalents (d) capital contributed during the year (e) revaluation gain on land (not reversing any previous revaluation) (f) judgements that management has made in classifying financial assets (g) income tax expense (h) provisions. Required State whether each item is reported: 1. in the statement of financial position 2. in profit or loss in the statement of profit or loss and other comprehensive income 3. in other comprehensive income in the statement of profit or loss and other comprehensive income 4. in the statement of changes in equity 5. in the notes to the financial statements. (LO2, LO3, LO4, LO5 and LO6) (a) (b) (c) (d) (e)

(g)

contingent liabilities dividends paid cash and cash equivalents capital contributed during the year revaluation gain on land (not reversing any previous revaluation) judgements that management has made in classifying financial assets income tax expense

(h)

provisions

(f)

5. notes 4. statement of changes in equity 1. statement of financial position 4. statement of changes in equity 3. other comprehensive income in statement of profit or loss and OCI 5. notes 2. in profit or loss in the statement of profit or loss and other comprehensive income 1. statement of financial position

16.37

Chapter16: Presentation of financial statements

Exercise 16.18 Preparation of a statement of financial position and statement of profit or loss and other comprehensive income The summarised general ledger trial balance of Roisin Ltd, a spare parts manufacturer, for the year ended 30 June 2022 is detailed below.

Additional information • Employee share plan loans receivable include $40 000 due within 1 year. • $30 000 of bank loans is repayable within 1 year. • $375 000 of other loans is repayable within 1 year.

16.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• • • • • •

Provision for employee benefits includes $108 000 payable within 1 year. The planned restructuring is intended to be fully implemented within 1 year. Provision for warranty is in respect of a 6-month warranty on certain goods sold. The financial assets were acquired during the current year and were revalued upward by $23 000 at the end of the reporting period. The related income tax was $8000. The financial assets are equity securities which the entity elected to recognise at fair value through other comprehensive income. The accumulated gain or loss will not be reclassified. Roisin Ltd uses the single statement format for the statement of profit or loss and other comprehensive income and presents an analysis of expenses by function in the statement.

Required Prepare the statement of financial position and statement of profit or loss and other comprehensive income of Roisin Ltd for the year ended 30 June 2022 in accordance with AASB 101/IAS 1, using statement captions that a listed company is likely to use. (LO3 and LO4) ROISIN LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022

Revenue Cost of sales Gross profit Other income Share of profits of associates Selling and distributions expenses Administrative expenses Finance costs Profit/(loss) before tax Income tax expense Profit/(loss) for the year Other comprehensive income: Items that will not be reclassified subsequently to profit or loss: Revaluation of financial assets recognised at fair value through OCI Related income tax Other comprehensive income Total comprehensive income

$'000 7 760 (5 378) 2 382 15 36 (1 710) (520) (80) 123 (141) (18)

23 (8) 15 (3)

Explanations • Other income comprises rent received $9 000 + other income $6 000 = $15 000. • Selling and distribution expenses comprises distribution expenses $243 000 + sales and marketing expenses $1 467 000 = $1 710 000. • Finance costs comprise interest paid $74 000 + other borrowing expenses $6 000 = $80 000.

16.39

Chapter16: Presentation of financial statements

ROISIN LTD Statement of financial position as at 30 June 2022 $'000 Assets Current assets Cash and cash equivalents Trade and other receivables Inventories Non-current assets Other receivables Investments accounted for using the equity method Financial assets recognised at fair value through OCI Property, plant and equipment Goodwill Total assets Equity and liabilities Current liabilities Trade and other payables Financial liabilities Current tax payable Short-term provisions Non-current liabilities Financial liabilities Deferred tax liability Long-term provisions

170 910 1 243 2 323 220 375 60 1 525 1 450 3 630 5 953

820 405 30 210 1 465

Total liabilities

516 100 45 661 2 126

Equity Share capital Reserves Retained earnings Total equity Total equity and liabilities

3 220 15 592 3 827 5 953

Explanations • Cash and cash equivalents comprise cash at bank $20 000 + cash on deposits, at call $150 000 = $170 000. • Trade and other receivables comprise trade debtors $740 000 – allowance for doubtful debts $24 000 + other debtors $154 000 + the current portion of the employee share plan loans $40 000 = $910 000. • Inventories comprises raw materials $53 000 + finished goods $1 190 000 = $1 243 000.

16.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

Other receivables under non-current assets comprise the employee share plan loans $260 000 – the non-current portion of the employee share plan loans $40 000 = $220 000.

•

Property, plant and equipment comprises: Land and buildings Accumulated depreciation Plant and equipment Accumulated depreciation

• • • •

Current financial liabilities comprise bank loans repayable within 1 year $30 000 + other loans repayable within 1 year $375 000 = $405 000. Short-term provisions comprise employee benefits $108 000 + provision for restructuring $62 000 (to be fully implemented within one year) + provision for warranty $40 000 (sixmonth warranty period) = $210 000. Long-term provisions comprise employee benefit provisions $153 000 – payable within one year $108 000 = $45 000. Non-current financial liabilities: Banks loans Repayable within 12 months Other loans Repayable within 12 months

•

$‘000 426 (61) 2 100 (940) 1 525

$’000 111 (30) 810 (375) 516

Retained earnings comprise balance 1 July 2021 $760 000 – loss for the year $18 000 – dividends $150 000 = $592 000.

16.41

Chapter16: Presentation of financial statements

Exercise 16.19 Preparation of a statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity The summarised general ledger trial balance of Flip Ltd, a manufacturing company, for the year ended 30 June 2022 is detailed below.

Additional information • $20 000 of bank loans is repayable within 1 year. • $90 000 of other loans is repayable within 1 year. • Flip Ltd uses the single statement format for the statement of profit or loss and other comprehensive income and presents an analysis of expenses by nature in the statement.

16.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required Prepare the statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity of Flip Ltd for the year ended 30 June 2022 in accordance with the requirements of AASB 101/IAS 1, using statement captions that a listed company is likely to use. (LO3, LO4 and LO5)

FLIP LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 $'000 Revenue 5 000 Other income 47 Changes in inventories of work-in-progress and finished goods (65) Raw materials used (2 200) Employee benefit expense (950) Depreciation expense (226) Amortisation of patent (25) Rental expenses (70) Advertising expenses (142) Insurance expense (45) Freight-out expense (133) Doubtful debts expense (10) Finance costs (30) Other expenses (8) Profit before tax 1 143 Income tax expense (320) Profit for year 823 Other comprehensive income Items that may be reclassified subsequently to profit or loss: Deferred cash flow hedge (65) Total comprehensive income 758 Explanations • This solution assumes that all of the deferred cash flow hedge arose in the current period and is, accordingly, recognised in comprehensive income for the year. • Other income comprises interest income $22 000 + sundry income $25 000 = $47 000. FLIP LTD Statement of financial position as at 30 June 2022 $’000 Assets Current assets Cash and cash equivalents Trade and other receivables Inventories

84 504 705 1 293

16.43

Chapter16: Presentation of financial statements

Non-current assets Property, plant and equipment Goodwill Other intangible assets Total assets Equity and liabilities Current liabilities Trade and other payables Financial liabilities Current tax payable Provisions Non-current liabilities Financial liabilities Deferred tax liability Total non-current liabilities Total liabilities Equity Share capital Retained earnings Cash flow hedge reserve Total equity Total equity and liabilities

1 322 620 90 2 032 3 325

452 110 35 120 717 432 140 572 1 289 1 178 923 (65) 2 036 3 365

Explanations • Cash and cash equivalents comprise cash $4 000 + cash on deposit, at call $80 000 = $84 000. • Trade and other receivables comprise: $'000 Trade debtors 495 Allowance for doubtful debts (18) Other debtors 27 504 • •

Inventories comprise raw materials $320 000 + finished goods $385 000 = $705 000. Property, plant and equipment comprises: $'000 Land 94 Buildings 220 Accumulated depreciation (52) Plant and equipment 1 380 Accumulated depreciation (320) 1 322

16.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• •

This answer assumes all of the provision for employee benefits is current. The current portion of financial liabilities comprises:

Bank loans repayable within one year Other loans repayable within one year •

$ 20 000 90 000 $110 000

Non-current financial liabilities comprise: $'000 92 (20) 450 (90) 432

Banks loans Repayable within 12 months Other loans Repayable within 12 months

Flip Ltd Statement of changes in equity for the year ended 30 June 2022

Balance at 30 June 2021 Comprehensive income for the year Dividends Dividends reinvested Balance at 30 June 2022

Share capital $’000 1 137

Retained Cash flow earnings hedge reserve $’000 $’000 310 0 823 (65) (210)

41 1 178

923

(65)

Total equity $’000 1 447 758 (210) 41 2 036

16.45

Chapter16: Presentation of financial statements

Exercise 16.20 Preparation of a statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity The summarised general ledger trial balance of Cob Ltd, a manufacturing company, for the year ended 30 June 2022 is detailed below. Dr Sales of goods Interest income Cost of sales Distribution expenses Sales and marketing expenses Administration expenses Interest expense Other borrowing expenses Income tax expense Cash on hand Cash on deposit, at call Trade debtors Allowance for doubtful debts Other debtors Raw materials inventories Finished goods inventories Financial assets recognised at fair value through other comprehensive income Land and buildings Accumulated depreciation — buildings Plant and equipment Accumulated depreciation — plant and equipment Patents Amortisation of patent Goodwill Bank loans Other loans Trade creditors Provision for employee benefits Warranty provision Current tax payable Deferred tax liability Retained earnings, 30 June 2021

Cr $ 4 769 000 6 000

$ 3 287 000 86 000 820 000 252 000 44 000 4 000 85 000 4 000 100 000 450 000 14 000 93 000 188 000 714 000 225 000 257 000 36 000 1 260 000 564 000 48 000 3 000 870 000 66 000 570 000 510 000 93 000 37 000 25 000 135 000 326 000

16.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dividends paid Land revaluation surplus Financial assets revaluation surplus Share capital

150 000 50 000 42 000 1 691 000 $ 8 937 000

$ 8 937 000

Additional information • Shares were issued during 2022 for $120 000. • Share capital was $1 541 000 at 30 June 2021. • Of the $150 000 dividend, $30 000 was reinvested as part of a dividend reinvestment plan. • The balances of the land revaluation surplus and the financial assets revaluation surplus at 30 June 2021 were $15 000 credit and $35 000 credit respectively. Both the land revaluation surplus and financial assets revaluation surplus will not be reclassified subsequently to profit or loss. • The following revaluations were recognised during the year ended 30 June 2022: land revalued upward by $50 000 (related income tax $15 000) and financial assets revalued upward by $10 000 (related income tax $3000). • The financial assets are held as part of a long-term investment strategy. • $45 000 of bank loans is repayable within 1 year. • $80 000 of other loans is repayable within 1 year. • The provision for employee benefits includes $57 000 payable within 1 year. • The warranty provision is in respect of a 12-month warranty given on certain goods sold. • Cob Ltd uses the single statement format for the statement of profit or loss and other comprehensive income and classifies expenses by function within the statement. Required Prepare the statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity of Cob Ltd for the year ended 30 June 2022 in accordance with the requirements of AASB 101/IAS 1, using statement captions that a listed company is likely to use. (LO3, LO4 and LO5) COB LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 $'000 Revenue 4 769 Cost of sales (3 287) Gross profit 1 482 Other income 6 Selling and distribution expenses (906) Administrative expenses (252) Finance costs (48) Profit before tax 282 Income tax expense (85)

16.47

Chapter16: Presentation of financial statements

Profit for the year Other comprehensive income Items that will not be reclassified to profit or loss: Revaluation of land, net of tax Revaluation of financial assets, net of tax Other comprehensive income, net of tax Total comprehensive income for the year

197

35 7 42 239

Explanations • Selling and distribution expenses comprise distribution expenses $86 000 + sales and marketing expenses $820 000 = $906 000. • Finance costs comprise interest $44 000 + other borrowing costs $4 000 = $48 000. • Alternatively, each item of other comprehensive income may be reported at gross e.g., land revaluation $50 000 + revaluation of financial assets $10 000, less tax related of $15 000 and $3 000, respectively. If adopting this approach, paragraph 91 of AASB 101/IAS 1 requires the amount of related tax to be reported separately for items that might be subsequently reclassified to profit or loss, and those for which subsequent reclassification is not permitted by Australian accounting standards.

16.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

COB LTD Statement of financial position as at 30 June 2022 Assets Current assets Cash and cash equivalents Trade and other receivables Inventories Non-current assets Financial assets recognised at fair value through OCI Goodwill Other intangible assets Property, plant and equipment Total assets Equity and liabilities Current liabilities Trade and other payables Borrowings Current tax payable Provisions Non-current liabilities Borrowings Deferred tax liability Provisions

$'000 104 529 902 1 535

225 870 45 917 2 057 3 592

510 125 25 94 754

Total liabilities Net assets

511 135 36 682 1 436 2 156

Equity Share capital Reserves Retained earnings Total equity

1 691 92 373 2 156

Explanations • Some items could be combined while still meeting minimum classifications of AASB 101/IAS 1 (e.g., goodwill and intangibles assets). • Cash and cash equivalents comprise cash on hand $4 000 + cash on deposit, at call $100 000 = $104 000.

16.49

Chapter16: Presentation of financial statements

•

Trade and other receivables comprise: $'000 450 (14) 93 529

Trade debtors Allowance for doubtful debts Sundry debtors • •

Inventories comprise raw materials $188 000 + finished goods $714 000 = $902 000. Property, plant and equipment comprise: $'000 Land and buildings 257 Accumulated depreciation – buildings (36) Plant and equipment 1260 Accumulated depreciation – plant and equipment (564) 917

•

Other intangible assets comprise patents $48 000 – amortisation of patent $3 000 = $45 000. • Current portion of long-term borrowings comprises bank loans $30 000 + other loans $110 000 = $140 000. • Provisions classified as current comprise $57 000 + warranty provision $37 000 = $94 000. • Long-term borrowings (or non-current financial liabilities) comprise: $'000 Banks loans 66 Repayable within 12 months (45) Other loans 570 Repayable within 12 months (80) 511 • •

Long-term provisions comprise employee benefit provisions $93 000 – $57 000 = $36 000. Reserves comprise land revaluation reserve $50 000 + financial assets revaluation reserve $42 000 = $92 000 (refer to the statement of changes in equity below for workings). COB LTD Statement of changes in equity for the year ended 30 June 2022 Share capital

Balance at 30 June 2021 Comprehensive income for the year Dividends Dividends reinvested Issues of share capital for cash Balance at 30 June 2022

$'000 1 541

30 120 1 691

Land Financial assets Retained Total revaluation revaluation earnings reserve reserve $'000 $'000 $'000 $'000 15 35 326 1 917 35 7 197 239

(150) (150) 30 120 373 2 156

16.50

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 16: Presentation of financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 16: Presentation of financial statements Multiple choice questions 1. AASB 101 Presentation of Financial Statements applies to the following sets of financial statements: a. b. *c. d.

interim financial statements. converted financial statements. general purpose financial statements. special purpose financial statements.

Answer: c Learning objective 16.1: describe the main components of financial statements.

2. Items that are dissimilar in nature must be presented separately in financial statements unless: a. b. c. *d.

they are financial items and can be off-set. the directors approve aggregation of the items. the auditors approval aggregation of the items. they are immaterial.

Answer: d Learning objective 16.2: explain the general principles underlying the preparation and presentation of financial statements.

3. Assets and liabilities, and income and expenses may be off-set if: a. *b. c. d.

there is no tax effect. required or permitted by a standard. they are financial assets and liabilities. they are in respect of borrowing and lending activities such as interest revenue and interest expense.

Answer: b Learning objective 16.2: explain the general principles underlying the preparation and presentation of financial statements.

16.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The primary source of information about an entity’s financial position is to be found in its statement of: a. b. *c. d.

cash flows. changes in equity. financial position. profit or loss and other comprehensive income.

Answer: c Learning objective 16.3: explain the requirements of the statement of financial position.

5. According to AASB 101 Presentation of Financial Statements, a required format for the presentation of a statement of financial position is: a. b. c. *d.

prescribed by the standard. not prescribed and no guidance is provided in the standard. not prescribed by the standard but details are found in the Corporations Act. not prescribed but guidance is provided in the standard for a suitable format.

Answer: d Learning objective 16.3: explain the requirements of the statement of financial position.

6. Which of the following items must be presented as a separate line item in the statement of financial position? *a. b. c. d.

Trade and other receivables. Share of profit of associates. Revenue. Cost of sales.

Answer: a Learning objective 16.3: explain the requirements of the statement of financial position.

7. An entity is required to classify its assets and liabilities as current or non-current unless it is considered more relevant and more reliable for decision-making purposes to present them according to their: a. b. *c. d.

age. value. liquidity. physical nature.

Answer: c Learning objective 16.3: explain the requirements of the statement of financial position.

16.2

Chapter 16: Presentation of financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

8. Under AASB 101 Presentation of Financial Statements, which of the following items is disclosed separately on the face of a statement of financial position? a. b. c. *d.

Investment property. Cash and cash equivalents. Current tax liability. All of these items.

Answer: d Learning objective 16.3: explain the requirements of the statement of financial position.

9. Industries where operating cycles may exceed twelve months typically include: a. b. c. *d.

retail. manufacturing. food preparation. property development.

Answer: d Learning objective 16.3: explain the requirements of the statement of financial position. 10. Which of the following items are normally classified as ‘current’ in a statement of financial position? I. II. III. IV.

deferred tax liabilities. accounts payable. inventories. goodwill.

*a. b. c. d.

II and III III and IV I, III and IV I, II, III and IV

Answer: a Learning objective 16.3: explain the requirements of the statement of financial position. 11. A liability will be classified as ‘non-current’ if it satisfies which of the following criterion? a. b. c. *d.

it is held primarily for the purposes of being traded. due to be settled within twelve months of the balance date. expected to be settled in the entity’s normal operating cycle. due to be settled more than twelve months after the statement of financial position date.

Answer: d Learning objective 16.3: explain the requirements of the statement of financial position.

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Testbank to accompany Financial reporting 3e by Loftus et al.

12. At reporting date for Year 1, Delta Limited had a loan from its financial institution that is expected to settle within six months. The loan term was renegotiated after reporting date and before the authorisation date of the financial statements and the repayment date was extended by two years. For the purposes of financial statement presentation for Year 1, this loan is classified by Delta Limited as a/an: *a. b. c. d.

current liability. contingent liability. non-current liability. off-statement of financial position liability.

Answer: a Learning objective 16.3: explain the requirements of the statement of financial position.

13. According to AASB 101, a required format for the presentation of the statement of profit or loss and other comprehensive income is: a. *b. c. d.

prescribed by the standard. not prescribed but guidance is provided in the standard for a suitable format. not prescribed and no guidance is provided in the standard for a suitable format. prescribed by the standard and further details are found in the Corporations Act.

Answer: b Learning objective 16.4: explain the requirements of the statement of profit or loss and other comprehensive income.

14. AASB 101 requires which of the following items to be disclosed separately in the statement of profit or loss and other comprehensive income: I. II. III. IV. V.

Cost of sales. Revenue. Finance costs. Share of the profit or loss from associates. Tax expense relating to extraordinary events.

a. b. *c. d.

I, II, and V II, III and V II, III, and IV III and V

Answer: c Learning objective 16.4: explain the requirements of the statement of profit or loss and other comprehensive income.

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Chapter 16: Presentation of financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

15. Which of the following items does not have to be presented as a line item on the face of a statement of profit or loss and other comprehensive income? *a. b. c. d.

Closing inventories. Post-tax profit or loss of discontinued operations. Profit or loss attributable to non-controlling interests. Revenue.

Answer: a Learning objective 16.4: explain the requirements of the statement of profit or loss and other comprehensive income.

16. In respect to the statement of profit or loss and other comprehensive income of an entity, AASB 101 prescribes: a. *b. c. d.

the presentation of line items of revenue, but not of income. line items that are considered to be of sufficient importance to warrant presentation. the presentation of line items comprising total expenses, but not line items comprising total revenue. a fixed format for the presentation of items in the statement of profit or loss and other comprehensive income.

Answer: b Learning objective 16.4: explain the requirements of the statement of profit or loss and other comprehensive income.

17. Under AASB 101, profit or loss attributable to non-controlling interests is required to be presented in the: a. b. c. *d.

statement of cash flows. statement of changes in equity. statement of financial position. statement of profit or loss and other comprehensive income.

Answer: d Learning objective 16.4: explain the requirements of the statement of profit or loss and other comprehensive income.

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Testbank to accompany Financial reporting 3e by Loftus et al.

18. Included in a statement of changes in equity are the following items: I. II. III. IV. V.

Gains or losses not recognised in the statement of profit or loss and other comprehensive income. New share issues. Dividends paid. Opening and closing balances. Profit or loss for the period.

a. b. *c. d.

I, II & III I, IV and V II, III, IV and IV I, II, IV and V

Answer: c Learning objective 16.5: explain the requirements of the statement of changes in equity.

19. Which of the following note disclosures are not required by AASB 101? a. b. *c. d.

Significant accounting policies used. Sources of estimation uncertainty in relation to impairment of assets. Names and qualifications of all directors of the entity. Dividends declared after end of reporting period but before the financial statements are authorised for issue.

Answer: c Learning objective 16.6: discuss other disclosures required by AASB 101/IAS 1 in the notes to the financial statements.

20. A set of financial statements prepared in accordance with AASB 101 comprises: I. II. III. IV. V.

A statement of cash flows. A statement of financial position. A statement of changes in equity. A statement of profit or loss and other comprehensive income. Notes.

a. *b. c. d.

I, II, and IV only I, II, III, IV and V. I, III and IV only I, II, III and IV only

Answer: b Learning objective 16.1: describe the main components of financial statements.

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Chapter 16: Presentation of financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

21. Under AASB 101, financial statements must be prepared and presented at least: a. *b. c. d.

monthly. annually. half-yearly. every four months.

Answer: b Learning objective 16.2: explain the general principles underlying the preparation and presentation of financial statements.

22. The application of International Financial Reporting Standards, with additional disclosure where necessary, is presumed to result in financial statements that: a. b. *c. d.

are unbiased. contain only material items. will result in a fair presentation. are free from error and misstatement.

Answer: c Learning objective 16.2: explain the general principles underlying the preparation and presentation of financial statements.

23. Which of the following items are included in a statement of changes in equity? I. II. III. IV.

Dividends paid. New share issues. Opening and closing balances. Profit or loss for the period.

a. b. c. *d.

II & III only. I, II, and III only. I, II and IV only. I, II, III and IV.

Answer: d Learning objective 16.5: explain the requirements of the statement of changes in equity.

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Testbank to accompany Financial reporting 3e by Loftus et al.

24. In relation to ‘retained earnings’, AASB 101 mandates the following disclosures: I. II. III. IV.

The beginning balance. The balance at reporting date. Any changes during the reporting period. The related tax adjustments in respect to any changes during the period.

*a. b. c. d.

I, II and III only. II, III and IV only. I, III and IV only. III and IV only.

Answer: a Learning objective 16.5: explain the requirements of the statement of changes in equity.

25. The issuing of bonus shares in lieu of a cash dividend would be separately disclosed in an entity’s: a. *b. c. d.

statement of cash flows. statement of changes in equity. statement of financial position. statement of comprehensive income.

Answer: b Learning objective 16.5: explain the requirements of the statement of changes in equity.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Janice Loftus

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 17: Statement of cash flows

Chapter 17: Statement of cash flows Comprehension questions 1. What is the purpose of a statement of cash flows? Refer to section 17.1. The purpose of a statement of cash flows is to present information about the changes in cash and cash equivalents of an entity during the period, classified by operating, investing and financing activities.

2. How might a statement of cash flows be used? Refer to section 17.1. A statement of cash flows may be used by investors, creditors and other users of financial statements to assist in evaluating the entity’s: (a) ability to generate cash and cash equivalents; (b) ability to affect the timing and certainty of generating future cash flows; and (c) need to utilise cash and cash equivalents. In conjunction with other financial statements, the statement of cash flows can be used to assist users in: (a) predicting future cash flows; (b) evaluating the entity’s financial structure, including liquidity, its ability to pay dividends, and its solvency, i.e., its ability to meet its obligations; (c) understanding the reasons for the difference between an entity’s profit and the net cash generated from operating activities, which can be helpful in evaluating the quality of earnings (profit); and (d) comparing the operating performance of different entities, particularly as cash flows are unaffected by different accounting choices and judgments under accrual accounting (although cash flows may be affected by decisions such as when to pay accounts); and (e) developing models to assess and compare the present value of expected future cash flows of different entities (however, this process is impeded in circumstances where it is difficult to identify non-recurring cash flows included in net cash flows from operating activities). 3. What is the meaning of ‘cash equivalents? Refer to section 17.2. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. They are held for the purpose of meeting short-term commitments and are not for investment or other purposes.

4. Explain the required classifications of cash flows under AASB107/IAS 7. Refer to section 17.3. Cash flows must be classified into cash flows from operating, investing and financing activities.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Operating activities are the principal revenue-producing activities of an entity and any other activities that do not fall within investing and financing activities. Examples include receipts from customers, payments to suppliers and employees, and income taxes. Operating cash flows may also include interest and dividends received (though these items may be classified as investing) and interest paid (though this item may be classified as financing). Investing activities are the acquisition and disposal of long-term assets (such as property, plant and equipment, subsidiaries, businesses and intangibles) and other investments not included in cash equivalents (such as shares in other entities). Only expenditures that result in an asset recognised in the statement of financial position are eligible for classification as investing activities. Financing activities are activities that result in changes in the size and composition of the contributed equity or borrowings of an entity (such as the issue of new shares, buyback of shares, new borrowings, repayment of borrowings and the payment of dividends, though payment of dividends is sometimes classified as an operating activity).

5. What sources of information are usually required to prepare a statement of cash flows? Refer to section 17.5. The statement of profit or loss and other comprehensive income and comparative statements of financial position and accounting records are the key sources of information used in the preparation of a statement of cash flows. Usually, the first step is to determine the net change in each class of assets, liabilities and equities over the relevant period from the comparative statements of financial position. The next step is to analyse the net amount of change in each item to enable the relevant receipts and payments to be identified. For example, the net change in net plant and equipment needs to be analysed between cash flows for purchases of new plant and equipment, changes arising from the disposal of plant and equipment and depreciation charged. Changes in the amount of outstanding accounts payable for the purchase of plant and equipment also need to be taken into account, together with any acquisitions or disposals for non-cash consideration (such as the issue of shares or through long-term borrowings or by way of a lease). The analysis typically requires information from the statement of profit or loss and other comprehensive income, such as information about sales revenue to analyse the change in accounts receivable. Other accounting records, such as borrowings and repayments, are also used.

6. Explain the differences between the presentation of cash flows from operating activities under the direct method and their presentation under the indirect method. Do you consider one method to be more useful than the other? Why? Refer to section 17.4.1. Under the direct method, classes of operating cash receipts and payments, such as receipts from customers and payments to suppliers and employees, are disclosed in the statement to arrive at net cash from operating activities. Under the indirect method the starting point is the profit before tax, which is adjusted for the effects of transactions of a non-cash nature (such as depreciation, impairment of non-current assets), and for any deferrals or accruals of past or future operating cash receipts or payments (increases or decreases in the amount of receivables or payables outstanding, changes in provisions) and items of income or expense included in the

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Chapter 17: Statement of cash flows

profit before tax that are associated with investing or financing activities (such as gains or losses on the sale of plant and equipment). Both methods have their advantages and disadvantages. The direct method shows the gross inflows and outflows that will assist a user in predicting future cash inflows and outflows and allows a comparison to be made of cash receipts from customers with reported revenues from customers. This comparison will assist in evaluating the quality of revenues. However, while the indirect method does not disclose the gross inflows and outflows arising from an entity’s operations, it does present a reconciliation of the operating profit before tax with the cash generated from operations. This is particularly useful in evaluating the quality of the earnings of an entity and flagging possible manipulation of earnings by management through varying accruals and provisions, such as a provision for restructuring.

7. The statement of cash flows is said to be of assistance in evaluating the financial strength of an entity, yet the statement can exclude significant non-cash transactions that can materially affect the financial strength of an entity. How does AASB 107/IAS 7 seek to overcome this issue? Refer to sections 17.6.2 and 17.6.3. AASB 107/IAS 7 seeks to overcome the problem referred to above by way of disclosure. Entities must disclose investing and financing transactions that do not involve cash flows, such as the acquisition of assets by means of a lease or by assuming other liabilities or through an equity issue, the conversion of debt to equity, the refinancing of a longterm debt, and the payment of dividends through a share reinvestment scheme. Changes in the investment structure of an entity may arise from changes in the ownership interests of subsidiaries or other business units. In such cases, AASB 107/IAS 7 requires the aggregate cash flows from obtaining control of subsidiaries and other business units and the aggregate cash flows from the loss of control of subsidiaries and other business units to be reported in the investing section of the statement of cash flows. This reporting is then required to be supplemented by separate disclosure in the notes of the aggregate: • total consideration paid or received • the portion of the consideration comprising cash and cash equivalents • the amount of cash and cash equivalents in the subsidiary or other business over which control is obtained or lost • the amount of the assets and liabilities other than cash and cash equivalents in the subsidiary or other business over which control is obtained or lost, summarised by each major category.

8. An entity may report significant profits over a number of successive years and still experience negative net cash flows from its operating activities. How can this happen? This question requires reflection on the differences between profit and net cash flows from operating activities. This situation is typical of an entity that is growing in size, such that increases in receivables, inventories and prepayments exceed increases in accounts payable, accrued liabilities and provisions. The collection of cash from customers usually lags the payment to

17.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

suppliers for purchases of goods and services. In a growth phase, this may generate negative operating cash flows because the entity incurs cash outflows to increase its working capital, particularly inventories, to accommodate expected increases in future sales volume.

9. An entity may report significant accounting losses over a number of successive years and still report positive net cash flows from operating activities over the same period. How can this happen? This question requires reflection on the differences between profit and net cash flows from operating activities. The situation is typical of an entity that has large non-cash charges to the statement of profit or loss and other comprehensive income, such as depreciation, impairment losses, and increasing provisions, including provisions for employee benefits. It may also arise when an entity decreases in size through reduction in the level of inventories and receivables where this is not accompanied by large cash outflows for restructuring or retrenchments.

10. What supplementary disclosures are required when a consolidated statement of cash flows is being prepared for a group that has obtained or lost control of a subsidiary? Refer to section 17.6.2. AASB 107/IAS 7 requires the separate reporting of the aggregate cash flows from obtaining or losing control as separate items in the investing section of the statement of cash flows. This reporting must be supplemented by separate disclosure in the notes of the aggregate: • consideration paid or received • the portion of the consideration that comprises cash and cash equivalents • the amount of cash and cash equivalents in the subsidiaries or other businesses over which control is obtained or lost • the amount of the assets and liabilities other than cash or cash equivalents in the subsidiaries or other businesses over which control is obtained or lost, summarised by each major category.

17.5

Chapter 17: Statement of cash flows

Case studies Case study 17.1 Increasing cash flow, decreasing profit Lana Ferdinand, the owner-manager of a small proprietary company, had carefully monitored the cash position over the past financial year, and was pleased to note at the end of the year that the cash position was strong, and had shown a healthy 50% increase over the year. When presented with the statement of profit or loss for the year, she was dismayed to note that profit had deteriorated significantly. In her anger, she accuses you of having made errors in the accounting since ‘such a silly situation could not possibly exist’. Required Explain how you would respond to Lana Ferdinand. An increase in cash does not necessarily correspond to generating a profit. There are several reasons for this. First, cash may be generated from operating, financing or investing activities, or any combination of these. The company’s net increase in cash may have resulted from cash generated from financing activities, such as borrowing, which has no direct effect on profit. Investing activities, such as the sale of equipment, may also be a source of cash inflows. The sale of equipment may increase or decrease profit depending on whether the proceeds of sale exceed the carrying amount. Lastly, even though operating activities may be a dominant source of net cash inflows, the company might not generate a profit result in the current period. Profit is determined on an accrual basis, which can give rise to timing differences between cash flows and the recognition of income and expenses. For example, some operating cash inflows, such as the collection of receivables outstanding at the beginning of the period, may relate to revenue that has already been recognised in a previous period. Similarly, profit may have been decreased by the recognition of expenses that have not yet resulted in a cash outflow.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 17.2 Classification of cash flows The accountant for Delta Ltd prepared the following statement of cash flows. The managers were worried that investors would be displeased by the negative operating cash flow and that the company’s share price might fall as a result. One manager suggested that the interest paid and interest received might be classified as financing cash flows and investing cash flows, respectively, so that the company’s cash flow would look better. Required 1. Calculate the net cash flows for each activity if Delta Ltd reclassified interest paid and interest received as suggested by the manager. 2. Drawing on your understanding of the efficient market hypothesis (see chapter 2), is the change in the classification of interest paid or received in the statement of cash flows likely to make a difference to the share price? Give reasons for your answer.

1. Applying the suggested classification of interest paid and interest received, net cash flow from each activity would be as follows: Net cash inflow from operating activities = $120 000 (workings: $870 000 - $650 000 - $100 000) Net cash outflow from investing activities = ($60 000) (workings: $300 000 - $400 000 + $40 000) Net cash outflow from financing activities = ($70 000) (workings: $160 000 - $30 000 - $200 000)

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Chapter 17: Statement of cash flows

2. The efficient market hypothesis (in the semi-strong form) predicts that the share price makes a rapid and unbiased response to the release of publicly available information, such that the share price reflects all publicly available information. The interest paid and received is disclosed in the statement of cash flows. Accordingly, if the market is efficient in the semi-strong form, the share price should reflect all the information about the cash flow items, including interest paid and received, and not just focus on the net cash flows from each activity.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 17.3 Cash flows of top Australian companies Select three ASX-listed companies from different industries (e.g. metals and mining, telecommunication services, consumer staples). Go to www.asx.com.au and find the most recent annual financial statements of the three companies. Required Compare the companies’ statements of cash flows and report your findings, especially with respect to the major categories of operating activities, investing activities and financing activities. Answers will vary depending on the companies and financial statements selected for the exercise. For purposes of illustration, the 2019 statement of cash flows for the following three companies have been selected: • BlueScope Limited: www.bluescope.com (select Investors) • Telstra Corporation Limited: www.telstra.com.au (select About us/Investors) • Wesfarmers: www.wesfarmers.com.au The three companies classify cash flows as operating, investing and financing, consistent with the requirements of AASB 107/IAS 7. Similarities and differences are summarised as follows:

Method of presentation of operating cash flows Classification of borrowing costs Classification of interest received Classification of dividends received Classification of dividends paid

BlueScope Direct Operating Operating Operating Financing

Telstra Direct Financing Investing Investing Financing

Wesfarmers Direct Operating Operating Operating Financing

The three companies use the direct method of presenting operating cash flows. They are consistent in classifying dividends paid as financing cash flows but differences arise in how other items are classified. BlueScope and Wesfarmers classify borrowing costs, interest received and dividends received as operating cash flows. In contrast, Telstra classifies borrowing costs as financing cash flows and classifies interest received and dividends received as investing cash flows.

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Chapter 17: Statement of cash flows

Application and analysis exercises Exercise 17.1 Cash received from customers At 30 June 2021, Ruby Ltd had net accounts receivable of $360 000. At 30 June 2022, accounts receivable were $440 000 and sales for the year amounted to $1 500 000. Doubtful debts expense was $75 000 for the year. Discount allowed was $45 000 for the year. Required Calculate cash received from customers by Ruby Ltd for the year ended 30 June 2022. (LO5) Increase in net accounts receivable from 30 June 2021 to 30 June 2022 = $440 000 – $360 000 = $80 000. Cash received from customers = Sales – Increase in net accounts receivable – Doubtful debts expense – Discount allowed = $1 500 000 – $80 000 – $75 000 – $45 000 = $1 300 000.

Balance 30 June 2021 Sales revenue

Accounts receivable (net) $ 360 000 Doubtful debts expense 1 500 000 Discount allowed Cash at bank (cash received) . Balance 30 June 2022 1 860 000

$ 75 000 45 000 1 300 000 440 000 1 860 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.2 Cash payments to suppliers Purple Ltd had the following balances.

Inventories Accounts payable for inventories purchases

30 June 2021

30 June 2022

$ 510 000 103 000

$ 630 000 95 000

Cost of sales was $2 400 000 for the year ended 30 June 2022. Required Calculate cash payments to suppliers for the year ended 30 June 2022. (LO5)

Inventory Accounts payable for inventory purchases

2021 $ 510 000 103 000

2022 $ 630 000 95 000

Increase (Decrease) $ 120 000 (8 000)

Cash payments to suppliers = Cost of sales + increase in inventory + decrease in accounts payable for inventory purchases = $2 400 000 + $120 000 + $8 000 = $2 528 000

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Chapter 17: Statement of cash flows

Exercise 17.3 Cash received from customers At 30 June 2021, Orange Ltd had accounts receivable of $200 000. At 30 June 2022, accounts receivable were $240 000 and sales for the year amounted to $2 100 000. Bad debts amounting to $50 000 had been written off during the year, and discounts of $17 000 had been allowed in respect of payments from customers made within prescribed credit terms. Orange Ltd did not have an allowance for doubtful debts in either year. Required Calculate cash received from customers for the year ended 30 June 2022. (LO5)

Accounts receivable

2021 $ 200 000

2022 $ 240 000

Increase $ 40 000

Cash received from customers = Sales – increase in accounts receivable – bad debts written-off – discounts allowed = $2 100 000 – $40 000 – $50 000 – $17 000 = $1 993 000.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.4 Financing cash flows The following information has been compiled from the accounting records of Marshall Ltd for the year ended 30 June 2022. Dividends — paid — dividend reinvestment scheme Additional cash borrowing Issue of shares — cash — dividend reinvestment

$ 50 000 30 000 75 000 75 000 30 000

Required Determine the amount of net cash from financing activities Marshall Ltd would report in its statement of cash flows for the year ended 30 June 2022. (LO5) Proceeds from borrowings Proceeds from share issue Dividends paid Net financing cash flows

$ 75 000 75 000 (50 000) 100 000

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Chapter 17: Statement of cash flows

Exercise 17.5 Net investing cash flows The statement of financial position of Lily Ltd at 30 June 2022 recorded the following items. 30 June 2021 Land, at independent valuation Plant, at cost Accumulated depreciation Investments at fair value through OCI Goodwill Land revaluation surplus Investments revaluation reserve

500 000 350 000 (100 000) 150 000 125 000 100 000 25 000

30 June 2022 $

600 000 425 000 (140 000) 200 000 100 000 170 000 55 000

Additional information • Impairment of goodwill was $25 000 in the year ended 30 June 2022. • There were no acquisitions or disposals of land. • There were no disposals of plant or investments. • The land revaluation surplus increase is net of deferred tax of $30 000. • The investments revaluation reserve increase for the year is net of deferred tax of $10 000. Required Prepare the investing section of the statement of cash flows for Lily Ltd for the year ended 30 June 2022. (LO5)

Land, at independent valuation Plant, at cost Accumulated depreciation Investments at fair value through OCI

2021 $ 500 000 350 000 (100 000) 150 000

Goodwill Deferred tax liability

125 000

Land revaluation surplus Investments revaluation reserve Impairment of goodwill Cash paid for plant Cash paid for investments

100 000 25 000

Dr $ (1) 100 000 (2) 75 000

Cr $

40 000 (3) 40 000 (4) 10 000 (5) 25 000 (1) 30 000 (3) 10 000 (1) 70 000 (3) 30 000 (5) 25 000

(2) 75 000 (4) 10 000

2022 $ 600 000 425 000 (140 000) 200 000 100 000

170 000 55 000 25 000 (75 000) (10 000)

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Explanations: (1) There are no acquisitions or disposals of land. Hence, the increase results from the revaluation of land at independent valuation amounting to $100 000. The offsetting credits are to deferred tax $30 000 and to land revaluation reserve $70 000. (2) There are no disposals of plant; hence, the increase in plant represents additions amounting to $75 000. (3) There were no disposals of investments. The investments revaluation reserve has increased by $30 000 and there is related deferred tax of $10 000. Hence the revaluation of investments must have amounted to $40 000. (4) Since investments increased by $50 000 the difference is accounted for by the purchase of additional investments $10 000 ($50 000 – $40 000). (5) The change in goodwill is wholly accounted for by the impairment write-off $25 000. Hence, investing activities comprise: Cash paid for plant Cash paid for investments Net cash used in investing activities

$ (75 000) (10 000) (85 000)

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Chapter 17: Statement of cash flows

Exercise 17.6 Investing cash flows The following information has been compiled from the accounting records of Robin Ltd for the year ended 30 June 2022.

Required Determine the amount of investing net cash outflows Robin Ltd would report in its statement of cash flows for the year ended 30 June 2022. (LO5)

Cash paid for land Cash paid for plant Proceeds from sale of plant Net investing cash flows

$ (250 000) (250 000) 42 000 (458 000)

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.7 Net financing cash flows The following information has been extracted from the accounting records of Barney Ltd. 30 June 2021 Borrowings Share capital Property revaluation surplus Retained earnings

100 000 200 000 50 000 75 000

30 June 2022 $

200 000 250 000 60 000 95 000

Additional information • Borrowings of $20 000 were repaid during the year to 30 June 2022. New borrowings include $50 000 vendor finance arising on the acquisition of a property. • The increase in share capital includes $30 000 arising from the company’s dividend reinvestment scheme. • The movement in retained earnings comprises profit for the year $90 000, net of dividends $70 000. • There were no dividends payable reported in the statement of financial position at either 30 June 2021 or 30 June 2022. Required Prepare the financing section of the statement of cash flows for Barney Ltd for the year ended 30 June 2022. (LO5)

Property Borrowings

2021 $ x 100 000

Share capital

200 000

Retained earnings Profit for year Repayment of borrowings Proceeds from borrowings Dividends paid Proceeds from share issue

75 000

Dr $ (2) 50 000 (1) 20 000

(5) 70 000 (4) 90 000

Cr $ (2) 50 000 (3) 70 000 (5) 30 000 (6) 20 000 (4) 90 000 (1) 20 000

(3) 70 000 (5) 40 000 (6) 20 000

2022 $ y 200 000 250 000 95 000 (20 000) 70 000 (40 000) 20 000

Explanations: (1) Represents repayment of borrowings $20 000 (refer to additional information). (2) Vendor finance $50 000 concerning acquisition of property. This is a non-cash transaction (refer to additional information).

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Chapter 17: Statement of cash flows

(3) New borrowings $70 000 - determined as the increase in borrowings after taking into account the repayment and the non-cash transaction. (4) Represents profit for year $90 000. (5) Dividends comprise dividends settled under share investment scheme $30 000 and paid in cash $40 000. (6) Shares issue for cash $20 000, calculated as the increase in share capital $50 000 less the amount explained by the share investment scheme $30 000. Hence, financing activities comprise: Proceeds from borrowings Repayment of borrowings Proceeds from share issue Dividends paid Net cash from financing activities

$ 70 000 (20 000) 20 000 (40 000) 30 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.8 Cash receipts from customers and cash paid to suppliers and employees The accounting records of Stella Ltd recorded the following information.

Accounts receivable Inventories Prepaid expenses Accounts payable for inventories purchased Employee liabilities Other accruals (including accrued interest: 2021 – $1 400; 2022 – $1 700) Sales revenue Cost of sales Expenses (including $10 000 depreciation and $4 000 interest)

30 June 2021

30 June 2022

80 000 64 000 2 000 30 000 10 000 8 000

100 000 68 000 6 000 32 000 11 000 7 600 1 200 000 960 000 150 000

Required 1. Calculate the amount of cash received from customers during the year ended 30 June 2022. 2. Calculate the amount of cash paid to suppliers and employees during the year ended 30 June 2022. (LO5)

Accounts receivable Inventories Prepaid expenses Accounts payable for inventory Employee liabilities Accruals – Interest Accruals – Other

2021

2022

$ 80 000 64 000 2 000 30 000 10 000 1 400 6 600

$ 100 000 68 000 6 000 32 000 11 000 1 700 5 900

Cash received from customers Sales Less increase in accounts receivables

Cash paid to suppliers and employees

Increase (Decrease) $ 20 000 4 000 4 000 2 000 1 000 300 (700) $ 1 200 000 (20 000) 1 180 000 $

17.19

Chapter 17: Statement of cash flows

Cost of sales Expenses Less depreciation expense Less interest expense Increase in inventories Increase in prepaid expenses Increase in accounts payable Increase in employee liabilities Decrease in other accruals excluding interest

960 000 150 000 (10 000) (4 000)

136 000 4 000 4 000 (2 000) (1 000) 700 1 101 700

17.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.9 Preparation of a statement of cash flows A summarised comparative statement of financial position of Graham Ltd is presented below. 30 June 2021 Cash Trade receivables Investments Plant Accumulated depreciation

Trade accounts payable

30 June 2022

54 000 94 000 35 000 260 000 (90 000)

82 000 146 000 30 000 360 000 (120 000)

353 000

498 000

95 000

122 000

— 200 000 58 000 —

Deferred tax liability Share capital Retained earnings Investment revaluation surplus $

353 000

6 000 250 000 113 000 7 000 $

498 000

Additional information • An investment was sold for $18 000. There was no gain or loss accumulated in the investment revaluation surplus in respect of this investment. • There were no disposals of plant. • The profit for the year was $97 000, after income tax expense of $38 000. • A dividend of $42 000 was paid during the year. • The only item of other comprehensive income was a gain on revaluation of financial investments and its associated tax effect. Required Using the indirect method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 17 for the year ended 30 June 2022. (LO3 and LO5)

Cash Trade receivables Investments Plant Accumulated depreciation

2021 $ 54 000 94 000 35 000 260 000 (90 000)

Dr $ 28 000 (2) 52 000 (9) 13 000 (4) 100 000

Cr $

2022 $ 82 000 146 000 (3) 18 000 30 000 360 000 (5) 30 000 (120 000)

17.21

Chapter 17: Statement of cash flows

353 000 95 000 200 000 58 000

Accounts payable Deferred tax liability Share capital Retained earnings Investment revaluation surplus

(1) 38 000 (8) 42 000

353 000

Operating activities Profit before tax Increase in accounts receivable Increase in accounts payable Depreciation expense Cash generated from operations Income tax paid Net cash from operating activities Investing activities Cash paid for plant Proceeds from sale of investments Financing activities Proceeds from share issue Dividends paid Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(6) 27 000 (9) 6 000 (7) 50 000 (1) 135 000 (9)

7 000

(1) 135 000 (2) 52 000 (6) 27 000 (5) 30 000 (1) 38 000

(3) 18 000

498 000 122 000 6 000 250 000 113 000 7 000 498 000 135 000 (52 000) 27 000 30 000 140 000 (38 000) 102 000

(4) 100 000 (100 000) 18 000 (82 000)

(7) 50 000 (8) 42 000

50 000 (42 000) 8 000 28 000 54 000 82 000

Explanations: (1) The profit before tax $135 000 is determined by adding back the income tax expense $38 000 to the profit for period $97 000. The income tax expense is equal to the amount of income tax paid as there was no income tax payable at 30 June 2021 or 2022, and the increase in the deferred tax liability results from the revaluation of investments. Refer to item (9). (2) Increase in accounts receivable $52 000. (3) Investments were sold for $18 000 as there was no gain reclassified to other comprehensive income from the investment revaluation surplus or otherwise recognised. Thus, both the cash proceeds and the carrying amount of investment sold was $18 000. (4) There were no disposals of plant; hence the increase in plant represents cash paid for purchase of plant $100 000. (5) As there were no disposals of plant, the change in accumulated depreciation represents the depreciation expense for the year $30 000. (6) Increase in accounts payable $27 000. (7) Increase in share capital $50 000 represents proceeds from share issue. (8) Dividends paid $42 000. (9) The amount of the revaluation of investments is determined as $13 000 because this is the increment necessary for the closing balance of Investments to be $30 000 after taking into

17.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

account the $18 000 reduction in the Investments account from the derecognition of investments that were sold. Refer to explanation item (3). As the revaluation of investments increased the accumulated surplus by $7 000, the corresponding tax effect must be $6 000 ($13 000 - $7 000). This explains the increase in the deferred tax liability. GRAHAM LTD Statement of cash flows for the year ended 30 June 2022 $ Cash flows from operating activities Profit before tax Depreciation expense Increase in accounts receivable Increase in accounts payable Cash generated from operations Income tax paid Net cash from operating activities

135 000 30 000 (52 000) 27 000 140 000 (38 000) 102 000

Cash flows from investing activities Cash paid for plant Proceeds from sale of investments Net cash used in investing activities

(100 000) 18 000 (82 000)

Cash flows from financing activities Proceeds from share issue Dividends paid Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

50 000 (42 000) 8 000 28 000 54 000 82 000

17.23

Chapter 17: Statement of cash flows

Exercise 17.10 Preparation of a statement of cash flows A summarised comparative statement of financial position of Charlton Ltd is presented below.

Cash Accounts receivable (net) Prepayments Inventories Land Plant Accumulated depreciation Deferred tax asset

Accounts payable Accrued liabilities Current tax payable Dividend payable Borrowings Share capital Retained earnings

30 June 2021

30 June 2022

96 000 147 000 20 000 60 000 40 000 368 000 (45 000) 20 000

49 000 163 000 15 000 104 000 40 000 420 000 (70 000) 24 000

$ 706 000

745 000

$ 140 000 36 000 24 000 56 000 73 000 335 000 42 000

152 000 42 000 31 000 50 000 75 000 345 000 50 000

$ 706 000

745 000

Additional information • Plant additions amounted to $72 000. Plant with a carrying amount value of $15 000. (cost $20 000, accumulated depreciation $5000) was sold for $22 000. The proceeds for the sale of plant had not been received by 30 June 2022. • Accounts payable at 30 June 2021 include $34 000 arising from the acquisition of plant. • Accrued liabilities include accrued interest of $3000 at 30 June 2021 and $4000 at 30 June 2022. • The increase in share capital of $10 000 arose from the reinvestment of dividends. • The profit for the year ended 30 June 2022 was $92 000, after interest expense of $6000 and income tax expense of $46 000. There were no other items of comprehensive income. • Dividends declared out of profits for the year were: interim dividend $34 000, final dividend $50 000. Required

17.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Using the indirect method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 30 June 2022. (LO3 and LO5)

Cash Accounts receivable - sale of plant Accounts receivable - other Prepayments Inventory Land Plant Accumulated depreciation Deferred tax asset Accounts payable - purchase of plant Accounts payable - other Accrued liabilities - interest Accrued liabilities - other Current tax payable Dividend payable Borrowings Share capital Retained earnings

2021 $ 96 000 147 000 20 000 60 000 40 000 368 000 (45 000) 20 000 706 000 34 000 106 000 3 000 33 000 24 000 56 000 73 000 335 000 42 000

Dr $

Cr $ (23) 47 000

(18) 22 000 (2) (3)

6 000 5 000

(4) 44 000 (14) 72 000 (16) 20 000 (17) 5 000 (8) 30 000 (13) 4 000 (15) 34 000 (5) 46 000 (10) 1 000 (6) 5 000 (12) 7 000 (22)

6 000

(19) 2 000 (20) 10 000 (11) 46 000 (1) 138 000 (21) 84 000

706 000 Operating activities Profit before tax Decrease in accounts receivable - other Decrease in prepayments Increase in inventory Increase in accounts payable - other Increase in accrued liabilities - other Depreciation expense Gain on sale of plant Interest expense Interest paid Income tax paid

2022 $ 49 000 22 000 141 000 15 000 104 000 40 000 420 000 (70 000) 24 000 745 000 152 000 4 000 38 000 31 000 50 000 75 000 345 000 50 000 745 000

(1) 138 000 (2) 6 000 (3) 5 000 (4) 44 000 (5) 46 000 (6) 5 000 (8) 30 000 (7) 7 000 6 000 236 000 51 000 (10) 1 000 (9) 6 000 (12) 7 000 (11) 46 000 (13) 4 000 244 000 107 000 (9)

Investing activities Cash paid for plant

138 000 6 000 5 000 (44 000) 46 000 5 000 30 000 (7 000) 6 000 185 000 (5 000) (43 000) 137 000

(14) 72 000

17.25

Chapter 17: Statement of cash flows

Proceeds from sale of plant

Financing activities Proceeds from borrowings Dividends paid

Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(15) 34 000 (16) 20 000 (17) 5 000 (7) 7 000 (18) 22 000 27 000 133 000

(106 000)

(19) 2 000 (20) 10 000 (21) 84 000 (22) 6 000 12 000 90 000 (23)

2 000

(106 000)

(80 000) (78 000) (47 000) 96 000 49 000

Explanations: (1) Profit before tax $138 000, calculated as profit + income tax expense. (2) Decrease in net accounts receivable (excluding receivables for plant) $6 000. (3) Decrease in prepayments $5 000. (4) Increase in inventory $44 000. (5) Increase in accounts payable (excluding accounts payable arising from the purchase of plant) $46 000. (6) Increase in accrued liabilities (excluding interest accrued liabilities) $5 000. (7) Gain on sale of plant $7 000. (8) Depreciation expense for the year $30 000. This is calculated as the increase in accumulated depreciation, after taking into account the reduction in accumulated depreciation for the plant sold during the year. Refer to explanation item (17). (9) Adjustment for interest expense $6 000 included in profit before tax. (10) Increase in accrued interest; note that the interest paid $5 000 = interest expense $6 000 – increase in accrued interest $1 000. (11) Income tax expense for year $46 000. (12) Increase in current tax payable $7 000. (13) Increase in deferred tax asset $4 000. As there were no items of other comprehensive income, the increase in deferred tax asset is recognised as the deferred component of income tax expense. (14) Plant additions for year $72 000. (15) Decrease in accounts payable for plant $34 000. (16) Cost of plant sold $20 000 (refer to additional information). (17) Accumulated depreciation on plant sold $5000. The book value of plant sold was $15 000; proceeds from sale = $15 000 + gain on sale $7 000 = $22 000. (18) Increase in accounts receivable arising from sale of plant $22 000; hence, there is no cash received in the current year arising from the sale of plant. (19) Increase in borrowings $2 000. This represents the increase in borrowings and in the absence of other information it is assumed there are no loan repayments. (20) Dividends reinvested as share capital $10 000 (refer to additional information). (21) Dividends declared out of profits for the year $84 000.

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(22)

(23)

Decrease in dividend payable $6 000. Note dividends paid amount to $80 000, which comprises dividend payable at beginning of year $56 000 + Interim dividend $34 000 – Reinvestment of dividends $10 000. Net decrease in cash and cash equivalent $47 000.

The doubtful debts expense is not used in calculating net cash from operating activities under the indirect method. It is a component of the movement in net receivables. CHARLTON LTD Statement of cash flows for the year ended 30 June 2022 $ Cash flows from operating activities Profit before tax 138 000 Interest expense 6 000 Depreciation expense 30 000 Gain on sale of plant (7 000) Decrease in accounts receivable 6 000 Increase in inventory (44 000) Decrease in prepayments 5 000 Increase in accounts payable 46 000 Increase in accrued liabilities 5 000 Cash generated from operations 185 000 Interest paid (5 000) Income tax paid (43 000) Net cash from operating activities 137 000 Cash flows from investing activities Cash paid for plant (106 000) Net cash used in investing activities (106 000) Cash flows from financing activities Proceeds from borrowings 2 000 Dividends paid (80 000) Net cash used in financing activities (78 000) Net decrease in cash and cash equivalents (47 000) Cash and cash equivalents at beginning of year 96 000 Cash and cash equivalents at end of year 49 000

17.27

Chapter 17: Statement of cash flows

Exercise 17.11 Preparation of a statement of cash flows A summarised comparative statement of financial position of Findlay Ltd is presented below.

Cash Trade accounts receivable Inventories Prepayments Land Plant Accumulated depreciation

Accounts payable Borrowings Share capital Retained earnings

30 June 2021

30 June 2022

40 000 130 000 116 000 20 000 160 000 540 000 (120 000)

906 000

$ 1 146 000

90 000 320 000 400 000 96 000

906 000

$ 1 146 000

182 000 180 000 124 000 24 000 180 000 640 000 (184 000)

96 000 400 000 460 000 190 000

Additional information • There were no disposals of land or plant during the year. • A $60 000 borrowing was settled through the issue of ordinary shares. There were no other repayments of borrowings. • Profit for the year was $240 000, interest expense was $28 000, and income tax expense was $82 000. There were no items of other comprehensive income. • A $146 000 dividend was paid during the year. • Sales revenue for the year was $600 000. There was no other revenue. Required 1. Using the indirect method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 30 June 2022. 2. Prepare the operating section of the statement of cash flows using the direct method. (LO3, LO4 and LO5) 2021 Dr Cr 2022 $ $ $ $ Cash 40 000 (14)142 000 182 000 Trade accounts receivable 130 000 (2) 50 000 180 000 Inventories 116 000 (3) 8 000 124 000 © John Wiley and Sons Australia Ltd, 2020

17.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Prepayments Land Plant Accumulated depreciation Accounts payable Borrowings Share capital Retained earnings

20 000 160 000 560 000 (120 000) 906 000 90 000 320 000 400 000 96 000

(4) 4 000 (12) 20 000 (13) 80 000 (7) 64 000 (5) 6 000 (9) 60 000 (10) 140 000 (9) 60 000 (11)146 000 (1) 322 000 (8) 82 000

906 000 Operating activities Profit before tax Increase in trade accounts receivable Increase in inventories Increase in prepayments Increase in accounts payable Interest expense Depreciation expense Cash generated from operations Interest paid Income taxes paid Net cash from operating activities

1 146 000 (1) 322 000

62 000 (6) 28 000 (8) 82 000 172 000

322 000 (50 000) (8 000) (4 000) 6 000 28 000 64 000 358 000 (28 000) (82 000) 248 000

(12) 20 000 (13) 100 000 120 000

(20 000) (100 000) (120 000)

(2) 50 000 (3) 8 000 (4) 4 000 (5) 6 000 (6) 28 000 (7) 64 000 420 000

420 000

Investing activities Cash paid for land Cash paid for plant Net cash used in investing activities Financing activities Proceeds from borrowings Dividend paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

24 000 180 000 640 000 (184 000) 1 146 000 96 000 400 000 460 000 190 000

(10) 140 000 (11) 146 000 140 000 146 000 (14)

140 000 (146 000) (6 000) 142 000 40 000 182 000

Explanations: (1) Profit before tax $322 000. (2) Increase in trade accounts receivable $50 000. (3) Increase in inventories $8 000 (4) Increase in prepayments $4 000. (5) Increase in accounts payable $6 000. (6) Interest expense $28 000, which, in the absence of accrued interest, equals interest paid. (7) There were no disposals of plant; hence the increase in accumulated depreciation must represent the depreciation expense for the year $64 000.

17.29

Chapter 17: Statement of cash flows

(8) (9) (10) (11) (12) (13) (14)

Tax expense $82 000; in the absence of current tax payable and deferred tax in the statement of financial position, it is assumed to also equal income tax paid. Borrowing of $60 000 settled through the issue of shares - a non-cash transaction. Proceeds from borrowings $140 000 is determined by as the difference in borrowings after adjusting for the $60 000 settlement. Dividend paid $146 000 (refer to additional information). There were no disposals of land and there is no revaluation reserve; hence the increase in the carrying value of land must represent the purchase of land $20 000. There were no disposals of plant, hence the increase in the carrying value of plant must represent the purchase of plant $80 000. Increase in cash and cash equivalents $142 000 ($182 000 - $40 000). FINDLAY LTD Statement of cash flows for the year ended 30 June 2022 Cash flows from operating activities Profit before tax Interest expense Depreciation expense Increase in trade accounts receivable Increase in inventory Increase in prepayments Increase in accounts payable Cash generated from operations Interest paid Income tax paid Net cash from operating activities

$ 322 000 28 000 64 000 (50 000) (8 000) (4 000) 6 000 358 000 (28 000) (82 000) 248 000

Cash flows from investing activities Cash paid for land Cash paid for plant Net cash used in investing activities

(20 000) (100 000) (120 000)

Cash flows from financing activities Proceeds from borrowings 140 000 Dividends paid (146 000) Net cash used in financing activities (6 000) Net increase in cash and cash equivalents 142 000 Cash and cash equivalents at beginning of year 40 000 Cash and cash equivalents at end of year 182 000 Cash received from customers = Sales – increase in trade accounts receivable = $600 000 - $50 000 = $550 000 Revenue - expenses (excluding tax expense) = profit before tax

17.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Hence, total expenses excluding income tax expense = $600 000 - $322 000 = $278 000 $ Total expenses 278 000 - depreciation expense (64 000) - interest expense (28 000) Expenses for supply of goods and services 186 000 + increase in inventory 8 000 + increase in prepayments 4 000 - increase in accounts payable (6 000) Cash paid to suppliers of goods and services 192 000 2. Cash from operations presented using the direct method: Cash flows from operating activities Cash received from customers Cash paid to suppliers of goods and services Interest paid Income tax paid Net cash from operating activities

$ 550 000 (192 000) (28 000) (82 000) 248 000

17.31

Chapter 17: Statement of cash flows

Exercise 17.12 Preparation of a statement of cash flows A summarised comparative statement of financial position of Danica Ltd is presented below, together with the statement of profit or loss and other comprehensive income for the year ended 30 June 2022.

Cash Trade receivables Inventories Investments at fair value through OCI Plant Accumulated depreciation

Accounts payable Accrued interest Current tax payable Deferred tax liability Borrowings Share capital Retained earnings Investment revaluation reserve

30 June 2021

30 June 2022

$ 30 000 46 000 30 000 35 000 125 000 (23 000)

$ 68 000 70 000 32 000 40 000 150 000 (35 000)

$ 243 000

$ 325 000

$ 39 000 3 000 10 000 — 60 000 100 000 31 000 —

$ 43 000 5 000 12 000 1 500 100 000 100 000 60 000 3 500

$ 243 000

$ 325 000

DANICA LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 Sales Cost of sales

700 000 (483 000)

Gross profit Distribution costs Administration costs Interest

217 000 (62 000) (74 000) (6 000)

Profit before tax

75 000

17.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Income tax expense

(23 000)

Profit for the year Other comprehensive income Gain on revaluation of investments (net of tax)

52 000 3 500

Total comprehensive income

55 500

Additional information • There were no disposals of investments or plant during the year. • A dividend of $23 000 was paid during the year. • The deferred tax liability is in relation to investments. Required Using the direct method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 30 June 2022. (LO3 and LO5)

Cash Trade receivables Inventory Investments Plant Accumulated depreciation Accounts payable Accrued interest Current tax payable Deferred tax liability Borrowings Share capital Retained earnings Investment revaluation reserve Receipts from customers Sales Increase in receivables Cash received from customers Payments to suppliers and employees Cost of sales Other expenses: Distribution costs

2021

2022

$ 30 000 46 000 30 000 35 000 125 000 (23 000) 243 000 39 000 3 000 10 000 60 000 100 000 31 000 243 000

$ 68 000 70 000 32 000 40 000 150 000 (35 000) 325 000 43 000 5 000 12 000 1 500 100 000 100 000 60 000 3 500 325 000

Increase (decrease) $ 38 000 24 000 2 000 5 000 25 000 12 000 4 000 2 000 2 000 1 500 40 000 29 000 3 500

700 000 (24 000) 676 000 483 000 62 000

17.33

Chapter 17: Statement of cash flows

Administration costs 74 000 Depreciation expense (12 000) 124 000 Increase in inventory 2 000 Increase in accounts payable (4 000) Cash paid to suppliers and employees 605 000 Interest paid Interest expense 6 000 Increase in accrued interest (2 000) Interest paid 4 000 Income tax paid Income tax expense 23 000 Increase in tax payable (2 000) Income tax paid 21 000 Investments Revaluation gain net of tax 3 500 Increase in deferred tax liability 1 500 Purchase of investments Increase in investments 5 000 Explanations: • The increase in deferred tax liability is the tax effect of the revaluation increment, as per the additional information. • As the increase in investments can be explained by the revaluation, and there were no disposals of investments, we can conclude that there were no purchases of investments during the year. • The purchases of plant are determined as the increase in plant in the absence of any disposals of plant during the year.

DANICA LTD Statement of cash flows for the year ended 30 June 2022 Cash flows from operating activities Receipts from customers Payments to suppliers and employees Cash generated from operations Interest paid Income tax paid Net cash from operating activities

$ 676 000 (605 000) 71 000 (4 000) (21 000) 46 000

Cash flows from investing activities Cash paid for plant Net cash used in investing activities

(25 000) (25 000)

Cash flows from financing activities Proceeds from borrowings

40 000

17.34

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Dividend paid Net cash from financing activities

(23 000) 17 000

Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

38 000 30 000 68 000

17.35

Chapter 17: Statement of cash flows

Exercise 17.13 Preparation of statement of cash flows A summarised comparative statement of financial position of Bronze Ltd is presented below, together with a statement of profit or loss and other comprehensive income for the year ended 30 June 2022.

30 June 2021 Cash Trade receivables Allowance for doubtful debts Inventories Equity investments Plant Accumulated depreciation

Accounts payable Accrued interest Current tax payable Deferred tax Borrowings Share capital Investment revaluation reserve Retained earnings

30 June 2022

45 000 69 000 (3 000) 45 000 53 000 187 000 (35 000)

35 000 105 000 (6 000) 67 000 60 000 225 000 (53 000)

$ 361 000

433 000

65 000 5 000 15 000 30 000 80 000 100 000 2 000 64 000

75 000 7 000 18 000 37 000 100 000 100 000 7 000 89 000

$ 361 000

433 000

BRONZE LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 Sales Cost of sales

$ 1 035 000 (774 000)

Gross profit Distribution costs Administration costs

261 000 (76 000) (96 000)

17.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Interest expense

(7 000)

Profit before tax Income tax expense

82 000 (24 000)

Profit for the year Other comprehensive income Gain on revaluation of investments (net of tax)

58 000 5 000

Total comprehensive income

63 000

Additional information • The movement in the allowance for doubtful debts for the year comprises: Balance at 30 June 2021 Charge for year Bad debts written off

3 000 5 000 (2 000)

Balance at 30 June 2022

6 000

• • • •

Equity investments are shares in other companies that are measured at fair value, with increases/decreases being recognised in other comprehensive income, and accumulated in the investment revaluation reserve until investments are sold. There were no disposals of plant during the year. A dividend of $33 000 was paid during the year. There were no acquisitions or disposals of investments during the year.

Required 1. Using the direct method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 30 June 2022. 2. Prepare the operating activities section of the statement of cash flows using the indirect method of presentation. (LO3, LO4 and LO5) 1. Cash Trade receivables Allowance for doubtful debts Inventories Equity investments Plant Accumulated depreciation Accounts payable Accrued interest

2021 Dr Cr $ $ $ 45 000 (15) 10 000 69 000 (2) 38 000 (1) 2 000 (3 000) (1) 2 000 (2) 5 000 45 000 (4) 22 000 53 000 (8) 7 000 187 000 (10) 38 000 (35 000) (11) 18 000 361 000 65 000 (5) 10 000 5 000 (6) 2 000

2022 $ 35 000 105 000 (6 000) 67 000 60 000 225 000 (53 000) 433 000 75 000 7 000

17.37

Chapter 17: Statement of cash flows

Current tax payable Deferred tax

15 000 30 000

Borrowings Share capital Investment revaluation reserve Retained earnings

80 000 100 000 2 000 64 000 361 000

Operating activities Receipts from customers Payments to suppliers and employees

Cash generated from operations Interest paid Income taxes paid

(7) 3 000 (8) 2 000 (9) 5 000 (12) 20 000

(14) 33 000

1 035 000 (774 000) (76 000) (96 000)

(5) 10 000 (3) 5 000 (11) 18 000

(7 000) (24 000)

(6) 2 000 (7) 3 000 (9) 5 000

(8) 5 000 (13) 58 000

(2) 33 000 (3) 5 000 (4) 22 000

Financing activities Proceeds from borrowings Dividend paid Net cash used in financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

100 000 100 000 7 000 89 000 433 000

997 000

(935 000) 62 000 (5 000) (16 000) 41 000

Net cash from operating activities Investing activities Cash paid for plant Net cash used in investing activities

18 000 37 000

(10) 38 000

(12) 20 000 (14) 33 000 (15)

(38 000) (38 000) 20 000 (33 000) (13 000) (10 000) 45 000 35 000

Explanations: • Receipts from customers – The starting point is sales for the year $1 035 000. This is shown as the first item in the operating activities section of the worksheet. The sales are then adjusted for the change in net trade receivables and for the doubtful debts expense. • The expenses other than interest and taxes reported in the statement of comprehensive income are used as the starting point to calculate payments to suppliers and employees. To calculate the payments to suppliers and employees, those expenses are adjusted for the changes in accounts payable and further adjusted for doubtful debts expense and depreciation expense. (1) (2)

The bad debt write-off does not affect the movement in net trade receivables. Net trade receivables increase by $33 000 from $66 000 to $99 000. It comprises an increase in gross receivables $38 000 and the increase in allowance for doubtful debts $5 000 (a non-cash expense).

17.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(3)

(4) (5) (6) (7) (8)

(9)

(10) (11)

(12) (13) (14) (15)

The doubtful debts expense is $5 000. Refer to additional information. The doubtful debts expense is deducted from sales revenue in the calculation of cash collected from customers because it is a component of the movement in net receivables that does not represent cash collected from customers. The doubtful debts expense is deducted from administration expenses in calculating cash paid to suppliers and employees. Increase in inventory $22 000. Increase in accounts payable $10 000. Increase in accrued interest $2 000. Increase in current tax payable $3 000. Deferred tax on revaluation of equity investments $2 000. The revaluation gain in the statement of comprehensive income is net of tax. As there were no acquisitions or disposals of investments during the year, the increase in investments, $7 000, is the revaluation increment. The related deferred tax amount is calculated as the difference between the revaluation increment $7 000 and the revaluation gain $5 000. The deferred component of the income tax expense for the year is $5 000, calculated as the increase in the deferred tax liability other than the increment recognised directly in equity (i.e., balance of movement in deferred tax liability). Cash paid for plant $38 000 (there are no disposals, refer to additional information). Depreciation expense for the year $18 000. As expenses are classified by function in the statement of profit or loss and other comprehensive income, the depreciation expense is not shown as a separate item. It must be deducted from expenses in the calculation of cash paid to suppliers of goods and services. New borrowings $20 000 (in the absence of other information, this has been calculated as the difference between borrowings at 2021 and at 2022). Profit for the year $58 000. Dividends paid $33 000 (refer to additional information). Decrease in cash $10 000. BRONZE LTD Statement of cash flows for the year ended 30 June 2022 $ Cash flows from operating activities Receipts from customers Payments to suppliers and employees Cash generated from operations Interest paid Income tax paid Net cash from operating activities Cash flows from investing activities Cash paid for plant Net cash used in investing activities Cash flows from financing activities Proceeds from borrowings Dividend paid Net cash used in financing activities

997 000 (935 000) 62 000 (5 000) (16 000) 41 000 (38 000) (38 000) 20 000 (33 000) (13 000)

17.39

Chapter 17: Statement of cash flows

Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(10 000) 45 000 35 000

Cash flows from operating activities Profit before tax Interest expense Depreciation expense Increase in net receivables Increase in inventories Increase in accounts payable Cash generated from operations Interest paid Income tax paid Net cash from operating activities

$ 82 000 7 000 18 000 (33 000) (22 000) 10 000 62 000 (5 000) (16 000) 41 000

17.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.14 Preparation of a statement of cash flows A comparative statement of financial position of Adele Ltd is presented below. 30 June 2021 Cash Trade receivables Inventories Land (at valuation) Plant Accumulated depreciation

Accounts payable Accrued interest Other accrued liabilities Current tax payable Provision for employee benefits Dividend payable Borrowings Deferred tax liability Share capital Revaluation surplus Retained earnings

30 June 2022

60 000 92 000 50 000 25 000 230 000 (45 000)

109 000 102 000 80 000 31 000 260 000 (60 000)

$ 412 000

522 000

75 000 6 000 22 500 15 000 19 000 — 47 500 29 000 175 000 6 000 17 000

77 500 8 000 21 500 17 000 21 000 30 000 52 500 19 500 190 000 10 000 75 000

$ 412 000

522 000

ADELE LTD Statement of profit or loss and other comprehensive income for the year ended 30 June 2022 Sales Cost of sales

$ 1 790 000 (1 432 000)

17.41

Chapter 17: Statement of cash flows

Gross profit Gain on sale of plant Dividend income Distribution costs Administrative costs Interest expense Other costs

358 000 8 000 2 000 (92 500) (80 000) (4 000) (20 000)

Profit before tax Income tax expense

171 500 (51 500)

Profit for the year Other comprehensive income Gain on asset revaluation (net of tax)

120 000

Total comprehensive income

4 000 $

124 000

Additional information • The increase to the revaluation surplus is net of deferred tax of $2000. • Plant with a carrying amount of $30 000 (cost $42 500, accumulated depreciation $12 500) was sold for $38 000. • Accounts payable at 30 June 2022 include $11 000 in respect of plant acquisitions. • There were borrowing repayments of $15 000 during the year. • The increase in share capital of $15 000 arose from the company’s dividend reinvestment scheme. • Dividends declared out of profits for the year were: interim dividend $32 000, final dividend $30 000. Required Using the direct method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 30 June 2022, including a reconciliation of cash flows arising from operating activities and profit in accordance with AASB 1054. (LO3 and LO5) Note: Classification of dividends received: There is no absolute right or wrong for the classification of dividends received and AASB 107 allows their classification as either operating or investing (paragraph 31). AASB 107 paragraph 33 states “...dividends received are usually classified as operating cash flows for a financial institution...there is no consensus on the classification of these cash flows for other entities”. In this question dividends received are classified as operating activities. 2021 Dr Cr 2022 $ $ $ $ Cash 60 000 (21) 49 000 109 000 Trade receivables 92 000 (1) 10 000 102 000 Inventory 50 000 (2) 30 000 80 000 Land (at valuation) 25 000 (9) 6 000 31 000

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Plant Accumulated depreciation Accounts payable – plant purchase Accounts payable Accrued interest Other accrued liabilities Current tax payable Provision for employee benefits Dividend payable Borrowings Deferred tax liability Share capital Revaluation surplus Retained earnings Operating activities Receipts from customers Payments to suppliers and employees

Gain on sale of plant Dividends received Interest paid Income tax paid

230 000 (45 000) 412 000

(11) 72 500 (13) 12 500

(12) 42 500 (10) 27 500 (20) 11 000

75 000 6 000 22 500 15 000 19 000 47 500 29 000 175 000 6 000 17 000 412 000 1 790 000 (1 432 000) (92 500) (52 500) (20 000) 8 000 2 000 (4 000) (51 500)

Investing activities Cash paid for plant Proceeds from sale of plant

(3) 8 500 (4)

2 000

(5) 1 000 (6) 2 000 (7) 2 000 (19) 30 000 (15) 15 000 (16) 20 000 (8) 11 500 (9) 2 000 (17) 15 000 (9) 4 000 (18) 62 000 (22) 120 000

2 000

(1) 10 000 8 500 30 000 1 000

(14) (4) 2 000 (6) 2 000

8 000

(8) 11 500

(20) 11 000 (11) 72 500 (12) 42 500 (13) 12 500 (14) 8 000

260 000 (60 000) 522 000 11 000 66 500 8 000 21 500 17 000 21 000 30 000 52 500 19 500 190 000 10 000 75 000 522 000 1 780 000

(1 634 500) 145 500 0 2 000 (2 000) (61 000) 84 500 (61 500) 38 000 (23 500)

Financing activities Proceeds from borrowings Repayment of borrowings Dividends paid

(16) 20 000 (15) 15 000 (17) 15 000 (18) 62 000 (19) 30 000

Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(21)

20 000 (15 000) (17 000) (12 000) 49 000 60 000 109 000

Explanations:

17.43

Chapter 17: Statement of cash flows

•

Receipts from customers – The starting point is sales for the year $1 790 000. This is adjusted by the increase in Trade receivables, $1 790 000 - $10 000 = $1 780 000. • Payments to suppliers and employees comprises: $ Cost of sales 1 432 000 Decrease in accounts payable (excludes plant acquisitions – refer to (3)) 8 500 Increase in inventory 30 000 Increase in provision for employee benefits (2 000) Decrease in other accrued liabilities 1 000 Distributions costs 92 500 Administrative costs (excludes depreciation expense – refer to (10)) 52 500 Other costs 20 000 1 634 500 (1) Increase in trade receivables $10 000. (2) Increase in inventory $30 000. (3) Decrease in accounts payable (excludes plant acquisitions) $8 500. (4) Increase in accrued interest $2 000. (5) Decrease in other accrued liabilities $1 000. (6) Increase in current tax payable $2 000. (7) Increase in provision for employee benefits $2 000. (8) Decrease in deferred tax liability related to amounts recognised in profit, calculated as $29 000 + $2 000 - $19 500 = $11 500. Refer to additional information for the deferred tax liability $4 000 recognised in relation to revaluation of land. (9) Land revaluation comprises: Increase in value of land $6 000; related deferred tax $2 000 (refer to additional information); revaluation gain (net of tax) $4 000. (10) Depreciation for year $27 500 (a non-cash expense included in expense accounts used as the starting point for payments to suppliers and employees). This amount has been calculated as the increase in accumulated depreciation $15 000 + accumulated depreciation on plant sold $12 500 = $27 500. (11) Plant additions for year $72 500. This amount has been calculated as the closing balance of plant $260 000 + cost of plant sold during the year $42 500 – opening balance of plant $230 000 = $72 500. (12) Cost of plant sold $42 500 (refer to additional information). (13) Accumulated depreciation on plant sold $12 500 (refer to additional information). (14) Gain on sale of plant $8 000 is excluded from cash receipts from operating activities; proceeds from sale of plant = Cost of plant sold $42 500 – Accumulated depreciation $12 500 + gain on sale of plant $8 000 = $38 000 (there are no accounts receivable adjustments). (15) Repayment of borrowings ($15 000) (refer to additional information). (16) Proceeds from borrowings are calculated as: Closing balance of borrowings $52 500 + repayment of borrowings $15 000 – opening balance $47 500 = $20 000. (17) The dividend reinvestment of $15 000 is a non-cash increase in share capital $15 000. (18) Represents dividends declared out of profits for the year $32 000 + $30 000 = $62 000. (19) Represents final dividend payable $30 000 (refer to the statement of financial position at 30 June 2022). The dividend paid of $17 000 represents the interim dividend of $32 000 – dividends re-invested $15 000. There was no dividend payable at 30 June 2021. (20) Increase in accounts payable for purchase of plant (refer to additional information).

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(21) (22)

Increase in cash and cash equivalents $49 000. Profit for the year. ADELE LTD Statement of cash flows for the year ended 30 June 2022 $ Cash flows from operating activities Receipts from customers Payments to suppliers and employees Cash generated from operations Dividends received Interest paid Income tax paid Net cash from operating activities

1 780 000 (1 634 500) 145 500 2 000 (2 000) (61 000) 84 500

Cash flows from investing activities Cash paid for plant Proceeds from sale of plant Net cash used in investing activities

(61 500) 38 000 (23 500)

Cash flows from financing activities Proceeds from borrowings Repayment of borrowings Dividend paid Net cash used in financing activities

20 000 (15 000) (17 000) (12 000)

Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

49 000 60 000 109 000

Notes to the financial statements for the year ended 30 June 2022. Reconciliation of profit to cash flows from operating activities: Profit for the year Add depreciation expense Less gain on sale of plant Less increase in trade receivables Less increase in inventory Less decrease in accounts payable Add increase in accrued interest Less decrease in other accruals Add increase in income tax payable Add increase in provision for employee benefits Less decrease in deferred tax liability

$ 120 000 27 500 (8 000) (10 000) (30 000) (8 500) 2 000 (1 000) 2 000 2 000 (11 500)

17.45

Chapter 17: Statement of cash flows

Net cash from operating activities

84 500

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Exercise 17.15 Preparing statement of cash flows The statement of profit or loss and other comprehensive income and comparative statements of financial position of Amber Ltd are as follows. AMBER LTD Statement of financial position as at 31 December 2021 Current assets Deposits at call Accounts receivable Allowance for doubtful debts Inventories Prepayments

Non-current assets Land Buildings Accumulated depreciation — buildings Plant Accumulated depreciation — plant

Total assets Current liabilities Bank overdraft Accounts payable Interest payable Final dividend payable Current tax payable

Non-current liabilities Borrowings Deferred tax liability

19 000 340 000 (19 000) 654 000 52 000

2022 $

30 000 320 000 (15 000) 670 000 55 000

$ 1 046 000

$ 1 060 000

400 000 1 175 000 (200 000) 850 000 (375 000)

400 000 1 850 000 (235 000) 940 000 (452 000)

1 850 000

2 503 000

$ 2 896 000

$ 3 563 000

140 000 553 000 25 000 205 000 70 000

49 000 570 000 30 000 230 000 77 000

993 000

956 000

900 000 12 000

$ 1 300 000 16 000

17.47

Chapter 17: Statement of cash flows

912 000

1 316 000

Total liabilities

$ 1 905 000

$ 2 272 000

Equity Share capital Retained earnings

800 000 191 000

$ 1 000 000 291 000

991 000

1 291 000

$ 2 896 000

$ 3 563 000

Total liabilities and equity

AMBER LTD Statement of profit or loss and other comprehensive income for the year ended 31 December 2022 Sales Less: Cost of sales

$ 8 550 000 4 517 000

Gross profit Gain on sale of plant

4 033 000 18 000 4 051 000

Distribution costs Administration costs Interest

(1 635 000) (1 566 000) (70 000)

Profit before tax Income tax expense

780 000 (250 000)

Profit for the period Other comprehensive income

530 000 —

Total comprehensive income

530 000

The following additional information has been extracted from the accounting records of Amber Ltd.

(a)

Movement in allowance for doubtful debts: Balance 31 December 2021 Charge for year Bad debts written off Balance 31 December 2022

19 000 7 000 (11 000)

15 000

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(b) (c)

Building additions were completed. There were no disposals. The movement in plant and accumulated depreciation on plant comprised the following. Cost

(d) (e)

(f) (g)

Accumulated depreciation

Balance 31 December 2021 Additions — cash Disposals Depreciation

850 000 160 000 (70 000) —

375 000 — (50 000) 127 000

Balance 31 December 2022

940 000

452 000

There was no outstanding interest payable at year-end. Income tax expense comprised: Income tax currently payable $ Deferred income tax

246 000 4 000

250 000

400 000

Additional cash borrowings Movement in equity

Share capital

Retained earnings

Balance 31 December 2021 Additional shares issued for cash Profit for the period Interim dividend — cash Final dividend payable

800 000 200 000 — —

191 000 — 530 000 (200 000) (230 000)

Balance 31 December 2022

1 000 000

291 000

Required 1. Prepare a summary of cash flows from operating activities using the indirect method of presentation. 2. Prepare a summary of cash flows from investing activities. 3. Prepare a summary of cash flows from financing activities. 4. Prepare a summary of cash flows from operating activities using the direct method of presentation. (LO2, LO3, LO4 and LO5)

Deposits at call Accounts receivable

2021 $ 19 000 340 000

Dr $ (22) 11 000

Cr $ (2) 20 000

2022 $ 30 000 320 000 17.49

Chapter 17: Statement of cash flows

Allowance for doubtful debts Inventories Prepayments Land Buildings Accumulated depreciation Plant Accumulated depreciation Bank overdraft Accounts payable Interest payable Dividend payable Current tax payable Borrowings Deferred tax liability Share capital Retained earnings

(19 000) 654 000 52 000 400 000 1 175 000 (200 000) 850 000 (375 000) 2 896 000 140 000 553 000 25 000 205 000 70 000 900 000 12 000 800 000 191 000

(3) 4 000 (4) 16 000 (5) 3 000 (14) 675 000 (15) 160 000 (17) 50 000

(6) 35 000 (16) 70 000 (6)127 000

(22) 91 000

(9) 250 000 (20) 430 000

(8) 17 000 (11) 5 000 (21) 25 000 (12) 7 000 (18)400 000 (13) 4 000 (19)200 000 (1)780 000

291 000 3 563 000

2 896 000 Operating activities Profit before tax Decrease in accounts receivable Decrease in allowance for doubtful debts Increase in inventories Increase in prepayments Increase in accounts payable Interest expense Depreciation expense Gain on sale of plant Cash generated from operations Interest paid Income taxes paid

(1) 780 000 (2) 20 000

Net cash used in investing activities

780 000 20 000 (3) 4 000 (4) 16 000 (5) 3 000

(8) 17 000 (10) 70 000 (6) 162 000

(11) 5 000 (12) 7 000 (13) 4 000

Net cash from operating activities Investing activities Cash paid for buildings Cash paid for plant Proceeds from sale of plant

(15 000) 670 000 55 000 400 000 1 850 000 (235 000) 940 000 (452 000) 3 563 000 49 000 570 000 30 000 230 000 77 000 1 300 000 16 000 1 000 000

(4 000) (16 000) (3 000) 17 000 70 000 162 000 (7) 18 000 (18 000) 1 008 000 (10) 70 000 (65 000) (9) 250 000 (239 000) 704 000

(14) 675 000 (675 000) (15) 160 000 (160 000) (16) 70 000 (17) 50 000 (7) 18 000 38 000 (797 000)

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Financing activities Proceeds from borrowings Proceeds from share issue Dividends paid Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(18) 400 000 400 000 (19) 200 000 200 000 (21) 25 000 (20) 430 000 (405 000) 195 000 (22) 102 000 (121 000) (19 000)

Explanations: (1) Profit before income tax $780 000. (2) Decrease in accounts receivable $20 000. (3) Decrease in allowance for doubtful debts $4 000. Considered with item (2), net receivables decreased by $16 000. (4) Increase in inventory $16 000. (5) Increase in prepayments $3 000. (6) Depreciation of buildings $35 000 (able to be calculated as the increase in accumulated depreciation, as there are no disposals of buildings); depreciation of plant $127 000 (see additional information, note c). Total depreciation expense = $162 000. (7) Gain on sale of plant $18 000 (refer to the statement of comprehensive income). (8) Increase in accounts payable $17 000. (9) Income tax expense $250 000. (10) Interest expense $70 000 (refer to the statement of profit or loss and other comprehensive income). (11) Increase in interest payable $5 000. (12) Increase in current tax payable $7 000. (13) Increase in deferred tax liability $4 000. All of this is recognised as income tax expense per additional information, note e. (14) Buildings additions $675 000 (calculated as the increase in buildings as there are no revaluations, per the statement of profit or loss and other comprehensive income, and no disposals of buildings, per additional information, note b). (15) Plant additions $160 000 (refer to additional information, note c). (16) Plant disposals $70 000 (refer to additional information, note c). (17) Accumulated depreciation on disposals $50 000 (refer to additional information, note c). Proceeds from the sale of plant ($38 000) are calculated as the gain on sale, $18 000, plus the book value (carrying amount) of plant sold, $20 000 ($70 000 - $50 000). (18) Proceeds from borrowings $400 000 (refer to additional information, note f); this amount accounts for the increase in borrowings between 2021 and 2022. (19) Increase in share capital $200 000 (refer to additional information, note g). (20) Dividends for year $430 000 ($200 000 + $230 000). (21) Increase in final dividend payable $25 000. (22) Cash and cash equivalents comprises deposits at call and the bank overdraft. Net increase in cash and cash equivalents comprises: Increase in deposits at call $11 000 + decrease in bank overdraft $91 000 = $102 000.

17.51

Chapter 17: Statement of cash flows

Workings for direct method: Cash collected from customers = sales + decrease in net receivables – doubtful debts expense = $8 550 000 + $16 000 - $7 000 = $8 559 000 Or Cash collected from customers = sales + decrease in gross receivables – bad debt written off = $8 550 000 + $20 000 - $11 000 = $8 559 000 Cash paid to suppliers of goods and services: Cash paid to suppliers of goods: Cost of goods sold Increase in inventory Increase in accounts payable Cash paid to suppliers of services: Distribution costs Administration costs Depreciation expense Doubtful debts expense Increase in prepayments Cash paid to suppliers of goods and services

$ 4 517 000 16 000 (17 000) 1 635 000 1 566 000 (162 000) (7 000) 3 000

4 516 000

3 035 000 7 551 000

1. Summary of cash flows from operating activities, using the indirect method: Cash flows from operating activities Profit before tax Depreciation expense Interest expense Gain on sale of plant Decrease in accounts receivable (net) Increase in inventories Increase in prepayments Increase in accounts payable Cash generated from operations Interest paid Income tax paid Net cash from operating activities

$ 780 000 162 000 70 000 (18 000) 16 000 (16 000) (3 000) 17 000 1 008 000 (65 000) (239 000) 704 000

2. Summary of cash flows from investing activities: Cash flows from investing activities Cash paid for buildings Cash paid for plant Proceeds from sale of plant Net cash used in investing activities

(675 000) (160 000) 38 000 (797 000)

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3. Summary of financing activities: Cash flows from financing activities Proceeds from borrowings Proceeds from share issue Dividends paid Net cash from financing activities

400 000 200 000 (405 000) 195 000

4. Summary of cash flows from operations using the direct method: Cash flows from operating activities Cash collected from customers Cash paid to suppliers of goods and services Cash generated from operations Interest paid Income tax paid Net cash from operating activities

8 559 000 (7 551 000) 1 008 000 (65 000) (239 000) 704 000

17.53

Chapter 17: Statement of cash flows

Exercise 17.16 Preparing a statement of cash flows with notes The statement of profit or loss and other comprehensive income and comparative statements of financial position of Dolphin Ltd were as follows. DOLPHIN LTD Statement of financial position as at 31 December 2021

2022

92 000 80 000 220 000 (24 000) 4 000 588 000 26 000

$ 104 000 140 000 234 000 (32 000) 6 000 640 000 18 000

$ 986 000

$ 1 110 000

$ 200 000 1 200 000 (280 000) 160 000 240 000

$ 280 000 1 400 000 (360 000) 184 000 180 000

1 520 000

1 684 000

Total assets

$ 2 506 000

$ 2 794 000

Current liabilities Accounts payable Accrued liabilities Current tax payable Current portion of long-term borrowings

$ 360 000 170 000 80 000 40 000

$ 392 000 184 000 86 000 40 000

$ 650 000

$ 702 000

Current assets Cash at bank Cash deposits (30-day) Accounts receivable Allowance for doubtful debts Interest receivable Inventories Prepayments

Non-current assets Land Plant Accumulated depreciation Investments in associate Brand names

Non-current liabilities

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Borrowings Deferred tax liability Provision for employee benefits

$ 196 000 70 000 80 000

$ 276 000 80 000 86 000

346 000

442 000

Total liabilities

$ 996 000

$ 1 144 000

Equity Share capital Retained earnings

$ 1 000 000 510 000

$ 1 060 000 590 000

1 510 000

1 650 000

$ 2 506 000

$ 2 794 000

Total liabilities and equity

DOLPHIN LTD Statement of profit or loss and other comprehensive income for the year ended 31 December 2022 Sales

3 560 000

Cost of sales

(2 060 000)

Gross profit

1 500 000

Interest

4 000

Share of profits of associate

40 000

Gain on sale of plant

16 000

Total income

1 560 000

704 000

Expenses Salaries and wages Depreciation

100 000

Discount allowed

16 000

Doubtful debts

12 000

Interest

42 000

Other (including impairment of brand names $30 000)

372 000 1 246 000

Profit before tax

314 000

Income tax expense

(94 000)

17.55

Chapter 17: Statement of cash flows

Profit for the period

220 000 —

Other comprehensive income Total comprehensive income

220 000

The following additional information has been extracted from the accounting records of Dolphin Ltd. (a) (b)

30-day cash deposits are used in the course of the daily cash management of the company. Movement in allowance for doubtful debts: Balance 31 December 2021 $ 24 000 Charge for year 12 000 Bad debts written off (4 000) Balance 31 December 2022

(f)

(g)

(h)

(i)

Land Additional cash purchase Plant Purchases for year (including $50 000 acquired by a lease) Disposals of plant Cost of disposals Accumulated depreciation Investments in associate Share of profit Dividends received Accounts payable Includes amounts owing in respect of plant purchases: 31 December 2021 31 December 2022 Accrued liabilities Includes accrued interest payable: 31 December 2021 31 December 2022 Income tax expense comprises: Current tax payable Deferred tax Income tax expense

32 000

80 000

300 000

100 000 (20 000)

40 000 16 000

24 000 36 000

8 000 10 000

84 000 10 000

94 000

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(j)

Dividends paid Under a dividend reinvestment scheme, shareholders have the right to receive additional shares in lieu of cash dividends. Dividends paid comprised: Dividends paid in cash during the year $ Dividends reinvested

80 000 60 000

Total dividends

140 000

Required 1. Using the direct method of presenting cash flows from operating activities, prepare a statement of cash flows in accordance with AASB 107/IAS 7 for the year ended 31 December 2022. 2. Prepare a note reconciling profit to cash flows from operating activities in accordance with AASB 1054. 3. Prepare any other notes to the statement of cash flows that you consider are required by AASB 107/IAS 7. (LO2, LO3, LO5 and LO6) 2021 Dr Cr 2022 $ $ $ Cash at bank 92 000 (29) 12 000 104 000 Cash deposits 80 000 (29) 60 000 140 000 Accounts receivable 220 000 (2) 14 000 234 000 Allowance for doubtful debts (24 000) (3) 8 000 (32 000) Interest receivable 4 000 (15) 2 000 6 000 Inventories 588 000 (4) 52 000 640 000 Prepayments 26 000 (5) 8 000 18 000 Land 200 000 (21) 80 000 280 000 Plant 1 200 000 (22)300 000 (24)100 000 1 400 000 Accumulated depreciation (280 000) (25) 20 000 (9)100 000 (360 000) Investment in associate 160 000 (13) 40 000 (12) 16 000 184 000 Brand names 240 000 (10) 60 000 180 000 2 506 000 2 794 000 Accounts payable – plant 24 000 (23) 12 000 39 000 Accounts payable – trade payables 336 000 (6) 20 000 356 000 Accrued liabilities – interest 8 000 (17) 2 000 10 000 Accrued liabilities – other 162 000 (7) 12 000 174 000 Current tax payable 80 000 (19) 6 000 86 000 Current portion of long-term borrowings 40 000 40 000 Borrowings 196 000 (27) 40 000 (26) 20 000 (22)100 000 276 000 Deferred tax liability 70 000 (20) 10 000 80 000 Provision for employee benefits 80 000 (8) 6 000 86 000 Share capital 1 000 000 (28) 60 000 1 060 000 Retained earnings 510 000 (18) 94 000 (1)314 000

17.57

Chapter 17: Statement of cash flows

(28)140 000

590 000 2 794 000

2 506 000 Operating activities Profit before tax Increase in accounts receivable Increase in allowance for doubtful debts Increase in inventories Decrease in prepayments Increase in trade payables Increase in accrued liabilities Increase in employee benefits Depreciation expense Impairment of brand names Gain on sale of plant Share of profits of associate Interest income Interest expense Cash generated from operations Dividend received Interest received Interest paid Income taxes paid

(1)314 000 (2) 14 000 (3) 8 000 (4) 52 000 (5) 8 000 (6) 20 000 (7) 12 000 (8) 6 000 (9)100 000 (10) 60 000 (11) 16 000 (13) 40 000 (14) 4 000 (16) 42 000 (12) 16 000 (14) 4 000 (17) 2 000 (19) 6 000 (20) 10 000

Net cash from operating activities Investing activities Cash paid for land Cash paid for plant Proceeds from sale of plant Net cash used in investing activities Financing activities Proceeds from borrowings Repayment of borrowings Dividend paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

(15) 2 000 (16) 42 000 (18) 94 000

314 000 (14 000) 8 000 (52 000) 8 000 20 000 12 000 6 000 100 000 60 000 (16 000) (40 000) (4 000) 42 000 444 000 16 000 2 000 (40 000) (78 000) 344 000

(21) 80 000 (80 000) (23) 12 000 (22) 200 000 (188 000) (24) 100 000 (25) 20 000 (11) 16 000 96 000 (172 000)

(26) 20 000

20 000 (27) 40 000 (40 000) (28) 80 000 (80 000) (100 000) (29) 72 000 172 000 244 000

Explanations: (1) Profit before tax $314 000. (2) Increase in accounts receivable $14 000.

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(3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20)

(21) (22) (23) (24) (25)

(26)

(27) (28) (29)

Increase in allowance for doubtful debts $8 000. Thus combining (2) and (3), net receivables increased by $6 000. Increase in inventory $52 000. Decrease in prepayments $8 000. Increase in trade payables (excluding payables arising from the purchase of plant) $20 000. Increase in accrued liabilities (other than accrued interest) $12 000. Increase in provision for employee benefits $6 000. Depreciation expense for the year $100 000. Impairment of brand names $60 000. Gain on sale of plant $16 000. Dividend received from associate $16 000. Dividends received must be disclosed separately per AASB 107/IAS 7 paragraph 31. Share of profit of associate $40 000. Interest income $4 000. Increase in interest receivable $2 000. Interest expense $42 000. Increase in accrued interest payable $2 000. Income tax expense $94 000. Increase in income tax payable $6 000. Increase in deferred tax liability $10 000. This increment has been recognised as the deferred component of income tax expense per additional information note i, as there were valuation gains or losses and associated tax effects recognised in other comprehensive income. Cash paid for land $80 000 (refer to additional information, note c). Cash paid for plant $300 000; this includes $100 000 acquired by a finance lease; hence $100 000 of the increase in plant and borrowings does not involve a cash flow. Increase in accounts payable arising from the purchase of plant $12 000. Cost of plant disposed $100 000. Accumulated depreciation on plant disposed $20 000; note the proceeds on sale is determined by adding the gain on sale $16 000 to the net book value of the plant sold ($100 000 - $20 000) = $96 000. Proceeds from borrowings $20 000. This is determined by difference: Non-current borrowings at end of year $276 000 – Lease liability $100 000 + current portion of longterm borrowing $40 000 (reclassified as current; the prior year balance is assumed to have been paid during the year) – non-current borrowings at beginning of year $196 000 = $20 000. $40 000 repayment of borrowings - refer to (26) above. Dividends paid in cash during the year $80 000; dividends re-invested $60 000 (adjusted against share capital) (refer to additional information, note j). Increase in cash and cash equivalents $72 000. This comprises: the increase in cash at bank $12 000 + increase in cash deposits $60 000.

Calculations for direct method of presenting cash flows from operating activities: Cash received from customers: $

17.59

Chapter 17: Statement of cash flows

Sales Increase in accounts receivable Bad debts written off Discount allowed Cash received from customers

3 566 000 (14 000) (4 000) (16 000) 3 526 000

Alternatively, cash received from customers could be calculated by adjusting sales for the movement in net accounts receivable. Under this approach, the adjustment includes the doubtful debts expense, which is a non-cash component of the change in net receivables, but does not include bad debts write off because it has no effect on net receivables.

Sales Increase in net accounts receivable Doubtful debts expense Discount allowed Cash received from customers

$ 3 560 000 (6 000) (12 000) (16 000) 3 526 000

Payments to suppliers and employees: Cost of sales Salaries and wages Other expenses (excluding impairment) Increase in inventory Decrease in prepayments Increase in trade payables Increase in accrued liabilities Increase in employee benefits

$ 2 060 000 706 000 312 000 52 000 (8 000) (20 000) (12 000) (6 000) 3 082 000

1. DOLPHIN LTD Statement of cash flows for the year ended 31 December 2022 $ Cash flows from operating activities Cash received from customers Payments to suppliers and employees Cash generated from operations Interest received Dividend received Interest paid Income tax paid Net cash from operating activities © John Wiley and Sons Australia Ltd, 2020

3 526 000 (3 082 000) 444 000 2 000 16 000 (40 000) (78 000) 344 000 17.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cash flows from investing activities Cash paid for land Cash paid for plant Proceeds from sale of plant Net cash used in investing activities

(80 000) (188 000) 96 000 (172 000)

Cash flows from financing activities Proceeds from borrowings Repayment of borrowings Dividends paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

20 000 (40 000) (80 000) (100 000) 72 000 172 000 244 000

2. Reconciliation between profit and net cash generated from operations: Profit for the period Depreciation expense Impairment of brand names Gain on sale of plant Share of profits of associate Increase in accounts receivable Increase in interest receivable Increase in inventory Decrease in prepayments Increase in trade payables Increase in accrued liabilities Increase in provision for employee benefits Dividend received from associate Increase in current tax payable Increase in deferred tax liability Cash from operating activities

220 000 100 000 60 000 (16 000) (40 000) (6 000) (2 000) (52 000) 8 000 20 000 14 000 6 000 16 000 6 000 10 000 344 000

3. Notes: Cash and cash equivalents comprise:

Cash at bank Cash deposits

2022 $ 104 000 140 000 244 000

2021 $ 92 000 80 000 172 000

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Chapter 17: Statement of cash flows

Non-cash financing and investing activities: (a) During the year ended 31 December 2022 Dolphin Ltd entered into a lease to acquire plant resulting in the recognition of a leased asset and a lease liability of $100 000. (b) During the year ended 31 December 2022 dividends amounting to $60 000 were re-invested under the company’s dividend re-investment scheme.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 17.17 Analysis of differences between profit and cash flows from operations Obtain the financial statements of Bega Cheese Limited for 2018, which includes 2017 comparative figures. The company’s profit for 2018 was $28 768 000. However, cash used in operations was $58 564 000 during the same period. Required Prepare a report for non-accountants to: 1. explain how a company can make a profit without generating positive net operating cash flows during the same period 2. identify the major factors contributing to the difference between Bega Cheese Limited’s profit and cash from operating activities during 2018. (LO1 and LO5) ‘Profit’ and ‘cash from operations’ are two key accounting measures used in monitoring performance of the business. This report will explain the conceptual differences between profit and cash from operations, followed by an analysis of the differences between these items reported in Bega Cheese Limited’s Annual Report. Profit is the difference between income and expenses during the period. When income and expenses are included in profit reported in the ‘statement of profit of loss and other comprehensive income’ is determined by the application of accounting standards that generally reflect accrualbased accounting and the recognition criteria in the conceptual framework. This means that items of income and expenses included in calculating profit do not necessarily coincide with the associated cash receipts and payments. For example, cost of goods sold expense includes the cost of goods sold during the period but the cash payment for the goods may have been made in the previous period or perhaps in the following period if the supplier has not yet been paid. Differences in classification of items can also result in differences between profit and cash from operations. For example, a gain or loss on the disposal of property, plant and equipment or other investment assets is included in calculating profit or loss but the cash flows arising from the transaction are classified as investing cash flows. Bega Cheese Limited’s profit for 2018 was $28 768 000. However, it incurred a net cash inflow from operations of $58 564 000 during the same period. The reasons for the difference can be identified from the reconciliation of profit for the period to net cash from operating activities, which is provided in Note 19 of the financial statements. The major items that explain the operating cash outflow are: • Increase in accounts receivable of $36 438 000. The ageing analysis of trade receivables in note 21B does not indicate any major problem with the collection of receivables. • Increase in inventories of $16 819 000. This represents an increase of 7.8% in inventory, calculated as: $16 819 000 / ($232 080 000 - $16 819 000). • Increase in trade and other payables of $49 241 000.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 17: Statement of cash flows Multiple choice questions 1. The basis of measurement used in the statement of cash flows is: a. b. c. *d.

accrual. current value. net present value. cash and cash equivalents.

Answer: d Learning objective 17.1: explain the purpose of a statement of cash flows.

2. An item or transaction will qualify for classification as a cash equivalent: *a. b. c. d.

only if it has a maturity of less than three months. only if its term to maturity is no greater than twelve months. only if it has a fixed maturity date of greater than twelve months. only if its term to maturity is no greater than twenty-four months.

Answer: a Learning objective 17.2: define cash and cash equivalents.

3. Bank borrowings are normally classified in the statement of cash flows as: a. *b. c. d.

financing activities, except for bank overdrafts that are repayable on demand. financing activities, except for bank overdrafts that are repayable on demand and which form an integral part of an entity’s cash management. operating activities, except for bank overdrafts that are repayable on demand and which form an integral part of an entity’s cash management. investing activities, except for bank overdrafts that are repayable on demand and which form an integral part of an entity’s cash management.

Answer: b Learning objective 17.2: define cash and cash equivalents. Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. According to AASB 107/IAS 7 Statement of Cash Flows, which of the following items does not fall within the definition of cash? *a. b. c. d.

Accounts receivable. Bank notes and coins. Non-bank bills that are readily convertible to cash. Deposits on the short-term money market with a term of less than 3 months.

Answer: a Learning objective 17.2: define cash and cash equivalents.

5. In accordance with AASB 107/IAS 7 Statement of Cash Flows, investing and financing transactions that do not require the use of cash or cash equivalents should be: *a. b. c. d.

excluded from a statement of cash flows. presented in a statement of cash flows before operating, investing and financing activities. presented in a statement of cash flows after the operating, investing and financing activities. presented in a statement of cash flows after operating activities and before investing and financing activities.

Answer: a Learning objective 17.2: define cash and cash equivalents. 6. Which of following is classified as part of ‘investing activities’ in the statement of cash flows? a. b. c. *d.

gain on sale of investments. depreciation of non-current assets. proceeds from an issue of shares. acquisition of non-current assets.

Answer: d Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

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Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following items is classified as a ‘financing activity’ in the statement of cash flows? a. b. *c. d.

cash received from accounts receivable. cash payment to purchase debentures of another entity. cash payment on redemption of the company’s debentures. payment of dividends through a dividend reinvestment scheme.

Answer: c Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

8. Operating activities on a statement of cash flows are generally associated with: a. *b. c. d.

changes in equity of an entity. revenues and expenses of an entity. acquisitions of non-current assets of an entity. movements in non-current liabilities of an entity.

Answer: b Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities. 9. Financing activities on an entity’s statement of cash flows are usually associated with: a. b. c. *d.

disposal of non-current assets. purchase on shares by the entity. sales of goods and services by the entity. movements in non-current liabilities and equity.

Answer: d Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

10. Which of the following cash flow activities are regarded as investing cash flows? a. b. *c. d.

interest paid. income taxes paid. acquisition of subsidiary net of cash acquired. proceeds from issue of debentures.

Answer: c Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

17.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. Which of the following items is classified as part of ‘operating activities’ in the statement of cash flows? a. b. c. *d.

Bad debts expense. Depreciation of non-current assets. Proceeds from the sale of non-current assets. Payments to suppliers for the purchase of goods.

Answer: d Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

12. For cash flow reporting purposes, operating activities include: a. b. c. *d.

acquisition and disposal of investments. buying and selling of non-current assets. incurring and extinguishing equity and debt. those not otherwise classified as financing and investing.

Answer: d Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

13. Investing activities are those relating to: *a. b. c. d.

the acquisition or disposal of non-current assets. changing the size or financial structure of an entity. altering the composition of the debt of an organisation. restructuring the working capital components of a business.

Answer: a Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

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Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Flash Limited had the following cash flows during the reporting period: Purchase of intangibles Proceeds from sale of plant Receipts from customers Payments to suppliers Interest received Income taxes paid

$80 000 $36 000 $853 000 $696 000 $ 36 500 $57 000

The net cash flows from operating activities was: a. *b. c. d.

$220 000 $136 500 $187 000 $193 500

Answer: b Feedback: $853 000 - $696 000 + $36 500 - $57 000 Learning objective 17.3: classify cash inflows and outflows into operating, investing and financing activities.

15. For operating cash flows, the presentation method that separates gross cash inflows from cash outflows is the: a. b. *c. d.

equity method. offset method. direct method. indirect method.

Answer: c Learning objective 17.4: contrast the direct and indirect methods of presenting net cash flows from operating activities.

16. Which of the following cash flows may be reported on a net basis? a. b. c. *d.

cash receipts and payments for items in which the turnover is quick, the amounts small, and the maturities are short. cash receipts and payments for items in which the turnover is slow, the amounts are large, and the maturities are short. cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are long-term. cash receipts and payments for items in which the turnover is quick, the amounts are large, and the maturities are short.

Answer: d Learning objective 17.4: contrast the direct and indirect methods of presenting net cash flows from operating activities.

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Testbank to accompany Financial reporting 3e by Loftus et al.

17. Which of the following cash flows may be reported on a net basis by a financial institution? I. II. III. IV.

a. b. *c. d.

Cash payments and receipts for the acceptance and repayment of deposits with a fixed maturity date. Cash receipts and payments for the acceptance and repayment of deposits with no fixed maturity date. The placement of deposits with and withdrawal of deposits from other financial institutions. Cash advances and loans made to customers and the repayment of those advances and loans. I, II and IV. II, III and IV. I, III and IV. I, II and III.

Answer: c Learning objective 17.4: contrast the direct and indirect methods of presenting net cash flows from operating activities.

18. Bamboo Co. Limited had a profit after tax of $75 000 for the financial year. Included in this profit was: Depreciation expense of $22 000 Gain on sale of investments of $6 000 Also, accounts receivable increased by $26 000 and inventories decreased by $8 000. The cash flow from operating activities during the year was: a. *b. c. d.

$48 000 $73 000 $78 000 $82 000

Answer: b Feedback: $75 000 + $22 000 - $6 000 - $26 000 + $8 000 = $42 000 Learning objective 17.5: prepare a statement of cash flows.

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Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

19. The following information was extracted from the records of Vincent Limited: Opening balance of machinery: $840 000 Closing balance of machinery: $960 000 Cost of new machinery: $240 000 Proceeds from sale of machinery: $48 000 (Cost $120 000; Carrying amount $40 000) The total cash flows from investing activities is determined as: a. b. *c. d.

$48 000 cash inflow. $240 000 cash outflow. $192 000 cash outflow. $288 000 cash inflow.

Answer: c Feedback: Inflow $48 000 - Outflow $240 000 = Net cash outflow $192 000 Learning objective 17.5: prepare a statement of cash flows.

20. A company reported the following information for a financial year: Profit from ordinary activities before income tax expense Income tax expense Depreciation expense Issue of shares Loan made to another company Increase in accounts receivable Decrease in inventories Cash received from loans receivable Dividends paid

264 000 70 000 24 000 120 000 24 000 8 000 12 000 4 000 16 000

What is the net cash inflow (outflow) from investing activities? a. b. *c. d.

$4 000 net cash inflow. $24 000 net cash inflow. $(20 000) net cash outflow. $(24 000) net cash outflow.

Answer: c Feedback: Loan made to another company $(24 000) outflow + Cash received from loans receivable $4 000 = net cash outflow $(20 000) Learning objective 17.5: prepare a statement of cash flows.

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Testbank to accompany Financial reporting 3e by Loftus et al.

21. A company reported the following information for a financial year: Profit from ordinary activities before income tax expense Income tax expense Depreciation expense Issue of shares Loan made to another company Increase in accounts receivable Decrease in inventories Cash received from loans receivable Dividends paid

264 000 70 000 24 000 120 000 24 000 8 000 12 000 4 000 16 000

What is the net cash inflow (outflow) from financing activities? *a. b. c. d.

$104 000 net cash inflow. $120 000 net cash inflow. $124 000 net cash inflow. $(16 000) net cash outflow.

Answer: a Feedback: Inflow from issue of shares $120 000 – outflow for dividends paid $(16 000) = net cash inflow $104 000 Learning objective 17.5: prepare a statement of cash flows.

22. A company reported the following information for a financial year: Profit from ordinary activities before income tax expense Income tax expense Depreciation expense Issue of shares Loan made to another company Increase in accounts receivable Decrease in inventories Cash received from loans receivable Dividends paid

264 000 70 000 24 000 120 000 24 000 8 000 12 000 4 000 16 000

What is the net cash inflow from operating activities? a. *b. c. d.

$166 000. $222 000. $236 000. $292 000.

Answer: b Feedback: $264 000 - $70 000 + $24 000 -$8 000 + $12 000 = $222 000 Learning objective 17.5: prepare a statement of cash flows.

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Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

23. Which of the following items must be separately disclosed in the statement of cash flows? I. II. III. IV. V. a. b. c. *d.

Interest paid Dividends paid Interest received Dividends received Auditor’s remuneration paid

II, III and IV only. I, II and V only. II, III, IV and V only. I, II, III and IV only.

Answer: d Learning objective 17.5: prepare a statement of cash flows.

24. Which of the following items is required to be presented in a statement of cash flows? a. b. *c. d.

Depositing cash on hand in the bank account. Payment of dividends through a share investment scheme. Proceeds from the issue of debentures. Acquisition of an investment in a subsidiary for consideration consisting of an exchange of non-current assets and liabilities.

Answer: c Learning objective 17.5: prepare a statement of cash flows.

25. During the financial year Delilah Limited had sales of $284 000. The opening balance of accounts receivable was $36 000, and the closing balance was $45 000. Bad debts amounting to $2 600 were written off during the period. The cash receipts from sales during the year amounted to: *a. b. c. d.

$272 400 $275 000 $281 400 $284 000

Answer: a Feedback: $284 000 – (45 000-36 000) - $2 600 = $272 400 Learning objective 17.5: prepare a statement of cash flows.

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Testbank to accompany Financial reporting 3e by Loftus et al.

26. Atkins Limited classifies interest paid and interest received as operating activities. Atkins Limited had the following cash flows during the reporting period: Consideration paid to acquire a subsidiary, net of cash acquired $150 000 Dividends paid $30 000 Repayment of borrowings $60 000 Interest paid on borrowings $24 000 Proceeds from sale of plant $100 000 The amount of the cash flows in relation to financing activities of Atkins Limited for the reporting period is: a. *b. c. d.

Net cash inflow $90 000. Net cash outflow $90 000. Net cash inflow $30 000. Net cash outflow $30 000.

Answer: b Feedback: dividends paid $30 000 + repayment of borrowings $60 000 = net cash outflow $90 000 Learning objective 17.5: prepare a statement of cash flows.

27. During the financial year Marina Limited had sales of $840 000. The opening balance of accounts receivable was $66 000, and the closing balance was $78 000. Bad debts amounting to $8 000 were written off during the period. The cash receipts from customers during the year amounted to: *a. b. c. d.

$820 000 $828 000 $840 000 $860 000

Answer: a Feedback: $840 000 – ($78 000 - $66 000) - $8 000 Learning objective 17.5: prepare a statement of cash flows.

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Chapter 17: Statement of cash flows Not for distribution in full. Instructors may assign selected questions in their LMS.

28. During the financial year, Jacaranda Limited had a cost of sales amounting to $260 000. Opening and ending balances of related accounts were:

Inventories Accounts Payable

Opening balance $68 000 $102 000

Closing balance $84 000 $112 000

A discount of $8 000 for prompt payment was received. The amount of cash paid for goods purchased during the year was: a. b. c. *d.

$260 000. $270 000. $286 000. $258 000.

Answer: d Feedback: Cost of sales $260 000 + Increase in inventories $16 000 – Increase in accounts payable $10 000 – discount $8 000 = $258 000 Learning objective 17.5: prepare a statement of cash flows.

29. The components of cash and cash equivalents: *a. b. c. d.

must be disclosed and reconciled to amounts reported in the statement of financial position. must be disclosed and reconciled to amounts reported in the statement of changes in equity. may be disclosed at the option of the entity and reconciled to amounts reported in the statement of financial position. must be disclosed and reconciled to amounts reported in the statement of profit or loss and other comprehensive income.

Answer: a Learning objective 17.6: prepare other disclosures required or encouraged by AASB 107/IAS 7.

17.11

Testbank to accompany Financial reporting 3e by Loftus et al.

30. AASB 107/IAS 7 does not require, but encourages, the disclosure of: I. II. III. IV.

a. b. *c. d.

The name(s) of the entity’s bankers. The aggregate amount of cash flows that represent increases in operating capacity separately from those cash flows that are required to maintain operating capacity. The amount of the cash flows arising from the operating, investing and financing activities of each reportable segment. The amount of undrawn borrowing facilities that may be available for future operating activities and to settle capital commitments, indicating any restrictions on the use of these facilities. I, II and IV. I, III and IV. II, III and IV. I, II and III.

Answer: c Learning objective 17.6: prepare other disclosures required or encouraged by AASB 107/IAS 7.

17.12

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Noel Boys

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter18: Accounting policies and other disclosures

Chapter 18: Accounting policies and other disclosures Comprehension questions 1. What disclosures are required by AASB 101/IAS 1 regarding accounting policies? The contents of the summary of significant accounting policies note are broadly outlined in paragraph 117 of AASB 101. However, the details may be prescribed by other accounting standards or be a matter for management judgement. The accounting policies note will usually disclose the following information, typically in Note 1 or 2. First, the note usually states that the financial statements are GPFS. The note also discloses the statutory basis or other reporting framework, if any, under which the financial statements are prepared and whether the entity is a for-profit or not-for-profit entity. Second, the note should disclose the measurement basis or bases used in preparing the financial statements. Third, the note should provide a description of accounting policies. AASB 101 paragraph 119 states that the information provided should allow users to understand how transactions and other events are reflected in the reported financial performance and position, but leaves the details to management judgement. Finally, the note should disclose information about the assumptions made concerning the future, and other major sources of estimation uncertainty at the end of the reporting period that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the note should include details of their nature and carrying amount at the end of the reporting period (AASB 101, paragraph 125).

2. Why would an accounting estimate change and how is the change accounted for? An accounting estimate may need revision if changes occur in the circumstances on which the estimate was based or as a result of new information or more experience. For example, technological changes may require the estimate of an asset’s useful life to be downgraded, or new information received about the financial status of a customer may require an increase in the estimate of bad debts. According to AASB 108, paragraph 36 the change in an accounting estimate must be applied prospectively by including it in profit or loss in the reporting period of the change. The change may affect only the current period’s profit or loss (e.g. bad debts) or profit or loss of both the current period and future periods (e.g. depreciation due to the change in the useful life of a non-current asset). Additionally, the nature and amount of the change shall be disclosed for the current, and if practicable, for future financial periods.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. What is a prior period error? How and when is it corrected? Prior period errors are omissions from, and other misstatements in, the entity’s financial statements for one or more previous reporting periods that are discovered in the current period. Errors can occur for a number of reasons, including mathematical mistakes, misinterpretation of information, mistakes in applying accounting policies, oversight or misinterpretation of facts, and fraud. If the error is material then AASB 108 requires that it be corrected in the period in which it was discovered by retrospective restatement of the financial statements affected by the error. In other words, the entity must change the prior year figures to reflect the figures that would have been reported had the error not occurred. This restatement may involve changing prior year comparative figures or restating the opening amounts of comparative figures depending on whether the error was in the prior year or further back. The aim is to present financial statements (restated) as if the error had never occurred by correcting the error in the comparative information for the previous period(s) in which it occurred. Extensive disclosures of the line by line effect of the error are also required in the year of correction. 4. What is the difference between ‘retrospective application’ and ‘retrospective restatement’? Retrospective application is used in the context of accounting policy changes (either when a new or revised accounting standard does not include any specific transitional provisions relating to the change, or, when an entity changes an accounting policy voluntarily), and refers to the application of a new accounting policy to transactions, other events and conditions as if that policy had always been applied. Retrospective restatement is used in the context of errors and refers to a correction of the recognition, measurement and disclosure of elements of financial statements as if a prior period error had never occurred.

5. When is it impracticable to make a retrospective change in an accounting policy or a retrospective restatement to correct an error? According to AASB 108 paragraph 5, applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. For a particular prior period, it is impracticable to apply a change in an accounting policy retrospectively or to make a retrospective restatement to correct an error if: • the effects are not determinable; • it requires assumptions about what management’s intent would have been in that period; or • it requires significant estimates of amounts and it is impossible to distinguish objectively information about those estimates.

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Chapter18: Accounting policies and other disclosures

6. Outline the concept of materiality as it applies to financial reporting. Materiality is a concept essential to the preparation and presentation of general purpose financial statements. The Corporations Act's requirement that financial statements present a 'true and fair' view does not mean that the financial statements must be absolutely accurate to the last cent or absolutely complete in terms of the information disclosed. Rather, the notion of 'true and fair' is one of reasonableness, whereby the user can assume that the financial statements contain no material errors or omissions. According to paragraph 5 of AASB 108 (and paragraph 7 of AASB 101) omissions or misstatements are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. In most cases, accounting standards apply only where information resulting from their application is material. Thus, preparers need to make judgements as to whether the information provided by the application of a standard is material to report users. If a company's sole lease arrangement is deemed to be immaterial in respect of either its financial performance or financial position, the disclosure requirements of AASB 16 need not be applied. 7. Explain the difference between adjusting and non-adjusting events occurring after the end of the reporting period. Describe the difference in the way such events impact on the preparation of financial statements. Events occurring after the end of the reporting period are defined in AASB 110 as those events, both favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. There are two types of events described in AASB 110: • Adjusting events: after the end of the reporting period which provide evidence of conditions that existed at end of the reporting period (e.g. the settlement of a court case after the end of the reporting period that confirms the company had a present obligation at the end of the reporting period). • Non-adjusting events: after the end of the reporting period are events that are indicative of conditions that arose after the end of the reporting period (e.g. a flood or fire after the end of the reporting period that destroys a company’s building and plant). The treatment in the financial statements is different in both cases. Paragraph 8 of AASB 110 requires the financial effect of the adjusting events to be reflected in the financial statements prepared at the end of the reporting period, i.e. an adjustment must be made to the financial statements before publication. AASB 110, paragraph 21 requires material non-adjusting events to be disclosed by way of note to the financial statements. Such disclosures should include the nature of the event and either an estimate of its financial effect or a statement that such an estimate could not be made.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 18.1 Accounting estimates The board of directors of Good Company Ltd has resolved to change the company’s accounting policy for capitalising gains or losses on its cash flow hedges recognised in other comprehensive income. To date, such gains or losses were capitalised to hedged items, but the directors now believe that taking such gains or losses to profit or loss is a more appropriate treatment. Due to a recent computer virus, all data from the noncurrent asset register, including specific depreciation details from prior periods, has been destroyed. Required The board of directors has approached you for advice regarding the disclosures, if any, that are required for this change in accounting policy. As the change in accounting policy was voluntary, the provisions of paragraph 29 of AASB 108 are applicable, requiring disclosures as follows: • the nature of the change • the reasons that applying the new accounting policy provides reliable and more relevant information • to the extent practicable, the amount of the adjustment for the current and previous periods to each financial statement line item affected and, if applicable, the basic and diluted earnings per share • the amount of the adjustment relating to periods prior to those presented to the extent practicable • if retrospective application is impracticable, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy was applied. To comply with paragraph 29, the change in accounting policy note may be worded as follows (other variations are possible): The board of directors has resolved to change its accounting policy with respect to its treatment of gains or losses on cash flow hedges recognised in other comprehensive income. Previously, such gains or losses were capitalised to hedged items but will now be taken to profit or loss. The board has taken the view that this policy change will lead to a consistent treatment of gains and losses on cash flow hedges throughout the term of such arrangements resulting in financial statements that provide a better reflection of the entity’s performance and financial position. Accordingly, the board believes the new accounting policy will provide reliable and more relevant information to its users. Retrospective application of this change in accounting policy is impracticable following a recent computer virus that destroyed the company’s accounting records.

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Chapter18: Accounting policies and other disclosures

Case study 18.2 Accounting policies Refer to case study 18.1. Assume the change in the accounting policy for capitalizing hedge gains or losses was due to the issue of a revised accounting standard, AASB 9/IAS 9 Financial Instruments, which requires all hedge gains or losses to be taken to profit or loss, thereby removing the choice to capitalise. Required Advise the company of the disclosures, if any, that are required by this change in accounting policy. As the change in accounting policy was due to the issue of a new accounting standard, the provisions of paragraph 28 of AASB 108 are applicable as follows: • the title of the standard • when applicable, that the change is made in accordance with the transitional provisions of the standard, a description of those provisions and provisions that might have an effect on future periods • the nature of the change in accounting policy • to the extent practicable, the amount of the adjustment for the current and previous periods to each financial statement line item affected and, if applicable, the basic and diluted earnings per share • the amount of any adjustment to periods prior to those presented to the extent practicable • if comparative information has not been restated because it is impracticable to do so, the circumstances that prevented retrospective application and a description of how and from when the change in accounting policy has been applied. To comply with paragraph 28, the change in accounting policy note may be worded as follows in the absence of any transitional provisions of the new accounting standard (other variations are possible). The entity’s accounts have been prepared applying the revised accounting standard AASB 9 / IAS 9 Financial Instruments issued by the Australian Accounting Standards Board. The revised standard requires entities to take all gains or losses on cash flow hedges recognised in other comprehensive income to profit or loss. Previously, the standard allowed for such gains or losses to either be taken to profit or loss or capitalised to the hedged item. Historically the entity chose to capitalise these gains or losses but now takes them to profit or loss in line with the revised standard. Retrospective application of this change in accounting policy is impracticable following a recent computer virus that destroyed the company’s accounting records.

18.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 18.3 Materiality Antelope Ltd is a catering company specialising in providing catering services to remote area mine sites. The company has operations in Australia but during the current year it acquired significant long-term contracts in Pakistan and Nigeria. AASB 8/IFRS 8 Operating Segments requires entities to disclose material segment information but Antelope Ltd has failed to comply with this requirement. Required Discuss whether the non-disclosure by Antelope Ltd of information about operations in Pakistan and Nigeria would be material. According to paragraph 7 of AASB 101, information is material if its omission or misstatement could influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The non-disclosure of information relating the existence of long-term contracts in both Pakistan and Nigeria would be material to the users of Antelope’s financial statement. Both countries are considered politically and economically unstable so there is a significant risk that these operations could be disrupted exposing Antelope Ltd to potential losses on the contracts and other losses if corporate employees are harmed or property is destroyed. Disclosing the information allows users to assess such risks when making predictions about the company’s future performance and position and ensures an informed decision can be made.

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Chapter18: Accounting policies and other disclosures

Case study 18.4 Events occurring after the end of the reporting period The statement of financial position of Waterbuck Ltd as at 30 June 2023 includes an asset ‘Debenture money receivable $500 000’ and a liability ‘Debentures $500 000’. Note 12 to the accounts reveals that the issue of the debentures to a private investor was approved by the board of directors on 28 June 2023 but the debenture issue did not take place until 17 July 2023. Required Comment on the accounting treatment of the debenture issue in accordance with the requirements of AASB 110/IAS 10. The issue of the debentures on 17 July 2023 is a non-adjusting event after the end of the reporting period as it is indicative of conditions that arose after the end of the reporting period. Approval by a board of directors does not create a present obligation to repay debentures hence no liability existed as at 30 June 2023 and the debenture asset and liability should not have been recognised. The end of the reporting period adjusting journal should be reversed and the debenture issue, including the amount, disclosed in a note to the financial statements accounts as required by AASB 110, paragraph 21.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 18.5 Compliance with accounting policy disclosure requirements Accounting policy disclosures contained in Notes 1 and 12 from CSR Limited’s 2019 annual report were provided in figure 18.1. Required Provide a brief description of CSR’s accounting policies with respect to the following: 1. compliance 2. currency 3. depreciation 4. rounding. 1. Compliance: CSR prepares general purpose financial report in accordance with: • the Corporations Act 2001 • applicable accounting standards and interpretations including Australian accounting standards ensuring the Group’s financial statements and notes comply with IFRS, and other requirements of the law. 2. Currency: CSR’s presentation currency is the Australian dollar which also CSR’s functional currency. 3. Depreciation: is applied to depreciable assets based on expected useful life using the straight-line method. 4. Rounding: amounts are rounded to the nearest tenth of a million dollars.

18.9

Chapter18: Accounting policies and other disclosures

Application and analysis exercises Exercise 18.1 Annual reporting requirements, true and fair view The directors of an Australian company, Mulga Ltd, have formed a view that compliance with a particular AASB standard will mean the company’s financial statements will not provide a true and fair view, which is contrary to the Corporations Act. Required Advise the directors how this problem can be resolved when preparing the company’s financial statements in accordance with AASB 101/IAS 1. (LO1 and LO5) Under s296(1) of the Corporations Act 2001, the financial report must comply with the accounting standards. The Act then addresses the issue of true and fair view under s297 as follows: s297 True and fair view The financial statements and notes for a financial year must give a true and fair view of: (a) the financial position and performance of the company, registered scheme or disclosing entity; and (b) if consolidated financial statements are required—the financial position and performance of the consolidated entity. This section does not affect the obligation under section 296 of the Corporations Act 2001 for a financial report to comply with accounting standards. Note: If the financial statements and notes prepared in compliance with the accounting standards would not give a true and fair view, additional information must be included in the notes to the financial statements under section 295(3)(c) of the Corporations Act 2001. AASB101 Presentation of Financial Statements states that the application of Australian Accounting Standards, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. (paragraph 15). However, paragraph 17, states that a fair presentation also requires an entity to: (a) select and apply accounting policies in accordance with AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors (b) present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information; and (c) provide additional disclosures when compliance with the specific requirements in Australian Accounting Standards is insufficient to enable users to understand the impact or particular transactions, other events and conditions on the entity’s financial position and financial performance. The directors of Mulga Ltd can resolve the problem by ensuring that additional information is disclosed in the notes to its financial statements explaining its compliance with the relevant accounting standard and how such compliance impacts on the entity’s financial performance and position.

18.10

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Exercise 18.2 Accounting policies Lin Ltd has provided the following information to help with the preparation of the accounting policy note to the financial statements for the year ended 30 June 2024. •

• •

•

Lin Ltd values its inventories at the lower of cost and net realisable value. Costs are assigned to inventories as follows. (a) Raw materials: purchase cost on a first-in-first-out basis. (b) Work in progress: cost of direct material and labour and a proportion of manufacturing overheads based on normal operating capacity. (c) Finished goods: same as work in progress. Items of plant and equipment are measured using the cost basis. Land and buildings are measured using the fair value basis. Independent valuations of land and buildings are obtained every year unless circumstances indicate that an earlier valuation is required. The valuations are based on the amount that could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arm’s-length transaction on the valuation date. Where the carrying amount of land and buildings is materially different from its fair value, valuation adjustments are made. Valuation increases are credited to an asset revaluation surplus unless they are reversed against a previous valuation decrease. Valuation decreases are expensed unless they are reversed against a previous valuation increase. Buildings, plant and equipment are depreciated on a straight-line basis so as to write off the cost or other value of each asset less estimated residual value at the end of the life of the asset over its expected useful life. Depreciation of assets starts when they are installed and ready for use. Depreciation rates used by the company are as follows.

Receivables are carried at nominal amounts less any allowance for doubtful debts. An estimate of doubtful debts is recognised when collection of the full nominal amount is no longer probable. Bad debts are written off as incurred. Credit sales are on 30-day terms. In determining cash flows for the year, the company includes in the cash balance all cash on hand and in banks net of any outstanding bank overdrafts. Long-term cash deposits are not part of the daily cash management function and are regarded as investments. The company recognises liabilities for the following employee entitlements accrued as at the end of the reporting period: wages and salaries, annual leave and longservice leave. Such liabilities are measured as required by AASB 119/IAS 19 Employee Benefits.

Required Prepare the accounting policy note for inclusion in the financial statements of Lin Ltd as at 30 June 2024. This task may require you to research the accounting policy disclosure requirements of applicable accounting standards. (LO1)

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Chapter18: Accounting policies and other disclosures

Read the disclosure requirements of AASB 101 Presentation of Financial Statements. As there is no indication in the information presented that there have been any changes to accounting policies during the year we can assume that the policies are consistent with those adopted in prior periods. AASB 101 paragraph 117(b) requires disclosure of ‘the other accounting policies used that are relevant to an understanding of the financial statements’. To comply with this requirement it will also be necessary to check other standards to determine if additional or specific disclosures are required about policies adopted with respect to individual classes of assets, liabilities, income and expenses. For example, AASB 102, paragraph 36(a) requires accounting policies adopted for measuring inventories to be disclosed. Note, there is no specific wording or order required for disclosures under AASB 101 - this is a matter for management discretion. Lin Ltd Notes to the financial statements 30 June 2024 Summary of significant accounting policies Basis of accounting The financial report is a general-purpose financial report prepared in accordance with applicable accounting standards and interpretations, and the requirements of the Corporations Act 2001. The financial statements have been prepared in accordance with the historical cost convention except for land and buildings, which are measured at fair value. Judgements, estimates and assumptions In order for financial statements to comply with AASB standards, management is required to make judgements, estimates and assumptions when applying the company’s accounting policies. All judgements, estimates and assumptions are believed to be reasonable under the circumstances. Actual results may differ from these judgements, estimates and assumptions. Changes to accounting policies There have been no changes to accounting policies during the year. Receivables Receivables are carried at nominal amounts less any allowance for doubtful debts. An estimate of doubtful debts is recognised when collection of the full nominal amount is no longer probable. Bad debts are written off as incurred. Credit sales are on 30 day terms. Inventories Inventories are valued at the lower of cost and net realisable value. Costs incurred in bringing each inventory item to its present location and conditions are allocated as follows: • Raw materials – purchase cost on a first-in-first-out basis • Work in progress and finished goods – direct material and labour cost and a proportion of manufacturing overheads based on normal operating capacity.

18.12

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Property, plant and equipment Measurement Land and buildings are measured on a fair value basis. At each reporting date, the value of each asset in these classes is reviewed to ensure that it does not differ materially from the asset’s fair value at that date. Where necessary, the asset is revalued to reflect its fair value. All other classes of plant and equipment are measured at cost. Depreciation Buildings, plant and equipment are depreciated on a straight-line basis so as to write off the cost or other value of each asset less estimated residual value at the end of the life of the asset over its expected useful life. Depreciation of assets commences when they are installed and ready for use. Major depreciation rates are: • •

Buildings Plant and equipment

2024 5% 15% – 25%

2023 5% 15% - 25%

Employee entitlements Provision is made for employee entitlement benefits accumulated as a result of employees rendering services up to the reporting date. These benefits include wages and salaries, annual leave and long service leave. Provisions made in respect of employee entitlement benefits expected to be settled within 12 months are measured at their nominal amounts. Provisions made in respect of employee entitlement benefits not expected to be settled within 12 months are measured at the present value of the estimated future cash outflow to be made in respect of benefits accrued up to the reporting date. Cash and cash equivalents For the purposes of the statement of cash flows, cash includes cash on hand and in banks net of outstanding bank overdrafts.

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Chapter18: Accounting policies and other disclosures

Exercise 18.3 Accounting estimates and errors Yung Ltd estimates its future liability for repairs to products sold with a 12-month warranty as a percentage of its net credit sales. Warranty expense and actual repair costs for the last 2 years ending 30 June were as follows.

2021–22 2022–23

Warranty provisions

Actual costs

$ 10 000 11 000

$ 16 000 18 250

Required Comment on Yung Ltd’s accounting method for warranty liabilities. What action should be taken with respect to the accounting estimates? If an investigation during 2023–24 finds that the figure for warranty expense was incorrectly calculated for 2022– 23 and should have been $17 500, what action is required under AASB 108/IAS 8? (LO2 and LO3) The significant variances between the provision for warranty and the actual repairs in the two years indicate that either the policy of using a percentage of net credit sales as a means of estimating warranty costs is not appropriate, or the percentage used is not adequate. The company needs to look at changing either its policy or perhaps simply increasing the percentage used. Past claims as a percentage of past net credit sales should provide a reliable measure. If a new percentage is adopted it will be applied prospectively (from 2023-2024 on) according to AASB 108 paragraph 36. If the variance for 2022-2023 was due to an error in calculation then, providing it is material, the figures for 2022-2023 should be retrospectively corrected (according to AASB 108 paragraph 42) by the following entry: Retained earnings (1 July 2024) Provision for warranty

Dr Cr

6 500 6 500

Such a correction would suggest that the variance between the warranties that would have been provided for had the error not occurred ($17 500) and the actual warranties incurred ($18 250) were not material (i.e. only $750 or only 4%) which indicates that the revised level of warranty provision is appropriate.

18.14

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Exercise 18.4 Events after the reporting period Magpie Ltd operates a fleet of fishing trawlers. The following events took place after the end of the reporting period, 30 June 2022, but before the date the accounts were authorised, 15 September 2022. (a) On 17 July 2022, Magpie Ltd’s main fishing fleet was sunk during a freak storm. Insurance will cover the replacement of the vessels but lost sales representing $275 000 in profits are not covered. (b) On 19 July 2022 Magpie Ltd took delivery of a fishing net for its prawn trawler. The net was purchased from a UK manufacturer on delivered duty paid shipping terms and was in transit at the end of the reporting period. An inspection of the net revealed significant structural flaws and the net was returned to the supplier on 28 July 2022. Magpie Ltd is to receive a full refund of the $325 000 purchase price which had been paid in advance on 29 June 2022. (c) On 29 August 2022 a lawsuit was lodged against the company by the families of crew members drowned in the 17 July storm, alleging negligence, and claiming $2 million in damages. No date has as yet been set for the court hearing. (d) On 1 September 2022 the directors resolved to issue to the public 8 000 5% debentures of $10 each, payable $5 on application and $5 on allotment. Required Classify the above events into adjusting and non-adjusting events after the end of the reporting period, justifying your choice. (LO6) Classification of after reporting period events Assuming all events are material by reason of size and nature: Date 17 July 2022

Classification Non-adjusting

Justification The storm which caused the loss of the fishing fleet and the uninsured loss of profits occurred after the end of the reporting period and impacts on future conditions.

19 July 2022

Adjusting

The receipt and subsequent return of the fishing net provides new information about the assets owned by Magpie Ltd as at the end of the reporting period.

29 August 2022

Non-adjusting

The lawsuit arose as a consequence of an event after the end of the reporting period (the storm on 17 July) and it may have material effects on future cash flows or operations if the company has to pay the $2 million damages claim.

1 September 2022

Non-adjusting

The issue of $80 000 5% debentures to the public does not relate to conditions existing at the end of the reporting period but will have a material impact on future cash flows.

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Chapter18: Accounting policies and other disclosures

Exercise 18.5 Accounting policies and accounting estimates The following relate to Dog Ltd. (a) The useful life of depreciable plant is determined as being 5 years. (b) Dog Ltd depreciates non-current assets. (c) Dog Ltd uses straight-line depreciation. (d) Dog Ltd determines that it will calculate its warranty provision using past experience of products returned for repair under warranty. (e) The current year’s warranty provision is calculated by providing for 1% of current year sales, based on last year’s warranty claimed amounting to 1% of sales. Required Indicate whether each item is an accounting policy or an accounting estimate. (LO1) (a) Accounting estimate. (b) Accounting policy. (c) Accounting estimate (the policy is to depreciate non-current assets – see (b) – estimates are then required regarding: useful life; residual value; and pattern of benefits). (d) Accounting policy. (e) Accounting estimate (i.e., an accounting estimate that is determined by applying a policy of estimating warranty provisions as a % of sales based on the prior period %).

18.16

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Exercise 18.6 Materiality and events after the reporting period The following information has been made available to you to assist in the preparation of the financial statements of Alys Ltd for the year ended 30 June 2022. (a) The company has been involved in a dispute with a government environment agency relating to the release of noxious gases from its manufacturing plant in early June 2022. An expert investigation was conducted to determine if the company was at fault. The draft financial report already discloses contingent liability in the notes detailing the investigation and estimating the potential damages at $1.25 million. The investigator’s report, released on 1 August 2022, found Alys Ltd to be responsible for the release and damages amounting to $1 500 000 were payable by the company. (b) On 9 July 2022, the sales manager raised credit notes worth $30 000 relating to sales of faulty goods in the last 2 weeks of June 2022 (c) On 25 September 2022, the company received notification that a customer owing $130 000 had gone into liquidation. The liquidator advised that unsecured creditors are likely to receive a distribution of only 20c in the dollar. The liquidation was caused by a flood in July 2022 which destroyed the customer’s operating plant and warehouse. The damage was not covered by insurance. Alys Ltd’s draft profit for the year ended 30 June 2024 is $720 000. Required In relation to the above events or transactions, prepare the necessary notes or general journal entries to comply with applicable accounting standards. (LO5 and LO6) (a) Release of investigator’s report on 1 August 2022: The release of the report and the decision that damages were payable by Alys Ltd provide new information about conditions existing at the end of the reporting period given that the release of the noxious gases occurred in June 2022. Assuming a profit before tax of $720 000, at the amount of $1 500 000 is clearly material and the following adjustment should be made: 30 June 2022 Damages expense Damages payable (Recognition of damages liability)

Dr 1 500 000 Cr

1 500 000

(b) Credit notes raised on 9 July 2022: As these credit notes relate to sales which occurred prior to the end of the reporting period this provides more information about conditions existing at 30 June 2022 and will (or may, subject to materiality) require adjustment by journal entry. As the credit notes represent only approximately 4% of profit before tax ($30 000/$720 000), it could be argued that no adjustment is necessary on the grounds of immateriality but consideration must also be given to the $30 000 relative to accounts receivable i.e. what percentage of accounts receivables is $30 000?. The journal entry (ignoring materiality considerations) is shown below:

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Chapter18: Accounting policies and other disclosures

30 June 2022 Sales returns and allowances Accounts receivable (Credit notes relating to June sales)

Dr Cr

30 000 30 000

(c) Liquidation of debtor: As the liquidation was caused by an event after the end of the reporting period no adjustment will be made as this information does not change the situation that existed at 30 June 2022. However, the $104 000 loss (80 cents in the dollar x $130 000) will be material to next year’s profits based on the current year’s profit before tax ($104 000/$720 000 = 14%), and must be disclosed by note. Alys Ltd Notes to the financial statements for the year ended 30 June 2022 Note X: Events occurring after the end of the reporting period. In September 2022, a debtor owing $130 000 went into liquidation. The company expects to recover only 20% of the amount owing. Note that the question did not indicate the date on which financial statements are authorised for issue. If the authorisation date was before September 25 then this event would not be disclosed in the 2022 financial statements.

18.18

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Exercise 18.7 Events after the reporting period Monty Ltd has provided the following information concerning events occurring between the end of the reporting period and the date the accounts were authorised. This information is to be considered in the preparation of the financial statements for the year ended 30 June 2023. (a) On 17 July 2022, a firebomb destroyed four of the company’s transport vehicles resulting in damages of $600 000. Insurance will cover $450 000 of the damages but payment of the insurance claim has been delayed by a police investigation. As a result of the loss of these vehicles, the company’s delivery schedules have been severely disrupted. (b) On 18 July 2022, the release of a far superior and cheaper product by a competitor caused a major decline in demand for Monty Ltd’s Product X. In an effort to sell remaining stock of the product, Monty Ltd has reduced its selling price to 50% of cost. Inventories on hand at 30 June 2022 were recorded at their cost of $306 000. (c) On 15 August 2022, the Department of Occupational Health and Safety charged the company over unsafe storage practices that resulted in the leakage of toxic materials into a local creek. The leakage occurred on 3 July 2022. If found to be negligent by the court, the company will have to pay a fine of $250 000 plus legal and clean-up costs in excess of $175 000. (d) On 21 August 2022, the purchasing manager discovered that a batch of invoices relating to June inventories purchases had not been processed. The invoices totalled $58 480. (e) On 30 August 2022, the company issued a prospectus offering 6000 10% debentures of $150 each for public subscription. The debentures are redeemable on 1 October 2025. Interest is payable annually in arrears. The debentures are secured by a floating charge over the company’s assets. Assume all events and transactions are material. Required 1. Classify the above events as either adjusting or non-adjusting events after the end of the reporting period. Justify your classification. 2. Based on your answer to requirement 1, prepare the necessary journal entries or note disclosures to comply with the requirements of AASB 110/IAS 10. (LO6) 1. Classification of events: Date Event 17 July

Firebombing of vehicles

18 July

Selling price reduction for product X

Condition at 30 June 2022 None as vehicles destroyed after 30 June 2022 Inventory on hand at cost of $306 000

New information

Classification

Future losses

Non-adjusting

Net realisable value of inventory only $153 000 (50% x $306 000)

Adjusting

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Chapter18: Accounting policies and other disclosures

15 August

Charge of environmental damage lodged

None as leak occurred after 30 June 2022

21 August

Unrecorded purchase invoices Debenture offer

Accounts payable and inventory

30 August

Future fines ($350 000) plus legal costs and clean-up costs (> $175 000) Understatement of both items by $58 480

Non-adjusting

None as debentures Future cash flow effects issued after 30 June and increase of liabilities 2022

Non-adjusting

Adjusting

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2. Adjusting journal entries: 30 June 2022 Inventory write-down expense Inventory – Product X (Write-down to net realisable value) Inventory Accounts payable (Recognition of unrecorded invoices)

Dr Cr

153 000

Dr Cr

58 480

153 000

58 480

Note disclosures Note X: Events occurring after the end of the reporting period. On 17 July 2022, a firebomb destroyed a number of transport vehicles resulting in disruption of delivery schedules and an uninsured loss of $150 000. On 15 August 2022, the company was charged with environmental damages arising from a leakage of toxic materials from the storage tanks on 3 July 2022. Possible losses from fines, legal and clean-up costs could be in excess of $425 000. The directors will vigorously defend the claim of negligence. On 30 August 2022, the company offered 6000 10% $150 debentures for public subscription. The debentures are secured by floating charge over the company’s assets and are redeemable on 1 October 2025.

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Chapter18: Accounting policies and other disclosures

Exercise 18.8 Errors The annual audit of the accounting records and draft financial statements of Mala Ltd as at 30 June 2022 revealed the following errors and omissions. (a) Credit notes totalling $52 000 relating to June sales were posted against sales made in July. (b) The purchase price of $71 200 for a new vehicle on 1 January 2021 was posted to the vehicle maintenance expense account. Motor vehicles are depreciated at 25% p.a. straight-line. (c) A manufacturing assembly line has been taken out of operation pending its sale. The asset had a carrying amount of $40 000 as at 30 June 2022 and is likely to be sold for a profit. (d) No disclosure has been made about a fire in the warehouse during May that caused damage worth $280 000. The warehouse and its contents are fully insured. (e) No adjustment to the allowance for doubtful debts has been made to reflect the fact that a major debtor owing $31 500 went into liquidation after the end of the reporting period. Correspondence with the liquidator indicates that the expected payout will be no more than 10c in the dollar. Required Assume all errors and omissions are material. Prepare the necessary adjustments (if any) for all items. (LO3) 30 June 2023 Sales revenue Dr Accounts receivable Cr (July credit notes raised in respect of June sales) Motor vehicles Retained earnings (Correction of error from prior period)

Dr Cr

52 000 52 000

71 200 71 200

Depreciation expense – Motor vehicles Dr 17 800 Retained earnings Dr 8 900 Accumulated depreciation Cr (Depreciation expense for 18 months; $71 200 x 25% x 1½) Allowance for doubtful debts Dr Accounts receivable Cr (Debt written off as uncollectible: 0.9 x $31 500)

26 700

28 350 28 350

Note: No journal entry is required for the reclassification of the manufacturing assembly line as ‘non-current asset held for sale’ in the statement of financial position as it is expected to be sold for a profit, therefore its fair value less costs to sell is greater than its carrying amount. No disclosure is required regarding the fully-insured warehouse damage as (presumably) there was no adverse impact or financial loss incurred.

18.22

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Exercise 18.9 Materiality, errors and events after the reporting period You are currently auditing the financial statements and records of Badger Ltd for the year ended 30 June 2022. In the course of your investigations you uncover the following transactions that occurred after the end of the reporting period but which appear to relate to the financial year ended 30 June 2022. (a) Warranty costs raised for goods returned in the final two weeks of June 2022 were posted as July 2022 sales returns. The goods returned were worth $16 500. (b) On 16 September 2022, there was a fire in the company’s main warehouse. Loss of inventories was covered by insurance but there was significant disruption to the flow of production output. The financial effects of the disruption are estimated to be $150 000, and are not covered by insurance. (c) Badger Ltd manufactures textiles and purchases raw cotton from overseas. A shipment of cotton was in transit at the end of the reporting period and, given that the price per bale is determined by quality, an estimated cost of $125 000 was recognised. (d) The cotton duly arrived on 18 July 2022 and after examination it was determined that the cost will be $163 000. (e) On 23 July 2022, a favourable judgement was handed down in a lawsuit lodged by Badger Ltd against a major supplier for damages arising from poor-quality materials delivered in April 2021. The damages and costs awarded to Badger Ltd totalled $1 500 000. The draft accounts currently report this as a contingent asset. Required 1. Discuss how you would determine whether or not each of the above events is material, stating any additional information you would require in making your determination. 2. Assuming each of these events is considered material and occurred prior to the date the accounts were authorised, explain which, if any, are adjusting or non-adjusting events after the reporting period. (LO5 and LO6) 1. (a) Misposting of sales returns notes: These incorrectly posted transactions overstate sales revenue, accounts receivable and warranty costs by $16 500. Management would then need to determine whether omitting (i.e. not making) the change to the 30 June 2022 accounts could influence the economic decisions of users either by way of its size or nature. To assist management’s decision, the most appropriate bases against which to assess the relative size would seem to be profit before tax, sales revenue, accounts receivable and warranty costs. (b) Uninsured disruption to production output: This disruption (financial effects estimated to be $150 000) will have an overall decreasing effect on future profits. Management would then need to determine whether omitting (i.e. not making) the disclosure in the 30 June 2022 accounts could influence the economic decisions of users either by way of its size or nature. As this affects future profits, the most appropriate

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Chapter18: Accounting policies and other disclosures

bases against which to assess the relative size would seem to be average profit before tax and average equity calculated using the past, say, 3 to 5 years. (c) Increased cost of raw cotton inventory: The increase in cost of the cotton shipment will increase inventory and accounts payable by $38 000 ($163 000 - $125 000). Management would then need to determine whether omitting (i.e. not making) the change to the 30 June 2022 accounts could influence the economic decisions of users either by way of its size or nature. To assist management’s decision, the most appropriate bases against which to assess the relative size would seem to be inventory / current assets and accounts payable / current liabilities. (d) Receipt of damages: The damages award will increase revenue and cash by $1.5 million. Management would then need to determine whether omitting (i.e. not making) the change to the 30 June 2022 accounts could influence the economic decisions of users either by way of its size or nature. To assist management’s decision, the most appropriate bases against which to assess the relative size would seem to be profit before tax and cash / current assets. 2. The following events provide more information about conditions existing at the end of the reporting period and are adjusting events: • • •

Misposting of sales returns notes Increase in cost of raw cotton inventory Receipt of damages

The following events do not relate to conditions existing at the end of the reporting period but do provide material information with respect to future financial performance or financial position and are non-adjusting events: •

Uninsured disruption to production output.

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Exercise 18.10 Accounting policies, accounting estimates and errors In order to comply with AASB 108/IAS 8, determine whether the following changes should be accounted for prospectively or retrospectively. 1. 2. 3. 4.

A change in accounting estimate. A voluntary change in an accounting policy. A change in accounting policy required by a new or revised accounting standard. An immaterial error discovered in the current year, relating to a transaction recorded three years ago. 5. In the current year, a material error was discovered relating to a transaction recorded three years ago. (management determines that retrospective application would cause undue cost and effort). (LO1, LO2 and LO4) 1.

Prospective.

Retrospective.

As required by the transitional provisions of that Standard; if not specified then retrospective.

The amount is immaterial and so may either be ignored or corrected in the current year.

Retrospective application is required unless impracticable to do so, but the definition of impracticable does not include undue cost and effort (AASB 108 paragraph 5).

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Chapter18: Accounting policies and other disclosures

Exercise 18.11 Changes in accounting estimates On 1 July 2016, Swan Ltd acquired a building for $12 500 000 with an estimated life of 25 years and a residual value of nil. Swan Ltd uses the straight-line method of depreciation. Based on expert advice provided to Swan Ltd in 2022, it was decided the building should be depreciated over a total period of 20 years. At 1 July 2021, details for the building were as follows. Cost Accumulated depreciation

12 500 000 (2 500 000) 10 000 000

Carrying amount

Required Prepare the accounting policy note required by AASB 108/IAS 8 for this change in an accounting estimate by Swan Ltd for the year ended 30 June 2022. Show all workings. (LO2) Swan Ltd Extract from notes Year ended 30 June 2022 Note xx At the beginning of the financial year, the total useful life to the company of the building was revised downwards from 25 to 20 years. For each of the remaining 15 years of the asset’s life, including the current financial year, depreciation expense will be increased by $166 667, from the original estimate of $500 000, to $666 667. Workings: • Depreciation over useful life of 25 years = $12 500 000/25 years = $500 000. • Remaining useful life from 1 July 2021 after revised estimate: 15 years. • Depreciation of remaining carrying amount over a useful life of 15 years = $10 000 000/15 years = $666 667. • Increase in depreciation expense $666 667 - $500 000 = $166 667.

18.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 18.12 Accounting policies and changes in accounting estimates Camel Ltd traditionally estimated its allowance for doubtful debts as a percentage of net credit sales for the year. An analysis of the variance between the allowance amount and the actual bad debts written off for the past 5 years has shown significant unfavourable discrepancies. In the previous year (ended 30 June 2020) the allowance was estimated at $24 000 but bad debts written off during the current year were $11 200 more than allowed for. Consequently, the accountant has decided to change the method of estimation from a percentage of net credit sales to an analysis of the accounts receivable balances. This analysis estimated that the allowance for doubtful debts should be $35 600 as at 30 June 2021 (the current year). Required 1. Show the following for the year ended 30 June 2021: (a) the ledger account for the allowance for doubtful debts (b) the end of the reporting period adjusting journal entry. 2. Justify your accounting treatment in requirement 1 by reference to the requirements of AASB 108/IAS 8. 3. Explain how and why the change in method of estimation should be disclosed by Camel Ltd. (LO1 and LO2) 1. Date 30/6/21 30/6/21

Allowance for doubtful debts Details $ Date Details Accounts receivable* 35 200 1/7/20 Balance b/d Balance c/d 35 600 30/6/21 Bad & doubtful debts expense** 70 800 1/7/21 Balance b/d

$ 24 000 46 800 70 800 35 600

*$35 200 bad debts written off ($24 000 + $11 200) **$46 800 = $35 600 + $11 200 Balance date adjustment entry: 30/6/21 Bad & doubtful debts expense Allowance for doubtful debts (Balance date adjustment)

46 800 46 800

2. AASB 108, paragraph 36 requires that the effect of a change in an accounting estimate shall be recognised prospectively by including it in profit or loss in the period of the change. New information in the form of debts which actually went bad during the year ended 30 June 2021 proved that the estimate of doubtful debts as at 30 June 2020 (last year) was inadequate and should have been $35 200 rather than $24 000. The amount of $11 200 ($35 200 - $24 000) in bad debts written off that was more than allowed for last year has been added to bad debts expense for the current year (i.e. prospectively) in accordance with paragraph 36. The balance of the bad debts expense for the current year, $46 800, is comprised of $35 600

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Chapter18: Accounting policies and other disclosures

(allowance for doubtful debts as at 30 June 2021 based on an analysis of outstanding account receivable balances) plus $11 200 (adjustment for underestimation of allowance for doubtful debts as at 30 June 2020). 3. The key issue here is whether or not the change in the way Camel Ltd estimates its doubtful debts is a change in an accounting policy. AASB 108, paragraph 35 states ‘A change in the measurement basis applied is a change in an accounting policy, and is not a change in an accounting estimate. When it is difficult to distinguish a change in an accounting policy from a change in an accounting estimate, the change is treated as a change in an accounting estimate.’ The asset here is accounts receivable, a financial asset which is measured at the lower of nominal value and recoverable amount. Where a debt is not expected to be collected in full it is disclosed in the financial statements at its expected amount via the allowance for doubtful debt adjustment. The change in the way this ‘recoverable amount’ is estimated does not change the measurement basis and is therefore not a change in accounting policy. Camel Ltd should disclose the nature and amount of any change in an accounting estimate (according to AASB 108 paragraph 39), usually in its accounting policy note.

18.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 18.13 Accounting policies At a meeting on 16 June 2022, the directors of Alpaca Ltd decided to change the company’s accounting policy in regard to research and development expenditure. • In previous years, research and development expenditure had been capitalised and amortised over 3 years. In line with this policy, $150 000 was capitalised on 1 January 2021. • The new policy is to write off all research and development to expense when incurred. • During the year ended 30 June 2022, the company spent a further $86 000 on research and development which was capitalised on 1 January 2022. Research and development expenditure is allowable as a deduction for tax purposes when incurred. Required Prepare any note disclosures required by AASB 108/IAS 8 in respect of the change in accounting policy. Show all workings. (LO1) To comply with AASB 108, paragraphs 19(b) and 22, the change of accounting policy in regard to research and development expenditure needs to be applied retrospectively, i.e. Alpaca Ltd has to calculate the effect of the change on the opening balance of retained earnings and both current year profit and non-current asset figures. The capitalisation policy adopted in the prior year would have resulted in the following figures being reported in the financial statements for the year ended 30 June 2021: Statement of financial position: 2021 Other non-current assets Research and development Accumulated amortisation

$150 000 *25 000 125 000

Statement of profit or loss and other comprehensive income: 2021 Expenses Amortisation - research and development *$25 000 = $150 000/3 x ½ year

*$25 000

Income tax effect: As the total amount spent on research and development is tax deductible in the year of expenditure, a taxable temporary difference would have existed at 30 June 2021 as shown below: Asset Carrying Future Future Tax base Taxable amount taxable deductible temporary amount amount difference Research and $125 000 ($125 000) $0 $0 $125 000 development

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Chapter18: Accounting policies and other disclosures

A deferred tax liability of $37 500 ($125 000 x 30%) would have been recognised as a result of the taxable temporary difference. To adopt the new accounting policy the following journal entries would be posted: 16 June 2023 Accumulated amortisation Dr 25 000 Retained earnings (1/7/21) Dr 125 000 Research and development Cr (Derecognition of research and development asset) Deferred tax liability* Retained earnings (1/7/21) (Derecognition of deferred tax liability) * $37 500 = 30% x $125 000

Dr Cr

150 000

37 500 37 500

Note: AASB 108, paragraph 29 also requires comparative figures to be restated. If the new accounting policy had always been in place the financial statements at 30 June 2022 would include the following figures assuming a tax rate of 30%: Statement of financial position: No asset would be recorded. The comparative amounts for retained earnings (1/7/21) and deferred tax liability would both be lower by $87 500 ($125 000 - $37 500) and $37 500 (respectively). Statement of profit or loss and other comprehensive income: 2022 Expenses Research and development expense $125 000

2021 $150 000

Disclosure of accounting policy change: Alpaca Ltd Notes to the financial statements 30 June 2022 Summary of significant accounting policies Changes in accounting policies An adjustment of $(87 500) has been made to the opening balance of retained earnings representing the effect of a change in accounting policy for the recognition of research and development costs. As these costs are not considered to represent future economic benefits they are now expensed when they are incurred rather than being capitalised and amortised over 3 years. Accordingly, the research and development asset has been derecognised and an adjustment made to the balance of deferred tax liability. Comparative information has been restated to reflect the change in accounting policy.

18.30

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 18: Accounting policies and other disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 18: Accounting policies and other disclosures Multiple choice questions 1. Which of the following is not required to be disclosed in an entity’s accounting policy note? a. b. c. *d.

A description of the entity’s key accounting policies. That the financial statements are general purpose financial statements. The measurement bases used in the preparation of the financial statements. That the financial statements have been prepared on the going concern basis.

Answer: d Learning objective 18.1: describe how accounting policies and changes to accounting policies are disclosed in general purpose financial statements.

2. Which of the following disclosures are required by AASB 108/IAS 8 for a voluntary change in accounting policy? a. b. c. *d.

The nature of the change. The reasons that applying the new accounting policy provides reliable and more relevant information. The amount of the adjustment relating to periods prior to those presented to the extent practicable. All of these disclosures are required.

Answer: d Learning objective 18.1: describe how accounting policies and changes to accounting policies are disclosed in general purpose financial statements.

3. Bailey Limited has discovered that the estimated useful life for a material depreciable asset is incorrect due to a change in the way the asset is being used. The correct accounting treatment for this event is to: a. b. *c. d.

treat it as an error and adjust retrospectively. disclose the change in the notes to the financial statements. treat it as a change in an accounting estimate and adjust prospectively. treat it as a change in an accounting estimate and adjust retrospectively.

Answer: c Learning objective 18.2: describe how changes in accounting estimates are accounted for and disclosed in general purpose financial statements.

18.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following does not require an entity to use estimates when preparing its financial statements? *a. b. c. d.

The original purchase price of an asset Provision for employee benefit such as long-service leave Doubtful debts expense Depreciation expense

Answer: a Learning objective 18.2: describe how changes in accounting estimates are accounted for and disclosed in general purpose financial statements.

5. The correction of a material error that occurred in a previous period must be accounted for by: a. b. c. *d.

an adjustment in future accounting periods. a prospective adjustment to the financial statements. ignoring it; errors made in prior periods can’t be corrected. a retrospective restatement in the first financial statements issued after the discovery of the error.

Answer: d Learning objective 18.3: explain how prior period errors arise, and how they are accounted for and disclosed in general purpose financial statements.

6. Errors can occur for which of the following reasons? I. II. III. IV.

Mistakes in applying accounting policies Misinterpretation of facts Mathematical mistakes Fraud

*a. b. c. d.

I, II, III and IV I, II and III only II, III and IV only I and III only

Answer: a Learning objective 18.3: explain how prior period errors arise, and how they are accounted for and disclosed in general purpose financial statements.

18.2

Chapter 18: Accounting policies and other disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Correcting the recognition, measurement and disclosure of amounts of financial statement elements as if a prior period error had never occurred is known as: a. b. *c. d.

prior period application. historical restatement. retrospective restatement. retrospective application.

Answer: c Learning objective 18.4: explain the requirements when it is impracticable to make retrospective adjustments for changes in accounting policies or correction of errors.

8. In determining whether an item is material, consideration must be given to: a. b. c. *d.

its value. its size only. its nature only. both its size and nature.

Answer: d Learning objective 18.5: describe the concept of materiality and how material items are identified.

9. Which of the following statements relating to materiality is correct? a. *b. c. d.

Materiality only ever depends on the size of an item. The disclosure provisions of accounting standards do not need to be applied if the resulting information is immaterial. Extensive guidance is given in accounting standards on the concept of materiality. The disclosure provisions of accounting standards must always be applied even if the resulting information is immaterial.

Answer: b Learning objective 18.5: describe the concept of materiality and how material items are identified.

10. According to AASB 108, omissions or misstatements are material if they: a. b. c. *d.

have resulted from an act of fraud. are less than 10% of the relevant base amount. are greater than 10% of the relevant base amount. could influence the economic decisions of users as based on the financial statements.

Answer: d Learning objective 18.5: describe the concept of materiality and how material items are identified. © John Wiley and Sons Australia, Ltd 202021

18.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. The financial statements of an entity are authorised for issue on: *a. c. d. b.

the day the directors’ declaration is signed. the last day of the financial year. the day the auditor’s report is signed. 30 June each year.

Answer: a Learning objective 18.6: explain the difference between types of events occurring after the end of the reporting period and how they are to be treated in the financial statements.

12. Events occurring after the end of the reporting period which provide evidence of conditions that existed at the end of the reporting period are known as: a. *b. c. d.

reporting events. adjusting events. disclosing events. non-adjusting events.

Answer: b Learning objective 18.6: explain the difference between types of events occurring after the end of the reporting period and how they are to be treated in the financial statements. 13. A company’s workforce went on strike for an indefinite period commencing on 28 July 2022. The strike was expected to cause severe financial conditions for the company. The financial statements for the year ended 30 June 2022 were expected to be finalised by 3 August 2022. In accordance with AASB 110 Events after the Reporting Period, the appropriate treatment regarding this event is to: a. b. *c. d.

adjust the financial statements, as it is an adjusting event. disclose as a note to the financial statements, as it is an adjusting event. disclose as a note to the financial statements, as it is a non-adjusting event. do nothing as the event has occurred after the end of the reporting period.

Answer: c Learning objective 18.6: explain the difference between types of events occurring after the end of the reporting period and how they are to be treated in the financial statements.

18.4

Chapter 18: Accounting policies and other disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Prior to the finalisation of the financial statements for the year ended 30 June 2021, a company experienced a number of material events, including: I. II. III.

on 15 July 2021 the directors decided to close a division of the company at an estimated cost of $920 000. on 18 August 2021 a court decision found the company liable to pay damages of $350 000 to a major customer who had commenced legal action in April 2020. an independent valuation of property conducted on 29 July 2021 revealed that the directors’ valuation included in the 30 June 2021 financial statements was overstated by $400 000.

General journal entries to adjust the financial statements will be required for which of the above events? a. b. c. *d.

I, II and III. II only, and make a note disclosure for I and III. III only, and make a note disclosure for I and II. II and III only, and make a note disclosure for I.

Answer: d Learning objective 18.6: explain the difference between types of events occurring after the end of the reporting period and how they are to be treated in the financial statements.

18.5

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 19: Earnings per share

Chapter 19: Earnings per share Comprehension questions 1. What is the earnings per share ratio used for? The earnings per share ratio is used to compare the after-tax profit available to ordinary shareholders of an entity on a per share basis, with that of other entities.

2. What are the components in the numerator and the denominator in the earnings per share calculation? Earnings per share is measured by dividing profit (or loss) attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period. This ratio is comprised of two components: a numerator (top line), and a denominator (bottom line) as follows. Numerator: Profit attributable to ordinary shareholders of the parent entity Denominator: Weighted average number of ordinary shares outstanding during the reporting period.

3. Where are the earnings per share figures for a parent entity presented? Under paragraph 4 of AASB 133/IAS 33, if an entity presents both consolidated and separate financial statements, the AASB 133/IAS 33 disclosures need only be determined on the basis of consolidated information. As the parent entity earnings per share information may be helpful to some users, entities have the option of also disclosing earnings per share figures for the parent entity. However, this information can only be presented in the parent’s separate financial statements and not in the consolidated financial statements (AASB 133/IAS 33 BC paragraphs 5, 6). 4. Why is a time-weighting factor used to determine the number of shares that is used in the calculation of basic earnings per share? As the earnings per share calculation is focused on the ordinary equity of an entity, the denominator in the calculation contains only ordinary share capital. Because entities are able to make new share issues during a reporting period, the number of shares on issue can increase. They are also able to repurchase or cancel shares, which will decrease the number of shares on issue, and to split or to consolidate shares which will vary the number of shares on issue. Other actions, including the conversion of convertible preference shares or other convertible securities into ordinary shares, can also vary the amount of shares outstanding. Accordingly, the number of ordinary shares that is used in the calculation of basic earnings per share is adjusted by a time-weighting factor, which is the number of days in the reporting period that the shares are outstanding as a proportion of the total number of days in the period (AASB 133/IAS 33, paragraph 20).

19.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

5. What is the treatment applied to treasury shares when calculating the weighted average number of shares used in the earnings per share calculation? Shares that are repurchased and held by the issuing entity are termed ‘Treasury’ shares. If a purchase of Treasury shares (share repurchase) occurs, then the weighted average number of shares outstanding for the period in which the transaction takes place must be adjusted for the reduction in the number of shares from the date of the event (AASB 133/IAS 33, paragraph 29). 6. Distinguish between basic earnings per share and diluted earnings per share. ‘Basic’ earnings per share is a ratio of the profit (or loss) attributable to ordinary shareholders, and the weighted average number of ordinary shares outstanding during the relevant reporting period. ‘Diluted’ earnings per share is a ratio which recognises the potential dilutive effect of the basic earnings per share ratio from the assumption that the entity’s convertible securities are converted, its warrants or options are exercised, or that its contingently issuable shares are issued. 7. Explain the effect of potential ordinary shares on the calculation of diluted earnings per share. In the measurement of diluted earnings per share, adjustments must be made to the profit(or loss) attributable to ordinary shareholders for: the after-tax amount of dividends, interest or other income or expenses recognised in the reporting period in respect of dilutive securities that would no longer arise if they were converted to ordinary shares. Adjustments must also be made to increase the weighted average number of ordinary shares outstanding to reflect what the weighted average would have been, assuming that all potential ordinary shares (dilutive securities) had been converted. 8. Explain how the amount of dilution from options is determined. When determining the effect of options on diluted earnings per share, the difference between the number of ordinary shares issued and the number that would have been issued at the average market price is treated as an issue of ordinary shares for no consideration. Options are regarded as dilutive if they would result in the issue of ordinary shares for less than the average market price during the reporting period. The amount of the dilution is determined as the average market price of ordinary shares during the period, minus the issue price. 9. When determining the amount of the proceeds from options and warrants, how is the average share price established? The proceeds from options and warrants are regarded as received from the issue of ordinary shares at the average market price during the period. AASB 133/IAS 33, paragraphs 45-46 require that the difference between the number of ordinary shares issued and the number that would have been issued at the average market price, be treated as an issue of ordinary shares for no consideration.

19.3

Chapter 19: Earnings per share

10. Why are retrospective adjustments made to earnings per share ratios? Retrospective adjustments are made to earnings per share ratios in order to restate the values of relevant items so that valid comparisons across time can be made. If, for example, the number of issued shares increases during a reporting period as a result of a bonus issue for no consideration, then the operating profit for the whole period in which the bonus issue occurred will be attributable to the increased number of shares, and not to the lesser number of shares outstanding at the beginning of the reporting period.

11. Where are the basic and diluted earnings per share ratios presented in a set of financial statements? The basic and diluted earnings per share ratios must be presented in an entity’s statement of profit or loss and other comprehensive income (AASB 133/IAS 33, paragraph 66), even if the amounts are negative (AASB 133/IAS 33, paragraph 69). If the items of profit or loss are presented in a separate statement then the basic and diluted earnings per share ratios are required to be presented in that statement.

19.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 19.1 Contingently issuable ordinary shares The directors of Carter Limited are not sure how to, or if they should, include ordinary shares issuable under employee share-based payment schemes in the calculation of the company’s earnings per share. Required Advise the directors on the considerations required regarding contingently issuable ordinary shares as per AASB 133/IAS 33. Paragraphs 52-57 of AASB 133/IAS 33 discuss the requirements for contingently issuable ordinary shares. The following points provide a summary of the regulations for contingently issuable ordinary shares. • Treated as outstanding and included in the calculation of earnings per share (both basic and diluted) if conditions are satisfied (the events have occurred). • They are to be included from the beginning of the period, or from the date of the contingent share agreement, if later. • If conditions to the agreement are not satisfied: - The number of shares included in diluted EPS based on the number that would be issuable if the end of the period were the end of the contingency period. - Restatement is not permitted if the conditions are not met when the contingency period expires. • If the contingent issue requires the attainment or maintenance of a specified amount of earnings for a period, and that amount is attained at the end of the period but needs to be maintained for an additional period, then the additional ordinary shares are considered to be outstanding in calculation of diluted EPS – only if the affect is dilutive. Basic EPS does not include such contingently issuable ordinary shares until the end of the contingency period as not all necessary conditions have been met. • If the contingent issue depends on a future market price for ordinary shares, they are considered outstanding and the number of shares is based on the number of ordinary shares that would be issued if the market price at the end of the period were the market price at the end of the contingency period – included in diluted EPS if dilutive. If the contingency is based on an average market price being maintained into a future period, then the average for the period of time that has lapsed is used. Basic EPS does not include such contingently issuable ordinary shares until the end of the contingency period as not all necessary conditions have been satisfied. • If the contingency is dependent on both the achievement of future earnings and future market price, then the number of ordinary shares included in the diluted EPS calculation is based on both conditions. They are not included in basic EPS unless both conditions have been satisfied. • If the contingency requires another condition, e.g. opening of a specific number of retail stores, the number of contingently issuable shares will be included in the diluted EPS assuming the conditions remain unchanged until the end of the contingency period.

19.5

Chapter 19: Earnings per share

•

Finally, exercise or conversion of contingently issuable ordinary shares can only be included in calculating diluted EPS if the exercise or conversion is assumed for similar outstanding potential ordinary shares that are not contingently issuable.

19.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 19.2 Earnings per share reported in notes Visit the websites of three Australian companies in the energy industry and access their latest annual reports. Compare the income statements and the notes to the financial statements with regards to information provided on the companies’ earnings per share. Report your findings, particularly in relation to items affecting the diluted earnings per share. Student responses will obviously vary. They should be reporting to the class on the classes of shares issued by each company, any share issues or repurchases affecting the weighted average number of shares calculation for basic EPS, and any potential ordinary shares that impact the diluted EPS. A list of Australian companies in the energy industry can be found at: • http://www.asx.com.au/asx/research/listedCompanies.do?coName=S

19.7

Chapter 19: Earnings per share

Case study 19.3 Comparing earnings per share Access the 2018 annual report of Wesfarmers Limited and compare the basic and diluted EPS results to those of Woolworths Group Limited for 2018 as provided in this chapter. Discuss which company appears to have the better earnings per share results. Students can access the annual reports for Woolworths Group Limited and Wesfarmers Limited at the following links: • http://www.woolworthslimited.com.au/annualreport/2018/ • http://ir.wesfarmers.com.au/phoenix.zhtml?c=144042&p=irol-irhome

19.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 19.1 Scope of AASB 133/IAS 33 If an entity presents both consolidated and separate financial statements, which statements are used for the calculation of basic earnings per share? Give reasons for your answer. (LO2) If an entity presents both consolidated and separate financial statements, the AASB 133/IAS 33 disclosures relating to basic earnings per share are determined on the basis of consolidated information. This disclosure is provided for in AASB 133/IAS 33, paragraph 4.

19.9

Chapter 19: Earnings per share

Exercise 19.2 Components of basic earnings per share Which of the following is a component of earnings used in the calculation of basic earnings per share? Give reasons for your answer. (a) Profit before tax expense (b) Preference dividends declared during the period (c) Income tax expense (d) Profit from discontinued operations (e) Prior year dividend paid to holders of cumulative preference shares (LO3) AASB 133/IAS 33, paragraphs 12 and 13 set out the components of earnings used in the calculation of basic earnings per share. Accordingly: (a) Profit before income tax expense is included (b) Preference dividends declared during the period are deducted (excluded) (c) Income tax expense is deducted (excluded) (d) Profit from discontinued operations is deducted (excluded) (e) Prior year dividend paid to holders of cumulative preference shares are deducted (excluded).

19.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 19.3 Measuring basic earnings per share On 30 June 2023, Samira Ltd determines profit attributable to ordinary shareholders as $600 000. At the beginning of the reporting period the company had 2 400 000 ordinary shares outstanding. The company had no share issues during the period. Required Calculate Samira Ltd’s 2023 basic earnings per share ratio. (LO3) $600 000 2 400 000

$0.25

19.11

Chapter 19: Earnings per share

Exercise 19.4 Theoretical ex-rights value Tully Ltd has 60 000 ordinary shares on issue. The company announced a 1-for-3 rights issue with an exercise price of $5 for each right. The market price of one ordinary share immediately before the exercise of the rights was $7. Required Determine the theoretical ex-rights value per share. (LO3) One for three rights issue: Number of shares on issue Number of new shares Theoretical ex-rights number of shares

60 000/3

60 000 20 000 80 000

Calculate the theoretical ex-rights value per share: (60 000 x $7) + (20 000 x $5) 80 000 $420 000 + $100 000 80 000 = $6.50

19.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 19.5 Rights adjustment factor and adjusted basic earnings per share Assume that in exercise 19.4 Tully Ltd announced the rights issue at the beginning of its reporting period (1 July 2023) and the last date for exercising the rights was 1 October 2023. Kelso Ltd announced profit attributable to ordinary shareholders of $329 175 for the full reporting period. Required Use the theoretical ex-rights value per share determined in exercise 19.4 to calculate the adjustment factor, and calculate adjusted basic earnings per share. (LO3) Theoretical ex-rights value per share (from exercise 19.4) $6.50 Share price immediately before the exercise of rights Adjustment factor

$7.00

$7.09 = 1.09 $6.50

Calculate adjusted basic earnings per share: $329 175 (60 000 x 1.09 x 3/12) + (80 000 x 9/12) = $329 175 76 350

= $4.31

19.13

Chapter 19: Earnings per share

Exercise 19.6 Categorising An entity announces a share split to occur in the current reporting period. There is no consideration payable by existing shareholders and therefore no corresponding increase in the entity’s resources. Required Should the entity recognise the additional shares in the weighted average number of shares used in calculating basic earnings per share? Explain. (LO3) The share split involves no consideration and has no corresponding increase in the entity’s resources. Therefore, the number of ordinary share outstanding before the event must be adjusted for the proportionate change in the number of outstanding as if it had occurred at the beginning of the earliest presented in the financial statements (AASB 133/IAS 33, paragraph 28). For example, under a share split, multiplying the number of ordinary shares outstanding before the share split determines the number of additional ordinary shares.

19.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 19.7 Bonus issue of shares On 1 January 2022, Rangeville Ltd has 50 000 ordinary shares outstanding. On 1 March 2022, the company announces a bonus issue of 2 shares for every share held on that date. By the end of the year Rangeville Ltd’s profit attributable to ordinary shareholders amounts to $225 000 (2021: $150 000). Required Calculate the 2022 and 2021 basic earnings per share amounts that Rangeville Ltd must disclose in its financial statements for the year ended 31 December 2022. (LO3) Bonus issue on 1 March 2022

50 000 x 2

100 000

Basic earnings per share 31 December 2022

$225 000 50 000 + 100 000

= $1.50

Basic earnings per share 31 December 2021

$150 000 50 000 + 100 000

= $1.00

19.15

Chapter 19: Earnings per share

Exercise 19.8 Measurement principles The directors of Singh Group have decided to repurchase 200 000 ordinary shares in an on-market’ arm’s length transaction. Required Are the treasury shares acquired in this transaction included in the weighted average number of shares outstanding when determining basic earnings per share? Explain your answer. (LO3) The treasury shares are not included in the number of shares outstanding when determining the basic earnings per share. The entity’s resources are reduced by any consideration paid in purchasing treasury shares, so if a purchase of treasury shares occurs, then the weighted average number of shares outstanding for the period must be adjusted for the reduction in the number of shares from the date of the event.

19.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 19.9 Effect of share options on diluted earnings per share Ryan Ltd determines profit attributable to ordinary shareholders for the reporting period ended 30 June 2023 as $48 000. The company has calculated its weighted average number of ordinary shares on issue during the period as 240 000. The weighted average number of shares under share options arrangements during the period is 12 000. The average market price of the entity’s shares during the period is $1.20 per share, and the exercise price of shares under option is $0.75. Required Prepare a schedule setting out the calculation of basic earnings per share and diluted earnings per share. (LO4)

Basic earnings per share is calculated as: Earnings $ Profit attributable to ordinary shareholders for the 48 000 reporting period 30 June 2023 Weighted average shares on issue during the period Basic earnings per share Diluted earnings per share is calculated as: Weighted average number of shares under option Weighted average number of shares that would have been issued at average market price, is (12 000 x $0.75)/$1.20 Diluted earnings per share 48 000

Per share $

240 000 0.20 12 000 (7 500)

244 500

0.196

19.17

Chapter 19: Earnings per share

Exercise 19.10 Determining the additional shares from potentially dilutive options Tenham Ltd has 30 000 ordinary shares outstanding during the reporting period ended 30 June 2024. The average market price of its ordinary shares during the period was $6.75 per share. The company also has 7500 options on issue with an exercise price of $6.00 each. Required Calculate the additional shares attributable to ordinary shareholders from the potentially dilutive options. (LO4) Potential ordinary shares from dilutive options Increase in earnings Additional shares issued for no consideration 7 500 x ($6.75 - $6.00)/$6.75 Earnings per additional share

$0 833.33 $0

19.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 19.11 Theoretical ex-rights value, rights adjustment factor and basic earnings per share effect of share options on diluted earnings per share At the beginning of the current reporting period (1 January 2023 – 31 December 2023) Daintree Ltd has 60 000 ordinary shares on issue. The company announced a 1-for-5 rights issue on 1 January 2023. The exercise price is $2 and the last date to exercise the rights is 1 April 2023. The market price of one share immediately before exercise on 1 April 2023 was $3. At the end of the current reporting period, Daintree Ltd determined profit attributable to ordinary shareholders at $244 650. Required Determine the theoretical ex-rights value per share, the rights adjustment factor, and the basic earnings per share. (LO5) 1-for-5 rights issue: Number of shares on issue 60 000 Number of new shares 60 000/5 = 12 000 Theoretical ex-rights number of shares 72 000 Theoretical ex-rights value per share: (60 000 x $3) + (12 000 x $2) 60 000 + 12 000 $204 000 72 000

$2.83

1.06

Rights adjustment factor: $3.00 $2.83 Basic earnings per share: $244 650 (60 000 x 1.06 x 3/12) + (72 000 x 9/12) $244 650 69 900

$3.50

19.19

Chapter 19: Earnings per share

Exercise 19.12 Disclosure Lismore Ltd operates an executive performance share plan. Under this plan, the company grants rights to employees which are convertible into ordinary shares of the company. It also grants options under the plan. The options have a term of 5 years and are converted into ordinary shares when the executives satisfy their individual performance conditions. The options granted during the current reporting period are considered antidilutive; however, in past years the options granted have been dilutive. Required Prepare an appropriate note to be included in the financial statements of Lismore Ltd disclosing the information concerning the classification of potential ordinary shares. (LO6) Lismore Ltd Notes to be financial statements for the year ended 30 June 20xx Note X. Earnings per share (a) Information concerning rights and options granted to employees Rights Rights granted to employees under the Executive Performance Share Plan (EPSP) are considered to be potential ordinary shares and have been included in the determination of diluted earnings per share to the extent to which they are dilutive. The rights have been excluded in the determination of basic earnings per share. Options Options granted to employees under the EPSP have a term of 5 years and vest when executives satisfy individual performance conditions. The options are considered to be potential ordinary shares and have been included in the determination of diluted earnings per share to the extent to which they are dilutive. In the current year the options are considered anti-dilutive (previous year; dilutive). The options could potentially dilute basic earnings per share in the future. The options have been excluded in the determination of basic earnings per share.

19.20

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 19: Earnings per share Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 19: Earnings per share Multiple choice questions

1. EPS refers to: a. *b. c. d.

equity per share. earnings per share. earnings per shareholder. earnings per subsidiary.

Answer: b Learning objective 19.1: explain the objective of AASB 133/IAS 33. 2. Earnings per share is calculated by comparing an entity’s revenue) with the : a. b. *c. d.

(profit or

profit; number of shareholders. revenue; number of shareholders. profit; number of ordinary shares it has on issue. revenue; number of ordinary shares it has on issue.

Answer: c Learning objective 19.1: explain the objective of AASB 133/IAS 33.

3. Earnings per share disclosed by reporting entities have limitations because of the: I. II. III. IV. *a. b. c. d.

Different accounting methods that can be used in the determination of profit. Different amounts of profit depending on the size of the entity. Different numbers of shareholders depending on the size of the entity. Ability of an entity to change the number of shares used in the denominator. I and IV. II and III. II and IV. I and III.

Answer: a Learning objective 19.1: explain the objective of AASB 133/IAS 33.

19.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Earnings per share is calculated by: a.

b. c.

*d.

dividing profit or loss attributable to preference shareholders of a parent entity, by the weighted average number of ordinary shares the entity has on issue during the reporting period. dividing profit or loss attributable to ordinary shareholders of a parent entity, by the number of ordinary shares the entity has on issue at the end of the reporting period. dividing profit or loss attributable to ordinary shareholders of a parent entity, by the number of ordinary shares the entity has on issue at the beginning of the reporting period. dividing profit or loss attributable to ordinary shareholders of a parent entity, by the weighted average number of ordinary shares the entity has on issue during the reporting period.

Answer: d Learning objective 19.1: explain the objective of AASB 133/IAS 33.

5. Under AASB 133, if an entity presents both consolidated and separate financial statements, the necessary disclosures need only be determined on the basis of: a. b. *c. d.

parent entity only. subsidiary entities only. consolidated information. the entity has choice of either parent entity or consolidation.

Answer: c Learning objective 19.2: discuss the application and scope of AASB 133/IAS 33.

6. AASB 133 applies to the computation and presentation of earnings per share by: a. b. c. *d.

both reporting and non-reporting entities. only reporting entities whose shares are publicly traded. only those entities that are in the process of issuing ordinary shares that will be traded in public markets. reporting entities whose shares are publicly traded, or of entities that are in the process of issuing ordinary shares that will be traded in public markets.

Answer: d Learning objective 19.2: discuss the application and scope of AASB 133/IAS 33.

19.2

Chapter 19: Earnings per share Not for distribution in full. Instructors may assign selected questions in their LMS.

7. The profit or loss that is used in the calculation of basic earnings per share is calculated as: a. *b. c. d.

profit before tax expense – tax expense – ordinary dividends. profit before tax expense – tax expense – preference dividends. profit before tax expense – tax expense. profit before tax expense.

Answer: b Learning objective 19.3: discuss the components of basic earnings per share and examine how it is measured.

8. The number of shares used in the calculation of earnings per share is: a. b.

*d.

the average of the number of ordinary shares outstanding at the beginning and end of the reporting period. the number of preference shares adjusted by a time-weighting factor which is the number of days in the reporting period that the shares are outstanding as a proportion of the total number of days in the period. the number of ordinary and preference shares adjusted by a time-weighting factor which is the number of days in the reporting period that the shares are outstanding as a proportion of the total number of days in the period. the number of ordinary shares adjusted by a time-weighting factor which is the number of days in the reporting period that the shares are outstanding as a proportion of the total number of days in the period.

Answer: d Learning objective 19.3: discuss the components of basic earnings per share and examine how it is measured.

9. On 1 July 2021, the beginning of the reporting period, Arthur Ltd has 40 000 ordinary shares on issue. On 1 April 2022, Arthur Ltd issued a further 10 000 ordinary shares for cash. The weighted average number of shares for use in the earnings per share calculation is: *a. b. c. d.

42 500 shares. 40 000 shares. 50 000 shares. 45 000 shares.

Answer: a Feedback: 40 000 + (10 000 x 3/12) Learning objective 19.3: discuss the components of basic earnings per share and examine how it is measured.

19.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. On 1 January 2021, the beginning of the reporting period, Jupiter Ltd has 50 000 ordinary shares on issue. On 30 June 2021, Jupiter Ltd issued a further 20 000 ordinary shares for cash. On 1 November 2021, Jupiter Ltd repurchased 2 400 shares at fair value in a market transaction. The weighted average number of shares for use in the earnings per share calculation is: a. b. *c. d.

60 000 shares. 70 000 shares. 60 400 shares. 72 400 shares.

Answer: c Feedback: 50 000 + (20 000 x 6/12) + (2 400 x 2/12) Learning objective 19.3: discuss the components of basic earnings per share and examine how it is measured.

11. Margaret Ltd determined its profit attributable to ordinary shareholders for the reporting period ended 30 June 2022 as $840 000. The number of ordinary shares on issue up to 31 October 2022 was 50 000. Margaret Ltd announced a two-for-one bonus issue of shares effective for each ordinary share outstanding at 31 October 2022. Basic earnings per share at 30 June 2023 is: *a. b. c. d.

$5.60 $7.20 $8.40 $16.80

Answer: a Feedback: $840 000 / [50 000 + (50 000 x 2)] = $840 000 / 150 000 Learning objective 19.3: discuss the components of basic earnings per share and examine how it is measured.

19.4

Chapter 19: Earnings per share Not for distribution in full. Instructors may assign selected questions in their LMS.

12. Murray Ltd determined its profit attributable to ordinary shareholders for the reporting period ended 30 June 2022 as $630 000. The average market price of the entity’s shares during the period is $3.00 per share. The weighted average number of ordinary shares on issue during the period is 100 000. The weighted average number of shares under share options arrangements during the year is 20 000 and the exercise price of shares under option is $1.50. Murray Ltd’s basic earnings per share at 30 June 2022 is: a. *b. c. d.

$0.63 $6.30 $5.25 $2.10

Answer: b Feedback: $630 000 / 100 000 Learning objective 19.4: explain the concept of diluted earnings per share and how it is measured.

13. For the purposes of calculating diluted earnings per share, an entity shall adjust the profit attributable to ordinary shareholders by the after-tax effect of the following item(s) related to dilutive potential ordinary shares: a. b. c. *d.

dividends only. interest only. other income or expenses only. dividends, interest, other income or expenses.

Answer: d Learning objective 19.4: explain the concept of diluted earnings per share and how it is measured.

14. If all of the dilutive securities were converted into ordinary shares, the diluted earnings per share ratio: a. b. *c. d.

must include an adjustment to increase the number of ordinary shares that would be outstanding. may include an adjustment to increase the weighted average number of ordinary shares that would be outstanding. must include an adjustment to increase the weighted average number of ordinary shares that would be outstanding. must include an adjustment to decrease the weighted average number of ordinary shares that would be outstanding.

Answer: c Learning objective 19.4: explain the concept of diluted earnings per share and how it is measured. © John Wiley and Sons Australia, Ltd 2020

19.5

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Any errors or adjustments resulting from changes in accounting policies that are accounted for retrospectively requires: a. *b. c. d.

no retrospective adjustment to either basic or diluted earnings per share. a retrospective adjustment to both basic and diluted earnings per share. a retrospective adjustment to basic earnings per share only. a retrospective adjustment to diluted earnings per share only.

Answer: b Learning objective 19.5: explain the need for retrospective adjustment of earnings per share.

16. A company issues bonus shares for no consideration on 1 August 2021. For the reporting period ended 30 June 2022, the calculation of: a. b. c.

*d.

only basic earnings per share must be adjusted retrospectively for all periods that are presented in the financial statements. only the diluted earnings per share must be adjusted retrospectively for all periods that are presented in the financial statements. both basic earnings per share and diluted earnings per share may be adjusted retrospectively at the option of the entity for all periods that are presented in the financial statements. both basic earnings per share and diluted earnings per share must be adjusted retrospectively for all periods that are presented in the financial statements.

Answer: d Learning objective 19.5: explain the need for retrospective adjustment of earnings per share.

17. The basic earnings per share and diluted earnings per share ratios must be presented in an entity’s: a. b. *c. d.

statement of financial position even if the amounts are negative. statement of changes in equity even if the amounts are negative. statement of profit or loss and other comprehensive income even if the amounts are negative. statement of profit or loss and other comprehensive income only if the amounts are positive.

Answer: c Learning objective 19.6: describe and apply the disclosure requirements of AASB 133/IAS 33.

19.6

Chapter 19: Earnings per share Not for distribution in full. Instructors may assign selected questions in their LMS.

18. Paragraphs 70–73 of AASB 133 prescribe various disclosures relating to earnings per share. The disclosures include: I. II. III. IV.

a. *b. c. d.

The amounts used as the numerators (earnings) in the ratios. The number of ordinary shares outstanding at the end of the financial year. The weighted average number of ordinary shares used as the denominator in the ratios. A reconciliation of the earnings amounts to the profit or loss attributable to the parent entity. for the period including the individual effect of each class of instruments that affects earnings per share. I, II and III. I, III and IV. II, III and IV. I, II and IV.

Answer: b Learning objective 19.6: describe and apply the disclosure requirements of AASB 133/IAS 33.

19. If the entity has a discontinued operation, then it must also calculate and disclose the: a. b. *c. d.

basic earnings per share ratio only for the discontinued operation in the statement of profit or loss and other comprehensive income. diluted earnings per share ratio only for the discontinued operation in the statement of profit or loss and other comprehensive income. basic and diluted earnings per share ratios for the discontinued operation in the statement of profit or loss and other comprehensive income. basic and diluted earnings per share ratios for the discontinued operation in the statement of profit or loss and other comprehensive income only if the discontinued operation contributed a profit in the current reporting period.

Answer: c Learning objective 19.6: describe and apply the disclosure requirements of AASB 133/IAS 33.

19.7

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Noel Boys

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 20: Operating segments

Chapter 20: Operating segments Comprehension questions 1. Segment disclosures are widely regarded as some of the most useful disclosures in financial reports because of the extent to which they disaggregate financial information into meaningful and often revealing groupings. Discuss this assertion by reference to the objectives of financial reporting by segments. Many entities operate in different geographical areas or provide products or services that are subject to differing rates of profitability, opportunities for growth, future prospects and risks. Disaggregation into meaningful and often revealing groupings assists users to better understand the entity’s past performance, to better assess the entity’s risks and returns, and make more informed judgements about the entity as a whole. For example, an entity may appear profitable on a consolidated basis but the segment disclosures may reveal that one part of the business is performing poorly while another part is performing well. Over time the poorly performing part may affect the entire entity’s performance. This affects the entity’s share price because analysts frequently look at predicted future cash flows in making their share price determinations

2. AASB 8/IFRS 8 contemplates that some entities not within its scope might voluntarily disclose segment information. Do you think many reporting entities would voluntarily provide these disclosures? Explain your answer. No – segment disclosures reveal information that may be commercially sensitive, and it may reveal competitive information such as profit margin by segment. It is unlikely that entities would volunteer to disclose more than they have to. Also, segment information involves a certain amount of judgment and managers are likely to be reluctant to make unnecessary disclosures involving judgment. Further, segment information can be costly to collate and this provides a further disincentive to management of entities to disclose additional, non-mandated segment-related information. 3. Explain what the “management approach” used in AASB 8/IFRS 8 means. The management approach means that the segment information is based on what is reported internally to the Chief Operating Decision-Maker (CODM). Whatever the CODM uses to measure and assess the operating segment is what is disclosed externally under AASB 8/IFRS 8. The only item that must be disclosed is “a measure” of segment result. That measure is whatever the CODM uses and need not be the AASB reported profit. Other items, such as segment assets and segment liabilities, are only reported externally if they are also reported internally to the CODM for the segments. This also extends to the allocation of amounts of profit or loss and assets and liabilities to segments. If the CODM uses information based on amounts that are allocated to segments, then those amounts should be allocated for the purposes of disclosing ‘a measure’. If the CODM does not use that information, the amounts should not be allocated.

20.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. Discuss the concerns raised about IFRS 8 (AASB 8) when it was first introduced. Compare the views of users and preparers when analysing these concerns. Do you think the concerns expressed by users will eventuate? Users were concerned that the lack of prescription in AASB 8/IFRS 8 as compared with the prescriptive approach in AASB 114/IAS 14 would mean that there would be a lack of comparability between companies, because each company would report externally only what it used for reporting to the CODM internally. This could differ significantly between companies. In addition, users were concerned that information disclosed externally might be reduced because of the lack of prescription as to what has to be disclosed under AASB 8/IFRS 8. Further, users were concerned that management might manipulate the disclosed information by reporting “nonGAAP” measures that could cause the segment results to appear more favourable than if the AASB profit were reported for each segment. On the other hand, preparers felt that the management approach would better help them reflect to users the way they (preparers) manage the business and thus that the AASB 8/IFRS 8 approach would be a better reflection of the business’s performance as seen through the eyes of management. In July 2013, the IASB announced it had completed its Post-implementation Review of IFRS 8 Operating Segments. Extensive feedback from a range of stakeholders indicated that investors were mixed in their views about how well the standard was working. The review concluded that “the Standard was generally functioning as anticipated” but conceded there was scope to improve some aspects. Source: http://www.ifrs.org/Alerts/ProjectUpdate/Pages/IASB-completes-Post-implementationReview-of-IFRS-8-Operating-Segments-July-2013.aspx

5. Distinguish between an operating segment and a reportable segment. An operating segment is component of an entity that engages in business activities whose operating results are regularly reviewed by the entity’s CODM and for which discrete financial information is available. A reportable segment is an operating segment that is identified to have exceeded prescribed thresholds under AASB 8/IFRS 8 for revenue, profit and/or assets and for which discrete financial information is required to be disclosed separately in the financial statements.

6. Describe how an entity determines its chief operating decision maker. According to paragraph 7 of AASB 8/IFRS 8, the term CODM identifies a function not necessarily a manager with a specific title. An entity identifies its CODM as the person or group of people whose function is to allocate resources to, and assess the performance of the operating segments of the entity. The CODM is often the CEO or COO but may be a group of executive directors or others.

20.3

Chapter 20: Operating segments

7. The 75% threshold relating to revenue refers to ‘external revenue’. Explain what is meant by external revenue and how a segment could generate revenue that is not external. Applying the definition in AASB 118/IAS 18, revenue is the gross inflow of economic benefits that result in an increase in equity other than those relating to contributions by equity participants. External revenue is therefore revenue earned from providing goods or services to external entities i.e. entities outside of the company or economic group. Large organisations’ segments (or departments) may provide goods or services to other segments or departments within the organisation. The segment providing the good or service would recognise this as revenue. Such revenue would be seen to be generated by the segment from an internal review perspective but does not constitute external revenue from an entity perspective and would not be reported in its general purpose financial statements.

8. Explain why the disclosure requirements of AASB 8/IFRS 8 are said to be less prescriptive compared with those of other standards. The disclosure requirements of AASB 8/IFRS 8 are said to be less prescriptive compared to those of other standards because the segment disclosures are largely determined by the nature of the information management used to perform the internal review of its operations. Other standards typically prescribe the recognition and measurement criteria for disclosure requirements, whereas segment information is disclosed according to management’s own internal reporting policies.

9. Evaluate whether the reconciliations required by paragraph 28 of AASB 8/IFRS 8 address a concern about lack of comparability between companies caused by management’s ability to select any measurement basis it chooses in reporting segment information. The reconciliations do address the concerns to some extent because they require a reconciliation of the measure of segment results used by the CODM to the reported AASB profit. Paragraph 27 of AASB 8/IFRS 8 also requires disclosure of the nature of any differences between the measure used by management and that required for AASB reporting. These reconciliations and disclosures are also required for segment assets and liabilities, but only if they are reported in the first place. However the reconciliations are not required for each reportable segment – only for the total of all segments, so users’ concerns may not be fully addressed.

10. AASB 8/IFRS 8 requires entities to disclose information about products and services, geographical areas and major customers. Discuss why such information may benefit users of financial statements. Segment disclosures provide users of financial statements with an insight into an entity not

20.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

provided by aggregated information provided in financial statements. While aggregated information can provide information about the general performance and financial position of an entity, segment disclosures can provide information about specific risks associated with the nature of the goods and services provided by the entity, the geographical regions in which it operates and its reliance on major customers. For example, if a disclosure informs a user that the entity generates a significant portion of its revenue from a particular customer and there are indications that customer’s future viability is questionable, the user can determine that the entity’s future capability to generate revenue may be threatened.

20.5

Case studies Case study 20.1 Controversy over IFRS 8 Download the document ‘EU Adoption of the IFRS 8 Standard on Operating Segments’. Refer to the section headed ‘Segment Reporting’ and prepare a summary of the four sets of questions raised by the author in relation to the adoption of IFRS 8. The purpose of this case study is to get students to be aware of and consider the issues and debate that can arise from the implementation of a new accounting standard. In this discussion paper, the author raises four sets of questions in relation to the adoption of IFRS 8 by comparison with the previous standard IAS 14: 1. The definition of operating segments and the respective merits of the management approach. The advantage of the management approach is the idea that users of financial statements get the opportunity to view the performance of the entity from the management perspective and that the costs of providing such information would be minimal. The disadvantage is the potential for managerial discretion to manipulate or distort the information provided. The contention here is that “aims of financial accounting differ fundamentally from those of management accounting” and that the indicators used for internal management may not be in synch with those required by investors. 2. The granularity of operating segments, and correspondingly the level of detail provided to users. The application of IFRS 8 (and IAS 14) does not result in the disclosure of as many segments as users or investors would like. Meanwhile SME’s resent the fact that their burden of disclosure is the same for them as for larger entities when they feel their smaller size justifies less disclosure. 3. The content of segment information. Under IFRS 8 there is a high degree of management discretion in determining the content of the segment disclosures compared with IAS 14. With no single accounting enforcement agency across EU member states, this could lead to inconsistencies across financial reports and the risk of “ad hoc segment information which conveys much less understanding about performance and risk” than that provided under IAS 14. 4. Geographical information. While IAS 14 required disclosure of geographical information, IFRS 8 allows for its nondisclosure on grounds of cost of producing it. The author argues that geographical information is important to financial users to understand risks linked to country or regional factors. Nonfinancial users may also be interested in this information from a corporate social responsibility standpoint. In summary, the author accepts both IFRS 8 and IAS 14 have benefits and shortcomings.

Chapter 20: Operating segments

Preparers prefer the discretion and cost benefits of presenting segment information under IFRS 8 while users prefer IAS 14 on the grounds that it produces information that is more reliable, promotes comparability and is less distortable by preparers. Auditors were somewhat divided between the two with technicians (not surprisingly, perhaps) preferring IAS 14 and “commercial and institutional arguments weighing in favour of IFRS 8”.

20.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 20.2 Experience of IFRS 8 Download the document ‘Post-implementation Review: Operating Segments’. Referring to page 7 of this document, prepare a brief report that summarises the key issues identified in the feedback received by the IASB with respect to areas for improvement and amendment to IFRS 8. The feedback received by the IASB was summarised under two broad headings. 1. Requests for implementation guidance: • There was confusion surrounding the term CODM and the ability to identify the CODM in practice. Suggestions were put forward to provide more guidance or replace CODM with the more common term ‘key management personnel’ as defined by IAS 24 Related Party Disclosures or ‘governing board’ as used in the Conceptual Framework. • There were concerns by preparers surrounding the presentation of reconciliations required by IFRS 8 and that such reconciliations were difficult for investors to understand. The suggestion was for the standard to provide application guidance that included examples to assist preparers. 2. Request for improved disclosures: • Changes in the basis of segment disclosure from one year to the next results in a loss of trend information for users. Investors suggested that in the event of any reorganisation, comparative information for segment information over 3 to 5 years should be presented. • There were inconsistencies in how entities defined ‘operating result’ or ‘operating cash flow’ which made comparisons between entities difficult. The feedback suggested that the standard require preparers to disclose how some line items had been defined to enable users to make their own calculations for analysis purposes. A further suggestion was to use the label ‘adjusted’ to indicate non-IFRS defined sub-totals. • Investors thought operating segments were aggregated inappropriately (reducing the value of the information) while some preparers found the aggregation guidance difficult to apply. The feedback suggested the standard should provide guidance on the nature of ‘similar economic characteristics’ and reconsider the use of quantitative thresholds so that preparers could apply the aggregation guidance more consistently and appropriately. • Some investors could not understand how reconciling amounts related to an individual segment. The feedback suggestion was to prepare reconciliations segment-by-segment but warned about allocating costs to segments when it cannot be done on a systematic basis.

20.3

Chapter 20: Operating segments

Application and analysis exercises Exercise 20.1 Defining operating segments AASB 8/IFRS 8 sets out three criteria that need to be followed in order to identify an operating segment. Required List and briefly explain the three criteria. (LO4) The three criteria are: 1. Does any component of the entity engage in business activities from which it may earn revenues and incur expenses? 2. Does the CODM regularly review the component’s operating results for the purposes of resource allocation and performance assessment? 3. Is discrete financial information available for the component?

20.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 20.2 Aggregating operating segments Yosemite Ltd is a listed manufacturing company. It produces most of its products in Australia but exports 90% of these products to the United States, Canada and Germany. It has only one main product line: scientific equipment. Yosemite Ltd is organised internally into two main business units: local and export. The export business unit is in turn divided into two sub-units: North America and Germany (North America includes Canada). Each business unit reports separate financial and operational information to the chief executive officer (CEO) and chief financial officer (CFO) who are identified as the CODM. The results of the two business units are then aggregated to form the consolidated financial information. Details of the identified operating segments are as follows.

Required Identify which operating segments, if any, meet the aggregation criteria of paragraph 12 of AASB 8/IFRS 8. Give reasons for your answer. (LO5) In order to be aggregated, the operating segments must have similar economic characteristics and be similar in each of the following respects: 1. The nature of the products and services. 2. The nature of the production processes. 3. The type or class of customer. 4. The distribution methods. 5. The nature of the regulatory environment, if applicable. Since only one product is produced and there is no further information on the production processes, one can assume that these are similar in all operating segments. The US and Canadian markets have similar economic characteristics. They are also closely linked so it is likely that their customer profiles and distribution methods are similar. Australia and Germany are each self-sustaining markets. Only Germany appears to have a special regulatory environment. From the information provided, it would appear that the US and Canada could be aggregated into one operating segment, but further information about customers and distribution methods is required.

20.5

Chapter 20: Operating segments

Exercise 20.3 Identifying reportable segments Using the information from exercise 20.2, identify Yosemite Ltd’s operating segments. (LO5) There is no further quantitative information, but based on the information provided, Yosemite Ltd has three reportable segments - North America (including Canada), Germany and Australia.

20.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 20.4 Identifying reportable segments Carnarvon Ltd is a listed diversified retail company. Its stores are located mainly in Australia. It has three main types of stores: general department stores, liquor stores and specialist toy stores. Each of these stores has different products, customer types and distribution processes. In accordance with AASB 8/IFRS 8, Carnarvon Ltd has identified three operating segments: general department stores, liquor stores and specialist toy stores. All three business units earn most of their revenue from external customers. Total consolidated revenue of Carnarvon Ltd is $800 million. General department stores $m Revenue Segment result (profit) Assets

500 28 800

Liquor stores $m 220 9 350

Toy stores $m 80 6 150

All segments $m 800 43 1 300

Required Identify Carnarvon Ltd’s reportable segments in accordance with AASB 8/IFRS 8. Explain your answer. (LO5) All three segments are reportable segments because each equals or exceeds at least one of the 10% thresholds set out in paragraph 13 of AASB 8/IFRS 8. General department stores and liquor stores exceed all three and toy stores exceed only the segment results and assets threshold. Because total revenue attributable to the reportable segments exceeds 75% of total consolidated revenue, there is no requirement to identify additional segments in accordance with paragraph 15 of AASB 8/IFRS 8.

20.7

Chapter 20: Operating segments

Exercise 20.5 Analysing the information provided Using the information provided about Carnarvon Ltd in exercise 20.4, analyse the relative profitability of the reportable segments. (LO5) General Liquor stores Toy stores All segments department stores $ $ $ $ Revenue 500m 220m 80m 800m Segment result 28m 9m 6m 43m Assets 800m 350m 150m 1 300m Segment profit 6% 4% 8% 5% margin Segment return on 4% 3% 4% 3% assets Profitability middle worst best ranking N.B. percentages have been rounded to the nearest whole amount. The segment profitability analysis reveals that the department store segment, although by far the largest in terms of revenues and assets, is the least profitable, whereas the smallest segment is the most profitable.

20.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 20.6 Disclosures Mobility Ltd, a listed manufacturing company, has two reportable segments, A and B. Both A and B are manufacturing segments. Required For each item listed, state whether or not it would be disclosed for each of the reportable segments, identify the segments for which it would be disclosed and explain what other disclosures, if any, are required in accordance with AASB 8/IFRS 8. 1.

Interest income - not reported to the CODM on a segment basis but regularly provided to the CODM for the group as a whole 2. Dividend income – not reported to the CODM on a segment basis but regularly provided to the CODM for the group as a whole 3. Share of profits from investments in equity-method associates attributable to segment A – reported to the CODM for Segment A 4. Interest expense - not reported to the CODM on a segment basis but regularly provided to the CODM for the group as a whole 5. Revenues from external customers for each of Segment A and Segment B 6. The amount of investments in associates accounted for by the equity method attributable to segment A 7. Payables and trade creditors attributable to segment B but not reported to the CODM 8. Borrowing costs that have been capitalised for Segment B and are regularly reported to the CODM. (LO5 and LO6) 1.

No. It is not reported to the CODM on a segment basis (paragraph 23 of AASB 8/IFRS 8).

No. Not required by AASB 8/IFRS 8 and not reported to the CODM on a segment basis.

Yes. Must be disclosed for Segment A, because it is reported to the CODM for Segment A. (paragraph 23(g) of AASB 8/IFRS 8)

No. It is not reported to the CODM on a segment basis (paragraph 23 of AASB 8/IFRS 8).

Yes. For each of Segment A and B (paragraph 23(a) of AASB 8/IFRS 8) but only if reported to the CODM. Further, paragraph 33 of AASB 8/IFRS 8 requires entity-wide segment disclosures of revenues from external customers attributed to geographic regions, regardless of whether these are reported to the CODM (unless the information is not available and the cost to produce it is excessive).

Yes. But only if reported to the CODM (paragraph 24 of AASB 8/IFRS 8).

No. Not reported to the CODM (paragraph 23 of AASB 8/IFRS 8)

Yes. Must be disclosed for Segment B (paragraph 23(i) of AASB 8/IFRS 8), assuming they are material.

20.9

Chapter 20: Operating segments

Exercise 20.7 Disclosures Jenkins Ltd has three reportable segments, A, B and C, which represent distinct geographical areas. The CODM receives financial information about the geographical areas. Segment A produces Product P and Product Y. Segment B produces Product P only. Segment C produces Product Y and sells Service Z. The following financial information about each segment is reported to the CODM: • • •

revenues from external customers earnings before interest, depreciation and amortisation and tax (EBITDA) depreciation and amortisation.

Required State whether each of the following statements is true or false, by reference to the relevant requirements of AASB 8/IFRS 8. (LO5 and LO6) 1. Jenkins Ltd must disclose EBITDA for each reportable segment. 2. Jenkins Ltd must disclose total assets for each reportable segment. 3. Jenkins Ltd must reconcile the total EBITDA of segments A, B and C to its reported profit determined in accordance with accounting standards before income tax and discontinued operations. 4. Jenkins Ltd must disclose total liabilities for each reportable segment. 5. Jenkins Ltd must disclose depreciation and amortisation for each reportable segment. 6. Jenkins Ltd must disclose revenue from external customers for each of Product P, Product Y and Service Z. (LO5 and LO6) 1.

True (paragraph 23 of AASB 8/IFRS 8).

False. A measure of total assets for each reportable segment is not reported to the CODM (paragraph 23 of AASB 8/IFRS 8).

True (paragraph 28(b) of AASB 8/IFRS 8).

False. A measure of total liabilities for each reportable segment is not reported to the CODM (paragraph 23 of AASB 8/IFRS 8).

True. These are reported to the CODM for each reportable segment (paragraph 23(e) of AASB 8/IFRS 8).

True (paragraph 32 of AASB 8/IFRS 8).

20.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 20.8 Reportable segments, allocating amounts to segments Simeon Ltd is a listed diversified retail company. Its stores are located mainly in Australia. It has three main types of stores: general department stores, liquor stores and specialist toy stores. Each of these stores has different products, customer types and distribution processes. Simeon Ltd has three business units: general department stores, liquor stores and specialist toy stores. For the year ended 30 June 2022 each business unit reported the following financial information to Simeon Ltd’s CODM.

Revenue Segment result (profit) Assets

General department stores $m

Liquor stores $m

Toy stores $m

All segments $m

800 30 1 800

200 14 400

100 8 200

1 100 52 2 400

Total consolidated revenue of Simeon Ltd for the year ended 30 June 2022 is $1 600 million. Included in general department stores’ revenue is $100 million of revenue from toy stores. As at the end of the reporting period toy stores owed general department stores $90 million. This amount is included in general department stores’ assets. Within the general department stores business unit there are five different legal entities including legal entities Y and Z. As at 30 June 2022 legal entity Z owed $46 million to legal entity Y. These amounts have not been eliminated in determining the assets of the general department stores segment. Intersegment asset balances are reported to the CODM but are not used by the CODM as the basis for determining reportable segments. Intrasegment assets are reported to the CODM and are eliminated in determining reportable segments. Required State whether the following statements are true or false. Give reasons for your answers. 1. 2. 3. 4.

Simeon Ltd has three reportable segments. The revenue figure that should be used by the general department stores segment for the purposes of determining whether or not it is a reportable segment is $700 million. Simeon Ltd must disclose the toy store’s segment liabilities after deducting the $90 million owed to general department stores. The assets figure that should be used by the general department stores segment for the purposes of determining whether or not it is a reportable segment is $1 800 million.

20.11

Chapter 20: Operating segments

The assets figure that should be used by the general department stores segment for the purposes of determining whether or not it is a reportable segment is $1 710 million. 6. The assets figure that should be used by the general department stores segment for the purposes of determining whether or not it is a reportable segment is $1 754 million. 7. Simeon Ltd must disclose a reconciliation of total segment assets to its consolidated assets of $2 264 million. (LO5, LO6 and LO7) 1. False. Total segment revenue (external) is only 68% of consolidated revenue ($1 100 million / $1 600 million) and therefore additional reportable segments must be identified. (AASB 8/IFRS 8 paragraph 15). 2. False. Segment revenue includes revenue from other segments (AASB 8/IFRS 8 paragraph 5(a) and 13(a)). Therefore, the revenue from toy stores is included and the figure to be used is $800 million. 3. False. Segment liabilities are not reported to the CODM and thus are not required to be disclosed. (AASB 8/IFRS 8 paragraph 23). 4. False. Intra-segment assets ($46 million) are reported to the CODM and are eliminated in determining reportable segments. 5. False. Inter-segment assets ($90 million) are reported to the CODM but are NOT used by the CODM as the basis for determining reportable segments. 6. True. Intra-segment assets ($46 million) are reported to the CODM and are eliminated in determining reportable segments. 7. True. Segment assets are reported to the CODM so these must be disclosed (AASB 8/IFRS 8 paragraph 23) by segment and a reconciliation of all segment assets to consolidated assets is required by paragraph 28(c). Consolidated assets are calculated as $2 400 million - $46 million - $90 million.

20.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 20.9 Disclosing segment information Nambour Ltd is a diversified manufacturing company. The CODM has been presented with the following information concerning eight operating segments that have been identified.

Nambour Ltd has no unallocated revenue. Required Show how this information would be presented in the Operating Segment disclosure note in the accounts. (LO5 and LO6) Total revenue of operating segments = $300 so the 10% threshold identifies A and B as reportable segments with revenue ≥ $30. Total profits of segments not reporting losses = $61 while total losses reported by segments = $11 so the profit threshold is based on which of these two figures is greater in absolute terms i.e. $61. The 10% threshold identifies A, C and F as reportable segments with profit or loss ≥ $6.1. Total assets of operating segments = $2 000 so the 10% threshold identifies A, B and E as reportable segments with assets ≥ $200. So, A, B, C, E and F are identified as reportable segments. Total external revenue of these reportable segments = $260 which is 87% of the Nambour Ltd’s total revenue of $300, exceeding the 75% threshold. D, G & H can be aggregated as “All other”. This information would be presented in the Operating Segment disclosure Note as follows:

Revenue Profit / (Loss) Assets

All other

Total

$ 150 38 750

$ 50 5 500

$ 25 7 100

$ 20 6 300

$ 15 (7) 50

$ 40 1 300

$ 300 50 2,000

20.13

Chapter 20: Operating segments

Exercise 20.10 Identifying reportable segments The following information concerning eight operating segments has been presented to the CODM of a large retail company. Segment A B C D E F G H All segments

Total revenue

Internal revenue

120 90 60 30 24 20 36 10

External revenue

10 — — — — — 20 —

110 90 60 30 24 20 16 10

360

Unallocated revenue

Total entity revenue

400

390

Required 1. Determine which of the segments A to H are reportable segments under AASB 8/IFRS 8. (LO5) 2. Prepare a reconciliation of the total reportable segment revenue with the total revenue of the entity. (LO6) 1. Total segment revenue = $390 so any operating segment reporting revenue ≥ $39 exceeds the 10% threshold and is a reportable segment. Accordingly, A, B and C are all reportable segments according to this 10% revenue threshold. The sum of the external revenue of these segments is $260 which is only 65% of the entity’s total revenue and below the 75% threshold required. Additional segments must be identified until the total revenue ≥ $300 (75% x 400), i.e. we must identify segments reporting an additional $40 of external revenue. Logic suggests management would continue selecting segments in ascending order until they find the extra $40 and so select Segments D and E. However, AASB 8 does not specify how additional segments must be selected, so management could use its discretion as long as the 75% threshold is achieved. For instance, for commercial confidentiality reasons management may

20.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

have a preference not to report information about, say, Segment D which may lead them to select other combinations such as Segments E and F or even E and G. For the purposes of this solution, we will assume management simply selects the segments in ascending order and so identifies A, B, C, D and E as reportable and aggregates F, G and H as Other Segments. 2. Reconciliation of total revenue from reportable segments with total revenue of the entity: Total revenue of reportable segments Total revenue of other segments Total segment revenue Unallocated revenue Elimination of inter-segment revenue Total reported revenue of the entity

$324 66 390 40 (30) $400

20.15

Chapter 20: Operating segments

Exercise 20.11 Analysing the segment information Jarek Ltd is a listed diversified manufacturing company. It is listed on the London Stock Exchange and produces most of its products in China and India. Its markets are in the European Union and the Asia–Pacific region. It produces three types of products and services: home furniture, office furniture and soft furnishings. The CODM has determined that Jarek Ltd’s operating segments should be based on geographical markets and has identified the reportable segments as listed below. The following information is reported to the CODM for each of the markets: 1. earnings before interest, depreciation and amortisation and taxation (EBITDA) 2. revenues from external customers. The following table sets out the financial information provided to the CODM for the year ended 31 December 2023. Each operating segment has been identified as a reportable segment.

Other information disclosed in the company’s 31 December 2023 financial statements includes: (a) Total consolidated revenue: $125 000 000 (b) Intersegment revenues represent wholesale sales from China and India to the other operating segments (c) Net profit before taxation: $25 625 000 (d) Total consolidated assets: $1 041 670 000. (e) Revenue from external customers for each type of product is: (i) home furniture: $78 525 000 (ii) office furniture: $17 700 000 (iii) soft furnishings: $28 775 000. Required Analyse Jarek Ltd’s business with reference to its reported segment information. Show all workings to support your analysis. (LO7) Revenue from external customers Inter-segment revenue Total EBITDA

France 22 300 000

Germany 35 654 000

UK 21 587 600

India 5 356 800

China 7 324 800

ANZ 8 763 400

Total 100 986 600

22 300 000 6 400 000

35 654 000 7 325 000

21 587 600 5 325 000

10 000 000 15 356 800 5 324 000

10 000 000 17 324 800 7 625 000

8 763 400 2 325 000

20 000 000 120 986 600 34 324 000

Consolidated 125 000 0001

Additional revenue of $24 013 400 has not been attributed to segments. The 75% revenue threshold test is met based on external revenues (AASB 8/IFRS 8 paragraph 15) even though inter-segment revenues are included when determining reportable segments (AASB 8/IFRS 8 paragraph 13(a)). External revenues are 81% of consolidated revenues.

20.16

29%

21%

25%

35% total; 99% if based only on external revenues

44% total; more than 100% if based only on external revenues

Net profit Net profit margin Total assets Return on assets

27%

28% total; 34% if based only on external revenues

25 625 000 21% 1 041 670 000 2% (based on net profit) 3% based on segment EBITDA

Key findings: 1. Intersegment revenues from the manufacturing countries (India and China) account for 17% of total segment revenue. 2. By allowing inter-segment revenues to be included in determining reportable segments, AASB 8/IFRS 8 allows management to clearly show the extent to which vertical integration affects the business. In this case the vertical integration is creating profit centres at the manufacturing locations. 3. China is the most profitable segment of the business, even though its revenues are only the fourth largest. 4. India is the second most profitable segment of the business, even though its revenues are only the fifth largest. 5. Germany has the highest revenues but is the least profitable segment. 6. Management uses EBITDA to manage the business and thus would focus on the EBITDA margin of 34% (based on external revenues) rather than the net profit margin of 21% (net profit as a % of consolidated revenues). 7. The EBITDA margin of 28% (based on total segment revenues including inter-segment revenues) is still higher than the net profit margin. Other factors/costs must be affecting the measurement of the net profit. These costs have not been identified as relevant to the segments, otherwise they would be regularly reported to the CODM. 8. The return on assets is very low, on both a net profit and EBITDA basis. Assets have not been allocated to the segments so it is not possible to identify where assets may be underutilised. 9. Home furniture is generating the highest revenue but there is not enough information provided to tell whether it is the most profitable product, because the segments have been identified on a geographic basis, not a product basis. (The information disclosed in accordance with AASB 8/IFRS 8 paragraph 32 is revenues only, not a measure of result by product).

20.17

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 20: Operating segments Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 20: Operating segments Multiple choice questions 1. AASB 8/IFRS 8 Operating Segments is primarily a: a. b. *c. d.

measurement standard. definition standard. disclosure standard. conceptual standard.

Answers: c Learning objective 20.1: discuss the objectives of financial reporting by segments.

2. Segment disclosures are designed to: *a. disaggregate selected consolidated financial data. b. condense particular items of consolidated financial data into one financial statement. c. combine components of consolidated financial data to provide a higher level of summarisation. d. aggregate revenues and expenses so that only net profit is shown for each important segment. Answer: a Learning objective 20.1: discuss the objectives of financial reporting by segments.

3. A key objective of providing financial reporting information by segment is: a. b. c. *d.

to allow detailed analysis to be undertaken by users such as segment profit margin analysis. to allow the user to better understand the entity’s future performance. to highlight poorly performing areas of an entity’s business to users. to allow users to better assess the entity’s risks and returns.

Answer: d Learning objective 20.1: discuss the objectives of financial reporting by segments.

20.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. AASB 8/IFRS 8 Operating Segments applies to: I. II. III. IV. a. b. c. *d.

listed entities. public companies. entities in the process of listing. any entity who voluntarily chooses to apply it.

I, II and III only. II, III and IV only. I, II and IV only. I, III and IV only.

Answer: d Learning objective 20.2: identify the types of entities that are within the scope of AASB 8/IFRS 8.

5. If an entity presents both consolidated financial statements and parent entity financial statements in the same financial report, it must present: a. b. *c. d.

condensed segment data that includes revenue information only. segment data only on the basis of the parent entity financial statements. segment data only on the basis of the consolidated financial statements. segment information on the basis of both the consolidated and the parent financial information.

Answer: c Learning objective 20.2: identify the types of entities that are within the scope of AASB 8/IFRS 8.

20.2

Chapter 20: Operating segments Not for distribution in full. Instructors may assign selected questions in their LMS.

6. Complete the following sentence: AASB 8/IFRS 8 Operating Segments came into effect for financial reporting periods _ on or after 1 January 2009. Early adoption was _______ . a. *b. c. d.

ending, permitted beginning, permitted beginning, not permitted ending, not permitted

Answer: b Learning objective 20.3: explain the controversy surrounding the issuance of AASB 8/IFRS 8.

7. Compared to AASB 114 Segment Reporting, AASB 8/IFRS 8 Operating Segments can be described as: *a. b. c. d.

less prescriptive. less onerous in terms of disclosure. more closely aligned to other accounting standards. preferred in the European Union to its predecessor.

Answer: a Learning objective 20.3: explain the controversy surrounding the issuance of AASB 8/IFRS 8.

8. For financial reporting periods commencing prior to 1 January 2009, the accounting standard relating to segment reporting was: a. *b. c. d.

AASB 8 Operating Segments. AASB 114 Segment Reporting. AASB 114 Operating Segments. AASB 8 Segment Reporting.

Answer: b Learning objective 20.3: explain the controversy surrounding the issuance of AASB 8/IFRS 8.

9. Which of the following statements is correct about the controversial issues surrounding AASB 8/IFRS 8? *a. b.

The management approach adopted in AASB 8/IFRS 8 was argued to put preparers’ needs ahead of users’ needs. The European Parliament was not able to endorse AASB 8/IFRS 8 due to strong oppositions from European countries.

20.3

Testbank to accompany Financial reporting 3e by Loftus et al.

c. d.

Despite the objections from different parties, all IASB board members at the time unanimously agreed that AASB 8/IFRS 8 should replace AASB 114. The proponents of AASB 114 argued that AASB 8/IFRS 8 contains too many mandatory disclosure requirements compared to AASB 114.

Answer: a Learning objective 20.3: explain the controversy surrounding the issuance of AASB 8/IFRS 8.

10. Based on the information provided below, which business unit(s) should be identified as Viewing Ltd’s operating segment(s)?

Can the component generate revenue and incur expenses from its business activities? Are the component’s operating results regularly reviewed by the CODM? Is discrete financial information available for the component?

a. b. *c. d.

Chidi Yes

Eleanor Yes

Jason Yes

Yes

Chidi only. Jason only. Eleanor only. Chidi and Jason.

Answer: c Learning objective 20.4: identify operating segments in accordance with AASB 8/IFRS 8.

11.

The key decision points in identifying an entity’s component as an operating segment include all the following criteria, except for:

*a. b. c. d.

the component’s manager is part of the CODM. discrete financial information are available for the component. the component’s operating results are regularly reviewed by the CODM. the component is able to generate revenue and incur expenses from its business activities.

Answer: a Learning objective 20.4: identify operating segments in accordance with AASB 8/IFRS 8.

20.4

Chapter 20: Operating segments Not for distribution in full. Instructors may assign selected questions in their LMS.

12.

Katoomba Ltd has a board of directors that consist of a Managing Director (MD. and nonexecutive directors. The MD has a regular monthly meeting with the Chief Operating Officer (COO) and the managers of Katoomba’s three business units. During the meeting, each manager would present an update of their unit’s financial performance. The financial information is then reviewed by the MD and the COO to assess the performance of each business unit and to make decisions related to resource allocation. In this case, who is the CODM of Katoomba?

a. b. *c. d.

The MD only. The board of directors. The MD and the COO. The MD, the COO, and the three managers.

Answer: c Learning objective 20.4: identify operating segments in accordance with AASB 8/IFRS 8.

13. Liza, Kelsey and Josh are the three operating segments of Young Company. Which of the following statements is correct based on the information provided below?

In $000 Revenue Profit/loss Assets

a. b. c. *d.

Liza

Kelsey 375 200 455

230 130 315

Josh 510 285 850

Total operating segments 1 115 615 1 620

Other business units 395 160 410

Total Young Company 1 510 775 2 030

Liza, Kelsey and Josh are reportable segments of Young Company. Only Kelsey and Josh should be disclosed as reportable segments. Kelsey is not a reportable segment as it does not satisfy the profit/loss quantitative threshold. Young Company needs to identify another reportable segment from ‘other business units’ component.

Answer: d Learning objective 20.5: apply the definition of reportable segments.

20.5

Testbank to accompany Financial reporting 3e by Loftus et al.

14. Assuming the three business units below are operating segments and all revenue earned are from external customers, in which of the following scenarios does Bromwell Ltd need to identify another reportable segment to be disclosed? Revenue Toby Bailey Ron in $000 I. II. III.

150 220 460

a. b. *c. d.

I only. I and II. I and III. II and III.

320 280 500

640 550 750

Total operating segments Other business units 1 110 1 050 1 710

500 350 630

Total Bromwell Ltd 1 610 1 400 2 340

Answer: c Learning objective 20.5: apply the definition of reportable segments.

15. Which of the following information is not required to be disclosed by entities complying with AASB 8/IFRS 8? a. b. c.

Revenues from external customers located in foreign countries. The nature and effect of the changes in measurement of segment profit or loss. A reconciliation of the total of the reportable segments’ liabilities to the entity’s liabilities.

Answer: d Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

16. AASB 8/IFRS 8 requires disclosure in relation to which of the following? a. *b. c. d.

The nature of any difference between the measurement of the reportable segments’ revenue and the entity’s revenue. The nature of any difference between the measurement of the reportable segments’ assets and liabilities and the entity’s assets and liabilities. The basis of accounting for all segments. The nature and effect of all symmetrical allocations to reportable segments.

Answer: b Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

20.6

Chapter 20: Operating segments Not for distribution in full. Instructors may assign selected questions in their LMS.

17. Under AASB 8/IFRS 8 all entities to which the standard applies are required to disclose: a. b. *c. d.

a measure of segment liabilities. factors used to identify all segments. the basis of accounting for any transactions between reportable segments. a reconciliation of total segment expenses to total consolidated expenses.

Answer: c Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

18. Which of the following statements is incorrect? AASB 8/IFRS 8 requires external revenue by product to be disclosed on an entity wide basis by all entities to which AASB 8/IFRS 8 applies: a. b. c. *d.

unless the information is not available and the cost to develop it would be excessive. unless the information has already been provided as part of the reportable segment information. and must be calculated based on the financial information used to produce the entity’s financial statements. unless providing such information would be considered to damage the entity’s competitive advantage.

Answer: d Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

19. Segments that do not satisfy the requirements of a reportable segment must: *a. b. c. d.

be combined and disclosed as ‘all other segments’. not be disclosed at all in the financial report. be reported in the notes to the financial statements. be combined with the smallest reportable segment.

Answer: a Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

20.7

Testbank to accompany Financial reporting 3e by Loftus et al.

20. Under AASB 8/IFRS 8, entities are required to provide reconciliations on the following, except for: a. *b. c. d.

the total of the reportable segment’s revenue to the entity’s revenue. the total of the reportable segment’s equity to the entity’s equity. the total of the reportable segment’s liabilities to the entity’s liabilities. the total of the reportable segment’s measures of profit and loss to the entity’s profit or loss.

Answer: b Learning objective 20.6: explain the disclosure requirements of AASB 8/IFRS 8.

20.8

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 21: Related party disclosures

Chapter 21: Related party disclosures Comprehension questions 1. Why do standard setters formulate rules for the disclosure of related party relationships? The standard setters formulate rules to govern the disclosure of related party transactions to ensure that an organisation’s financial statements contain the disclosures necessary to an understanding of the potential effect of transactions and outstanding balances and commitments with related parties. 2. Explain how the mere existence of a related party relationship might have the potential to affect transactions with other parties. The simple existence of a related party relationship has the potential to affect transactions with other parties. Accordingly, knowledge of business relationships, related party transactions, outstanding balances and commitments with related parties may also affect assessments of the business risks faced by entities. For these reasons, information about related parties, including related party transactions and outstanding balances and commitments is necessary to provide users of financial statements with sufficient knowledge to enable them to make independent assessments of the risks and opportunities facing entities. 3. Explain why key management personnel are regarded as related parties. Key management personnel are regarded as people who have the authority and responsibility to plan, direct and control the activities of organisations. This has the potential to affect the profit and loss and the financial position of the organisation. As such they are regarded as related parties of those organisations, and their related party relationship must be disclosed. 4. An alternative to disclosing information about related parties is to restate related party events as though they had occurred between independent parties in arm’s length transactions. Explain why this approach has not been adopted by the standard setters. An alternative to the disclosure of related party transactions is to restate the events as though they had occurred between independent parties in arm’s length transactions. However, in many instances valuation of the events and their impacts would be very difficult, if not impossible to determine as comparable transactions simply may not exist. 5. Explain why a parent company and its subsidiary entities are regarded as related parties. A subsidiary entity might operate on the instructions of its parent entity and this relationship has the potential to affect the risks and opportunities faced by both of the entities. For this reason parent and subsidiary entities are regarded as ‘related’ and information about transactions

21.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

between them, outstanding balances, and commitments is necessary to enable a full understanding of the risks and opportunities. 6. Outline the rationale for including an employee-sponsored post-employment benefit plan as a related party of the employer entity. Although AASB 124/IAS 24 does not provide a rational for treating post-employment benefits plans as related to an entity, it is likely that the entity sponsoring a post-employment benefit plan is likely to have either control or significant influence over the plan. 7. Distinguish between control, joint control and significant influence. Control is deemed to be when an investor is exposed, or has rights to variable returns from its involvement in the investee and has the ability to affect those returns through its power over the investee. Joint control is the contractually agreed sharing of control of an arrangement. Significant influence is the power to participate in the financial and operating policy decisions of an entity, and may be gained by share ownership, statute or agreement. 8. Provide four examples of related party transactions that must be disclosed by a related party disclosing entity. (1) A loan by an entity to a director of the entity. (2) The provision of consultancy services (e.g. legal, financial, accounting, engineering, etc.) to an entity by a key management person of that entity. (3) A guarantee of the corporate debt of a subsidiary by a parent entity. (4) The sale (or purchase) of goods by a subsidiary (or parent) to its parent (or subsidiary) entity. See the textbook for further examples. 9. AASB 124/IAS 24 requires the identity of key management personnel to be disclosed. Explain how an entity determines whether an employee is a member of key management personnel. Key management personnel are people who have the authority and responsibility for planning, directing and controlling an entity’s activities either directly or indirectly during the financial year. This includes directors, whether they are executive or non-executive directors.

21.3

Chapter 21: Related party disclosures

Case studies Case study 21.1 Executive remuneration The following text outlines the purpose of the Australian Government Productivity Commission’s public inquiry into executive remuneration.

Required Go to the website of the Australian Government’s Productivity Commission (www.pc.gov.au) and locate the above project summary. Follow the link to the Government’s response and discuss whether or not you agree with the responses provided for each recommendation. Consider the explanation provided by the Government regarding any variances to the Commission’s recommendations. The report on executive compensation released by the Australian government’s Productivity Commission on 4 January 20101 can be found at the link below: https://www.pc.gov.au/inquiries/completed/executive-remuneration/report The 15 recommendations are listed on pages 37-42. According to the media release: The Commission's final recommendations constitute an integrated package of reforms that would strengthen board decision-making on executive remuneration, by reducing board 'clubbiness', removing potential for conflicts of interest and enhancing accountability for pay outcomes. Shareholders would get better information and would have more 'say on pay'. Students should read the details of the recommendations and comment on their appropriateness in the current economic environment.

21.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 21.2 Related party disclosures Choose the most recent annual report of two Australian publicly listed companies (other than Woolworths Group Ltd). Locate the remuneration report and the financial statement notes dealing with related party disclosures. Compare the details provided by each company. Do you consider there is too much/not enough disclosure about related party relationships (including key management personnel remuneration), transactions, balances and commitments? Explain. Students are to choose two companies from the ASX website and locate their latest annual report. Annual reports are available from the link below. http://www.asx.com.au/asx/research/listedCompanies.do. Students will notice that the related party disclosures are quite detailed, and they should be encouraged to question whether the disclosures in the current form provide appropriate details about related party relationships, transactions, balances and commitments.

21.5

Chapter 21: Related party disclosures

Case study 21.3 Related party loans At the end of the 2018 financial reporting period, Bank of Queensland had a number of outstanding loans/advances to related parties, including a balance of $1.9 million to key management personnel. Required Locate Note 6.4 in Bank of Queensland’s 2018 annual report (www.boq.com.au/Shareholder-centre/financial-information/Annual-Report) and write a report on the appropriateness of the disclosures of the related party transactions to (1) key management personnel, and (2) other related parties. Your report should explain why the AASB/IASB requires information about loans with key management personnel to be disclosed. It should also include a summary of the other related party disclosures included in Note 6.4. Bank of Queensland 2018 Annual Report Note 6.4 Other information about loans with related parties that must be disclosed includes Interest paid and payable, interest not charged, and the opening and closing balances of loans. Students should include in their report a comment on the total amount of the loans provided to the directors and key management personnel. A discussion on the requirements of AASB 124I/AS 24 that specifically relate to key management personnel compensation should also be included. (paragraphs 17 to 24).

21.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 21.1 Scope of AASB 124/IAS 124 Which of the following are related parties of an entity within the scope of AASB 124/IAS 124? Give reasons for your answer. (a) A person who has the authority to plan, direct and control the activities of the entity (b) The domestic partner and children of a director of the entity. (c) The non-dependent sister of a director of the entity. (d) A subsidiary company that is directly controlled by the entity. (e) Dividend payment to employees who are holders of an entity’s shares. (LO2 and LO3) (a) Yes. Such persons are regarded as key management personnel of the entity. (b) Yes. Under AASB 124/IAS 124, paragraph 9, the children, spouse or domestic partner, other children of the spouse or domestic partner, and dependents of the key management person or of their spouse or domestic partner, are all regarded as related parties of the entity. (c) Yes. AASB 124/IAS 24, paragraph 9 (a) includes close members of person’s (director’s) family. (d) Yes. AASB 124/IAS 124, paragraph 9 considers members of the same corporate group to be related parties. (e) No. If the share investment made by the employee is an arm’s length transaction and the terms and conditions are not more favourable than would occur with other non-related parties, then the dividends on those share investments are not regarded as related party transactions. If the employee is a key management person, then, yes, the dividend payment to that employee would be considered a related party transaction.

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Chapter 21: Related party disclosures

Exercise 21.2 Recognition principles Felix Anderson is a newly appointed director of Elite Sports Ltd, a listed company that organises major sporting events. Felix has provided consultancy services to Elite Sports Ltd for the past 10 years. In the most recent financial year these services amounted to $400 000. Required Determine whether the consultancy service provided by Felix is a related party transaction that should be disclosed in the financial statements of Elite Sports Ltd. Explain your answer. (LO2 and LO3) As Felix is a director of the entity Elite Sports Ltd, AASB 124/IAS 124, paragraph 9 regards any transactions between her and the entity to be as related party transactions. This related party transaction must be disclosed in the financial statements of Elite Sports Ltd.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 21.3 Recognition principles The Golden Years Company operates a pension scheme that offers defined benefit pensions for the benefit of the company’s employees. At the end of the reporting period, the present value of the defined benefit obligation is $85 million and the fair value of the defined benefit scheme assets is $90 million. Required Is the pension scheme a related party of the The Golden Years Company? Explain. (LO2 and LO3) AASB 124/IAS 124, paragraph 21 considers post-employment benefit plans to be related party entities. The defined benefit pension scheme operated by The Golden Years Company would be regarded as a related party, and any transactions with that entity would need to be disclosed in the financial statements of the The Golden Years Company.

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Chapter 21: Related party disclosures

Exercise 21.4 Determining whether parties are related Hasan holds 100% of the shares in Matheson Ltd and he is also a director of Sinaga Ltd. All of the shares in Sinaga Ltd are held by Roberts Ltd. Required Determine the related party relationships for Matheson Ltd. (LO2 and LO3) In this set of circumstances, Hasan is a related party of Matheson Ltd because Hasan controls Matheson Ltd. As Hasan controls Matheson Ltd and he is also a member of the key management personnel of Sinaga Ltd, Matheson Ltd and Sinaga Ltd are considered to be related parties.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 21.5 Identifying related party transactions Many entities have transactions with related parties which occur under normal terms and conditions. For example, banks provide a wide range of banking and other financial services and products, some of which are used by bank directors and their close family members. Required Choose one entity from each of the following three business sectors and identify the types of transactions (e.g. goods and services) that the entities might engage in with related parties under normal commercial terms and conditions. (a) Transport sector (b) Retailing sector (c) Construction sector (LO3) The disclosures regarding remuneration (compensation) paid to key management personnel are contained in AASB 124/IAS 24, paragraph Aus 29. These disclosures are quite broad and include: • Aus 29.4, 6 Compensation arrangements for short-term, long-term, termination, and sharebased payment benefits. • Aus 29.5 Principles of compensation arrangements for key management personnel. • Aus 29.7 Equity instruments and transactions, as part of share-based remuneration. Students should be encouraged to discuss the issue of costs and benefits of making disclosures. Disclosure provides information that enables users of financial statements to assess the risks and opportunities associated with entities. Arguably, asymmetric information creates costs to users. However, all disclosures have an attaching Buffer cost to the entity providing that data.

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Chapter 21: Related party disclosures

Exercise 21.6 Determining whether transactions are related party transactions Which of the following is a related party transaction and, under AASB 124/IAS 24, requires disclosure in the annual financial statements? (a) A performance-related amount paid to the directors of the entity. (b) A loan for $100 000 that was made to a retired director of an entity, and which was written off as an uncollectible debt during the current financial year. (c) A loan of $30 000 advanced to the chief financial officer of an entity and which is outstanding at the end of the reporting period. (d) An annual cash bonus amount paid to factory workers employed by the entity. (LO2, LO3 and LO4) (a) Yes; directors of the entity, whether they are executive or non-executive, are regarded as related parties of the entity, and transactions between them must be disclosed. (b) Yes; the loan was made to a retired director, and the debt written-off can be regarded as a post-employment benefit. (c) Yes; the chief financial officer would usually be regarded as a member of key management personnel as that person would have the authority and responsibility to plan, direct and control the activities of the entity. (d) Not regarded as a related party transaction. The cash bonus occurred in an arm’s length transaction and the factory workers would not be considered as key management personnel.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 21.7 Disclosure During the period ended 30 June 2023, Ru Li, an employee of Westside Company, purchased goods from the company on normal commercial terms and conditions. Li receives remuneration consisting of cash and other short-term benefits amounting to $240 000. During the 30 June 2023 financial year, Li also received a grant of 75 000 options from the company which is conditional on her continuing to work for the company for the next 3 years. Li is considered to be a member of the key management personnel of the Westside Company. Required Prepare appropriate disclosures reflecting the related party relationship and transactions between Westside Company and its employee Ru Li for the period ended 30 June 2023. (LO4) Transactions with the Westside Company and related parties Details of certain transactions between Westside Company and related parties are set out below. Westside Company granted 75 000 options to a member of its key management personnel, Ru Li. The options are conditional upon Ms Li remaining with the Westside Company for a period of three years. Ms Li purchased goods from the Westside Company which were billed at normal commercial rates and terms.

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Chapter 21: Related party disclosures

Exercise 21.8 Exemption from disclosure for government-related entities Buffer Zone is a government organisation which directly controls another entity — Evergreen Ltd, and through its interest in Evergreen Ltd it indirectly controls Olive Ltd and Rose Ltd. Required Determine the extent to which Olive Ltd can apply the partial disclosure exemption for government-related entities. (LO5) AASB 124/IAS 24, paragraph 25 provides an exemption from some of the disclosure requirements for transactions between entities. Olive Ltd can apply the exemption for transactions with Buffer Zone, Evergreen Ltd and Rose Ltd.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 21: Related party disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 21: Related party disclosures Multiple choice questions

1. AASB 124 shall be applied in identifying the following, except for: *a. b. c. d.

insider trading with related parties. related party relationships and transactions. circumstances in which disclosures of transactions with related parties are required. outstanding balances, including commitments, between an entity and its related parties.

Answer: a Learning objective 21.1: explain the objective, application and scope of AASB 124/IAS 24 Related Party Disclosures.

2. An entity is related to a reporting entity if any of the following conditions apply, except: a. b. *c. d.

both entities are joint venture of the same third party. the entity is the subsidiary of the reporting entity. the reporting entity has significant economic dependence on the entity. the entity is a post-employment benefit plan for the reporting entity’s employees.

Answer: c Learning objective 21.2: identify an entity’s related parties.

3. The power to participate in the financial and operating policy decisions of an entity is known as: *a. b. c. d.

control. joint control. share ownership. significant influence.

Answer: a Learning objective 21.2: identify an entity’s related parties.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. The contractually agreed sharing of control over an economic entity is known as: *a. b. c. d.

joint venture. joint control. significant influence. significant control.

Answer: a Learning objective 21.2: identify an entity’s related parties.

5. Howard is one of the directors of Chester Limited. In the current financial year, Chester Limited paid $60 000 to Longfield Agency, where Howard’s brother works, for the consultancy services it provided. In addition, Chester Limited also paid $4000 to Howard for a once-off consultancy he provided on a specific project. Which of the following statements describes the relationship between Howard, Chester Limited, and Longfield Agency? a. b. c. *d.

Howard is not a related party to Chester Limited. Longfield Agency is a related party to Chester Limited. The $4 000 consultancy fee is not a related party transaction. The $60 000 consultancy fee is not a related party transaction.

Answer: d Learning objective 21.2: identify an entity’s related parties. 6. Larry is the owner and founder of Manchester Limited. Larry’s wife, Katie, has a controlling investment in Hudson Limited. Which of the following describes the relationship between Manchester Limited and Hudson Limited? a. b. *c. d.

No disclosure about transactions with Hudson Limited is required in the financial statements of Manchester Limited. Manchester Limited and Hudson Limited are not related parties. Manchester Limited is a related party of Hudson Limited. Manchester Limited has control over Hudson Limited.

Answer: c Learning objective 21.2: identify an entity’s related parties.

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Chapter 21: Related party disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following is the related party of a reporting entity within the scope of AASB 124? a. *b. c. d.

A supplier of the reporting entity. Another subsidiary of the reporting entity’s parent. The domestic partner of a director of the reporting entity. The non-dependent children of the reporting entity’s CEO.

Answer: b Learning objective 21.2: identify an entity’s related parties.

8. Amy Limited and Sheldon Limited are the two subsidiaries of Big Bang Company. Leonard, one of the directors of Big Bang Company, is also a director of Sheldon Limited. Leonard’s wife, Penny, has 10% shareholding in Sheldon Limited. Which of the following are related parties to Amy Limited? *a. b. c. d.

Big Bang Company and Sheldon Limited. Big Bang Company and Leonard. Sheldon Limited and Leonard. Leonard and Penny.

Answer: a Learning objective 21.2: identify an entity’s related parties.

9. Flower Limited is a listed company operating in the retail industry with three business units: Aster, Rose, and Jasmine. Which of the following is likely to be the key management personnel of Flower Limited? a. b. *c. d.

The company’s auditor. The company’s IT manager. The general manager of Aster. The managing director’s personal assistant.

Answer: c Learning objective 21.2: identify an entity’s related parties.

10. An entity in which an investor has significant influence is known as a/an: *a. b. c. d.

associate. subsidiary. related party. joint venture.

Answer: a Learning objective 21.2: identify an entity’s related parties.

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Testbank to accompany Financial reporting 3e by Loftus et al.

11. Chris holds an investment in Lee Limited that gives him a significant influence over the company. Chris’s daughter, Chloe, also has a significant influence over another entity, Chang Limited. What is the relationship between Lee Limited and Chang Limited? a. *b. c. d.

Lee Limited has a significant influence over Chang Limited. Lee Limited and Chang Limited are not related parties. Lee Limited is a related party of Chang Limited. Lee Limited has control over Chang Limited.

Answer: b Learning objective 21.2: identify an entity’s related parties.

12. Amanda is one of the directors in Lions Limited, which is one of the subsidiaries of Harrisville Limited. She also has a joint control with Barry in Zephyr Limited. In this circumstance, the following are related parties to Lions Limited, except for: *a. b. c. d.

Barry. Amanda. Harrisville Limited. Zephyr Limited.

Answer: a Learning objective 21.2: identify an entity’s related parties.

13. Which of the following are most likely to be considered as key management personnel of an entity? I. II. a. b. *c. d.

Chief Financial Officer Admin Officer

III. IV.

Non-executive directors General manager

I, II and III. II, III and IV. I, III and IV. I, II, III and IV.

Answer: c Learning objective 21.2: identify an entity’s related parties.

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Chapter 21: Related party disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Which of the following transactions are not related party transactions for an entity? I. II. III. IV.

An employee purchased the entity’s products on normal trading terms. A subsidiary of the entity supplied raw materials to the entity. The entity lent money to one of its directors. The entity made an agreement with a trade union about increase in employee’s wages.

a. b. *c. d.

I and II only. II and III only. I and IV only. III and IV only.

Answer: c Learning objective 21.3: identify relationships that do not give rise to a related party relationship as envisaged under AASB 124/IAS 24. 15. Jack is a non-executive director of Shanghi Limited and Jiang Limited. Jack’s wife, Sarah, is a non-executive director of Huang Limited. Which of the following statements is correct? a. b. c. *d.

Sarah is a related party to Jiang Limited. Jack is not a related party to Shanghi Limited. Shanghi Limited and Huang Limited are related parties. Shanghi Limited and Jiang Limited are not related parties.

Answer: d Learning objective 21.3: identify relationships that do not give rise to a related party relationship as envisaged under AASB 124/IAS 24.

16. Thompson Limited is a subsidiary of Victor Limited. Which of the following is not a related party to Thompson Limited? a. b. *c. d.

A pension scheme that offers benefits to employees of Thompson Limited. The Managing Director of Victor Limited. A distributor of Thompson Limited’s products. An associate of Thompson Limited.

Answer: c Learning objective 21.3: identify relationships that do not give rise to a related party relationship as envisaged under AASB 124/IAS 24.

21.5

Testbank to accompany Financial reporting 3e by Loftus et al.

17. Two entities are not regarded as related parties simply because: a. b. c. *d.

one entity is a subsidiary of the other entity. one entity is a post- employment benefit plan for the other entity. a member of the key management personnel of one entity controls the other entity. a member of the key management personnel of one entity has significant influence over the other entity.

Answer: d Learning objective 21.3: identify relationships that do not give rise to a related party relationship as envisaged under AASB 124/IAS 24.

18. Barry Allen is one of the non-executive directors of Rose Company. In this current financial year, Rose Company had transactions with the following entities: I. II. III. IV.

Borrowed money from City Bank. Purchased raw materials from Arrow Company. Loaned money to one of its subsidiaries, Firestorm Company, with 10% per annum. Sold products to Star Labs Company, of which Barry Allen is also a director.

Which transactions are not related party transactions between Rose Company and another entity? a. *b. c. d.

I and II only. I, II and IV. II and III only. II, III, and IV.

Answer: b Learning objective 21.3: identify relationships that do not give rise to a related party relationship as envisaged under AASB 124/IAS 24.

19. According to AASB 124, related party disclosures are required irrespective of whether there have been related party transactions when: *a. b. c. d.

control exists. significant influence exists. economic dependence exists. all of the above.

Answer: a Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

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Chapter 21: Related party disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

20. The following remuneration categories must be disclosed for key management personnel, except for: a. *b. c. d.

share-based payments. bonus payments. post-employment benefits. termination benefits.

Answer: b Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

21. In the case where financial statements of parent entity or the ultimate controlling entity are not made publicly available, the reporting entity must disclose: a. b. *c. d.

the name of the entity’s largest shareholder. the level of share ownership of the next most senior parent entity. the name of the next most senior parent entity whose financial statements are publicly available. the reason of why the parent entity does not make its financial statements publicly available.

Answer: c Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

22. Kelly is the general manager of Ned Limited and is considered to be the member of key management personnel. The following transactions occurred between Kelly and Ned Limited: Kelly purchased a product of Ned Limited on normal trading terms; Kelly received remuneration from Ned Limited amounting to $400 000; Ned Limited issued 80 000 options to Kelly, which can be converted into Ned Limited’s shares if target profit margin of 25% is achieved in the next three years. Which of the above transactions must be disclosed as related party transactions? *a. b. c. d.

Kelly’s remuneration and the grant of options. The purchase of product and the grant of options. The purchase of product and Kelly’s remuneration. All of the above transactions are related party transactions.

Answer: a Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

21.7

Testbank to accompany Financial reporting 3e by Loftus et al.

23. The minimum disclosures for related party transactions include the following, except: a. *b. c. d.

the amount of transactions. the key management personnel of the related party. the amount of the outstanding balances and commitments. provision of doubtful debts related to outstanding balances.

Answer: b Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

24. Examples of related party transactions that must be disclosed include: a. b. c. *d.

purchase or sales of goods. settlement of liabilities. disposal of assets. all of the above.

Answer: d Learning objective 21.4: describe and apply the disclosures required by AASB 124/IAS 24.

25. A government entity controls both James Limited and Claire Limited. Collum Limited and Dougall Limited are the subsidiaries of James Limited. Frank Randall is the managing director of James Limited. James Limited can apply the partial exemption disclosures in paragraph 25 of AASB 124 to transactions with the following parties, except for: *a. b. c. d.

Frank Randall. Claire Limited. Collum Limited. the government entity.

Answer: a Learning objective 21.5: explain why a government-related entity has a partial exemption from related party disclosures.

26. Walton Co is a government agency that controls Science Limited. Science Limited has two subsidiaries: Physics Limited and Biology Limited. To which entities can Physics Limited apply the disclosure exemption in paragraph 25 of AASB 124? a. b. c. *d.

Science Limited only. Walton Co Limited only. Science Limited and Biology Limited only. Walton Co Limited, Science Limited and Biology Limited.

Answer: d Learning objective 21.5: explain why a government-related entity has a partial exemption from related party disclosures. © John Wiley and Sons Australia, Ltd 2020

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Chapter 21: Related party disclosures Not for distribution in full. Instructors may assign selected questions in their LMS.

27. If an entity chooses to apply the disclosure exemption in paragraph 25 of AASB 124, it is still required to do the following, except: a. b. *c. d.

identify the government to which it is related. disclose the nature of the relationship with the government-related entities. the nature and amount of every transaction with government-related entities. a qualitative or a quantitative indication of the extent of other transactions that are collectively significant.

Answer: c Learning objective 21.5: explain why a government-related entity has a partial exemption from related party disclosures.

21.9

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Belinda Luke

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 22: Sustainability and corporate social responsibility reporting

Chapter 22: Sustainability and corporate social responsibility reporting Comprehension questions 1. Explain the meaning of sustainability. Sustainability, or sustainable development, is concerned with development that meets the needs of the present without compromising the ability of future generations to meet their own needs. It refers to three main areas – economic development, environmental development and social development. 2. Explain the difference between eco-justice and eco-efficiency, and outline how both might relate to business activities. Eco-justice considers the ability to meet the needs of the current inhabitants, including strategies to alleviate poverty, access to basic water, food and shelter. It also takes a longterm focus where it recognizes that consumption of resources today needs to consider the effect this will have on the quality of life of future inhabitants. These two aspects of ecojustice are referred to as intragenerational equity and intergenerational equity respectively. Eco-efficiency, on the other hand, focuses on how efficiently resources are used to minimize the impact on the environment. Some businesses are larger than some governments. As such, they have a great deal of power over resources. Given businesses control the majority of the world’s resources, entities can put systems in place to contribute to the efficient use of these resources to meet ecoefficiency demands. They also have control over the extent to which resources are depleted to avoid eco-justice considerations relating to intergenerational equity. Many businesses operate globally, so are in a position to be able to assist to alleviate poverty, and ensure their employees in developing countries, and their communities have access to food, clean water and shelter. 3. What reasons might an entity provide for adopting sustainable development? There are a number of reasons that businesses can provide for adopting sustainable development. A good discussion is provided in Figure 11.1, which presents reasons that BHP Billiton embraces sustainable development. These include: to reduce business risk and enhance business opportunities; to gain an maintain their ‘licence to operate’ – which is also referred to as a social contract; to improve operational performance and efficiency; improved attraction and retention of its workforce; maintain security of operations; enhanced brand recognition and reputation and to enhance their ability to strategically plan for the longerterm. 4.

Identify what information entities are likely to provide if they use sustainability reporting.

If entities use/adopt sustainability reporting, they are likely to include information on financial, social, environmental, and governance related performance. Specific information may depend on the industry in which the entity operates, however examples include details relating to customers, industry associations, compliance with government regulations, matters affecting shareholders and other stakeholders more broadly, employee safety, human rights, pollution, GHG emissions.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

5. Explain the difference between sustainability reporting and traditional financial reporting. Traditional financial reporting focuses on recognising the financial effects of an entity’s transactions. It follows generally accepted accounting principles and accounting standards and is audited by an external auditor. The financial report is limited to transactions that have a financial impact. Sustainability reporting however goes beyond this. It includes reporting on the environmental activities and of the entity as well as its social impacts. These are combined with financial information.

6. What benefits should entities expect from preparing sustainability reports? The following benefits can be gained from preparing sustainability reports: • Embedding sound corporate governance and ethics systems throughout the organisation • Improved management of risk through enhanced management systems and performance monitoring • Formalising and enhancing communication with key stakeholders • Attracting and retaining competent staff • Ability to benchmark performance with other entities.

7. What is international integrated reporting and how does it differ from the current financial reporting system? Integrated reporting is designed to improve sustainability reporting and integrate it more closely with financial and governance reporting. It is designed to bring together financial, environmental, social and governance information in a clear, concise, consistent and comparable format. It differs from our current financial reporting system as it goes beyond the financial impact of activities, and a general disclosure of governance to include a framework to integrate environmental and social reporting together in an integrated way. 8. What is the Global Reporting Initiative, and what is its purpose? The Global Reporting Initiative was launched in 1997 as an initiative to develop a globally accepted reporting framework to enhance the quality of sustainability reporting. It provides a framework of principles and performance indicators that organisations can use to measure and report their social and environmental performance. Its purpose is to enhance the transparency, comparability and clarity of sustainability reports. 9. Identify four corporate stakeholders and explain how they affect a business’s operations. Figure 22.4 provides examples of a range of stakeholders. These can include: • Shareholders: provide funds to the entity. Their support is essential for continued success of the entity, as their support affects share price and corporate value. • Customers: major users of the entity’s products and services. A continued and growing supply of customers is essential to the continued success of the entity.

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Chapter 22: Sustainability and corporate social responsibility reporting

• • • •

Fund investors: like shareholders, they buy shares in the company and support companies for which they see opportunities for growth in value. Community groups: may supply labour to the entity, but need to support the entity’s operations if the entity and community are to exist harmoniously. Media: can impact the views of other stakeholders by voicing concerns and making other groups aware of the businesses operations and activities Government and regulators: monitor mandatory reporting, impose taxes and charges and uphold legislation that the entity needs to follow.

10. Identify why you would expect the finance sector — and investment funds in particular — to have an interest in climate change. Identify how ethical investment can affect corporate decision making regarding sustainable business operations. The finance sector, and investment funds in particular have an interest in climate change as the performance of companies they invest in is impacted by environmental performance (e.g. GHG emissions). By way of example, companies which have high GHG emissions may face increased expenses directly through a carbon tax. Further, such companies may be affected indirectly through loss of support, resulting in decreased share price. They may also be forced to consider investment in lower emissions technology (where possible), which represents another direct cost to the entity. The increased awareness of ethical investment and ethical investment funds represents a pressure on corporate performance and reporting, as institutional investors increasingly voice their concerns regarding environmental risks (e.g. climate change) faced by companies, and requiring companies to provide information on how they plan to address these risks. 11. Explain what an environmental management system is and how it can be used to improve environmental performance. An environmental management system (EMS) is a system that organisations implement to measure, record and manage their environmental performance. It is useful to assist in improving environmental performance because it allows entities to measure and record their performance, set benchmarks or key performance indicators, and put in place mechanisms to meet these benchmarks. It is often said you can’t control what you can’t measure. An EMS allows an entity to measure its environmental outputs in order to look towards controlling and reducing them, thus improving performance.

12. Explain how emissions trading schemes are likely to affect financial reporting. An emissions trading schemes is a system designed to control emissions by allowing participants to trade excess emissions permits. This is likely to affect financial reporting because it will require companies to measure and report emissions permits it holds, through grants from government and those it purchases. There are also likely to be financial implications from the trade of permits. While there are currently no financial reporting guidelines around the operation of an emissions trading scheme it is likely that emissions permits are likely to be reported as either financial instruments or intangible assets, and both are used in jurisdictions which currently have an emissions trading scheme in place.

22.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 22.1 Sustainability reporting The manager of Gladstone Ltd is not convinced of the scientific evidence behind climate change, and does not consider it necessary to adopt changes in the company’s operations which would decrease its greenhouse gas emissions. Gladstone Ltd’s accountant, however, has argued that if the company does not try to decrease its greenhouse gas emissions, the company’s carbon footprint will begin to appear on its statement of financial position with the introduction of a carbon emissions trading scheme. Required Explain what the accountant means by a ‘carbon footprint appearing on the statement of financial position’, and whether this ‘footprint’ would be visible to investors. Depending on the terms of the ETS relevant to Gladstone Ltd, the company’s ‘carbon footprint’ – its environmental impact – will not appear directly on the statement of financial position. However, it will likely impact on the statement of financial position if the company: • has to purchase additional permits (i.e. if its actual emissions exceed its allocated/allowable emissions). • is fined for exceeding its allowable emissions. While both these items represent expenses (affecting the profit and loss) they may also be included as liabilities (current liabilities) if the expenses remain payable at year end. Similarly, future profits and retained earnings may also be impacted, if the company expects these expenses will continue to arise in future years. Further, decreased profits (due to these expenses) will impact retained earnings in the statement of financial position. While the company’s carbon footprint (its environmental impact in terms of tonnes of CO2 emitted, for example) may not be directly visible to investors (depending on disclosure requirements), the financial implications of this footprint would be visible in the financial statements (as noted above).

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Chapter 22: Sustainability and corporate social responsibility reporting

Case study 22.2 Costs and benefits of environmentally friendly business practices The directors of Perth Ltd are concerned about the increased costs proposed by the company in adopting new, more environmentally friendly technology. Management has argued that the company was ‘always going to pay a price for carbon reduction’, but contends the short-term costs will be outweighed by the long-term benefits. Required Explain what benefits management might be referring to. The adoption (purchase) of new technology with lower GHG emissions is a strategy of the company which results in immediate (short-term) costs. However, this strategy presents potential ongoing (long-term) financial benefits (presuming the company operates in a jurisdiction which has a carbon tax or ETS), as decreased emissions will result in lower carbon tax or permit costs. This strategy also presents long-term benefits for the environment (reduced pollution), as well as potential benefits for the company where stakeholders respond positively to the company’s environmentally aware decisions (e.g. increased share price, increased customer base).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 22.3 Stakeholders Darwin Ltd wants to focus on ‘people, profits, planet’. The board of directors has proposed linking top managers’ pay to broad measures of environmental sustainability, and worker and customer satisfaction. The board proposes that bonuses for management will be linked to targets such as the reduction of greenhouse gas emissions and energy use, the introduction of new environmentally friendly products and improvements in workforce morale. Required Advise the board of the potential implications, both positive and negative, of the proposed remuneration policy. Positive implications: • Increased focus on environment may result in decreased pollution, a more socially responsible company, decreased costs (particularly if an ETS or carbon tax is introduced); potentially resulting in increased market share and profits. • Increased focused on people may result in a more engaged and productive workforce, with increased productivity and lower turnover potentially resulting in decreased costs and increased profits. • If cost savings are passed on to consumers (though decreased prices), this can also enhance market share, profits, reputation, and competitive advantage. • Increased focus on customers may result in enhanced reputation, ability to increase prices (charge more through tailoring goods and services), resulting in increased profits and market share. • Thus, the proposed remuneration policy could effectively reward managers for helping to create an environmentally aware, employee and customer focused organisation. Negative implications: • Environmental initiatives may involve significant short-term costs (e.g. investing in new equipment), resulting in decreased profits. • Employees may have a range of different and conflicting satisfaction expectations making it difficult please everyone in a way which benefits the business (e.g. more autonomy versus more guidance or training), and may involve additional costs. • Customers may also have a range of different and conflicting satisfaction expectations (e.g. increased quality, lower price), such that it is difficult to balance both, and some requests may not be commercially viable (i.e. there is an additional cost associated with tailored goods, which customers may not be willing to pay for, or which the company may not be able to provide on a cost-effective (competitive) basis). • If managers do not have authority over decision-making on these issues (e.g. new investments, new employee and customer initiatives), then arguably it is not equitable to judge their performance on and link their remuneration to these issues. In this case, the policy would effectively be unfairly disadvantaging managers who do not have decisionmaking power over these issues.

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Chapter 22: Sustainability and corporate social responsibility reporting

Case study 22.4 Ethical investment The report Carbon counts 2011: The carbon footprints of Australian superannuation investment managers examines 14 of the largest superannuation funds in Australia, accounting for $36 billion in equity holdings, and looks at the greenhouse gas emissions associated with 88 equity portfolios that employ different investment styles. The report is considered to have a significant impact on the investment strategies of superannuation funds. Required Outline the type of influence the report may have. The report has a significant influence by highlighting those portfolios that are environmentally aware or have low emissions and those portfolios that have high emissions. Given the large volume of funds invested in superannuation each year, and the increasing awareness of companies’ environmental impact, this type of report helps to highlight environmentally aware investments available. For investors, it informs them which portfolios may be considered both financial and social investments. For fund managers it provides valuable feedback on how they compare with other superannuation funds in terms of social/ environmental performance.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 22.5 Ethical investment Refer again to the report mentioned in case study 22.4. While some investment categories have a smaller carbon footprint than others (due to a focus on different industries), it has been argued that it is not just the size of the carbon footprint that it important, but also the relative performance of companies within an industry group. The board of Onslow Ltd has proposed a review of the company’s superannuation fund portfolio to shift from overweight carbon-efficient companies to underweight carbonintensive companies. Required Explain what the board means in relation to these terms. Overweight carbon efficient companies refers to companies in carbon efficient industries (i.e. typically low carbon emissions – service companies such as banks and financial institutions) but which have relatively high emissions compared to other companies in that industry. Underweight carbon intensive companies refers to companies in high carbon (carbon intensive) industries (e.g. manufacturing companies such as those in mining), but which have relatively low emissions compared to other companies in that industry. The terms highlight that emissions are a result of the industry in which companies operate, but also how companies operate within an industry.

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Chapter 22: Sustainability and corporate social responsibility reporting

Application and analysis exercises Exercise 22.1 Sustainability reporting Obtain the most recent sustainability report by Shell (Royal Dutch Shell plc). Required Prepare a report that addresses the following issues. 1. Shell’s vision and mission statement, and how these might relate to sustainability (if at all) 2. Shell’s stakeholders and how the company has engaged with each of stakeholder group 3. Governance mechanisms in place on the board of directors to address sustainability 4. How Shell links sustainability to its risk management systems 5. Any guidance Shell used in implementing environmental and social performance and reporting systems (LO1, LO2, LO3 and LO4) Sustainability Report, 2018, Royal Dutch Shell plc 1. Shell’s vision and mission statement - Consider Shell’s business strategy and approach to sustainability 2. Shell’s stakeholder engagement - Through the report, Shell discusses various methods of stakeholder engagement. 3. Under the ‘Sustainability Governance’ section of the report the company reports on the role of the Corporate and Social Responsibility Committee (CSRC). 4. Shell maintains a risk management framework that regularly assesses their response to, and risk appetite for, identified risk factors. 5. Page 6-7 summarises Shell’s responses to the previous year’s recommendations.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 22.2 Stakeholder engagement This chapter has identified a range of stakeholders that managers should consider when determining sustainability performance and reporting. Determine how managers should engage with each of these stake-holders and document what sustainability issues they would be likely to discuss during this engagement process. (LO2) Shareholders: direct emails, provide information in annual reports and stand-alone sustainability reports, website. The entity would be likely to discuss their sustainable business activities and how these will add to firm value. This might also include how it is addressing legislation on carbon emissions. Customers: directly through email and other written communication. The media and the corporate website would also be useful. Customers may be interested in the source of products, with some actively seeking green or fair trade products. Consequently entities will communicate the environmental credentials of products including the extent to which they are sourced from sustainable sources. Fund investors: direct communication through email, phone, meetings with fund managers and through providing sustainability information in written form, for example the sustainability report. Some investors search out socially responsible companies to invest in. Entities will report their social and environmental activities to attract ethical fund investors. Managers will also discuss how the entity is addressing issues such as carbon emissions disclosure and reduction requirements. Community groups: can use the media, company website, attending community meetings, and through local government. Entities will discuss facilities and services provided to local community groups, and issues such as job creation, health, and emissions information relating to the local environment. Media: media releases, direct communication through email, phone and by providing copies of sustainability reports. Given the media acts as a voice that sets the agenda relating to many issues an entity will wish to advise any positive social and environmental activities. Government and regulators: direct reporting to show are compliant with regulations, email and phone. The entity will discuss the potential impacts of legislative changes relating to social and/or environmental activities.

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Chapter 22: Sustainability and corporate social responsibility reporting

Exercise 22.3 Sustainability index Explain the purpose of the Dow Jones Sustainability Index. (LO2) The Dow Jones Sustainability Indexes (DJSIs) aims to draw attention to and track the financial performance of the leading sustainability-driven companies worldwide. With the support of Sustainable Asset Management (SAM) — an international investment group — the DJSIs provide asset managers with objective benchmarks to manage sustainability portfolios. In addition to providing information to investors, the DJSIs provide feedback to participating companies on their sustainability performance, and how they rank compared to industry averages.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 22.4 Reporting Explain the difference between an integrated report and a CSR report. What are some of the benefits and limitations of each? (LO3) The term integrated reporting refers to combining details of a company’s financial performance with its social, environmental, and governance performance. It represents the notion that these issues are interrelated, as highlighted by the global financial crisis, and has the benefit of presenting all information in one report. However, while the IIRC has developed an integrated reporting framework (with guiding principles and content elements), there is no prescribed format for integrated reporting, making it difficult to compare reports across companies. A CSR report focuses specifically on an organisation’s social and environmental activities, and is often presented separately to the organisation’s financial report. This separation potentially makes the information clearer, distinguishing financial information which is comparable across firms (due to clear rules and disclosure requirements), from non/less comparable information on social and environmental performance information.

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Chapter 22: Sustainability and corporate social responsibility reporting

Exercise 22.5 Impact on financial reporting There are no IFRS accounting standards for the reporting of social and environmental activities. Evaluate what issues this presents for the preparation of financial reports. (LO3 and LO4) Given there are no IFRS accounting standards for the reporting of social and environmental activities this means that these activities are not going to be included in the transactions reflected in the financial statements. For example, an entity’s impact on the environment, in terms of pollution is not costed and included as an expense. While entities are required to account for the present value of future clean-up costs of contaminated sites, they do not have to account for the ongoing impact of this contamination on the environment. Similarly, entities are not currently required to account for any social cost which does not have a direct financial impact.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 22.6 Sustainability – developing countries You are the accountant of a company that is considering expanding its operations to a developing country. The CEO has asked for a report outlining what issues the company should consider from a sustainability perspective when making this decision. Outline some of the key issues to be included in the report. (LO1, LO2 and LO5) There are a range of issues the CEO needs to consider from a sustainability perspective. These include but are not limited to: • Environmental impacts of the activities. • Access to resources using sustainable transport methods. • Depletion of resources to the detriment of the local community. • Providing appropriate wages and facilities for employees. It is likely that the company will need to provide additional support in the form of shelter, food and water to employees and their families. • Government regulations.

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Chapter 22: Sustainability and corporate social responsibility reporting

Exercise 22.7 ETS Explain the difference between an emissions trading scheme and a carbon tax. What are some of the benefits and limitations of each? (LO5) Under an ETS, permits are either given, sold, or auctioned to businesses, with a cap or limit set on the level of emissions permitted by the organisation. If a company’s level of emissions exceeds the amount allowed based on the permits held, they are required to buy additional permits to avoid substantial fines. If however, their actual emissions are less than the amount permitted, they may be able to trade (sell) these to other organisations. Under a carbon tax, there is no cap set on the level of emissions, and companies pay tax based on the level of emissions generated. The benefit of an ETS is that over time, governments can lower the cap, for the purposes of moving towards achieving the country’s national emissions reduction target. This is a weakness of the carbon tax, as it has been argued that a tax will not necessarily decrease emissions, provided companies can afford to pay the tax (or see it as an economically viable alternative to investing in expensive low emissions technology). However, a benefit of a carbon tax is that it sends an immediate price signal to the market, highlighting both the cost and the underlying issue (carbon emissions).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 22.8 ETS Research and prepare a report on the different approaches for accounting for carbon emissions under the EU ETS. Despite several attempts by various regulators, there is currently no guidance on how to account for carbon pollution permits or emissions trading activities. Organisations face a number of short-term and long-term financial implications from the operation of a carbon trading scheme. One issue facing organisations is the accounting for annual allowances allocated by government. Should they be recognised at fair value or cost? Another issue is whether allocated emissions allowances should be treated differently to purchased emissions allowances. Are they an intangible asset or a financial instrument? Organisations are also under an obligation to the government to ‘pay’ for their emissions. How should this obligation be recognised in the financial reports? Should organisations be allowed to use hedge accounting to reduce the risk associated with their allowance asset and emissions liability? Climate change has an impact on the valuations and impairments of assets as consumer preferences to ‘green’ products and technologies are lowering the value of assets used to produce products no longer in demand.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 22: Sustainability and corporate social responsibility recording Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 22: Sustainability and corporate social responsibility reporting Multiple choice questions

1. The UN report, Our Common Future, defined sustainable development as ‘development that…’: a. b. c. *d.

allows all societies to meet their needs to an equal degree. continues at the current pace, neither increasing nor decreasing into the foreseeable future. meets the needs of the future without compromising the ability of current generations to meet their own needs. meets the needs of the present without compromising the ability of future generations to meet their own needs.

Answer: d Learning objective 22.1: explain why an entity might adopt sustainable development and corporate social responsibility practices.

2. Which of the following statements about intragenerational equity is not true? a. b. *c. d.

It is an important aspect of eco-justice. It is concerned with poverty and access to food, water and shelter. It means that future generations should not have a lower quality of life. none of the above. They are all true.

Answer: c Learning objective 22.1: explain why an entity might adopt sustainable development and corporate social responsibility practices.

3. Which of the following is not considered a stakeholder with potential interests in corporate sustainability? a. b. c. *d.

Media. Government. Financial Institutions. None of the above. They are all potentially interested in corporate sustainability.

Answer: d Learning objective 22.2: discuss stakeholder influence on sustainable business practice.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. Stakeholder power is generally considered to relate to which of the following factors? a. b. *c. d.

How vocal they are prepared to be. The amount of impact the organisation has on them. The degree of control they have over resources required by the organisation. None of the above.

Answer: c Learning objective 22.2: discuss stakeholder influence on sustainable business practice.

5. Ethical investment funds might be concerned about how individual companies address climate change because: a. b. *c. d.

they believe carbon emissions proxy for economic performance. they don’t want to invest money on companies that waste money. they believe companies that address environmental risks will perform better in the long run. none of the above.

Answer: c Learning objective 22.2: discuss stakeholder influence on sustainable business practice.

6. Which of the following terms is commonly used to mean sustainability reporting? a. b. c. *d.

Corporate social reporting. Triple bottom line reporting. Environmental, social and governance reporting. All of the above.

Answer: d Learning objective 22.3: describe a range of methods used to report on social and environmental performance.

7. Which of the following make up the three parts of the triple bottom line? I II III a. *b. c. d.

Social Government Economic

IV V VI

Environmental Stakeholder Financial

II, IV and VI I, III and IV I, III and VI II, IV and V

Answer: b Learning objective 22.3: describe a range of methods used to report on social and environmental performance.

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Chapter 22: Sustainability and corporate social responsibility recording Not for distribution in full. Instructors may assign selected questions in their LMS.

8. The International Integrated Reporting Committee was formed by which two bodies? *a. b. c. d.

GRI and A4S NGO and GRI UNHCR and IASB IASB and FASB

Answer: a Learning objective 22.3: describe a range of methods used to report on social and environmental performance.

9. According to the research undertaken to date, what is the relationship between environmental performance and disclosure of corporations? a. b. c. *d.

Poor performers have poor disclosure, but no relationship has been found for good performers. Poor performers have good disclosure, but no relationship has been found for good performers. Good performers have good disclosure, but no relationship has been found for poor performers. Research has not drawn any clear conclusions

Answer: d Learning objective 22.3: describe a range of methods used to report on social and environmental performance. 10. The UN’s Principles for Responsible Investment have mainly been adopted by which types of organisations? a. b. c. *d.

Builders. Governments. Mining companies. Institutional investors.

Answer: d Learning objective 22.4: describe the commonly used guidelines for sustainability reporting.

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Testbank to accompany Financial reporting 3e by Loftus et al.

11. Which of the following is an environmental performance indicator under the GRI framework? a. *b. c. d.

Anti-corruption policies. Impacts of transport. Rates of injury. None of the above.

Answer: b Learning objective 22.4: describe the commonly used guidelines for sustainability reporting.

12. Which of the following is not an indicator under the GRI of labour practices and decent work performance? a. b. *c. d.

Workforce by gender. Education and training programs in place. Assessment of product life cycle stages for health and safety risks. None of the above. They are all indicators of labour practices and decent work performance.

Answer: c Learning objective 22.4: describe the commonly used guidelines for sustainability reporting.

13. Which of the following statements is most correct regarding environmental, social and governance reports? a. b. c. *d.

They are not currently required in any country. They are required as part of the IASB’s accounting standards. Norway is leading the way with regards to requiring reporting. They are becoming mandatory in an increasing number of countries.

Answer: d Learning objective 22.4: describe the commonly used guidelines for sustainability reporting.

14. The Kyoto Protocol: *a. b. c. d.

commits countries to achieving specific greenhouse gas emissions reductions. sets standards on corporate reporting of carbon emissions. forbids trading in greenhouse gases. All of the above.

Answer: a Learning objective 22.5: evaluate the implications of climate change for accounting.

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Chapter 22: Sustainability and corporate social responsibility recording Not for distribution in full. Instructors may assign selected questions in their LMS.

15. An emissions trading scheme: a. b. c. *d.

allows the trade of excess emissions permits. can also be referred to as a ‘cap and trade’ scheme. usually involves substantial fines for excessive polluters. All of the above.

Answer: d Learning objective 22.5: evaluate the implications of climate change for accounting.

16. The IASB project on accounting for carbon emissions: a. *b. c. d.

does not exist. remains unresolved. is complete with the release of IFRS 4. is currently an exposure draft (ED133/A..

Answer: b Learning objective 22.5: evaluate the implications of climate change for accounting.

17. Climate change has the ability to impact on traditional financial accounting in what way? a. b. c. *d.

Valuation of liabilities. Impairment of assets. Disclosure of risks. All of the above

Answer: d Learning objective 22.5: evaluate the implications of climate change for accounting.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 23: Foreign currency transactions and forward exchange contracts

Chapter 23: Foreign currency transactions and forward exchange contracts Comprehension questions 1. Explain the financial reporting issue that arises when a company enters into foreign currency transactions. Provide examples of various foreign currency transactions and indicate whether each transaction involves the initial recognition of a monetary item or non-monetary item or both. Financial statements presented in Australian dollars must include the financial effects of all transactions during the reporting period including the financial effects of foreign currency transactions. The foreign currency transactions have to be recognised using accrual accounting. Accordingly, monetary assets and monetary liabilities may be recognised before there is a cash receipt or cash payment that concludes or settles the transaction. Pursuant to accrual accounting, monetary assets and monetary liabilities are translated into A$ on the date of initial recognition and then subsequently at the end of a reporting period and on cash settlement. The need for the re-translation of monetary items creates the financial reporting issue of exchange differences and how such differences should be recognised in the financial statements. Examples of foreign currency transactions that result in the initial recognition and measurement of a monetary item are as follows. Transaction Initial recognition and measurement Monetary item Non-monetary item Purchase of inventories on account Purchase of plant on account Purchase of services on account Issue of debentures for cash Issue of debentures for land Loan funds arranged from a bank Sale of inventories on account Right to receive dividend Loan funds provided to another entity

Accounts payable Payable to supplier Payable to supplier Debentures liability Debentures liability Loan payable Accounts receivable Dividend receivable Loan receivable

Inventories Plant Land

2. Explain what is meant by the term ‘functional currency’. The functional currency of a company is the currency of the primary economic environment in which the company operates (AASB 121/IAS 21 paragraph 8). The primary economic environment of a company is the one in which the company primarily generates and expends cash (paragraph 9). Normally, the functional currency of an Australian company is A$ because the company primarily generates and expends cash in Australia. The functional currency of an Australian company determined to be A$ or some other currency would remain the same from one reporting period to the next unless the company’s underlying transactions, events and conditions changed in such a way as to justify a change in the functional currency (AASB 121/IAS 21 paragraph 13).

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3. Describe the indicators used in determining the functional currency of an entity. In determining the functional currency of an Australian company, AASB 121/IAS 21 paragraph 9 gives priority to the following three indicators below. i. The currency that mainly affects the sales prices for its goods and services, which is usually the currency in which the sales prices are denominated and settled. ii. The currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. iii. The currency that mainly influences labour, material and other costs of providing its goods or services, which is usually the currency in which such costs are denominated and settled. The functional currency for an Australian company may not be obvious when the three indicators provide mixed results. An Australian company may produce commodities from mines in the Pilbara region of Western Australia (e.g. gold, copper, aluminium, lead, nickel, tin, zinc, silver and iron ore), but the commodity prices may be denominated in US$. In this case, the US$ is the currency that mainly affects sales prices, while the A$ is the currency that mainly affects costs. If the three main indicators yield mixed results, AASB 121/IAS 21 requires management to use its judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions (paragraph 12). In exercising this judgement, paragraph 10 suggests that management may consider the following two additional indicators: • The currency in which funds from issuing debt and equity instruments are generated. • The currency in which receipts from operating activities are banked and retained. 4. Explain what is meant by a spot exchange rate, closing exchange rate and forward exchange rate. A spot exchange rate is the exchange rate for immediate delivery at a particular point in time. (AASB 121/IAS 21, paragraph 8), for example, on 1 January 2018 at 4.59 pm, A$1 = US$0.85. A closing exchange rate is the spot exchange rate at the end of the reporting period (AASB 121/IAS 21, paragraph 8), for example, on 30 June 2018 at close of business A$1 = US$0.90 A forward exchange rate is the exchange rate specified for currency exchange at a specified future date, for example, a 3 month forward exchange contract entered into on 1 July 2018 specifies a currency exchange on 30 September 2018 at the a forward rate of A$1 = US$87.

5. Illustrate the direct and indirect methods of quoting exchange rates. Foreign exchange dealers may quote the exchange rates using the indirect form of quotation, which sets out the equivalent amount of foreign currency for one unit of local currency. In Australia, this form is also preferred by the media in the presentation of financial news. For Australia, an example of the indirect form of quotation is as follows. Indirect form: A$1.00 equals US$0.6961/0.7754.

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The exchange rate shown in the indirect form above sets out the prices for buying and selling A$1.00 as: • •

US$0.6961 is the buying rate for A$1.00, being the price the foreign exchange dealer will pay to buy A$1.00 from a customer. US$0.7754 is the selling rate for A$1.00, being the price the foreign exchange dealer will ask to sell A$1.00 to a customer.

Accordingly, a person travelling to the United States will sell A$ (and buy US$) based on the exchange rate of A$1.00 equals US$0.6961. A person returning from the United States will sell US$ (and buy A$) based on the exchange rate of A$1.00 equals US$0.7754. The difference between the buying (bid) and selling (ask) rates is known as the bid–ask spread and it provides a profit margin to the foreign exchange dealer for acting as the medium through which market participants buy and sell currencies. An alternative approach is to present exchange rates using the direct form of quotation that sets out the equivalent amount of local currency for one unit of foreign currency. For Australia, an example of the direct form of quotation is as follows. Direct form: US$1.00 equals A$1.2897/1.4366. The exchange rate shown in direct form sets out the prices for buying and selling US$1.00 as: • A$1.2897 is the buying rate for US$1.00, being the price the foreign exchange dealer will pay to buy US$1.00 from a customer. • A$1.4366 is the selling rate for US$1.00, being the price the foreign exchange dealer will ask to sell US$1.00 to a customer. As a foreign exchange dealer buying US$ with A$ is essentially selling A$ in the process, the rates shown in the direct form of quotation are the reciprocals of the relevant exchange rates shown in the indirect form of quotation; that is, 1 ÷ US$0.6961 equals A$1.4366 and 1 ÷ US$0.7754 equals A$1.2897. The foreign exchange dealer that buys A$ at the rate of A$1.00 equals US$0.6961 is essentially selling US$ at the rate of US$1.00 equals A$1.4366. The foreign exchange dealer that sells A$ at the rate of A$1.00 equals US$0.7754 is essentially selling US$ at the rate of US$1.00 equals A$1.2897. In general: • The buying rate under the indirect form of quotation is the inverse of the selling rate under the direct form of quotation. • The selling rate under the indirect form of quotation is the inverse of the buying rate under the direct form of quotation.

How currencies are expressed

Example of quoted rates Translation process

Direct method

Indirect method

One unit of foreign currency expressed in Australian currency US$1 = A$1.2897/1.4366 multiplication

One unit of Australian currency expressed in foreign currency A$1 = US$$0.6961/0.7754 division

The application of exchange rates to translate foreign currency balances into A$ is

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

demonstrated next by a simple example. Assume an Australian company has a foreign currency payable of US$5000 that must be translated into A$ using the exchange rates shown in this section. In the first instance, it is necessary to determine whether the buying or selling rate should be used for the purpose of the translation. The liability balance denominated in US$ means that the Australian company has an obligation to pay US$, which means it needs to sell A$ to get the US$ necessary to settle its obligation; therefore, it will need to find a foreign exchange dealer willing to buy A$ and sell US$. In this case, the relevant exchange rate for translation is either the foreign exchange dealer’s buying rate for A$ (in the indirect form of quotation) or their selling rate for US$ (in the direct form of quotation). Accordingly, the translation of the foreign currency payable of US$5 000 proceeds as follows. Translation of foreign currency payable: Indirect: US$5 000 ÷ 0.6961 equals A$7 183. Direct: US$5 000 × 1.4366 equals A$7 183. This example highlights a rule of thumb that can be relied on when translating foreign currency balances; that is, translation is a process of division if rates are expressed in indirect form (A$1.00 = US$ equivalent) and multiplication if rates are expressed in direct form (US$1.00 = A$ equivalent). In contrast, an Australian company with a foreign currency receivable of US$5000 has an asset balance denominated in US$ and a right to receive US$. In this case, the Australian company wanting A$ will need to consider selling US$ received to buy A$ and therefore will need to find a find a foreign exchange dealer willing to sell A$ and buy US$. The relevant exchange rate for translation is then either the foreign exchange dealer’s selling rate for A$ (in the indirect form of quotation) or the buying rate for US$ (in the direct form of quotation). Accordingly, the translation of the foreign currency receivable of US$5 000 proceeds as follows. Translation of foreign currency receivable: Indirect: US$5 000 ÷ 0.7754 equals A$6 448. Direct: US$5 000 × 1.2897 equals A$6 448.

6. Explain how the items that arise from foreign currency transactions are translated into A$ when initially recognised in the accounting records. Each asset, liability, item of equity, revenue or expense that arises from entering a foreign currency transaction must initially be recognised using the spot rate at the date of the transaction between the A$ and the foreign currency (AASB 121/IAS 21 paragraph 21). A spot exchange rate is the exchange rate for immediate delivery at a particular point in time. (AASB 121/IAS 21 paragraph 8), for example, on 1 January 2018 at 4.59 pm, A$1 = US$0.85.

7. Describe how the transaction date is determined for the purpose of initially recognising items arising from foreign currency transactions. The date of the transaction depends on when control of the future economic benefits embodied

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Chapter 23: Foreign currency transactions and forward exchange contracts

in the asset are obtained from or transferred to another entity. AASB 102/IAS 2 Inventories paragraph 6 indicates that inventories are recognised only if the definition of an asset in the conceptual framework is satisfied. AASB 116/IAS 16 Property, Plant and Equipment paragraph 7 states that the initial recognition of an item arises only when it is probable that the future economic benefits will flow to the entity and the cost can be measured reliably. In relation to revenue recognition in the case of sale of goods to customers, AASB 15/IFRS 15 Revenue from Contracts with Customers requires an entity to satisfy performance obligations and transfer control of the asset to the customer. In most instances, the terms of agreements between a company and its foreign customers or suppliers will determine the date of the transaction for the sale or purchase of goods. A free on board (FOB) clause is usually included in contracts stipulating who has title to the goods during shipment. A contract that is FOB destination means that the seller retains ownership while the goods are in transit and ownership changes only at the point when the buyer has received the goods into its stores. A contract that is FOB shipping point means that the seller retains ownership of the goods only to the point when the goods are placed on the ship. In this case, ownership changes at the point when the seller transfers the goods to the specific carrier agreed with the buyer. Another contract variant is FOB origin, which means the seller bears responsibility for the goods while the goods remain in the country of origin. 8. Explain what are monetary and non-monetary items. AASB 121/IAS 21 defines monetary items as units of currency held and assets and liabilities to be received or paid in a fixed or determinable amount of currency (paragraph 8). A monetary item therefore refers to cash or another item that constitutes a claim to cash or an obligation to pay cash. An Australian company with a functional currency of A$ could have monetary items denominated in foreign currency, such as: • cash at bank US$60 000 • accounts payable of €200 000 • accounts receivable of ¥400 000 • payable for plant purchase US$72 000 000 • borrowings £500 000 • interest payable £20 000. Monetary items should not be confused with financial assets. Shares held in companies listed on the Australian Securities Exchange (ASX) are financial assets and can easily be converted into cash through sale. The shares held, however, do not represent a claim to a fixed number of dollars or currency and therefore do not constitute a monetary item. In contrast, foreign currency borrowings is a monetary item because it represents an obligation to pay a fixed number of foreign currency units, even if exchange rate movements cause the obligation measured in A$ to vary. A non-monetary item is an asset or liability that is not a monetary item. Examples of nonmonetary items include inventories and property, plant and equipment. 9. Explain what is meant by the term ‘exchange difference’. Distinguish between an unrealised exchange loss and a realised exchange loss. Provide an overview of the

23.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

accounting requirements of AASB 121/IAS 21 in relation to foreign currency transactions and exchange differences. Definition of exchange difference Paragraph 8 of AASB 121/IAS 21 defines an exchange difference to mean: the difference resulting from translating a given number of units of one currency into another currency at different exchange rates. Therefore, an exchange difference arises when a balance denominated in foreign currency is re-measured and there has been a movement in exchange rates between two dates. AASB 121/IAS 21 recognises exchange differences on the foreign currency monetary items. Exchange differences on foreign currency monetary items are determined by comparing the foreign currency amount translated at the applicable exchange rate at the reporting date (or, where the monetary item is settled during the reporting period, at the date of settlement) with that same foreign currency amount translated at the date on which the original transaction took place (or, if later, the last reporting date). Exchange differences: realised versus unrealised A realised exchange difference arises on the cash realisation of a recognised asset or cash settlement of a recognised liability. In the case of a monetary item (e.g. an accounts payable), the realised exchange difference equals the difference between the translated amount at the date of initial recognition and translated amount at the date of cash settlement. Date of transaction

Settlement date Realised Exchange Difference .

Record the transaction at the spot rate (initial recognition of monetary asset or liability).

Re-measure monetary asset or liability at the spot rate for cash settlement

In contrast, an unrealised exchange difference arises whenever a recognised asset or recognised liability continues to be recognised in the financial statements but is re-measured using an exchange rate that is different to the historic exchange rate. Monetary items that are re-measured at the end of the financial reporting period give result in unrealised exchange differences. Date of transaction

Reporting Date Unrealised Exchange Difference .

Record the transaction at the spot rate (initial recognition of monetary asset or liability).

Re-measure monetary asset or liability at the closing rate for inclusion in the statement of financial position

Another exchange difference arises if a monetary item is remeasured at settlement date after having been included in the statement of financial position at the end of a previous reporting period. In effect, this is an adjustment of the exchange difference. The adjustment ensures that the total exchange difference recognised for the monetary item in the current and prior periods equals the realised exchange difference.

23.7

Chapter 23: Foreign currency transactions and forward exchange contracts

Reporting Date

Settlement Date Adjustment Exchange Difference

Re-measure monetary asset or liability at the closing rate for inclusion in the statement of financial position

Re-measure monetary asset or liability at the spot rate for cash settlement

Accounting treatment of exchange differences The accounting treatment of exchange differences for monetary items is set out at paragraph 28 of AASB 121/IAS 21 as follows. • Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements, shall be recognised in profit or loss in the period in which they arise The accounting treatment of exchange differences for non-monetary items is set out at paragraph 30 of AASB 121/IAS 21 as follows. • When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss shall be recognised in other comprehensive income. Conversely, when a gain of loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss. The following table summarises the required approach. Item

Recognition of exchange differences

Monetary items • Accounts payable • Accounts receivable

In profit or loss as exchange rates change In profit or loss as exchange rates change

Non-monetary items • Land at cost • Land at fair value > cost • • •

Land at fair value < cost Inventories at NRV Impaired asset at recoverable amount

None In other comprehensive income as part of revaluation gain to reserve In profit or loss as part of revaluation loss In profit or loss as part of inventories expense In profit or loss as part of impairment loss

10. Describe how monetary items designated in a foreign currency are subsequently remeasured under AASB 121/IAS 21? At what dates does the remeasurement occur? Foreign currency monetary items that are outstanding at reporting date must be subsequently measured (i.e. retranslated) at the spot rate at the reporting date, for example, at the end of the financial year (AASB 121/IAS 21 paragraph 23). Foreign currency monetary items must also be remeasured at the date of settlement in order that their balances accord with the cash flow that occurs on the date of settlement (AASB 121/IAS 21 paragraph 29).

23.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Initial recognition and subsequent measurement of foreign currency monetary items can be depicted as follows. Date of transaction

Reporting date

Settlement date

Record the transaction at the Re-measure monetary asset or Re-measure monetary asset or spot rate (initial recognition liability at the closing rate. liability at the spot rate. of monetary asset or liability). Record cash settlement of monetary asset or liability at spot rate.

11. Describe the conditions under which non-monetary items designated in a foreign currency are subsequently remeasured under AASB 121/IAS 21? Non-monetary items measured in terms of historic cost are translated using the applicable historic exchange rate. Non-monetary items that are revalued (e.g. an asset measured at fair value) are retranslated using the exchange rate at the date of the revaluation (AASB 121/IAS 21 paragraph 23). AASB 121/IAS 21 paragraph 23(b) requires that a non-monetary item measured in terms of historical cost in a foreign currency be translated using the exchange rate at the date of the historical transaction. The subsequent measurement of a non-monetary item will not give rise to any exchange differences if the original translated cost continues to apply. Three scenarios where exchange differences do affect the measurement of a non-monetary asset are as follows. • The first scenario is exchange differences in the nature of interest costs that relate to a ‘qualifying asset’. • The second scenario is exchange differences on a non-monetary asset that is subsequently measured at fair value rather than historical cost. • The third scenario is the recognition of inventories write-downs and impairment losses on other assets. 12. Explain what is meant by the term ‘qualifying asset’. Describe the accounting treatment for exchange differences that relate to qualifying assets. Definition of qualifying asset Paragraph 5 of AASB 123/IAS 23 Borrowing costs defines a qualifying asset as follows. A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Examples of qualifying assets In accordance with paragraph 7 of AASB 123/IAS 23 examples of qualifying assets include the following: (a) inventories that require a substantial period of time to bring them to saleable condition (b) manufacturing plants (c) power generation facilities

23.9

Chapter 23: Foreign currency transactions and forward exchange contracts

(d) intangible assets (e) investment properties. Another example found in practice would be the construction of a cable network or mobile phone network for a telecommunications company. Qualifying assets do NOT include: • Financial assets such as investments in shares. • Inventories manufactured over a short period of time. • Assets ready for use or sale when acquired. Definition of borrowing costs Paragraph 5 of AASB 123/IAS 23 defines borrowing costs as follows. •

Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.

Borrowing costs include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs. Capitalisation of borrowing costs including exchange differences Paragraph 8 of AASB 123/IAS 23 sets out the accounting treatment for borrowing costs as follows. An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them. 13. If land or inventories can only be realised in foreign currency, then how should the recoverable amount of the land or realisable value of the inventories be measured? Non-monetary assets such as land or inventories that are subsequently measured at historic cost are translated using the historic exchange rate at the date of the acquisition of the asset. In contrast, land subsequently measured at recoverable amount is translated using the spot exchange rate at the date of valuation. Similarly, inventories that is subsequently measured at net realisable value is translated at the date of valuation. An example can be used to demonstrate the required approach. Land acquired for US$500 000 when US$1 = A$1.30. Land recoverable amount US$510 000 when US$1 = A$1.20. Translated cost is A$650 000 (US$500 000 x 1.3). Translated recoverable amount is A$612 000 (US$510 000 x 1.2).

23.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Impairment loss is $38 000 including foreign exchange difference. 14. What is meant by foreign exchange risk? How can forward exchange contracts be used to manage foreign exchange risk? Foreign exchange risk is the risk that an entity’s financial position, financial performance or cash flows will be affected by fluctuations in exchange rates, that is, fluctuations between the A$ and other currencies such as the $US. In an accounting context, foreign exchange risk may relate to the following: 1. recognised assets and liabilities 2. unrecognised firm commitments to buy or sell an asset 3. a forecasted or planned transaction to buy or sell an asset. A forward exchange contract is an agreement between two parties to exchange a specified quantity of one currency for another at a specified exchange rate (the forward rate) on a specified future date. The advantage of using a forward exchange contract for hedging is the ease of acquisition and its flexibility. Contracts are readily available from financial institutions and can be arranged for settlement at specific dates and for specific amounts of foreign currency. An Australian company may enter a forward exchange contract to buy foreign currency or sell foreign currency. A forward contract that buys foreign currency fixes the amount to be paid in A$ for a specified quantity of foreign currency. For example, a forward contract to buy $US100 000 at the forward rate of A$1=$US0.80 ensures that a company receives $US100 000 in exchange for A$125 000. Hence, a forward contract that buys US$ manages the foreign exchange risk associated with recognised liabilities or recognised firm commitments and planned transactions to buy assets. In effect, the forward contract to buy $US locks in the A$ cost of the foreign currency needed for a future outflow of economic resources (e.g. a future cash payment to settle a payable in $US). A forward contract that sells foreign currency fixes the amount to be received in A$ for specified quantity of foreign currency. For example, a forward contract to sell $US100 000 at the forward rate of A$1=$US0.80 ensures that a company receives A$125 000 in exchange for $US100 000. Hence a forward contract that sells $US manages the foreign exchange risk associated with recognised assets or recognised firm commitments and planned transactions to sell assets. In effect, the forward contract to sell $US locks in A$ amount to be received for the foreign currency arising from a future inflow of economic resources (e.g. a future cash receipt for a receivable in $US). 15. Explain how the fair value of a forward contract is measured at inception date, at the end of the reporting period and at settlement date. The fair value of a forward contract is the net discounted cash flow that would result if the

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Chapter 23: Foreign currency transactions and forward exchange contracts

financial effects of the original forward contract were offset by taking out another forward contract. For example, a forward contract to buy $US100 000 on 1 August 2019 can be offset by entering into another forward contract to sell $US100 000 on the same date. At inception date, the fair value of a forward contract is $Nil on the basis that the opposing position could be entered into on the same date at the same forward rate. At a reporting date or settlement date however, the forward rate for the opposing position has usually changed from the date of inception and the forward contract will have a positive or negative fair value. The diagram below illustrates the measurement at fair value of a forward contract to buy US$100 000 ignoring discounting. 1 June 2019

30 June 2019

1 August 2019

Inception date

Reporting date

Settlement date

Contract to buy $US100 000

Right at fwd rate of 0.80 = $125 000

Right at fwd rate of 0.50 = $200 000

Right at fwd rate of 0.67 = $149 254

Obligation at fwd rate of 0.80 = $125 000

Fair value = $Nil

Fair value = $75 000

Fair value = $24 254

Gain on fwd contract $75 000

Loss on fwd contract $50 746

Realised gain on fwd contract $24 254

16. Distinguish between a fair value hedge and a cash flow hedge that uses a forward exchange contract as the hedging instrument. Describe the accounting treatment of any gains or losses on a forward contract that qualifies for hedge accounting. A forward contract designated as a hedging instrument for a hedged item that is a recognised asset or liability is referred to as a fair value hedge. The gain or loss on a forward contract in a fair value hedge is immediately recognised to the profit or loss. A forward contract designated as a hedging instrument for a hedged item that is a highly probable forecast transaction is referred to as a cash flow hedge. The gain or loss on a forward contract that is a cash flow hedge is recognised in other comprehensive income and a cash flow hedge reserve. When the forecast transaction occurs, the gain or loss in the cash flow reserve is transferred into the amount of a recognised asset or liability or reclassified in other comprehensive income and recognised to the profit or loss. A forward contract designated as a hedging instrument for a firm commitment may be recognised as fair value hedge or a cash flow hedge. The gain or loss on the unrecognised firm commitment is recognised consistently with the gain or loss on the forward contract, that is, in the profit or loss or in other comprehensive income.

23.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

23.13

Chapter 23: Foreign currency transactions and forward exchange contracts

Case studies Case study 23.1 Recognition of liabilities You are the technical accounting consultant of a Big 4 accounting firm. One of your clients is an Australian travel company that arranges package tours to overseas destinations. The client states: ‘When we arrange accommodation in foreign hotels we recognise a liability at the spot rate. Then when we pay for the accommodation any exchange gain or loss is included in the profit or loss. We believe that we are complying with AASB 121/IAS 21’. Required Do you agree with the client’s position? Explain why. A travel agent is likely to make foreign exchange gains or losses on foreign currency transactions because of fluctuations in exchange rates. In the case of the Australian travel company, an expense and liability are recognised when a firm booking is made with an overseas hotel. The amount of Australian dollars needed to settle the foreign currency obligation (the recorded liability) however, might vary from the date of the booking because of fluctuations in the exchange rate. The difference in exchange rates between the date of the transaction and the date of settlement result in a realised exchange gain or loss. The accounting policy suggested by the Australian travel agent is to recognise exchange gains and losses in the reporting periods that they are realised. In contrast, AASB 121/IAS 21 generally requires that exchange gains and losses are recognised in the profit or loss in the reporting period in which the exchange rates change. Realisation of exchange gains and losses is NOT the criteria for recognition of exchange gains and losses. The recognition of exchange differences based on realisation fails the requirements of AASB 121 when the date of the foreign currency transaction and settlement of a related foreign currency monetary item straddle the end of reporting period: This can be illustrated as follows. Date of Transaction

End of Reporting Period 2022

Date of Settlement

FC obligation at spot rate

FC obligation at closing exchange rate

FC cash payment at spot exchange rate

Unrealised exchange difference recognised in profit or loss for 2022

End of Reporting Period 2023

Exchange difference to date of settlement recognised in profit or loss for 2023

Realised exchange difference recognised in profit or loss for 2023

23.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 23.2 Recognition methods AASB 121/IAS 21 mandates the immediate recognition method where exchange differences on monetary items are recognised in the profit or loss in the period of exchange rate movement. Other methods, such as the ‘defer and amortise’, or ‘recognition on realisation’ are not permitted. Required Do you agree that the correct decision been made from the point of view of the conceptual framework? Are there other reasons to prefer the immediate recognition method? AASB 121 requires the immediate recognition of exchange gains and losses on foreign currency monetary items. The application of the immediate recognition method to non-current monetary items is problematic because by definition the life of the non-current monetary item will span several accounting periods during which significant movements in exchange rates may occur. In accounting for unrealised exchange gains and losses on non-current monetary items, the three main methods that have been considered by standard setters are as follows. i. ii. iii.

Recognise the exchange difference in the profit or loss only when the settlement of the monetary item occurs. Recognise the exchange difference as an asset or liability and then amortise it to the profit and loss over the term or life of the monetary item. Immediately recognise the exchange difference in the profit and loss.

In addition, some combination of these three methods is possible, for example, immediate recognition of exchange losses but deferral of exchange gains. All the above approaches had been used in practice in years prior to the first release of an Australian Accounting Standard (AAS 20) in October 1985. Recognition on settlement only Recognition of exchange differences only on settlement of monetary items is conceptually the weakest approach because it defies the basic tenets of accrual accounting. In the ordinary course, the recognition of revenues and expenses does not depend on a cash transaction. Deferred into the statement of financial position and then amortised to profit or loss In the first version of AAS 20, the required accounting treatment for non-current monetary items was that exchange differences be deferred (initially recognised as an asset or liability balance) and then systematically amortised or allocated to the profit and loss over the term of the monetary item. The matching principle was used as the justification for this approach. The implicit assumption adopted was that an exchange difference on a non-current foreign currency borrowing represented an adjustment to the effective interest rate on that borrowing and therefore formed

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Chapter 23: Foreign currency transactions and forward exchange contracts

part of the cost of borrowing in a foreign currency. Therefore, these exchange differences ought to be matched against the revenue over the period during which the funds were available to the borrower. This issue was debated at length by the (then) Accounting Standards Review Board prior to the re-release of AAS 20 in December 1987. At this point, the matching argument lost out and the ‘defer and amortise’ method for unrealised exchange differences on non-current monetary items was dropped in favour of the immediate recognition method. Immediate recognition There were several reasons why the Australian standards setters decided to change from defer and amortise to immediate recognition. First, it was argued that an accounting treatment should not depend upon an arbitrary balance sheet classification between current and non-current items. Second, amortisation allocated the effect of an economic event (an exchange rate change) to periods other than the period in which the event occurred. Third, from a balance sheet perspective, deferred foreign exchange differences do not fall into the definition of an asset or liability. For example, ‘assets’ had been tentatively defined by the Accounting Standards Review Board in its original (February 1985) Release 100 (paragraph 35) as follows. •

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Arguably, a deferred exchange loss cannot be carried forward as an asset because it conveys no future economic benefit. Similarly, a deferred exchange gain did not satisfy the ASRB's definition (paragraph 43) of liabilities, which was as follows. •

Probable future sacrifices of economic benefits.

In accordance with the definitions of assets and liabilities, the immediate recognition method should be used for all foreign currency monetary items including forward exchange contracts. Another reason to prefer the immediate recognition method is that it makes the effects of foreign exchange risk on a company for the period transparent in its financial report. The standard setters believe that managers will be more likely to manage foreign exchange risk if it is regularly brought to account in the financial statements. This is an example of how the accounting approach used can have real economic consequences through affecting management behaviour.

23.16

Application and analysis exercises Exercise 23.1 Translation of various foreign currency transactions and balances On 1 June 2023, Laurie Ltd, an Australian company with a functional currency of A$ entered into various transactions in NZ$ when the exchange rate was A$1.00 = NZ$1.30. Any assets arising from the NZ$ transactions are still on hand and any liabilities remain unsettled. On 30 June 2023, the exchange rate is A$1.00 = NZ$1.20. Required Translate each of following items for initial and subsequent measurement as appropriate. 1. sales revenue and accounts receivable of NZ$20 000 2. inventories and accounts payable of NZ$32 000 3. plant NZ$72 000 4. interest-free borrowings of NZ$125 000. (LO3 and LO6) 1. Date of transaction 1.6.23

Reporting date 30.6.23

Record the sales at spot rate

Restate the monetary item to closing rate

Accounts receivable $NZ20 000  1.3 = A$15 385

Accounts receivable $NZ20 000  1.2 = A$16 667

Exchange gain of A$1 282

01.06.23

30.06.23

Accounts receivable Sales

Dr Cr

15 385

Accounts receivable Foreign exchange gain

Dr Cr

1 382

15 385

1 382

2. Date of transaction 1.6.23

Reporting date 30.6.23

Record inventories purchase at spot rate

Restate the monetary item to closing rate

Accounts payable NZ$32 000  1.3 = $ A24 615

Accounts payable NZ$32 000  1.2 = A$26 667

Exchange loss of A$2 052

Chapter 23: Foreign currency transactions and forward exchange contracts

01.06.23

30.06.23

Inventories Accounts payable

Dr Cr

24 615

Foreign exchange loss Accounts payable

Dr Cr

2 052

24 615

2 052

3. Date of transaction 1.6.23

Reporting date 30.6.23

Record acquisition at spot rate

Plant at cost is a non-monetary item that is NOT restated.

Plant NZ$72 000  1.3 = A$55 385

01.06.23

Plant

Dr Cr

Cash

55 385 55 385

4. Date of transaction 1.6.23

Reporting date 30.6.23

Record the borrowings at spot rate

Restate the monetary item to closing rate

Borrowings NZ$125 000  1.3 = A$96 154

Borrowings NZ$125 000  1.2 =A$104 167

Exchange loss of A$8 013

01.06.23

Cash Borrowings

30.06.23

Foreign exchange loss Borrowings

Dr Cr

96 154

Dr Cr

8 013

96 154

8 013

23.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.2 Translation of various foreign currency transaction and balances Know Your Product Ltd is an Australian company with a functional currency of A$. The company entered into a number of transactions denominated in US$ during the year ended 30 June 2023. If the closing exchange rate is A$1.00 = US$0.77, determine the translated amount that will be included in the financial statements for each of the following transactions or events. 1. Land at cost of US$600 0000 acquired on 1 February 2023 when the exchange rate is A$1.00 = US$0.67. 2. Land revalued to US$900 000 on 30 June 2023 that had cost US$400 000 on 1 February 2023 when the exchange rate was A$1.00 = US$0.67. 3. Credit sale of US$240 000 on 12 March 2023 when the exchange rate is A$1.00 = US$0.68. Received cash from debtor of US$120 000 on 30 June 2023. 4. Credit purchase of inventories of US$320 000 on 15 June 2023 when the exchange rate is A$1.00 = US$0.62. The creditor remains unpaid at 30 June 2023. 5. A loan payable of US$500 000 arranged on 1 January 2023 when the exchange rate is A$1.00 = US$0.60. On 30 June 2023, the outstanding interest on the loan is US$50 000. 6. A 6-month forward contract to buy US$2 000 000 entered into on 1 April 2023 at the forward rate of A$1.00 = US$0.75. On 30 June 2023, the forward rate for a 3-month forward to buy US$2 000 000 is A$1.00 = US$0.70. Assume a 3-month discount rate of 2% applies at 30 June 2023. (LO6 and LO7) 1. Date of transaction 1.2.23

Reporting date 30.6.23

Record acquisition at spot rate

Land at cost is a non-monetary item that is NOT restated.

Land US$600 000  0.67 = A$895 522

1.2.23

Land Cash at bank

Dr Cr

895 522 895 522

2. Date of transaction 1.2.23

Reporting date 30.6.23

Record acquisition at spot rate

Land restated to fair value at spot rate

Land US$600 000  0.67 = A$895 522

Land US$900 000  0.77 = A$1 168 831

Gain on revaluation of A$273 309

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Chapter 23: Foreign currency transactions and forward exchange contracts

1.2.23

30.6.23

Land Cash at bank

Dr Cr

895 522

Land Gain on revaluation (OCI)

Dr Cr

273 309

895 522

273 309

3. Date of transaction 12.3.23

Reporting date and Settlement date 30.6.23

Record the sales at spot rate

Restate the monetary item to closing rate

Accounts receivable US$240 000  0.68 = A$352 941

Accounts receivable US$240 000  0.77 = A$311 688

Exchange loss of A$41 253 Record cash receipt at spot rate US$120 000  0.77 = A$155 844

12.3.23

30.6.23

Accounts receivable Sales

Dr Cr

352 941

Foreign exchange loss Accounts receivable

Dr Cr

41 253

Cash at bank Accounts receivable

Dr Cr

155 844

352 941

41 253

155 844

4. Date of transaction 15.6.23

Reporting date 30.6.23

Record inventories purchase at spot rate

Restate the monetary item to closing rate

Accounts payable US$320 000  0.62 = A$516 129

Accounts payable US$320 000  0.77 =A$415 584

Exchange gain of A$78 551

15.6.23

30.6.23

Inventories Accounts payable

Dr Cr

516 129

Accounts payable Foreign exchange gain

Dr Cr

415 584

516 129

415 584

23.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

5. Date of transaction 1.1.23

Reporting date 30.6.23

Record the loan transaction at spot rate

Restate the monetary item to closing rate

Loan payable US$500 000  0.60 = A$833 333

Loan payable US$500 000  0.77 =A$649 351

Exchange gain of A$183 982 Recognise interest for the period Interest payable US$50 000  0.77 =A$64 935

1.1.23

30.6.23

Cash at bank Loan payable

Dr Cr

833 333

Loan payable Foreign exchange gain

Dr Cr

183 982

833 333

183 982 64 935

Borrowing costs expense* Interest payable

Dr Cr

64 935

*Borrowing costs include interest expense and foreign exchange differences in the nature of adjustments to interest costs. 6. Date of transaction 1.4.23

Reporting date 30.6.23

Initial recognition of forward contract Contract right to receive US$ US$2 000 000  0.75 = A$2 666 667 Contract obligation fixed in A$ US$2 000 000  0.75 = A$2 666 667

Subsequent measurement of forward contract Contract right to receive US$ US$2 000 000  0.70 = A$2 857 143 Contract obligation fixed in A$ US$2 000 000  0.75 = A$2 666 667

Fair value = A$0

Net contract position = receivable A$190 473 Fair value =A$190 476  1.02 = A$186 741

Gain in fair value of contract A$116 713

30.6.23

Forward contract Gain on forward contract*

Dr Cr

186 741 186 741

*The gain on the fair value of the forward contract is recognised in the profit or loss.

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Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.3 Translation of consulting service expense Koala Ltd is an Australian company that receives management consulting services from Spin Incorporated. On 15 June 2023, Koala Ltd received an invoice from Spin Incorporated amounting to US$5 million for services provided over the period 1 January 2023 to 31 May 2023. On 15 July 2023, Koala Ltd paid the invoice. The functional currency of Koala Ltd is A$ and its financial year ends on 30 June. Applicable exchange rates are as follows. 1 Jan. 2023 31 May 2023 Average 1 Jan. 2023 to 31 May 2023 15 June 2023 30 June 2023 15 July 2023

A$1=US$0.70 A$1=US$0.64 A$1=US$0.65 A$1=US$0.62 A$1=US$0.60 A$1=US$0.58

Required Prepare the entries of Koala Ltd to record the effects of the management fee transaction in accordance with AASB 121/IAS 21. (LO3, LO6 and LO7) Date of transaction 15 June 2023

Reporting date 30 June 2023

Initial measurement Payable US$5m  0.62 = A$8 064 516

Subsequent measurement Payable US$5m  0.60 = A$8 333 333.

Exchange loss A$268 817

Settlement Date 15 July 2023 Subsequent measurement Payable US$5m  0.58 = A$8 620 690

Exchange loss A$287 357

Expense US$5m  0.65 = A$7 692 308

Cash payment US$5m  0.58 = A$8 620 690

Exchange loss $372 208 15.6.23

30.6.23

15.7.23

Management services expense Foreign exchange loss Payable to supplier

Dr Dr Cr

7 692 308 372 208

Foreign exchange loss Payable to supplier

Dr Cr

268 817

Foreign exchange loss Payable to supplier

Dr Cr

287 357

Payable to supplier Cash at bank

Dr Cr

8 620 690

8 064 516

268 817

287 357

8 620 690

23.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In contrast to a sales transaction or purchase transaction for inventories, the management expense is incurred over a period of time rather than at a point in time. Accordingly, the expense should be translated using an average exchange rate for the relevant period.

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Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.4 Translation of purchase of inventories on credit terms Stranded Ltd is an Australian company that purchases inventories from Hammers plc, which is an English company. The following information is relevant to a recent acquisition of inventories for £200 000 pursuant to a contract with terms including FOB shipping point. Date

Event

Exchange rate

11 May 2023 22 June 2023 30 June 2023 31 July 2023

Inventories shipped Inventories delivered End of reporting period Cash payment of £200 000 to Hammers plc

A$1=£0.41 A$1=£0.42 A$1=£0.43 A$1=£0.39

Required Prepare all of the entries of Stranded Ltd that relate to the foreign currency purchase of inventories in accordance with AASB 121/IAS 21. How would your answer change if the inventories acquired had a net realisable value of £170 000 at 30 June 2023? (LO3, LO6 and LO7) 11.5.23

30.6.23

31.7.23

Inventories Accounts payable (Inventories purchase £200 000  0.41)

Dr Cr

487 805

Accounts payable Foreign exchange gain (Re-measurement of Accounts payable £200 000  0.43 less £200 000  0.41)

Dr Cr

22 689

Foreign exchange loss Accounts payable (Re-measurement of Accounts payable £200 000  0.39 less £200 000  0.43)

Dr Cr

47 705

Dr Cr

512 821

Accounts payable Cash at bank (Cash payment £200 000  0.39)

487 805

22 689

47 705

512 821

Additional explanations: • The date of the transaction for inventories purchased FOB shipping is the date of shipping, that is, 11 May 2023. • Stranded Ltd’s statement of financial position as at 30 June 2023 will include an accounts payable balance of $465 116, that is, £200 000 translated at the closing rate of 0.43. Stranded Ltd’s statement of profit or loss for the year ending 30 June 2023 will include a foreign exchange gain of $22 689 whilst its statement of profit or loss for the year ending 30 June 2024 will include a foreign exchange loss of $47 705 • The realised exchange difference is a foreign exchange loss of $25 016, that is, $512 821 © John Wiley and Sons Australia Ltd, 2020

23.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

less $487 805 OR $47 705 less $22 689. If the net realisable value of the inventories is £170 000 at 30 June 2023, the translated net realisable value would be $395 349 (i.e. £170 000  0.43). Inventories must be measured at the lower of cost and net realisable value at reporting date. Hence, an inventories expense of $92 456 (i.e. $487 805 less $395 349) would have to be recognised for the year to 30 June 2023.

23.25

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.5 Translation of sale of inventories on credit terms Tropic Ltd is an Australian company that makes and sells small electronic goods. On 1 February 2023, a customer from the United States ordered some goods from Tropic Ltd at an invoice cost of US$400 000 on terms FOB destination. On 30 April 2023, the goods were delivered to the customer. The agreed payment arrangements are that 30% of the total amount owing would be paid on delivery, 20% three months after delivery, and the remaining 50% four months after delivery. The end of the reporting period for Tropic Ltd is 30 June. The following exchange rates are applicable. 1 February 2023 30 April 2023 30 June 2023 31 July 2023 31 August 2023

A$1=US$0.75 A$1=US$0.73 A$1=US$0.68 A$1=US$0.72 A$1=US$0.76

Required Prepare the journal entries of Tropic Ltd necessary to record the above transactions in its accounting records. (LO3, LO6 and LO7) 30.4.23

Accounts receivable Cash at bank Sales

Dr Dr Cr

204 400 87 600

Foreign exchange loss Accounts receivable

Dr Cr

14 000

Accounts receivables Foreign exchange gain

Dr Cr

11 200

31.7.23

Cash at bank Accounts receivable

Dr Cr

57 600

30.8.23

Accounts receivable Foreign exchange gain

Dr Cr

8 000

Cash at bank Accounts receivable

Dr Cr

152 000

30.6.23 31.7.23

30.8.23

292 000 14 000 11 200

57 600 8 000

152 000

Additional explanations: • The date of the transaction for inventories sold FOB destination is the date of delivery to the customer, that is, 30 April 2023. • Tropic Ltd’s statement of financial position as at 30 June 2023 will include an accounts receivable balance of $190 400, that is, US$280 000 (70% x US$400 000) translated at the closing rate of 0.68. Tropic Ltd’s statement of profit or loss for the year ending 30 June 2023 will include a foreign exchange loss of $14 000 whilst its statement of profit or loss for the year ending 30 June 2024 will include a foreign exchange gain of $19 200. • The realised exchange difference is a foreign exchange gain of $5 200, that is, $297 200 less $292 000 OR $19 200 less $14 000.

23.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.6 Translation of foreign currency borrowings and interest costs On 1 October 2022, the Australian company Run Down Ltd enters a loan agreement with the Bank of Scotland to borrow £2 000 000 for a period of 5 years. The interest on the borrowings is payable half-yearly in arrears at the fixed interest rate of 10% p.a. with interest payments of £100 000 (i.e. £2 000 000 × 10% × ½ year) due on 31 March and 30 September each year. The functional currency of Run Down Ltd is A$. It has reporting periods ending on 31 December and 30 June. Applicable exchange rates during the financial period ending 30 June 2023 are as follows. 1 Oct. 2022 31 Dec. 2022 31 Mar. 2023 30 June 2023

A$1=£0.42 A$1=£0.40 A$1=£0.38 A$1=£0.36

Required In accordance with AASB 121/IAS 21, prepare the entries of Run Down Ltd to record the borrowing transaction, the borrowing costs expense, the borrowings costs paid and the remeasurement of the borrowings at the end of the reporting period. (LO3 and LO6) 1.10.22

31.12.22

31.3.23

Cash at bank Non-current borrowings (Initial recognition and measurement of borrowings £2m  0.42)

Dr Cr

4 761 905

Foreign exchange loss Non-current borrowings (Subsequent measurement of borrowings £2m 0.40 – £2m  0.42)

Dr Cr

238 095

Borrowing costs expense Interest payable (Recognition of interest payable £2m x ¼ year x 10%  0.40)

Dr Cr

125 000

Interest payable Borrowing costs expense Cash at bank (Cash payment of interest £2m x 1/2 year x 10%  0.38)

Dr Dr Cr

125 000 138 158

4 761 905

238 095

125 000

263 158

23.27

Chapter 23: Foreign currency transactions and forward exchange contracts

30.6.23

• •

Foreign exchange loss Non-current borrowings (Subsequent measurement of borrowings £2m 0.36 – £2m  0.40)

Dr Cr

555 556

Borrowing costs expense Interest payable (Recognition of interest payable £2m x ¼ year x 10%  0.36)

Dr Cr

138 889

555 556

138 889

The carrying amount of the borrowings at 30 June 2023 is $5 555 556, that is £2m  0.36. The recording of interest based on ½ year or ¼ year is a simplification as interest is usually determined on a daily basis. For example, interest payable at 30 June 2023 is more accurately calculated as $138 508, that is, £2m x 91/365 days x 10%  0.36.

23.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.7 Translation of purchase of plant, sale of inventories and interest free loan Apples Ltd is an Australian company. The functional currency of Apples Ltd is A$. It has reporting periods ending on 31 December and 30 June. During the year ended 30 June 2023, Apples Ltd entered into various foreign currency transactions in Euros (€) as follows. (a) On 15 November 2022 Apples Ltd ordered plant costing €400 000 from an Italian company under a FOB destination contract. On 30 November 2022, the plant was delivered. On 25 January 2023, the invoice for the plant purchase was paid. (b) On 30 November 2022 Apples Ltd sold inventories to a German customer for the agreed price of €250 000. The inventories had a cost of $175 000. On 31 January 2023, the sales invoice was paid by the customer. (c) On 1 July 2022, Apples Ltd made an interest-free loan to a related French company, Attitude Cavaliere, for €500 000. The term of the loan is set at 5 years at which time Attitude Cavaliere will be required to arrange its debt finances independently. Applicable exchange rates are as follows. 1 July 2022

€1=A$1.27

15 Nov. 2022

€1=A$1.20

30 Nov. 2022

€1=A$1.30

31 Dec. 2022

€1=A$1.25

25 Jan. 2023

€1=A$1.23

31 Jan. 2023

€1=A$1.21

30 June 2023

€1=A$1.35

Required In accordance with AASB 121/IAS 21, prepare the entries of Apples Ltd for the half year to 31 December 2022 and the full year to 30 June 2022. (LO3, LO6 and LO7) (a) Purchase of plant from Italian supplier for €800 000: 15 November 2022

31 December 2022

Date of purchase Plant and Payable initially measured at spot rate

Reporting date Re-measure Payable at closing rate

€400 000 x 1.20 = $480 000

€400 000 x 1.25 = $500 000 Exchange loss $20 000

25 January 2023 Settlement date Re-measure Payable Record cash settlement at spot rate €400 000 x 1.23 = $492 000 Exchange gain $8 000

23.29

Chapter 23: Foreign currency transactions and forward exchange contracts

15.11.22

Plant

Dr Cr

480 000

Foreign exchange loss Payable to supplier (Re-measurement of Payable €400 000 x 1.25 - €400 000 x 1.2)

Dr Cr

20 000

Payable to supplier Foreign exchange gain (Re-measurement of Payable €400 000 x 1.23 - €400 000 x 1.25)

Dr Cr

8 000

Payable to supplier Cash at bank (Cash payment €400 000 x 1.23)

Dr Cr

492 000

Payable to supplier (Plant purchase €400 000 x 1.2) 31.12.22

25.1.23

480 000

20 000

8 000

492 000

(b) Sale of inventories to German customer for €500 000: 30 November 2022

31 December 2022

31 January 2023

Date of sale Sale and Receivable recognised at spot rate

Reporting date Re-measure Receivable at closing rate

€250 000 x 1.3 = $325 000

€250 000 x 1.25 = $312 500

Settlement date Re-measure Receivable Record cash settlement at spot rate €250,000 x 1.21 = $302 500

Exchange loss $12 500

Exchange loss A$10 000

23.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30.11.22

31.12.22

31.1.23

Accounts receivable Sales (Sale €250 000 x 1.3)

Dr Cr

325 000

Cost of sales Inventories

Dr Cr

175 000

Foreign exchange loss Accounts receivable (Re-measurement of Receivable €250 000 x 1.25 - €250 000 x 1.3)

Dr Cr

12 500

Foreign exchange loss Accounts receivable (Re-measurement of Receivable €250 000 x 1.21 - €250 000 x 1.25)

Dr Cr

10 000

Cash at bank Accounts receivable (Cash receipt €250 000 x 1.21)

Dr Cr

302 500

325 000

175 000

12 500

10 000

302 500

31 December 2022

Date of loan transaction Receivable initially measured at spot rate €500 000 x 1.27 =$635 000

Reporting date Receivable re-measured at closing rate €500 000 x 1.25 = $625 000

Exchange loss $10 000 1.7.22

31.12.22

30.6.23

30 June 2023 Reporting date Receivable re-measured at closing rate €500 000 x 1.35 =$675 000

Exchange gain $50 000

Loan receivable Cash at bank (Receivable €500 000 x 1.27)

Dr Cr

635 000

Foreign exchange loss Loan receivable (Re-measurement of loan receivable €500 000 x 1.25 - €500 000 x 1.27)

Dr Cr

10 000

Loan receivable Foreign exchange gain (Re-measurement of loan receivable €500 000 x 1.35 - €500 000 x 1.25)

Dr Cr

50 000

635 000

10 000

50 000

23.31

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.8 Translation of purchases of inventories on credit terms You are the financial controller of Delight Ltd, an Australian company listed on the ASX that distributes imported food products in the local market. The functional currency of Delight Ltd is A$. Delight Ltd’s purchases of inventories in foreign currency during the year ended 30 June 2023 are set out below. Exchange rates at delivery date, shipment date, the end of the reporting period and payment date are expressed to A$1. Madras Curry Monster

Thai Satay Saucy

Russian Caviary

Turkish Delightful

German Sausagez

Foreign currency

Indian rupee (IR)

Thai baht (THB)

Russian rouble (RR)

Turkish lire (TL)

Euros (€)

Invoice amount

3 000 000

900 000

40 000 000

80 000 000

500 000

Contract basis

FOB shipping

FOB destination

FOB shipping

FOB destination

Shipment date

20 Jul. 2022

31 Jul. 2022

1 Nov. 2022

31 Mar. 2023

30 Apr. 2023

Delivery date

31 Jul. 2022

30 Aug. 2022

31 Dec. 2022

30 Apr. 2023

30 Jun. 2023

Payment date

30 Sept. 2022

31 Oct. 2022

31 Jan. 2023

31 Jul. 2023

31 Aug. 2023

Rate on delivery

IR 10

THB 2

RR 1 000

TL 10 000

€0.80

Rate on shipping

IR 12

THB 3

RR 2 000

TL 10 500

€0.78

Rate at the end of the reporting period

IR 18

THB 10

RR 1 800

TL 10 750

€0.70

Rate on payment

IR 15

THB 4

RR 500

TL 11 000

€0.75

Supplier

Required In accordance with AASB 121/IAS 21, prepare the necessary entries in relation to the inventories purchase transactions up until and including 31 August 2023. (LO3 and LO7) FOB shipping: • Ownership passes to purchaser upon goods being loaded onto shipping vessel, that is, the date of transaction is the shipping date. FOB destination: • Ownership passes to purchaser upon goods being delivered to purchaser, that is, the date of transaction is the delivery date. Madras Curry Monster 20.7.22

Inventories Accounts payable (Purchase IR3 000 000  12)

Dr Cr

250 000 250 000

23.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30.9.22

Accounts payable Foreign exchange gain (Re-measurement of payable IR3 000 000  15 – IR3 000 000  12)

Dr Cr

50 000

Accounts payable Cash at bank (Cash payment IR3 000 000  15)

Dr Cr

200 000

Inventories Accounts payable (Purchase THB900 000  2)

Dr Cr

450 000

Accounts payable Foreign exchange gain (Re-measurement of payable THB900 000  2 – THB900 000  4)

Dr Cr

225 000

Accounts payable Cash at bank (Cash payment THB900 000  4)

Dr Cr

225 000

Inventories Accounts payable (Purchase RR40m  2 000)

Dr Cr

20 000

Foreign exchange loss Accounts payable (Re-measurement of payable RR40m  500 – RR40m  2 000)

Dr Cr

60 000

Accounts payable Cash at bank (Cash payment RR40m  500)

Dr Cr

80 000

Dr Cr

7 619

50 000

200 000

Thai Satay Saucy 30.8.22

31.10.22

450 000

225 000

Russian Caviary 1.11.22

31.1.23

20 000

60 000

80 000

Turkish Delightful 31.3.23

Inventories Accounts payable (Purchase TL80m  10 500)

7 619

23.33

Chapter 23: Foreign currency transactions and forward exchange contracts

30.6.23

31.7.23

Accounts Payable Foreign exchange gain (Re-measurement of payable TL80m  10 750 – TL80m  10 500)

Dr Cr

177

Accounts payable Foreign exchange gain (Re-measurement of payable TL80m  11 000 – TL80m  10 750)

Dr Cr

169

Dr Cr

7 273

Inventories Accounts payable (Purchase €500 000  0.80)

Dr Cr

625 000

Foreign exchange loss Accounts payable (Re-measurement of payable €500 000  0.75 – €500 000  0.80)

Dr Cr

41 667

Accounts payable Cash at bank (Cash payment €500 000  0.75)

Dr Cr

666 667

Accounts payable Cash at bank (Cash payment TL80m  11 000)

177

169

7 273

German Sausagez 30.6.23

31.8.23

625 000

41 667

666 667

23.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.9 Translation of sales of inventories on credit terms You are the financial controller of Valley VinesLtd, an Australian company listed on the ASX that sells premium Australian wines into overseas markets. Valley Vines’ sales of inventories in foreign currency during the year ended 30 June 2023 are set out below. Exchange rates at delivery date, shipment date, the end of the reporting period and payment date are expressed to A$1. Customer

Israel #3

Dubai #6

Turkey #4

Egypt #8

United States #9

Foreign currency

Israeli shekel (NIS)

Dubai dirham (AED)

Turkish lire (TL)

Egyptian dinar (ED)

US dollar (US$)

Invoice amount

4 500 000

30 000 000

20 000 000 000

750 000 000

4 000 000

Contract basis

FOB shipping

FOB destination

FOB shipping

Delivery date

30 Aug. 2022

31 Oct. 2022

31 Jan. 2023

31 Mar. 2023

30 Apr. 2023

Shipment date

31 Jul. 2022

30 Sept. 2022

30 Nov. 2022

28 Feb. 2023

15 Apr. 2023

Cash receipt date

31 Oct. 2022

5 Feb. 2023

31 Mar. 2023

31 Jul. 2023

31 Aug. 2023

Rate on delivery

NIS 1.6

AED 3.5

TL 9 500

ED 5 000

US$0.75

Rate on shipment

NIS 1.4

AED 4

TL 9 000

ED 5 500

US$0.80

NIS 1.2

AED 3.8

TL 10 750

ED 5 750

US$0.88

NIS 1.3

AED 4.2

TL 10 500

ED 6 000

US$0.86

Rate at the end of the reporting period Rate on cash receipt

Required In accordance with AASB 121/IAS 21, prepare the necessary entries in relation to the sale transactions up until and including 31 August 2023. (LO3, LO6 and LO7) FOB shipping: • Ownership passes to customer upon goods being loaded onto shipping vessel, that is, the date of transaction is the shipping date. FOB destination: • Ownership passes to customer upon goods being delivered to customer, that is, the date of transaction is the delivery date. Customer # 3 in Israel

23.35

Chapter 23: Foreign currency transactions and forward exchange contracts

31.7.22

31.10.22

Accounts receivable Sales (Sale NIS4.5m  1.4)

Dr Cr

3 214 286

Accounts receivable Foreign exchange gain (Re-measurement of Receivable NIS4.5m  1.3 – NIS4.5m  1.4)

Dr Cr

247 252

Cash at bank Accounts receivable (Cash receipt NIS4.5m  1.3)

Dr Cr

3 461 538

Accounts receivable Sales (Sale AED30m  4)

Dr Cr

7 500 000

Foreign exchange loss Accounts receivable (Re-measurement of Receivable AED30m  4.2 – AED30m  4)

Dr Cr

357 143

Cash at bank Accounts receivable (Cash receipt AED30m  4.2)

Dr Cr

7 142 857

Accounts receivable Sales (Sale TL20bn  9 500)

Dr Cr

2 105 263

Foreign exchange loss Accounts receivable (Re-measurement of Receivable TL20bn  10 500 – T20bn  9 500)

Dr Cr

200 501

Cash at bank Accounts receivable (Cash receipt TL20bn  10 500)

Dr Cr

1 904 762

3 214 286

247 252

3 461 538

Customer # 6 in Dubai 30.9.22

5.2.23

7 500 000

357 143

7 142 857

Customer # 4 in Turkey 31.1.23

31.3.23

2 105 263

200 501

1 904 762

Customer # 8 in Egypt

23.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

31.3.23

30.6.23

31.7.23

Accounts receivable Sales (Sale ED750m  5 000)

Dr Cr

150 000

Foreign exchange loss Accounts receivable (Re-measurement of Receivable ED750m  5 750 – ED750m  5 000)

Dr Cr

19 565

Foreign exchange loss Accounts receivable (Re-measurement of Receivable ED750m  6 000 – ED750m  5 750)

Dr Cr

5 435

Cash at bank Accounts receivable (Cash receipt ED750m  6 000)

Dr Cr

125 000

Accounts receivable Sales (Sale US$4m  0.80)

Dr Cr

5 000 000

Foreign exchange loss Accounts receivable (Re-measurement of Receivable US$4m  0.88 – US$4m  0.80)

Dr Cr

454 545

Accounts receivable Foreign exchange gain (Re-measurement of Receivable US$4m  0.86 – US$4m  0.88)

Dr Cr

105 708

Cash at bank Accounts receivable (Cash receipt US$4m  0.86)

Dr Cr

4 651 163

150 000

19 565

5 435

125 000

Customer # 9 in United States 15.4.23

30.6.23

31.8.23

5 000 000

454 545

105 708

4 651 163

23.37

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.10 Qualifying assets On 1 July 2022, Remote Ltd, an Australian company that has A$ as its functional currency, enters a loan agreement with a lender in Hong Kong to borrow HK$800 000 and uses the funds to acquire components for construction of a warehouse. By 31 December 2022, when the warehouse is ready to use, further costs of A$100 000 have been paid to finish its construction. The interest on the borrowings is payable half-yearly in arrears at the fixed interest rate of 10% p.a. with interest payments of HK$40 000 (HK$800 000  10%  ½ year) due on 31 December and 30 June each year. Remote Ltd prepares halfyearly reports and its reporting periods end 30 June and 31 December each year. The following exchange rates are applicable for the annual financial period to 30 June 2023. 1 July 2022 Average July–Dec. 2022 31 Dec. 2022 Average Jan.– June 2023 30 June 2023

A$1=HK$5.60 A$1=HK$5.65 A$1=HK$5.70 A$1=HK$5.72 A$1=HK$5.75

Required In accordance with AASB 121/IAS 21, prepare the necessary entries in relation to the transactions up until and including 30 June 2023. (LO3, LO6, LO7)

23.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1.7.22

31.12.22

30.6.23

Warehouse under construction Borrowings (Initial recognition and measurement of borrowings at transaction date using the spot rate, HK$800 000  5.60)

Dr Cr

142 857

Warehouse under construction Cash at bank (Capitalisation of interest costs for the December half-year comprised of interest expense of HK$40 000  5.65 and adjusted for the foreign exchange gain of HK$40 000  5.65 less HK$40 000  5.70)

Dr Cr

7 018

Warehouse under construction Cash at bank (Additional costs paid to finalise construction of plant)

Dr Cr

100 000

Warehouse (cost) Warehouse under construction (Reclassification of asset on the date it ceases to be a qualifying asset)

Dr Cr

249 875

Interest expense Foreign exchange gain Cash at bank (Recognition of interest expense for the June half year of HK$40 000  5.72 and the foreign exchange gain of HK$40 000  5.72 less HK$40 000  5.75)

Dr Cr Cr

6 993

142 857

7 018

100 000

249 875

36 6 957

23.39

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.11 Revalued assets and inventories write-downs On 15 July 2022, Adelaide Ltd, an Australian company that has A$ as its functional currency, acquires land in Paris, France, for a cash consideration of €500 000. On 1 January 2023, Adelaide Ltd acquires inventories on credit for €75 000. Subsequently at 30 June 2023, Adelaide Ltd revalues the land to its fair value of €700 000. The inventories are still on hand at 30 June 2023 and have a net realisable value of €70 000. On 1 August 2023, Adelaide Ltd pays in full the inventories purchased. Relevant exchange rates are as follows. 15 July 2022

A$1=€0.85

1 Jan. 2023

A$1=€0.80

30 June 2023

A$1=€0.82

1 Aug. 2023

A$1=€0.83

Required In accordance with AASB 121/IAS 21, prepare the necessary entries for Adelaide Ltd up until and including 1 August 2023. (LO3, LO6 and LO7)

23.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

15.7.22

Land

Dr Cr

588 235

Dr Cr

93 750

Dr Gain on revaluation (OCI) Cr (Revaluation of land to fair value using the spot rate at the date of revaluation)

259 146

Cash at bank (Initial recognition and measurement of land at transaction date using the spot rate, €500 000  0.85) 1.1.23

30.6.23

1.8.23

Inventories Accounts payable (Initial recognition and measurement of inventories at transaction date using the spot rate, €75 000  0.8) Land

Inventories write down expense Inventories (Remeasurement of inventories to net realisable value at the end of the reporting period)

588 235

93 750

259 146

Dr Cr

8 385

Accounts payable Dr Foreign exchange gain Cr (Remeasurement of accounts payable at the Cr end of the reporting period, €75 000  0.8 less €75 000  0.82)

2 287

Accounts payable Foreign exchange gain Cash at bank (Cash payment of $75 000  0.83 and recognition of foreign exchange gain of $75 000  0.82 less $75 000  0.83)

91 463

Dr Cr Cr

8 385

2 287

1 102 90 361

There are two components included in the gain on revaluation of the land of $259 146: • The translated revaluation gain on the land; that is, €200 000 ÷ $0.82 = $243 902. • A foreign exchange gain on the land; that is, €500 000 ÷ 0.82 less €500 000 ÷ 0.85 = $15 244. There are two components included in the inventories write down expense of $8 385: • The translated impairment loss; that is, €5 000 ÷ $0.82 = $6 098. • A foreign exchange loss on the inventories; that is, €75 000 ÷ 0.82 less €75 000 ÷ 0.8 = $2 287.

23.41

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.12 Forward contract with no hedging On 1 February 2023, Rosewood Ltd, an Australian company that has A$ as its functional currency, enters a forward exchange contract to buy £200 000 in six months’ time at 31 July 2023. The contract is entered into for speculative purposes as the management of Rosewood Ltd believe that future economic conditions will lead to an appreciation in the £ relative to the A$. Relevant exchange rates are as follows.

Spot rate

Forward rate (for 31/7/2023)

1 Feb. 2023 — date of contract inception 30 June 2023 — end of reporting period

£1=A$1.68 £1=A$1.72

£1=A$1.80 £1=A$1.82

31 July 2023 — date of contract settlement

£1=A$1.65

Assume a discount rate of 0% for fair value calculations. Required 1. Prepare the necessary entries for Rosewood Ltd up until and including 31 July 2023 in accordance with AASB 121/IAS 21. 2. Assuming that the forward contract entered is to sell £200 000, prepare the necessary entries for Rosewood Ltd up until and including 31 July 2023. The other features of the contract stay the same. (LO3, LO6 and 10) 1. 1.2.23

No entry

30.6.23

Forward contract to buy £’s Gain to forward contract (Subsequent measurement of forward contract to buy £ at the end of the reporting period: £200 000 x 1.82 – £200 000 x 1.80)

Dr Cr

4 000

Forward contract to buy £’s Gain on forward contract (Subsequent measurement of forward contract to buy £ at settlement date: £200 000 x 1.82 – £200 000 x 1.65)

Dr Cr

26 000

Cash at bank Forward contract to buy £’s (Settlement of contract £200 000 x 1.80 – £200 000 x 1.65)

Dr Cr

30 000

31.7.23

4 000

26 000

30 000

23.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. 1.2.23

No entry

30.6.23

Loss to forward contract Forward contract to sell £’s (Subsequent measurement of forward contract to sell £ at the end of the reporting period: £200 000 x 1.82 – £200 000 x 1.80)

Dr Cr

4 000

Loss on forward contract Forward contract to sell £’s (Subsequent measurement of forward contract to sell £ at settlement date: £200 000 x 1.82 – £200 000 x 1.65)

Dr Cr

26 000

Forward contract to sell £’s Cash at bank (Settlement of contract £200 000 x 1.80 – £200 000 x 1.65)

Dr Cr

30 000

31.7.23

4 000

26 000

30 000

23.43

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.13 Forward contract with fair value hedging On 1 May 2024, Edmund Ltd, an Australian company that has A$ as its functional currency, purchases inventories for US$200 000 with the invoice to be paid on 30 October 2024. On the same date as the inventories purchase, Edmund Ltd enters into a forward exchange contract to buy US$200 000 on 30 October 2024. Assume a discount rate of 0% for fair value calculations. Relevant exchange rates are as follows.

Spot rate 1 May 2024 30 June 2024 30 October 2024

US$1=A$1.53 US$1=A$1.56 US$1=A$1.48

Forward rate (for 30/10/2024) US$1=A$1.57 US$1=A$1.60 US$1=A$1.48

Required Prepare the necessary entries for Edmund Ltd up until and including 30 October 2024 in accordance with AASB 121/IAS 21. (LO10)

23.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1.5.24

30.6.24

30.10.24

Inventories Accounts payable (Initial recognition and measurement of accounts payable and inventories at transaction date using the spot rate, US$200 000 x 1.53)

Dr Cr

306 000

Foreign exchange loss Accounts payable (Re-measurement of payable, US$200 000 x 1.56 – US$200 000 x 1.53)

Dr Cr

6 000

Forward contract Gain on forward contract (Gain on forward contract on remeasurement to fair value, US$200 000 x 1.60 – US$200 000 x 1.57)

Dr Cr

6 000

Accounts payable Foreign exchange gain (Re-measurement of payable, US$200 000 x 1.56 – US$200 000 x 1.48)

Dr Cr

16 000

Loss on forward contract Forward contract (Loss on forward contract on remeasurement to fair value, US$200 000 x 1.60 – US$200 000 x 1.48)

Dr Cr

24 000

Accounts payable Cash at bank (Cash settlement of the account at spot rate, US$200 000 x 1.48)

Dr Cr

296 000

Forward contract Cash (Cash settlement of the forward contract, US$200 000 x 1.57 – US$200 000 x 1.48)

Dr Cr

18 000

306 000

6 000

16 000

24 000

296 000

18 000

23.45

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.14 Forward contract with fair value hedging On 1 March 2024, Frank Ltd, an Australian company that has A$ as its functional currency, enters into a firm commitment with a foreign supplier to buy an equipment for US$500 000. The ownership of the equipment and the consideration for the purchase are transferred on 31 August 2024. On the same day as entering the firm commitment, Frank Ltd enters into a forward exchange contract to buy US$500 000 on 31 August 2024. Assume a discount rate of 0% for fair value calculations. Relevant exchange rates are as follows.

Spot rate 1 March 2024 30 June 2024 31 August 2024

US$1=A$1.36 US$1=A$1.37 US$1=A$1.38

Forward rate (for 31/8/2024) US$1=A$1.39 US$1=A$1.41 US$1=A$1.38

Required Prepare the necessary entries for Frank Ltd up until and including 31 August 2024 in accordance with AASB 121/IAS 21. (LO10)

23.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30.6.24

31.8.24

Loss on unrecognised firm commitment Unrecognised firm commitment (Loss on unrecognised firm commitment arising from change in fair value, US$500 000 x 1.41 – US$500 000 x 1.39)

Dr Cr

10 000

Forward contract Gain on forward contract (Gain on forward contract on remeasurement to fair value, US$500 000 x 1.41 – US$500 000 X 1.39)

Dr Cr

10 000

Unrecognised firm commitment Gain on unrecognised firm commitment (Loss on unrecognised firm commitment arising from change in fair value, US$500 000 x 1.41 – US$500 000 x 1.38)

Dr Cr

15 000

Loss on forward contract Forward contract (Loss on forward contract on remeasurement to fair value, US$500 000 x 1.41 – US$500 000 x 1.38)

Dr Cr

15 000

Equipment Unrecognised firm commitment Cash at bank (Recognition of cumulative changes in the fair value of the unrecognised firm commitment into the cost of acquisition of the equipment)

Dr Cr Cr

695 000

Forward contract Cash (Cash settlement of the forward contract, US$500 000 x 1.39 – US$500 000 x 1.38)

Dr Cr

5 000

10 000

15 000

5 000 690 000

5 000

23.47

Chapter 23: Foreign currency transactions and forward exchange contracts

Exercise 23.15 Forward contract with cash flow hedging On 1 January 2023, Toby Ltd, an Australian company that has A$ as its functional currency, enters into a forward exchange contract to sell €300 000 on 31 August 2023. The forward contract is designated as a hedge for a sales transaction of €300 000 that Toby Ltd expects to have with a German customer on 31 August 2023. The sales transaction is highly probable based on past experience. Assume a discount rate of 0% for fair value calculations. Relevant exchange rates are as follows. Forward rate (for 31/8/2023)

Spot rate 1 January 2023 30 June 2023 31 August 2023

€1=A$1.27 €1=A$1.30 €1=A$1.36

€1=A$1.32 €1=A$1.35 €1=A$1.36

Required Prepare the necessary entries for Toby Ltd up until and including 31 August 2023 in accordance with AASB 121/IAS 21. (LO10) Assume the sale transaction with the German customer takes place as anticipated on 31 August 2023. 30.6.23

31.8.23

Loss on forward contract to reserve (OCI) Dr Forward contract Cr (Gain on forward contract on remeasurement to fair value, €300 000 x 1.35 – €300 000 x 1.32)

9 000

Loss on forward contract to reserve (OCI) Forward contract Cash at bank (Gain on forward contract on remeasurement to fair value recognised to cash flow hedge reserve, €300 000 x 1.36 – €300 000 x 1.35 and cash settlement of the contract)

3 000 9 000

9 000

Dr Cr

Accounts receivable Dr Reclassification adjustment from reserve Cr (OCI) Sales revenue Cr (Reclassification adjustment of the cumulative changes in the cash flow hedge on recognition of the sale)

12 000

408 000

12 000 396 000

23.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.16 Translation of purchase on inventories paid in instalments and translation of borrowing hedged by forward contract You are the finance director of the Australian listed company, Fire Ltd that has a functional currency in A$. Fire Ltd purchases goods from Hong Kong and has borrowings from a US bank. The company’s financial year ends on 30 June 2023. Fire Ltd entered the following transactions during the year. (a) Fire Ltd purchased inventories from a Hong Kong supplier for HK$2 700 000 on 15 April 2023. The purchase contract is settled in three equal instalments of HK$900 000. The following exchange rates apply. 15 Apr. 2023 31 May 2023 30 June 2023 31 Aug. 2023 30 Sept. 2023

Date of purchase HK$2 700 000 1st payment of HK$900 000 End of the reporting period 2nd payment of HK$900 000 3rd payment of HK$900 000

A$1=HK$5.99 A$1=HK$6.01 A$1=HK$6.21 A$1=HK$6.18 A$1=HK$6.24

(b) On 1 January 2023, Fire Ltd borrowed US$3 000 000 from an investment bank in the United States for a 12-month period. The borrowing has a fixed rate of interest at 10% p.a. payable at 6-month intervals. On 1 April 2023, Fire Ltd entered a 9-month forward contract to buy US$2 500 000 in order to hedge against the foreign exchange risk on the US$ loan principal. The following exchange rates apply.

Date 1 Jan. 2023 1 Apr. 2023 30 June 2023 31 Dec. 2023

Spot rate

Forward rate for 31/12/2023

A$1=US$0.89 A$1=US$0.86 A$1=US$0.85 A$1=US$0.80

A$1=US$0.84 A$1=US$0.82 A$1=US$0.79 A$1=US$0.80

Assume a 0% discount rate for fair value calculations. Required Prepare the entries of Fire Ltd to account for its foreign currency transactions in accordance with AASB 121/IAS 21. (LO3, LO6 and LO10) (a) Purchase of inventories from Hong Kong supplier with three repayments: 15.4.23

Inventories Accounts payable (Purchase $HK2.7m  5.99)

Dr Cr

450 751 450 751

23.49

Chapter 23: Foreign currency transactions and forward exchange contracts

31.5.23

30.6.23

31.8.23

30.9.23

Accounts payable Foreign exchange gain (Re-measurement of payable $HK2.7m  6.01 – $HK2.7m  5.99)

Dr Cr

Accounts payable Cash at bank st (1 cash payment $HK0.9m  6.01)

Dr Cr

Accounts payable Foreign exchange gain (Re-measurement of payable $HK1.8m  6.21 – $HK1.8m  6.01)

Dr Cr

Date 15/04/23 31/05/23 31/08/23 30/09/23

1 500

149 750 149 750

9 646 9 646

Foreign exchange loss Accounts payable (Re-measurement of payable $HK1.8m  6.18 – $HK1.8m  6.21)

Dr Cr

1 407

Accounts payable Cash at bank nd (2 cash payment $HK0.9m  6.18)

Dr Cr

145 631

Accounts payable Foreign exchange gain (Re-measurement of payable $HK0.9m  6.24 – $HK0.9m  6.18)

Dr Cr

1 400

Accounts payable Cash at bank rd (3 cash payment $HK0.9m  6.24)

Dr Cr

144 231

HK’000 $

Exchange Rate (HK$)

Purchase Remeasure Remeasure Remeasure Remeasure

2 700 2 700 1 800 900 -

5.99 6.01 6.21 6.18 6.24

Purchase 1st Pymt 2nd Pymt 3rd Pymt

HK’000 $ 2 700 900 900 900

Date 15/04/23 31/05/23 30/06/23 31/08/23 30/09/23

1 500

Exchange Rate (HK$) 5.99 6.01 6.18 6.24 Total Pymts

1 407

145 631

1 400

144 231

Exchange Gain (Loss)

Less Payment (A$) see table below

Net Exchange Gain (Loss)

450 751 449 251 289 855 145 631 check

1 500 159 396 144 224 145 631 -

0 149 750 145 631 144 231 439 612

1 500 9 646 (1 407) 1 400 11 139

Payment in A$ 149 750 145 631 144 231 439 612

23.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b) Borrowings of US$6 000 000 at interest of 10% p.a. and forward contract to hedge principal repayment due. 1.1.23

30.6.23

31.12.23

Cash at bank Borrowings (Initial borrowings US$3m  0.89)

Dr Cr

3 370 787

Foreign exchange loss Borrowings (Re-measurement of borrowings US$3m  0.85 – US$3m  0.89)

Dr Cr

158 625

Borrowing costs expense Cash at bank (US$3m x 10% x 181/365  0.85)

Dr Cr

175 020

Forward contract to buy US$5m Gain on forward contract (Re-measurement of fwd contract US$2.5m  0.79 – US$2.5m  0.82)

Dr Cr

115 777

Foreign exchange loss Borrowings (Re-measurement of borrowings US$3m  0.80 – US$3m  0.85)

Dr Cr

220 588

Borrowings Cash at bank (Borrowings repaid US$3m  0.80)

Dr Cr

3 750 000

Borrowing costs expense Cash at bank ($.U.S.3m x 10% x 184/365  0.80)

Dr Cr

189 041

Loss on forward contract Forward contract to buy US$5m (Re-measurement of fwd contract US$2.5m  0.80 – US$2.5m  0.79)

Dr Cr

39 557

Cash at bank Forward contract to buy US$5m (Settlement of fwd contract US$2.5m  0.80 – US$2.5m  0.82)

Dr Cr

79 220

3 370 787

158 625

175 020

115 777

220 588

3 750 000

189 041

39 557

79 220

In this case, the hedged item is a recognised liability therefore, it is a fair value hedge with gains and losses on the hedging instrument (the forward contract) recognised to profit or loss as incurred.

23.51

Chapter 23: Foreign currency transactions and forward exchange contracts

Date

US$

Exchange Rate (US$)

Exchange Gain (Loss)

1/01/2023

Borrowings

3 000 000

0.89

3 370 787

30/06/2023

Remeasure

3 000 000

0.85

3 529 412

158 625

31/12/2023

Payment

3 000 000

0.80

3 750 000

220 588 379 213

check

379 213

Borrowing Costs 30/06/2023

Interest

148 767

0.85

175 020

31/12/2023

Interest

151 233

0.80

189 041

Forward contract 1/04/2023

Contract Date

2 500 000

0.82

3 048 780

30/06/2023

Remeasure

2 500 000

0.79

3 164 557

115 776

31/12/2023

Remeasure

2 500 000

0.80

3 125 000

(39 557) 76 220

check

76 220

23.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.17 Translation of purchase of inventories paid in instalments, translation of borrowing with hedged interest commitment, and translations of purchase of inventories with hedged liability to supplier You are the finance director of Gripweed Ltd, an Australian company listed on the ASX. The company is an importer of goods from overseas markets. The company’s financial year ends on 30 June 2023. The company entered the following transactions during the year. (a) Gripweed Ltd purchased inventories from a Hong Kong supplier for HK$300 000. The title to the goods passes to the company on delivery. The payment for the inventories is due in equal instalments. The following exchange rates are applicable. 22 Apr. 2023 30 Apr. 2023 31 May 2023 30 June 2023 31 July 2023

Date of order for inventories Date of delivery for inventories 1st payment of HK$100 000 2nd payment of HK$100 000 3rd payment of HK$100 000

A$1=HK$8.40 A$1=HK$8.90 A$1=HK$8.96 A$1=HK$8.99 A$1=HK$9.44

(b) Gripweed Ltd purchased land in Japan on 1 July 2022 for ¥60 000 000. The land is subsequently revalued on 30 June 2023 to its fair value of ¥90 000 000. The following exchange rates are applicable. 1 July 2022 30 June 2023

Date of acquisition of land Date of revaluation of land

A$1=¥180 A$1=¥265

(c) Gripweed Ltd arranged interest-only borrowings on 1 January 2023 for US$20 000 000. The borrowings have a 10-year term and interest is paid half-yearly at the rate of 7.6% p.a. Gripweed Ltd took out a 6-month forward exchange contract on 1 January 2023 as a hedge against the initial interest payment due. The following exchange rates are applicable.

1 Jan. 2023 30 June 2023

Spot rate

Forward rate for 30/6/2023

A$1=US$0.80 A$1=US$0.65

A$1=US$0.75 A$1=US$0.65

(d) Gripweed Ltd purchases inventories on 1 May 2023 from an English supplier for £450 000. On the same date, Gripweed enters a 3-month forward exchange contract to buy £450 000 to hedge its liability to the supplier. On 31 July 2023, the supplier is paid and the forward contract is settled. The following exchange rates are applicable.

23.53

Chapter 23: Foreign currency transactions and forward exchange contracts

1 May 2023 30 June 2023 31 July 2023

Spot rate

Forward rate for 31/7/2023

A$1=£0.64 A$1=£0.52 A$1=£0.37

A$1=£0.62 A$1=£0.47 A$1=£0.37

(e) Assume the same facts as part (d) except that the date of the purchase of inventories is 31 July 2023 and at 1 May 2023 it is a highly probable forecast transaction. Required In accordance with AASB 121/IAS 21, prepare the entries of Gripweed Ltd to account for its foreign currency transactions. Assume a 0% discount rate for fair value calculations. Explain the techniques applied in respect of each transaction. (LO3, LO7 and LO10) (a) Purchase of inventories from Hong Kong supplier with three repayments: 30/04/23

31/05/23

Inventories Accounts payable (Purchase HK$300 000/8.9)

Dr Cr

33 708

Accounts payable Foreign exchange gain (Payable re-measured HK$300 000/8.96 – HK$300 000/8.9)

Dr Cr

226

Accounts payable Cash at bank (1st repayment HK$100 000/8.96)

Dr Cr

11 161

33 708

226

11 161

23.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30/06/ 23

30/06/

Accounts payable Foreign exchange gain (Payable re-measured HK$200 000/8.99 – HK$200 000/8.96) Accounts payable Cash at bank (2nd repayment HK$100 000/8.99)

23 Accounts payable Foreign exchange gain (Payable re-measured HK$100 000/9.44 – HK$100 000/8.99) 31/07/ 23

Accounts payable Cash at bank (3rd repayment HK$100 000/9.44)

7D r 4 7 C4 r

1 1 D1 1 r 1 C1 r 2 2 3 3 D r 5 C5 r 3 3 0 0

31/07/ 23

D r 1 C1 r 0 0 5 5 9 9 3 3

Date

HK$

Exchange Rate (HK$)

L e s N s E e P x t a c E y h x m a c e n h n g a t e n ( A G g A $ a e $ i G ) n a s ( i e L n e o ( t s L a s o b ) s l s e ) b e l

23.55

Chapter 23: Foreign currency transactions and forward exchange contracts

o w

30/04/2 3

31/05/2 3

30/06/2 3

31/07/2 3

Purcha se

Remea sure

300 000

200 000

100 000

Remea sure

Date

HK$

8.90

3 3 7 - 0 8 -

8.96

1 2 1 1 2 2 1 3 2 3 1 8 6 2 6 6 1 1

8.99

1 1 1 1 1 1 7 1 1 1 4 9 2 2 8 3 3

9.44

P a y m e n t i n A $

Exchange Rate (HK$)

30/04/2 3

Purcha se

300 000

31/05/2 3

1st Pymt

100 000

8.96

30/06/2 3

2nd Pymt

100 000

8.99

8.40

1 1 1 5 0 - 1 3 5 2 0 9 3 3 c 3 h 2 8 e - 8 3 c 7 0 k 7 3 3 7 0 8

1 1 1 6 1 1

23.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. 1 1 2 3

31/07/2 3

3rd Pymt

100 000

9.44

Total Pymts

1 0 5 9 3 3 2 8 7 7

(b) Purchase of land in Japan subsequently revalued to fair value: 1.1.23

30.6.23

Land – at cost Cash at bank (Land acquired ¥60m  180)

Dr Cr

333 333

Land – at fair value Land – at cost Gain on revaluation (OCI) (Land revalued to fair value ¥90m  265 – ¥60m  180)

Dr Cr Cr

339 623

333 333

333 333 6 290

The gain on revaluation includes a foreign exchange loss because the translated amount of the revaluation increment by itself is a gain of $113 208 (i.e. ¥30m  265). (c) Interest only long-term borrowings in US$ and forward contract to hedge future interest commitment:

23.57

Chapter 23: Foreign currency transactions and forward exchange contracts

1.1.23

30.6.23

Cash at bank Borrowings (Initial borrowings US$20m  0.80)

Dr Cr

25 000 000

Foreign exchange loss Borrowings (Re-measurement of borrowings US$20m  0.65 – US$20m  0.80)

Dr Cr

5 769 231

Borrowing costs expense Cash at bank (US$20m x 7.6% x 181/365  0.65)

Dr Cr

1 159 621

Forward contract to buy US$ Gain to hedge reserve (OCI) (Contract fair value US$753 753  0.65 US$753 753  0.75)

Dr Cr

Cash at bank Forward contract to buy US$ (Settlement of contract US$753 753  0.65 – US$753 753  0.75)

Dr Cr

Reclassification from reserve (OCI) Borrowing costs expense (Reclassification from cash flow hedge reserve to profit or loss)

Dr Cr

25 000 000

5 769 231

1 159 621

154 616 154 616

In this case, the hedged item is the initial interest due on 30 June 2023 equal to US$753 753 (i.e. US$20m x 7.6% x 181/365 days), therefore it is a cash flow hedge. Gains or losses on the forward contract are recognised to other comprehensive income and a cash flow hedge reserve. When the borrowing costs expense is recognised the amount in the cash flow hedge reserve is reclassified to the profit or loss. The borrowing costs expense for the period net of the gain on the forward contract is $1 005 005 (i.e. $1 159 621 – 154 616), which is the same as the interest commitment at the forward rate on the inception of the contract (i.e. US$753 753  0.75) (d) Purchase of inventories from England and forward contract on same date: 1.5.23

Inventories Accounts payable (Purchase £450 000  0.64)

Dr Cr

703 125 703 125

23.58

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

30.6.23

31.7.23

Foreign exchange loss Accounts payable (Re-measurement of payable £450 000  0.52 – £450 000  0.64)

Dr Cr

162 260

Forward contract to buy £’s Gain on forward contract (Re-measurement of fwd contract £450 000  0.47 – £450 000  0.62)

Dr Cr

231 640

Foreign exchange loss Accounts payable (Re-measurement of payable £450 000  0.37 – £450 000  0.52)

Dr Cr

350 832

Accounts payable Cash at bank

Dr Cr

1 216 216

Forward contract to buy £’s Gain on forward contract (Re-measurement of fwd contract £450 000  0.37 – £450 000  0.47)

Dr Cr

258 769

Cash at bank Forward contract to buy £’s (Settlement of contract £450 000  0.37 – £450 000  0.62)

Dr Cr

490 410

162 260

231 640

350 832

1 216 216

258 769

490 410

In this case, the hedged item is a recognised liability (i.e. accounts payable of £450 000 and there is a fair value hedge. Gains or losses on the fair value of the hedging instrument must be recognised to the profit or loss as incurred. The final amount paid to the English supplier is $1 216 216 however, the hedging instrument contributes cash of $490 410. The net cash outflow for the hedged item and hedging instrument is $725 806 (i.e. $1 216 216 – $490 410). Given a discount rate of 0%, the amount paid for the recognised liability is effectively £450 000 at the forward rate of A$1 = £0.62. (e) Purchase of inventories from England and forward contract in anticipation: 1.5.23

No entry

30.6.23

Forward contract to buy £’s Gain to hedge reserve (OCI) (Re-measurement of fwd contract £450 000  0.47 – £450 000  0.62)

Dr Cr

231 640

Forward contract to buy £’s Gain to hedge reserve (OCI) (Re-measurement of fwd contract £450 000  0.37 – £450 000  0.47)

Dr Cr

258 769

31.7.23

231 640

258 769

23.59

Chapter 23: Foreign currency transactions and forward exchange contracts

31.7.23

Inventories Transfer from hedge reserve Accounts payable (Payable £450 000  0.37 and transfer of gain from hedge reserve)

Dr Dr Cr

725 806 490 410

Cash at bank Forward contract to buy £’s (Settlement of contract £450 000  0.37 – £450 000  0.62)

Dr Cr

490 410

1 216 216

490 410

In this case, the hedged item is a highly probable forecasted purchase of inventories transaction and there is a cash flow hedge. Gains or losses on the fair value of the hedging instrument must be recognised in other comprehensive income and the cash flow hedge reserve. When the forecasted purchase transaction occurs, the net amount of the gains or losses recognised to the cash flow hedge reserve are transferred out of the reserve and form part of the cost of the inventories recognised. The cost of the inventories is $725 806 after the gains on the hedging instrument. Given a discount rate of 0%, the cost of the inventories is effectively £450 000 at the forward rate of A$1 = £0.62.

23.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.18 Translation of sale of inventories with no hedge, fair value hedge and cash flow hedge Cool Ltd is an Australian mining company listed on the ASX. The company is an exporter of iron ore to overseas steel mills. The company’s functional currency is A$ and its financial year ends on 30 June 2023. The company entered various sale transactions during the year. Relevant exchange rates are as follows.

1 Apr. 2023 1 June 2023 30 June 2023 31 July 2023

Spot rate

Forward rate for 31/7/2023

A$1=US$0.78 A$1=US$0.76 A$1=US$0.78 A$1=US$0.80

A$1=US$0.75 A$1=US$0.72 A$1=US$0.74 A$1=US$0.80

(a) On 1 April 2023, Cool Ltd sold iron ore to a Japanese customer for US$2 500 000. On 31 July 2023, the customer paid for the iron ore. (b) On 1 June 2023, Cool Ltd sold iron ore to a Chinese customer for US$4 250 000. On 31 July 2023, the customer paid for the iron ore. On 1 June 2023, the company entered into a forward exchange contract to sell US$4 250 000, which it designated as a hedge of the customer account. (c) On 1 April 2023, in anticipation of a highly probable transaction with its Korean customer, Cool Ltd entered into a forward exchange contract to sell US$1 500 000 as a hedging instrument. The forward contract has a settlement date of 31 July 2023. On 1 June 2023, Cool Ltd sold iron ore to a Korean customer for US$1 500 000. On 31 July 2023, the customer paid for the iron ore. Required In accordance with AASB 121/IAS 21, prepare the entries of Cool Ltd to account for it foreign currency transactions. Assume a 0% discount rate for fair value calculations. (LO3, LO7 and LO10) (a) Japanese customer: 1 April 2023

30 June 2023

31 July 2023

Date of sale

Reporting date

Settlement date

Initial recognition of receivable US$2.5m  0.78 = $3 205 128

Restate receivable US$2.5m  0.78 = $3 205 128

Restate receivable &cash receipt US$2.5m  0.80 = $3 125 000

Exchange loss on debtor nil

Exchange loss on debtor $80 128

23.61

Chapter 23: Foreign currency transactions and forward exchange contracts

1.4.23

Accounts receivable Sales

30.6.23

Foreign exchange gain/loss is NIL Spot rate is the same as before

31.7.23

Foreign exchange loss Cash at bank Accounts receivable

Dr Cr

3 205 128

Dr Dr Cr

80 128 3 125 000

3 205 128

Cool Ltd makes a realised exchange loss of $80 128 from date of sale to date of cash receipt. (b) Chinese customer: 1 June 2023

30 June 2023

31 July 2023

Date of sale

Reporting date

Settlement date

Initial recognition of receivable US$4.25m  0.76 = $5 592 105

Restate receivable US$4.25m  0.78 = $5 448 718

Restate receivable &cash receipt US$4.25m  0.80 = $5 312 500

Exchange loss on debtor $143 387

Exchange loss on debtor $136 218

Fwd contract to sell US$

Right US$4 25m  0.72 = $5 902 778

Obligation US$4.25m  0.72 = $5 902 778 Fair value = $0

Obligation US$4.25m  0.74 = $5 743 243 Fair value = $159 535

Obligation US$4.25m  0.80 = $5 312 500 Fair value = 430 743

Gain on fwd contract $159 535

Gain on fwd contract $271 208

23.62

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1.6.23

30.6.23

31.7.23

Accounts receivable Sales

Dr Cr

5 592 105

Foreign exchange loss Accounts receivable

Dr Cr

143 387

Forward contract to sell US$ Gain on forward contract

Dr Cr

159 535

Foreign exchange loss Cash at bank Accounts receivable

Dr Dr Cr

5 136 218 312 500

Cash at bank Gain on forward contract Forward contract to sell US$

Dr Cr Cr

430 743

5 592 105

143 387

159 535

5 448 718

271 208 159 535

Cool Ltd’s fair value hedge ensures that $5 902 778 is collected after the date of sale. (c) Korean customer: 1 June 2023

30 June 2023

31 July 2023

Date of sale

Reporting date

Settlement date

Initial recognition of receivable US$1.5m  0.76 = $1 973 684

Restate receivable US$1.5m  0.78 = $1 923 077

Restate receivable &cash receipt US$1.5m  0.80 = $1 875 000

Exchange loss on debtor $50 607

Exchange loss on debtor $48 077

Fwd contract to sell US$

Right US$1.5m  0.75 = $2 000 000

Obligation US$1.5m  0.72 = $2 083 333

Obligation US$1.5m  0.74 = $2 027 027

Right US$1.5m  0.75 = $2 000 000 Obligation US$1.5m  0.80 = $1 875 000

Fair value = ($83 333)

Fair value = ($27 027)

Fair value = $125 000

Gain on fwd contract $56 306

Gain on fwd contract $152 027

23.63

Chapter 23: Foreign currency transactions and forward exchange contracts

1.6.23

Loss to hedge reserve (OCI) Forward contract to sell US$ Accounts receivable 1.6.23

Reclassification

from

Dr Cr

83 333

1 973 684

83 333

83 333 1 890 351

reserve Cr Cr

(OCI) Sales 30.6.23 Foreign exchange loss Accounts receivable 30.6.23 Forward contract to sell US$ Gain on forward contract 31.7.23 Foreign exchange loss Cash at bank Accounts receivable 31.7.23 Cash at bank Forward contract to sell US$ Gain on forward contract

Dr Cr

50 607

Dr Cr

56 306

Dr Dr Cr

48 077 1 875 000

Dr Dr Cr

125 000 27 027

50 607

56 306

1 923 077

152 027

23.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 23.19 Translation of hedged firm commitment, hedged highly probable forecast transaction, hedged recognised liability and borrowings and interest attributable to a qualifying asset Aloha Ltd is an Australian company that purchases inventories and specialised equipment from US suppliers. The company’s functional currency is A$ and its financial year ends on 30 June 2023. The company entered various transactions denominated in US$ during the year. Assume a discount rate of 0% for fair value calculations. Relevant exchange rates are as follows.

1 Jan. 2023 1 Mar. 2023 1 May 2023 30 June 2023 31 Aug. 2023

Spot rate

Forward rate for 31/8/2023

A$1=US$0.85 A$1=US$0.79 A$1=US$0.75 A$1=US$0.70 A$1=US$0.77

A$1=US$0.83 A$1=US$0.76 A$1=US$0.73 A$1=US$0.67 A$1=US$0.77

(a) On 1 March 2023, Aloha Ltd entered into a firm commitment with a US company to build a new equipment item for US$1 800 000. On 31 August 2023, the item of equipment is delivered and installed and recognised as an asset in Aloha Ltd’s accounting records. On 1 March 2023, Aloha Ltd entered a 6-month forward contract to buy US$1 800 000 for settlement on 31 August 2023. The forward contract is designated as a hedging instrument for an unrecognised firm commitment. (b) On 31 August 2023, Aloha Ltd acquired inventories, as normal around this time of year, from a US supplier for US$5 000 000. On 1 January 2023, Aloha Ltd entered an 8-month forward contract to buy US$5 000 000 for settlement on 31 August 2023. The forward contract is designated as a hedging instrument for a highly probable forecast inventories purchase transaction. (d) On 1 May 2023, Aloha Ltd acquired inventories from a US supplier for US$500 000. The invoice is paid in full on 31 August 2023. On 1 May 2023, Aloha Ltd entered a 4month forward exchange contract to buy US$500 000 for settlement on 31 August 2023. The forward contract is designated as a hedging instrument for a recognised liability. (d) On 1 January 2023, Aloha Ltd commenced the construction of an item of specialised plant. The estimated construction period for the plant is 18 months. On 1 January 2023, Aloha Ltd borrowed US$18 000 000 to finance the construction of the plant. The interest on the borrowings is 10% p.a. paid at the end of each year. The average exchange rate for the period 1 January 2023 to 30 June 2023 is A$1.00 = US$0.825. Required In accordance with AASB 121/IAS 21, prepare the entries of Aloha Ltd to account for its foreign currency transactions. Assume a 0% discount rate for fair value calculations. (LO3, LO7 and LO10) (a) Hedge of firm commitment:

23.65

Chapter 23: Foreign currency transactions and forward exchange contracts

1.3.23

No entries

30.6.23

Forward contract to buy US$ Gain on forward contract (Forward contract US$1.8m  0.67 – US$1.8m  0.76)

Dr Cr

318 146

Loss on firm commitment Firm commitment to buy asset (Firm commitment US$1.8m  0.67 – US$1.8m  0.76)

Dr Cr

318 146

Loss on forward contract Forward contract to buy $U.S (Forward contract US$1.8m  0.77 – US$1.8m  0.67)

Dr Cr

348 905

Forward contract to buy US$ Cash at bank (Settlement of contract US$1.8m  0.77 – US$1.8m  0.76)

Dr Cr

30 759

Firm commitment to buy asset Gain on firm commitment (Firm commitment US$1.8m  0.77 – US$1.8m  0.67)

Dr Cr

348 905

Equipment Firm commitment to buy asset Payable to supplier

Dr Cr Cr

2 368 421

30.6.23

31.8.23

318 146

348 905

30 759

348 905

30 759 2 337 662

Equipment cost of US$1.8m at the forward rate of 0.76 is $2 368 421.

(b) Hedge of highly probable forecasted inventories purchase:

23.66

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1.1.23

No entry

30.6.23

Forward contract to buy US$ Gain to hedge reserve (OCI) (Re-measurement of fwd contract US$5m  0.67 – US$5m  0.83)

Dr Cr

1 438 591

Loss to hedge reserve (OCI) Forward contract to buy US$ (Re-measurement of fwd contract US$5m  0.77 – US$5m  0.67)

Dr Cr

969 181

Inventories Transfer from hedge reserve Accounts payable (Payable US$5m  0.77 and transfer or net gain from hedge reserve)

Dr Dr Cr

6 493 506 469 410

Cash at bank Forward contract to buy US$ (Settlement of contract US$5m  0.77 – US$5m  0.83)

Dr Cr

469 410

31.8.23

1 438 591

969 181

6 962 916

469 410

Inventories of US$5m at the forward rate of 0.83 is $6 024 096.

30.6.23

Inventories Accounts payable (Purchase US$0.5m  0.75)

Dr Cr

666 667

Foreign exchange loss Accounts payable (Re-measure payable US$0.5m  0.7 – US$0.5m  0.75)

Dr Cr

47 619

Forward contract to buy US$ Gain on forward contract (Re-measure fwd contract US$0.5m  0.67 – US$0.5m  0.73)

Dr Cr

61 337

666 667

47 619

61 337

23.67

Chapter 23: Foreign currency transactions and forward exchange contracts

31.8.23

Accounts payable Foreign exchange gain Cash at bank (Re-measure payable and settlement at US$0.5m  0.77)

Dr Cr Cr

714 286

Loss on forward contract Forward contract to buy US$ Cash at bank (Re-measure and settle fwd contract US$0.5m  0.77 – US$0.5m  0.73)

Dr Cr Cr

96 918

64 935 649 351

61 337 35 581

Cash payment made to supplier for inventories purchase of US$0.5m at the forward rate of 0.73 is $684 932 (d) Borrowings for qualifying asset: 1.1.23

30.6.23

Cash at bank Borrowings (Initial measurement of borrowings US$18m  0.85)

Dr Cr

21 176 471

Foreign exchange loss Borrowings (Re-measure borrowings US$18m  0.7 – US$18m  0.85)

Dr Cr

4 537 815

Plant under construction Interest payable (Borrowing costs accrued and capitalised US$18m x 10% x 181/365  0.7)

Dr Cr

1 2785 147

21 176 471

4 537 815

1 275 147

Interest expense of US$18m x 10% x 181/365 day is US$892 603. Interest payable of US$892 603 at the closing rate of 0.7 is $1 275 147. Interest expense of US$892 603 at the average rate of 0.825 is $1 081 943. The difference between interest expense and interest payable is the foreign exchange loss on interest equal to $193 204. Both the interest expense and the foreign exchange loss on interest are capitalised into the cost of the qualifying asset.

23.68

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 23: Foreign currency transactions and forward exchange contracts Multiple choice questions 1. The main issue in accounting for foreign currency transactions is: *a. b. c. d.

how to treat any foreign exchange differences that arise when assets or liabilities are remeasured at the end of the reporting period using the closing rate. how to translate the financial statements of a foreign operation. how to distinguish between denomination currency or settlement currency. how to record transactions with foreign operations.

Answer: a Learning objective 23.1: explain the need to translate foreign currency transactions. 2. According to AASB 121, all the following items are ‘monetary items’ except for: a. b. c. *d.

borrowings €60 000. trade payable of ₤100 000. trade receivable of US$24 000. shares held in BHP Ltd listed on the ASX.

Answer: d Learning objective 23.1: explain the need to translate foreign currency transactions.

3. For a company that has A$ as its functional currency, which of the following is not a foreign currency transaction? a. b. *c. d.

goods sold at prices denominated in UK pounds equipment sold at prices denominated in Japanese Yen. inventory sold to a customer in Hong Kong who pays in A$. borrowing funds where amounts are payable in NZ$.

Answer: c Learning objective 23.1: explain the need to translate foreign currency transactions.

23.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The accounting standard, AASB 121 The Effects of Changes in Foreign Exchange Rates, covers which of the following? a. b. c. *d.

Treatment of any exchange differences that arise. Subsequent measurement of assets and liabilities at the end of the reporting period. Initial recognition and measurement of financial statement elements arising from foreign currency transactions. All of these options.

Answer: d Learning objective 23.1: explain the need to translate foreign currency transactions. 5. The Australian Financial News quoted A$1.00 equals US$1.15/1.18. What does this represent? a. b. c. *d.

A bid rate of A$1.15. A bid rate of US$1.18. An offer rate of A$1.18. An offer rate of US$1.18.

Answer: d Learning objective 23.2: explain how exchange rates function.

6. The exchange rate used at the end of the reporting period is: a. *b. c. d.

the spot rate. the closing rate. the ending rate. the indirect rate.

Answer: b Learning objective 23.2: explain how exchange rates function.

7. The Australian financial news quoted US$1.00 equals A$0.8836/0.9105. What does this represent? *a. b. c. d.

The direct form of quotation. A bid rate of A$0.9105. An offer rate of A$0.8836. A bid-ask spread of A$0.0269.

Answer: a Learning objective 23.2: explain how exchange rates function.

23.2

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

8. Revenues and expenses denominated in a foreign currency, if assumed to be earned or incurred evenly during the financial period, and translated using the: a. b. *c. d.

exchange rate at the beginning of the financial period. exchange rate at the end of the financial period. average exchange rate for the financial period. exchange rate at the transaction date.

Answer: c Learning objective 23.3: prepare entries for the initial measurement of foreign currency items at transaction date.

9. FOB is the term of agreement whereby the seller retains ownership while the goods are in transit and the buyer obtains ownership when the goods have been received into its store. a. *b. c. d.

origin. destination. foreign country. shipping point.

Answer: b Learning objective 23.3: prepare entries for the initial measurement of foreign currency items at transaction date.

10. Outback Limited, an Australian company, purchased machinery from Southern Ranches Limited, a US company, on credit terms for US$600 000. At the transaction date, the exchange rate was US$1 = A$1.20. The journal entry recorded by Outback Limited for this purchase would be: *a. b. c. d.

DR Machinery $720 000; CR Payable to Southern Ranches Limited $720 000. DR Machinery $600 000; CR Payable to Southern Ranches Limited $600 000. DR Receivable from Southern Ranches Limited $600 000; CR Cash $600 000 DR Machinery $720 000; CR Cash $720 000

Answer: a Learning objective 23.3: prepare entries for the initial measurement of foreign currency items at transaction date.

23.3

Testbank to accompany Financial reporting 3e by Loftus et al.

11. Subsequent measurement of items resulting from a foreign currency transaction depend on whether the items are: a. *b. c. d.

foreign or local. monetary or non-monetary. classified as current or non-current. initially measured using the correct exchange rate.

Answer: b Learning objective 23.4: describe what are monetary and non-monetary items.

12. Monetary items include the following except for: a. b. *c. d.

payables for goods purchased. accounts receivable. financial assets. borrowings.

Answer: c Learning objective 23.4: describe what are monetary and non-monetary items.

13. A decrease in the direct rate of US$1 to A$# results in: a. *b. c. d.

an exchange loss. a decrease in A$ amount for a payable in US$. an increase in A$ amount for receivable in US$. an increase in US$ amount for a payable in A$.

Answer: b Learning objective 23.5: describe how foreign exchange differences impact on monetary assets or liabilities. 14. An exchange difference is ‘realised’: a. b. *c. d.

on initial recognition of a monetary asset. on remeasurement of a monetary liability at the end of the reporting period. when the exchange rate changes between initial recognition and cash settlement. when the exchange rate changes between initial recognition and end of reporting period.

Answer: c Learning objective 23.5: describe how foreign exchange differences impact on monetary assets or liabilities.

23.4

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

15. At the date of the transaction, a foreign currency monetary item is initially recognised and measured using: *a. b. c. d.

the spot exchange rate. US dollars. the closing rate. the foreign currency monetary value.

Answer: a Learning objective 23.6: prepare entries for the subsequent measurement of monetary items that are denominated in foreign currency.

16. At the end of the reporting period, a foreign currency monetary item is remeasured using: a. *b. c. d.

US dollars. the closing rate. the spot exchange rate. the foreign currency monetary value.

Answer: b Learning objective 23.6: prepare entries for the subsequent measurement of monetary items that are denominated in foreign currency.

17. On 25 June, Wattle Ltd acquires equipment on credit terms from a New Zealand supplier, Timaru Ltd, for NZ$240 000. The exchange rate at 25 June was NZ$1.00 = A$095. On 30 June the exchange rate is NZ$1.00 = A$0.90. Wattle Ltd pays Timaru Ltd in full on 7 July when the exchange rate is NZ$1.00 = A$0.92. The journal entry recorded by Wattle Ltd for the purchase of the equipment on 25 June is: a. *b. c. d.

DR Equipment A$240 000; CR Cash A$240 000 DR Equipment A$228 000; CR Payable to Timaru Ltd A$228 000 DR Equipment A$216 000; CR Payable to Timaru Ltd A$216 000 DR Equipment A$220 800; CR Payable to Timaru Ltd A$220 800

Answer: b Feedback: NZ$240 000 x A$0.95 = A$228 000 Learning objective 23.6: prepare entries for the subsequent measurement of monetary items that are denominated in foreign currency.

23.5

Testbank to accompany Financial reporting 3e by Loftus et al.

18. On 25 June, Wattle Ltd acquires equipment on credit terms from a New Zealand supplier, Timaru Ltd, for NZ$240 000. The exchange rate at 25 June was NZ$1.00 = A$095. On 30 June the exchange rate is NZ$1.00 = A$0.90. Wattle Ltd pays Timaru Ltd in full on 7 July when the exchange rate is NZ$1.00 = A$0.92. The journal entry recorded by Wattle Ltd to remeasure the outstanding foreign currency monetary unit at 30 June is: a. b. c. *d.

DR Foreign Exchange Loss A$13 235; Payable to Timaru Ltd A$13 235 DR Payable to Timaru Ltd A$13 235; Foreign Exchange Gain A$13 235 DR Foreign Exchange Loss A$9 000; Payable to Timaru Ltd A$9 000 DR Payable to Timaru Ltd A$9 000; Foreign Exchange Gain A$9 000

Answer: d Feedback: At 25 June: NZ$240 000 x A$0.95 = A$228 000. At 30 June: NZ$240 000 x A$0.90 = A$216 000. FX Gain = A$228 000 – A$216 000 = A$12 000 Learning objective 23.6: prepare entries for the subsequent measurement of monetary items that are denominated in foreign currency.

19. On 25 June, Wattle Ltd acquires equipment on credit terms from a New Zealand supplier, Timaru Ltd, for NZ$240 000. The exchange rate at 25 June was NZ$1.00 = A$095. On 30 June the exchange rate is NZ$1.00 = A$0.90. Wattle Ltd pays Timaru Ltd in full on 7 July when the exchange rate is NZ$1.00 = A$0.92. The journal entry recorded by Wattle Ltd to remeasure the foreign currency monetary unit at settlement date of 7 July is: a. b. *c. d.

DR Payable to Timaru Ltd A$5488; Foreign Exchange Gain A$5488 DR Foreign Exchange Loss A$3600; Payable to Timaru Ltd A$3600 DR Foreign Exchange Loss A$3600; Payable to Timaru Ltd A$3600 DR Payable to Timaru Ltd A$5488; Foreign Exchange Gain A$5488

Answer: c Feedback: At 30 June: NZ$240 000 x A$0.90 = A$216 000. At 7 July: NZ$240 000 x A$0.92 = A$220 800. FX Loss = A$216 000 – A$220 800 = A$(4 800) Learning objective 23.6: prepare entries for the subsequent measurement of monetary items that are denominated in foreign currency. 20. The following assets can be defined as ‘qualifying assets’ except for: *a. b. c. d.

inventories purchased ready for sale. power generation facilities investment properties. manufacturing plants.

Answer: a Learning objective 23.7: prepare entries for the subsequent measurement of non-monetary items that are denominated in foreign currency. © John Wiley and Sons Australia, Ltd 2020

23.6

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

21. On 28 March 2022, Blue Gum Ltd acquired land in California for a cash consideration of US$400 000. At 30 June 2022 the land is revalued to a fair value of US$500 000. The relevant exchange rates are: 28 March 2022 30 June 2022

US$1.00 = A$1.15 US$1.00 = A$1.10

On 30 June 2022, Blue Gum Ltd will record a revaluation gain on the land for: a. *b. c. d.

A$100 000 A$160 000 A$200 000 A$217 948

Answer: b Feedback: US$400 000 x A$1.15 = A$460 000; US$500 000 x A$1.10 = A$550 000 Increase in value of land is A$90 000 Learning objective 23.7: prepare entries for the subsequent measurement of non-monetary items that are denominated in foreign currency.

22. On 1 June 2022, Dubbo Ltd acquires inventories for cash of US$400 000. All of the inventories are still on hand at 30 June 2022 and have a net realisable value at that date of US$420 000. Relevant exchange rates are: 1 June 2022 30 June 2022

US$1.00 = A$1.30 US$1.00 = A$1.20

The journal entry recorded by Dubbo Ltd to remeasure the inventories at 30 June 2022 is: *a. b. c. d.

DR Inventories write-down expense A$16 000; CR Inventories A$16 000 DR Inventories write-down expense A$42 000; CR Inventories A$42 000 DR Inventories A$42 000; CR Gain on revaluation (OCI) A$42 000 DR Inventories A$16 000; CR Gain on revaluation (OCI) A$16 000

Answer: a Feedback: US$400 000 x A$1.30 = A$520 000; US$420 000 x A$1.20 = A$504 000. Decrease in value of inventories = A$16 000 Learning objective 23.7: prepare entries for the subsequent measurement of non-monetary items that are denominated in foreign currency.

23.7

Testbank to accompany Financial reporting 3e by Loftus et al.

23. On 1 July 2022, Jimbour Ltd enters a loan agreement with the Bank of New Zealand to borrow NZ$200 000. The funds are to be used to purchase materials needed for the construction of a manufacturing plant. By 31 December 2022, additional costs of A$75 000 have been paid to complete the manufacturing plant. Interest on the funds borrowed is payable half-yearly in arrears at the fixed interest rate of 5% p.a. Relevant exchange rates are: 1 July 2022 Average July to December 2022 31 December 2022 Average January to June 2023 30 June 2023

NZ$1.00 = A$0.75 NZ$1.00 = A$0.77 NZ$1.00 = A$0.85 NZ$1.00 = A$0.80 NZ$1.00 = A$0.70

The interest expense and any foreign exchange gain or loss on the interest at 31 December 2022 is: a. *b. c. d.

Interest expense A$3 850; Foreign exchange gain A$400 Interest expense A$3 850; Foreign exchange loss A$400 Interest expense A$6 494; Foreign exchange loss A$611 Interest expense A$6 494; Foreign exchange loss A$611

Answer: b Feedback: Half-yearly interest = NZ$200 000 x 5% x ½ = NZ$5 000. Interest expense to 31/12/22 = NZ$5 000 x Avg rate of A$0.77 = A$3 850. Interest amount at closing rate = NZ$5 000 x A$0.85 = A$4 250. Exchange loss on interest expense = A$3850 – A$4250 = A$(400). Learning objective 23.7: prepare entries for the subsequent measurement of non-monetary items that are denominated in foreign currency. 24. Foreign exchange risk may relate to: a. b. c. *d.

recognised assets and liabilities. unrecognised firm commitments. planned foreign currency transactions. all of the above.

Answer: d Learning objective 23.8: explain what is meant by ‘foreign exchange risk’ and the circumstances in which it can arise.

23.8

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

25. If an Australian company enters a forward exchange contract to buy US$30 000, then which of the following applies? a. *b. c. d.

The company’s forward contract will act as a hedge against a recognised asset. The company’s contractual obligation (at the forward rate) and contractual right (at the spot rate) are settled on a net basis. The company has a contractual obligation to deliver foreign currency at the settlement date and that obligation is realised at the spot rate. The company has a contractual right to receive US$30 000 at the settlement date and that right is an asset fixed in A$ at the forward rate.

Answer: b Learning objective 23.9: describe a ‘forward exchange contract’.

26. On 1 May 2022, Ocean Blue Ltd enters a forward exchange contract to sell US$180 000 in 8 months’ time at 31 December 2022. The relevant exchange rates are: Spot Rate 1 May 2022 30 June 2022 - end of reporting period 31 December 2022 – contract settlement date

US$1.00 = A$1.00 US$1.00 = A$0.98 US$1.00 = A$0.95

Forward Rate (for 31 Dec. 2022) US$1.00 = A$1.05 US$1.00 = A$1.02 US$1.00 = A$0.95

The journal entry required at 30 June 2022 to record any foreign exchange gain or loss on the forward contract is: a. b. *c. d.

DR Loss of forward contract A$5400; CR Forward contract A$5400 DR Loss of forward contract A$5042; CR Forward contract A$5042 DR Forward contract A$5400; CR Gain on forward contract A$5400 No entry is required.

Answer: c Learning objective 23.9: describe a ‘forward exchange contract’.

23.9

Testbank to accompany Financial reporting 3e by Loftus et al.

27. On 1 May 2022, Ocean Blue Ltd enters a forward exchange contract to sell US$180 000 in 8 months’ time at 31 December 2022. The relevant exchange rates are: Spot Rate

Forward Rate (for 31 Dec. 2022) 1 May 2022 US$1.00 = US$1.00 = A$1.00 A$1.05 30 June 2022 - end of reporting period US$1.00 = US$1.00 = A$0.98 A$1.02 31 December 2022 – contract settlement US$1.00 = US$1.00 = date A$0.95 A$0.95 The premium (or discount) on the exchange rate at 30 June 2022 is: a. b. *c. d.

Premium of $0.02 Discount of $0.03 Premium of $0.04 Discount of $0.05

Answer: c Learning objective 23.9: describe a ‘forward exchange contract’.

28. The formal documentation of a hedging relationship must include identification of: I. II. III. IV.

The hedging instrument The hedged item The nature of the risk being hedged How the entity will assess hedge effectiveness

*a. b. c. d.

I, II, III and IV. I, II and III only. I, II and IV only. II, III and IV only.

Answer: a Learning objective 23.10: explain hedge accounting.

29. Which of the following is not an example of a fair value hedge? a. b. c. *d.

a forward contract to buy US$ hedging a recognised trade payable in US$. a forward contract to sell US$ hedging a recognised loan receivable in US$. a forward contract to sell US$ hedging a recognised trade receivable in US$. a forward contract to buy US$ hedging a highly probable purchase of inventory in US$.

Answer: d Learning objective 23.10: explain hedge accounting.

23.10

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

23.11

Testbank to accompany Financial reporting 3e by Loftus et al.

30. Hedge effectiveness is ascertained from: a. an economic relationship between the hedging instrument and the hedged item. b. the effect of credit risk does not dominate the economic relationship hedging instrument and the hedged item. c. the hedge ratio of the hedging relationship reflects actual quantities and is consistent with the purpose of hedge accounting. *d. all of the options are correct. Answer: d Learning objective 23.10: explain hedge accounting.

31. Which of the following is not an example of a cash flow hedge? *a. b. c. d.

a forward contract to buy US$ hedging recognised borrowings in US$. a forward contract to sell US$ hedging a highly probable sale of inventory in US$. a forward contract to buy US$ hedging future interest payments on variable rate debt in US$. a forward contract to buy US$ hedging an unrecognised firm commitment to purchase goods in US$.

Answer: a Learning objective 23.10: explain hedge accounting.

32. The type of hedge which is of the exposure to the variability in cash flows that is attributable to a particular risk that is associated with all, or some component of, a recognised asset or liability is a: a. *b. c. d.

fair value hedge cash flow hedge hedge of a net investment in a foreign operation all of the above

Answer: b Learning objective 23.10: explain hedge accounting.

33. The degree to which changes in the fair value of a forward contract offset changes in the fair value or cash flows of a hedged item, describes: a. b. *c. d.

hedge exposure. transaction exposure. hedge effectiveness. transaction variability.

Answer: c Learning objective 23.10: explain hedge accounting.

23.12

Chapter 23: Foreign currency transactions and forward exchange contracts Not for distribution in full. Instructors may assign selected questions in their LMS.

34. A forward contact to buy US$450 000 for a planned purchase transaction of US$600 000 has a hedge ratio of: a. *b. c. d.

25%. 75%. 15%. 133%.

Answer: b Learning objective 23.10: explain hedge accounting.

35. AASB 121 requires which of the following to be disclosed in the financial reports? a. b.

Any change in functional currency and reason for change. The net exchange differences recognised in OCI and accumulated in a separate component of equity. c. The amount of exchange differences recognised in the profit or loss for the period other than those that relate to financial instruments measured at fair value through profit or loss. *d. All of the above. Answer: d Learning objective 23.11: describe the disclosures required in the financial report relating to foreign currency transactions.

23.13

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 24: Translation of foreign currency financial statements

Chapter 24: Translation of foreign currency financial statements Comprehension questions 1. Why are financial statements translated from one currency to another? Paragraph 3 of AASB 121/IAS 21 notes 2 reasons for translating the financial statements of an entity from one currency to another: • Translation of results and financial position of foreign operations for the purpose of including those results in the consolidated financial statements of a group, or to allow an investor to equity account for these results. • Translation of an entity’s results and financial position into another currency for presentation purposes. In general, the translation of financial statements from one currency to another is undertaken in order to provide more relevant information to the users of financial statements. 2. What is meant by ‘functional currency’? Paragraph 8 of AASB 121/IAS 21 defines functional currency as “the currency of the primary economic environment in which the entity operates”. In determining the functional currency of a foreign operation of a reporting entity it is then necessary to analyse the underlying economics of the situation. 3. What is the rationale behind the choice of an exchange rate as an entity’s functional currency? One of the objectives of the translation process is to provide information that is generally compatible with the expected economic effects of an exchange rate change on an entity’s cash flows and equity. A parent entity that has an investment if a foreign subsidiary has assets under its control that are exposed to a change in the exchange rate. Capturing the extent of this exposure should be reflected in the choice of exchange rate. Where a subsidiary acts simply as a conduit for the parent’s transactions, then the consolidation approach must treat the foreign currency statements of the subsidiary as artefacts that must be translated into the currency of the parent. Where the subsidiary is not just a conduit for the parent, but the latter is dependent on its own economic environment than the choice of exchange rate must reflect the fact that the functional currency is that of the subsidiary not the parent.

4. What guidelines are used to determine the functional currency of an entity? See paragraphs 9-12 of AASB 121/IAS 21 and section 24.2.2 of the text, particularly Tables 24.1-24.3.

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The following factors, given in paragraph 9(a) and (b) of AASB 121/IAS 21, should be considered in answering this question. • • •

Which currency mainly influences sales prices for goods and services? What is the currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services? What is the currency that mainly influences labour, material and other costs of providing goods and services?

If answers to the above questions do not supply a clear answer on what is the functional currency, then paragraph 10 of AASB 121/IAS 21 provides further factors that may also provide evidence of an entity’s functional currency. These factors can be expressed in terms of further questions that should be asked: • In which currency are the funds from financing activities, such as issue of debt and equity instruments, generated? • In which currency are the funds from operations normally retained? These are the financing indicators of functional currency. Table 24.2 illustrates these indicators. The activities of a foreign operation may also provide clues on what is the functional currency. In this regard, paragraph 11 of AASB 121/IAS 21 provides additional factors to be considered in determining the functional currency of a foreign operation. These can be expressed in the form of the following questions that may be asked. • • • •

Are the activities of the foreign operation carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy? Are the transactions with the reporting entity a high or a low proportion of the foreign operation’s activities? Do the cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity, and are they readily available for remittance to it? Are the cash flows from the activities of the foreign operation sufficient to service existing and normally expected debt obligations without funds having to be made available from the reporting entity?

Table 24.3 provides a discussion of these activity indicators. Paragraph 12 of AASB 121/IAS 21 notes that management may have to use its judgement to determine the functional currency, the objective being to choose the currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. Priority is given to the primary factors in paragraph 9 before the indicators in paragraphs 10 and 11 are considered. The latter provide supporting evidence to the information provided by considering the primary factors. Hence in situations where the functional currency is that of the foreign operation, it should be expected that the foreign operation is a self-contained operation and primarily operating independently within a particular country or economic environment. The daily operations of the foreign operation both in terms of inputs and outputs are independent from the economic environment of the reporting entity. The funding of the foreign operation primarily comes from its own operations or from successful fundraising activities that it undertakes. The cash © John Wiley and Sons Australia Ltd, 2020

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Chapter 24: Translation of the financial statements of foreign entities

flows of the reporting entity are then not affected to any great extent by the activities of the foreign operation. In situations where the functional currency of the foreign operation is that of the reporting entity, it should be seen that the foreign operation is acting as an extension of the reporting entity itself. The cash flows of the foreign operation are integrated with the reporting entity in that products are acquired from the reporting entity or from that entity’s country, and sales are made to the reporting entity, or in that entity’s country. The cash flows of the reporting entity are affected by the activities of the foreign operation. Funding for the foreign operation comes primarily from the reporting entity. As in all situations, the economic environment must be examined to determine where the cash is primarily generated and expended.

5. How are statement of profit or loss and other comprehensive income items translated from the local currency into the functional currency? Revenues: these are translated at the rates current at the dates the transactions occurred, but an approximation such as an average rate for a period may be used. Expenses: these are translated at the rates current at the dates the transactions occurred, but an approximation such as an average rate for a period may be used. For expenses that relate to non-monetary assets, such as depreciation and amortisation, the rates applicable are those used to translate the related non-monetary assets. Dividends paid: these are translated at the rate current at the date of payment. Dividends declared: these are translated at the rate current at the date of declaration. 6. How are statement of financial position items translated from the local currency into the functional currency? Paragraph 23 of AASB 121/IAS 21 states that: • Foreign currency monetary items are translated using the closing rate. • Non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rate at the date of the transaction. • Non-monetary items that are measured at fair value in a foreign currency re translated using the exchange rates at the date when the value was determined. Assets: assets should first be classified as monetary or non-monetary. Monetary assets: monetary assets are translated at the rate existing at the end of the reporting period; that is, the closing rate. Non-monetary assets: for a non-monetary asset, the exchange rate used is the rate current at the date at which the recorded amount for the asset has been entered into the accounts. Hence, for non-monetary assets recorded at historical cost, the rates used are those existing when the historical cost was recorded. For non-monetary assets that have been revalued, whether upwards or downwards, the exchange rates used will relate to the dates of revaluation.

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Liabilities: liabilities should first be classified as monetary or non-monetary. Monetary liabilities: as with monetary assets, the closing rate is used. Non-monetary liabilities: as with non-monetary assets, the exchange rate at the date the liability was measured is used. Equity: in selecting the appropriate exchange rate, two factors are important. First, equity is divided into pre-acquisition and post-acquisition equity. Where a reporting entity acquires an investment in a foreign operation, then the equity recorded by the foreign operation at acquisition date is pre-acquisition equity. Equity earned by the foreign operation subsequent to acquisition date is post-acquisition equity. If a reporting entity establishes a foreign operation, the equity used to form the foreign operation is pre-acquisition equity. Second, movements in other reserves and retained earnings constituting transfers within equity are treated differently from other reserves such as asset revaluation surpluses which are created by the application of the revaluation model. Share capital: the capital is translated at the rate existing at acquisition or investment. Other reserves: if pre-acquisition, the reserves are translated at the rate existing at acquisition date. If the reserves are post-acquisition and result from internal transfers, the rate used is that current at the date the amounts transferred were originally recognised in equity. If the reserves are post-acquisition and not created from internal transfers, the rate used is that current at the date the reserves are first recognised in the accounts. Retained earnings: if pre-acquisition, the retained earnings are translated at the rate of exchange current at the acquisition date. Post-acquisition profits are carried forward balances from translation of previous periods’ statements of profit or loss and other comprehensive income.

7. How are foreign exchange gains and losses calculated when translating from local currency to functional currency? Exchange differences arise from translating the foreign operation’s monetary items at current rates while the non-monetary items are translated using an historical rate. For non-monetary items exchange differences arise only when they are sold or exchanged. Hence, exchange differences are calculated by examining movements in the monetary items over the period. 8. What is meant by ‘presentation currency’? Paragraph 8 of AASB 121/IAS 21 states that presentation currency is the currency in which the financial statements are presented.

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9. How are statement of comprehensive income items translated from functional currency to presentation currency? Revenues and expenses: these are translated at the rates current at the applicable transaction dates. For items that occur regularly throughout the period, such as purchases of inventories and sales, for practical reasons average or standard rates that approximate the relevant rates may be employed. In relation to items such as depreciation, which are allocations for a period, even though they may be recognised in the accounts only at year-end (because they reflect events occurring throughout the period) an average-for-the-period exchange rate may be used. Dividends paid/declared: these are translated at the rates current when the dividends were paid or declared. Transfer to/from reserves: if these are transfers internal to equity, the rate used for the transfer and the reserve created is the rate existing when the amounts transferred were originally recognised in equity.

10. How are statement of financial position items translated from functional currency to presentation currency? Assets: all assets, whether current or non-current, monetary or non-monetary, are translated at the closing rate, which is the exchange rate current at the end of the reporting period. This includes all contra-asset accounts such as accumulated depreciation and allowance for doubtful debts. Liabilities: all liabilities are translated at the same rate as for assets, namely the closing rate current at the end of the reporting period. Equity: in selecting the appropriate exchange rate, two factors are important. First, equity is divided into pre-acquisition and post-acquisition equity. Where a reporting entity acquires an investment in a foreign operation, then the equity recorded by the foreign operation at acquisition date is pre-acquisition equity. If a reporting entity establishes a foreign operation, the equity used to form the foreign operation is pre-acquisition equity. Equity earned by the foreign operation subsequent to acquisition date is post-acquisition equity. Second, movements in other reserves and retained earnings constituting transfers within equity are treated differently from other reserves such as asset revaluation surpluses which are created by the application of the revaluation model. Share capital: if on hand at acquisition date or created by investment, this is translated at the rate current at acquisition date or investment. If created by transfer from a reserve, such as general reserve via a bonus issue, this is translated at the rate current at the date the amounts transferred were originally recognised in equity. Other reserves: if on hand at acquisition date, these are translated at the exchange rate existing at acquisition date. If reserves are post-acquisition and created by an internal transfer within equity, they are translated at the rate existing at the date the reserve from which the transfer was made was originally recognised in the accounts. If post-acquisition and not the

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result of an internal transfer (e.g. an asset revaluation surplus), the rate used is that current at the date the reserve is recognised in the accounts. Retained earnings: if on hand at acquisition date, they are translated at the exchange rate existing at acquisition. Post-acquisition profits are carried forward balances from translation of previous periods’ statements of profit or loss and other comprehensive income.

11. What causes a foreign currency translation reserve to arise? A foreign currency translation reserve will arise when the financial statements are translated into the presentation currency. It arises because income and expense items are translated at dates of the transactions and not the closing rate, and in the case of a net investment in a foreign operation where the opening net assets are translated at an exchange rate different from the closing rate.

12. Why are gains/losses on translation taken to a foreign currency translation reserve rather than to profit and loss for the period? According to paragraph 41 of AASB 121/IAS 21, these exchange differences have little or no direct effect on the present and future cash flows from operations. Movements in the foreign currency translation reserve are, however, shown as part of other comprehensive income for the period.

13. Discuss the differences in the translation process when translating from a local currency to a functional currency compared with translating from a functional currency to a presentation currency. Note paragraph 23 of AASB 121/IAS 21 for functional currency translation. Note paragraph 39 of AASB 121/IAS 21 for presentation currency translation. In relation to the income statement, there is little difference in that in both cases, most revenues and expenses are translated at the average rate for the period. Differences will occur in relation to depreciation. In relation to share capital, no differences occur in translation. In relation to the statement of financial position, there is no difference in translation of the monetary items as current rates are always used. With non-monetary items, functional currency translation for items measured in terms of historical cost are translated at historical rates, while for presentation translation current rates are used. For non-monetary items measured at fair value, current rates are always used. Note that for a functional currency translation, exchange differences on monetary items are recognised in profit or loss [paragraph 28] while presentation translation results in exchange differences being recognised in other comprehensive income [paragraph 39].

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Chapter 24: Translation of the financial statements of foreign entities

Case studies Case study 24.1 Financial reporting In Note 29 (p. 87) of the 2018 annual report of the Qantas Group, the following information is provided. (D) FOREIGN CURRENCY i. Foreign Currency Transactions Transactions in foreign currencies are translated into the respective functional currencies of the Group’s companies at the exchange rates at the date of the transactions. Monetary assets and liabilities denominated in foreign currencies are translated into the functional currency at the exchange rate at the reporting date. Nonmonetary assets and liabilities that are measured at fair value in a foreign currency are translated into the functional currency at the exchange rate when the fair value was determined. Non-monetary items that are measured based on historical cost in a foreign currency are translated at the exchange rate at the date of the transactions. Foreign currency differences are generally recognised in the Consolidated Income Statement. ii. Foreign Operations The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, are translated into AUD at the exchange rates at the reporting date. The income and expenses of foreign operations are translated into AUD at the exchange rates at the date of the transactions. Foreign currency differences are recognised in the Consolidated Statement of Comprehensive Income and accumulated in the Foreign Currency Translation Reserve, except to the extent that the translation difference is allocated to noncontrolling interests. When a foreign operation is disposed of in its entirety or partially such that control, significant influence or joint control is lost, the cumulative amount in the Foreign Currency Translation Reserve related to that foreign operation is reclassified to the Consolidated Income Statement as part of the gain or loss on disposal. If the Group disposes of part of its interests in a subsidiary but retains control, then the relevant proportion of the cumulative amount is reattributed to non-controlling interests. When the Group disposes of only part of an associate or joint venture while retaining significant influence or joint control, the relevant proportion of the cumulative amount is reclassified to the Consolidated Income Statement. Required Explain this note to a reader of the Qantas report.

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This note is concerned with the financial statements of foreign entities controlled by Qantas. These financial statements have probably been prepared in a currency other than the A$. The note does not tell us anything about the functional currencies of the overseas operations but is concerned with the translation of the foreign operations’ financial statements into A$, the functional currency of Qantas Group so that can be included in the consolidated financial statements of the Qantas Group. A$ is also the presentation currency of the group. The method used to translate a functional currency into a presentation currency involves the following translation process: Assets: all assets, whether current or non-current, monetary or non-monetary, are translated at the reporting date (closing rate). This includes all contra-asset accounts such as accumulated depreciation and allowance for doubtful debts. Liabilities: all liabilities are translated at the same rate as for assets, namely the closing rate current at the end of the reporting period. Equity: in selecting the appropriate exchange rate, two factors are important. First, equity is divided into pre-acquisition and post-acquisition equity. Where a reporting entity acquires an investment in a foreign operation, then the equity recorded by the foreign operation at acquisition date is pre-acquisition equity. If a reporting entity establishes a foreign operation, the equity used to form the foreign operation is pre-acquisition equity. Equity earned by the foreign operation subsequent to acquisition date is post-acquisition equity. Second, movements in other reserves and retained earnings constituting transfers within equity are treated differently from other reserves such as asset revaluation surpluses which are created by the application of the revaluation model. Share capital: if on hand at acquisition date or created by investment, this is translated at the rate current at acquisition date or investment. If created by transfer from a reserve, such as general reserve via a bonus issue, this is translated at the rate current at the date the amounts transferred were originally recognised in equity. Other reserves: if on hand at acquisition date, these are translated at the exchange rate existing at acquisition date. If reserves are post-acquisition and created by an internal transfer within equity, they are translated at the rate existing at the date the reserve from which the transfer was made was originally recognised in the accounts. If post-acquisition and not the result of an internal transfer (e.g. an asset revaluation surplus), the rate used is that current at the date the reserve is recognised in the accounts. Retained earnings: if on hand at acquisition date, they are translated at the exchange rate existing at acquisition. Post-acquisition profits are carried forward balances from translation of previous periods’ statements of profit or loss and other comprehensive income. Revenues and expenses: these are translated at the rates current at the applicable transaction dates. For items that occur regularly throughout the period, such as purchases of inventories and sales, for practical reasons average or standard rates that approximate the relevant rates may be employed. In relation to items such as depreciation, which are allocations for a period, even though they may be recognised in the accounts only at year-end (because they

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reflect events occurring throughout the period) an average-for-the-period exchange rate may be used. Dividends paid/declared: these are translated at the rates current when the dividends were paid or declared. Transfer to/from reserves: if these are transfers internal to equity, the rate used for the transfer and the reserve created is the rate existing when the amounts transferred were originally recognised in equity. Under this translation method, exchange differences arise because the opening net assets are translated at a rate different from the closing rate while revenues/expenses are translated at rates different from the closing rate. These exchange differences are not recognised in profit or loss. They are recognised in other comprehensive income and transferred to a foreign currency translation reserve account.

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Case study 24.2 Financial reporting In its 2018 annual report (p. 135), Wesfarmers Limited notes all subsidiaries (with some exceptions) are incorporated in Australia and therefore produce their financial statements in Australian dollars. However, there are a number of subsidiaries that were not incorporated in Australia and therefore adopt the functional currency of the country of incorporation. For example, Bunnings (NZ) Ltd for which the functional currency is the New Zealand dollar (NZD), and Wesfarmers Risk Management (Singapore) Pte Ltd for which the functional currency is the Singapore dollar (SGD). Required Discuss the translation process that will occur so that these subsidiaries can be included in the consolidated financial statements of Wesfarmers Limited. The financial statements of foreign operations are being prepared in their functional currencies, generally the currency of the country in which the country operates e.g. New Zealand or Singapore. In order to include the financial statements prepared in a functional currency other than the A$, they must be translated into the presentation currency of A$. This process involves the following translation process: Assets: all assets, whether current or non-current, monetary or non-monetary, are translated at the closing rate, which is the exchange rate current at the end of the reporting period. This includes all contra-asset accounts such as accumulated depreciation and allowance for doubtful debts. Liabilities: all liabilities are translated at the same rate as for assets, namely the closing rate current at the end of the reporting period. Equity: in selecting the appropriate exchange rate, two factors are important. First, equity is divided into pre-acquisition and post-acquisition equity. Where a reporting entity acquires an investment in a foreign operation, then the equity recorded by the foreign operation at acquisition date is pre-acquisition equity. If a reporting entity establishes a foreign operation, the equity used to form the foreign operation is pre-acquisition equity. Equity earned by the foreign operation subsequent to acquisition date is post-acquisition equity. Second, movements in other reserves and retained earnings constituting transfers within equity are treated differently from other reserves such as asset revaluation surpluses which are created by the application of the revaluation model. Share capital: if on hand at acquisition date or created by investment, this is translated at the rate current at acquisition date or investment. If created by transfer from a reserve, such as general reserve via a bonus issue, this is translated at the rate current at the date the amounts transferred were originally recognised in equity. Other reserves: if on hand at acquisition date, these are translated at the exchange rate existing at acquisition date. If reserves are post-acquisition and created by an internal transfer within equity, they are translated at the rate existing at the date the reserve from which the © John Wiley and Sons Australia Ltd, 2020

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transfer was made was originally recognised in the accounts. If post-acquisition and not the result of an internal transfer (e.g. an asset revaluation surplus), the rate used is that current at the date the reserve is recognised in the accounts. Retained earnings: if on hand at acquisition date, they are translated at the exchange rate existing at acquisition. Post-acquisition profits are carried forward balances from translation of previous periods’ statements of profit or loss and other comprehensive income. Revenues and expenses: these are translated at the rates current at the applicable transaction dates. For items that occur regularly throughout the period, such as purchases of inventories and sales, for practical reasons average or standard rates that approximate the relevant rates may be employed. In relation to items such as depreciation, which are allocations for a period, even though they may be recognised in the accounts only at year-end (because they reflect events occurring throughout the period) an average-for-the-period exchange rate may be used. Dividends paid/declared: these are translated at the rates current when the dividends were paid or declared. Transfer to/from reserves: if these are transfers internal to equity, the rate used for the transfer and the reserve created is the rate existing when the amounts transferred were originally recognised in equity. Under this translation method, exchange differences arise because the opening net assets are translated at a rate different from the closing rate while revenues/expenses are translated at rates different from the closing rate. These exchange differences are not recognised in profit or loss. They are recognised in other comprehensive income and transferred to a foreign currency translation reserve account.

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Note: Case studies 24.3 and 24.4 are adapted Radford (1996). Case study 24.3 Determination of functional currency Case A A Malaysian operation manufactures a product using Malaysian materials and labour. Specialised equipment and senior operations staff are supplied by its Australian parent. Reimbursement invoices for these services are denominated in the Malaysian ringgit. The product is sold in the Malaysian market at a price, denominated in Malaysian ringgit, which is determined by competition with similar locally produced products. The foreign operation retains sufficient cash to meet wages and day-to-day operating costs and further investment needs, with only a very small amount being paid as dividends to the Australian parent. The receipt of dividends from the foreign operation is not important to the parent’s cash management function. Long-term financing is arranged and serviced by the Malaysian operation. Case B A Korean operation is a wholly owned subsidiary of an Australian company which regards the operation as a long-term investment, and thus takes no part in the day-today decision making of the operation. The operation purchases parts from various nonrelated Australian manufacturers for assembly by Korean labour. The finished product is exported to a number of countries but South Korea is still the major market. Consequently, sales prices are mainly determined by competition within South Korea. Required In relation to these cases, discuss the choice of a functional currency. In answering this question, reference must be made to: • •

The definition of functional currency in paragraph 8 of AASB 121/IAS 21, particularly noting the need to identify the “primary economic environment”. The factors in paragraphs 9-11 of AASB 121/IAS 21, with paragraph 9 containing the primary indicators.

Case A The choice for functional currency is the Australian dollar or the Malaysian ringgit. Note: • Malaysian materials and labour are used. • Specialised equipment & senior operations staff are supplied by Australia, but invoices are denominated in Malaysian ringgit. • Selling prices is determined by local competition in Malaysia. • Dividends are paid to Australian parent. • The Malaysian operation arranges its own long-term finance. Relating this to AASB 121/IAS 21:

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Paragraph 9(a)(i):

the Malaysian ringgit influences sales prices and is the currency in which goods and services are settled. Paragraph 9(a)(ii): the Malaysian ringgit is the currency whose competitive forces and regulations mainly determine sales prices. Paragraph 9(b): the Malaysian ringgit is the currency that mainly influences labour, material and other costs. Paragraph 10: financing is provided in Malaysian ringgit. Paragraph 11: the activities are not an extension of the parent. the cash flows from the activities of the foreign operation do not significantly affect the cash flows of the reporting entity. The primary indicators are those in paragraph 9 of AASB 121/IAS 21. It is concluded here that the functional currency is the Malaysian ringgit. Case B The choice for functional currency is the Australian $ or the Korean currency. Note: • The operation is a long-term investment of the parent. • The parent does not participate in daily management decisions of the subsidiary. • Inputs are from Australia and based on $A. • Labour costs are denominated in the Korean currency. • Sales revenue is denominated in the Korean currency. • Selling prices is determined by local competition in South Korea. Relating this to AASB 121/IAS 21: Paragraph 9(a)(i): the Korean currency mainly influences sales prices. Paragraph 9(a)(ii): South Korean competitive forces & regulations affect sales prices. Paragraph 9(b): A$ influences material inputs, while Korean currency influences labour costs. Based on paragraph 9 of AASB 121/IAS 21, the functional currency is the Korean currency.

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Case study 24.4 Determination of functional currency Case A An Indonesian operation manufactures a product using Indonesian materials and labour. Patented processes and senior operations staff are supplied by its Australian parent. Reimbursement invoices for these services are denominated in Australian dollars. The product is sold in the Australian market at a price, denominated in Australian dollars, that is determined by competition with similar locally produced products. The Indonesian operation remits all revenue to the Australian parent, retaining only sufficient cash to meet wages and day-to-day operating costs. The receipt of cash from the Indonesian operation is important to the parent’s cash management function. Long-term financing is arranged and serviced by the parent. Case B A New Zealand operation is a wholly owned subsidiary of an Australian company. The parent regards the operation as a strategic investment and all financial and operational decisions are made by Australian management. The New Zealand operation purchases parts from various non-related Australian manufacturers for assembly in New Zealand. The finished product is exported to a number of countries with Australia as the major market. Consequently, sales prices are determined by competition within Australia. Required In relation to these cases, discuss which currency is the functional currency of the foreign entity. In answering this question reference must be made to: • The definition of functional currency in paragraph 8 of AASB 121/IAS 21, particularly noting the need to identify the “primary economic environment”. • The factors in paragraphs 9-11 of AASB 121/IAS 21, with paragraph 9 containing the primary indicators. Case A The functional currency is either Indonesian rupiah or Australian dollars. Note: • Indonesian materials and labour are used. • Processes & staff supplied from Australia and denominated in A$. • Product is sold in Australia and the prices are determined by local competition in Australia. • All profits remitted to Australia. • Long-term financing provided by parent. Relating this to AASB 121/IAS 21: Paragraph 9(a): Australian dollar influences sales prices. Australian competitive forces and regulations affect sales prices. Paragraph 9(b): Some costs are denominated in A$ and others in rupiah. Paragraph 10(a): Long-term financing is in A$. © John Wiley and Sons Australia Ltd, 2020

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Paragraph 10(b): Paragraph 11:

Operating activities usually denominated in rupiah. Activities do not have a degree of autonomy – all decisions are taken by the Australian parent. Cash flows from the foreign operation significantly affect Australian parent.

The functional currency seems to be the Australian dollar, particularly given evidence provided in accordance with paragraph 9’s indicators. Case B The functional currency is either the New Zealand dollar or the Australian dollar. Note: • Managed from Australia. • Parts are supplied from Australia. • Assembly is in NZ. • Australia is major market. • Sales prices determined by Australian market forces. Relating this to AASB 121/IAS 21: Paragraph 9(a): A$ influences sales prices. Australian competitive forces & regulations affect sales prices. Paragraph 9(b): Input costs are mixed A$ and NZ$. Paragraph 11: Not much autonomy for NZ operation. The functional currency seems to be the Australian dollar, particularly given evidence provided in accordance with paragraph 9’s indicators.

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Case study 24.5 Determination of functional currency Foreign Ltd is a Queensland software developer that specialises in software that controls the operations of open cut mining. To exploit opportunities in the US market, the firm has established a wholly owned subsidiary operating in Atlanta, Georgia. The operations of the subsidiary (Opencut Inc.) essentially involve the marketing of software initially developed in Australia but which is further developed by the US subsidiary to suit the special requirements of particular US customers. Foreign Ltd does not charge Opencut Inc. for the software successfully amended and marketed in the United States. At this stage no dividends have been paid by Opencut Inc; however, it is expected that dividends will commence within 12 months. With respect to working capital, Opencut Inc. has a ‘revolving credit’ agreement (overdraft facility) with the Bank of Georgia, which has been guaranteed by the Australian parent. Required Discuss the process of translating the financial statements of Opencut Inc. for consolidation with Foreign Ltd. Step 1 is to determine the functional currency which is either the A$ or the US$. Note: • Product is developed in Australia. • Further costs of development and marketing occur in the US. • Sales are to US customers. • Finance is provided in US dollars. Relating this to AASB 121/IAS 21: Paragraph 9(a):

Paragraph 9(b): Paragraph 10: Paragraph 11:

the US$ influences sales prices. the US is the country whose regulations and competitive forces determine the sales price. the main input costs are in A$. finances are in US$. Receipts from operating activities are retained in US$. Not a great deal of autonomy.

The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. In this example, the country in which the cash is generated is the US, while the country in which it expends the most cash for developing the product is Australia. Given that further costs are incurred in the US (and proportion is unknown), and the fact that financing is based on US$, the functional currency is probably the US dollar.

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Chapter 24: Translation of the financial statements of foreign entities

Case study 24.6 Determination of functional currency Victory Ltd is an Australian company with two overseas subsidiaries, one in Indonesia and the other in South Korea. The Indonesian subsidiary has as its major activity the distribution in Indonesia of Victory Ltd’s products. It has been agreed that the subsidiary will, for a period of time, retain all profits in order to expand its distribution network in Indonesia. In the past it has remitted most of its profits to the Australian parent company. The South Korean subsidiary has been established to manufacture a range of products for the South-East Asian market. There is also an expectation that it could in the future become the major manufacturing plant for Victory Ltd and provide a supply of products for the Australian market. Required Based on the above, determine the functional currency of the foreign subsidiaries. Explain your choice. In answering this question, reference must be made to: • The definition of functional currency in paragraph 8 of AASB 121/IAS 21, particularly noting the need to identify the “primary economic environment”. • The factors in paragraphs 9-11 of AASB 121/IAS 21, with paragraph 9 containing the primary indicators. In relation to the Indonesian subsidiary: • Products are supplied from Australia. • Profits may be retained in Indonesia. • Sales are made in Indonesia. Relating this to AASB 121/IAS 21: Paragraph 9: The Indonesian currency influences sales prices and Indonesia is the country whose competitive forces and regulations mainly determine sales prices. The Australian dollar mainly influences input costs. Paragraph 10: The Indonesian rupiah is the currency in which receipts from operating activities are usually retained. Paragraph 11: The activities of the foreign operation are carried out as an extension of the reporting entity. It is concluded that the functional currency is the Australian dollar. In relation to the South Korean subsidiary: • Products are manufactured in South Korea. • Sales are made in South-East Asia, maybe including Korea. • The subsidiary could supply products for sale in Australia in the future. Relating this to AASB 121/IAS 21:

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Paragraph 9: Not sufficient information is given to determine where major sales occur, but indications are that sales are made in many Asian countries. The South Korean currency influences input costs. Paragraph 10: Receipts from operating activities are kept in South Korean currency. Paragraph 11: Subsidiary is not just an extension of parent. Functional currency is South Korean currency. It’s unlikely that this would change even if eventually sales of products are made in Australia, as the latter would be only one of the markets serviced by the subsidiary.

24.19

Chapter 24: Translation of the financial statements of foreign entities

Application and analysis questions Exercise 24.1 Multiple choice Select the best answer for each of the following items. 1. The account balances of a foreign subsidiary are to be translated from the local currency into the functional currency. The functional currency is: (a) the currency in which the transactions are recorded by the foreign entity. (b) the Australian dollar. (c) the local currency of the foreign subsidiary in which the records are maintained. (d) the currency of the primary economic environment in which the entity operates. 2. When the functional currency of a foreign subsidiary in Singapore is the Australian dollar (A$), translation gains and losses resulting from translating the financial statements of the Singapore subsidiary into A$ for presentation purposes should be included: (a) in the statement of profit or loss and other comprehensive income in the period in which they arise. (b) in other comprehensive income and accumulated in equity. (c) as a deferred item in the statement of financial position. 3. In order to translate the financial statements of a foreign subsidiary into Australian dollars for consolidation of those statements with those of the parent, it is necessary to identify the functional currency. Which of the following factors indicates that the functional currency is the local currency of the foreign subsidiary? (a) financing of the subsidiary is primarily from local sources. (b) sales contracts are determined in Australian dollars. (c) there is a high volume of transactions between the two entities. (d) profits generated by the foreign subsidiary are remitted to the Australian parent entity. 4. The temporal method is being applied to translate the financial statements of a foreign entity into its functional currency. The historical exchange rate should be used to translate: (a) plant measured at cost, but not the related depreciation expense and accumulated depreciation. (b) plant measured at cost and the related accumulated depreciation, but not the related depreciation expense. (c) plant measured at cost, the related accumulated depreciation and the related depreciation expense. (LO2, LO3 and LO4) 1. (d) 2. (b)

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3. (a) 4. (c)

24.21

Chapter 24: Translation of the financial statements of foreign entities

Exercise 24.2 Identifying the exchange rate The accounts listed below are those for Sentosa Ltd, a foreign subsidiary in Singapore, that maintains its accounting records in Singapore dollars (S$). The parent is an Australian company, Dreamscapes Ltd. In the spaces provided indicate the exchange rates that would be applied in translating the accounts shown in the accounting statements of the Singapore subsidiary into Australian dollars (A$) assuming: (a) the functional currency is the A$ (b) the functional currency is the S$ Use the following letters to identify the appropriate exchange rate: H — historical exchange rate C — current exchange rate A — average exchange rate for the current period Exchange rate if the functional currency is: Account

Cash Prepaid expenses Inventories at cost Inventories at net realisable value Plant at cost Accumulated depreciation — plant Goodwill Accounts payable Debentures Capital Sales Wages expense Depreciation expense (LO3)

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DREAMSCAPES LTD – SENTOSA LTD H — historical exchange rate C — current exchange rate at the end of the current period A — average exchange rate for the current period.

Cash Prepaid expenses Inventory at cost Inventory at NRV Plant at cost Accumulated depreciation – plant Goodwill Accounts payable Debentures Capital Sales Wages expense Depreciation expense

A$ is functional currency C H H C H H H C C H A A H

Foreign currency S$ is functional currency C C C C C C C C C H A A C

24.23

Chapter 24: Translation of the financial statements of foreign entities

Exercise 24.3 Translation into functional currency Jurong Ltd, a company incorporated in Singapore, acquired all the issued shares of Victoria Ltd, a Hong Kong company, on 1 July 2022. The trial balance of Victoria Ltd at 30 June 2023 was: HK$ Dr Share capital Retained earnings (1/7/22) General reserve Payables Deferred tax liability Current tax liability Provisions Sales Proceeds on sale of land Accumulated depreciation — plant Plant Land Cash Accounts receivable Inventories at 1 July 2022 Purchases Depreciation — plant Carrying amount of land sold Income tax expense Other expenses

HK$ Cr 400 000 120 000 50 000 80 000 60 000 10 000 40 000 305 000 125 000 170 000

460 000 200 000 120 000 150 000 30 000 130 000 78 000 100 000 25 000 67 000 1 360 000

1 360 000

Additional information • Exchange rates based on equivalence to HK$1 were as follows. S$ 1 July 2022 8 October 2022 1 December 2022 1 January 2023

0.20 0.25 0.28 0.30

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2 April 2023 30 June 2023 Average for last quarter 2022–23 Average for 2022–23 • • • • •

0.27 0.22 0.24 0.26

Inventories were acquired evenly throughout the year. The closing inventories of HK$30 000 were acquired during the last quarter of the year. Sales and other expenses occurred evenly throughout the year. The Singapore tax rate is 20%. The land on hand at the beginning of the year was sold on 8 October 2022. The land on hand at the end of the year was acquired on 1 December 2022. Movements in plant over the year ended 30 June 2023 were as follows. HK$

Plant at 1 July 2022 Acquisitions — 8 October 2022 — 2 April 2023

300 000 100 000 60 000

Plant at 30 June 2023

460 000

Depreciation on plant is measured at 20% p.a. on cost. Where assets are acquired during a month, a full month’s depreciation is charged. • The functional currency of Victoria Ltd is the Singaporean dollar. Required 1. Prepare the financial statements of Victoria Ltd in Singaporean dollars at 30 June 2023. 2. Verify the foreign currency translation adjustment. (LO4 and LO5) 1. Sales Cost of sales: Opening inventory Purchases Closing inventory Gross profit Proceeds of land sold Carrying amount of land sold Gain on sale Expenses: Depreciation

Other

HK$ 305 000

Rate 0.26

S$ 79 300

30 000 130 000 160 000 30 000 130 000 175 000

0.20 0.26

6 000 33 800 39 800 7 200 32 600 46 700

125 000 100 000 25 000 200 000

0.25 0.20

31 250 20 000 11 250 57 950

60 000 15 000 3 000 67 000

0.20 0.25 0.27 0.26

12 000 3 750 810 17 420

0.24

24.25

Chapter 24: Translation of the financial statements of foreign entities

145 000 55 000 FC translation gain/(loss) Profit before income tax Income tax expense Profit Retained earnings (op) Retained earnings (cl) Share capital General reserve Plant

Accumulated depreciation

Land Inventory Cash Accounts receivable Total assets Payables Deferred tax liability Current tax liability Provisions Total liabilities Net assets

25 000 30 000 120 000 150 000 400 000 50 000 600 000 300 000 100 000 60 000 (92 000) (60 000) (15 000) (3 000) 200 000 30 000 120 000 150 000 790 000 80 000 60 000 10 000 40 000 190 000 600 000

0.26 0.20 0.20 0.20 0.20 0.25 0.27 0.20 0.20 0.25 0.27 0.28 0.24 0.22 0.22 0.22 0.22 0.22 0.22 0.22

33 980 23 970 15 570 39 540 6 500 33 040 24 000 57 040 80 000 10 000 147 040 60 000 25 000 16 200 (18 400) (12 000) (3 750) (810) 56 000 7 200 26 400 33 000 188 840 17 600 13 200 2 200 8 800 41 800 147 040

2. Verification of translation adjustment: Net monetary assets at 1/7/22 Increases: Sales Proceeds – land Decreases: Purchases Land Plant Other expenses Tax Net monetary assets at 30/6/23

* opening balance sheet was: Share capital Retained earnings General reserve Plant Accumulated depreciation Land

232 000*

0.22 – 0.20

4 640

305 000 125 000 662 000

0.22 – 0.26 0.22 – 0.25

(12 200) (3 750) (11 310)

130 000 200 000 100 000 60 000 67 000 25 000 582 000 80 000

0.22 – 0.26 0.22 – 0.28 0.22 – 0.25 0.22 – 0.27 0.22 – 0.26 0.22 – 0.26

5 200 12 000 3 000 3 000 2 680 1 000 26 880 15 570

HK$ 400 000 120 000 200 000 570 000 300 000 (92 000) 100 000

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Inventory Net monetary assets

30 000 232 000 570 000

24.27

Chapter 24: Translation of the financial statements of foreign entities

Exercise 24.4 Translation into functional and presentation currency Perth Ltd is a manufacturer of sheepskin products in Australia. It is a wholly owned subsidiary of a Singapore company, Kowloon Ltd. The following assets are held by Perth Ltd at 30 June 2022.

Plant: Tanner Benches Presses

Cost A$ 40 00 0 20 00 0 70 00 0

Useful life(year s)

Acquisition date

Exchange rate on acquisition date (A$1 = HK$)

10/8/18

5.4

8/3/20

5.8

6/10/21

6.2

Plant is depreciated on a straight-line basis, with zero residual values. All assets acquired in the first half of a month are allocated a full month’s depreciation. Inventories: • At 1 July 2021, the inventories on hand of A$25 000 was acquired during the last month of the period ended 30 June 2021. • Inventories acquired during the period ended 30 June 2022 was acquired evenly throughout the period. Total purchases of A$420 000 were acquired during that period. • The inventories of A$30 000 on hand at 30 June 2022 was acquired during June 2022. Relevant exchange rates (quoted as A$1 = HK$) are as follows. Average for June 2021 1 July 2021 Average for 2021–22 Average for June 2022 Average for October 2021 – June 2022 30 June 2022

7.2 7.0 7.5 7.7 7.6 7.8

Required 1. Assuming the functional currency for Perth Ltd is the A$, calculate: (a) the balances for the plant items and inventories in HK$ at 30 June 2022. (b) the depreciation and cost of sales amounts in HK$ in the statement of profit or loss and other comprehensive income for the period ended 30 June 2022. 2. Assuming the functional currency is the HK$ and the presentation currency is $A, calculate: (a) the balances for the plant items and inventories in HK$ at 30 June 2022 (b) the depreciation and cost of sales amounts in HK$ in the statement of profit or

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loss and other comprehensive income for the period ended 30 June 2022. (LO4 and LO5) PERTH LTD – KOWLOON LTD 1. The functional currency for Perth Ltd is the A$: (a) A$

Rate

HK$

Tanner Accumulated depreciation (40 000 x 47/60)

40 000

7.8

312 000

31 333

7.8

244 400

Benches Accumulated depreciation (20 000 x 28/96)

20 000

7.8

156 000

5 833

7.8

45 500

Presses Accumulated depreciation (70 000 x 9/84)

70 000

7.8

546 000

7 500

7.6

57 000

30 000

7.8

8 000 2 500 7 500

7.5 7.5 7.5

60 000 18 750 56 250

25 000 420 000 445 000 30 000 415 000

7.2 7.5

180 000 3 150 000 3 330 000 231 000 3 099 000

HK$

Plant

Inventory

67 600

110 500

489 000 667 100 234 000

(b) Depreciation: Tanner: 1/5 x 40 000 Benches: 1/8 x 20 000 Presses: 1/7 x 70 000 x 9/12 Cost of sales: Opening stock Purchases Closing stock

7.7

135 000

2. The functional currency for Perth Ltd is the HK$: (a) A$

Rate

HK$

Tanner Accumulated depreciation (40 000 x 47/60)

40 000

5.4

216 000

31 333

5.4

169 200

Benches Accumulated depreciation

20 000

5.8

116 000

HK$

Plant

46 800

24.29

Chapter 24: Translation of the financial statements of foreign entities

(20 000 x 28/96)

5 833

5.8

33 832

Presses Accumulated depreciation (70 000 x 9/84)

70 000

6.2

434 000

7 500

6.2

46 500

30 000

7.7

8 000 2 500 7 500

5.4 5.8 6.2

43 200 14 500 46 500

25 000 420 000 445 000 30 000 415 000

7.2 7.5

180 000 3 150 000 3 330 000 231 000 3 099 000

Inventory

82 168

387 500 516 468 231 000

(b) Depreciation: Tanner: 1/5 x 40 000 Benches: 1/8 x 20 000 Presses: 1/7 x 70 000 x 9/12 Cost of sales: Opening stock Purchases Closing stock

7.7

104 200

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Exercise 24.5 Translation into functional currency On 1 July 2023, Orbost Ltd, an Australian company, acquired the issued shares of Chicago Ltd, a company incorporated in the United States. The draft statements of profit or loss and other comprehensive income and statement of financial position of Chicago Ltd at 30 June 2024 were as follows. US$

US$ 4 800 000

Sales revenues Cost of sales: Opening inventories Purchases

420 000 2 520 000

Closing inventories

2 940 000 840 000

2 100 000 2 700 000

Gross profit Expenses: Depreciation Other

270 000 810 000

1 080 000

Profit before income tax Income tax expense

1 620 000 600 000

Profit Retained earnings as at 1 July 2023

1 020 000 600 000 1 620 000 360 000 600 000

Dividend paid Dividend declared

960 000 660 000

Retained earnings as at 30 June 2024

2024 US$

2023 US$

Current assets: Inventories Accounts receivable Cash

840 000 60 000 60 000

420 000 390 000 1 710 000

Total current assets

960 000

2 520 000

Non-current assets: © John Wiley and Sons Australia Ltd, 2020

24.31

Chapter 24: Translation of the financial statements of foreign entities

Patent Plant Accumulated depreciation Land Buildings

240 000 2 160 000 (390 000) 1 500 000 2 760 000

240 000 1 800 000 (240 000) 900 000 2 460 000

Accumulated depreciation

(360 000)

(240 000)

Total non-current assets

5 910 000

4 920 000

Total assets Current liabilities: Provisions Dividends payable Accounts payable

6 870 000

7 440 000

900 000 600 000 960 000

1 860 000 — 2 820 000

Total current liabilities Non-current liabilities: Loan from Orbost Ltd

2 460 000

4 680 000

1 590 000

—

Total liabilities

4 050 000

4 680 000

Net assets

2 820 000

2 760 000

Equity: Share capital Retained earnings

2 160 000 660 000

2 160 000 600 000

Total equity

2 820 000

2 760 000

Additional information • On 1 January 2024, Chicago Ltd acquired new plant for US$120 000. This plant is depreciated over a 5-year period. • On 1 April 2024, Chicago Ltd acquired US$200 000 worth of land. • On 1 October 2023, Chicago Ltd acquired US$100 000 worth of new buildings. These buildings are depreciated evenly over a 10-year period. • The interim dividend was paid on 1 January 2024, half of which was from profits earned prior to 1 July 2023, while the dividend payable was declared on 30 June 2024. • Sales, purchases and expenses occurred evenly throughout the period. The inventories on hand at 30 June 2024 were acquired during June 2024. • The loan of US$530 000 from Orbost Ltd was granted on 1 July 2023. The interest rate is 8% p.a. Interest is paid on 30 June and 1 January each year. • The exchange rates for the financial year were as follows.

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US$1 = A$ 1 July 2023 1 October 2023 1 January 2024 1 April 2024 30 June 2024 Average for October 2023 – June 2024 Average for June 2024 Average for 2023–24

2.00 1.80 1.70 1.60 1.50 1.65 1.52 1.75

Required 1. If the functional currency for Chicago Ltd is the Australian dollar, prepare the financial statements of Chicago Ltd at 30 June 2024 in the functional currency. 2. Verify the foreign currency translation adjustment. (LO4) ORBOST LTD – CHICAGO LTD 1. Translation to functional currency: US$ Sales Cost of sales: Opening stock Purchases Closing inventory Gross profit Depreciation: Plant - Old Plant - New Buildings - Old Buildings - New Interest Other expenses

Foreign exchange gain/(loss) Profit before income tax Income tax expense Profit for the period

4 800 000

Exchange rate 1.75

420 000 2 520 000 2 940 000 840 000 2 100 000 2 700 000

2.00 1.75

114 000 36 000 97 500 22 500 63 600 63 600 682 800 1 080 000

2.00 1.70 2.00 1.80 1.70 1.50 1.75

1 620 000 600 000 1 020 000 © John Wiley and Sons Australia Ltd, 2020

1.52

1.75

A$ 8 400 000 840 000 4 410 000 5 250 000 1 276 800 3 973 200 4 426 800 228 000 61 200 195 000 40 500 108 120 95 400 1 194 900 1 923 120 2 503 680 1 347 420 3 851 100 1 050 000 2 801 100 24.33

Chapter 24: Translation of the financial statements of foreign entities

Retained earnings at 1 July 2023 Dividend paid Dividend declared Retained earnings at 30 June 2021 Share capital Loan from Orbost Ltd Provisions Dividends payable Accounts payable Inventory Accounts receivable Cash Patent Plant Accumulated depreciation Land Buildings Accumulated depreciation

600 000 1 620 000 360 000 600 000 960 000 660 000 2 160 000 1 590 000 900 000 600 000 960 000 6 870 000 840 000 60 000 60 000 240 000 1 800 000 360 000 (354 000) (36 000) 900 000 600 000 2 460 000 300 000 (337 500) (22 500) 6 870 000

2.00 1.70 1.50

2.00 1.50 1.50 1.50 1.50 1.52 1.50 1.50 2.00 2.00 1.70 2.00 1.70 2.00 1.60 2.00 1.80 2.00 1.80

1 200 000 4 001 100 612 000 900 000 1 512 000 2 489 100 4 320 000 2 385 000 1 350 000 900 000 1 440 000 12 884 100 1 276 800 90 000 90 000 480 000 3 600 000 612 000 (708 000) (61 200) 1 800 000 960 000 4 920 000 540 000 (675 000) (40 500) 12 884 100

2. Verification of foreign currency translation adjustment: Net monetary assets at 1 July 2023 Increases: Sales - inventory Decreases: Plant Land Buildings Purchases Other expenses Interest Income tax expense Dividend paid Dividend declared Net monetary assets at end

US$ (2 580 000)

1.50 – 2.00

Gain/(loss) 1 290 000

4 800 000 2 220 000

1.50 – 1.75

(1 200 000) 90 000

360 000 600 000 300 000 2 520 000 682 800 63 600 63 600 600 000 360 000 600 000 6 150 000 (3 930 000)

1.50 – 1.70 1.50 – 1.60 1.50 – 1.80 1.50 – 1.75 1.50 – 1.75 1.50 – 1.70 1.50 – 1.50 1.50 – 1.75 1.50 – 1.70 1.50 – 1.50

72 000 60 000 90 000 630 000 170 700 12 720 150 000 72 000 ____1 257 420 1 347 420

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Exercise 24.6 Translation into presentation currency Use the information in exercise 24.5 and assume an average exchange rate of 1.70 for January – June 2024. Required 1. If the functional currency for Chicago Ltd is the US dollar, prepare the financial statements of Chicago Ltd at 30 June 2024 in the presentation currency of the Australian dollar. 2. Verify the foreign currency translation adjustment. (LO5) ORBOST LTD – CHICAGO LTD 1. Translation into presentation currency of A$: US$ Sales Cost of sales: Opening stock Purchases

4 800 000

Closing inventory Gross profit Depreciation: Plant - Old Plant - New Buildings - Old Buildings - New Interest Other expenses Profit before income tax Income tax expense Profit for the period Retained earnings at 1 July 2023 Dividend paid Dividend declared Retained earnings at 30 June 2021 Share capital

Exchange rate 1.75

420 000 2 520 000 2 940 000 840 000 2 100 000 2 700 000

2.00 1.75

114 000 36 000 97 500 22 500 63 600 63 600 682 800 1 080 000 1 620 000 600 000 1 020 000 600 000 1 620 000 360 000 600 000 960 000 660 000 2 160 000

1.75 1.70 1.75 1.65 1.70 1.50 1.75

1.52

1.75 2.00 1.70 1.50

2.00

A$ 8 400 000 840 000 4 410 000 5 250 000 1 276 800 3 973 200 4 426 800 199 500 61 200 170 625 37 125 108 120 95 400 1 194 900 1 866 870 2 559 930 1 050 000 1 509 930 1 200 000 2 709 930 612 000 900 000 1 512 000 1 197 930 4 320 000 24.35

Chapter 24: Translation of the financial statements of foreign entities

Foreign currency translation reserve Loan from Orbost Ltd Provisions Dividends payable Accounts payable

Inventory Accounts receivable Cash Patent Plant Accumulated depreciation Land Buildings Accumulated depreciation

1 590 000 900 000 600 000 960 000 6 870 000

1.50 1.50 1.50 1.50

840 000 60 000 60 000 240 000 2 160 000 (390 000) 1 500 000 2 760 000 (360 000) 6 870 000

1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50

1 287 930 2 385 000 1 350 000 900 000 1 440 000 10 305 000 1 260 000 90 000 90 000 360 000 3 240 000 (585 000) 2 250 000 4 140 000 (540 000) 10 305 000

2. Verification of translation adjustment: Movement in retained earnings Movement x closing rate Movement as translated Translation gain Net investment at 1 July 2023 Net investment x opening rate Net investment x closing rate Translation loss Total translation loss

= = = = = = =

US$660 000 – US$600 000 US$60 000 60 000 x 1.50 A$90 000 A$1 197 930 – A$1 200 000 A$(2 070) A$92 070

= = = = = = =

US$2 760 000 2 760 000 x 2.00 A$5 520 000 2 760 000 x 1.50 A$4 140 000 A$(1 380 000) A$(1 287 930)

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Exercise 24.7 Translation into functional currency On 1 January 2022, Southern Ltd formed a company, Cross Ltd, in the United States to sell Australian products such as boomerangs and cuddly toys depicting Drakes and kangaroos. The initial capital was US$500 000. On 1 February 2022, a lease was signed on a shop for US$20 000, payable on the first day of each month. On 15 February 2022, store furnishings were acquired for US$448 000; these were expected to have a useful life of 4 years. On 10 June 2022, more fittings were acquired at a cost of US$124 000, again with an expected life of 4 years. Additional information • Where non-current assets are acquired during a month, a full month’s depreciation is applied. • The tax rate in the United States is 20%, while the tax rate in Australia is 30%. • The functional currency for Cross Ltd is the Australian dollar. • Exchange rates for the financial year were (A$1 = US$): 1 January 2022 1 February 15 February 10 June 30 June Average for first half year 30 September 1 December Average for second half year 31 December 2022 • • •

0.72 0.75 0.76 0.78 0.77 0.75 0.78 0.81 0.77 0.82

Sales in the first half of the year amounted to US$210 000. Expenses, other than depreciation, leases costs, and purchases in the first half of the year amounted to US$60 000. Financial information relating to Cross Ltd for the year ended 31 December 2022 is as follows.

24.37

Chapter 24: Translation of the financial statements of foreign entities

Required Translate the financial statements of Cross Ltd into Australian dollars for inclusion in the consolidated financial statements of Southern Ltd at 31 December 2022. (LO5)

SOUTHERN LTD – CROSS LTD Translation into A$ US$ Sales First half Second half

rate

210 000 470 000 680 000

1/0.75 1/0.77

280 000 610 390 890 390

60 000 170 000 230 000 20 000 210 000 470 000

1/0.75 1/0.77

80 000 220 779 300 779 25 974 274 805 615 585

102 667 18 083 Other expenses 60 000 90 000 Leases expenses 100 000 120 000 490 750 Trading loss (20 750) Foreign currency translation loss

1/0.76 1/0.78 1/0.75 1/0.77 1/0.75 1/0.77

Cost of sales: Purchases

Closing inventory Gross profit Expenses: Depreciation: fittings

1/0.77

135 088 23 183 80 000 116 883 133 333 155 844 644 331 (28 746) (39 790)

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Loss for the period

(20 750)

Share capital Retained earnings

500 000 (20 750) 479 250 14 600 33 400 448 000 124 000 (102 667) (18 083) 20 000 519 250 40 000 479 250

Cash Accounts receivable Fittings Accumulated depreciation Inventory Total assets Accounts payable Net assets

(68 536) 1/0.72

1/0.82 1/0.82 1/0.76 1/0.78 1/0.76 1/0.78 1/0.77 1/0.82

694 444 (68 536) 625 908 17 805 40 732 589 474 158 974 (135 088) (23 183) 25 974 674 688 48 780 625 908

24.39

Chapter 24: Translation of the financial statements of foreign entities

Verification of translation loss Net monetary assets at 1/1/22 Increases: sales

Decreases: Acquisition of furniture Purchases Lease expenses Other expenses

Net monetary assets at 31/12/22

US$ 500 000 210 000 470 000 1 180 000

rate change 1/0.82 – 1/0.72 1/0.82 – 1/0.75 1/0.82 – 1/0.77

gain/(loss) (84 688) (23 902) (37 219) (145 810)

448 000 124 000 60 000 170 000 100 000 120 000 60 000 90 000 1 172 000 8 000

1/0.82 – 1/0.76 1/0.82 – 1/0.78 1/0.82 – 1/0.75 1/0.82 – 1/0.77 1/0.82 – 1/0.75 1/0.82 – 1/0.77 1/0.82 – 1/0.75 1/0.82 – 1/0.77

43 132 7 755 6 829 13 462 11 382 9 503 6 829 7 127 106 020 (39 790) (rounded)

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Exercise 24.8 Translation into presentation currency n 1 July 2021, Pictures Ltd, an Australian company, acquired shares in North Point Ltd, a company based in Singapore. At this date, the equity of North Point Ltd was as follows.

At 30 June 2022 and 30 June 2023 respectively, the retained earnings balances of North Point Ltd were HK$400 000 and HK$450 000 respectively. All transactions occurred evenly throughout these years. The internal financial statements of the two companies at 30 June 2024 were as follows. Statements of profit or loss and other comprehensive income Pictures Ltd A$

North Point Ltd HK$

Sales Cost of sales

700 000 300 000

595 000 400 000

Expenses

400 000 210 200

195 000 100 000

Dividend revenue

189 800 12 000

95 000 —

Profit before income tax Tax expense

201 800 51 800

95 000 20 000

Profit Retained earnings as at 1/7/23

150 000 750 000

75 000 450 000

Dividend paid

900 000 100 000

525 000 25 000

Retained earnings as at 30/6/24

800 000

500 000

Statements of financial position Pictures Ltd A$ Current assets Shares in North Point Ltd Property, plant and equipment (net)

311 520 288 480 700 000

North Point Ltd HK$ 250 000 — 500 000 24.41

Chapter 24: Translation of the financial statements of foreign entities

100 000

150 000

Total assets Liabilities

1 400 000 100 000

900 000 100 000

Net assets

1 300 000

800 000

500 000 — 800 000

200 000 100 000 500 000

1 300 000

800 000

Patents and trademarks

Equity Share capital General reserve Retained earnings Total equity

Additional information (a) The dividend paid by North Point Ltd (and recognised as dividend revenue of A$12 000 by Pictures Ltd) was paid on 1 May 2024. (b) Some relevant exchange rates are as follows. 1 July 2021 Average for 2021–22 1 July 2022 Average for 2022–23 1 July 2023 Average for 2023–24 1 May 2024 30 June 2024

HK$1 = A$0.60 0.62 0.65 0.68 0.70 0.65 0.60 0.58

Required Translate the financial statements of North Point Ltd as at 30 June 2024 into the presentation currency of Australian dollars, assuming that the functional currency is the Singapore dollar. (LO5)

PICTURES LTD – NORTH POINT LTD Translated accounts of North Point Ltd as at 30 June 2024: HK$ Sales Cost of sales Expenses Tax expense Profit for the period Retained earnings (1/7/23)

595 000 400 000 195 000 100 000 95 000 20 000 75 000 450 000 525 000

Exchange Rate 0.65 0.65 0.65 0.65

A$ 386 750 260 000 126 750 65 000 61 750 13 000 48 750 *276 000 324 750

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dividend paid Retained earnings (30/6/24) Share capital General reserve FCTR Total equity

25 000 500 000 200 000 100 000 _______ 800 000

0.60

Current assets Property, plant & equipment (net) Patents and trademarks

250 000 500 000 150 000 900 000 100 000 800 000

0.58 0.58 0.58

Liabilities Net assets

0.60 0.60

0.58

15 000 309 750 120 000 60 000 (25 750) 464 000 145 000 290 000 87 000 522 000 58 000 464 000

Foreign currency translation reserve (FCTR) at 30 June 2024: 2021-22 Opening equity Profit for the period FCTR at 30 June 2022

= = = = =

HK$(200 000 + 100 000 + 300 000) HK$600 000 HK$100 000 600 000 (0.65 - 0.60) + 100 000 (0.65 - 0.62) A$33 000 (credit)

= = = = =

HK$(200 000 + 100 000 + 400 000) HK$700 000 HK$50 000 700 000 (0.70 - 0.65) + 50 000 (0.70 - 0.68) A$36 000 (credit)

2022-23 Opening equity Profit for the period FCTR change

Hence at 30 June 2023, the FCTR has a credit balance of A$69 000. 2023-24 Opening equity

= = = = =

Profit for the period Dividend FCTR change

HK$(200 000 + 100 000 + 450 000) HK$750 000 HK$75 000 HK$25 000 750 000 (0.58 - 0.70) + 75 000 (0.58 - 0.65) – 25 000 (0.58 - 0.60) A$(94 750) (debit)

The balance of the FCTR at 30 June 2024 is then A$(25 750). *Retained earnings balance at 1 July 2023: Retained earnings (1/7/21) Profit 2021-22

= = = =

HK$300 000 x 0.60 A$180 000 HK$100 000 x 0.62 A$62 000

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Chapter 24: Translation of the financial statements of foreign entities

Profit 2022-23 Retained earnings (1/7/23)

= HK$50 000 x 0.68 = A$34 000 = A$276 000

24.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 24.9 Translation into presentation currency Lion Ltd is an international company resident in Singapore. It acquired the issued shares of an Australian company, Drake Ltd, on 1 July 2022 for A$700 000. At 30 June 2023, the following information was available about the two companies. Lion Ltd S$ Share capital Retained earnings as at 1/7/22 Provisions Payables Sales Dividend revenue Accumulated depreciation — plant

Cash Accounts receivable Inventories Shares in Drake Ltd Buildings (net) Plant Cost of sales Depreciation — plant Tax expense Other expenses Dividend paid Dividend declared

Drake Ltd A$

560 000 330 000 34 000 14 000 620 000 6 400 210 000

350 000 170 000 30 000 40 000 310 000 0 160 000

1 785 40 0

1 060 000

92 100 145 300 110 000 336 000 84 000 420 000 390 000 85 000 23 000 50 000 20 000 30 000

30 000 115 000 80 000 0 220 000 400 000 120 000 40 000 15 000 10 000 10 000 20 000

1 785 40 0

1 060 000

Additional information • Sales, purchases and other expenses were incurred evenly throughout the period ended 30 June 2023. The dividend paid by Drake Ltd was received by Lion Ltd on 1 January 2023, while the dividend declared by Drake Ltd was announced on 30 June 2023. • Drake Ltd acquired A$100 000 additional new plant on 1 January 2023. Of the © John Wiley and Sons Australia Ltd, 2020

24.45

Chapter 24: Translation of the financial statements of foreign entities

•

depreciation charged in the period ended 30 June 2023, A$8000 related to the new plant. The rates of exchange between the Australian dollar and the Singapore dollar were (expressed as A$1 = S$): 1 July 2022 1 December 2022 1 January 2023 30 June 2023 Average for January–June 2023 Average for 2022–23

•

0.60 0.64 0.68 0.70 0.72 0.65

The functional currency of Drake Ltd is the Australian dollar.

Required 1. Translate the financial statements of Drake Ltd into Singapore dollars for inclusion in the consolidated financial statements of Lion Ltd. 2. Verify the foreign currency translation adjustment. (LO5)

LION LTD – DRAKE LTD 1. Translation of subsidiary’s accounts into S$ (presentation currency): A$ 310 000 120 000 190 000 32 000 8 000 10 000 50 000 Profit before tax 140 000 Tax expense 15 000 Profit 125 000 Retained earnings 1/7/22 170 000 295 000 Dividend paid 10 000 Dividend declared 20 000 30 000 Retained earnings 30/6/23 265 000 Share capital 350 000 Foreign currency trans. reserve -Provisions 30 000 Sales Cost of sales Gross profit Depreciation – old plant Depreciation – new plant Other expenses

Rate 0.65 0.65 0.65 0.72 0.65

0.65 0.60 0.68 0.70

0.60 0.70

S$ 201 500 78 000 123 500 20 800 5 760 6 500 33 060 90 440 9 750 80 690 102 000 182 690 6 800 14 000 20 800 161 890 210 000 58 610 21 000

24.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Payables Total equity & liabilities Cash Accounts receivable Inventory Buildings (net) Plant Accumulated depreciation Total assets

40 000 685 000 30 000 115 000 80 000 220 000 400 000 (160 000) 685 000

0.70 0.70 0.70 0.70 0.70 0.70 0.70

28 000 479 500 21 000 80 500 56 000 154 000 280 000 (112 000) 479 500

2. Verification of foreign currency translation adjustment: Opening equity of subsidiary Opening equity x opening rate Opening equity x closing rate Exchange gain Change in equity of subsidiary Change in equity as translated Change in equity x closing rate Exchange gain Net FCTR

= = = = = = = = = = = = = = =

A$520 000 520 000 x 0.60 S$312 000 520 000 x 0.70 S$364 000 S$52 000 A$125 000 – (A$10 000 + A$20 000) A$95 000 S$80 690 – (S$6 800 + S$14 000) S$59 890 95 000 x 0.70 S$66 500 S$6 610 S$52 000 + S$6 610 S$58 610

24.47

Chapter 24: Translation of the financial statements of foreign entities

Exercise 24.10 Translation into functional and presentation currency Canberra Ltd, an Australian company, acquired all the issued shares of Washington Ltd, a US company, on 1 January 2023. At this date, the net assets of Washington Ltd are shown below. US$ Property, plant and equipment Accumulated depreciation

310 000 (60 000)

Cash Inventories Accounts receivable

250 000) 20 000 40 000 20 000

Total assets Accounts payable

330 000 30 000

Net assets

300 000

The trial balance prepared by the US company, Washington Ltd, at 31 December 2023 contained the following information: US$ Dr Share capital Retained earnings Accounts payable Sales Accumulated depreciation — plant and equipment Property, plant and equipment Accounts receivable Inventories Cash Cost of sales Depreciation Administrative expenses Rent expenses Insurance expenses

US$ Cr 200 000 100 000 84 000 180 000 90 000

310 000 80 000 90 000 24 000 60 000 30 000 4 000 6 000 5 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

41 000 4 000

Wages expenses Other expenses

654 000

Additional information • No property, plant and equipment were acquired in the period ended 31 December 2023. • All sales and expenses were acquired evenly throughout the period. The inventories on hand at the end of the year were acquired during December 2023. • Exchange rates were (A$1 = US$): 1 January 2023 31 December 2023 Average for December 2023 Average for 2023 •

0.52 0.60 0.58 0.56

The functional currency for Washington Ltd is the US dollar.

Required 1. Prepare the financial statements of Washington Ltd at 31 December 2023 in the presentation currency of Australian dollars. 2. Verify the foreign currency translation adjustment. 3. Discuss the differences that would occur if the functional currency of Washington Ltd was the Australian dollar. 4. If the functional currency was the Australian dollar, calculate the foreign currency translation adjustment. (LO4 and LO5) CANBERRA LTD – WASHINGTON LTD 1. Functional currency is the US$ - Presentation currency is the A$: Sales Cost of sales: Opening stock Purchases Closing stock Cost of sales Gross profit Expenses: Depreciation Administration Rent Insurance

US$ 180 000

rate 1/0.56

A$ 321 429

40 000 110 000 150 000 90 000 60 000 120 000

1/0.52 1/0.56

76 923 196 429 273 352 155 172 118 180 203 249

30 000 4 000 6 000 5 000

1/0.56 1/0.56 1/0.56 1/0.56

1/0.58

53 571 7 143 10 714 8 929 24.49

Chapter 24: Translation of the financial statements of foreign entities

Wages Other Profit for the period Retained earnings at 1/1/23 Retained earnings at 31/12/23 Share capital Foreign currency translation reserve Total equity Property, plant & equipment Accumulated depreciation Accounts receivable Inventory Cash Accounts payable Net assets

41 000 4 000 90 000 30 000 100 000 130 000 200 000 ______ 330 000 310 000 90 000 220 000 80 000 90 000 24 000 414 000 84 000 330 000

1/0.56 1/0.56

1/0.52 1/0.52

1/0.60 1/0.60 1/0.60 1/0.60 1/0.60 1/0.60

73 214 7 143 160 714 42 535 192 308 234 843 384 615 (69 458) 550 000 516 667 150 000 366 667 133 333 150 000 40 000 690 000 140 000 550 000

2. Verifying the foreign currency translation reserve: Profit as translated Profit x closing rate: 30 000 x 1/0.60 Translation gain

42 535 50 000 7 465

Opening net assets Opening net assets x opening rate (300 000 x 1/0.52) Opening net assets x closing rate (300 000 x 1/0.6) Translation loss

300 000 576 923 500 000 (76 923)

Total foreign currency translation reserve

(69 458)

3. Functional currency is the A$: Sales Cost of sales: Opening stock Purchases Closing stock Cost of sales Gross profit Expenses: Depreciation Administration Rent Insurance Wages Other Profit Foreign currency translation loss Profit

US$ 180 000

rate 1/0.56

A$ 321 429

40 000 110 000 150 000 90 000 60 000 120 000

1/0.52 1/0.56

76 923 196 429 273 352 160 714 112 638 208 791

30 000 4 000 6 000 5 000 41 000 4 000 90 000 30 000

1/0.52 1/0.56 1/0.56 1/0.56 1/0.56 1/0.56

1/0.56

57 692 7 143 10 714 8 929 73 214 7 143 164 835 43 956 (3 755) 40 201

24.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings at 1/1/23 Retained earnings at 31/12/23 Share capital Total equity

100 000 130 000 200 000 330 000

1/0.52

Property, plant & equipment Accumulated depreciation

310 000 90 000 220 000 80 000 90 000 24 000 414 000 84 000 330 000

1/0.52 1/0.52

Accounts receivable Inventory Cash Accounts payable Net assets

1/0.52

1/0.60 1/0.56 1/0.60 1/0.60

192 308 232 59 384 615 617 124 596 154 173 077 423 077 133 333 160 714 40 000 757 124 140 000 617 124

4. Verification of translation adjustment: Net monetary assets at 1 January 2023 Increases: sales Decreases: Purchases Expenses Net monetary assets at 31 December 2023

US$ 10 000 180 000 190 000

rate change gain/(loss) (1/0.6 – 1/0.52) (2 564) (1/0.6 – 1/0.56) (21 429) (23 993)

110 000 60 000 170 000 20 000

(1/0.6 – 1/0.56) (1/0.6 – 1/0.56)

13 095 7 143 20 238 (3 755)

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Chapter 24: Translation of the financial statements of foreign entities

Exercise 24.11 Translation into functional and presentation currency On 1 July 2023, Toowoomba Ltd, an Australian company, acquired all the issued shares of Sussex Ltd, an UK company. At this date, the equity of Sussex Ltd consisted of the following.

The financial statements of Sussex Ltd at 30 June 2024 were as follows. Statement of comprehensive income for Sussex Ltd for the year ended 30 June 2024 £ 2 000 00 0

Sales Cost of sales Opening inventories Purchases Ending inventories

(400 000) (900 000) 200 000

Depreciation Other expenses

(1 100 00) 0 (100 000) (500 000)

Profit before tax

300 000

Income tax expense

(100 000)

Profit after tax

200 000

Statement of financial position for Sussex Ltd as at 30 June 2024 £ 1 500 000 (300 000)

Plant and equipment Accumulated depreciation

1 200 000 Cash

100 000

Inventories

200 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

100 000

Accounts receivable

1 600 000

Total assets Accounts payable Bank loan

100 000 300 000

Total liabilities

400 000 1 200 000

Net assets

800 000 400 000

Share capital Retained earnings

Additional information • Exchange rates for the year ending 30 June 2024 were as follows (£1 = A$). 1 July 2023 1 March 2024 1 April 2024 1 May 2024 Average for May–June 2024 Average for 2023–24 30 June 2024 • • • • •

1.80 1.82 1.78 1.84 1.85 1.79 1.76

Sales, purchases and other expenses were incurred evenly throughout the year. The ending inventory was acquired on 1 March 2024 by paying cash of £20 000 and the balance on credit. The plant at 30 June 2024 includes a new plant acquired for £120 000 on 1 May 2024 by paying cash. Depreciation on plant and equipment is calculated at 10% p.a. on cost. The bank loan was taken out on 1 April 2024, with interest rate at 8% p.a. paid quarterly on 30 June, 30 September, 31 December and 31 March each year. The interest expense on the loan for the year was included under ‘Other expenses’ in the statement of comprehensive income.

Required 1. Assuming the functional currency for Sussex Ltd is the Australian dollar, translate the financial statements of Sussex Ltd into the functional currency. 2. Assuming the functional currency for Sussex Ltd is the UK pound and the presentation currency of Toowoomba Ltd’s group is Australian dollars, translate the financial statements of Sussex Ltd into the presentation currency. (LO4 and LO5) 1. Statement of comprehensive income for Sussex Ltd © John Wiley and Sons Australia Ltd, 2020

24.53

Chapter 24: Translation of the financial statements of foreign entities

for the year ended 30 June 2024

Sales Cost of sales Inventory 1.7.23 Purchases Inventory 30.6.24 Depreciation Depreciation Other expenses Interest expense Foreign exchange loss Profit before tax Income tax expense Profit after tax Retained earnings 1.7.23 Retained earnings 30.6.24

£ 2 000 000

Rate 1.82

A$ 3 640 000

(400 000) (900 000) 200 000 (98 000) (2 000) (494 000) (6 000)

1.80 1.82 1.82 1.80 1.84 1.82 1.76

(720 000) (1 638 000) 364 000 (176 400) (3 680) (899 080) (10 560) (13 560) 542 720 (182 000) 360 720 360 000 720 720

300 000 (100 000) 200 000 200 000 400 000

1.82 1.80

Statement of financial position for Sussex Ltd as at 30 June 2024

Share capital Retained earnings Bank loan Payable Plant and equipment Plant and equipment Plant and equipment Accumulated depreciation Accumulated depreciation Accumulated depreciation Inventory Cash and receivable

£ 800 000 400 000 1 200 000 300 000 100 000 1 600 000 980 000 400 000 120 000 (98 000) (2 000) (200 000) 200 000 200 000 1 600 000

Rate 1.80

1.76 1.76 1.80 1.76 1.84 1.80 1.84 1.80 1.82 1.76

A$ 1 440 000 720 720 2 160 720 528 000 176 000 2 864 720 1 764 000 704 000 220 800 (176 400) (3 680) (360 000) 364 000 352 000 2 864 720

2. Statement of comprehensive income for Sussex Ltd for the year ended 30 June 2024 Sales Cost of sales Inventory 1.7.23

£ 2 000 000

Rate 1.82

A$ 3 640 000

(400 000)

1.80

(720 000)

24.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Purchases Inventory 30.6.24 Depreciation Other expenses Interest expense Profit before tax Income tax expense Profit after tax Retained earnings 1.7.23 Retained earnings 30.6.24

(900 000) 200 000 (100 000) (494 000) (6 000) 300 000 (100 000) 200 000 200 000 400 000

1.82 1.82 1.82 1.82 1.76 1.82 1.80

(1 638 000) 364 000 (182 000) (899 080) (10 560) 554 360 (182 000) 372 360 360 000 732 360

Statement of financial position for Sussex Ltd as at 30 June 2024 Share capital Retained earnings Foreign exchange translation reserve Bank loan Payable Plant and equipment Accumulated depreciation Inventory Cash and receivable

£ Rate 800 000 1.80 400 000 300 000 100 000 1 600 000 1 500 000 (300 000) 200 000 200 000 1 600 000

1.76 1.76 1.76 1.76 1.76 1.76

A$ 1 440 000 732 360 (60 360) 528 000 176 000 2 816 000 2 640 000 (528 000) 352 000 352 000 2 816 000

24.55

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 24: Translation of foreign currency financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 24: Translation of foreign currency financial statements Multiple choice questions 1. The financial statements of a foreign subsidiary with an Australian parent company must: a. *b. c. d.

remain in the foreign currency for the purposes of consolidating the financial statements of the Australian parent company. be translated into Australian dollars for the purposes of consolidating the financial statements of the Australian parent company. be translated into Australian dollars for the purposes of presenting the financial statements in the country of its foreign operations. None of these options are correct.

Answer: b Learning objective 24.1: discuss the need for translation of foreign entities’ financial statements.

2. According to AASB 121 The Effects of Changes in Foreign Exchange Rates, the currency of the primary economic environment in which the foreign entity operates is the: a. b. *c. d.

local currency. foreign currency. functional currency. presentation currency.

Answer: c Learning objective 24.2: explain the difference between functional and presentation currencies.

3. Which of the following is not an activity economic indicator for determining the functional currency? a. *b. c. d.

Autonomy. Retention of funds. Intercompany transactions. Servicing of debt obligations.

Answer: b Learning objective 24.2: explain the difference between functional and presentation currencies.

23.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following factors should be considered when determining the functional currency? a. b. *c. d.

Which currency mainly influences the costs of labour and materials? Which currency mainly influences the selling price of the goods and services provided? Which country has the most influence over competitive forces and regulations for the sales price of the goods and services? All of these options should be considered.

Answer: c Learning objective 24.2: explain the difference between functional and presentation currencies.

5. According to AASB 121 The Effects of Changes in Foreign Exchange Rates, the currency in which the financial statements are presented by the reporting entity is the: a. b. c. *d.

economic currency. domestic currency. functional currency. presentation currency.

Answer: d Learning objective 24.2: explain the difference between functional and presentation currencies.

6. Indicators pointing towards the local overseas currency as the functional currency include: I. II. III. IV.

Parent’s cash flows are directly affected on a current basis. Production costs are determined primarily by local conditions. Sales prices are primarily responsive to exchange rate changes in the short-term. Cash flows are primarily in the local currency and do not affect the parent’s cash flows.

*a. b. c. d.

II and IV only. I and III only. I, III and IV only. I, II and IV only.

Answer: a Learning objective 24.3: understand the main methods used in the translation process.

23.2

Chapter 24: Translation of foreign currency financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

7. When translating into the functional currency, foreign currency denominated non-monetary items measured using historical cost must be translated using the: a. b. *c. d.

rate current at end of reporting period. average rate for the reporting period. exchange rate at the date of the transaction. rate prevailing at the end of the previous financial year.

Answer: c Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

8. Monetary items are best described as: a. b. c. *d.

plant and equipment. all items that are contingent in nature. all intangible items including goodwill. units of currency held and assets and liabilities to be received or paid in fixed numbers of currency units.

Answer: d Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

9. Post-acquisition date retained earnings that are denominated in a foreign currency are: a. *b. c. d.

translated into the functional currency using the average rate since acquisition date. balances carried forward from translation of previous statement of comprehensive income and do not need to be translated. translated into the functional currency using the rates at the end of each year since acquisition date. translated into the functional currency using the rate current at the latest end of reporting period.

Answer: b Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

23.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. When translating into the functional currency, monetary liabilities are translated using the: a. b. *c. d.

exchange rate prevailing at the end of the last reporting period. exchange rate current at the date the item was first recorded. exchange rate current at end of reporting period. closing exchange rate.

Answer: c Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

11. When translating foreign currency denominated financial statements into the functional currency, the exchange differences are recognised: *a. b. c. d.

as an item of gain or loss in the statement of profit or loss and other comprehensive income. directly in the retained earnings account. as a deferred asset or liability. as a separate component of equity.

Answer: a Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

12. Which of the following items will be regarded as a monetary item when applying the definition provided in AASB 121 The Effects of Changes in Foreign Exchange Rates? a. *b. c. d.

property, plant and equipment. accounts receivable. land and buildings. inventories.

Answer: b Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

23.4

Chapter 24: Translation of foreign currency financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

13. When translating the revenue and expenses in the statement of profit or loss and other comprehensive income, theoretically each item of revenue and expense should be translated using the spot exchange rate between the: a. b. c. *d.

functional currency and the foreign currency on the reporting date. presentation currency and the local currency on the transaction date. presentation currency and the functional currency on the reporting date. functional currency and the foreign currency on the date the transaction occurred.

Answer: d Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

14. The general rule for translating liabilities denominated in a foreign currency into the functional currency is to: a. *b. c. d.

first classify the liabilities into current and non-current. first classify the liabilities as monetary or non-monetary. translate all liabilities using the current rate existing at end of reporting period. translate all liabilities using the rate current on entering into the transaction.

Answer: b Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

15. If foreign currency denominated non-monetary items are measured using the fair value method, they must be translated into the functional currency using the: *a. b. c. d.

exchange rate at the date when the value was determined. exchange rate current at end of reporting period. closing exchange rate for the financial year. exchange rate at the transaction date.

Answer: a Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

23.5

Testbank to accompany Financial reporting 3e by Loftus et al.

16. Banjo Ltd acquired 100% of Wellington Ltd on 1 July 2021. The balance sheet of Wellington Ltd on that date was as follows: Balance sheet at 1 July 2021 NZ$ 560,000 400,000 100,000 140,000 1,200,000

Machinery at cost Investment property Receivables Cash

Share capital General reserve Retained earnings

NZ$ 400,000 200,000 600,000 1,200,000

The balance sheet of Wellington Ltd as at 30 June 2022 is as follows: Balance sheet as at 30 June 2022 NZ$ 300,000 400,000 500,000 600,000

Machinery — carrying value Investment property Receivables Cash

Share capital General Reserve Retained earnings Accounts payable Income tax payable

1,800,000

NZ$ 400,000 200,000 1,000,000 170,000 30,000 1,800,000

Relevant exchange rates are as follows:

1 July 2021 30 June 2022 Average 2021-22

NZ$ 1.00 = 1.00 = 1.00 =

A$ 0.95 0.85 0.90

If the local currency of Wellington Ltd is New Zealand dollars and the functional currency is Australian dollars the total assets of NZ$1,800,000 would translate into Australian dollars as: a. b. *c. d.

$1,710,000 $1,530,000 $1,560,000 $1,620,000

Answer: c Learning objective 24.4: translate a set of financial statements from local currency into the functional currency and account for exchange differences.

23.6

Chapter 24: Translation of foreign currency financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

17. Banjo Ltd acquired 100% of Wellington Ltd on 1 July 2021. The balance sheet of Wellington Ltd on that date was as follows: Balance sheet at 1 July 2021 NZ$ 560,000 400,000 100,000 140,000 1,200,000

Machinery at cost Investment property Receivables Cash

Share capital General reserve Retained earnings

NZ$ 400,000 200,000 600,000 1,200,000

The balance sheet of Wellington Ltd as at 30 June 2022 is as follows: Balance sheet as at 30 June 2022 NZ$ 300,000 400,000 500,000 600,000

Machinery — carrying value Investment property Receivables Cash

Share capital General Reserve Retained earnings Accounts payable Income tax payable

1,800,000

NZ$ 400,000 200,000 1,000,000 170,000 30,000 1,800,000

Relevant exchange rates are as follows:

1 July 2021 30 June 2022 Average 2021-22

NZ$ 1.00 = 1.00 = 1.00 =

A$ 0.95 0.85 0.90

If the functional currency of Wellington Ltd is New Zealand dollars and the presentation currency is Australian dollars the total assets of NZ$1,800 000 would translate into Australian dollars as: a. *b. c. d.

$1,560,000 $1,530,000 $1,710,000 $1,620,000

Answer: b Learning objective 24.5: translate a set of financial statements from functional currency into the presentation currency and account for exchange differences.

23.7

Testbank to accompany Financial reporting 3e by Loftus et al.

18. When translating into the presentation currency the translation difference is recognised: a. b. *c. d.

in retained earnings. in profit or loss. as a separate component of equity. as an asset or liability, depending on whether it is a debit or credit balance.

Answer: c Learning objective 24.5: translate a set of financial statements from functional currency into the presentation currency and account for exchange differences.

19. Bondi Ltd has an investment in Christchurch Ltd. The shares in Christchurch were acquired on 15 April 2074. Christchurch uses the revaluation model to account for equipment. Equipment acquired by Christchurch on 1 May 2015 was revalued on 25 May 2022. The exchange rate used to translate the building into the presentation currency for the year ending 30 June 2022 is the rate that applied on: a. b. c. *d.

1 May 2015. 15 April 2017. 25 May 2022. 30 June 2022.

Answer: d Learning objective 24.5: translate a set of financial statements from functional currency into the presentation currency and account for exchange differences.

20. When translating from the local to functional currency as opposed to the functional to presentation currency differences arise in relation to the treatment of which of the following? a. b. *c. d.

Share capital. Cost of goods sold. Depreciation expense. Accounts receivable.

Answer: c Learning objective 24.5: translate a set of financial statements from functional currency into the presentation currency and account for exchange differences.

23.8

Chapter 24: Translation of foreign currency financial statements Not for distribution in full. Instructors may assign selected questions in their LMS.

21. Zephyr Limited has the following items in its statement of profit or loss and other comprehensive income: NZ$ Revenue 140 000 Cost of goods sold 85 000 Interest expense 14 000 Income tax expense 12 000 All items arose evenly across the year. The following exchange rates applied: End of reporting period Average rate for year

NZ$1.00 = A$0.90 NZ$1.00 = A$0.85

The net profit after tax translated into the presentation currency of A$ is: a. *b. c. d.

$46 750 $24 650 $34 118 $26 100

Answer: b Feedback: NZ$(140 000 -85 000 – 14 000 – 12 000) x A$0.85 Learning objective 24.5: translate a set of financial statements from functional currency into the presentation currency and account for exchange differences.

22. Under AASB 121 The Effects of Changes in Foreign Exchange Rates, an entity must disclose which of the following items in particular? I. II. III. IV.

a. b. c. *d.

Whether a change in the functional currency has occurred. The amount of exchange differences included in profit or loss of the period. The amount of the exchange difference included directly in share capital during the period. The reason for using a presentation currency that is different from the functional currency. I and IV only. II and III only. I, II, III and IV. I, II and IV only.

Answer: d Learning objective 24.6: prepare the disclosures required by AASB 121/IAS 21.

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Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 25: Business combinations

Chapter 25: Business combinations Comprehension questions 1. What is meant by a ‘business combination’? AASB 3/IFRS 3 Appendix A: A business combination is defined as: • A transaction or other event in which an acquirer obtains control of one or more businesses. A business is then defined as: • An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. Paragraph B7 of AASB 3/IFRS 3 identifies three elements of a business being inputs, processes and outputs.

2. Discuss the importance of identifying the acquisition date. Acquisition date is the date on which the acquirer obtains control of the acquiree. Important because on this date: • The fair values of the identifiable assets acquired and liabilities assumed are measured. • The fair value of the consideration transferred is measured • The goodwill or gain on bargain purchase is calculated. 3. What is meant by ‘contingent consideration’ and how is it accounted for? AASB 3/IFRS 3 Appendix A: Contingent consideration is defined as: • Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met. See AASB 3/IFRS 3 paragraphs 39-40 and 58 for details on how to account for contingent consideration. Paragraph 39: The consideration transferred includes any asset or liability resulting from a contingent consideration arrangement. This is measured at fair value at acquisition date.

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Paragraph 40: The acquirer shall classify the obligation to pay contingent consideration as a liability or equity (depending on the characteristics of the instrument being transferred). Paragraph 58: Changes in the measurement of the obligation subsequent to acquisition date resulting from events after the acquisition date are accounted for differently depending on whether the obligation was classified as equity or debt. If classified as equity, the equity shall not be remeasured. If classified as liability, it is accounted under AASB 9/IFRS 9 as appropriate. 4. Explain the key components of ‘core’ goodwill. Core goodwill has two main components: (i) Going concern goodwill: relates to the net assets of the acquiree, in that the acquiree’s net assets together are worth more than the net assets separately, caused by the synergy created by the acquiree’s net assets within the acquiree as a going concern. (ii) Combination goodwill: relates to the extra benefits accruing because of the synergy created by the acquirer and the acquiree combining together e.g. if the raw materials available to the acquiree are of particular use to the acquirer. These benefits could affect the recorded earnings of the acquirer or the acquiree [or both] depending on the nature of the benefits.

5. What recognition criteria are applied to assets and liabilities acquired in a business combination? Paragraph 10 of AASB 3/IFRS 3 states that the identifiable assets acquired and liabilities assumed shall be recognised separately from goodwill. Because the assets and liabilities are measured at fair value, the assets and liabilities are recognised regardless of the degree of probability of inflow/outflow of economic benefits. The fair value reflects such expectations in its measurement. The assets and liabilities recognised must meet the definitions of assets and liabilities in the Framework. [paragraph 11 of AASB 3/IFRS 3]. The assets and liabilities recognised must also be part of the exchange transaction rather than resulting from separate transactions [paragraph 12 of AASB 3/IFRS 3].

6. How is an acquirer identified? Paragraph 6 of AASB 3/IFRS 3: For each business combination, one of the combining entities shall be identified as the acquirer. Appendix A of AASB 3/IFRS 3: The acquirer is the entity that obtains control of the acquiree. Appendix A of AASB 3/IFRS 3: Control is the power to govern the financial and operating policies of the acquiree so as to obtain benefits from its activities.

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Chapter 25: Business combinations

Determination of the acquirer requires judgement. Paragraphs B13-B18 of AASB 3/IFRS 3 provides indicators/guidelines to assist in this judgement: • Form of consideration: did one entity transfer cash or other assets for the shares of the other? [paragraph B14]; did one entity issue its own equity interests in exchange for another entity’s equity interests? [paragraph B15] Was there a premium paid by one of the entities? [paragraph B16(e)] • Subsequent management: which entity’s management subsequently controls the business combination? What are the relative voting rights after the business combination? [paragraph B15(a)] What is the composition of the senior management of the combined entity? [paragraph B15(d)] • Large minority voting interest: The acquirer normally holds the largest minority voting interest in the combined entity. [paragraph B15(b)] • Predator or target: which entity initiated the combination? [paragraph B17] • Relative size of the businesses: is the fair value of one entity significantly greater than another? [paragraph B16] Large entities normally take over small entities.

7. Explain the key steps in the acquisition method. AASB 3/IFRS 3 paragraph 5: 1. Identify the acquirer (refer to answer to question 6 above) 2. Determine the acquisition date i.e. the date on which the acquirer obtains control 3. Recognise and measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquire i.e. at their acquisition-date fair values 4. Recognise and measure goodwill or a gain from a bargain purchase i.e. the difference between the fair value of consideration transferred and the fair value of net assets acquired.

8. How is the consideration transferred calculated? AASB 3/IFRS 3 paragraph 37 states that the consideration transferred shall be • Measured at fair value, determined at acquisition date, and • Calculated as the sum of the fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer, and the equity interests issued by the acquirer.

9. How is a gain on bargain purchase accounted for? AASB 3/IFRS 3 paragraph 34 specifies the measurement of the gain, identified as the amount by which the fair value of net assets acquired exceeds the fair value of consideration transferred. Paragraph 36 requires an acquirer to: • reassess the identification and measurement of the identifiable assets acquired and liabilities assumed, and measurement of the consideration transferred. This review is to ensure that the measurements are appropriate. Paragraph 34 requires an acquirer, subsequent to paragraph 36 procedures, recognise any remaining gain on bargain purchase immediately in profit or loss. © John Wiley and Sons Australia Ltd, 2020

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10. Why is it important to identify an acquirer in a business combination? Consider the example in paragraph B18 in Appendix B to AASB 3/IFRS 3. Assume A Ltd and B Ltd combine together by creating C Ltd which acquires all the shares in A Ltd and B Ltd and issues its own shares in exchange. As noted in para B18, C Ltd is not necessarily the acquirer. What differences occur if either A Ltd or B Ltd is identified as the acquirer? Two effects: (i) the consideration transferred is based on what the acquirer gives up; and (ii) the acquiree’s net assets are measured at fair value. In relation to point (ii), if A Ltd is the acquirer then in the consolidated financial statements B Ltd’s net assets are adjusted to fair value while A Ltd’s net assets are at the carrying amounts in A Ltd. If B Ltd is the acquirer, A Ltd’s net assets are adjusted to fair value while B Ltd’s net assets are at the carrying amounts in B Ltd.

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Chapter 25: Business combinations

Case studies Case study 25.1 Applying AASB 3/IFRS 3 Walter Ltd has recently undertaken a business combination with Lily Ltd. At the start of negotiations, Walter Ltd owned 30% of the shares of Lily Ltd. The current discussions between the two entities concerned Walter Ltd’s acquisition of the remaining 70% of shares of Lily Ltd. The negotiations began on 1 January 2022 and enough shareholders in Lily Ltd agreed to the deal by 30 September 2022. The purchase agreement was for shareholders in Lily Ltd to receive in exchange shares in Walter Ltd. Over the negotiation period, the share price of Walter Ltd shares reached a low of $5.40 and a high of $6.20. The accountant for Walter Ltd, Mr Spencer, knows that AASB 3/IFRS 3 has to be applied in accounting for business combinations. However, he is confused as to how to account for the original 30% investment in Lily Ltd, what share price to use to account for the issue of Walter Ltd’s shares, and how the varying dates such as the date of exchange and acquisition date will affect the accounting for the business combination. Required Provide Mr Spencer with advice on the issues that are confusing him. Issue 1: how to account for the original 30% investment in Lily Ltd. • • •

Initially recorded at fair value plus transactions cost, based on paragraph 5.1.1 of AASB 9/IFRS 9. Subsequently accounted for under AASB9/IFRS 9 e.g. could be measured at fair value with changes in value included in profit or loss or changes recognised directly in equity. On formation of the business combination, paragraph 42 of AASB 3/IFRS 3 requires that the acquirer remeasure its previously held equity interest in the acquiree at its acquisitiondate fair value and recognise the resultant gain/loss in profit or loss. Where the investment had been measured at fair value with increments recognised directly in equity, these amounts are transferred at acquisition date to profit or loss as well, and disclosed as reclassification adjustments.

Issue 2: what share price to use. Paragraph 37 of AASB 3/IFRS 3 requires the use of the fair value at the date of acquisition. This price will include all expectations of the takeover, including any premium for control. Issue 3: effects of different dates. AASB 3/IFRS 3 refers to acquisition date only. All measures of fair value are made on acquisition date, for both the consideration transferred and the assets acquired and liabilities assumed.

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As noted under Issue 1, the initial 30% investment that was first recognised on the date it was acquired must be remeasured to fair value at the acquisition date of the business combination i.e. the date the remaining 70% is acquired.

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Chapter 25: Business combinations

Case study 25.2 Accounting for goodwill Silver Ltd has acquired a Blink manufacturing division from Lining Ltd. The accountant, Mr Wilson, has shown the board of directors of Silver Ltd the financial information regarding the acquisition. Mr Wilson calculated a residual amount of $45 000 to be reported as goodwill in the accounts. The directors are not sure whether they want to record goodwill on Silver Ltd’s statement of financial position. Some directors are not sure what goodwill is or why the company has bought it. Other directors even query whether goodwill is an asset, with some being concerned with future effects on the statement of profit or loss and other comprehensive income. Required Prepare a report for Mr Wilson to present to the directors to help them understand the nature of goodwill and how to account for it. Nature of goodwill: Goodwill is an intangible asset and is only recognised when it is acquired as a result of a business combination. Paragraph 11 of AASB 138/IAS 38 states: the future economic benefits [of goodwill] may result from synergy between the identifiable assets acquired or from assets that, individually, do not qualify for recognition. Goodwill represents the premium paid by the acquirer over and above the fair value of the net assets presumably in the belief that the business will generate additional benefits from such synergy. It may arise because the acquirer has identified undervalued or unrecorded assets that the acquiree did not or could not (under accounting standards) recognise. Importantly, only acquired goodwill may be recognised. Paragraph 48 of AASB 138/IAS 38 explicitly states internally generated goodwill shall not be recognised as an asset. How to account for it: •

Acquired goodwill - Recognised, as an asset, only in a business combination. - Measured as a residual under paragraph 32. - Subject to annual impairment test. - If allocated to CGU, any impairment loss is first allocated to goodwill until it is exhausted. - Goodwill impairment losses cannot be reversed (on the basis that to do so would be recognising internally generated goodwill).

•

Future effects on statement of profit or loss and other comprehensive income - Will only be an expense if an impairment loss is recognised. - Impairment loss cushioned by various accounting treatments such as use of cost method for PPE, non-recognition of internally generated goodwill & internally generated intangibles.

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Case study 25.3 Identifying the acquirer White Ltd has been negotiating with Cloud Ltd for several months, and agreements have finally been reached for the two companies to combine. In considering the accounting for the combined entities, management realises that, in applying AASB 3/IFRS 3, an acquirer must be identified. However, there is debate among the accounting staff as to which entity is the acquirer. Required 1. What factors/indicators should management consider in determining which entity is the acquirer? 2. Why is it necessary to identify an acquirer? In particular, what differences in accounting would arise if White Ltd or Cloud Ltd were identified as the acquirer? The acquirer is the combining entity that obtains control of the other combining entities. [Appendix A, AASB 3/IFRS 3] 1. Factors: Determination of the acquirer requires judgement. Paragraphs B13-B18 of AASB 3/IFRS 3 provide indicators/guidelines to assist in this judgement in that the acquirer is usually the entity: • Form of consideration: that transfers cash or other assets for the shares of the other [paragraph B14]; that issues its own equity interests in exchange for another entity’s equity interests [paragraph B15] that pays a premium to one of the entities [paragraph B16(e)]. • Subsequent management: whose management subsequently controls the business combination and retains or receives the largest relative voting rights after the business combination [paragraph B15(a)] whose management dominates the senior management of the combined entity [paragraph B15(d)]. • Large minority voting interest: that holds the largest minority voting interest in the combined entity [paragraph B15(b)]. • Predator or target: that initiated the combination [paragraph B17]. • Relative size of the businesses: whose fair value is significantly greater than that of the other combining entities [paragraph B16]]. (Large entities normally take over small entities) 2. Why identify an acquirer? The consideration transferred is measured on the basis of the consideration given by the acquirer, while the identifiable assets and liabilities of the acquiree are measured at fair value. Differences: In relation to White Ltd – Cloud Ltd, the main effect then would be:

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Chapter 25: Business combinations

• •

If White Ltd is the acquirer, the identifiable assets, liabilities and contingent liabilities of Cloud Ltd would be measured at their acquisition-date fair value while White Ltd assets and liabilities remain at their original carrying amounts. If Cloud Ltd were the acquirer, it would be White Ltd’s assets and liabilities that would be measured at their acquisition-date fair value.

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Case study 25.4 Accounting for research Terry Ltd has acquired all the net assets of Graham Ltd with the latter going into liquidation. Both companies operate in the area of testing and manufacturing pharmaceutical products. One of the main reasons that Terry Ltd sought to acquire Graham Ltd was that the latter company had an impressive record in the development of drugs for the cure of some mosquito-related diseases. Graham Ltd employed a number of scientists who were considered to be international experts in their area and at the leading edge of research in their field. Much of the recent work undertaken by these scientists was classified for accounting purposes as research, and as per AASB 138/IAS 38 Intangible Assets was expensed by Graham Ltd. However, in deciding what it would pay to take over Graham Ltd, Terry Ltd had paid a sizeable amount of money for the ongoing research being undertaken by Graham Ltd as it was expected that it would be successful eventually. The accountant for Terry Ltd, Ms Tully, has suggested that the amount paid by Terry Ltd for this research should be shown as goodwill in the company’s statement of financial position. However, the directors of the company do not believe that this faithfully represents the true nature of the assets acquired in the business combination, and want to recognise this as an asset separately from goodwill. Ms Tully believes that this will not be in accordance with AASB 138/IAS 38. Required Provide the directors with advice on the accounting for the aforementioned transaction. One of the problems in accounting for a business combination is that it is only after the acquirer obtains control of the acquiree that it can accurately determine what are the assets and liabilities of the acquiree and measure their fair values. This takes time. Hence, the initial accounting for the business combination is done using best estimates – the provisional numbers - and will need to be adjusted after fair values have been reliably determined. The reason given for the provisional numbers is that there is to be a review of the fair values that have been used in the accounting for the business combination. Note paragraph 45 of AASB 3/IFRS 3: • If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer shall report in its financial statements provisional amounts for the items for which the accounting is incomplete. During the measurement period, the acquirer shall retrospectively adjust the provisional amounts recognised at the acquisition date to reflect new information obtained about facts and circumstances that existed as of the acquisition date and, if known, would have affected the measurement of the amounts recognised as of that date. During the measurement period, the acquirer shall also recognise additional assets or liabilities if new information is obtained about facts and circumstances that existed as of the acquisition date and, if known, would have resulted in the recognition of those assets and liabilities as of that date. The measurement period ends as soon as the acquirer receives the information it was seeking about facts and circumstances that existed as of the

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Chapter 25: Business combinations

acquisition date or learns that more information is not obtainable. However, the measurement period shall not exceed one year from the acquisition date. Note the requirement in relation to a maximum 12 month period from the acquisition date. Paragraph B67 sets out disclosures in relation to acquisitions where the accounting for the business combination is incomplete and numbers have been determined provisionally.

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Case study 25.5 Accounting for acquisition-related costs One of the responsibilities of the group accountant for Southland Ltd, Mr Henry, is to explain to the company’s board of directors the accounting principles applied by the company in preparing the annual report. Having analysed AASB 3/IFRS 3, Mr Henry is puzzled by the requirement in paragraph 53 that any acquisition-related costs such as fees for lawyers and valuers should be expensed. Mr Henry has analysed other accounting standards such as AASB 116/IAS 16 Property, Plant and Equipment and notes that under this standard such costs are capitalised into the cost of any property, plant and equipment acquired. She therefore believes that to expense such costs in accounting for a business combination would not be consistent with accounting for acquisitions of other assets. Further, Mr Henry believes that to expense such costs would result in a loss being reported in the statement of profit or loss and other comprehensive income in the period the business combination occurs. She is not sure how she will explain to the board of directors that the company makes a loss every time it enters a business combination. She believes the directors will wonder why the company enters into business combinations if immediate losses occur — surely losses indicate that bad decisions have been made by the company. Required Prepare a report for Mr Henry on how she should explain the accounting for acquisition-related costs to the board of directors. Arguments in favour of expensing: • These costs are not part of the fair value exchange between the buyer and the seller. • The services received from the outlays have been consumed, and so do not give rise to assets. Arguments against expensing: • Inconsistent with other accounting standards such as AASB 116 Property, Plant and Equipment. • The costs are an integral part of the acquisition price, with the outlays being incurred in order to generate future benefits. Under AASB 3/IFRS 3, a fair value model is adopted so consistency with AASB 116 is not a strong argument. The acquirer is prepared to incur the costs at acquisition. Hence there must be an expectation on the acquirer’s part that these will be recouped via future benefits from the business combination. As noted by Mr Henry, business combinations do not result in immediate losses. However, because the fair value model is used, the assets acquired cannot be stated in excess of fair value – compare the initial measurement of financial instruments acquired under paragraph 5.1.1 of AASB 9/IFRS 9. If goodwill reflects expected future benefits and is measured as a residual, then it may be argued the total benefits acquired by the acquirer are reflected in the cost of the combination

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Chapter 25: Business combinations

being the sum of the consideration transferred and the directly attributable costs. Under this view there would be a larger goodwill measured than currently recognised under AASB 3/IFRS 3, but no expense for the acquisition-related costs. Note paragraph BC366 of the Basis for Conclusions for AASB 3/IFRS 3, the IASB argues: 1. Acquisition-related costs are not part of the fair value exchange between the buyer and the seller. 2. They are separate transactions for which the buyer pays the fair value for the services received. 3. These amounts do not generally represent assets of the acquirer at acquisition date because the benefits obtained are consumed as the services are received.

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Application and analysis exercises Exercise 25.1 Accounting by an acquirer On 1 July 2023, Sonic Ltd acquired the following assets and liabilities from Screwdriver Ltd. Carrying amount Land Plant (cost $800 000) Inventories Cash Accounts payable Loans

600 000 560 000 160 000 30 000 (40 000) (160 000)

Fair value $

700 000 580 000 170 000 30 000 (40 000) (160 000)

In exchange for these assets and liabilities, Sonic Ltd issued 200 000 shares that had been issued for $2.20 per share but at 1 July 2023 had a fair value of $4.50 per share. Required 1. Prepare the journal entries in the records of Sonic Ltd to account for the acquisition of the assets and liabilities of Screwdriver Ltd. 2. Prepare the journal entries assuming that the fair value of Sonic Ltd shares was $4 per share. (LO6) SONIC LTD – SCREWDRIVER LTD Acquisition analysis: Net fair value of identifiable assets and liabilities acquired: Land $700 000 Plant 580 000 Inventories 170 000 Cash 30 000 1 480 000 Accounts payable Loans Net assets Consideration transferred: 200 000 shares at $4.50 each Gain on bargain purchase = $1 280 000 - $900 000

40 000 160 000 200 000 $1 280 000

$900 000 = $380 000

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Chapter 25: Business combinations

1. Journal entries: Sonic Ltd, FV of shares = $4.50: Land Plant Inventories Cash Gain on bargain purchase Accounts payable Loans Share capital

Dr Dr Dr Dr Cr Cr Cr Cr

700 000 580 000 170 000 30 000 380 000 40 000 160 000 900 000

2. Journal entries: Sonic Ltd, FV of shares = $4.00: Fair value of acquiree’s net assets Consideration transferred: 200 000 x $4 Gain on bargain purchase Land Plant Inventories Cash Accounts payable Loans Share capital Gain on bargain purchase

$1 280 000 $800 000 $480 000 Dr Dr Dr Dr Cr Cr Cr Cr

700 000 580 000 170 000 30 000

40 000 160 000 800 000 480 000

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Exercise 25.2 Accounting by an acquirer Tony Ltd acquired all the assets and liabilities of Jennings Ltd on 1 July 2024. At this date, the assets and liabilities of Jennings Ltd consisted of:

In exchange for these net assets, Tony Ltd agreed to: • issue 10 Tony Ltd shares for every Jennings Ltd share — Tony Ltd shares were considered to have a fair value of $10 per share; costs of share issue were $500 • transfer a patent to the former shareholders of Jennings Ltd — the patent was carried in the records of Tony Ltd at $350 000 but was considered to have a fair value of $1 million • pay $5.20 per share in cash to each of the former shareholders of Jennings Ltd. Tony Ltd incurred $10 000 in costs associated with the acquisition of these net assets. Required 1. Prepare an acquisition analysis in relation to this acquisition. 2. Prepare the journal entries in Tony Ltd to record the acquisition at 1 July 2024. (LO6) TONY LTD – JENNINGS LTD 1. Acquisition analysis: Fair value of identifiable assets and liabilities acquired: Current assets Non-current assets Liabilities

$980 000 4 220 000 5 200 000 500 000 $4 700 000

Consideration transferred:

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Chapter 25: Business combinations

Shares: 100 000 x 10 x $10 Patent Cash: 100 000 x $5.20

$10 000 000 1 000 000 520 000 $11 520 000

Goodwill = $11 520 000 - $4 700 000 = $6 820 000 2. Journal entries for Tony Ltd: Patent Dr Gain Cr (Re-measurement as part of consideration transferred in a business combination) Current assets Non-current assets Goodwill Liabilities Share capital Patent Cash (Acquisition of Jennings Ltd)

650 000 650 000

Dr Dr Dr Cr Cr Cr Cr

980 000 4 220 000 6 820 000

Acquisition-related expenses Dr Cash Cr (Payment of directly attributable costs)

10 000

Share capital Cash (Costs of issuing shares)

Dr Cr

500 000 10 000 000 1 000 000 520 000

10 000

500

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Exercise 25.3 Accounting by an acquirer David Ltd, a supplier of snooker equipment, agreed to acquire the business of a rival company, Tennant Ltd, taking over all assets and liabilities as at 1 June 2023. The price agreed on was $60 000, payable $20 000 in cash and the balance by the issue to the selling company of 16 000 fully paid shares in David Ltd, these shares having a fair value of $2.50 per share. The trial balances of the two companies as at 1 June 2023 were as follows.

All the identifiable net assets of Tennant Ltd were recorded by Tennant Ltd at fair value except for the inventories, which were considered to be worth $28 000 (assume no tax effect). The plant had an expected remaining life of 5 years. The business combination was completed and Tennant Ltd went into liquidation. David Ltd incurred incidental costs of $500 in relation to the acquisition. Costs of issuing shares in David Ltd were $400. Required 1. Prepare the journal entries in the records of David Ltd to record the business combination. 2. Show the statement of financial position of David Ltd after completion of the business combination. (LO6) Acquisition analysis: Consideration transferred:

cash shares (16 000 x $2.50)

$20 000 $40 000 $60 000

Net fair value of identifiable assets and liabilities acquired: Plant Inventories

$30 000 28 000

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Chapter 25: Business combinations

Accounts receivable

20 000 $78 000 (20 000) $58 000

Accounts payable

Note that goodwill carried by Tennant Ltd is not an identifiable asset. Therefore: Net fair value of identifiable assets and liabilities acquired Consideration transferred Goodwill

$58 000 $60 000 $2 000

The journal entries are: Plant Dr 30 000 Inventories Dr 28 000 Accounts receivable Dr 20 000 Goodwill Dr 2 000 Cash Cr Accounts payable Cr Share capital Cr (Net assets acquired from Tennant Ltd and issue of shares) Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

500

Share capital Cash (Share issue costs)

Dr Cr

400

20 000 20 000 40 000

500

400

2. DAVID LTD Statement of Financial Position as at 1 June 2023 Current Assets Cash Accounts receivable Inventories Total Current Assets Non-current Assets Plant Government bonds Goodwill Total Non-current Assets Total Assets Current Liabilities Accounts payable Net Assets

$ 9 1001 28 000 42 000 79 100 80 000 12 000 2 000 94 000 173 100 22 000 151 100

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Equity Share capital Retained earnings Total Equity

139 6002 11 5003 151 100

1. $30 000 – $20 000 (cash paid as consideration) – $500 (acquisition-related expenses) – $400 (share issue costs) 2. $100 000 + $40 000 (shares issued as consideration) – $400 (share issue costs) 3. $12 000 – $500 (acquisition-related expenses)

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Chapter 25: Business combinations

Exercise 25.4 Consideration transferred On 1 September 2022, the directors of Toby Ltd approached the directors of Bailey Ltd with the following proposal for the acquisition of the issued shares of Bailey Ltd, conditional on acceptance by 90% of the shareholders of Bailey Ltd by 30 November 2022. • Two fully paid ordinary shares in Toby Ltd plus $6.20 cash for every preference share in Bailey Ltd, payable at acquisition date. • Three fully paid ordinary shares in Toby Ltd plus $2.40 cash for every ordinary share in Bailey Ltd. Half the cash is payable at acquisition, and the other half in one year’s time. By 30 November, 90% of the ordinary shareholders and all of the preference shareholders of Bailey Ltd had accepted the offer. The directors of Toby Ltd decided not to acquire the remaining ordinary shares. Share transfer forms covering the transfer were dated 30 November 2022, and showed a price per Toby Ltd ordinary share of $8.40. Toby Ltd’s incremental borrowing rate is 8% p.a. Toby Ltd then appointed a new board of directors of Bailey Ltd. This board took office on 1 December 2022 and immediately: • revalued the asset Shares in Other Companies to its market value (assume no tax effect) • used the surplus so created to make a bonus issue of $64 000 to ordinary shareholders, each shareholder being allocated two ordinary shares for every ten ordinary shares held. The statement of financial position of Bailey Ltd at 30 November 2022 was as follows. BAILEY LTD Statement of financial position as at 30 November 2022 $ 240 000

Current assets Non‐current assets $ 406 000 336 000

Land and buildings Plant and equipment Less: Accumulated depreciation

(90 000)

Shares in other companies listed on stock exchange at cost (market $380 000)

60 000

Government bonds, at cost

100 000 812 000

Total non‐current assets

1 052 000

Total assets Current liabilities

60 000

Net assets

992 000

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Equity Share capital 160 000 ordinary shares fully paid

320 000

100 000 6% preference shares fully paid

200 000

520 000 472 000

Retained earnings

$ 992 000

Total equity

Required Prepare all journal entries (in general form) to record the above transactions in the records of (a) Toby Ltd and (b) Bailey Ltd. (LO6) Consideration transferred to preference shareholders: Cash = $6.20 x 100 000 = $620 000 Shares = (2 x 100 000) x $8.40 = $1 680 000 Consideration transferred to ordinary shareholders: Cash = ($2.40 x ½ x 144 000) + ($2.40 x ½ x 144 000 x 0.9259 [T1 8% 1yr]) = $172 800 + $160 000 = $332 800 Shares = (3 x 144 000) x $8.40 = $3 628 800 Total

= =

$952 800 (Cash) + $4 308 800 (shares) $5 261 600

(a) Journal entries: Toby Ltd: 30/11/22 Preference shares in Bailey Ltd Dr 2 300 000 Cash Cr 620 000 Share capital Cr 1 680 000 (Acquisition of all preference shares of Bailey Ltd) Ordinary shares in Bailey Ltd Dr 3 961 600 Cash Cr 172 800 Payable to ex-Bailey Ltd shareholders Cr 160 000 Share capital Cr 3 628 800 (Acquisition of 90% of the ordinary shares of Bailey Ltd) 30/11/23 Payable (to ex-Bailey Ltd shareholders) Interest expense Cash (Payment of deferred amount)

Dr Dr Cr

160 000 12 800

172 800

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(b) Journal entries: Bailey Ltd: 1/12/22 Shares in other companies Asset revaluation surplus (Revaluation of asset)

Dr Cr

380 000

1/12/22 Asset revaluation surplus Bonus dividend payable (Declaration of bonus dividends)

Dr Cr

64 000

380 000

Bonus dividend payable Dr 64 000 Share capital – Ordinary Cr (Issue of 32 000 ordinary shares as bonus share dividend)

64 000

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Exercise 25.5 Accounting by an acquirer Penny Ltd is seeking to expand its share of the widgets market and has negotiated to take over the operations of Robinson Ltd on 1 January 2024. The statements of financial position of the two companies as at 31 December 2023 were as follows.

Penny Ltd is to acquire all the identifiable assets, except cash, of Robinson Ltd. The assets of Robinson Ltd are all recorded at fair value except the following.

In exchange, Penny Ltd is to provide sufficient extra cash to allow Robinson Ltd to repay all of its outstanding debts and its liquidation costs of $2400, plus two fully paid shares in Penny Ltd for every three shares held in Robinson Ltd. The fair value of a share in Penny Ltd is $3.20. Costs of issuing the shares were $1200. Required Prepare the acquisition analysis and journal entries to record the business combination in the records of Penny Ltd. (LO6) Net fair value of identifiable assets and liabilities acquired:

25.25

Chapter 25: Business combinations

Accounts receivable Inventory Freehold land Buildings Plant and equipment

$34 700 39 000 130 000 40 000 46 000 $289 700

Consideration transferred: Shares: 2/3 x 60 000 x $3.20

$128 000

Cash to cover the following liabilities: Accounts payable Mortgage and interest Debentures and premium Liquidation expenses

$45 100 44 000 52 500 2 400 144 000 (12 000) $132 000

Cash already held by Robinson

Total consideration transferred

$260 000

Gain on bargain purchase = $289 700 - $260 000 =

$29 700

The journal entries Penny Ltd are:

record

the

business

combination

Accounts receivable Dr 34 700 Inventory Dr 39 000 Freehold land Dr 130 000 Buildings Dr 40 000 Plant and equipment Dr 46 000 Cash Cr Share capital Cr Gain on bargain purchase Cr (Acquisition of net assets of Robinson Ltd and shares issued) Share capital Cash (Costs of issuing shares)

Dr Cr

the

journal

132 000 128 000 29 700

1 200

25.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 25.6 Accounting for business combination by acquirer Police Ltd and Box Ltd are small family-owned companies engaged in vegetable growing and distribution. The Jones family owns the shares in Box Ltd and the Tyler family owns the shares in Police Ltd. The head of the Jones family wishes to retire but his two sons are not interested in carrying on the family business. Accordingly, on 1 July 2024, Police Ltd is to take over the operations of Box Ltd, which will then liquidate. Police Ltd is asset-rich but has limited overdraft facilities so the following arrangement has been made. Police Ltd is to acquire all of the assets, except cash, delivery trucks and motor vehicles, of Box Ltd and will assume all of the liabilities except accounts payable. In return, Police Ltd is to give the shareholders of Box Ltd a block of vacant land, two delivery vehicles and sufficient additional cash to enable the company to pay off the accounts payable and the liquidation costs of $1500. On the liquidation of Box Ltd, Mr Jones to receive the land and the motor vehicles and his two sons are to receive the delivery trucks. The land and vehicles had the following market values at 30 June 2024.

The statements of financial position of the two companies as at 30 June 2021 were as follows.

25.27

Chapter 25: Business combinations

All the assets of Box Ltd are recorded at fair value, with the exception of:

Required 1. Prepare the acquisition analysis and the journal entries to record the acquisition of Box Ltd’s operations in the records of Police Ltd. 2. Prepare the statement of financial position of Police Ltd after the business combination. (LO6)

25.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

POLICE LTD – BOX LTD 1. Acquisition analysis: Fair value of identifiable assets and liabilities acquired: Accounts receivable Freehold land Buildings Cultivation equipment Irrigation equipment

$15 000 120 000 40 000 40 000 22 000

Loan – Bank of Gallifrey Loan – Williams Bros Loan – Smith Corp.

(80 000) (35 000) (52 500)

$237 000

167 500 $69 500

Consideration transferred: Freehold land Delivery trucks Cash to cover liabilities Accounts payable Liquidation expenses Cash held

$120 000 28 000 $23 500 1 500

$25 000 (2 000)

Goodwill = $171 000 - $69 500 =

23 000 $171 000 $101 500

Freehold land Dr 70 000 Gain on revaluation of land Cr (Re-measurement of land as part of consideration transferred)

70 000

Loss on revaluation of delivery trucks Dr 2 000 Delivery trucks Cr 2 000 (Re-measurement of delivery trucks as part of consideration transferred) Accounts receivable Freehold land Buildings Cultivation equipment Irrigation equipment Goodwill Loan – Bank of Gallifrey Loan – Williams Bros Loan – Smith Corp Freehold land Delivery trucks Cash (Acquisition of net assets of Box Ltd)

Dr Dr Dr Dr Dr Dr Cr Cr Cr Cr Cr Cr

15 000 120 000 40 000 40 000 22 000 101 500

80 000 35 000 52 500 120 000 28 000 23 000

25.29

Chapter 25: Business combinations

2. POLICE LTD Statement of Financial Position as at 1 July 2024 Current Assets Accounts receivable (25 000 + 15 000) Total Current Assets Non-Current Assets Freehold land (250 000 + 70 000 – 120 000 + 120 000) Buildings (25 000 + 40 000) Cultivation equipment (65 000 + 40 000) Irrigation equipment (16 000 + 22 000) Delivery trucks (45 000 – 2000 – 28 000) Motor vehicles Goodwill Total Non-current Assets Total Assets

$40 000 40 000 320 000 65 000 105 000 38 000 15 000 25 000 101 500 669 500 709 500

Current Liabilities Bank overdraft (3 500 – 23 000) Accounts payable Total Current Liabilities Non-current Liabilities Loan – Bank of Gallifrey (150 000 + 80 000) Loan – Williams Bros (35 000 + 35 000) Loan – Smith Corp (70 000 + 52 500) Total Non-current Liabilities Total Liabilities Net Assets

230 000 70 000 122 500 422 500 468 000 $241 500

Equity Share capital Other reserves Retained earnings (45 000 + 70 000 – 2 000) Total Equity

$100 000 28 500 113 000 $241 500

19 500 26 000 45 500

25.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 25.7 Accounting for business combination by acquirer Yarra Ltd and River Ltd are two family-owned flax-producing companies in Queensland. Yarra Ltd is owned by the Jones family and the Smith family owns River Ltd. The Jones family has only one son and he is engaged to be married to the daughter of the Smith family. Because the son is currently managing River Ltd, it is proposed that, after the wedding, he should manage both companies. As a result, it is agreed by the two families that Yarra Ltd should take over the net assets of River Ltd. The statement of financial position of River Ltd immediately before the takeover is as follows. Carrying amount Cash Accounts receivable Land Buildings (net) Farm equipment (net) Irrigation equipment (net) Vehicles (net)

Accounts payable Loan — Trevally Bank Share capital Retained earnings

10 000 70 000 310 000 265 000 180 000 110 000 80 000

1 025 000

40 000 240 000 335 000 410 000

1 025 000

Fair value $

10 000 62 500 420 000 275 000 182 000 112 500 86 000

40 000 240 000

The takeover agreement specified the following details. • Yarra Ltd is to acquire all the assets of River Ltd except for cash, and one of the vehicles (having a carrying amount of $22 500 and a fair value of $24 000), and assume all the liabilities except for the loan from the Trevally Bank. River Ltd is then to go into liquidation. The vehicle is to be transferred to Mr and Mrs Smith. • Yarra Ltd is to supply sufficient cash to enable the debt to the Trevally Bank to be paid off and to cover the liquidation costs of $2750. It will also give $75 000 to be distributed to Mr and Mrs Smith to help pay the costs of the wedding. • Yarra Ltd is also to give a piece of its own prime land to River Ltd to be distributed to Mr and Mrs Smith, this eventually being available to be given to any offspring of the forthcoming marriage. The piece of land in question has a carrying amount of $40 000 and a fair value of $110 000.

25.31

Chapter 25: Business combinations

•

Yarra Ltd is to issue 50 000 shares, these having a fair value of $14 per share, to be distributed via River Ltd to the soon to-be-married-daughter of Mr and Mrs Smith, Dalek is currently a shareholder in River Ltd.

The takeover proceeded as per the agreement, with Yarra Ltd incurring incidental costs of $12 500 and share issue costs of $9 000. Required Prepare the acquisition analysis and the journal entries to record the acquisition of River Ltd in the records of Yarra Ltd. (LO6)

YARRA LTD – RIVER LTD Acquisition analysis: Net fair value of identifiable assets and liabilities acquired: Accounts receivable Land Buildings Farm equipment Irrigation equipment Vehicles ($86 000 - $24 000)

$62 500 420 000 275 000 182 000 112 500 62 000 1 114 000 40 000 $1 074 000

Accounts payable Consideration transferred: Shares: Cash: Land:

Goodwill:

50 000 x $14 per share $240 000 + $2 750 +$75 000 - $10 000

$700 000 307 750 110 000 $1 117 750

$1 117 750 - $1 074 000 =

$43 750

The journal entries in Yarra Ltd are: Land

Dr 70 000 Gain on revaluation of land Cr (Re-measurement of land as part of consideration transferred) Accounts receivable Land Buildings Farm equipment Irrigation equipment Vehicles

Dr Dr Dr Dr Dr Dr

70 000

62 500 420 000 275 000 182 000 112 500 62 000

25.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill Accounts payable Share capital Cash Land (Acquisition of net assets of River Ltd)

Dr Cr Cr Cr Cr

43 750

Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

12 500

Share capital Cash (Share issue costs)

Dr Cr

9 000

40 000 700 000 307 750 110 000

12 500

9 000

25.33

Chapter 25: Business combinations

Exercise 25.8 Acquisition analysis On 1 July 2024, Donna Ltd and Noble Ltd sign an agreement whereby the operations of Noble Ltd are to be taken over by Donna Ltd. Noble Ltd will liquidate after the transfer is complete. The statements of financial position of the two companies on that day were as shown below. Donna Ltd Cash Accounts receivable Inventories Land Plant and equipment Accumulated depreciation — plant and equipment Patents Shares in London Ltd Debentures in Jack Ltd (nominal value)

Accounts payable Mortgage loan 10% debentures (face value) Contributed equity: Ordinary shares of $1, fully paid A class shares of $2, fully paid B class shares of $1, fully paid Retained earnings

Noble Ltd

50 000 75 000 46 000 65 000 180 000 (60 000) 10 000 0 10 000

20 000 56 000 29 000 0 167 000 (40 000) 0 26 000 0

$ 376 000

258 000

31 000 21 500 30 000

62 000 75 000 100 000 100 000 0

0 40 000 60 000 75 500

39 000 $ 376 000

258 000

Donna Ltd is to acquire all the assets of Noble Ltd (except for cash). The assets of Noble Ltd are recorded at their fair values except for: Carrying amount Inventories Plant and equipment Shares in London Ltd

29 000 127 000 26 000

Fair value $ 39 200 140 000 22 500

25.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In exchange, the A class shareholders of Noble Ltd are to receive one 7% debenture in Donna Ltd, redeemable on 1 July 2025, for every share held in Noble Ltd. The fair value of each debenture is $3.50. Donna Ltd will also provide one of its patents to be held jointly by the A class shareholders of Noble Ltd and for which they will receive future royalties. The patent is carried at $4 000 in the records of Donna Ltd, but is considered to have a fair value of $5 000. The B class shareholders of Noble Ltd are to receive two shares in Donna Ltd for every three shares held in Noble Ltd. The fair value of each Donna Ltd share is $2.70. Costs to issue these shares amount to $900. Additionally, Donna Ltd is to provide Noble Ltd with sufficient cash, additional to that already held, to enable Noble Ltd to pay its liabilities. The outstanding debentures are to be redeemed at a 10% premium. Annual leave entitlements of $16 200 outstanding at 1 July 2024 and expected liquidation costs of $5 000 have not been recognised by Noble Ltd. Costs incurred in arranging the business combination amounted to $1 600. Required Prepare the journal entries in the records of Donna Ltd to record the acquisition of Noble Ltd. (LO6) Acquisition analysis: Net fair value of identifiable assets and liabilities acquired: Accounts receivable Inventories Plant and equipment Shares in London Ltd

$56 000 39 200 140 000 22 500 $257 700

Consideration transferred: Shareholders: Debentures A shares of Noble Ltd 20 000 Debentures in Donna Ltd (1/1) 20 000 x $3.50 Shares B shares of Noble Ltd 60 000 Shares in Donna Ltd (2/3) 40 000 x $2.70 Patent Creditors: Cash Debentures issued 30 000 Plus premium (10%) 3 000 33 000 Accounts payable 31 000 Mortgage loan 21 500 Liquidation costs 5 000 Annual leave 16 200 Total cash required 106 700 Less cash already held (20 000)

Goodwill:

[$269 700 – $257 700]

$70 000 108 000 5 000

86 700 $269 700 $12 000

25.35

Chapter 25: Business combinations

DONNA LTD General Journal Patent Gain on revaluation of patent

Dr Cr

1 000

Accounts receivable Inventories Plant and equipment Shares in London Ltd Goodwill Cash Patent Share capital 7% Debentures (Acquisition of Noble Ltd)

Dr Dr Dr Dr Dr Cr Cr Cr Cr

56 000 39 200 140 000 22 500 12 000

Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

1 600

Share capital Cash (Payment of share issue costs)

Dr Cr

900

1 000

86 700 5 000 108 000 70 000

1 600

900

25.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 25.9 Accounting for a business combination by the acquirer Cyborg Ltd was finding difficulty in raising finance for expansion while Dalek Ltd was interested in achieving economies by marketing a wider range of products. They entered discussions on how they could mutually achieve added benefits to both companies. They prepared the following financial positions of the companies at 30 June 2023. Cyborg Ltd Share capital 160 000 shares 360 000 shares Retained earnings

$ 160 000 48 000

$ 360 000 120 000

208 000

480 000

80 000 168 000

— 48 000

248 000

48 000

$ 456 000

$ 528 000

48 000 72 000 172 000 92 000 208 000 (136 000 )

$ 456 000

$ 528 000

Liabilities: Debentures (secured by floating charge) Accounts payable

Total equity and liabilities Assets: Cash Accounts receivable Inventories (at cost) Land and buildings (at cost) Plant and machinery (at cost) Accumulated depreciation on plant and machinery Total assets

Dalek Ltd

96 000 80 000 188 000 76 000 164 000 (76 000)

It was agreed that it would be mutually advantageous for Cyborg Ltd to specialise in manufacturing, and for marketing, purchasing and promotion to be handled by Dalek Ltd. Accordingly, Dalek Ltd sold part of its assets to Cyborg Ltd on 1 July 2023, the identifiable assets acquired having the following fair values. Inventories Land and buildings Plant and machinery

$88 000 (cost $60 000) $136 000 (carrying amount $40 000) $108 000 (cost $152 000, accumulated depreciation $72 000)

25.37

Chapter 25: Business combinations

The acquisition was satisfied by the issue of 160 000 ‘A’ ordinary shares (fully paid) in Cyborg Ltd. Required 1. Assuming the assets acquired constitute a business, show the journal entries to record the above transactions in the records of Cyborg Ltd: (a) if the fair value of the ‘A’ ordinary shares of Cyborg Ltd was $2 per share (b) if the fair value of the ‘A’ ordinary shares of Cyborg Ltd was $2.20 per share. 2. Show the statement of financial position of Cyborg Ltd after the transactions, assuming the fair value of Cyborg’s Ltd’s ‘A’ ordinary shares was $2.20 per share. (LO6) 1. (a) Acquisition analysis: Assuming the fair value of “A” ordinary shares was $2 per share: Net fair value of identifiable assets and liabilities acquired + + = Consideration transferred = Gain on bargain purchase = Journal entries: Inventories Land and buildings Plant and machinery Gain on bargain purchase Share capital “A” Ordinary (Assets acquired and shares issued)

Dr Dr Dr Cr Cr

$88 000 (inventory) $136 000 (land and buildings) $108 000 (plant and machinery) $332 000 160 000 shares x $2.00 $320 000 $12 000

88 000 136 000 108 000 12 000 240 000

(b) Acquisition analysis: Assuming the fair value of “A” ordinary shares was $2.20 per share: Net fair value of identifiable assets and liabilities acquired Consideration transferred Goodwill Journal entries: Inventory Land and buildings Plant and machinery Goodwill Share capital “A” Ordinary

= = = =

Dr Dr Dr Dr Cr

$332 000 160 000 shares x $2.20 $352 000 $20 000

88 000 136 000 108 000 20 000

352 000

25.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(Assets acquired and shares issued) 2. CYBORG LTD Statement of Financial Position as at 30 June 2023 $ Current Assets Cash Accounts receivable Inventory Total Current Assets Non-Current Assets Land and buildings Plant and machinery Accumulated depreciation Goodwill Total Non-Current Assets Total Assets

48 000 72 000 260 000 380 000

228 000 316 000 136 000

Current Liabilities Accounts payable Non-current Liabilities Debentures Total Liabilities Net Assets Equity Share capital 160 000 ordinary shares, fully paid 160 000 “A” ordinary shares, fully paid Retained earnings Total Equity

180 000 20 000 428 000 808 000

168 000 80 000 248 000 560 000

160 000 352 000

512 000 48 000 560 000

25.39

Chapter 25: Business combinations

Exercise 25.10 Accounting for acquisitions of a business and shares in another entity Blink Ltd is seeking to expand its share of the men’s products market and has negotiated to acquire the operations of Weeping Ltd and the shares of Angel Ltd. At 1 July 2023, the trial balances of the three companies were as follows.

Blink Ltd Cash Accounts receivable Inventories Shares in listed companies Land and buildings (net) Plant and equipment (net) Goodwill (net)

Accounts payable Bank overdraft Debentures Mortgage loan Contributed equity: Ordinary shares of $1, fully paid Other reserves Retained earnings (30/6/23)

Weeping Ltd

Angel Ltd

5 200

$ 84 000

21 300 30 000 22 000 40 000 105 000

12 000 25 400 7 000 36 000 25 000

$ 145 00 0 34 000 56 000 16 000 70 000 130 00 0 6 000

5 000

5 600

$ 457 00 0

$ 228 500

$ 195 000

$ 65 000 0 50 000 100 00 0

$ 40 000 0 0 30 000

$ 29 000 1 500 100 000 0

200 00 0 15 000 27 000

150 000

60 000

6 500 2 000

2 500 2 000

$ 457 00 0

$ 228 500

$ 195 000

Weeping Ltd Blink Ltd is to acquire all assets (except cash and shares in listed companies) of Weeping Ltd. Acquisition-related costs are expected to be $7 600. The net assets of Weeping Ltd are recorded at fair value except for the following.

25.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In exchange, the shareholders of Weeping Ltd are to receive, for every three Weeping Ltd shares held, one Blink Ltd share worth $2.50 each. Costs to issue these shares are $950. Additionally, Blink Ltd will transfer to Weeping Ltd its ‘Shares in Listed Companies’ asset, which has a fair value of $15 000. These shares, together with those already owned by Weeping Ltd will be sold and the proceeds distributed to the Weeping Ltd shareholders. Assume that the shares were sold for their fair values. Blink Ltd will also give Weeping Ltd sufficient additional cash to enable Weeping Ltd to pay all its creditors. Weeping Ltd will then liquidate. Liquidation costs are estimated to be $8700. Angel Ltd Blink Ltd is to acquire all the issued shares of Angel Ltd. In exchange, the shareholders of Angel Ltd are to receive: • one Blink Ltd share, worth $2.50 • $1.50 cash for every two Angel Ltd shares held. Required 1. Prepare the acquisition analysis and journal entries to record the acquisitions in the records of Blink Ltd. 2. Explain in detail why, if Weeping Ltd has recorded a goodwill asset of $5000, Blink Ltd calculates the goodwill acquired via an acquisition analysis. Why does Blink Ltd not determine a fair value for the goodwill asset and record that figure as it has done for other assets acquired from Weeping Ltd? 3. Shortly after the business combination, the liquidator of Weeping Ltd receives a valid claim of $25 000 from a creditor. As Blink Ltd has agreed to provide sufficient cash to pay all the liabilities of Weeping Ltd at acquisition date, the liquidator requests and receives a cheque for $25 000 from Blink Ltd. How should Blink Ltd record this payment? Why? (LO6) 1. Acquisition Analysis – Blink Ltd - Weeping Ltd Fair value of identifiable assets and liabilities acquired: Accounts receivable Inventory Land and buildings Plant and equipment

$21 300 26 000 80 000 105 000 $232 300

Consideration transferred: To shareholders Shares

Shares of Weeping Ltd

150 000

25.41

Chapter 25: Business combinations

Shares in Blink Ltd (1/3) Shares in Listed Companies

50 000

x $2.50

$125 000 15 000

To creditors Cash Accounts payable Mortgage loan Liquidation costs Annual leave Total cash required Less cash already held

Goodwill

$49 100 30 000 8 700 29 700 117 500 (5 200)

112 300 $252 300

$252 300 – $232 300

$20 000

Acquisition Analysis – Blink Ltd - Angel Ltd Consideration transferred: To shareholders: Shares

Shares of Angel Ltd Shares in Blink Ltd (1/2)

Cash

60 000 30 000 30 000

x $2.50 x $1.50

$75 000 45 000 $120 000

Loss on revaluation of shares in listed comp Dr 1 000 Shares in listed companies Cr 1 000 (Re-measurement as part of consideration transferred in a business combination) Accounts receivable Inventories Land and buildings Plant and equipment Goodwill Cash Shares in listed companies Share capital (Acquisition of Weeping Ltd’s assets)

Dr Dr Dr Dr Dr Cr Cr Cr

21 300 26 000 80 000 105 000 20 000

Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

7 600

Share capital Cash (Payment of share issue costs)

Dr Cr

950

Shares in Angel Ltd Share capital Cash

Dr Cr Cr

120 000

112 300 15 000 125 000

7 600

950

75 000 45 000

25.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(Acquisition of shares in Angel Ltd) 2. Goodwill is measured differently for two reasons: (a) AASB 138/IAS 38 prohibits the recognition of internally generated goodwill so the figure recorded in the books of Weeping Ltd does not necessarily represent the ‘value’ of goodwill of the company at acquisition date. (b) Goodwill cannot be separated from the company and sold separately so no fair value is available. The only way goodwill can be measured is to compare the total value of the company against the fair values of its identifiable net assets, any surplus is deemed to represent the value of the net unidentifiable assets or goodwill. 3. Blink Ltd should post the following journal: Goodwill Cash (Payment to Weeping Ltd)

Dr Cr

25 000 25 000

If the liability had been identified at acquisition date then Blink Ltd would have paid an extra $25 000 cash to acquire the assets of Weeping Ltd. As the cost of the combination has increased (from $252 300 to $277 300) but there has been no change in the fair values of identifiable assets and liabilities, then the value of goodwill acquired must increase (from $20 000 to $45 000).

25.43

Chapter 25: Business combinations

Exercise 25.11 Acquisition of two businesses Amy Ltd is a manufacturer of specialised industrial equipment seeking to diversify its operations. After protracted negotiations, the directors decided to purchase the assets and liabilities of Pond Ltd and the spare parts retail division of Rory Ltd. At 30 June 2024 the statements of financial position of the three entities were as follows.

Land and buildings (net) Plant and equipment (net) Office equipment (net) Shares in listed companies Debentures in listed companies Accounts receivable Inventories Cash Goodwill

Accounts payable Current tax liability Provision for leave Bank loan Debentures Share capital (issued at $1, fully paid) Retained earnings

Amy Ltd

Pond Ltd

Rory Ltd

60 000 100 000 16 000 24 000 20 000 35 000 150 000 59 000 0

$ 25 000 36 000 4 000 15 000 0 26 000 54 000 11 000 7 000

$ 40 000 76 000 6 000 20 800 0 42 000 30 200 9 000 0

$ 464 000

$ 178 000

$ 224 000

26 000 21 000 36 000 83 000 60 000 200 000 38 000

$ 14 000 6 000 10 000 16 000 50 000 60 000 22 000

$ 27 000 7 000 17 500 43 500 0 90 000 39 000

$ 464 000

$ 178 000

$ 224 000

The acquisition agreement details are as follows. Pond Ltd Amy Ltd is to acquire all the identifiable assets (other than cash) and liabilities (other than debentures, provisions and tax liabilities) of Pond Ltd for the following purchase consideration: • •

Shareholders in Pond Ltd are to receive three shares in Amy Ltd, credited as fully paid, in exchange for every four shares held. The shares in Amy Ltd are to be issued at their fair value of $3 per share. Costs of share issue amounted to $2000. Amy Ltd is to provide sufficient cash which, when added to the cash already held, will enable Pond Ltd to pay out the current tax liability and provision for leave, to © John Wiley and Sons Australia Ltd, 2020

25.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

redeem the debentures at a premium of 5%, and to pay its liquidation expenses of $2500. The fair values of the assets and liabilities of Pond Ltd are equal to their carrying amounts with the exception of the following. Fair value Land and buildings Plant and equipment

60 000 50 000

Incidental costs associated with the acquisition amount to $2500. Rory Ltd Amy Ltd is to acquire the spare parts retail business of Rory Ltd. The following information is available concerning that business, relative to the whole of Rory Ltd.

Total amount

Land and buildings (net) Plant and equipment (net) Office equipment (net) Accounts receivable Inventories Accounts payable Provision for leave

Spare parts division

Carrying amount

Fair value

$ 40 000 76 000 6 000 42 000 30 200 27 000 17 500

$ 20 000 32 000 2 000 21 000 12 000 14 000 7 000

$ 30 000 34 500 2 500 20 000 12 000 14 000 7 000

The divisional net assets are to be acquired for $10 000 cash, plus 11 000 ordinary shares in Amy Ltd issued at their fair value of $3, plus the land and buildings that have been purchased from Pond Ltd. Incidental costs associated with the acquisition are $1000. Required 1. Prepare the acquisition analysis for the acquisition transactions of Amy Ltd. 2. Prepare the journal entries for the acquisition transactions in the records of Amy Ltd. (LO6) 1. Acquisition Analysis: Amy Ltd – Pond Ltd: Net fair value of identifiable assets and liabilities acquired:

25.45

Chapter 25: Business combinations

Land & buildings Plant & equipment Office equipment Shares in listed companies Accounts receivable Inventories

$60 000 50 000 4 000 15 000 26 000 54 000 209 000 14 000 16 000 30 000 $179 000

Accounts payable Bank loan Net fair value of identifiable assets and liabilities acquired Consideration transferred: Shares in Amy Ltd Shares issued by Pond Ltd Shares in Amy Ltd to issue: (3/4 x 60 000)

60 000 45 000 x $3.00

$135 000

Cash Current tax liability Provision for leave Debentures 5% premium Liquidation costs Less cash already held by Pond Ltd Total consideration Goodwill:

$6 000 10 000 50 000 2 500 2 500 71 000 11 000

60 000 $195 000

[$195 000 - $179 000]

$16 000

Acquisition Analysis: Amy – Rory Ltd’s Spare Parts Retail Division: Net fair value of identifiable assets and liabilities acquired: Land & buildings Plant & machinery Office equipment Accounts receivable Inventories Accounts payable Provision for leave Consideration transferred: Cash Shares Land and Buildings

$30 000 34 500 2 500 20 000 12 000 99 000 $14 000 7 000

[11 000 x $3.00]

21 000 $78 000 $10 000 33 000 60 000 $103 000

25.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill:

[$103 000 - $78 000]

$25 000

2. Land & buildings Dr 60 000 Plant & machinery Dr 50 000 Office equipment Dr 4 000 Shares in listed companies Dr 15 000 Accounts receivable Dr 26 000 Inventories Dr 54 000 Goodwill Dr 16 000 Accounts payable Cr Bank loan Cr Cash Cr Share capital Cr (Acquisition of assets and liabilities of Pond Ltd and issue of shares) Share capital Cash (Payment of costs of issuing shares) Acquisition-related expenses Cash (Costs related to acquisition)

Dr Cr

2 000

Dr Cr

2 500

14 000 16 000 60 000 135 000

2 000

2 500

Land & buildings Dr 30 000 Plant & machinery Dr 34 500 Office equipment Dr 2 500 Accounts receivable Dr 20 000 Inventories Dr 12 000 Goodwill Dr 25 000 Accounts payable Cr 14 000 Provision for leave Cr 7 000 Cash Cr 10 000 Share capital Cr 33 000 Land & buildings Cr 60 000 (Acquisition of the spare parts retail division of Rory Ltd and issue of shares) Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

1 000 1 000

25.47

Chapter 25: Business combinations

Exercise 25.12 Accounting by acquirer, liquidation journal entries by acquiree The financial statements of Sicily Ltd at 1 August 2022 contained the following information. Assets Vehicles Accumulated depreciation

Equity $ 90 000 (13 200)

Share capital: 150 000 shares Retained earnings

$144 000 76 800

Delivery trucks

105 000

Total equity

220 800

Accumulated depreciation Machinery Accumulated depreciation Buildings Accumulated depreciation

(18 600) 59 400 (9 000) 144 000 (12 000)

Liabilities Loans Provisions Payables Accounts payable

192 000 84 000 126 000 56 400

Land

240 000

Total liabilities

458 400

Cash Accounts receivable Inventories

6 000 36 000 51 600 Total equity and liabilities

$679 200

Total assets

$ 679 200

Sicily Ltd is involved in the manufacture of fine Italian leather handbags. The company was established by the de Niro brothers over 100 years ago. The family became very wealthy as their handbags were prized by the fashion conscious in the community. However, the current manager, Roberto de Niro, wishes to retire and offers to sell the business to his main rival, Al Ltd, which is headed up by the manager and owner, Vito Corleone. Vito and Roberto come to an agreement by which Al Ltd will take over Sicily Ltd. Al Ltd will acquire all the assets of Sicily Ltd except for the cash and the motor vehicles. In exchange, Al Ltd will give the shareholders of Sicily Ltd a block of land valued at $288 000 and a motor vehicle valued at $61 200. These assets are currently held by Al Ltd. The land is carried at cost of $120 000 while the motor vehicle is carried at $60 000, being cost of $63 000 and accumulated depreciation of $3000. Al Ltd will also provide sufficient additional cash to enable Sicily Ltd to pay off the accounts payable and the liquidation expenses of $3600. On liquidation of Sicily Ltd, the land and the motor vehicles will be distributed to members of the de Niro family. Al Ltd incurred legal and valuation costs of $6000 in undertaking the business combination.

25.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The assets and liabilities of Sicily Ltd are recorded at amounts equal to fair value except for the following. Fair value Land Buildings Machinery Delivery trucks Inventories

300 000 168 000 60 000 90 000 60 000

Al Ltd also recognised the brand ‘Sicily’ that was not recognised in the records of Sicily Ltd as it was an internally developed brand. It was calculated that this brand had a fair value of $78 000. Required Prepare the journal entries in Al Ltd to record the acquisition of the assets and liabilities of Sicily Ltd. (LO6 and LO7) Acquisition analysis: Fair value of identifiable assets and liabilities acquired: Land Buildings Machinery Delivery trucks Inventory Accounts receivable Brand “Sicily” Loans Provisions Payables

$300 000 168 000 60 000 90 000 60 000 36 000 78 000 (192 000) (84 000) (126 000)

Consideration transferred: Land Motor vehicles Cash: Accounts payable Liquidation expenses Cash held

$792 000

402 000 $390 000 $288 000 61 200

$56 400 3 600

$60 000 (6 000)

Goodwill = $403 200 - $390 000

54 000 $403 200 $13 200

Land Dr 168 000 Gain on revaluation of land Cr 168 000 (Re-measurement as part of consideration transferred in a business combination)

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Chapter 25: Business combinations

Accumulated depreciation – motor vehicles Dr 3 000 Motor vehicles Cr 1 800 Gain of revaluation of motor vehicles Cr 1 200 (Re-measurement as part of consideration transferred in a business combination) Land Buildings Machinery Delivery trucks Inventories Accounts receivable Brand “Sicily” Goodwill Loans Provisions Payables Land Motor vehicles Cash (Acquisition of net assets of Sicily Ltd)

Dr Dr Dr Dr Dr Dr Dr Dr Cr Cr Cr Cr Cr Cr

200 000 168 000 60 000 90 000 60 000 36 000 78 000 13 200

Acquisition expenses Dr Cash Cr (Costs associated with the business combination)

6 000

192 000 84 000 126 000 288 000 61 200 54 000

6 000

25.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 25.13 Accounting by the acquirer, liquidation of the acquiree Rove Ltd is a manufacturer of frozen foods in Fitzroy. The company’s products include many forms of vegetables and meats but one item lacking in its product range is frozen fish. The board of Rove Ltd decided to investigate a takeover of a Tasmanian company, McManus Ltd, whose prime product was the packaging of frozen Huon salmon. The reason this company was of particular interest was that Rove Ltd already owned a number of factories in Hobart some of which were underutilised. If McManus were acquired, then Rove Ltd would liquidate the company and transfer all the processing work to its other Hobart factories. The financial statements of McManus Ltd at 1 December 2022 showed the following information.

All the assets and liabilities of McManus Ltd were recorded at amounts equal to fair value except as follows.

McManus Ltd also had a brand ‘Comec’ that was not recorded by the company because it had been internally generated. It was valued at $10 000. McManus Ltd had not recorded the interest accrued on the loans amounting to $22 800 or annual leave entitlements of $13 000. Rove Ltd decided to acquire all the assets of McManus Ltd except for the cash. In exchange for these assets, Rove Ltd agreed to provide:  Two shares in Rove Ltd for every three A ordinary shares held in McManus Ltd. The fair value of each Rove Ltd share was agreed to be $2.16.

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Chapter 25: Business combinations

 

Artworks to the owners of the B ordinary shares held in McManus Ltd. (These artworks were held in the records of Rove Ltd at $40 000 and valued at $58 000.) Sufficient additional cash to enable McManus Ltd to pay off its liabilities including the expected liquidation costs of $4000.

The business combination occurred on 1 December 2022. Legal and accounting costs incurred by Rove Ltd in undertaking this business combination amounted to $1300. Costs to issue the shares to the A ordinary shareholders of McManus Ltd were $700. Required 1. Prepare the journal entries in the records of Rove Ltd at 1 December 2022 to record the business combination. (LO6 and LO7) Acquisition Analysis – Rove Ltd – McManus Ltd Net fair value of identifiable assets and liabilities acquired: Accounts receivable Inventories Plant Land Brand “Comec”

$44 800 28 000 112 000 35 800 10 000 $230 600

Consideration transferred: Shareholders Shares Artworks Creditors Cash:

Goodwill:

‘A’ shares of McManus Ltd Shares in Rove (2/3) to B ordinary shareholders

60 000 40 000 x $2.16

Accounts payable Provisions Loans Liquidation costs Interest on loans Annual leave Total cash required Less cash already held

24 800 24 000 17 200 4 000 22 800 13 000 105 800 (16 000)

[$234 200 – $230 600]

$86 400 58 000 144 400

89 800 $234 200 $3 600

Artworks Dr 18 000 Gain Cr 18 000 (Gain on re-measurement of artworks used as part of consideration in acquisition)

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Accounts receivable Inventory Plant Land Brand “Comec” Goodwill Cash Share capital Artworks (Acquisition of McManus Ltd)

Dr Dr Dr Dr Dr Dr Cr Cr Cr

44 800 28 000 112 000 35 800 10 000 3 600

Acquisition-related expenses Cash (Payment of acquisition-related costs)

Dr Cr

1 300

Share capital Cash (Payment of share issue costs)

Dr Cr

700

89 800 86 400 58 000

1 300

700

25.53

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 25: Business combinations Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 25: Business combinations Multiple choice questions 1. A business combination is defined as: a. b. *c. d.

a transaction in which an acquirer obtains control of an acquiree. a transaction in which one entity obtains control of one or more other entities. a transaction or other event in which an acquirer obtains control of one or more businesses. a transaction or other event in which an entity obtains control of one or more businesses.

Answer: c Learning objective 25.2: determine whether a transaction is a business combination.

2. AASB 3/IFRS 3 is relevant when accounting for a business combination that: a. b. c. *d.

involves mutual entities. results in the formation of a joint venture. involves entities or businesses that are not investor owned. results in an entity acquiring the net assets of another entity.

Answer: d Learning objective 25.2: determine whether a transaction is a business combination.

3. Under AASB 3/IFRS 3, the method of accounting for a business combination is the: a. *b. c. d.

purchase method. acquisition method. joint venture method. market value method.

Answer: b Learning objective 25.3: explain the key steps in the acquisition method.

4. In a business combination, the acquiree is the party that: a. b. *c. d.

pays the acquisition consideration. finances the business combination. gives up control over the net assets acquired. obtains control of the net assets the other entity.

Answer: c Learning objective 25.3: explain the key steps in the acquisition method.

25.1

Testbank to accompany Financial reporting 3e by Loftus et al.

5. An acquirer accounting for a business combination must consider: I. II. III. IV. a. b. c. *d.

Recognition of the liabilities assumed. Measurement of the liabilities assumed. Recognition of the identifiable assets acquired. Measurement of the identifiable assets acquired.

I and II only. I and III only. II and IV only. I, II, III and IV.

Answer: d Learning objective 25.3: explain the key steps in the acquisition method.

6. In a business combination, the acquirer is the party that: a. *b. c. d.

sells the acquired entity. obtains control of the other entities. receives the acquisition consideration. concedes control over the acquired entities.

Answer: b Learning objective 25.4: explain the nature of an acquirer and key factors in the identification of an acquirer.

7. The acquisition date for a business combination is the date on which: a. b. *c. d.

the business combination is announced to the public. the acquirer announces the acquisition to the acquiree. the acquirer effectively obtains control of the acquiree. a substantive agreement between the combining parties is reached.

Answer: c Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

25.2

Chapter 25: Business combinations Not for distribution in full. Instructors may assign selected questions in their LMS.

8. Where the acquirer purchases assets and assumes liabilities of another entity it does not need to consider measurement of: a. b. c. *d.

goodwill. consideration transferred. fair values of identifiable net assets. carrying amounts of identifiable net assets.

Answer: d Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

9. For a tangible asset to be recognised by an acquirer under a business combination it must be probable that future economic benefits will flow to the acquirer and: a. b. *c. d.

it must be a current item. it may not be a non-monetary asset. its fair value can be reliably measured. it must be measured using the present value method.

Answer: c Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

10. Which of the following items would not be recognised as an intangible asset in a business combination? *a. b. c. d.

experienced marketing team. newspaper mastheads. patents. trademarks.

Answer: a Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

11. The net amount of employee benefit liabilities acquired in a business combination are measured by using the: a. b. *c. d.

estimated total of future cash outflows, undiscounted. face value of the liabilities. present value method. cash method.

Answer: c Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

25.3

Testbank to accompany Financial reporting 3e by Loftus et al.

12. Kingscliff Limited estimated that the net present value of future cash flows from machinery acquired in a business combination is $70 000. The cost of replacing the machinery is estimated to be $76 000. The machinery has been independently appraised at a value of $68 000. A similar item of machinery cost the acquirer $78 000 last year. The value at which the machinery will be recognised when recording the business combination is: a. b. *c. d.

$76 000. $78 000. $68 000. $70 000.

Answer: c Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

13. Byron Limited estimated the net present value of future cash flows from specialised equipment acquired under a business combination to be $120 000. A replacement cost for the equipment is estimated to be $132 000. The equipment has been independently appraised at a value of $122 000. A similar item of equipment cost the acquirer $118 000 last year. What is the value for recognition of the equipment under a business combination? a. *b. c. d.

$118 000. $122 000. $120 000. $132 000.

Answer: b Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

14. When accounting for a business combination a contingent liability is recognised if: *a. b. c. d.

its fair value can be measured reliably. it is a possible obligation and it is probable that it will occur. it is a present obligation that has failed to meet the recognition criteria. it is probable that an outflow of resources may occur in order to settle the obligation.

Answer: a Learning objective 25.6: explain when to recognise and how to measure the identifiable assets acquired and liabilities assumed by an acquirer.

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Chapter 25: Business combinations Not for distribution in full. Instructors may assign selected questions in their LMS.

15. If shares are issued as part of the consideration paid, transactions costs such as brokerage fees may be incurred. Under AASB 3/IFRS 3 Business Combinations, the appropriate accounting treatment for such costs in the records of the acquirer is a debit to: a. b. *c. d.

cash. investments. share capital. acquisition expenses.

Answer: c Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

16. The consideration transferred in a business combination is measured as the fair value of the: *a. b. c. d.

consideration given. net assets acquired. costs directly attributable to the combination. consideration given plus directly attributable costs.

Answer: a Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

17. Watson Limited acquires the net assets of Lake Limited for a cash consideration of $160 000. One half is to be paid on acquisition date and the other half is payable in one year’s time. The appropriate discount rate is 8% p.a. The present value of the cash outflow in one year’s time is: a. *b. c. d.

$800 000 $74 072 $86 402 $72 728

Answer: b Feedback: ($160 000/2) x 0.9259 Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

25.5

Testbank to accompany Financial reporting 3e by Loftus et al.

18. Under AASB 3/IFRS 3 Business Combinations, a gain on bargain purchase arises when the acquirer’s interest in the fair value of the acquiree’s identifiable assets and liabilities is: a. *b. c. d.

less than the consideration transferred. greater than the consideration transferred. less than the carrying amount of the net assets acquired. more than the book values of the identifiable assets acquired.

Answer: b Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

19. Mary Limited acquired the identifiable assets and liabilities of Joan Limited for $530 000. The items acquired, stated at fair value, are: equipment $296 000; inventories $160 000; accounts receivable $104 000; patents $60 000; accounts payable $80 000. The difference on acquisition is: a. b. *c. d.

goodwill of $10 000 goodwill of $170 000 gain on bargain purchase $10 000 gain on bargain purchase $170 000

Answer: c Feedback: 530 000 – (296 000 + 160 000 + 104 000 + 60 000 – 80 000) = (10 000) Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

20. Goodwill arising in a business combination is classified as a(n): *a. b. c. d.

asset. liability. expense associated with the acquisition. item in equity.

Answer: a Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

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Chapter 25: Business combinations Not for distribution in full. Instructors may assign selected questions in their LMS.

21. Goodwill is measured as the difference between the: a. b. c. *d.

cost of the assets given up, and the cost of the net assets acquired. cost of the net assets acquired, and the net present value of the consideration given up. present value of the consideration transferred, and the present value of the net assets acquired fair value of the consideration transferred, and the fair value of the assets and liabilities acquired.

Answer: d Learning objective 25.7: discuss the nature of goodwill and how it is measured as well as how to measure a gain on bargain purchase.

22. The information contained within Appendix B of AASB 3/IFRS 3 in relation to disclosure: a. *b. c. d.

is not mandatory, but contains optional additional disclosures. is an integral part of AASB 3/IFRS 3. contains prescribed presentation formats for disclosure of business combinations. is complementary to the main disclosure requirements within the body of AASB 3/IFRS 3.

Answer: b Learning objective 25.8: identify the disclosures required by AASB 3/IFRS 3.

23. Appendix B of AASB 3/IFRS 3 requires disclosure of which of the following? I. II. III. IV.

*a. b. c. d.

A qualitative description of the factors that make up goodwill. Details of contingent consideration. The date of exchange. Carrying amounts of assets and liabilities in business combinations where shares are acquired.

I, II and IV only. I, III and IV only. I, II and III only. I, II, III and IV.

Answer: a Learning objective 25.8: identify the disclosures required by AASB 3/IFRS 3.

25.7

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter26: Consolidation: controlled entities

Chapter 26: Consolidation: controlled entities Comprehension questions 1. What are the consolidated financial statements? According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements, the consolidated financial statements are: The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. As stated in paragraph B86 of AASB 10/IFRS 10, consolidated financial statements “combine like items of assets, liabilities, equity, income, expenses and cash flows” of the entities in the group.

2. What is the purpose of preparing consolidated financial statements? The purpose of preparing consolidated financial statements is to show the combined financial position, financial performance and cash flows of the group of entities as if they were a single economic entity. As such, they consist of a consolidated statement of financial position, a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of changes in equity and a consolidated statement of cash flows. These consolidated statements reflect only the effects of transactions with external parties to the group.

3. What is a group, a parent and a subsidiary? According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements: • A group is formed by a parent and all its subsidiaries. • A parent is an entity that controls one or more entities. • A subsidiary is an entity that is controlled by another entity, a parent.

4. What is a parent–subsidiary relationship? The parent–subsidiary relationship is a special case of an investor–investee relationship, where the investor (the parent) has control over the investee (the subsidiary). The parent–subsidiary relationship gives rise to a group for which normally consolidated financial statements need to be prepared. 5. How many parents can a group have? In a group there can be only one parent. The control cannot be shared. Note, however, that for a number of entities that are interconnected there may be a main group and, within it, a number of subgroups, each with its own unique parent. The existence of subgroups inside the main group does not mean that a group may have more than one parent.

26.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

6. Why do the regulators require the parent entity to prepare consolidated financial statements? Some of the reasons for which the regulators require the parent entity to prepare consolidated financial statements are as follows: i. To supply relevant information to investors in the parent entity. The information obtained from the consolidated financial statements is relevant to investors in the parent entity. A shareholder’s wealth in the parent is dependent not only on how that entity performs, but also on the performance of the other entities controlled by the parent. To require these investors in analysing their investment to source their information from the financial statements of each of the entities comprising the group would place a large cost burden on those investors. ii. To allow comparison of the group with similar entities. Some entities are organised into a group structure such that different activities are undertaken by separate entities within the group. Other entities are organised differently, with some having all activities conducted within the one entity. Access to consolidated financial statements makes comparisons across the group an easier task for the users of financial statements. iii. To assist in the discharge of accountability by management of the group. A key purpose of financial reporting is the discharge of accountability by management. Entities that are responsible or accountable for managing a pool of resources — being the recipients of economic benefits and responsible for payment of obligations — are generally required to report on their activities and are held accountable for the management of those activities. The consolidated financial statements report the assets under the control of the group management together with the claims on those assets, as well as the performance obtained in the management of those assets. Based on the information contained within these statements, the management of the group can be held accountable for their actions. iv. To report the risks and benefits of the group as a single economic entity. There are risks associated with managing an entity, and an entity rarely obtains control of another without also obtaining significant opportunities to benefit from that control. The consolidated financial statements allow an assessment of these risks and benefits. Note, however, that the benefits from intragroup transactions are eliminated when preparing consolidated financial statements, as those statements should only reflect the effects of transactions with external parties. v. To ensure consistency of information provided to users. The consolidated financial statements are prepared after adjusting the separate financial statements of the entities within the group for the different accounting policies applied, making sure that all the items reported are combined after being recognised and measured consistently.

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Chapter26: Consolidation: controlled entities

7. What is meant by the term ‘control’? Control of an investee is defined in Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements as follows: An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

8. What are the key elements of control? Based on the definition of control from Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements, paragraph 7 of AASB 10/IFRS 10 identifies three elements that must be held by an investor in order for it to have control: • • •

Power over the investee. Exposure or rights to variable returns from the parent’s involvement with the subsidiary The ability to use the power over the subsidiary to affect the amount of the parent’s returns.

9. When does an investor have power over an investee? Power is defined in Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements as “existing rights that give the current ability to direct the relevant activities”. An investor has power over an investor when it has the current right to direct the relevant activities of the investee. Based on this definition, four characteristics of power can be identified: • power is related to relevant activities • power arises from existing rights • power is the ability to direct • the ability to direct must be current to have power. 10. What are ‘relevant’ activities? Relevant activities are defined in Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements as activities of the subsidiary that significantly affect the investee’s returns. Examples provided in paragraph B11 of AASB 10/IFRS 10 are: (a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding. The determination of relevant activities may change over time and they differ between entities based on the purpose and design of the investees; hence it may be necessary to analyse the purpose and design of the investees in order to identify the relevant activities.

26.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

11. What are substantive rights and protective rights? According to paragraph B22 of AASB 10/IFRS 10 Consolidated Financial Statements, substantive rights are rights that an investor have practical ability to exercise. Judgement is required in assessing whether rights are substantive. Paragraph B23 of AASB 10/IFRS 10 provides some factors to consider in making that determination. •

• •

Whether there are any barriers—economic or otherwise—that prevent a holder from exercising the rights. Examples of such barriers are financial penalties, terms and conditions that make it unlikely that rights will be exercised, and the absence of specialised services necessary for exercising the rights. Paragraph B23(a) provides a detailed list of possible barriers. Where more than one party is involved, whether there is a mechanism in place to enable those parties to practically exercise the rights. Whether the party or parties that hold the rights would benefit from the exercise of those rights; for example, potential voting rights.

Paragraph B24 of AASB 10/IFRS 10 adds that for rights to be substantive, they must be exercisable when decisions about the direction of the relevant activities need to be made. If the rights are purely protective rights, the holder does not have power (AASB 10/IFRS 10 paragraph 14). Protective rights are defined in Appendix A of AASB 10/IFRS 10 as follows. Rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate. Paragraph B28 provides examples of protective rights, which include: (a) a lender’s right to restrict a borrower from undertaking activities that could significantly change the credit risk of the borrower to the detriment of the lender. (b) the right of a party holding a non-controlling interest in an investee to approve capital expenditure greater than that required in the ordinary course of business, or to approve the issue of equity or debt instruments. (c) the right of a lender to seize the assets of a borrower if the borrower fails to meet specified loan repayment conditions.

12. What are variable returns? The returns that an investor that has control over an investee receives must have the potential to vary based on the performance of the investee. Paragraph B57 of AASB 10/IFRS 10 Consolidated Financial Statements provides examples of such variable returns: • dividends from ordinary shares that will change based on the profit performance of the investee • fixed interest payments from a bond, as they expose the investor to the credit risk of the issuer of the bond, namely the investee • fixed performance fees for management of the investee’s assets, as they expose the investor to the performance risk of the investee. If the returns that the investor is entitled to receive are not variable based on the performance of the investee, the investor cannot recognise that they have control over the investee. As such, if the investor only invests in the debt instruments issued by the investee and receives returns in the form of interest that is not linked to the performance of the investee, then the investor does not have control over the investee.

26.5

Chapter26: Consolidation: controlled entities

13. What benefits could be sought by an entity that obtains control over another entity? Consider: • Dividends • Returns from structuring activities with the investee e.g. obtaining a supply of raw material, access to a port facility • Returns from denying or regulating access to a subsidiary’s assets e.g. a patent for a competing product • Returns from economies of scale • Remuneration from provision of services such as servicing of assets, and management

14. What is the link between ownership interest and control? As paragraph B35 of AASB 10/IFRS 10 Consolidated Financial Statements states, where an investor holds more than half of the voting rights of the investee, the investor has power over the investee in the absence of other evidence. Different classes of shares may have different voting rights. However, unless otherwise specified in the company’s constitution, each shareholder has one vote for each share held. Therefore, it is normally assumed that the percentage of ownership interest of an investor is equivalent to the percentage of voting rights that this investor holds in the investee. As such, it is normally assumed that an investor that has more than 50% ownership interest in an investee has the power over the investee. Given that the shares give to the shareholders the right to receive dividends, it is further assumed that an investor holding more 50% ownership interest has control. Of course, a shareholder with less than 50% ownership interest may still have control if there is any other evidence that the shareholder is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Also, a shareholder with more than 50% ownership interest may not have control, especially if most of the shares held are non-voting shares.

15. When are potential voting rights considered in determining if one entity controls another? Paragraphs B47–B50 of AASB 10/IFRS 10 Consolidated Financial Statements discuss the issue of whether potential voting rights should be considered in assessing the existence of power and control. These rights may be transferable to voting rights, such as those within a share option or convertible instrument (paragraph B47). If the potential voting rights can be easily converted by the investor into voting rights at any point in time with no restriction or significant loss, they must be taken into consideration when assessing the existence of power.

16. Explain the link between power and returns. A parent must have the ability to use its power over the investee to affect the returns received from the investee. The parent must be able to use its power to increase the benefits and limit its losses from the subsidiary’s activities.

26.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

There is then a link between the holding of the power and the returns receivable. However, there is no specification of the level of returns to be received. AASB 10/IFRS 10 Consolidated Financial Statements only requires that some variable returns be receivable and that the parent by its actions can affect the amount of those returns.

17. What is an agent or a principal? According to paragraph B58 of AASB 10/IFRS 10 Consolidated Financial Statements: • An agent is a party primarily engaged to act on behalf and for the benefit of another party or parties (the principal(s)) and therefore does not control the investee when it exercises its decision-making authority. Paragraph B60 of AASB 10/IFRS 10 provides a number of factors to consider in determining whether a decision maker is a principal or an agent: • the scope of its decision-making authority over the investee—this relates to the range of activities that the decision maker is permitted to direct • the rights held by other parties (e.g. whether another entity has substantive removal rights over the decision maker) • the remuneration to which it is entitled in accordance with the remuneration agreement— the remuneration of an agent would be expected to be commensurate with the level of skills needed to provide the management service while the remuneration agreement would contain terms and conditions normally included in arrangements for similar services • the decision maker’s exposure to variability of returns from other interest that it holds in the investee—the greater the decision maker’s exposure to variable returns from its involvement in the investee, the more likely it is that the decision maker is not an agent. Where a decision maker is determined to be an agent, it is the principal that may be considered the controlling entity over the investee.

18. Describe the consolidation process. The consolidation process is described in AASB 10/IFRS 10 Consolidated Financial Statements that establishes the principles for the preparation of consolidated financial statements. In applying AASB 10/IFRS 10 in the preparation of the consolidated financial statements, AASB 3/ IFRS 3 Business Combinations is also considered. The consolidated financial statements are prepared by combining the financial statements of the individual entities within the group (i.e. adding items in individual statements line by line), subject to some very important adjustments. These adjustments include the elimination of intragroup shareholdings, as well as the removal of the effects of intragroup transactions—because the group as an entity cannot have investments in itself, assets receivable from within itself, liabilities payable to itself or profits or losses generated from transactions with itself. The process of adding the financial statements together in order to prepare consolidated financial statements can be seen in its simplest form in figure 26.4. The consolidated financial statements are prepared by first adding together the assets and liabilities of both entities, followed by the adjustments necessary to eliminate intragroup shareholdings and the effects on intragroup transactions. In chapter 27 a consolidation worksheet is used to describe this process.

26.7

Chapter26: Consolidation: controlled entities

Note that the consolidation process does not involve making adjustments to the individual financial statements or in the accounts of the entities in the group. The consolidated financial statements are an additional set of financial statements and are prepared using a worksheet to facilitate the addition and adjustment process. Note also that, when preparing the consolidated financial statements, paragraph 19 of AASB 10/IFRS 10 requires the use of uniform accounting policies for like transactions and other events in similar circumstances. If the reporting periods of the parent and subsidiaries differ, the subsidiaries must prepare, for consolidation purposes, additional financial information as of the same date and for the same period as the financial statements of the parent. If it is impracticable to prepare this additional information, the most recent financial statements of subsidiaries with a different reporting period to the parent will be used for consolidation purposes provided that: • those financial statements are adjusted for the effects of significant transactions or events that occur between the date of those financial statements and the date of the consolidated financial statements • the difference between the date of those subsidiaries’ financial statements and that of the consolidated financial statements shall be no more than three months • the length of the reporting periods and any difference between the dates of the financial statements shall be the same from period to period.

19. Which entities are required to prepare consolidated financial statements and which entities are exempted? Paragraph 4(a) of AASB 10/IFRS 10 Consolidated Financial Statements requires each parent to prepare consolidated financial statements, except in those circumstances where it meets all of the following conditions: (i) it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; (ii) its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); (iii) it did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and (iv) its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with International Financial Reporting Standards (IFRSs). In September 2010, the AASB issued Exposure Draft ED 205 Extending Relief from Consolidation, the Equity Method and Proportionate Consolidation. The AASB was concerned about the effects of condition (iv) in paragraph 4(a) of AASB 10/IFRS 10 in circumstances where, because of the effects of the reduced disclosure requirements (as part of AASB’s Differential Reporting Project), the ultimate or the intermediary parents may not have prepared IFRS-compliant consolidated financial statements. Hence, the AASB added paragraph Aus4.1 to AASB 10 to extend the relief from preparing consolidated financial statements currently provided under paragraph 4 of AASB 10/IFRS 10. To apply paragraph Aus4.1, a parent must still meet conditions (i)–(iii). If that parent has an ultimate or intermediate parent that prepares consolidated financial statements available for public use, then according to paragraph Aus4.1

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it does not have to prepare consolidated financial statements under certain conditions. Paragraph Aus4.1 of AASB 10 states: Notwithstanding paragraph 4(a)(iv), a parent that meets the criteria in paragraphs 4(a)(i), 4(a)(ii) and 4(a)(iii) need not present consolidated financial statements if its ultimate or any intermediate parent produces financial statements available for public use in which subsidiaries are consolidated or are measured at fair value through profit or loss in accordance with this Standard and: (a) the parent and its ultimate or intermediate parent are: (i) both not-for-profit entities complying with Australian Accounting Standards; or (ii) both entities complying with Australian Accounting Standards—Reduced Disclosure Requirements; or (b) the parent is an entity complying with Australian Accounting Standards—Reduced Disclosure Requirements and its ultimate or intermediate parent is a not-for-profit entity complying with Australian Accounting Standards. The AASB has also added paragraph Aus4.2 to AASB 10: • Notwithstanding paragraphs 4(a) and Aus4.1, the ultimate Australian parent shall present consolidated financial statements that consolidate its investments in subsidiaries in accordance with this Standard when either the parent or the group is a reporting entity or both the parent and the group are reporting entities, except if the ultimate Australian parent is required, in accordance with paragraph 31 of this Standard, to measure all of its subsidiaries at fair value through profit or loss. Paragraph 31 of AASB 10/IFRS 10 provides another exception to the principle that parents shall consolidate their subsidiaries. Paragraph 31 requires a parent that is an investment entity to measure its investments in subsidiaries, other than those that provide services that relate to the investment entity’s investment activities, at fair value through profit or loss in accordance with AASB 9/IFRS 9 Financial Instruments instead of consolidating them. An investment entity is defined in Appendix A of AASB 10: An entity that: (a) obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services; (b) commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both; and (c) measures and evaluates the performance of substantially all of its investments on a fair value basis. An example of such an investment entity would be where a number of investors establish a limited partnership that has control of a number of entities in which it has invested solely for the purpose of capital appreciation, investment income—such as dividends, interest or rental income—or both. Paragraphs B85A–B85W of AASB 10 provide guidance on determining whether an entity is an investment entity. To help assess whether an entity is an investment entity, paragraph 28 of AASB 10 provides the following as typical characteristics of an investment entity: (a) it has more than one investment (see paragraphs B85O–B85P); (b) it has more than one investor (see paragraphs B85Q–B85S); (c) it has investors that are not related parties of the entity (see paragraphs B85T–B85U); and

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(d) it has ownership interests in the form of equity or similar interests (see paragraphs B85V– B85W). The absence of any of these typical characteristics does not necessarily disqualify an entity from being classified as an investment entity. An investment entity that does not have all of these typical characteristics provides additional disclosure required by paragraph 9A of AASB 12/IFRS 12.

20. What is the key objective of AASB 12/IFRS 12? The key objective of AASB 12/IFRS 12 Disclosure of Interests in Other Entities is stated in paragraph 1 of the standard: The objective of this Standard is to require an entity to disclose information that enables users of its financial statements to evaluate: (a) the nature of, and risks associated with, its interests in other entities; and (b) the effects of those interests on its financial position, financial performance and cash flows.

21. What needs to be disclosed according to AASB 12/IFRS 12 for each subsidiary where a non-controlling interest exists? Where a non-controlling interest exists in a subsidiary, paragraph 12 of AASB 12/IFRS 12 Disclosure of Interests in Other Entities requires that an entity disclose for each such subsidiary: (a) the name of the subsidiary (b) the principal place of business (and country of incorporation if different from the principal place of business) of the subsidiary (c) the proportion of ownership interests held by non-controlling interests (d) the proportion of voting rights held by non-controlling interests, if different from the proportion of ownership interests held (e) the profit or loss allocated to non-controlling interests of the subsidiary during the reporting period (f)accumulated non-controlling interests of the subsidiary at the end of the reporting period (g) summarised financial information about the subsidiary (see paragraph B10). Paragraph B10 of AASB 12/IFRS 12 further states: For each subsidiary that has non-controlling interests that are material to the reporting entity, an entity shall disclose: (a) dividends paid to non-controlling interests. (b) summarised financial information about the assets, liabilities, profit or loss and cash flows of the subsidiary that enables users to understand the interest that non-controlling interests have in the group’s activities and cash flows. That information might include but is not limited to, for example, current assets, non-current assets, current liabilities, non-current liabilities, revenue, profit or loss and total comprehensive income.

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22. What is a structured entity? In Appendix A, a structured entity is defined as follows. • An entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements. Paragraph 14 of AASB 12/IFRS 12 deals with consolidated structured entities. Paragraphs B22–B24 of AASB 12/IFRS 12 provide further information about structured entities. According to paragraph B22, a structured entity may have the following features. (a) Restricted activities. (b) A narrow and well-defined objective, such as to effect a tax-efficient lease, carry out research and development activities, provide a source of capital or funding to an entity or provide investment opportunities for investors by passing on risks and rewards associated with the assets of the structured entity to investors. (c) Insufficient equity to permit the structured entity to finance its activities without subordinated financial support. (d) Financing in the form of multiple contractually linked instruments to investors that create concentrations of credit or other risks (tranches). The following examples of entities that are regarded as structured entities are noted in paragraph B23: (a) Securitisation vehicles. (b) Asset-backed financings. (c) Some investment funds.

23. When does a parent need to prepare separate financial statements according to AASB 127/IAS 27? There are two situations in which separate financial statements are prepared according to AASB 127/IAS 27 Separate Financial Statements. (a) Where a parent is exempted from preparing consolidated financial statements in accordance with paragraph 4(a) of AASB 10/IFRS 10. In this case, paragraph 16 of AASB 127/IAS 27 requires the parent to supply the following information in the separate financial statements prepared by the parent: (a) The fact that the financial statements are separate financial statements; that the exemption from consolidation has been used; the name and principal place of business (and country of incorporation, if different) of the entity whose consolidated financial statements that comply with International Financial Reporting Standards have been produced for public use; and the address where those consolidated financial statements are obtainable. (b) A list of significant investments in subsidiaries, joint ventures and associates, including: (i) the name of those investees (ii) the principal place of business (and country of incorporation, if different) of those investees

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(iii)

its proportion of the ownership interest (and its proportion of voting rights, if different) held in those investees. (c) A description of the method used to account for the investments listed under (b). (b) Where a parent prepares separate financial statements in addition to consolidated financial statements. Historically, the Corporations Act 2001 required parents to present parent entity financial statements together with consolidated financial statements within the annual report. A discussion paper prepared by Cotter (2003) researched the relevance of parent entity financial reports for consolidated entities and proposed the removal of the requirement for parent entity financial reports to be published in the annual report. The Corporations Amendment (Corporate Reporting Reform) Act 2010 amended the Corporations Act 2001 so that those reporting entities that present consolidated financial statements are no longer required to present parent entity financial statements. This change applied for financial reports for the year ended 30 June 2010 onwards. However, reporting entities that choose to still present parent entity financial statements are allowed to do so.

24. What needs to be disclosed in the separate financial statements prepared by a parent according to AASB 127/IAS 27? Paragraph 17 of AASB 127/IAS 27 requires the following information to be disclosed in the separate financial statements. (a) The fact that the statements are separate financial statements and the reasons why those statements are prepared if not required by law. (b) A list of significant investments in subsidiaries, joint ventures and associates, including: (i) the name of those investees (ii) the principal place of business (and country of incorporation, if different) of those investees (iii) its proportion of the ownership interest (and its proportion of the voting rights, if different) held in those investees. (c) A description of the method used to account for the investments listed under (b).

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Case studies Case study 26.1 Nature of control The following comment was received by the IASB on 6 April 2009 from the Swedish Financial Reporting Board in response to the issue of ED 10 Consolidated Financial Statements (the predecessor of IFRS 10). We agree that consolidated financial statements would be improved, if they include entities under ‘de facto’ control. However, the problem is to establish which entities are really under ‘de facto’ control. There are situations where it is very clear that the dominant shareholder de facto controls another entity, but there are also lots of situations, where it is not clear that the dominant shareholder de facto controls the other entity. We suggest that the requirement for consolidation based on ‘de facto’ control is restricted to situations, where it is beyond reasonable doubt that control really exists. Required Discuss whether AASB 10/IFRS 10 in the current form has the problem raised by the Swedish Financial Reporting Board. De facto control Paragraphs B73 to B75 of AASB 10/IFRS 10 discuss an investor’s relationship with other parties. Paragraph B73: • When assessing control, an investor shall consider the nature of its relationship with other parties and whether those other parties are acting on the investor’s behalf (i.e. they are ‘de facto agents’). The determination of whether other parties are acting as de facto agents requires judgement, considering not only the nature of the relationship but also how those parties interact with each other and the investor. Paragraph B74: • Such a relationship need not involve a contractual arrangement. A party is a de facto agent when the investor has, or those that direct the activities of the investor have, the ability to direct that party to act on the investor’s behalf. Paragraph B75: Examples of other parties that might act as de facto agents for the investor: (a) the investor’s related parties (b) a party that received its interest in the investee as a contribution or loan from the investor (c) a party that has agreed not to sell, transfer or encumber its interests in the investee without the investor’s prior approval (d) a party that cannot finance its operations without subordinated financial support from the investor

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(e) an investee for which the majority of the members of its governing body or for which its key management personnel are the same as those of the investor (f) a party that has a close business relationship with the investor, such as the relationship between a professional service provider and one of its significant clients. Reasonable doubt AASB 10/IFRS 10 requires: • an investor to consider all facts and circumstances when assessing control (AASB 10/IFRS 10, paragraph 8) • an investor to consider factors in determining control (e.g. AASB 10/IFRS 10, paragraph B3) • the application of judgement (e.g. AASB 10/IFRS 10, paragraphs B23 and B73). To introduce a “beyond reasonable doubt” test may not necessarily help the judgement process. There presumably would be a need to determine how this test would be applied as well as determining what is reasonable and who assesses what is reasonable. This may raise just another level of problems and points of view.

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Case study 26.2 Power and relevant activities According to paragraph BC43 of the Basis for Conclusions on AASB 10/IFRS 10 Consolidated Financial Statements: Respondents to ED 10 did not object to changing the definition of control to power to direct the activities of an investee. Many were confused, however, about what the Board meant by ‘power to direct’ and which ‘activities’ the Board had in mind. They asked for a clear articulation of the principle behind the term ‘power to direct’. They also expressed the view that power should relate to significant activities of an investee, and not those activities that have little effect on the investee’s returns. Required Discuss whether AASB 10/IFRS 10 addressed the comments made by the respondents to ED 10. Power to direct Some aspects of power raised in AASB 10/IFRS 10 include: • Power needs to be absolute (AASB 10/IFRS 10, paragraph 9). • Power need not have been exercised. (AASB 10/IFRS 10, paragraph 12). • Power precludes others from controlling an investee. • Power is not defined just as the legal or contractual right to direct the activities of an investee, even though this would require less judgement. Instead power is defined in terms of the current ability to direct the activities. (AASB 10/IFRS 10, Appendix A). • Power exists even if the investor does not actively direct the activities of an investee e.g. if one investee held 70% of the voting power but did not exercise its voting power while another investee held 30% of the voting power and actively exercised its voting power, the former entity would still be the parent. • Power does not require the investor to be able to act today i.e. it may be necessary for the investor to undertake steps in order to act, such as call a meeting before it can exercise its voting or other rights. (AASB 10/IFRS 10, paragraph B24). Activities In order to control an investee an investor must have the current ability to direct the activities of the investee that significantly affect the investee’s returns – the relevant activities. (AASB 10/IFRS 10, paragraphs 10, 13 and Appendix A). The activities would not just be the administrative activities of an investee. In general the relevant activities would be those that relate to the operating and financing activities of an investee – such as: • selling goods or services • purchasing inventory • making capital expenditure • obtaining finance (AASB 10/IFRS 10, paragraphs B11, B12). © John Wiley and Sons Australia Ltd, 2020

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Case study 26.3 Right to variable returns Some have argued that the criteria for consolidation should refer to significant variable returns. These parties argue that the consolidated financial statements are not meaningful if they include subsidiaries in which the parent’s level of returns is less than 50% or is not significant. Required Discuss: 1. the place of a returns criterion in the definition of control 2. possible returns that could occur as a result of obtaining control of another entity 3. the need to place a specified level of returns in the definition of control. The concept of control has basically 3 tests: • Power over the investee. • Exposure, or rights, to variable returns from its involvement with the investee. • The ability to use its power over the investee to affect the amount of the investor’s returns. 1. Place of a returns criterion: The objective is to identify entities that are effectively able to use the assets and direct the activities of another and to benefit from such use as if those assets were held and those activities were undertaken on their behalf. It is doubtful that an entity would control another if there were no benefits in doing so. Assets are repositories of benefits. One holds assets in order to receive the benefits. 2. Possible returns: • Cash distribution via dividends or residual interest. • Production of product or service complementary to the operation of the parent e.g. guaranteed source of raw material such as sand useful to the parent’s manufacture of glass. • The subsidiary has assets of use to the parent e.g. a patent that it may use or may control the production of competing products by others. 3. Need for a specified level of returns: For example, must the parent be entitled to at least 50% of the returns from the subsidiary? If the returns were purely dividends/residual interest, this may be of interest. Given the variety of possible returns as noted above, the concept of a majority of returns seems both unnecessary and unworkable as the measurement of the relative returns would be very difficult. Measurement of the relative worth of different types of returns could be difficult. The ability to control is not dependent on the level of returns to be received. If the need for consolidation is based on concepts such as accountability, then the level of returns is not

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important. It is more crucial to determine whether management can affect the returns from another entity.

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Application and analysis exercises Exercise 26.1 Parent-subsidiary relationship Visit the website of Woolworths Group Ltd (www.woolworthslimited.com.au/) and retrieve the most recent annual report. Required 1. Identify and discuss the principles of consolidation used as disclosed in note 1 to the consolidated financial statements. 2. Identify the subsidiaries, as disclosed in the notes to the consolidated financial statements, describing the differences between the wholly owned and partially owned subsidiaries. 3. Discuss potential reasons the regulators require Woolworths Group Ltd to prepare consolidated financial statements. (LO1, LO2 and LO3) 1. Students should read “Note 1. Significant Accounting Policies” from the annual report and identify the basis for consolidation used by Woolworths Group Ltd paying attention to the following aspects: • • • •

that the consolidated financial statements incorporate the assets and liabilities as at the end of the period and the results for the period of the parent and all its subsidiaries that the subsidiaries are fully consolidated from the date on which control is obtained until the date when the control ceases that the non-controlling interests in the equity and results of the subsidiaries are separately disclosed that the intragroup balances and intra-group transactions are eliminated when preparing the consolidated financial statements.

2. Students should read the note which includes the list of subsidiaries paying attention to the ownership interest of the group in each of them. 3. Students should discuss the following reasons for regulators to require the preparation of consolidated financial statements as they may apply to Woolworths Group Ltd: (i)To supply relevant information to investors in the parent entity. (ii)To allow comparison of the group with similar entities. (iii)To assist in the discharge of accountability by management of the group. (iv)To report the risks and benefits of the group as a single economic entity. (v)To ensure consistency of information provided to users.

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Exercise 26.2 Parent-subsidiary relationship In the following independent situations, determine whether a parent–subsidiary relationship exists, and which entity, if any, is a parent. 1. Tom Ltd is a company that was hurt by a major downturn in the economy. It previously obtained a significant loan from Jenson Bank, and when Tom Ltd was unable to make its loan repayments, the bank made an agreement with Tom Ltd to become involved in the management of that company. Under the agreement between the two entities, Tom Ltd’s managers had to obtain authority from the bank for acquisitions over $10 000 and were required to have bank approval for the company’s budgets. 2. Sawyer Ltd is a major financing company whose interest in investing is return on the investment. Sawyer Ltd does not get involved in the management of its investments. If an investee is not managed properly, Sawyer Ltd sells its shares in that investee and selects a more profitable investee to invest in. It previously held a 35% interest in Anderson Ltd as well as providing substantial convertible debt finance to that entity. Recently, Anderson Ltd was having cash flow difficulties and persuaded Sawyer Ltd to convert some of the convertible debt into equity so as to ease the effects of interest payments on cash flow. As a result, Sawyer Ltd’s equity interest in Anderson Ltd increased to 52%. Sawyer Ltd still wanted to remain as a passive investor, with no changes in the directors on the board of Anderson Ltd. These directors were appointed by the holders of the 48% of shares not held by Sawyer Ltd. (LO2) In each of these circumstances the following principle from the Basis of Conclusions to AASB 10/IFRS 10 should be used: BC41 The definition of control includes three elements, namely an investor’s: (a) power over the investee; (b) exposure, or rights, to variable returns from its involvement with the investee; and (c) the ability to use its power over the investee to affect the amount of the investor’s returns. 1. This question will be looked at under two scenarios: (i) Tom Ltd is not a subsidiary of any other entity. The key issue is whether the fact that the bank has authority in relation to acquisitions and approval of budgets is sufficient to give the bank the status of a parent. The bank will receive a return from Tom Ltd in the form of interest on the loan. Jenson Bank has: • Power over Tom Ltd, as it has rights arising from the legal contract • It can affect some of the relevant activities e.g. acquisitions, but not others such as appointment of key management personnel. Tom Ltd will not be a subsidiary of Jenson Bank because: • The bank is not exposed to variable returns from its involvement with Tom Ltd. The interest payments are not affected by the profitability of Tom Ltd.

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•

It cannot use its power over Tom Ltd to affect the amount of its returns, as the returns are fixed interest payments.

(ii) Tom Ltd is a wholly owned subsidiary of another entity, Chuck Jones Ltd. The key issue in this scenario is whether the authority given to the bank in relation to acquisitions and budget approval is sufficient to state that Chuck Jones Ltd does not control Tom Ltd. The key issue is whether Chuck Jones Ltd still has power over Tom Ltd given the arrangements with the bank. Relevant activities over which a parent should have power include: (a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding. Decisions about relevant activities include: (a) establishing operating and capital decisions of the investee, including budgets; and (b) appointing and remunerating an investee’s key management personnel or service providers and terminating their services or employment. The key issue then is whether Chuck Jones Ltd has the ability to direct the relevant activities i.e. those activities that most significantly affect the investee’s returns. It is probable that Chuck Jones Ltd no longer controls Tom Ltd as the bank can: veto any changes to significant transactions for the benefit of Chuck Jones Ltd. It can deny the company its ability to make acquisitions, and it can reject moves within a budget to undertake changes in inventory production. In conclusion, a parent-subsidiary relationship does not exist in this case. 2. Sawyer Ltd currently holds 52% of the shares of Anderson Ltd. It does not want to become involved in the management of Anderson Ltd, and the directors are appointed by the noncontrolling interest (NCI). Control is not based on actual control but on the capacity to control. Sawyer Ltd: • has power over the investee via its share ownership • is exposed to variable returns via dividends arising from its share ownership • has the ability to affect those returns as it can become involved in management whenever it wishes, given its superior voting power. Sawyer Ltd is a parent of Anderson Ltd. Further, when Sawyer Ltd held a 35% interest in Anderson Ltd it also held convertible debt in that entity which could, if converted, give it an equity interest of 52%. In this situation, Sawyer Ltd was a parent of Anderson Ltd. It would appear under the circumstances that the conversion was substantive i.e. economically feasible, and currently exercisable.

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Exercise 26.3 Voting rights Falco Ltd owns 40% of the shares of Skye Ltd; no other party owns more than 3% of the shares. The annual general meeting of Skye Ltd is to be held in one month’s time. Historically, only the holders of around 75% of the shares were present and voted in each of the previous years’ annual meetings. Required Discuss the potential for Skye Ltd to be classified as a subsidiary of Falco Ltd. (LO2) Falco Ltd

Skye Ltd

40% Discuss: • The concept of control. • The need for judgement. • Factors to consider when determining the existence of control: - NCI = 60% - no other party > 3% interest - only 75% attendance at AGM last years. • Apply to above situation. It will probably be concluded that Falco Ltd is the parent of Skye Ltd as Falco Ltd seems to have the current ability to control as it has the majority interest, the other shareholders are dispersed and some are not interested in the management of the entity. However, the students should also consider and discuss: • The difference between actual control and capacity to control: the party actually controlling the other entity may not have the capacity to control. For example, just because Falco Ltd’s nominees may be elected as Board members does not automatically mean that it becomes the parent of Skye Ltd. It simply means that it actually controls that entity. The question is whether it has the capacity to control. • Attendance at AGMs: If holders of 90% of the voting shares attended the AGM this year, then holders of 50% of the shares could have outvoted Falco Ltd. They may allow Falco Ltd to manage Skye Ltd because of the great managerial skills or business connections of Falco Ltd. In this case, Falco Ltd is not the parent of Skye Ltd. • The purpose of consolidation: If Falco Ltd is actually controlling Skye Ltd, even though it does not have the capacity to control, would the shareholders of Falco Ltd be interested in a set of consolidated financial statements for the combined group? Does the issue of accountability provide sufficient grounds for the consolidation of the two entities?

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Exercise 26.4 Voting rights Alvin Ltd has 37% of the voting interest in Theodore Ltd. An investment bank with which Alvin Ltd has business relationships holds a 15% voting interest in Theodore Ltd. Because of the closeness of the business relationship with the bank, Alvin Ltd believes it can rely on the bank’s support to ensure it cannot be outvoted at general meetings of Theodore Ltd. However, there is no guarantee that the bank will always support Alvin Ltd. Required Discuss whether Alvin Ltd is a parent of Theodore Ltd. (LO2) Discuss: • the concept of control • the need to apply judgement • these situations are often referred to “strawmen” – other parties that act as agents or in conjunction with others. In the example in this question, Alvin Ltd has the expectation that the voting of the investment bank will most likely be aligned with its own, ensuring that it cannot be outvoted. If control is the basis for consolidation, a factor to consider is the influence available through a friendly party. Note that there is no guarantee that the investment bank will always vote with Alvin Ltd – the relationship may change over time. However, many of the other factors considered in relation to an investor and control, such as the attendance at the AGM and the size of blocks of shareholdings may also change over time. What it matters is whether currently the voting of the investment bank is aligned with Alvin Ltd and that seems to be the case, meaning that Alvin Ltd is the parent of Theodore Ltd.

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Exercise 26.5 Options Rose Ltd, Lily Ltd and Carnation Ltd each own one-third of the ordinary shares that carry voting rights at a general meeting of shareholders of Bloom Ltd. Rose Ltd, Lily Ltd and Carnation Ltd each have the right to appoint two directors to the board of Bloom Ltd. Rose Ltd also owns call options that are exercisable at a fixed price at any time and, if exercised, would increase Rose Ltd’s voting rights in Bloom Ltd to 60%, while Lily Ltd’s and Carnation Ltd’s would become 20% each. The management of Rose Ltd does not intend to exercise the call options. Required Discuss whether Bloom Ltd is a subsidiary of any of the other entities. (LO2) Facts: Rose Ltd Lily Ltd Carnation Ltd

each have 1/3 of ordinary shares of Bloom Ltd

Rose Ltd owns call options that would give it 60% of the voting rights of Bloom Ltd. When considering potential voting rights, an investor shall consider the purpose and design of the instrument, as well as the purpose and design of any other involvement the investor has with the investee. This includes an assessment of the various terms and conditions of the instrument as well as the investor’s apparent expectations, motives and reasons for agreeing to those terms and conditions. If the investor also has voting or other decision-making rights relating to the investee’s activities, the investor assesses whether those rights, in combination with potential voting rights, give the investor power. An investor, in assessing whether it has power, considers only substantive rights relating to an investee (held by the investor and others). For a right to be substantive, the holder must have the practical ability to exercise that right. It is necessary to consider any barriers that might prevent the holder from exercising the rights. Examples of such barriers include: (i) Financial penalties and incentives that would prevent (or deter) the holder from exercising its rights. (ii) An exercise or conversion price that creates a financial barrier that would prevent (or deter) the holder from exercising its rights. (iii) Terms and conditions that make it unlikely that the rights would be exercised, for example, conditions that narrowly limit the timing of their exercise. (iv) The absence of an explicit, reasonable mechanism in the founding documents of an investee or in applicable laws or regulations that would allow the holder to exercise its rights. (v) The inability of the holder of the rights to obtain the information necessary to exercise its rights.

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(vi) Operational barriers or incentives that would prevent (or deter) the holder from exercising its rights (e.g. the absence of other managers willing or able to provide specialised services or provide the services and take on other interests held by the incumbent manager). (vii) Legal or regulatory requirements that prevent the holder from exercising its rights (e.g. where a foreign investor is prohibited from exercising its rights). In this situation, management do not intend to exercise the options, presumably because it is not in their economic interest to do so. As such, the options are not substantive and therefore they should not be considered in determining control. In conclusion, Bloom Ltd is not a subsidiary of any of the three companies.

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Exercise 26.6 Options Thomas Ltd and Jackson Ltd own 80% and 20% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Stanmar Ltd. Thomas Ltd sells half of its interest to Benson Ltd and buys call options from Benson Ltd that are exercisable at any time at a premium to the market price when issued and, if exercised, would give Thomas Ltd its original 80% ownership interest and voting rights. At the end of the current financial period, the options are out of the money. Required Discuss whether Thomas Ltd is the parent of Stanmar Ltd. (LO2) Facts: Thomas Ltd Jackson Ltd Benson Ltd

40% of ordinary shares of Stanmar Ltd 20% of ordinary shares of Stanmar Ltd 40% of ordinary shares of Stanmar Ltd

Thomas Ltd owns call options that would give it 80% of the voting rights of Stanmar Ltd. When considering potential voting rights, an investor shall consider the purpose and design of the instrument, as well as the purpose and design of any other involvement the investor has with the investee. This includes an assessment of the various terms and conditions of the instrument as well as the investor’s apparent expectations, motives and reasons for agreeing to those terms and conditions. If the investor also has voting or other decision-making rights relating to the investee’s activities, the investor assesses whether those rights, in combination with potential voting rights, give the investor power. An investor, in assessing whether it has power, considers only substantive rights relating to an investee (held by the investor and others). For a right to be substantive, the holder must have the practical ability to exercise that right. It is necessary to consider any barriers that might prevent the holder from exercising the rights. Examples of such barriers include: (i) Financial penalties and incentives that would prevent (or deter) the holder from exercising its rights. (ii) An exercise or conversion price that creates a financial barrier that would prevent (or deter) the holder from exercising its rights. (iii) Terms and conditions that make it unlikely that the rights would be exercised, for example, conditions that narrowly limit the timing of their exercise. (iv) The absence of an explicit, reasonable mechanism in the founding documents of an investee or in applicable laws or regulations that would allow the holder to exercise its rights. (v) The inability of the holder of the rights to obtain the information necessary to exercise its rights. (vi) Operational barriers or incentives that would prevent (or deter) the holder from exercising its rights (e.g. the absence of other managers willing or able to provide specialised services or provide the services and take on other interests held by the incumbent manager).

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(vii) Legal or regulatory requirements that prevent the holder from exercising its rights (e.g. where a foreign investor is prohibited from exercising its rights). As the call options are out of money, Thomas Ltd’s management will certainly not exercise the options. As such, the options are not substantive and therefore they should not be considered in determining control. In conclusion, Thomas Ltd is not the parent of Stanmar Ltd.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 26.7 Parent-subsidiary relationship In the following independent situations, determine whether a parent–subsidiary relationship exists and which entity, if any, is a parent. 1. Bernadette Ltd and Howard Ltd each hold 50% of the shares in Jerry Ltd, all companies being involved in the computer software industry. Bernadette Ltd agrees that Howard Ltd should provide the management of Jerry Ltd because of the expertise provided by its managing director, Barry Kripke. Howard Ltd receives a management fee for providing its expertise. 2. Penny Ltd has recently acquired a 35% interest in Leonard Ltd, a company that has discovered large deposits of iron ore. Penny Ltd has extensive experience in the mining industry and, as a result, has been able to have four of its directors elected to the board of Leonard Ltd, which has six directors in total. 3. Amy Ltd holds 30% of the shares issued by Sheldon Ltd. The other shareholders come from mixed backgrounds, but each holds on average 10% of shares in Sheldon Ltd. Only three of the other shareholders have an interest in the management of the company. There are seven directors of Sheldon Ltd. Four of these are appointed by Amy Ltd. The other three directors are appointed by the three other shareholders who have an interest in the management of the company. Most of the remaining shareholders live outside Australia and rarely attend general meetings of Sheldon Ltd unless they have other business to attend to in the country around the same time as the general meetings are held. (LO2) In each of these circumstances the following principles from the Basis of Conclusions to AASB 10 should be used: B2 To determine whether it controls an investee an investor shall assess whether it has all the following: (a) power over the investee; (b) exposure, or rights, to variable returns from its involvement with the investee; and (c) the ability to use its power over the investee to affect the amount of the investor’s returns. B3 Consideration of the following factors may assist in making that determination: (a) the purpose and design of the investee; (b) what the relevant activities are and how decisions about those activities are made; (c) whether the rights of the investor give it the current ability to direct the relevant activities; (d) whether the investor is exposed, or has rights, to variable returns from its involvement with the investee; and (e) whether the investor has the ability to use its power over the investee to affect the amount of the investor’s returns. B2 To determine whether it controls an investee an investor shall assess whether it has all the following: (a) power over the investee; (b) exposure, or rights, to variable returns from its involvement with the investee; and (c) the ability to use its power over the investee to affect the amount of the investor’s returns.

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B3 Consideration of the following factors may assist in making that determination: (a) the purpose and design of the investee; (b) what the relevant activities are and how decisions about those activities are made; (c) whether the rights of the investor give it the current ability to direct the relevant activities; (d) whether the investor is exposed, or has rights, to variable returns from its involvement with the investee; and (e) whether the investor has the ability to use its power over the investee to affect the amount of the investor’s returns 1. Both Bernadette Ltd and Howard Ltd hold 50% of the shares in Jerry Ltd, with Howard Ltd actually directing Jerry Ltd because of its management expertise. In this circumstance, Jerry Ltd is not a subsidiary of either company. Neither investor has the power over Jerry Ltd, as neither investor holds existing rights to enable it to direct the relevant activities of Jerry Ltd. Although Bernadette Ltd allows Howard Ltd to currently manage the investee, it can step in at any time and challenge the management arrangements. As neither investor holds more than 50% of the shares, neither has power. Hence there is no need for any consolidated financial statements to be prepared. 2. Penny Ltd currently has the ability to elect a majority of directors of Leonard Ltd. This has occurred potentially just because of its expertise in the mining industry. As in (a) above, this does not give it power over Leonard Ltd. There is no information to suggest that the other 65% of shareholders in Leonard Ltd could not get together and change the management of Leonard Ltd. Penny Ltd does not have power over Leonard Ltd. 3. Currently Amy Ltd holds 30% of the shares of Sheldon Ltd. The remaining shareholders consist of 7 shareholders having on average 10% of Sheldon Ltd’s shares. In relation to these investors: • most live outside Australia • most do not attend AGMs. Where an investor has less than a 50% holding of shares in the investee, judgement is required to determine whether control exists. It is necessary to examine the potential actions of the holders of the other shares in Sheldon Ltd. In this case, it is difficult to make a decision as: • The fact that there are only 7 others shareholders with 10% each, only 3 of these need to get together to have the same voting capacity as Amy Ltd. This lessens the likelihood of Amy Ltd having control. • The fact that most live outside the country lessens the probability of these shareholders getting together to take control. However, they could give their proxies to each other. • The attendance at AGMs by the other shareholders is low. This however can change if these shareholders become dissatisfied with Amy Ltd as a manager. • The other shareholders have an interest in management shown by their appointing 3 of the directors – only 1 less than Amy’s 4 directors. As the shareholders have an interest – as © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

opposed to being apathetic – the probability of becoming involved if they become dissatisfied with Amy Ltd is higher. On balance, Amy Ltd is probably not a parent of Sheldon Ltd as it does not have sufficient power to continue to direct the relevant activities of Sheldon Ltd.

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Exercise 26.8 Relevant activities Oliver Ltd and Felicity Ltd decide to establish a new entity, Arrow Ltd. The purpose of Arrow Ltd is to develop and market a new car seat designed for use by babies when travelling in a car. Oliver Ltd and Felicity Ltd have specific roles in the new company and have unilateral ability to make all decisions in relation to their specified roles. Oliver Ltd has agreed that it will be responsible for developing the new car seat and obtaining all the approvals from the relevant safety bodies in Australia. Once the seat has been designed and all safety approvals have been received, Felicity Ltd will manufacture and market the product. Required Discuss the activities undertaken by the Oliver Ltd and Felicity Ltd in relation to the determination of which entity controls Arrow Ltd. (LO2) Power is defined as “existing rights that give the current ability to direct the relevant activities”. Relevant activities are “activities of the investee that significantly affect the investee’s returns”. Discuss whether either or both activities affect the returns of Ghost Ltd. If the activities of Oliver Ltd and Felicity Ltd both affect the investee’s returns then it is necessary to determine which activities – developing and obtaining regulatory approval or manufacturing and marketing – MOST significantly affect the investee's returns. In determining this, it would be necessary to consider: • the purpose and design of the investee; • the factors that determine the profit margin, revenue and value of the investee as well as the value of the car seat product; • the effect on the investee’s returns resulting from each investor’s decision-making authority with respect to the factors in the dot point above; and • the investors’ exposure to variability of returns. In this particular example, the investors would also consider: • the uncertainty of, and effort required in, obtaining regulatory approval (considering the investor’s record of successfully developing and obtaining regulatory approval of car seat products); and • which investor controls the car seat product once the development phase is successful.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 26.9 Determining subsidiary status During the current financial period, Laurel Ltd acquired 40% of the ordinary shares of Lance Ltd. Under the company’s constitution, each share is entitled to one vote. On the basis of past experience, only 65% of the eligible votes are typically cast at the annual general meetings of Lance Ltd. No other shareholder holds a major block of shares in Lance Ltd. The directors of Laurel Ltd argue that they are not required under AASB 10/IFRS 10 to include Lance Ltd as a subsidiary in Laurel Ltd’s consolidated financial statements as there is no conclusive evidence that Laurel Ltd can control the relevant activities of Lance Ltd. The auditors of Laurel Ltd disagree, referring specifically to the votes cast in the past years. Required Provide a report to Laurel Ltd on whether it should regard Lance Ltd as a subsidiary in its preparation of consolidated financial statements. (LO2) 40% Laurel Ltd

Lance Ltd

Discuss: • The concept of control. • The need for judgement. • Factors to consider when determining the existence of control, such as: - NCI is 60% - 65% of voting power is exercised at AGM - no block holdings of shares other than Laurel Ltd. It is expected that Laurel Ltd is the parent of Lance Ltd due to its ownership of 40% of the shares in Lance Ltd and the dispersion and lack of interest of the other shareholders. Paragraph 4 of AASB 10 establishes which parent entities must prepare consolidated financial statements. More specifically, paragraph 4 of AASB 10 states that an entity that is a parent shall present consolidated financial statements except: (a) a parent need not present consolidated financial statements if it meets all the following conditions: (i) it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; (ii) its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); (iii) it did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and

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(iv)

its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with International Financial Reporting Standards (IFRSs).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 26.10 Convertible debt Barry Ltd and Allen Ltd own 55% and 45% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Flash Ltd. Allen Ltd also holds debt instruments that are convertible into ordinary shares of Flash Ltd. The debt can be converted at a substantial price, in comparison with Allen Ltd’s net assets, at any time, and if converted would require Allen Ltd to borrow additional funds to make the payment. If the debt were to be converted, Allen Ltd would hold 70% of the voting rights and Barry Ltd’s interest would reduce to 30%. Given the effect of increasing its debt on its debt–equity ratio, Allen Ltd does not believe that it has the financial ability to enter into conversion of the debt. Required Discuss whether Allen Ltd is a parent of Flash Ltd. (LO2) Barry Ltd

55% Flash Ltd

Allen Ltd 45% Allen Ltd holds convertible debt in Flash Ltd that would, on exercise, give it 70% of Flash Ltd. However, this would result in a substantial increase in Allen Ltd’s debt-equity ratio raising doubts about the company’s capacity to exercise the options. When considering potential voting rights, an investor shall consider the purpose and design of the instrument, as well as the purpose and design of any other involvement the investor has with the investee. This includes an assessment of the various terms and conditions of the instrument as well as the investor’s apparent expectations, motives and reasons for agreeing to those terms and conditions. If the investor also has voting or other decision-making rights relating to the investee’s activities, the investor assesses whether those rights, in combination with potential voting rights, give the investor power. In this situation, although the debt instruments are convertible at a substantial price, they are currently convertible and the conversion feature gives Allen Ltd the power to affect the returns from Flash Ltd. The existence of the potential voting rights is considered and it is determined that Allen Ltd not Barry Ltd controls Flash Ltd. The financial ability of Allen Ltd to pay the conversion price does not influence the assessment. An investor, in assessing whether it has power, considers only substantive rights relating to an investee (held by the investor and others). For a right to be substantive, the holder must have the practical ability to exercise that right. It is necessary to consider any barriers that might prevent the holder from exercising the rights. Examples of such barriers include: (i) Financial penalties and incentives that would prevent (or deter) the holder from exercising its rights. (ii) An exercise or conversion price that creates a financial barrier that would prevent (or deter) the holder from exercising its rights.

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(iii) Terms and conditions that make it unlikely that the rights would be exercised, for example, conditions that narrowly limit the timing of their exercise. (iv) The absence of an explicit, reasonable mechanism in the founding documents of an investee or in applicable laws or regulations that would allow the holder to exercise its rights. (v) The inability of the holder of the rights to obtain the information necessary to exercise its rights. (vi) Operational barriers or incentives that would prevent (or deter) the holder from exercising its rights (e.g. the absence of other managers willing or able to provide specialised services or provide the services and take on other interests held by the incumbent manager). (vii) Legal or regulatory requirements that prevent the holder from exercising its rights (e.g. where a foreign investor is prohibited from exercising its rights). If Allen Ltd does not have the financial ability to enter into the conversion of the debt, then it does not have the practical ability to exercise those rights. Hence, the existence of the convertible debt cannot affect the determination of control. Barry Ltd would then be the parent of Flash Ltd.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 26.11 Control Barney Ltd has acquired, during the current year, the following investments in shares issued by other companies. Ted Ltd Mosby Ltd

$120 000 (40% of issued capital) $117 000 (35% of issued capital)

Barney Ltd is unsure how to account for these investments and has asked you, as the auditor, for some professional advice. Specifically, Barney Ltd is concerned that it may need to prepare consolidated financial statements under AASB 10/IFRS 10. To help you, the company has provided the following information about the two investee companies: Ted Ltd • The remaining shares in Ted Ltd are owned by a diverse group of investors who each hold a small parcel of shares. • Historically, only a small number of the shareholders attend the general meetings or question the actions of the directors. • The current board of directors has five members, out of which three are retiring at the next annual general meeting. Barney Ltd has nominated three new directors to replace the ones that are retiring and expects that they will be appointed at the next annual general meeting. Mosby Ltd • The remaining shares in Mosby Ltd are owned by a small group of investors who each own approximately 15% of the issued shares. One of these shareholders is Ted Ltd, which owns 17%. • The shareholders take a keen interest in the running of the company and attend all meetings. • Two of the other shareholders, including Ted Ltd, already have representatives on the board of directors who have indicated their intention of nominating for re-election. Required 1. Advise Barney Ltd as to whether, under AASB 10/IFRS 10, it controls Ted Ltd and/or Mosby Ltd. Support your conclusion. 2. Would your conclusion be different if the remaining shares in Ted Ltd were owned by three institutional investors each holding 20%? If so, why? (LO2) 1. Barney Ltd 40%

35%

Ted Ltd

Mosby Ltd

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17% - NCI is a diverse group - low attendance at AGM - Barney Ltd expects to appoint 3/5 directors

- NCI is small group - keen interest - interested in directors

Consider the definition of control. Power to govern or capacity to control depends on an entity having the ability to direct the policies of another entity so as to affect the returns of that entity and to be able to use that power to increase those returns. Determination of control is a judgement. Ability to exert control depends on such factors as: • size of the voting interest • the dispersion of other shareholdings • level of disorganisation or apathy of the NCI shareholders • attendance at AGMs • contractual arrangements • arrangements between friendly parties. Applying these to the above example, it is expected that Ted Ltd is a subsidiary of Barney Ltd. If Ted Ltd is a subsidiary of Barney Ltd, then Mosby Ltd is also a subsidiary of Barney Ltd as Barney Ltd would control 52% of the vote. 2. A change in the relative ownerships within Ted Ltd would suggest that, dependent on other factors, it would lose its subsidiary status. Mosby Ltd would also then lose its subsidiary status.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 26.12 Entities required to prepare consolidated financial statements In the following independent situations, discuss which entity, if any, may be a parent required to prepare consolidated financial statements under AASB 10/IFRS 10. 1. Lily Ltd owns 100% of the shares of Aldrin Ltd, which owns 100% of the shares of Mira Ltd. All companies prepare their own financial reports under AASB/IFRS accounting standards. Although the shares of Aldrin Ltd are not traded on any public stock exchange, it is in the process of issuing debt instruments in a public market. 2. Marshall Ltd owns 80% of the shares of Eriksen Ltd, which owns 100% of the shares of New York Ltd. All companies prepare their own financial reports under AASB/IFRS accounting standards. Although the shares of Eriksen Ltd are not traded on any public stock exchange, its debt instruments are publicly traded. 3. Barney Ltd owns 100% of the shares of Stinson Ltd, which owns 80% of the shares of Harris Ltd. All companies prepare their own financial reports under AASB/IFRS accounting standards. Stinson Ltd does not have debt or equity instruments traded in a public market, nor does it intend to issue any. (LO2 and LO4) 1. Lily Ltd

100%

Aldrin Ltd

100%

Mira Ltd

Lily Ltd is the ultimate parent of this group and needs to prepare consolidated financial statements for itself, Aldrin Ltd and Mira Ltd. However, the issue is whether Aldrin Ltd may also need to prepare a set of consolidated financial statements for itself and Mira Ltd, as Aldrin Ltd is the parent of Mira Ltd (by virtue of owning 100% of the shares in Mira Ltd), but at the same time Aldrin Ltd is a subsidiary of Lily Ltd, the ultimate parent. Note that all criteria from paragraph 4 of AASB 10/IFRS 10 are required to be met for Aldrin Ltd not to be required to prepare consolidated financial statements. Paragraph 4(a) of AASB 10/IFRS 10 Consolidated Financial Statements requires each parent to prepare consolidated financial statements, except in those circumstances where it meets all of the following conditions: (i) it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements; (ii) its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); (iii) it did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and (iv) its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with International Financial Reporting Standards (IFRSs).

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In this example: (i) Aldrin Ltd is a wholly owned subsidiary of Lily Ltd (ii) The ultimate parent, Lily Ltd, prepares reports under AASBs, which comply with IFRSs However, Aldrin Ltd is in the process of issuing debt instruments to the market which means that it breaches 4(a)(iii). Hence Aldrin Ltd is not exempt from preparing consolidated financial statements. Both Lily Ltd and Aldrin Ltd would be required to prepare consolidated financial statements for their respective groups. 2. Runner Ltd

80%

Eriksen Ltd

100%

Looney Ltd

Marshall Ltd is the ultimate parent of this group and needs to prepare consolidated financial statements for itself, Eriksen Ltd and New York Ltd. However, the issue is whether Eriksen Ltd needs to also prepare a set of consolidated financial statements for itself and New York Ltd, as Eriksen Ltd is the parent of New York Ltd (by virtue of owning 100% of the shares in New York Ltd), but at the same time Eriksen Ltd is a subsidiary of Marshall Ltd, the ultimate parent. Note that all criteria from paragraph 4 of AASB 10/IFRS 10 are required to be met for Eriksen Ltd not to be required to prepare consolidated financial statements. In this example: (i) Eriksen Ltd is a partially owned subsidiary of Marshall Ltd (however, there is no information about whether the non-controlling interest in Eriksen Ltd requests Eriksen Ltd to prepare consolidated financial statements). (ii) The ultimate parent, Marshall Ltd, prepares reports under AASBs, which comply with IFRSs. However, the debt instruments of Eriksen Ltd are traded publicly which means that it breaches 4(a)(ii) above. Hence Eriksen Ltd is not exempt from preparing consolidated financial statements. Both Marshall Ltd and Eriksen Ltd would be required to prepare consolidated financial statements for their respective groups. 3. Barney Ltd

100%

Stinson Ltd

80%

Harris Ltd

Barney Ltd is the ultimate parent of this group and needs to prepare consolidated financial statements for itself, Stinson Ltd and Harris Ltd. However, the issue is whether Lin Ltd needs to also prepare a set of consolidated financial statements for itself and Harris Ltd, as Lin Ltd is the parent of Harris Ltd (by virtue of owning 80% of the shares in Harris Ltd), but at the same time Stinson Ltd is a subsidiary of Barney Ltd, the ultimate parent.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Note that all criteria from paragraph 4 of AASB 10/IFRS 10 are required to be met for Stinson Ltd not to be required to prepare consolidated financial statements. In this example: (i) Stinson Ltd is a wholly owned subsidiary of Barney Ltd. (ii) Stinson Ltd does not have debt or equity instruments traded in a public market, nor does it intend to issue any. (iii) The ultimate parent, Marshall Ltd, prepares reports under AASBs, which comply with IFRSs. Therefore, all the conditions are met and hence Stinson Ltd is exempt from preparing consolidated financial statements. Only Barney Ltd would be required to prepare consolidated financial statements.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 26: Consolidation: controlled entities Multiple choice questions 1. Financial statements that combine the separate sets of financial statements for all entities within an economic entity are known as: a. b. c. *d.

concise financial reports. condensed financial reports. combined financial statements. consolidated financial statements.

Answer: d Learning objective 26.1: explain the purpose of consolidated financial statements.

2. For the purposes of consolidated financial statements, a group consists of: a. *b. c. d.

an investor and its investees. a parent entity and all its subsidiaries. an entity that is controlled by a parent. an entity that has one or more subsidiaries.

Answer: b Learning objective 26.1: explain the purpose of consolidated financial statements.

3. The entity that is represented by a single set of consolidated financial statements is the: a. b. *c. d.

legal entity. parent entity. economic entity. subsidiary entity.

Answer: c Learning objective 26.1: explain the purpose of consolidated financial statements.

4. The consolidated financial statements reflect the effects of transactions: *a. b. c. d.

with external parties to the group only. between internal parties to the group only. with some internal and external parties to the group. both between internal parties and with external parties to the group.

Answer: a Learning objective 26.1: explain the purpose of consolidated financial statements.

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Testbank to accompany Financial reporting 3e by Loftus et al.

5. When preparing consolidated financial statements, what is the name given to the combined entities that are made up of a parent entity and all its subsidiary entities? a. b. c. *d.

Consolidation Combination Associates Group

Answer: d Learning objective 26.1: explain the purpose of consolidated financial statements.

6. A subsidiary is an entity that: *a. b. c. d.

is controlled by another entity. exercises control over a parent entity. has the power to control a parent entity. has significant influence over a parent entity.

Answer: a Learning objective 26.1: explain the purpose of consolidated financial statements. 7. When one entity controls another entity, the business combination results in which of the following types of relationship? a. *b. c. d.

Investor–investee. Parent–subsidiary. Investor–associate. Parent–child.

Answer: b Learning objective 26.1: explain the purpose of consolidated financial statements.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

8. AASB 10/IFRS 10 Consolidated Financial Statements defines a ‘parent’ and a ‘subsidiary’ as which of the following? Parent An entity which is controlled by another entity. II. An entity that controls one or more entities. III. An entity which owns more than 20% of the voting shares of another entity. IV An entity that has one or more . subsidiaries. I.

a. *b. c. d.

Subsidiary An entity that controls one or more entities. An entity which is controlled by another entity. An entity which is owned partly by another entity. An entity which is controlled by a parent entity.

I. II. III. IV.

Answer: b Learning objective 26.1: explain the purpose of consolidated financial statements.

9. A group may: *a. b. c. d.

only have one parent. have more than one parent. have a few different sub-groups. only have one parent, but it may have a few different sub-group.

Answer: a Learning objective 26.1: explain the purpose of consolidated financial statements. 10. Reasons for the preparation of consolidated financial statements include: a. b. c. *d.

Allowing comparison of the group with similar entities. Supply of relevant information to investors in the parent entity. Reporting of risks and benefits of the group as a single economic entity. All of the options are correct.

Answer: d Learning objective 26.1: explain the purpose of consolidated financial statements.

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Testbank to accompany Financial reporting 3e by Loftus et al.

11. The key characteristic that determines when consolidated financial statements should be prepared is: *a. b. c. d.

control. significant influence. substance over form. the existence of transactions between the entities.

Answer: a Learning objective 26.2: discuss the meaning and application of the criterion of control.

12. In a consolidated group of entities, control over the subsidiaries in the group: a. b. *c. d.

requires 100% ownership of the subsidiaries’ shares. can exist where the rights are purely protective rights. may not be shared control. can be shared with other entities.

Answer: c Learning objective 26.2: discuss the meaning and application of the criterion of control. 13. With regards to the concept of control, power over an investee: a. *b. c. d.

means the ability to significantly influence the investee. is related to relevant activities of the investee. arises from potential rights. means directing the investee.

Answer: b Learning objective 26.2: discuss the meaning and application of the criterion of control.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

14. According to AASB 10/IFRS 10 Consolidated Financial Statements, which of the following factors indicate the existence of control? I. II.

Ownership of more than 50% of the voting rights in another entity. Shared power in the governance of financial and operating policies of another entity so as to obtain benefits. III. Possessing existing rights that give the current ability to direct the relevant activities of another entity. IV. The power to have significant influence over the operating policies of an entity so as to obtain benefits. a. *b. c. d.

I, II and IV only. I and III only. II and IV only. II only.

Answer: b Learning objective 26.2: discuss the meaning and application of the criterion of control.

15. Which of the following is not one of the three elements of control according to AASB 10/IFRS 10 Consolidated Financial Statements? a. b. *c. d.

The ability to use power over the investee to affect the amount of the investor’s returns. Exposure, or rights, to variable returns from involvement with the investee. Dominating the decision making of the investee. Power over the investee.

Answer: c Learning objective 26.2: discuss the meaning and application of the criterion of control.

16. In the context of control, relevant activities are: *a. b. c. d.

activities of the investee that significantly affect the investee’s returns. activities of the investor that significantly affect the investor’s returns. activities of the investor that significantly affect the investee’s returns. activities of the investor that are similar to the investee’s activities.

Answer: a Learning objective 26.2: discuss the meaning and application of the criterion of control.

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Testbank to accompany Financial reporting 3e by Loftus et al.

17. In the context of control, examples of relevant activities include: a. b. c. *d.

managing financial assets. selling and purchasing goods and services. determining a funding structure or obtaining funding. all of the options are examples of relevant activities.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

18. Examples of rights that determine the existence of power include: a. b. c. *d.

rights to direct the investee to enter into, or veto any changes to, transactions that affect the investee’s returns. rights to appoint, reassign or remove members of an investee’s key management personnel rights to appoint or remove another entity that participates in management decisions. all of the options are correct.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

19. At balance date, Company K has 40% of the voting rights in Company L. In addition, Company K holds potential voting rights in Company L amounting to 8% that are currently exercisable, and a further 12% of voting rights in Company L that can be exercised in two years’ time. Which of the following statements is correct? *a. b. c. d.

Consolidated financial statements need not be prepared for Company K and L for the current year. Consolidated financial statements must be prepared for Company K and L in the current year. Consolidated financial statements must be prepared as Company K controls Company L at balance date. Consolidated financial statements must be prepared as Company K has more than half of the voting rights in Company L at balance date.

Answer: a Learning objective 26.2: discuss the meaning and application of the criterion of control.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

20. In determining the existence of power, together with size of the investor’s voting interest, the following factors need to be examined in relation to the holders of the other shares in the investee: a. b. c. *d.

the existence of contracts. attendance at annual general meetings. level of dilution and disorganization or apathy of the remaining shareholders. all of the above factors need to be examined.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

21. When deciding whether or not one entity controls another entity: a. b. *c. d.

the controlling entity must be actively involved in the decision making of the other entity. the controlling entity must have exercised its power to control. it is sufficient that the controlling entity has the capacity to control. the controlling entity must have exerted its control over the financing policies of the other entity.

Answer: c Learning objective 26.2: discuss the meaning and application of the criterion of control.

22. The equity in a subsidiary that is not attributable to a parent is known as a/an: a. b. c. *d.

external interest. attributable interest. non-direct interest. non-controlling interest.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

23. In the context of control, the correct statement regarding rights is: a. *b. c. d.

They must be protective rights. They must be substantive rights. They must arise from a legal contract. They must arise as a result of future events.

Answer: b Learning objective 26.2: discuss the meaning and application of the criterion of control.

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Testbank to accompany Financial reporting 3e by Loftus et al.

24. Under paragraph B23 of AASB 10/IFRS 10 Consolidated Financial Statements, factors to consider in assessing whether the rights over an investee are substantive include: a. b. c. *d.

whether there are any barriers that prevent the investor from exercising them. where more than one party is involved, whether there is a mechanism in place to enable those parties to practically exercise them. whether the party or parties that hold the rights would benefit from the exercise of those rights. all of the options are correct.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

25. Protective rights include: a. the right of a party holding a non-controlling interest in an investee to approve capital expenditure greater than that required in the ordinary course of business, or to approve the issue of equity or debt instruments. b. the right of a lender to seize the assets of a borrower if the borrower fails to meet specified loan repayment conditions. c. a lender’s right to restrict a borrower from undertaking activities that could significantly change the credit risk of the borrower to the detriment of the lender. *d. all of the options are correct. Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

26. North Bank has lent Sophie Limited $600 000. Part of the loan contract prevents Sophie from borrowing money in the future from other banks without the permission of North. As a result of this relationship: a. b. *c. d.

North Bank is regarded as a parent entity of Sophie Limited. Sophie Limited is regarded as a subsidiary of North Bank. a parent-subsidiary relationship does not exist between these two parties. a parent-subsidiary relationship exists between these two parties as North Bank is able to direct the relevant activities of Sophie Limited.

Answer: c Learning objective 26.2: discuss the meaning and application of the criterion of control.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

27. Rights to variable returns from an investee include: a. b. c. *d.

returns from denying or regulating access to a subsidiary’s assets. economies of scale. remuneration from provision of services. all of the options are correct.

Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

28. Variable returns from an investee include: a. fixed interest payments from a bond, as they expose the investor to the credit risk of the issuer of the bond, namely the investee b. dividends from ordinary shares that will change based on the profit performance of the investee c. fixed performance fees for management of the investee’s assets, as they expose the investor to the performance risk of the investee. *d. all of the options are correct. Answer: d Learning objective 26.2: discuss the meaning and application of the criterion of control.

29. An agent is: *a. b. c. d.

a party primarily engaged to act for the benefit of another party and therefore does not control the investee when it exercises its decision-making authority. a party primarily engaged to act for its own benefit. a party primarily engaged to act for the benefit of another party. a party primarily engaged to act for its own benefit and therefore controls the investee when it exercises its decision-making authority.

Answer: a Learning objective 26.2: discuss the meaning and application of the criterion of control.

30. The process of preparing the combined financial statements of a group of entities is known as: a. *b. c. d.

aggregation. consolidation. accumulation. combination.

Answer: b Learning objective 26.3: describe the consolidation process.

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Testbank to accompany Financial reporting 3e by Loftus et al.

31. A group of entities comprised of Mark Limited (parent entity), Roger Limited (subsidiary entity) and Graham Limited (subsidiary entity) have the following inventories balances. Mark Limited Roger Limited Graham Limited

$70 000 $32 000 $58 000

Which of the following amounts is shown as the consolidated inventories balance in the consolidated financial statements? a. b. *c. d.

$70 000. $20 000. $160 000. $90 000.

Answer: c Learning objective 26.3: describe the consolidation process.

32. The process of preparing consolidated financial statements requires that: a. b. c. *d.

adjusting journal entries be recorded in the ledger accounts of the parent only. adjusting journal entries be recorded in the ledger accounts of the subsidiaries only. accruals of expenses and revenues be recorded directly into the retained earnings account of the parent entity. no adjustments be made to the individual financial statements or ledger accounts of the entities in the group.

Answer: d Learning objective 26.3: describe the consolidation process.

33. The process of preparing consolidated financial statements requires that: a. the individual financial statements of the parent and all its subsidiaries use uniform accounting practices for like transactions and other events in similar circumstances. b. the subsidiaries must prepare, if practicable, financial information as of the same date and for the same period as the financial statements of the parent. c. the individual financial statements of the parent and all its subsidiaries use uniform accounting policies for like transactions and other events in similar circumstances. *d. the individual financial statements of the parent and all its subsidiaries use uniform accounting policies for like transactions and other events in similar circumstances and that the subsidiaries must prepare, if practicable, financial information as of the same date and for the same period as the financial statements of the parent. Answer: d Learning objective 26.3: describe the consolidation process.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

34. According to AASB 10/IFRS 10 Consolidated Financial Statements, all parent entities are required to present consolidated statements unless which of the following conditions apply to them? I. II. III. IV.

*a. b. c. d.

The parent is a wholly owned subsidiary. The parent’s debt or equity securities are traded in a public market. The parent is a partly owned subsidiary and its other owners do not object to the non-presentation of consolidated financial statements. The parent is not in the process of applying to issue any securities in a public market.

I, III and IV only. I and III only. I, II and III only. I, II, III and IV.

Answer: a Learning objective 26.4: explain the circumstances under which a parent entity may be exempt from preparing consolidated financial statements.

35. Summer Company is a listed public company and has a 60% controlling interest in Winter Company. Winter Company is the parent of Starlight Company. In which of the following situations will Winter Company not be required to prepare consolidated financial statements? a. Where it is likely that there are external users dependant on the information. b. If Winter Company prepares separate financial statements that comply with IFRS. *c. If the other owners of Winter Company have consented to the non-preparation of consolidated financial statements. d. Winter Company would never be required to prepare consolidated financial statements. Answer: c Learning objective 26.4: explain the circumstances under which a parent entity may be exempt from preparing consolidated financial statements.

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Testbank to accompany Financial reporting 3e by Loftus et al.

36. Merlion Limited is an entity listed in Singapore. Merlion Limited holds a 100% investment in Kookaburra Pty Ltd, an Australian based company, who in turn holds a 90% interest in Kangaroo Pty Ltd. Kookaburra Pty Ltd and the Kookaburra group (comprising Kookaburra and Kangaroo) are both non-reporting entities. Which of the following statements is correct? a. Kookaburra Pty Ltd will be required to prepare consolidated financial statements as the ultimate Australian parent. b. Kookaburra Pty Ltd will be required to prepare consolidated financial statements only if directed to do so by ASIC. c. Kookaburra Pty Ltd will not be required to prepare consolidated financial statements as Merlion is a listed foreign entity. *d. Kookaburra Pty Ltd will not be required to prepare consolidated financial statements as they are a non-reporting entity. Answer: d Learning objective 26.4: explain the circumstances under which a parent entity may be exempt from preparing consolidated financial statements.

37. The disclosure requirements in consolidated financial statements are included in which of the following accounting standards? a. AASB 127/IAS 127 Separate Financial Statements. b. AASB 10/IFRS 10 Consolidated Financial Statements. *c. AASB 12/IFRS 12 Disclosure of Interests in Other Entities. d. AASB 10/IFRS 10 Consolidated Financial Statements and AASB 12/IFRS 12 Disclosure of Interests in Other Entities. Answer: c Learning objective 26.5: discuss the disclosure requirements related to consolidated entities.

38. According to paragraph 9 of AASB 12/IFRS 12 Disclosure of Interests in Other Entities, which of the following is an example of a situation where it is necessary to disclose significant judgements and assumptions in relation to subsidiaries? a. where an entity is an agent or a principal. b. where an entity controls another entity but it holds less than half of the voting rights of the other entity. c. where an entity does not control another entity but it holds more than half of the voting rights in the other entity. *d. all of the options are correct. Answer: d Learning objective 26.5: discuss the disclosure requirements related to consolidated entities.

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Chapter 26: Consolidation: controlled entities Not for distribution in full. Instructors may assign selected questions in their LMS.

39. According to paragraph 10 of AASB 12/IFRS 12 Disclosure of Interests in Other Entities, an entity shall disclose information that enables users of its consolidated financial statements to evaluate which of the following? I. II. III. IV.

*a. b. c. d.

The consequences of losing control of a subsidiary. The composition of the group. The nature and extent of significant restrictions on its ability to access or use assets, and settle liabilities, of the group. The interest that non-controlling interests have in the group’s activities and cash flows. I and III only II and IV only I, III and IV only I, II, III and IV

Answer: a Learning objective 26.5: discuss the disclosure requirements related to consolidated entities.

40. Where the financial statements of a subsidiary are prepared at a date differing from that of the parent, the group must disclose: a. *b. c. d.

the date used by the subsidiary. the reason for the parent using a different date. the reason for the subsidiary using a different date. both the date used by the subsidiary as well as the reason for the subsidiary using a different date.

Answer: b Learning objective 26.5: discuss the disclosure requirements related to consolidated entities.

26.13

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 27: Consolidation: wholly owned entities

Chapter 27: Consolidation: wholly owned entities Comprehension questions 1. Briefly describe the consolidation process in the case of wholly owned entities. The consolidation process in the process through which consolidated financial statements are prepared by adding together, line by line, the financial statements of the parent and its subsidiary to some very important consolidation adjustments. First, the financial statements that are added together must be comparable. Therefore, before undertaking the consolidation process it may be necessary to make adjustments in relation to the content of the financial statements of the subsidiary. Second, as part of the consolidation process, a number of other adjustments are made to the parent’s and the subsidiary’s statements, these being expressed in the form of journal entries. A worksheet or computer spreadsheet is often used to facilitate the addition process and to make the adjustments.

2. Explain the initial adjustments that may be required before undertaking the consolidation process. Before undertaking the consolidation process it may be necessary to make adjustments in relation to the content of the financial statements of the subsidiary. •

•

If the end of a subsidiary’s reporting period does not coincide with the end of the parent’s reporting period, adjustments must be made for the effects of significant transactions and events that occur between those dates, with additional financial statements being prepared where it is practicable to do so (AASB 10/IFRS 10 paragraphs B92–B93). In most such cases, the subsidiary will prepare adjusted financial statements as at the end of the parent’s reporting period, so that adjustments are not necessary on consolidation. Where the preparation of adjusted financial statements is unduly costly, the financial statements of the subsidiary prepared at a different date from the parent may be used, subject to adjustments for significant transactions. However, as paragraph B93 states, for this to be a viable option, the difference between the ends of the reporting periods can be no longer than 3 months. Further, the length of the reporting periods, as well as any difference between the ends of the reporting periods, must be the same from period to period. The consolidated financial statements are to be prepared using uniform accounting policies for like transactions and other events in similar circumstances (AASB 10/IFRS 10 paragraph 19). Where the parent and the subsidiary used different policies, adjustments are made so that like transactions are accounted for under a uniform policy in the consolidated financial statements (normally the policy used by the parent).

3. Explain the adjustments that may be required as part of the consolidation process. As part of the consolidation process, a number of other adjustments are made to the parent’s and the subsidiary’s statements, these being expressed in the form of journal entries. •

As required by AASB 3/IFRS 3, at the acquisition date the acquirer must recognise the identifiable assets acquired and liabilities assumed of the subsidiary at fair value. Adjusting the carrying amounts of the subsidiary’s assets and liabilities to fair value and recognising

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

any identifiable assets acquired and liabilities assumed as part of the business combination, but not recorded by the subsidiary, is a part of the consolidation process. The entries used to make these adjustments are referred to in this chapter as the business combination valuation entries. As noted in section 27.2, these adjusting entries are generally not made in the records of the subsidiary itself, but in a consolidation worksheet. Where the parent has an ownership interest (i.e. owns shares) in a subsidiary, another set of adjusting entries are made, referred to in this chapter as the pre‐acquisition entries. As noted in paragraph B86(b) of AASB 10/IFRS 10, this involves eliminating the carrying amount of the parent’s investment in the subsidiary and the parent’s portion of pre‐ acquisition equity in the subsidiary. This avoids double counting of the group’s assets and equity. The name of these entries is derived from the fact that the equity of the subsidiary at the acquisition date is referred to as pre‐acquisition equity, and it is this equity that is being eliminated. These entries are also made in the consolidation worksheet, not in the records of the subsidiary. The third set of adjustments is for transactions between the entities within the group subsequent to the acquisition date, including sales of inventories or non‐current assets. These intragroup transactions are referred to in paragraph B86(c) of AASB 10/IFRS 10. Adjustments for these transactions are discussed in detail in chapter 28.

4. Explain the purpose and format of the consolidated worksheet. A consolidation worksheet is often used to facilitate the consolidation process, and to make the business combination valuation and pre-acquisition entry adjustments, among other adjustments. From the worksheet, the following statements are prepared: the consolidated statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity. Note the following points about the worksheet: • Column 1 contains the names of the accounts, as the financial statements are combined on a line-by-line basis. • Columns 2 and 3 contain the financial information for the parent and its subsidiary. This information is obtained from the financial statements of the separate legal entities. The number of columns is expanded if there are more subsidiaries within the group. • The next four columns, headed ‘Adjustments’, are used to post and reference the adjustments required in the consolidation process. These include the business combination valuation entries, pre-acquisition entries and the adjustments for intragroup transactions. These adjustments, written in the form of journal entries in the consolidation journal, are recorded in the worksheet, separately from the individual records of the parent and subsidiary, so they do not affect the individual financial statements. Where there are many adjustments, each journal entry should be numbered so that it is clear which items are being affected by a particular adjustment entry. • Th right-hand column, headed ‘Group’, includes the calculated consolidated amounts for each line item, together with totals and subtotals. The figures in the ‘Group’ column provide the information for preparing the consolidated statement of profit or loss and other comprehensive income, consolidated statement of changes in equity and consolidated statement of financial position. These statements will not include all the line items in the consolidation worksheet. However, information for the notes to these statements is also obtained from line items in the worksheet.

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Chapter 27: Consolidation: wholly owned entities

5. Explain the purpose of the acquisition analysis in the preparation of consolidated financial statements. According to AASB 3/IFRS 3 and as described in chapter 25, entities need to account for business combinations using the acquisition method. As part of the acquisition method, an acquisition analysis is conducted at acquisition date because it is necessary to recognise all the identifiable assets and liabilities of the subsidiary at fair value (including those previously not recorded by the subsidiary), and to determine whether there has been any goodwill acquired or whether a gain on bargain purchase has occurred. The acquisition analysis is considered the first step in the consolidation process as it identifies the information necessary for making both the business combination valuation and pre-acquisition entry adjustments for the consolidation worksheet. The end result of the acquisition analysis will be the determination of whether there is any goodwill acquired or gain on bargain purchase.

6. How does AASB 3/IFRS 3 Business Combinations affect the acquisition analysis? The formation of a parent–subsidiary relationship by the parent obtaining control over the subsidiary is a business combination. The parent, being the controlling entity is an acquirer, with the subsidiary being the acquiree. The acquisition analysis is then totally based on AASB 3/IFRS 3. The acquisition analysis reflects the application of the acquisition method: Step 1: Identify the acquirer – in this case, it is the parent. Step 2: Determine the acquisition date Step 3: Recognise and measure the identifiable assets acquired and the liabilities assumed at fair value. The differences between the carrying amounts and fair values of the identifiable assets, liabilities and contingent liabilities of the subsidiary are recognised via business combination valuation reserves. The effect is to recognise the assets and liabilities of the subsidiary at fair value. Step 4: Recognise and measure goodwill or a gain from a bargain purchase. The goodwill is recognised in the BCVR entries while the gain is recognised in the pre-acquisition entries.

7. At the date the parent acquires a controlling interest in a subsidiary, if the carrying amounts of the subsidiary’s assets are not equal to their fair value, explain why adjustments to these assets are required in the preparation of the consolidated financial statements. AASB 3/IFRS 3, paragraph 18, requires that identifiable assets and liabilities of the subsidiary are to be measured at fair value at acquisition date. The standard-setters believe that the fair value of the assets and liabilities provides the most relevant information to users. Even though the standard refers to an allocation of the cost of a business combination, the standard does not require the identifiable assets and liabilities acquired to be recorded at cost. The only asset acquired that is not measured at fair value is goodwill. The fair value approach is emphasised by the required accounting for any bargain purchase on combination. It is not accounted for as a reduction in the fair values of the identifiable assets and liabilities acquired such that these items are recorded at cost. Instead, the fair values are unchanged and the excess is recognised as a gain.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8. If the parent assesses that some of the subsidiary’s identifiable assets and liabilities are not recorded by the subsidiary at acquisition date, explain why adjustments to these assets and liabilities are required in the preparation of the consolidated financial statements. According to AASB 3/IFRS 3 and as described in chapter 25, entities need to account for business combinations using the acquisition method. As part of the acquisition method, an acquisition analysis is conducted at acquisition date because it is necessary to recognise all the identifiable assets and liabilities of the subsidiary at fair value (including those previously not recorded by the subsidiary).

9. Explain the purpose of the business combination valuation entries in the preparation of consolidated financial statements. The purpose of these entries is to make consolidation adjustments so that in the consolidated statement of financial position the identifiable assets, liabilities and contingent liabilities of the subsidiary are reported at fair value. This is to fulfil step 3 of the acquisition method required to account for business combinations by AASB 3/IFRS 3.

10. Explain the purpose of the pre-acquisition entries in the preparation of consolidated financial statements. The purpose of the pre-acquisition entries is to: • prevent double counting of the assets of the economic entity • prevent double counting of the equity of the economic entity • recognise any gain on bargain purchase. A simple example such as that below could be used to illustrate these points. A Ltd has acquired all the issued shares of B Ltd for $150. The balance sheets of both companies immediately after acquisition are as follows. Share capital Reserves

$200 100 300

Shares in B Ltd Cash

150 150 $300

Share capital Reserves

Cash

$100 50 150 -150 $150

Having acquired the shares in B Ltd, A Ltd records as an asset the investment account ‘Shares in B Ltd’ at $150. This asset represents the actual net assets of B Ltd; that is, the ownership of the shares gives A Ltd the right to the assets and liabilities of B Ltd. To include both the asset investment account ‘Shares in B Ltd’ and the assets and liabilities of B Ltd in the consolidated statement of financial position would double count the assets and liabilities of the subsidiary. On consolidation, the investment account is therefore eliminated.

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Chapter 27: Consolidation: wholly owned entities

Similarly, A Ltd has equity of $300, which represents its net assets including the investment account, ‘Shares in B Ltd’. Because the investment in the subsidiary represents the actual net assets of B Ltd, or, in other words, the equity of the subsidiary, the equity of the parent effectively includes the equity of the subsidiary. To include both the equity of the subsidiary at acquisition date and the equity of the parent in the consolidated statement of financial position would double-count the pre-acquisition equity of the subsidiary. On consolidation, the equity of the subsidiary at acquisition date is therefore eliminated.

11. When there is a dividend payable by the subsidiary at acquisition date, under what conditions should it be taken into consideration in preparing the pre-acquisition entries? Discuss: • the difference between ex div. and cum div. acquisitions • the effects on the consolidation journal entries in the records of the parent under each circumstance. Assume for example that A Ltd acquires all the issued shares of B Ltd for $500 000 when at acquisition date B Ltd has recorded a dividend payable of $10 000. Discuss: • The effects on the acquisition analysis: - For cum div. acquisitions, the dividend payable is considered as a refund on the consideration transferred and therefore the net consideration transferred of $490 000 is used to calculate goodwill/gain on bargain purchase: ▪ If the total shareholder’s equity of B Ltd at acquisition date was $450 000 and all its identifiable assets and liabilities were recorded at fair value, there will be a goodwill of $40 000 which will be recognised in the BCVR as part of the BCVR entries at acquisition date and every period after that. This BCVR will be eliminated in the pre-acquisition entry. ▪ If the total shareholder’s equity of B Ltd at acquisition date was $520 000 and all its identifiable assets and liabilities were recorded at fair value, there will be a gain on bargain purchase of $30 000 which will be recognised in the pre-acquisition entries at acquisition date. In the periods after the period of acquisition, it will be taken out of the opening balance of “Retained earnings” that will be eliminated in the pre-acquisition entries. - For ex div. acquisitions, the dividend is not considered on consolidation and therefore the value of the consideration transferred used to calculate goodwill/gain on bargain purchase would be $500 000: ▪ If the total shareholder’s equity of B Ltd at acquisition date was $450 000 and all its identifiable assets and liabilities were recorded at fair value, there will be a goodwill of $50 000 which will be recognised in the BCVR as part of the BCVR entries at acquisition date and every period after that. This BCVR will be eliminated in the pre-acquisition entry. ▪ If the total shareholder’s equity of B Ltd at acquisition date was $520 000 and all its identifiable assets and liabilities were recorded at fair value, there will be a gain on bargain purchase of $20 000 which will be recognised in the pre-acquisition entries at acquisition date. In the periods after the period of acquisition, it will be taken out of the opening balance of “Retained earnings” that will be eliminated in the pre-acquisition entries.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

Other differences in the pre-acquisition entries: - For cum div. acquisitions, the pre-acquisition entries at acquisition date will need to eliminate the dividend receivable raised by the parent and the dividend payable raised by the subsidiary as they are related to a dividend that was declared out of pre-acquisition equity; the pre-acquisition entries after the acquisition date will most likely not need to eliminate this dividend receivable and payable as the dividend would have been paid by the time the pre-acquisition entries need to be prepared. - For ex div. acquisitions, the pre-acquisition entries will not be further affected by this dividend.

12. Is it necessary to distinguish pre-acquisition dividends from post-acquisition dividends? Why? Discuss: • the definition of acquisition date • the meaning of pre-acquisition and post-acquisition equity • the treatment of dividends according to paragraph 38A of AASB 127/IAS 27: i.e., an entity shall recognise a dividend from a subsidiary in profit or loss i.e. as revenue – regardless of whether it is paid from pre- or post-acquisition equity. Under AASB 127/IAS 27, all dividends declared after acquisition and paid or payable by the subsidiary to a parent are recognised as revenue in the profit or loss of the parent. However, the dividends from pre-acquisition equity are, by definition, a distribution of pre-acquisition equity, which decreases the pre-acquisition equity and may reduce the value of the investment recognised by the parent. By treating those dividends as revenue, the parent may overstate its income. To reduce any risk of any possible overstatement of income by a parent, the IASB looked at the impairment testing of the investment account recorded by the parent. If the investment account decreases in value as a result of the dividends from pre-acquisition equity, an impairment loss needs to be recognised by the parent. To determine whether there is an impairment of the investment account that should be recognised as a result of dividends distribution, paragraph 12(h) of AASB 136/IAS 36 Impairment of Assets contains a scenario that may provide evidence that the impairment of the investment account occurred: for an investment in a subsidiary, joint venture or associate, the investor recognises a dividend from the investment and evidence is available that: (i) the carrying amount of the investment in the separate financial statements exceeds the carrying amounts in the consolidated financial statements of the investee’s net assets, including associated goodwill; or (ii) the dividend exceeds the total comprehensive income of the subsidiary, joint venture or associate in the period the dividend is declared. As such, the pre-acquisition dividends that cause the impairment of the investment account determine an adjustment to be posted in the pre-acquisition entries and that is to eliminate the impairment loss recognised in the individual account by the parent. This entry in the case of the pre-acquisition dividend complements the pre-acquisition entries necessary to eliminate the dividend income and dividend paid/declared (in the period of dividend declaration or payment) and, if the dividend was not yet paid, dividend receivable and dividend payable. If the dividend is a post-acquisition dividend, the only entries will be those necessary to eliminate dividend income and dividend paid/declared (in the period of dividend declaration or payment) and, if © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

the dividend was not yet paid, dividend receivable and dividend payable – these entries are not part of pre-acquisition entries, but they will be posted in the consolidation worksheet separately as eliminations of intragroup transactions (see chapter 28).

13. If the subsidiary has recorded goodwill in its records at acquisition date, how does this affect the acquisition analysis, the business combination valuation entries and the pre-acquisition entries? Discuss: • the difference between the previously recorded goodwill and acquired goodwill • the effects on consolidation in relation to the goodwill. In the acquisition analysis, when calculating the net fair value of the identifiable assets and liabilities acquired, there must be an adjustment for the unidentifiable asset previously recorded by the subsidiary to calculate the goodwill acquired by the group or the gain on bargain purchase (i.e. the goodwill recorded in the records of the subsidiary prior to acquisition date is subtracted from the value of the shareholders’ equity (net assets) to get to the net value of the identifiable assets and liabilities acquired): •

• •

•

If the goodwill acquired (i.e. the goodwill determined in the acquisition analysis) is greater than the previously recorded goodwill, the unrecorded part is recognised in the business combination valuation entries as part of the BCVR. The pre-acquisition entries will then eliminate the BCVR as that is part of pre-acquisition equity. If the goodwill acquired is equal to the previously recorded goodwill, there are no extra entries required. If the goodwill acquired is lower than the previously recorded goodwill, the recorded part over the goodwill acquired is written off in the business combination valuation entries as a debit to BCVR. The pre-acquisition entries will then eliminate this debit to BCVR by crediting the account. If there is a gain on bargain purchase, the entire previously recorded goodwill is written off in the business combination valuation entries as a debit to BCVR. The pre-acquisition entries will then eliminate this debit to BCVR.

These adjustments are necessary so that the group’s goodwill is shown in the consolidated statement of financial position. This goodwill is the total of the goodwill recognised by the subsidiary at acquisition date and the goodwill recognised on consolidation. This equals the total goodwill acquired by the parent in its acquisition of the subsidiary.

14. Explain how the existence of a gain on bargain purchase affects the pre-acquisition entries, both in the year of acquisition and in subsequent years. In the presence of a gain on bargain purchase, the pre-acquisition entry at acquisition date should recognise this gain as a part of the consolidated profit for the period starting at acquisition date, and not eliminate it. This is because it is considered to belong to postacquisition equity. In subsequent periods after the acquisition date, the gain on bargain purchase is included in retained earnings (opening balance) and therefore reduces the adjustment to the opening balance of retained earnings posted in pre-acquisition entries.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

15. Why are some adjustment entries in the previous period’s consolidation worksheet also made in the current period’s worksheet? The consolidation worksheet entries do not affect the underlying financial statements or the accounts of the parent or the subsidiary. As the consolidation is done every year based on the individual financial statements or the accounts of the parent or the subsidiary, the entries in the consolidation worksheet from previous years do not carry over and they need to be repeated, sometimes exactly the same as in previous years, something with some adjustments. For example, if the last year’s profits are required to be adjusted on consolidation, then retained earnings (opening balance) will need to be adjusted in the current period. Similarly, a BCVR entry to recognise at fair value the land on hand at acquisition is made in the consolidation worksheet for each year that the land remains in the subsidiary. The entry does not change from year to year. Again the reason is that the adjustment to the carrying amount of the land is only made in a worksheet and not in the actual records of the subsidiary itself. However, the BCVR entries for non-current assets subject to depreciation need to be adjusted from year to year.

16. Explain how and why the business combination valuation entries will be adjusted in subsequent years after the acquisition date. In any period after acquisition, business combination valuation entries are prepared for the assets and liabilities that were not recorded at fair value at acquisition date to the extent that they are still on hand with the subsidiary at the beginning of that period: • If they are sold, fully depreciated or settled by the beginning of that period, no business combination valuation entries need to be prepared for those items. • If they are still on hand with the subsidiary at the beginning of that period, but they are sold, fully depreciated or settled by the end of the current period, business combination valuation entries only need to be prepared to adjust the gains generated by the sale and the expenses generated by depreciation, amortisation or impairment of assets or settlement of liabilities, recognising also the tax effects. • If they are still on hand with the subsidiary at the end of that period, business combination valuation entries need to be prepared to adjust the expenses generated by the depreciation, amortisation or impairment of assets or the gains from the partial settlement of liabilities, recognising also the tax effects, but also to adjust the actual assets and liabilities to the fair value at the beginning of the current period. If adjustments are needed to expenses for the previous periods, those adjustments are posted against Retained Earnings (opening balance). Those adjustments are needed to make sure that only the assets and liabilities that are still affecting the consolidated financial statements and their effects are recognised at the right value for the consolidated entity. The assets and liabilities that do not have any effect on the consolidated financial statements because they were de-recognised or settled prior to the beginning of the current period do not need to be considered.

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Chapter 27: Consolidation: wholly owned entities

17. Explain how and why the pre-acquisition entries will be adjusted in subsequent years after the acquisition date. There are two sets of events that can cause a change in the pre-acquisition entries after acquisition date: • changes in the pre-acquisition equity, due to transfers between pre-acquisition equity accounts, including transfers from business combination valuation reserve, other transfers between pre-acquisition reserves and bonus share dividends. • changes in the investment account recognised by the parent, due to impairment as a result of pre-acquisition dividends or due to the parent paying calls on the partly paid shares of the subsidiary. In the case of calls on partly paid shares of the subsidiary, a change in preacquisition equity (share capital) is recognised, together with a change in the investment account. In any particular year, some of these events will have occurred in previous periods, and some will occur in the current period. The pre-acquisition entries for a period after the acquisition consist of: • a combined pre-acquisition entry at the beginning of the current period (i.e. the preacquisition entry at the acquisition date adjusted for the effects of all pre-acquisition equity changes and changes in the investment account recognised by the parent up to the beginning of the current period) and • entries relating to those changes in the current period.

18. Using an example, explain how the business combination entries affect the preacquisition entries, both at acquisition date and in the subsequent years. Assume at acquisition date, the subsidiary has land recorded at a carrying amount of $10 000 and having a fair value of $15 000. The tax rate is 30%. At acquisition date, the BCVR entries will recognise an increment to land of $5 000, a deferred tax liability of $1 500 and a BCVR of $3 500. This BCVR is pre-acquisition equity. Hence in the pre-acquisition entry, if prepared at acquisition date, there would be a debit adjustment to BCVR to eliminate the balance of pre-acquisition equity. In subsequent periods, if the land is sold, in the BCVR entries, on sale of the land, there would be a credit adjustment to “Transfer from BCVR”, as the reserve is transferred to retained earnings. In preparing the pre-acquisition entries in the year of sale, the initial entry repeated from the previous period will still include the BCVR relating to land. A further entry is then required debiting the “Transfer from BCVR” account – hence eliminating pre-acquisition equity – and crediting the BCVR account as this account no longer exists.

19. Explain the choices that may be available to revalue the identifiable assets recorded by the subsidiary at carrying amounts different from fair value at the acquisition date. AASB 3/IFRS 3 does not discuss whether the revaluation of the assets of the subsidiary at acquisition date should be done in the consolidation worksheet or in the records of the subsidiary. Most entities will make their adjustments in the consolidation worksheet, mainly for two reasons.

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•

Adjustments to fair value for assets such as goodwill and inventories are not allowed in the actual records of the subsidiary. Goodwill is not allowed to be revalued and inventories should always be recognised at the lowest of the cost and net realisable value, not at fair value. The revaluation of non‐current assets in the records of the subsidiary require the subsidiary to adopt the revaluation model of accounting for the whole class of assets that those assets belong to, and to use that model in all post‐acquisition periods. Applying the revaluation model for whole classes of assets each year may be too costly for the subsidiary and, therefore, not preferable.

Nevertheless, some subsidiaries may decide to revalue some of the assets for which the fair value was different from the carrying amount at acquisition date in their own accounts. In that case, there will not be any business combination valuation entries for the revalued assets. Moreover, the pre‐acquisition entries will change. Note that the business combination valuation entries applied in the consolidation worksheet for property, plant and equipment assets in this chapter are of the same form as those applied for property, plant and equipment in Chapter 5. The difference is that the after‐tax revaluation increment was recognised as business combination valuation reserve and not asset revaluation surplus.

20. At acquisition date, the subsidiary may have the choice to revalue (or not) in its own accounts the identifiable assets previously recorded at carrying amounts different from fair value. Discuss how the business combination entries and the pre‐acquisition entries will be affected by this choice. If the subsidiary revalues some assets in its own accounts, an asset revaluation surplus will be recognised (and not a business combination valuation reserve) and, being part of pre‐ acquisition equity, it will need to be considered when preparing the pre‐acquisition entries. As asset revaluation surplus behaves in the same manner as business combination valuation reserve, the pre‐acquisition entries will be affected if the revalued asset is derecognised, as the asset revaluation surplus will be transferred to retained earnings. Nevertheless, as the asset revaluation surplus or its transfer to retained earnings will be eliminated in pre‐acquisition entries just like the business combination valuation reserve and its transfer, the consolidated financial statements at acquisition date are the same regardless of whether revaluation occurs on consolidation or in the records of the subsidiary.

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Chapter 27: Consolidation: wholly owned entities

Case studies Case study 27.1 Unrecorded assets Lynx Ltd has just acquired all the issued shares of Indus Ltd. The accounting staff at Lynx Ltd has been analysing the assets and liabilities acquired as a result of this business combination. This analysis found that Indus Ltd had been expensing its research outlays in accordance with AASB 138/IAS 38 Intangible Assets. Over the past 3 years before the acquisition, the company has expensed a total of $20 000, including $8000 immediately before the acquisition date. One of the reasons that Lynx Ltd acquired Indus Ltd was its promising research findings in an area that could benefit the products being produced by Lynx Ltd. There is disagreement among the accounting staff as to how to account for the research outlays of Indus Ltd. Some of the staff argue that, since it is research expenditure, the correct accounting is to expense it, and so no adjustments need to be done on consolidation. Other members of the accounting staff believe that it should be recognised on consolidation as an asset, but are unsure of the accounting entries to use, and are concerned about the future effects of recognition of an asset. Required Advise the accountants that prepare the consolidated financial statements of Lynx Ltd on what accounting choice is most appropriate in these circumstances. Accounting for research and development in the subsidiary itself is governed by AASB 138/IAS 38 Intangible Assets. Research outlays are expensed under AASB 138/IAS 38 paragraph 54. Recognition of intangibles acquired in a business combination is discussed in paragraphs 3341 of AASB 138/IAS 38. Paragraph 13 of AASB 3/IFRS 3 recognises that some intangible assets not recognised by an acquiree may be recognisable by the acquirer. In a business combination the intangible asset is measured at its fair value, using the hierarchy in AASB 138/IAS 38. In order to recognise an intangible asset, it must meet the definition of an asset. In preparing the consolidated financial statements, Lynx Ltd will recognise the in-process research asset in its business combination valuation entries, for example: In-process research Deferred tax liability Business combination valuation reserve

Dr Cr Cr

x x x

The tax-effect, in this case a liability relating to the expected tax to be paid on the earnings from the research asset, is recognised. The in-process research will be subject to the amortisation procedures in AASB 138/IAS 38, resulting in further BCVR entries. In the first period after acquisition, the further BCVR entries will be:

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Amortisation expense – in-process research Accumulated amortisation - in-process research

Deferred tax liability Income tax expense

Dr Cr

x x x

In the next periods before the period when the in-process research is fully amortised and derecognised, the further BCVR entries will be: Amortisation expense - in-process research Retained earnings (opening balance) Accumulated amortisation - in-process research

Dr Dr

x x*

*For the previous periods’ amortisation expenses. Deferred tax liability Income tax expense Retained earnings (opening balance)

Dr Cr Cr

x x x*

*For the tax effect of the previous periods’ amortisation expenses. When the in-process research is fully amortised, the BCVR for it will be transferred to retained earnings and the BCVR entries will only include the following entry: Amortisation expense - in-process research Income tax expense Retained earnings (opening balance) Transfer from BCVR

Dr Cr Dr Cr

x x* x x

*For the tax effect of the current periods’ amortisation expenses In the next periods, no future consolidation adjustments will be necessary.

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Chapter 27: Consolidation: wholly owned entities

Case study 27.2 Unrecorded liability Scorpio Ltd has finally concluded its negotiations to acquire Norma Ltd, and has secured ownership of all the shares of Norma Ltd. One of the areas of discussion during the negotiation process was the current court case that Norma Ltd was involved in. The company was being sued by some former employees who were retrenched, but are now claiming damages for unfair dismissal. The company did not believe that it owed these employees anything. However, realising that industrial relations was an uncertain area, particularly given the country’s current confusing industrial relations laws, it had raised a note to the accounts issued before the takeover by Scorpio Ltd reporting the existence of the court case as a contingent liability. No monetary amount was disclosed, but the company’s lawyers had placed a $56 700 amount on the probable payout to settle the case. The accounting staff of Scorpio Ltd are unsure of the effect of this contingent liability on the accounting for the consolidated group after the acquisition. Some argue that it is not a liability of the group and so should not be recognised on consolidation, but are willing to accept some form of note disclosure. A further concern being raised is the effects on the accounts, depending on whether Norma Ltd wins or loses the case. If Norma Ltd wins the court case, it will not have to pay out any damages and could get reimbursement of its court costs, estimated to be around $40 000. Required Give your opinion on the treatment of the contingent liability at acquisition date for consolidation purposes, as well as any subsequent effects when Norma Ltd either wins or loses the case. Under paragraph 27 of AASB 137/IAS 37 Provisions, Contingent Liabilities and Contingent Assets, an entity’s contingent liabilities are not recognised in the accounts of the entity but are reported by way of note to the accounts. Under AASB 3/IFRS 3 paragraph 36, an acquirer must recognise at the acquisition date the acquiree’s identifiable assets and liabilities that satisfy the recognition criteria at their fair values at that date. Paragraph 23 of AASB 3/IFRS 3 state that the requirements of AASB 137/IAS 37 do not apply in determining which contingent liabilities to recognise as of acquisition date. However, the liability recognised must be a present obligation – not a possible obligation. Also, contrary to AASB 137/IAS 37, the acquirer recognises contingent liability even if it not probable that an outflow of resources will be required. The fair value measurement takes into account the probability of outflows occurring. Scorpio Ltd must then recognise the liability in its consolidated financial statements at fair value. This is done using the BCVR entries, assuming a fair value of $40 000: Business combination valuation reserve Deferred tax asset Provision for damages

Dr Dr Cr

28 000 12 000 40 000

If Norma Ltd wins the court case and no damages have to be paid, the consolidation worksheet

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entry changes to*: Transfer from BCVR Income tax expense Gain from court case

Dr Dr Cr

28 000 12 000 40 000

*Note that this entry is actually a combination of the entries as follows: Business combination valuation reserve Dr Deferred tax asset Dr Provision for damages Cr (To recognise the provision as of acquisition date)

28 000 12 000 40 000

Provision for damages Dr 40 000 Gain from court case Cr 40 000 (To recognise the settlement of the court case during the current period) Transfer from BCVR Dr 28 000 Business combination valuation reserve Cr 28 000 (To recognise that the BCVR is transferred to retained earnings as the provision was de-recognised) Income tax expense Dr 12 000 Deferred tax asset Cr (To recognise the tax effect on the current period’s gain)

12 000

If Norma Ltd loses the court case and pays damages of an amount less than $40 000, say $30 000, then the worksheet entry is: Transfer from BCVR Income tax expense Gain from court case Damages expense

Dr Dr Cr Cr

28 000 12 000 10 000 30 000*

*The credit to “Damages expense” is posted on consolidation to eliminate the damages expense that now would have been recognised in the subsidiary’s accounts. This elimination is necessary because this damages expense related to the course case is an expense for the subsidiary now, but it was already recognised on consolidation at acquisition date as part of the provision in the acquisition analysis. If Norma Ltd loses the court case and pays damages of an amount equal to or greater than $40 000, say $50 000, then the worksheet entry is: Transfer from BCVR Income tax expense Damages expense

Dr Dr Cr

28 000 12 000 40 000

In relation to the court costs, assume that Norma Ltd has at the date of acquisition already incurred court costs of, say, $10 000 and expects to win the case and get these costs reimbursed. © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

Under AASB 137/IAS 37, Norma Ltd does not itself recognise a contingent asset in its records. Further under AASB 3/IFRS 3, contingent assets are not recognised by the acquirer as a part of step 3 of the acquisition method. They therefore do not affect the consolidation process. If the $10 000 were received by Norma Ltd in a later period upon winning the court case, it would be recognised as a gain by both Norma Ltd and the group. If the BCVR entries include a debit to Transfer from BCVR (on settlement of the court case), that will be reversed in the pre-acquisition entries for the period when the settlement occurs by having the following entry posted in the consolidation worksheet: Business combination valuation reserve Transfer from BCVR

Dr Cr

28 000

27.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 27.3 Misvalued and unrecorded assets and liabilities Mensa Ltd has acquired all the shares of Careers Ltd. The accountant for Mensa Ltd, having studied the requirements of AASB 3/IFRS 3 Business Combinations, realises that all the identifiable assets and liabilities of Careers Ltd must be recognised in the consolidated financial statements at fair value. Although she understands the need to revalue items recorded by the subsidiary at carrying amounts different from fair value and to recognise previously unrecorded assets or liabilities at fair value, she is unsure of a number of matters associated with accounting for these assets and liabilities. She has approached you and asked for your advice. Required Write a report for the accountant at Mensa Ltd advising on the following issues: 1. Should the adjustments to fair value be made in the consolidation worksheet or in the accounts of Careers Ltd? 2. What equity accounts should be used when revaluing or recognising assets and liabilities? 3. Do these equity accounts remain in existence indefinitely, since they do not seem to be related to the equity accounts recognised by Careers Ltd itself? 1. From the point of view of AASB 3/IFRS 3 and AASB 127/IAS 27, there is no specification on where the adjustments are made. However if the assets of the subsidiary are adjusted to fair value in the accounts of the subsidiary itself then this amounts to adoption of the revaluation model by the subsidiary and all the regulations in AASB 116/IAS 16 and AASB 138/IAS 38 apply. In particular, the assets must be continuously adjusted to reflect current fair values. If, on the other hand, the adjustments are made in the consolidation worksheet, this is a recognition on consolidation of the cost of the assets to the group entity rather than an adoption of the revaluation model. Hence the recognition of the subsidiary’s assets at fair value is to measure cost to the acquirer. There is then no need to make subsequent adjustments to the assets when the fair values change. Because of the costs associated with using the revaluation model, it is expected that most entities will make the adjustments in the consolidation worksheet rather than in the accounts of the subsidiary itself. Note also that some assets cannot be revalued at fair value in the individual accounts of a subsidiary (e.g. inventories). 2. The accounting standards do not specify the name of the equity account raised on valuation of the assets and liabilities of the subsidiary. Hence, an asset revaluation reserve account could be used for the assets. The textbook uses a BCVR because adjustments are made to both assets and liabilities and the BCVR is then a generic account for all adjustments arising as a result of the business combination. It is not appropriate to use income for liabilities as the recognition of equity for both assets and liabilities does not affect current period profit or loss. There is no gain by the acquirer on recognition of assets or liabilities not recognised by the subsidiary. 3. The BCVR remains in existence while the underlying assets and liabilities remain unsold, unconsumed or unsettled. With asset revaluation reserves under the revaluation model there is no requirement that it ever be transferred to retained earnings, although this is normal practice and is allowed under AASB 116/IAS 16. Similarly, the BCV reserves could remain © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

indefinitely. However, the extra benefits/expenses resulting from using the assets or settling the liabilities will flow into the subsidiary’s retained earnings account. Hence the group recognises the net benefits in the BCVR while the subsidiary recognises them in retained earnings. This situation requires an adjustment in the consolidation worksheet every year while such a difference in equity classification occurs. If on consolidation as the assets are used up or sold and the liabilities settled the BCVR is transferred to retained earnings, no subsequent consolidation adjustment is required.

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Case study 27.4 Goodwill When Hydra Ltd acquired the shares of Draco Ltd, one of the assets in the statement of financial position of Draco Ltd was $15 000 goodwill, which had been recognised by Draco Ltd upon its acquisition of a business from Valhalla Ltd. Having prepared the acquisition analysis as part of the process of preparing the consolidated financial statements for Hydra Ltd, the group accountant has asked for your opinion. Required Provide advice on the following issues: 1. How does the goodwill previously recorded by the subsidiary affect the accounting for the group’s goodwill? 2. If, in subsequent years, goodwill is impaired, for example by $10 000, should the impairment loss be recognised in the records of Hydra Ltd or as a consolidation adjustment? 1. The goodwill recorded by the subsidiary affects the adjustment to goodwill on consolidation. If the acquisition analysis results in the calculation of a group goodwill of, say, $20 000 (by comparing the consideration transferred with the net fair value of identifiable assets and liabilities that does not include the previously recorded goodwill), then as the subsidiary has already recorded $15 000, a debit adjustment of $5 000 is required in the consolidation worksheet. If the acquisition analysis results in the calculation of a group goodwill of, say, $12 000, then as the subsidiary has already recorded $15 000, a credit adjustment of $3 000 is required in the consolidation worksheet. If the acquisition analysis determines an excess of, say, $2 000, then the whole $15 000 goodwill is eliminated on consolidation. Any accumulated impairment losses recorded by the subsidiary at acquisition date must be adjusted for in the consolidation worksheet, normally by writing them off. 2. The determination of the impairment loss would be based on the subsidiary as a CGU with the consolidated numbers representing the carrying amounts of the CGU. In writing off goodwill as the result of an impairment loss, the goodwill written off could be either that recognised by the subsidiary or that recognised on consolidation. If the goodwill on consolidation is written off this is done via the pre-acquisition entries. If the subsidiary writes off its recorded goodwill, no adjustment is required on consolidation for the impairment write-down. If the consolidated goodwill was $20 000, then if an impairment loss of $10 000 occurred, an amount of at least $5 000 would have to be written off in the subsidiary’s accounts. Case study 27.5 Gain on bargain purchase The accountant for Carina Ltd, Ms Finn, has sought your advice on an accounting issue that has been puzzling her. When preparing the acquisition analysis relating to Carina Ltd’s acquisition of Lyra Ltd, she calculated that there was a gain on bargain purchase of $10 000. Being unsure of how to account for this, she was informed by professional acquaintances that this should be recognised as income. However, she reasoned that this © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

would increase the consolidated profit in the first year after acquisition date. As she is aware that the pre-acquisition equity of the subsidiary needs to be eliminated on consolidation, she is unsure of whether this profit is all post- or pre-acquisition profit or a mixture of the two. Required Compile a detailed report on the nature of the gain on bargain purchase, its recognition on acquisition and the effects of its recognition on subsequent consolidated financial statements. If the net fair value of the identifiable assets and liabilities of the subsidiary is greater than the consideration transferred, in accordance with paragraph 36 of AASB 3/IFRS 3 the acquirer must firstly reassess the identification and measurement of the subsidiary’s identifiable assets and liabilities as well as the measurement of the consideration transferred. The expectation under AASB 3/IFRS 3 is that the excess of the net fair value over the consideration transferred is usually the result of measurement errors rather than being a real gain to the acquirer. However, having confirmed the identification and measurement of both amounts paid and net assets acquired, if an excess still exists, under paragraph 34 of AASB 3/IFRS 3 it is recognised immediately in profit as a gain on bargain purchase. The gain on bargain purchase is recognised as part of the post-acquisition equity and not preacquisition equity since it is considered to be generated at acquisition date. The existence of a gain on bargain purchase has no effect on the business combination valuation entries unless, as discussed in section 27.4.4, the subsidiary has previously recorded goodwill. In that case, a business combination revaluation entry crediting goodwill and debiting business combination valuation reserve for the amount of goodwill recorded by the subsidiary would be required. (If impairment losses have been recognised on that goodwill, the journal entry would include a credit to goodwill for the amount of goodwill recorded by the subsidiary at cost, a debit for business combination valuation reserve for the carrying amount of goodwill and another debit for the accumulated impairment losses on this goodwill). That is because the previously recorded goodwill has to be eliminated. In the presence of a gain on bargain purchase, the pre-acquisition entry at acquisition date should recognise this gain as a part of the consolidated profit for the period starting at acquisition date, and not eliminate it. This is because it is considered to belong to postacquisition equity. In subsequent periods after the acquisition date, the gain on bargain purchase is included in retained earnings (opening balance) and therefore reduces the adjustment to the opening balance of retained earnings posted in pre-acquisition entries.

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Application and analysis exercises Exercise 27.1 Acquisition analysis, acquisition date entries On 1 July 2022, Keith Ltd acquired the remaining 80% of the issued shares that it did not previously own in Urban Ltd, transferring 400 000 Keith Ltd shares to Urban Ltd’s former shareholders. At that date, the financial statements of Urban Ltd showed the following information. Share capital

$ 700 000

Asset revaluation surplus

140 000

Retained earnings

460 000

All the assets and liabilities of Urban Ltd were recorded at amounts equal to their fair values at the acquisition date. The fair value of Keith Ltd’s shares at acquisition date was $3.50 per share. The previously held interest by Keith Ltd in Urban Ltd (i.e. 20% of the issued shares) was recognised in Keith Ltd’s accounts at the fair value at acquisition date of $260 000. Keith Ltd incurred $25 000 in acquisition‐related costs, including $12 000 in share issue costs. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the journal entries for Keith Ltd to recognise the additional investment in Urban Ltd at 1 July 2022. 3. Prepare the consolidation worksheet entries for Keith Ltd’s group at 1 July 2022. (LO3 and LO4) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired

Consideration transferred Fair value of prior investment Total investment at fair value Goodwill

= =

$700 000 + $140 000 + $460 000 (equity) $1 300 000

= = =

400 000 x $3.50 $1 400 000 $260 000

= = = =

$1 400 000 + $260 000 $1 660 000 $1 660 000 – $1 300 000 $360 000

2. Journal entries for Keith Ltd to recognise the additional investment in Urban Ltd at 1 July 2022: Shares in Urban Ltd Share capital

Dr 1 400 000 Cr

1 400 000

Chapter 27: Consolidation: wholly owned entities

Acquisition expenses Share capital Cash

Dr Dr Cr

13 000 12 000 25 000

The acquisition-related costs are not part of the consideration transferred as those amounts are not paid to the former shareholders of Urban Ltd in exchange of their shares. Therefore, they are not recognised as part of the investment in Urban Ltd: the share issue costs are treated as a reduction in the share capital (as all the share issue costs), while the remaining costs are recognised as expenses in the year of acquisition. 3. Consolidation worksheet entries at 1 July 2022: BCVR entry at 1 July 2022: There is a BCVR entry only for goodwill identified in the acquisition analysis as all the identifiable assets and liabilities of Urban Ltd were recorded at amounts equal to their fair values at acquisition date. Goodwill Business combination valuation reserve

Dr Cr

360 000

Dr Dr Dr Dr Cr

460 000 700 000 140 000 360 000

360 000

Pre-acquisition entry at 1 July 2022: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Shares in Urban Ltd

1 660 000

The pre-acquisition entry eliminates the pre-acquisition equity (including the business combination valuation reserve recognised for the goodwill acquired) against the investment account recognised by the parent based on the consideration transferred and the fair value of the previously held interest.

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Exercise 27.2 Acquisition analysis, acquisition date entries On 1 July 2022, Michael Ltd acquired all the issued shares of Andrew Ltd, paying $60 000 cash and transferring 50 000 of its own shares to Andrew Ltd’s former shareholders. At that date, the financial statements of Andrew Ltd showed the following information. Share capital

$ 50 000

General reserve

25 000

Retained earnings

75 000

All the assets and liabilities of Andrew Ltd were recorded at amounts equal to their fair values at the acquisition date. The fair value of Michael Ltd’s shares at acquisition date was $2 per share. Michael Ltd incurred $15 000 in acquisition-related costs that included $2500 as share issue costs. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the journal entries for Michael Ltd to recognise the investment in Andrew Ltd at 1 July 2022. 3. Prepare the consolidation worksheet entries for Michael Ltd’s group at 1 July 2022. (LO3 and LO4) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired Consideration transferred Goodwill

= = = = = =

$50 000 + $25 000 + $75 000 (equity) $150 000 $60 000 + 50 000 x $2 $160 000 $160 000 – $150 000 $10 000

2. Journal entries for Michael Ltd to recognise the additional investment in Andrew Ltd at 1 July 2022: Shares in Andrew Ltd Cash Share capital

Dr Cr Cr

160 000

Acquisition expenses Share capital Cash

Dr Dr Cr

12 500 2 500

60 000 100 000

15 000

The acquisition-related costs are not part of the consideration transferred as those amounts are not paid to the former shareholders of Andrew Ltd in exchange of their shares. Therefore, they are not recognised as part of the investment in Andrew Ltd: the share issue costs are treated as a reduction in the share capital (as all the share issue costs), while the remaining costs are recognised as expenses in the year of acquisition. 3. Consolidation worksheet entries at 1 July 2022: © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

BCVR entry at 1 July 2022: There is a BCVR entry only for goodwill identified in the acquisition analysis as all the identifiable assets and liabilities of Andrew Ltd were recorded at amounts equal to their fair values at acquisition date. Goodwill Business combination valuation reserve

Dr Cr

10 000 10 000

Pre-acquisition entry at 1 July 2022: Retained earnings (1/7/22) Dr 75 000 Share capital Dr 50 000 General reserve Dr 25 000 Business combination valuation reserve Dr 10 000 Shares in Andrew Ltd Cr 160 000 The pre-acquisition entry eliminates the pre-acquisition equity (including the business combination valuation reserve recognised for the goodwill acquired) against the investment account recognised by the parent based on the consideration transferred. Please note that if the fair value of the consideration transferred would have been less than the net fair value at acquisition date of identifiable assets acquired and liabilities assumed, the acquisition analysis will identify a gain on bargain purchase instead of a goodwill. Therefore, there won’t be any BCVR entries in that case and the pre-acquisition entry will need to eliminate the retained earnings, share capital and the general reserve of the subsidiary at acquisition date, together with the investment account recognised by the parent and recognise the gain on bargain purchase. For example, if the fair value of the consideration transferred would have been $135 000, the gain on bargain purchase would have been $30 000 and the only consolidation worksheet entry would have been the following pre-acquisition entry: Retained earnings (1/7/22) Share capital General reserve Gain on bargain purchase Shares in Andrew Ltd

Dr Dr Dr Cr Cr

75 000 50 000 25 000

15 000 135 000

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Exercise 27.3 Undervalued and unrecorded assets On 1 July 2022, Nicole Ltd acquired all the issued shares of Kidman Ltd, paying $250 000 cash. At that date, the financial statements of Kidman Ltd showed the following information.

All the assets and liabilities of Kidman Ltd were recorded at amounts equal to their fair values at the acquisition date, except some inventories recorded at $10 000 below their fair value. Also, Nicole Ltd identified at acquisition date a patent with a fair value of $40 000 that Kidman Ltd has not recorded in its own accounts. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Nicole Ltd’s group at 1 July 2022. 3. Discuss how the answers for 1 and 2, above, would change if the Nicole Ltd paid only $200 000 cash for the shares in Kidman Ltd. (LO3 and LO6) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired

Consideration transferred Goodwill

= + + = = = =

$100 000 + $100 000 (equity) $10 000 x (1 – 30%) (BCVR – inventories) $40 000 x (1 – 30%) (BCVR – patent) $235 000 $250 000 $250 000 – $235 000 $15 000

2. Consolidation worksheet entries at 1 July 2022: BCVR entries at 1 July 2022: The BCVR entries will need to recognise the increase in value of inventories, the identifiable asset – patent that was not recorded prior to the acquisition date in the subsidiary’s accounts and the goodwill identified in the acquisition analysis. Inventories Business combination valuation reserve Deferred tax liability

Dr Cr Cr

10 000

Patent Business combination valuation reserve Deferred tax liability

Dr Cr Cr

40 000

Goodwill

15 000

7 000 3 000

28 000 12 000

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Chapter 27: Consolidation: wholly owned entities

Business combination valuation reserve

15 000

Pre-acquisition entry at 1 July 2022: Retained earnings (1/7/22) Share capital Business combination valuation reserve Shares in Kidman Ltd

Dr Dr Dr Cr

100 000 100 000 50 000 250 000

3. Please note that if the fair value of the consideration transferred would have been $200 000, less than the net fair value at acquisition date of identifiable assets acquired and liabilities assumed of $235 000, the acquisition analysis will identify a gain on bargain purchase of $35 000 instead of a goodwill. Therefore, the BCVR entries will only need to recognise the increase in value of the inventories and the identifiable assets – patent that was not recorded prior to the acquisition by the subsidiary, while the pre-acquisition entry will need to eliminate the retained earnings and share capital of the subsidiary at acquisition date, together with the business combination valuation reserve for inventories and patent and the investment account recognised by the parent and recognise the gain on bargain purchase. Specifically, the answers to requirement (1) and (2) would be: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired

= $100 000 + $100 000 (equity) + $10 000 x (1 – 30%) (BCVR – inventories) + $40 000 x (1 – 30%) (BCVR – patent) = $235 000 Consideration transferred = $200 000 Gain on bargain purchase = $235 000 – $200 000 = $35 000 Consolidation worksheet entries at 1 July 2022: BCVR entries at 1 July 2022: Inventories Business combination valuation reserve Deferred tax liability

Dr Cr Cr

10 000

Patent Business combination valuation reserve Deferred tax liability

Dr Cr Cr

40 000

Dr Dr Dr Cr Cr

100 000 100 000 35 000

7 000 3 000

28 000 12 000

Pre-acquisition entry at 1 July 2022: Retained earnings (1/7/22) Share capital Business combination valuation reserve Gain on bargain purchase Shares in Kidman Ltd

35 000 200 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.4 Undervalued and unrecorded assets, unrecorded liabilities On 1 July 2022, Dean Ltd acquired all the issued shares of Lewis Ltd for a cash consideration of $1 000 000. At that date, the financial statements of Lewis Ltd showed the following information.

All the assets and liabilities of Lewis Ltd were recorded at amounts equal to their fair values at the acquisition date, except some equipment recorded at $50 000 below its fair value with a related accumulated depreciation of $80 000. Also, Dean Ltd identified at acquisition date a contingent liability related to a lawsuit where Lewis Ltd was sued by a former supplier and attached a fair value of $40 000 to that liability. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Dean Ltd’s group at 1 July 2022, assuming that Lewis Ltd has not revalued the equipment in its own accounts. 3. Prepare the consolidation worksheet entries for Dean Ltd’s group at 1 July 2022, assuming that Lewis Ltd has revalued the equipment in its own accounts. (LO3 and LO4)

1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired

Consideration transferred Goodwill

= + = = = =

$650 000 + $20 000 + $250 000 (equity) $50 000 x (1 – 30%) (BCVR – equipment) $40 000 x (1 – 30%) (BCVR – cont. liability) $927 000 $1 000 000 $1 000 000 – $927 000 $73 000

2. Consolidation worksheet entries at 1 July 2022 if the equipment is not revalued in subsidiary’s accounts: BCVR entries at 1 July 2022: The BCVR entries will need to recognise the increase in value of the equipment, the contingent liability that was not recorded prior to the acquisition date in the subsidiary’s accounts and the goodwill identified in the acquisition analysis. It is assumed that the carrying amount of the © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

equipment is $50 000 below its fair value, meaning its historical cost is $30 000 above its fair value given the accumulated depreciation of $80 000. Accumulated depreciation – equipment Equipment Business combination valuation reserve Deferred tax liability

Dr Cr Cr Cr

80 000

Deferred tax asset Business combination valuation reserve Provision for damages

Dr Cr Cr

12 000 28 000

Goodwill Business combination valuation reserve

Dr Cr

73 000

Dr Dr Dr Dr Cr

250 000 20 000 650 000 80 000

30 000 35 000 15 000

40 000

73 000

Pre-acquisition entry at 1 July 2022: Retained earnings (1/7/22) General reserve Share capital Business combination valuation reserve Shares in Lewis Ltd

1 000 000

3. Consolidation worksheet entries at 1 July 2022 if the equipment is revalued in subsidiary’s accounts: BCVR entries at 1 July 2022: The BCVR entries will only need to recognise the contingent liability that was not recorded prior to the acquisition date in the subsidiary’s accounts and the goodwill identified in the acquisition analysis. The value increment for the equipment is recognised in the subsidiary’s accounts. Deferred tax asset Business combination valuation reserve Provision for damages

Dr Cr Cr

12 000 28 000

Goodwill Business combination valuation reserve

Dr Cr

73 000

40 000

73 000

Pre-acquisition entry at 1 July 2022: If the value increment for the equipment is recognised in the subsidiary’s accounts, an asset revaluation surplus would have been raised for the increase in value after tax (i.e. $50 000 x (1-30%)). The pre-acquisition entry would then need to eliminate that asset revaluation surplus, together with the retained earnings, general reserve and share capital recorded by the subsidiary at acquisition date, the business combination valuation reserve recorded in the BCVR entries above and the investment accounts recognised by the parent in the subsidiary based on the consideration transferred at acquisition date.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings (1/7/22) General reserve Share capital Asset revaluation surplus Business combination valuation reserve Shares in Lewis Ltd

Dr Dr Dr Dr Dr Cr

250 000 20 000 650 000 35 000 45 000

1 000 000

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Chapter 27: Consolidation: wholly owned entities

Exercise 27.5 Pre- and post-acquisition dividends On 1 July 2022, Jersey Ltd acquired all the issued shares (cum div.) of Ezra Ltd for $480 000. At that date, the financial statements of Ezra Ltd showed the following information. Share capital

200 000

General reserve

100 000

Retained earnings

140 000

Dividend payable

40 000

All the assets and liabilities of Jersey Ltd were recorded at amounts equal to their fair values at the acquisition date. The dividend payable reported at 1 July 2022 by Ezra Ltd was paid on 15 August 2022. Ezra Ltd paid a further dividend of $50 000 on 2 February 2023 from post-acquisition profits. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Jersey Ltd’s group at 1 July 2022. 3. Prepare the consolidation worksheet entries for Jersey Ltd’s group at 30 June 2023. 4. How would the entries for 2 and 3 above change if the shares were bought on an ex div. basis? (LO3, LO4 and LO5) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired

= $200 000 + $100 000 + $140 000 (equity) = $440 000 Net consideration transferred = $480 000 – $40 000 (dividend)* = $440 000 Goodwill = $440 000 – $440 000 = $0 * As the shares were acquired cum div., Jersey Ltd is entitled to receive the dividend that was declared by the subsidiary prior to the acquisition and therefore it will regard it as a refund on the consideration transferred. 2. Worksheet entries at 1 July 2022: There are no BCVR entries as all the assets and liabilities of Jersey Ltd were recorded at amounts equal to their fair values at acquisition date and there is no goodwill. The only worksheet entries will be the pre-acquisition entries below: Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve

Dr Dr Dr

140 000 200 000 100 000

27.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Shares in Ezra Ltd

Dividend payable Dividend receivable

Dr Cr

440 000 40 000 40 000

The first pre-acquisition entry eliminates the pre-acquisition equity against the investment account recognised by the parent based on the net consideration transferred. As the dividend was declared out of pre-acquisition equity, the dividend payable and the dividend receivable related to it are eliminated in the second pre-acquisition entry. 3. Worksheet entries at 30 June 2023: There are no BCVR entries as all the assets and liabilities of Jersey Ltd were recorded at amounts equal to their fair values at acquisition date and there is no goodwill. The only worksheet entries will be the pre-acquisition entries below: Pre-acquisition entries: Retained earnings (1/7/22) Dr 140 000 Share capital Dr 200 000 General reserve Dr 100 000 Shares in Ezra Ltd Cr 440 000 The pre-acquisition entry is the same as the first pre-acquisition entry on 1 July 2022 because 1 July 2022 is the beginning of the current period. There are no other pre-acquisition entries as in the current period there are no transfers from pre-acquisition equity or changes in the investment account. Also, the second pre-acquisition entry at 1 July 2022 regarding the preacquisition dividend does not need to be repeated now as the dividend was paid in the meantime and therefore there are no more dividend payable and receivable to eliminate. The postacquisition dividend paid on 2 February 2023 is not considered in the pre-acquisition entries as it relates to post-acquisition equity – its effects are eliminated on consolidation in a separate set of adjustments that eliminate the effects of intragroup transactions (see chapter 28). 4. Differences if shares issued on an ex div basis: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired Consideration transferred Goodwill

= = = = =

$200 000 + $100 000 + $140 000 (equity) $440 000 $480 000* $480 000 – $440 000 $40 000

* As the shares were acquired ex div., Jersey Ltd is not entitled to receive the dividend that was declared by the subsidiary prior to the acquisition and therefore it will not regard it as a refund on the consideration transferred. At 1 July 2022 and 30 June 2023 the group will recognise a goodwill of $40 000 in the BCVR entries and will eliminate the pre-acquisition equity of the subsidiary (including the BCVR) and the investment in the subsidiary in the pre-acquisition entries. There is no need for an entry © John Wiley and Sons Australia Ltd, 2020

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Chapter 27: Consolidation: wholly owned entities

to eliminate the dividend declared prior to acquisition as the parent would not have recognised a dividend receivable (because they are not entitled to it) and the subsidiary recognised a liability that, as long as it is not paid, is a liability to the group that should be reported in the consolidated financial statements. Business combination valuation entries: Goodwill Business combination valuation reserve

Dr Cr

40 000

Dr Dr Dr Cr Cr

140 000 200 000 100 000 40 000

40 000

Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Shares in Ezra Ltd

480 000

The pre-acquisition entry at 30 June 2023 is the same as the pre-acquisition entry on 1 July 2022 above because 1 July 2022 is the beginning of the current period. There are no other preacquisition entries as in the current period there are no transfers from pre-acquisition equity or changes in the investment account.

27.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.6 Previously recorded goodwill On 1 July 2022, Shawn Ltd acquired all the issued shares of Mendes Ltd for $153 000.At this date the equity of Mendes Ltd was recorded as follows.

All the identifiable assets and liabilities were recorded at amounts equal to their fair values. Required 1. Prepare the consolidation worksheet entries for Shawn Ltd’s group at 1 July 2022 and 30 June 2023. 2. Prepare the consolidation worksheet entries for Shawn Ltd’s group at 1 July 2022 and 30 June 2023, assuming Shawn Ltd paid $148 000 for the shares in Mendes Ltd. 3. Prepare the consolidation worksheet entries for Shawn Ltd’s group at 1 July 2022 and 30 June 2023, assuming Shawn Ltd paid $145 000 for the shares in Mendes Ltd and at that date Mendes Ltd had goodwill of $4000 recorded prior to the acquisition. (LO4 and LO5) The entries at 30 June 2023 are the same as the entries at 1 July 2022, no matter the consideration paid or whether goodwill was recorded prior to the acquisition. That is because: • All the identifiable assets and liabilities were recorded at amounts equal to their fair value at acquisition date. If some of the identifiable assets and liabilities were not recorded at fair value, the BCVR entries may change between 1 July 2022 and 30 June 2023, especially if some of those are non-current depreciable assets (depreciation adjustments will need to be considered as of 30 June 2023) or if those assets or liabilities are disposed or their values change during the period. • There are no movements in pre-acquisition equity during the period ended 30 June 2023. If pre-acquisition equity movements occur, the pre-acquisition entries at 30 June 2023 should include entries to reverse those transfers. Nevertheless, the entries recorded at 1 July 2022 will be different across each of the three cases considered as demonstrated below. 1. Consideration of $153 000: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Mendes Ltd = = Consideration transferred = Goodwill acquired = =

($80 000 + $30 000 + $40 000) (equity) $150 000 $153 000 $153 000 – $150 000 $3 000

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Chapter 27: Consolidation: wholly owned entities

Worksheet entries at 1 July 2022: Business combination valuation entries: Goodwill Business combination valuation reserve

Dr Cr

3 000

Dr Dr Dr Dr Cr

40 000 80 000 30 000 3 000

3 000

Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Shares in Mendes Ltd

153 000

The BCVR entry recognises the goodwill acquired. The pre-acquisition entry eliminates the pre-acquisition equity (including the BCVR) against the investment account recognised by the parent based on the net consideration transferred. Worksheet entries at 30 June 2023: The entries are the same as those above as 1 July 2022 is the beginning of the period ended 30 June 2023 and there are no other events that impact on pre-acquisition equity or on the investment account during the period ended 30 June 2023. 2. Consideration of $148 000: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Mendes Ltd = = Consideration transferred = Gain on bargain purchase = = Worksheet entries at 1 July 2022:

($80 000 + $30 000 + $40 000) (equity) $150 000 $148 000 $150 000 – $148 000 $2 000

Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Gain on bargain purchase Shares in Mendes Ltd

Dr Dr Dr Cr Cr

40 000 80 000 30 000 2 000 148 000

There are no BCVR entries as there are no assets recorded at carrying amounts different from the fair value at acquisition date, no intangibles previously not recognised (including goodwill) and no contingent liabilities that need to be recognised on consolidation. The pre-acquisition entry eliminates the pre-acquisition equity against the investment account recognised by the parent based on the consideration transferred and recognises the gain on bargain purchase.

27.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Worksheet entries at 30 June 2023: The entries are the same as those above because 1 July 2022 is the beginning of the period ended 30 June 2023 and there are no transfers from pre-acquisition equity or changes in the investment account during the period. The entries at 30 June 2023, however, assuming no other events occur during the period, will not include a credit to Gain on bargain purchase anymore as the gain will belong to Retained Earnings (1/7/20) and normally will need to be recognised as a credit to it. However, since the pre-acquisition journal entry still needs to eliminate the pre-acquisition retained earnings from Retained Earnings (1/7/20) by debiting the account, the journal entry will only include a debit to Retained Earnings (1/7/20) for the difference between the pre-acquisition retained earnings and the gain on bargain purchase. 3. Consideration of $145 000 and recorded goodwill of $4000: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Mendes Ltd = – = Consideration transferred = Gain on bargain purchase = = Recorded goodwill = Goodwill written off =

($80 000 + $30 000 + $40 000) (equity) $4 000 (goodwill) $146 000 $145 000 $146 000 – $145 000 $1 000 $4 000 $4 000

Worksheet entries at 1 July 2022: Business combination valuation reserve entries: Business combination valuation reserve Goodwill

Dr Cr

4 000 4 000

The previously recorded goodwill needs to be written off in the BCVR entries because now a gain on bargain purchase has been determined as a result of the acquisition analysis. Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Gain on bargain purchase Shares in Mendes Ltd

Dr Dr Dr Cr Cr Cr

40 000 80 000 30 000 4 000 1 000 145 000

As the BCVR has a debit balance due to the goodwill writing off, the pre-acquisition entry should include a credit to BCVR to eliminate it. Worksheet entries at 30 June 2023: The entries are the same as those above as 1 July 2022 is the beginning of the period ended 30 June 2023 and there are no other events that impact on pre-acquisition equity during the period ended 30 June 2023. © John Wiley and Sons Australia Ltd, 2020

27.35

Chapter 27: Consolidation: wholly owned entities

Exercise 27.7 Pre-acquisition dividends, previously recorded goodwill On 1 January 2023, Daniel Ltd acquired all the issued shares (cum div.) of Powter Ltd for $526 000. At that date the equity of Powter Ltd was recorded as follows. Share capital

$ 300 000

General reserve

80 000

Retained earnings

120 000

On 1 January 2023, the records of Powter Ltd showed that the company had previously recorded a goodwill at cost of $10 000. Further, Powter Ltd had a dividend payable of $20 000, the dividend to be paid in March 2023. All other assets and liabilities were carried at amounts equal to their fair values. Required 1. Prepare the acquisition analysis at 1 January 2023. 2. Prepare the consolidation worksheet entries for Daniel Ltd’s group at 1 January 2023. 3. Prepare the consolidation worksheet entries for Daniel Ltd’s group at 30 June 2023. 4. How will the entries for 2 and 3 above change if the consideration transferred was $498 000. (LO3, LO4 and LO5) 1. Acquisition analysis at 1 January 2023: Net fair value of identifiable assets and liabilities of Powter Ltd = – = Net consideration transferred = = Goodwill acquired = = Recorded goodwill = Unrecorded goodwill = =

($300 000 + $80 000 + $120 000) (equity) $10 000 (goodwill) $490 000 $526 000 – $20 000 (dividend)* $506 000 $506 000 – $490 000 $16 000 $10 000 $16 000 – $10 000 $6 000

* As the dividend was declared prior to the acquisition and the acquisition is cum div., the dividend is recognised as a refund of the consideration transferred. That also means that the investment account recognised by Daniel Ltd as Shares in Powter Ltd will be recognised as $406 000 (net consideration transferred) and not $526 000. 2. Consolidation worksheet entries at 1 January 2023: Business combination valuation entries: The BCVR entries only record the previously not recorded goodwill.

27.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill Business combination valuation reserve

Dr Cr

6 000 6 000

Pre-acquisition entries: Retained earnings (1/1/23) Share capital General reserve Business combination valuation reserve Shares in Powter Ltd

Dr 120 000 Dr 300 000 Dr 80 000 Dr 6 000 Cr

406 000

Dividend payable Dividend receivable

Dr Cr

20 000

As the dividend was declared prior to the acquisition out of pre-acquisition equity and it is recognised by Daniel Ltd as receivable (the acquisition is cum div.), the dividend payable and the dividend receivable related to it are eliminated in the pre-acquisition entry. 3. Consolidation worksheet entries at 30 June 2023: The entries are the same as in 2 above except that the dividend payable/receivable entry will no longer be required as the dividend has been paid by Powter Ltd.

4. If the consideration transferred was $498 000, then the entries may change as the goodwill changes and it may even become a gain on bargain purchase. To identify the changes, a new acquisition analysis will need to be performed as at 1 January 2023: Net fair value of identifiable assets and liabilities of Powter Ltd = – = Net consideration transferred = = Gain on bargain purchase = = Recorded goodwill = Goodwill written off =

($300 000 + $80 000 + $120 000) (equity) $10 000 (goodwill) $490 000 $498 000 – $20 000 (dividend) $478 000 $490 000 – $478 000 $12 000 $10 000 $10 000

If, as a result of the acquisition analysis it is determined that there is a gain on bargain purchase and not goodwill, at 1 January 2023, the previously recorded goodwill needs to be written-off in the BCVR entries by debiting the BCVR account. In the pre-acquisition entries at 1 January 2023, the gain on bargain purchase needs to be recognised and the BCVR needs to be eliminated by crediting the account. Business combination valuation entries: Business combination valuation reserve Goodwill

Dr Cr

10 000

27.37

Chapter 27: Consolidation: wholly owned entities

Pre-acquisition entries: Retained earnings (1/1/23) Share capital General reserve Gain on bargain purchase Business combination valuation reserve Shares in Powter Ltd

Dr 120 000 Dr 300 000 Dr 80 000 Cr Cr Cr

12 000 10 000 478 000

Dividend payable Dividend receivable

Dr Cr

20 000

The entries at 30 June 2023 will not include the dividend payable/receivable entry as the dividend has been paid by Powter Ltd. However, the main pre-acquisition entry at 1 January 2023 will be repeated unchanged at 30 June 2023. There will not be any other pre-acquisition entries because there were no other events that impacted on pre-acquisition equity during the period.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.8 Pre-acquisition reserves transfers On 1 July 2022, Kate Ltd acquired all the issued shares of Miller Ltd for $200 000. The financial statements of Miller Ltd showed its equity at that date to be:

All the assets and liabilities of Miller Ltd were recorded at amounts equal to their fair values at that date. During the year ending 30 June 2023, Miller Ltd undertook the following actions: • On 10 September 2022, paid a dividend of $20 000 from the profits earned prior to 1 July 2022. • On 1 January 2023, transferred $15 000 from the general reserve existing at 1 July 2022 to retained earnings. • On 28 June 2023, declared a dividend of $20 000 from the profits earned after 1 July 2022 to be paid on 15 August 2023. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Kate Ltd’s group at 1 July 2022. 3. Prepare the consolidation worksheet entries for Kate Ltd’s group at 30 June 2023. (LO3, LO4 and LO5)

1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities acquired Consideration transferred Goodwill

= = = = =

$100 000 + $40 000 + $60 000 (equity) $200 000 $200 000 $200 000 – $200 000 $0

2. Consolidation worksheet entries at 1 July 2022: There are no BCVR entries as all the assets and liabilities of Miller Ltd were recorded at amounts equal to their fair values at acquisition date and there is no goodwill. The only worksheet entries will be the pre-acquisition entry as shown below: Pre-acquisition entries: Retained earnings (1/7/22) Share capital

Dr Dr

60 000 100 000

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Chapter 27: Consolidation: wholly owned entities

General reserve Shares in Miller Ltd

Dr Cr

40 000 200 000

The pre-acquisition entry eliminates the pre-acquisition equity against the investment account recognised by the parent based on the consideration transferred.

3. Consolidation worksheet entries at 30 June 2023: There are no BCVR entries as all the assets and liabilities of Miller Ltd were recorded at amounts equal to their fair values at acquisition date and there is no goodwill. The only worksheet entries will be the pre-acquisition entries as shown below: Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Shares in Miller Ltd

Dr Dr Dr Cr

60 000 100 000 40 000

Dividend revenue Dividend paid

Dr Cr

20 000

Transfer from general reserve General reserve

Dr Cr

15 000

200 000

20 000

15 000

Note that the first pre-acquisition entry at 30 June 2023 is the same as the one at 1 July 2022 (the beginning of the current period). The next pre-acquisition entries reverse the effects of the pre-acquisition equity transfers that happen during the current period. Note that the dividends declared from post-acquisition equity do not have any impact on pre-acquisition equity and therefore no pre-acquisition entries are prepared for them.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.9 Undervalued and unrecorded assets, unrecorded liabilities In the year ended 30 June 2018, Sam Ltd acquired 40% of the issued shares of Hunt Ltd for $72 000. This acquisition did not give Sam Ltd control of Hunt Ltd, because the ownership of Hunt Ltd was held by a small number of shareholders (Hunt Ltd was developed as a family business in 2004). On 1 July 2022, Sam Ltd approached these family members following a death in the family and persuaded them to sell the remainder of the shares in Hunt Ltd to Sam Ltd for $137 700 on a cum div. basis. Information about the two companies at 1 July 2022 included the following. • Sam Ltd recorded its original investment in Hunt Ltd at fair value, with changes in fair value being recognised in profit or loss. At 1 July 2022, the investment was recorded at $91 800. • The equity of Hunt Ltd at 1 July 2022 consisted of $144 000 share capital and $36 000 retained earnings. • Included in the assets and liabilities recorded by Hunt Ltd at 1 July 2022 were goodwill of $5400 (net of accumulated impairment losses of $3600) and dividend payable of $4500. • On the acquisition date all the identifiable assets and liabilities of Hunt Ltd were recorded at carrying amounts equal to their fair values except for inventories for which the fair value of $39 600 was $3600 greater than its carrying amount, and equipment for which the fair value of $94 500 was greater than the carrying amount, this being cost of $108 000 less accumulated depreciation of $18 000. • Sam Ltd discovered that Hunt Ltd had two assets that had not been recorded by Hunt Ltd. These were internally generated patents that had a fair value of $45 000 and inprocess research and development for which Hunt Ltd had expensed $90 000, but Sam Ltd considered that an asset was created with a fair value of $18 000. • In the notes to the financial statements at 30 June 2022, Hunt Ltd had reported the existence of a contingent liability relating to guarantees for loans. Sam Ltd determined that this liability had a fair value of $9000 at 1 July 2022. The tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Sam Ltd’s group at 1 July 2022. (LO3 and LO4) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Hunt Ltd = ($144 000 + $36 000) (equity) – $5 400 (goodwill) + $3 600 (1– 30%) (BCVR – inventories) + ($94 500 – ($108 000 – $18 000)) (1 – 30%) (BCVR – equipment) + $45 000 (1 – 30%) (BCVR – patents) + $18 000 (1 – 30%) (BCVR – research) – $9 000 (1 – 30%) (BCVR – liability) = $218 070 © John Wiley and Sons Australia Ltd, 2020

27.41

Chapter 27: Consolidation: wholly owned entities

Net consideration transferred Previously held equity interest Goodwill acquired Recorded goodwill Unrecorded goodwill

= $137 700 – $4 500 x 60% (dividend)* = $135 000 = $91 800 (fair value) = ($135 000 + $91 800) – $218 070 = $8 730 = $5 400 = $8 730 – $5 400 = $3 330

* As the dividend was declared prior to the acquisition and the acquisition of the remaining interest of 60% is cum div., 60% of the dividend is recognised as a refund of the consideration transferred. It is assumed that the other 40% of the dividend related to the previously held interest was already recognised by the parent prior to the acquisition as dividend receivable. 2. Consolidation worksheet entries for Sam Ltd’s group at 1 July 2022: Business combination valuation entries at 1 July 2022: The BCVR entries at acquisition date will need to recognise: • adjustments to fair value for inventories and equipment • the previously not recognised patents and in-process research at fair value • the previously not recognised contingent liability at fair value • the unrecorded part of the goodwill acquired. Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

3 600

Accumulated depreciation - equipment Equipment Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

18 000

Dr Cr

18 000

Dr Cr Cr

4 500

*Alternative BCVR entries for Equipment Accumulated depreciation - equipment Equipment Equipment Deferred tax liability Business combination valuation reserve

1 080 2 520

13 500 1 350 3 150

18 000

1 350 3 150

The above alternative BCVR entries for equipment demonstrate the 2 steps for the recognition of a change in fair value on consolidation for a depreciable non-current asset: 1. Write back all of the accumulated depreciation for the asset at date of acquisition. 2. Recognise the increase/decrease to the asset’s fair value with the tax effect. Patents Deferred tax liability Business combination valuation reserve

Dr Cr Cr

45 000

13 500 31 500

27.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

In-process research Deferred tax liability Business combination valuation reserve

Dr Cr Cr

18 000

Business combination valuation reserve Deferred tax asset Guarantee payable

Dr Dr Cr

6 300 2 700

Accumulated impairment losses – goodwill Goodwill

Dr Cr

3 600

Goodwill Business combination valuation reserve

Dr Cr

3 330

5 400 12 600

9 000

3 600

3 330

Pre-acquisition entries at 1 July 2022: Retained earnings (1/7/22) Dr 36 000 Share capital Dr 144 000 Business combination valuation reserve Dr 46 800* Shares in Hunt Ltd Cr 226 800** *$2 520 (BCVR – inventories) + $3 150 (BCVR – equipment) + $31 500 (BCVR – patents) + $12 600 (BCVR – research) – $6 300 (BCVR – contingent liability) + $3 330 (BCVR – unrecorded goodwill) ** $91 800 (previously held interest) + $135 000 (net consideration transferred) Dividend payable Dividend receivable

Dr Cr

4 500 4 500

As the dividend was declared prior to the acquisition out of pre-acquisition equity and it is now entirely recognised by Sam Ltd as receivable (40% from before the acquisition and 60% at acquisition as the acquisition is cum div.), 100% of the dividend payable and the dividend receivable related to it are eliminated in the pre-acquisition entry.

27.43

Chapter 27: Consolidation: wholly owned entities

Exercise 27.10 Previously recorded goodwill, pre-acquisition reserves transfers On 1 July 2021, Calum Ltd acquired all the issued shares (ex div.) of Scott Ltd. At this date the financial statements of Scott Ltd showed the following balances in its accounts: Share capital

$300 000

General reserve

80 000

Retained earnings

160 000

Dividend payable

40 000

Goodwill

20 000

At 1 July 2021, all the identifiable assets and liabilities of Scott Ltd were recorded at amounts equal to their fair values. The financial statements of Calum Ltd and Scott Ltd at 30 June 2022 contained the following information: Calum Ltd Scott Ltd Profit for the period

70 000 $

50 000

180 000

160 000

20 000

250 000

230 000

Share capital

1 400 000

300 000

General reserve

184 000

60 000

Total equity

$1 834 000 $

590 000

Provisions

60 000

40 000

Payables

30 000

50 000

Long‐term loans

100 000

220 000

Total liabilities

$ 190 000 $

310 000

Total equity and liabilities

$ 2 024 000 $

900 000

Plant

1 200 000

1 640 000

Accumulated depreciation — plant

(590 000) (1 300 000)

Fixtures

600 000

240 000

Accumulated depreciation — fixtures

(360 000)

(160 000)

Land

400 000

280 000

Brands

100 000

60 000

Shares in Scott Ltd

544 000

Retained earnings (1/7/21) Transfer from general reserve Retained earnings (30/6/22)

27.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Calum Ltd Scott Ltd Goodwill

20 000

Inventories

90 000

80 000

Cash

10 000

14 000

Receivables

30 000

26 000

Total assets

$2 024 000 $

900 000

Required 1. Prepare the acquisition analysis at 1 July 2021. 2. Prepare the consolidation worksheet entries for Calum Ltd’s group at 30 June 2022. 3. Prepare the consolidated financial statements for Calum Ltd’s group at 30 June 2022. (LO3 and LO4) 1. Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Scott Ltd = ($300 000 + $80 000 + $160 000) (equity) – $20 000 (goodwill) = $520 000 Consideration transferred = $544 000* Goodwill acquired = $544 000 – $520 000 = $24 000 Recorded goodwill = $20 000 Unrecorded goodwill = $24 000 – $20 000 = $4 000 *Note that the amount of the consideration transferred is taken from the financial statement of Calum Ltd, being the balance of the “Shares in Scott Ltd” account. The dividend declared prior to the acquisition by the subsidiary (and recorded as payable for $40 000) will not be considered at part of the acquisition analysis as the acquisition was ex div. However, if the acquisition was cum div., the balance of the “Shares in Scott Ltd” account would still be the net consideration transferred that is needed in the acquisition analysis, while the actual consideration transferred would have been that amount plus $40 000. 2. Consolidation worksheet entries at 30 June 2022: (1) Business combination valuation entries: Goodwill Business combination valuation reserve

Dr Cr

4 000 4 000

(2) Pre-acquisition entries: The pre-acquisition entries at 30 June 2022 will consist of the pre-acquisition entry prepared at 1 July 2021 to eliminate the pre-acquisition equity and the investment account and the entry to reverse the pre-acquisition equity transfer from general reserve recorded in the financial statements of Scott Ltd for the period ended 30 June 2022. Even though the question does not © John Wiley and Sons Australia Ltd, 2020

27.45

Chapter 27: Consolidation: wholly owned entities

specify that this transfer is from pre-acquisition equity, it can be safely assumed to be as the general reserve was $80 000 at acquisition and it is only $60 000 at 30 June 2022. Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Scott Ltd

Dr 160 000 Dr 300 000 Dr 80 000 Dr 4 000 Cr

544 000

Transfer from general reserve General reserve

Dr Cr

20 000

3. Consolidated financial statements for Calum Ltd’s group at 30 June 2022: To help prepare the consolidated financial statements, the consolidation worksheet at 30 June 2022 is first prepared based on the entries above. The consolidation worksheet at 30 June 2022 is then:

Profit for the period Retained earnings (1/7/21) Transfer from general reserve Retained earnings (30/6/22) Share capital General reserve Business combination valuation reserve Provisions Payables Loans Plant Accumulated depreciation - plant Fixtures Accumulated depreciation fixtures Land Brands Shares in Scott Ltd Inventories Cash Receivables

Calum Ltd 70 000 180 000

Scott Ltd 50 000 160 000

Adjustments Dr Cr

Group

160 000

120 000 180 000

20 000

250 000

230 000

1 400 000 184 000 0

300 000 60 000 0

300 000 2 2 2

300 000 80 000 4 000

20 000 4 000

2 1

60 000 40 000 30 000 50 000 100 000 220 000 2 024 000 900 000 1 200 000 1 640 000 (590 000) (1 300 000)

1 400 000 184 000 0

600 000 (360 000)

240 000 (160 000)

100 000 80 000 320 000 2 384 000 2 840 000 (1 890 000) 840 000 (520 000)

400 000 100 000 544 000 90 000 10 000 30 000

280 000 60 000 0 80 000 14 000 26 000

680 000 160 000 0 170 000 24 000 56 000

544 000

27.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill

0 2 024 000

20 000 900 000

4 000 568 000

24 000 2 384 000

568 000

CALUM LTD Consolidated Statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Profit for the period Other comprehensive income Total comprehensive income

$120 000 _____0 $120 000

CALUM LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022 Comprehensive income for the period

$120 000

Retained earnings at 1 July 2021 Profit for the period Retained earnings at 30 June 2022

$180 000 120 000 $300 000

Share capital at 1 July 2021 Share capital at 30 June 2022

$1 400 000 $1 400 000

General reserve at 1 July 2021 General reserve at 30 June 2022

$184 000 $184 000

CALUM LTD Consolidated statement of financial position as at 30 June 2022 Current assets Cash Receivables Inventories Total current assets Non-current assets Plant Accumulated depreciation - plant Fixtures Accumulated depreciation - fixtures Land Brands Goodwill © John Wiley and Sons Australia Ltd, 2020

$24 000 56 000 170 000 $250 000 $2 840 000 (1 890 000) 840 000 (520 000) 680 000 160 000 24 000 27.47

Chapter 27: Consolidation: wholly owned entities

Total non-current assets Total assets Current liabilities Provisions Payables Total current liabilities Non-current liabilities Long-term loans Total liabilities Equity Share capital General reserve Retained earnings Total equity Total equity and liabilities

$2 134 000 $2 384 000

100 000 80 000 $180 000 $320 000 $500 000

$1 400 000 184 000 300 000 $1 884 000 $2 384 000

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Exercise 27.11 Undervalued assets, pre-acquisition reserves transfers On 1 July 2022, Birds Ltd acquired all the issued shares of Tokyo Ltd for $174 800. At this date the equity of Tokyo Ltd consisted of share capital of $80 000 and retained earnings of $68 800. All the identifiable assets and liabilities of Tokyo Ltd were recorded at amounts equal to fair value except for:

The patent was considered to have an indefinite life. It was estimated that the plant had a further life of 10 years, and was depreciated on a straight-line basis. All the inventories were sold by 30 June 2023. In May 2023, Tokyo Ltd transferred $20 000 from the retained earnings on hand at 1 July 2022 to a general reserve. In June 2023, Tokyo Ltd conducted an impairment test on the patent and on the goodwill acquired. As a result, the goodwill was considered to be impaired by $1200. The tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 July 2022. 2. Prepare the consolidation worksheet entries for Birds Ltd’s group at 1 July 2022. 3. Prepare the consolidation worksheet entries for Birds Ltd’s group at 30 June 2023. (LO3, LO4 and LO5) 1. Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Tokyo Ltd = ($80 000 + $68 800) (equity) + ($72 000 – $60 000) (1 – 30%) (BCVR – patent) + ($48 000 – $40 000) (1 – 30%) (BCVR – plant) + ($28 000 – $21 699) (1 – 30%) (BCVR – inventories) = $167 280 Consideration transferred = $174 800 Goodwill = $174 800 – $167 280 = $7 520 2. Worksheet entries at 1 July 2022: (1) Business combination valuation entries: The BCVR entries at acquisition date will need to recognise: • adjustments to fair value for patent, plant and inventories • the goodwill acquired.

27.49

Chapter 27: Consolidation: wholly owned entities

Patent Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

*Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

40 000

Dr Cr

40 000

Dr Cr Cr

8 000

*Alternative BCVR entries for plant Accumulated depreciation - plant Plant Plant Deferred tax liability Business combination valuation reserve

3 600 8 400

32 000 2 400 5 600

40 000

2 400 5 600

The above BCVR entries demonstrate the 2 steps for the recognition of a change in fair value on consolidation for a depreciable non-current asset: 1. Write back all of the accumulated depreciation for the asset at date of acquisition. 2. Recognise the increase/decrease to the asset’s fair value with the tax effect. NB: From these 2 journal entries it is easier to see that the depreciation adjustments then required at the end of each year for consolidation purposes are based on the $8 000 increase to fair value. That is, the additional amount of the asset that needs to be depreciated. In this question $8 000 / 10 years = $800 per year. Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

6 400

Goodwill Business combination valuation reserve

Dr Cr

7 520

Dr Dr Dr Cr

68 800 80 000 26 000

1 920 4 480

7 520

(2) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Shares in Tokyo Ltd

147 800

3. Worksheet entries at 30 June 2023: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2023: • the depreciation of the plant during the current period • the sale of the inventories during the current period • the impairment of the goodwill during the current period.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

For the other asset not affected by the above events (i.e. the patent), the BCVR entries at 30 June 2023 will be the same as those at acquisition date, 1 July 2022. Patent Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

*Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

40 000

3 600 8 400

32 000 2 400 5 600

Depreciation expense Accumulated depreciation - plant ($8 000 / 10 years)

Dr Cr

800

Deferred tax liability Income tax expense (30% x $800)

Dr Cr

240

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

6 400

Goodwill Business combination valuation reserve

Dr Cr

7 520

Impairment loss – goodwill Accum. impairment losses – goodwill

Dr Cr

1 200

800

240

1 920 4 480

7 520

1 200

(2) Pre-acquisition entries: The first pre-acquisition entry at 30 June 2023 is the same as the one at 1 July 2022 because 1 July 2022 is the beginning of the period ended 30 June 2023. The other pre-acquisition entries need to reverse the current period transfers from pre-acquisition equity, i.e.: • From business combination valuation reserve due to the sale of inventories (i.e. the amount of $4 480 that represents the BCVR for inventories). • From pre-acquisition retained earnings to general reserve (i.e. the amount of $20 000 that was transferred in May 2023). The reason for reversing those current period transfers from pre-acquisition equity in the other pre-acquisition entries is because the first pre-acquisition entry eliminates the amounts that were in the equity accounts at the beginning of the current period, but some of the equity is not in the same accounts as at the beginning of the current period – by reversing those current period transfers and having that together with the first pre-acquisition entry we make sure all pre-acquisition equity is eliminated. Retained earnings (1/7/22) Share capital Business combination valuation reserve Shares in Tokyo Ltd

Dr Dr Dr Cr

68 800 80 000 26 000

174 800 27.51

Chapter 27: Consolidation: wholly owned entities

Transfer from BCVR Business combination valuation reserve

Dr Cr

4 480

General reserve Transfer to general reserve

Dr Cr

20 000

4 48060

20 000

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Exercise 27.12 Undervalued assets, pre-acquisition reserves transfers Billy Ltd acquired all the issued shares of Joel Ltd on 1 January 2022 for $36 000. At this date the equity of Joel Ltd consisted of the following. Share capital

$25 000

General reserve

6 250

Retained earnings

2 500

All the identifiable assets and liabilities of Joel Ltd were recorded at amounts equal to their fair values except for the following. Carrying amount Inventories

Plant (cost $35 000)

Fair value 6 000

25 000

8 000 26 000

Of the inventories on hand at 1 January 2022, 90% was sold by 30 June 2022. The remainder was sold by 30 June 2023. The plant was considered to have a further 2-year useful life with benefits to be received equally in each of those years. The tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 January 2022. 2. Prepare the consolidation worksheet entries for Billy Ltd’s group at 30 June 2022. 3. Prepare the consolidation worksheet entries for Billy Ltd’s group at 30 June 2023. 4. Prepare the consolidation worksheet entries for Billy Ltd’s group at 30 June 2024. (LO3, LO4 and LO5) 1. Acquisition analysis at 1 January 2022: Fair value of identifiable assets and liabilities of Joel Ltd = + + = Consideration transferred = Goodwill =

$25 000 + $6 250 + $2 500 (equity) ($8 000 – $6 000) (1 – 30%) (BCVR – inventories) ($26 000 – $25 000) (1 – 30%) (BCVR – plant) $35 850 $36 000 $150

2. Worksheet entries at 30 June 2022: Business combination valuation entries: The entries are affected by the following events that took place during the period from acquisition to 30 June 2022: • the sale of 90% of the inventories during the current period ended 30 June 2022 © John Wiley and Sons Australia Ltd, 2020

27.53

Chapter 27: Consolidation: wholly owned entities

•

the depreciation of the plant during the current period ended 30 June 2022.

The BCVR entry for the inventory unsold during the current period will be the same as the BCVR entry for inventory at acquisition date, but only for the 10%. The BCVR entry for goodwill is repeated as prepared at acquisition date. Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

1 800 540 1 260

This entry relates to the 90% of the inventories that has been sold by 30 June 2022. Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

200 60 140

This entry relates to the 10% of the inventories still on hand at 30 June 2022. Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

10 000

Depreciation expense Accumulated depreciation - plant (1/2 x $500 p.a.)

Dr Cr

250

Deferred tax liability Income tax expense (30% x $250)

Dr Cr

Goodwill Business combination valuation reserve

Dr Cr

150

9 000 300 700

250

150

Pre-acquisition entries: The first pre-acquisition entry is the same as the one at 1 January 2022. The other preacquisition entry needs to reverse: • the current period transfer from business combination valuation reserve due to the sale of 90% of the inventories.

Retained earnings (1/1/22) Share capital Reserves Business combination valuation reserve Shares in Joel Ltd

Dr Dr Dr Dr Cr

2 500 25 000 6 250 2 250

Transfer from BCVR

1 260

36 000

27.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Business combination valuation reserve

1 260

3. Worksheet entries at 30 June 2023: Business combination valuation entries: The entries are affected by the following events that took place during the period from acquisition to 30 June 2023: • the sale of the remaining 10% of inventories during the current period ended 30 June 2023 • the depreciation of the plant during the previous period ended 30 June 2022 and current period ended 30 June 2023. The BCVR entries will not need to consider adjustments for the sale of inventories in the previous period because those inventories were not in the business at the beginning of the current period. The BCVR entry for goodwill is repeated as prepared at acquisition date. Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

200

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

10 000

Depreciation expense Retained earnings (1/7/19) Accumulated depreciation - plant

Dr Dr Cr

500 250

Deferred tax liability Income tax expense Retained earnings (1/7/19) (30% x amounts in above depreciation entry)

Dr Cr Cr

225

Goodwill Business combination valuation reserve

Dr Cr

150

60 140

9 000 300 700

750

150 75

150

Pre-acquisition entries: The first pre-acquisition entry is the combination of the ones at 30 June 2022, knowing that “Transfer from business combination valuation reserve” is now “Retained earnings”. Another method to prepare it is to consider the entry at acquisition date and adjust it for all the preacquisition equity transfers up to the beginning of the current period. The other pre-acquisition entry needs to reverse: • the current period transfer from business combination valuation reserve due to the sale of inventories. Retained earnings (1/7/22) Share capital General reserve

Dr Dr Dr

3 760 25 000 6 250

27.55

Chapter 27: Consolidation: wholly owned entities

Business combination valuation reserve Shares in Joel Ltd

Dr Cr

990

Transfer from BCVR Business combination valuation reserve

Dr Cr

140

36 000

140

4. Worksheet entries at 30 June 2024: Business combination valuation entries: The entries are affected by the following events that took place during the period from acquisition to 30 June 2024: • the depreciation of the plant for the previous periods up to 30 June 2023 and the current period ended 30 June 2024 • the de-recognition of the plant in the current period as a result of it being fully depreciated. The BCVR entries will not need to consider adjustments for the sale on inventories is the previous periods because those inventories were not in the business at the beginning of the current period. The BCVR entry for goodwill is repeated as prepared at acquisition date. *Depreciation expense Retained earnings (1/7/23) Income tax expense Transfer from BCVR

Dr Dr Cr Cr

250 525 75 700

*As the plant is now fully depreciated, it is not recognised anymore in the subsidiary’s accounts, so no adjustments are needed on consolidation to the plant account or the related accumulated depreciation account. The only adjustments needed are to the current period depreciation and its tax effect and also to the previous periods’ depreciations which are recorded in the “Retained Earnings (1/7/23)”. Also, the BCVR recorded at acquisition date for plant is now transferred to retained earnings by using the “Transfer from business combination valuation reserve” account. Goodwill Business combination valuation reserve

Dr Cr

150 150

Pre-acquisition entries: The first pre-acquisition entry is the combination of the ones at 30 June 2023, knowing that “Transfer from business combination valuation reserve” is now “Retained earnings”. Another method to prepare it is to consider the entry at acquisition date and adjust it for all the preacquisition equity transfers up to the beginning of the current period.

The other pre-acquisition entry needs to reverse: • The current period transfer from business combination valuation reserve due to derecognition of the plant. Retained earnings (1/7/23)* Share capital General reserve

Dr Dr Dr

3 900 25 000 6 250

27.56

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Business combination valuation reserve Shares in Joel Ltd * 2 500 + $2 000 (1 - 30%) or $3 760 + $140 Transfer from BCVR Business combination valuation reserve

Dr Cr

850

Dr Cr

700

36 000

700

27.57

Chapter 27: Consolidation: wholly owned entities

Exercise 27.13 Undervalued assets, pre-acquisition reserves transfers Bruno Ltd acquired all the issued shares (ex div.) of Mars Ltd on 1 July 2021 for $110 000. At this date Mars Ltd recorded a dividend payable of $10 000 and equity of the following.

All the identifiable assets and liabilities of Mars Ltd were recorded at amounts equal to their fair values at acquisition date except for the following.

Of the inventories, 90% was sold by 30 June 2022. The remainder was sold by 30 June 2023. The machinery was considered to have a further 5-year life and it is depreciated on a straight-line basis. Both Mars Ltd and Bruno Ltd use the revaluation model for land. At 1 July 2021, the balance of Bruno Ltd’s asset revaluation surplus was $13 500. In May 2022, Mars Ltd transferred $3000 from the retained earnings at 1 July 2021 to a general reserve. The tax rate is 30%. The following information was provided by the two companies at 30 June 2022. Bruno Ltd Mars Ltd Profit before tax

120 000

12 500

Income tax expense

(56 000)

(4 200)

Profit for the year

64 000

8 300

Retained earnings (1/7/21)

80 000

36 000

144 000

44 300

Transfer to general reserve

(0)

(3 000)

Retained earnings (30/6/22)

$ 144 000 $ 41 300

Share capital

360 000

54 000

Retained earnings

144 000

41 300

General reserve

10 000

3 000

27.58

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Bruno Ltd Mars Ltd Asset revaluation surplus

18 500

20 000

Liabilities

42 500

13 000

$ 575 000 $131 300 Land

$ 160 000 $ 20 000

Plant and machinery

360 000 125 600

Accumulated depreciation — plant and machinery (110 000) (33 000) Inventories

55 000

18 700

Shares in Mars Ltd

110 000

$ 575 000 $131 300

Required 1. Prepare the acquisition analysis at 1 July 2021. 2. Prepare the consolidation worksheet entries for Bruno Ltd’s group at 30 June 2022. 3. Prepare the consolidated financial statements for Bruno Ltd’s group at 30 June 2022. (LO3, LO4, LO6 and LO7) 1. Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Mars Ltd = ($54 000 + $36 000 + $18 000) (equity) + ($16 000 – $14 000) (1 – 30%) (BCVR – inventories) + ($94 000 – $92 500) (1 – 30%) (BCVR – machinery) = $110 450 Consideration transferred = $110 000 Gain on bargain purchase = $110 450 – $110 000 = $450 As the acquisition of shares is ex div., the dividend declared by the subsidiary prior to the acquisition is not considered in the acquisition analysis. 2. Worksheet entries at 30 June 2022: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2022: • the sale of 90% of the inventories during the current period • the depreciation of the machinery during the current period. The BCVR entry for the inventory unsold during the current period will be the same as the BCVR entry for inventory at acquisition date, but only for the 10%. Cost of sales Income tax expense

Dr Cr

1 800

540 27.59

Chapter 27: Consolidation: wholly owned entities

Transfer from BCVR

1 260

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

200

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

7 500

Depreciation expense Accumulated depreciation - machinery (1/5 x $1 500)

Dr Cr

300

Deferred tax liability Income tax expense (30% x $300)

Dr Cr

60 140

6 000 450 1 050

300

(2) Pre-acquisition entries: At 1 July 2021: Retained earnings (1/7/21) Share capital Asset revaluation surplus Business combination valuation reserve Gain on bargain purchase Shares in Mars Ltd

Dr Dr Dr Dr Cr Cr

36 000 54 000 18 000 2 450 450 110 000

At 30 June 2022: The pre-acquisition entries at 30 June 2022 are affected by: • the transfer from business combination valuation reserve as a result of the sale of 90% of the inventories during the current period • the transfer from pre-acquisition equity to general reserve of $3 000 during the current period. The first pre-acquisition entry is the same as the one at 1 July 2021. The other pre-acquisition entry needs to reverse: • the current period transfer from business combination valuation reserve due to the sale of 90% of the inventories • the current period transfer from pre-acquisition retained earnings to general reserve. Retained earnings (1/7/21) Share capital Asset revaluation surplus Business combination valuation reserve Gain on bargain purchase Shares in Mars Ltd

Dr Dr Dr Dr Cr Cr

36 000 54 000 18 000 2 450

450 110 000

27.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Transfer from BCVR Business combination valuation reserve

Dr Cr

1 260

General reserve Transfer to general reserve

Dr Cr

3 000

1 260

3 000

3. Consolidated financial statements for Bruno Ltd’s group at 30 June 2022: In order to prepare the consolidated financial statements, the consolidation worksheet at 30 June 2022 is first prepared based on the entries above. The consolidation worksheet at 30 June 2022 is then: Bruno Mars Adjustments Group Ltd Ltd Dr Cr Profit before tax 120 000 12 500 1 300 450 2 130 850 1 1 800 Income tax expense 56 000 4 200 90 1 59 570 540 1 Profit for the year 64 000 8 300 71 280 Retained earnings 80 000 36 000 2 36 000 80 000 (1/7/21) Transfer from - 2 1 260 1 260 1 0 BCVR 144 000 44 300 151 280 Transfer to general 0 3 000 3 000 2 0 reserve Retained earnings 144 000 41 300 151 280 (30/6/22) Share capital 360 000 54 000 2 54 000 360 000 BCVR - 2 2 450 1 050 1 0 140 1 1 260 2 General reserve 10 000 3 000 2 3 000 10 000 514 000 98 300 521 280 Asset revaluation 13 500 18 000 2 18 000 13 500 surplus (1/7/21) Gains 5 000 2 000 7 000 Asset revaluation 18 500 20 000 20 500 surplus (30/6/22) 532 500 118 300 541 780 Liabilities 42 500 13 000 1 90 450 1 55 920 60 1 575 000 131 300 597 700 Land 160 000 20 000 180 000 Plant and 360 000 125 600 6 000 1 479 600 machinery Accumulated (110 000) (33 000) 1 7 500 300 1 (135 800) depreciation – plant and machinery © John Wiley and Sons Australia Ltd, 2020

27.61

Chapter 27: Consolidation: wholly owned entities

Inventories Shares in Mars Ltd

55 000 110 000 575 000

18 700 131 300

200 124 600

110 000 124 600

73 900 0 597 700

BRUNO LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Profit before income tax Income tax expense Profit for the period Other comprehensive income Gains on revaluation of assets Total comprehensive income

$130 850 59 570 $71 280 7 000 $78 280

BRUNO LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022 Comprehensive income for the period

$78 280

Retained earnings at 1 July 2021 Profit for the period Retained earnings at 30 June 2022

$80 000 71 280 $151 280

Share capital at 1 July 2021 Share capital at 30 June 2022

$360 000 $360 000

Asset revaluation surplus at 1 July 2021 Gains Asset revaluation surplus at 30 June 2022

$13 500 7 000 $20 500

General reserve at 1 July 2021 General reserve at 30 June 2022

$10 000 $10 000

BRUNO LTD Consolidated statement of financial position as at 30 June 2022 Current assets Inventories Non-current assets Property, plant and equipment: Land Plant and machinery Accumulated depreciation – plant and machinery Total non-current assets

$73 900

180 000 $479 600 (135 800)

343 800 $523 800

Total assets

$597 700

Total liabilities

$55 920 © John Wiley and Sons Australia Ltd, 2020

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Equity Share capital Retained earnings General reserve Asset revaluation surplus Total equity Total equity and liabilities

$360 000 151 280 10 000 20 500 $541 780 $597 700

27.63

Chapter 27: Consolidation: wholly owned entities

Exercise 27.14 Undervalued and unrecorded assets, pre-acquisition reserves transfers On 1 July 2021, Cold Ltd held an investment in the shares in Chisel Ltd previously measured at $9 300. Cold Ltd uses the fair value method to measure this investment with movements in fair value being recognised in profit or loss. Cold Ltd had acquired these shares 2 years earlier for $6 150. The shares had a fair value at 1 July 2021 of $10 000. On 1 July 2021, Cold Ltd acquired the remaining 80% of the shares (cum div.) in Chisel Ltd. The consideration for these shares consisted of 15 000 shares in Cold Ltd valued at $2.00 per share plus a brand that was carried in the records of Cold Ltd at $10 000 (net of accumulated amortisation of $1500), but the fair value at acquisition date is $12 400. On 1 July 2021, the equity of Chisel Ltd consisted of the following. Share capital

$ 25 000

Retained earnings

16 000

At this date, Chisel Ltd had in its accounts a dividend payable of $3000, which was paid on 15 August 2021. Chisel Ltd had also recorded goodwill of $2500, net of accumulated impairment losses of $3500. Chisel Ltd had an unrecorded asset relating to internally generated trademarks that had a fair value of $8000. These had a future expected useful life of 8 years. All other identifiable assets and liabilities of Chisel Ltd were recorded at amounts equal to fair value except for the following. Carrying amount Fair value Plant (cost $45 000) $

37 000 $ 40 000

Inventories

9 000

11 500

The plant was expected to have a further 6-year useful life. In relation to the inventories held at 1 July 2021, 90% was sold by 30 June 2022 and the rest by 30 June 2023. The tax rate is 30%. In June 2022, Chisel Ltd transferred $1000 from retained earnings on hand at 1 July 2021 to general reserve, and a further $1500 in June 2023. The following information was provided by the two companies at 30 June 2023. Cold Ltd Chisel Ltd Profit before tax

$ 30 000 $ 27 500

Income tax expense

(11 000)

(9 000)

Profit for the year

19 000

18 500

Retained earnings (1/7/22)

22 000

19 000

41 000

37 500

27.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cold Ltd Chisel Ltd Transfer to general reserve

(12 000)

(2 500)

Retained earnings (30/6/23)

$ 29 000 $ 35 000

Share capital

$ 75 000 $ 25 000

General reserve

21 000

3 500

Retained earnings

29 000

35 000

Total equity

125 000

63 500

Provisions

27 500

6 000

Payables

17 500

4 000

Total liabilities

45 000

10 000

Total equity and liabilities

$170 000 $ 73 500

Cash

$ 12 500 $

7 000

Accounts receivable

25 000

12 500

Inventories

20 000

18 500

Goodwill

6 000

Accumulated impairment losses

(3 500)

Shares in Chisel Ltd

50 000

Plant

105 000

45 000

Accumulated depreciation — plant (42 500)

(12 000)

Total assets

$170 000 $ 73 500

Required 1. Prepare the journal entries for Cold Ltd at 1 July 2021 in relation to the investment in Chisel Ltd and for the receipt of the dividend in August 2021. 2. Prepare the consolidation worksheet for Cold Ltd’s group at 30 June 2023. 3. Prepare the consolidated financial statements for Cold Ltd’s group at 30 June 2023. (LO3, LO4, LO5 and LO7) 1. Journal entries for Cold Ltd: 1 July 2021 Shares in Chisel Ltd Dr 700 Gain Cr (Revaluation of investment in Chisel Ltd from $9 300 to $10 000) Accumulated amortisation - brand Brand (Writing down to carrying amount)

Dr Cr

700

1 500 1 500 27.65

Chapter 27: Consolidation: wholly owned entities

Brand Gain on revaluation of plant (Revaluation prior to sale)

Dr Cr

2 400

Shares in Chisel Ltd Dividend receivable Brand Share capital (Acquisition of additional shares in Chisel Ltd)

Dr Dr Cr Cr

40 000* 2 400

2 400

12 400 30 000

*Note that the investment account recognises the fair value of the net consideration transferred (after subtracting 80% the dividend declared by the subsidiary prior to the acquisition from the fair value of the consideration transferred as that dividend is considered as a refund). For the 80% of the dividend, Cold Ltd recognises an increase in dividend receivable. Prior to the acquisition of the remaining shares Cold Ltd recognised the 20% of the dividend declared by the subsidiary as dividend receivable. 15 August 2021 Cash Dividend receivable

Dr Cr

3 000 3 000

2. Consolidation worksheet at 30 June 2023: Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Chisel Ltd = ($25 000 + $16 000) (equity) – $2 500 (goodwill) + ($40 000 – $37 000) (1 – 30%) (BCVR – plant) + ($11 500 – $9 000) (1 – 30%) (BCVR – inventories) + $4 000 (1 – 30%) (BCVR – trademarks) = $45 150 Net consideration transferred = $2 x 15 000 (shares) + $12 400 (brand) – 80% x $3 000 (dividend) = $40 000 Previously held equity interest = $10 000 Goodwill acquired = ($40 000 + $10 000) – $45 150 = $4 850 Goodwill recorded = $2 500 Unrecorded goodwill = $4 850 – $2 500 = $2 350 (1) Business combination valuation entries: The BCVR entries at 30 June 2023 are affected by the following events that took place during the period from acquisition to 30 June 2023: • the depreciation of the plant during the previous period and during the current period • the sale of 10% of the inventories during the current period

27.66

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

the amortisation of the trademark during the previous period and during the current period.

The BCVR entries will not need to consider adjustments for the sale on inventories in the previous period because those inventories were not in the business at the beginning of the current period. The BCVR entry for goodwill is repeated as prepared at acquisition date. Accumulated depreciation – plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

8 000

Depreciation expense Retained earnings (1/7/22) Accumulated depreciation - plant (1/6 x $3 000 p.a.)

Dr Dr Cr

500 500

Deferred tax liability Income tax expense Retained earnings (1/7/22)

Dr Cr Cr

300

Cost of sales Income tax expense Transfer from BCVR Trademark Deferred tax liability Business combination valuation reserve

Dr Cr Cr Dr Cr Cr

250

Amortisation expense Retained earnings (1/7/21) Accumulated amortisation - trademark (1/8 x $4 000 p.a.)

Dr Dr Cr

500 500

Deferred tax liability Income tax expense Retained earnings (1/7/22)

Dr Cr Cr

300

Accumulated impairment losses - goodwill Goodwill

Dr Cr

3 500

Cr Cr

2 350

Goodwill Business combination valuation reserve

5 000 900 2 100

1 000

150 150

75 175 4 000 1 200 2 800

1 000

150 150 3 500

2 350

(2) Pre-acquisition entries: The pre-acquisition entries for a period after the acquisition consist of: • A combined pre-acquisition entry at the beginning of the current period (i.e. the preacquisition entry at the acquisition date adjusted for the effects of all pre-acquisition equity changes and changes in the investment account recognised by the parent up to the beginning of the current period). • Entries reversing the changes in pre-acquisition equity and in the investment account in the current period as follows.

27.67

Chapter 27: Consolidation: wholly owned entities

- Changes in the pre-acquisition equity, due to transfers between pre-acquisition equity accounts, including transfers from business combination valuation reserve, other transfers between pre-acquisition reserves and bonus share dividends. - Changes in the investment account recognised by the parent, due to impairment as a result of pre-acquisition dividends or due to the parent paying calls on the partly paid shares of the subsidiary. In the case of calls on partly paid shares of the subsidiary, a change in pre-acquisition equity (share capital) is recognised, together with a change in the investment account. The first pre-acquisition entry is based on the one at 1 July 2021 adjusted for: • the previous period transfer from business combination valuation reserve due to the sale of 90% of the inventories • the previous period transfer from pre-acquisition retained earnings to general reserve. The other pre-acquisition entry needs to reverse: • the current period transfer from business combination valuation reserve due to the sale of 10% of the inventories • the current period transfer from pre-acquisition retained earnings to general reserve. Retained earnings (1/7/22) * Dr 16 575 Share capital Dr 25 000 General reserve Dr 1 000 Business combination valuation reserve ** Dr 7 425 Shares in Chisel Ltd Cr 50 000 * 16 000 + 90% x $1 750 (BCVR - inventories) - $1 000 (transfer to general reserve) ** $2 100 + $175 + $2 800 + $2 350 Transfer from BCVR* Dr 175 Business combination valuation reserve Cr 175 * 10% x $1 750 (BCVR - inventories) General reserve Transfer to general reserve

Dr Cr

1 500 1 500

3. Consolidated financial statements for Cold Ltd’s group at 30 June 2023: In order to prepare the consolidated financial statements, the consolidation worksheet at 30 June 2023 is first prepared based on the entries above. The consolidation worksheet at 30 June 2023 is then: Profit before tax

Cold Ltd 30 000

Chisel Ltd 27 500

Income tax expense

11 000

9 000

Profit for the year Retained earnings (1/7/22)

19 000 22 000

18 500 19 000

Transfer from BCVR

0 41 000

0 37 500

1 1 1

1 1 2 2

Adjustments Dr Cr 500 250 500

500 500 16 575 175

Group 56 250

150 75 150

1 1 1

150 150

1 1

175

19 625

36 625 23 725

0 60 350

27.68

12 000

2 500

29 000

35 000

21 000

3 500

Share capital Provisions Deferred tax liability

75 000 27 500 0

25 000 6 000 0

Payables

17 500 170 000 12 500 25 000 20 000 50 000 105 000 (42 500)

4 000 73 500 7 000 12 500 18 500 0 45 000 (12 000)

0 0

BCVR

Cash Accounts receivable Inventories Shares in Chisel Ltd Plant Accum. depreciation plant Trademark Accum. amortisation trademark Goodwill Accum. impairment losses - goodwill

1 500

13 000 47 350

2 2 2

1 000 1 500 7 425

25 000

1 1

300 300

22 000 2 100 2 800 2 350 175

900 1 200

1 1 1 2

75 000 33 500 1 500

1 1

50 000 5 000 1 000

2 1 1

21 500 200 850 19 500 37 500 38 500 0 145 000 (47 500)

1 000

4 000 (1 000)

2 350 3 500

3 500

72 375

8 000

0 0

4 000

0 0

6 000 (3 500)

1 1

170 000

73 500

4 850 0 200 850

COLD LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2023 Profit before income tax Income tax expense Profit for the period Total comprehensive income

$56 250 19 625 $36 625 $36 625

COLD LTD Consolidated statement of changes in equity for the financial year ended 30 June 2023 Comprehensive income for the period

$36 625

Retained earnings at 1 July 2022 Profit for the period Transfer to general reserve Retained earnings at 30 June 2023

$23 725 36 625 (13 000) $47 350

Share capital at 1 July 2022 Share capital at 30 June 2023

$75 000 $75 000

27.69

Chapter 27: Consolidation: wholly owned entities

General reserve at 1 July 2022 Transfer from retained earnings General reserve at 30 June 2023

$9 000 13 000 $22 000

COLD LTD Consolidated statement of financial position as at 30 June 2023 Current assets Cash Accounts receivable Inventories Total current assets

$19 500 37 500 38 500 $95 500

Non-current assets Plant Accumulated depreciation - plant Trademark Accumulated amortisation - trademark Goodwill Accumulated impairment losses - goodwill Total non-current assets

$145 000 (47 500) 4 000 (1 000) 4 850 (0)

Total assets

97 500 3 000 4 850 $105 350 $200 850

Current liabilities Payables Total current Liabilities Non-current Liabilities Provisions Deferred tax liability Total non-current liabilities Equity Share capital Retained earnings General reserve Total equity Total equity and liabilities

21 500 21 500 33 500 1 500 35 000 $75 000 47 350 22 000 $144 350 $200 850

27.70

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.15 Undervalued and unrecorded assets, unrecorded liabilities, pre-acquisition reserves transfers On 1 August 2019, Ed Ltd acquired 10% of the shares in Sherran Ltd for $8000. Ed Ltd used the fair value method to measure this investment with movements in fair value being recognised in profit or loss. At 1 July 2021, the fair value of this investment was $15 400. The original investment in Sherran Ltd was due to the fact that Sherran Ltd was undertaking research into particular microbiological elements that could influence the profitability of Ed Ltd. With the continuing success of this research, Ed Ltd decided to acquire the remaining shares (cum div.) in Sherran Ltd. On 1 July 2021, Ed Ltd made an offer to buy the remaining shares in Sherran Ltd for $151 000 cash. This offer was accepted by the shareholders of Sherran Ltd. On 1 July 2021, immediately after the business combination, the statement of financial position of Sherran Ltd was as follows. Ed Ltd Share capital

130 000

Sherran Ltd $

90 000

General reserve

56 500

12 000

Retained earnings

93 500

36 000

Total equity

280 000

138 000

Dividend payable

25 000

12 600

Other liabilities

75 000

25 000

Total liabilities

100 000

37 600

Total equity and liabilities

380 000

175 600

Cash

11 000

20 600

Receivables

25 200

20 000

Other assets

10 000

8 000

Shares in Sherran Ltd

153 800

Inventories

55 000

42 000

Plant and equipment

210 000

107 000

Accumulated depreciation — plant and equipment

(85 000)

(22 000)

Total assets

380 000

175 600

On analysing the financial statements of Sherran Ltd, Ed Ltd determined that all the assets and liabilities recorded by Sherran Ltd were shown at amounts equal to their fair values except for the following.

27.71

Chapter 27: Consolidation: wholly owned entities

The plant and equipment is expected to have a further 4-year useful life and is depreciated on a straight-line basis. The inventories were all sold by 30 June 2022. Sherran Ltd had expensed all the outlays on research and development. Ed Ltd considered that an asset was created and placed a fair value of $12 000 on this asset. The research and development is amortised evenly over a 10-year period. Sherran Ltd also had reported a contingent liability at 30 June 2021 in relation to claims by customers for damaged goods. Ed Ltd placed a fair value of $3000 on these claims. The claims by customers were settled in May 2022 for $2800. The tax rate is 30%. Required 1. Prepare the consolidated financial statements for Ed Ltd’s group at 1 July 2021. 2. Prepare the consolidation worksheet entries for Ed Ltd’s group at 30 June 2022. (LO4 and LO5) 1. Consolidated financial statements for Ed Ltd’s group at 1 July 2021: Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Sherran Ltd = ($90 000 + $12 000 + $36 000) (equity) + ($43 000 – $35 000) (1 – 30%) (BCVR – plant) + ($46 000 – $42 000) (1 – 30%) (BCVR – inventories) + $12 000 (1 – 30%) (BCVR – R&D) – $3 000 (1 – 30%) (BCVR – claims) = $152 700 Net consideration transferred = $151 000 – $12 600 (dividend) = $138 400 Previously acquired equity interest = $15 400 Goodwill = ($138 400 + $15 400) – $152 700 = $1 100 *Note that the net consideration transferred (that together with the fair value of previously held interest gives the balance of the ‘Shares in Sherran Ltd’ account at of 1 July 2021, i.e. $153 800) is calculated after subtracting 100% the dividend declared by the subsidiary prior to the acquisition from the fair value of the consideration transferred as it is assumed that prior to the acquisition of the remaining shares Ed Ltd did not recognise the 10% of the dividend declared by the subsidiary and the fair value of the previously held investment is not affected by it. Consolidation worksheet entries at 1 July 2021: (1) Business combination valuation entries: The BCVR entries at acquisition date will need to recognise: • adjustments to fair value for plant and inventories • the previously not recognised research and development at fair value

27.72

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• •

the previously not recognised contingent liability at fair value the goodwill acquired. Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

11 000

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

4 000

Deferred research and development Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

Business combination valuation reserve Deferred tax asset Provision for customer claims

Dr Dr Cr

2 100 900

Goodwill Business combination valuation reserve

Dr Cr

1 100

Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Sherran Ltd

Dr Dr Dr Dr Cr

36 000 90 000 12 000 15 800

Dividend payable Dividend receivable

Dr Cr

12 600*

3 000 2 400 5 600

1 200 2 800

3 600 8 400

3 000

1 100

(2) Pre-acquisition entries:

153 800

12 600

*This entry needs to be posted here to eliminate the dividend declared by the subsidiary prior to the acquisition and recognised entirely (100%) by the parent at acquisition date as this dividend is part of pre-acquisition equity.

Consolidation worksheet at 1 July 2021: Ed Sherran Ltd Ltd Cash 11 000 20 600 Receivables 25 200 20 000 Other assets 10 000 8 000

Inventories Shares in Sherran Ltd

55 000 153 800

42 000 0

Adjustments Dr Cr

1 1 1 1

Group

12 600

153 800

12 000 900 1 100 4 000

31 600 32 600 32 000

101 000 0

27.73

Chapter 27: Consolidation: wholly owned entities

Plant and equipment Accum. depreciation – plant and equipment

210 000 (85 000)

107 000 (22 000)

380 000

175 600

Dividend payable Other liabilities

25 000 75 000

12 600 25 000

Share capital Retained earnings General reserve Business combination valuation reserve

130 000 93 500 56 500 -

90 000 36 000 12 000 -

380 000

175 600

3 000 1

11 000

314 000 (96 000)

415 200 2

12 600 3 000 2 400 1 200 3 600

1 2

90 000 36 000 12 000 2 100 15 800

197 500

5 600 2 800 8 400 1 100 197 500

1 1 1 1

25 000 110 200

130 000 93 500 56 500 0

415 200

Consolidated financial statements at 1 July 2021: Only the consolidation statement of financial position can be prepared as at 1 July 2021. SHERRAN LTD Consolidated statement of financial position as at 1 July 2021 Current assets Cash and equivalents Receivables Inventories Total current assets Non-current assets Plant and equipment Accumulated depreciation Other assets Total non-current assets Total assets Current liabilities Dividend payable Other liabilities Total liabilities Equity Share capital Retained earnings General reserve Total equity Total equity and liabilities

$31 600 32 600 101 000 $165 200 314 000 (96 000) 218 000 32 000 $250 000 $415 200 25 000 110 200 $135 200 130 000 93 500 56 500 $280 000 $415 200

27.74

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dr Cr Cr Cr

11 000

Depreciation expense Accumulated depreciation - plant (1/4 x $8 000)

Dr Cr

2 000

Deferred tax liability Income tax expense

Dr Cr

600

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

4 000

Deferred research and development (R&D) Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

Amortisation expense Dr Accumulated amortisation – deferred R&D Cr

1 200

3 000 2 400 5 600

2 000

600 1 200 2 800 3 600 8 400 1 200

Deferred tax liability Income tax expense

Dr Cr

360

Transfer from BCVR Income tax expense Damages expense Gain on claims settlement

Dr Dr Cr Cr

2 100 900

Goodwill Business combination valuation reserve

Dr Cr

1 100

360

2 800 200 1 100

(2) Pre-acquisition entries:

27.75

Chapter 27: Consolidation: wholly owned entities

The first pre-acquisition entry is the same as the pre-acquisition entry on 1 July 2021 because 1 July 2021 is the beginning of the current period. The further pre-acquisition entries reverse the current period transfers from pre-acquisition equity caused by the sale of inventories and settlement of the claims. Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Sherran Ltd

Dr Dr Dr Dr Cr

36 000 90 000 12 000 15 800

Transfer from BCVR Business combination valuation reserve

Dr Cr

2 800

Business combination valuation reserve Transfer from BCVR

Dr Cr

2 100

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

11 000

Depreciation expense Accumulated depreciation - plant (1/4 x $8 000)

Dr Cr

2 000

Deferred tax liability Income tax expense

Dr Cr

600

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

4 000

Deferred research and development (R&D) Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

Amortisation expense Dr Accumulated amortisation – deferred R&D Cr

1 200

153 800 2 800 2 100

2. Consolidation worksheet entries at 30 June 2022: (1) Business combination valuation entries:

3 000 2 400 5 600

2 000

600

1 200 2 800

3 600 8 400

1 200

Deferred tax liability Income tax expense

Dr Cr

360

Transfer from BCVR Income tax expense Damages expense Gain on claims settlement

Dr Dr Cr Cr

2 100 900

360

2 800 200

27.76

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill Business combination valuation reserve

Dr Cr

2 360

Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Sherran Ltd

Dr Dr Dr Dr Cr

36 000 90 000 12 000 17 060

Transfer from BCVR Business combination valuation reserve

Dr Cr

2 800

Business combination valuation reserve Transfer from BCVR

Dr Cr

2 100

2 360

(2) Pre-acquisition entries:

155 060

2 800

2 100

27.77

Chapter 27: Consolidation: wholly owned entities

Exercise 27.16 Undervalued and unrecorded assets, unrecorded liabilities, pre-acquisition reserves transfers Garth Ltd is a major Australian manufacturer of women’s clothing. One of its major competitors was Brooks Ltd whose business was established by a French family over 30 years ago. It had won numerous awards for its designs and has established a number of brands that have been successful, especially with teenagers. In order to expand its business as well as to increase its market power, Garth Ltd acquired on 1 July 2019 all the issued shares (cum div.) of Brooks Ltd for $330 000. At this date, the equity of Brooks Ltd was as follows.

All the identifiable assets and liabilities of Brooks Ltd were recorded at amounts equal to their fair values except for the following.

The plant’s expected remaining useful life was 5 years with benefits being expected evenly over that period. The plant was sold on 1 January 2022 for $187 000. The land was sold in February 2018 for $250 000. Of the inventories, 90% was sold by 30 June 2023 and the rest by 30 June 2021. At 1 July 2019, Brooks Ltd had recorded a dividend payable of $10 000 that was paid in September 2019. Brooks Ltd also had some unrecorded assets, in particular the brands relating to the clothing sold in the teenage market. Garth Ltd valued these brands at $12 000 and assessed them to have an indefinite life. In the notes to its financial statements at 30 June 2019, Brooks Ltd disclosed a contingent liability relating to a guarantee it had made to one of its related companies. Garth Ltd assessed the fair value of the guarantee payable as being $10 000. In August 2021, Brooks Ltd was required to pay $2500 in relation to the guarantee. All transfers to the general reserve made by Brooks Ltd have been from retained earnings earned prior to 1 July 2019. The tax rate is 30%. The financial information provided by the two companies at 30 June 2022 is as follows. Garth Ltd Brooks Ltd Revenues Expenses

Gains on sale of non‐current assets

$ 190 000 $ 110 000 (80 000)

(76 000)

110 000

34 000

5 000

4 000

27.78

115 000

38 000

Income tax expense

(40 000)

(6 000)

Profit for the year

75 000

32 000

12 000

Other comprehensive income: Gains on revaluation of plant

Comprehensive income for the year $ 87 000 $

32 000

Profit for the year

$ 75 000 $

32 000

80 000

88 000

155 000

120 000

(34 000)

(15 000)

(34 000)

(15 000)

Retained earnings (1/7/21)

Dividend paid Transfer to general reserve

Retained earnings (30/6/22)

$ 121 000 $ 105 000

Share capital

$ 280 000 $ 200 000

General reserve

20 000

48 000

Asset revaluation surplus

24 000

Retained earnings

121 000

105 000

Total equity

445 000

353 000

Provisions

15 000

12 000

Payables

40 000

8 000

Total liabilities

55 000

20 000

Total equity and liabilities

$ 500 000 $ 373 000

Cash

$ 12 000 $

30 000

Accounts receivable

28 000

12 000

Inventories

30 000

51 000

Plant

230 000

320 000

Accumulated depreciation — plant

(120 000)

(40 000)

Shares in Brooks Ltd

320 000

Total assets

$ 500 000 $ 373 000

Required 1. Prepare the acquisition analysis at 1 July 2019. 2. Prepare the consolidation worksheet entries for Garth Ltd’s group at 30 June 2022. 3. Prepare the consolidated financial statements for Garth Ltd’s group at 30 June 2022. (LO3, LO5 and LO7) © John Wiley and Sons Australia Ltd, 2020

27.79

Chapter 27: Consolidation: wholly owned entities

1. Acquisition analysis at 1 July 2019: Net fair value of identifiable assets and liabilities of Brooks Ltd = + + + + – =

$200 000 + $20 000 + $50 000 (equity) ($186 000 – 180 000) (1 – 30%) (BCVR – plant) ($210 000 – $190 000) (1 – 30%) (BCVR – land) ($28 000 – $20 000) (1 – 30%) (BCVR – inventories) $12 000 (1 – 30%) (BCVR – brands) $10 000 (1 – 30%) (BCVR – guarantee liability) $295 200

Net consideration transferred

= =

$330 000 – $10 000 (dividend) $320 000

Goodwill

= =

$320 000 – $295 200 $24 800

2. Consolidation worksheet entries at 30 June 2022: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2022: • the depreciation of the plant during the previous periods and current period • the sale of plant during the current period • the settlement of the claim during the current period. There are no BCVR entries for the assets that were sold prior to the beginning of the current period (i.e. land and inventories). The BCVR entries for the assets still on hand at the beginning of the current period that are not affected by any events during the current period (i.e. brands and goodwill) are the same as the entries posted at acquisition date for those assets. *Depreciation expense Dr 600 Gain on sale of plant Dr 3 000 Income tax expense Cr Retained earnings (1/7/21) Dr 1 680 Transfer from BCVR Cr (Final adjustment for plant and its depreciation to the date of sale)

1 080 4 200

*As the plant is now sold, it is not recognised anymore in the subsidiary’s accounts, so no adjustments are needed on consolidation to the plant account or the related accumulated depreciation account. The only adjustments needed are to the current period depreciation and to the gain on sale of plant (and their related tax effect) and also to the previous periods’ depreciations which are recorded in the “Retained Earnings (1/7/21)”. Also, the BCVR recorded at acquisition date for plant is now transferred to retained earnings by using the “Transfer from business combination valuation reserve” account. Brands Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

3 600 8 400

27.80

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Transfer from BCVR Income tax expense Gain on guarantee Guarantee expense

Dr Dr Cr Cr

7 000 3 000 7 500 2 500

*The credit to “Guarantee expense” is posted on consolidation to eliminate the “Guarantee Expense” that now would have been recognised in the subsidiary’s accounts. This elimination is necessary because this expense related to the guarantee is an expense for the subsidiary now, but it was already recognised on consolidation at acquisition date as part of the provision in the acquisition analysis. Goodwill Business combination valuation reserve

Dr Cr

24 800

Dr Dr Dr Dr Cr

50 000 200 000 20 000 50 000

24 800

(2) Pre-acquisition entries: At 1 July 2019: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve Shares in Brooks Ltd

320 000

At 30 June 2022: The pre-acquisition entries for a period after the acquisition consist of: • a combined pre-acquisition entry at the beginning of the current period (i.e. the preacquisition entry at the acquisition date adjusted for the effects of all pre-acquisition equity changes and changes in the investment account recognised by the parent up to the beginning of the current period) and • entries reversing the changes in pre-acquisition equity and in the investment account in the current period as follows. - Changes in the pre-acquisition equity, due to transfers between pre-acquisition equity accounts, including transfers from business combination valuation reserve, other transfers between pre-acquisition reserves and bonus share dividends. - Changes in the investment account recognised by the parent, due to impairment as a result of pre-acquisition dividends or due to the parent paying calls on the partly paid shares of the subsidiary. In the case of calls on partly paid shares of the subsidiary, a change in pre-acquisition equity (share capital) is recognised, together with a change in the investment account. The pre-acquisition entries at 30 June 2022 are affected by: •

Sale of land in February 2021 – prior period. © John Wiley and Sons Australia Ltd, 2020

Their effects will adjust the first pre-acquisition entry 27.81

Chapter 27: Consolidation: wholly owned entities

• •

Sale of inventories by 30 June 2021 – prior period. Transfer to general reserve of $13 000 – prior period.

• • •

Sale of plant – current period. Settlement of guaranteed loan – current period. Transfer to general reserve of $15 000 – current period. Retained earnings (1/7/21) * Share capital General reserve Business combination valuation reserve Shares in Perseus Ltd

Dr Dr Dr Dr Cr

Their effects will be reversed in the other pre-acquisition entries 56 600 200 000 33 000 30 400 320 000

*$50 000 + $14 000 (BCVR - land) + $5 600 (BCVR - inventories) - $13 000 (general reserve) Transfer from BCVR Business combination valuation reserve (Sale of plant) Business combination valuation reserve Transfer from BCVR (Settlement of loan)

Dr Cr

4 200

Dr Cr

7 000

General reserve Transfer to general reserve

Dr Cr

15 000

4 200

7 000

15 000

3. Consolidated financial statements at 30 June 2022: In order to prepare the consolidated financial statements, the consolidation worksheet at 30 June 2022 is prepared first based on the entries above. The consolidation worksheet at 30 June 2022 is then: Revenues Expenses Gains on sale of noncurrent assets Profit before tax Tax expense Profit for the year Retained earnings (1/7/21) Transfer from BCVR

Dividend paid Transfer to general reserve Retained earnings (30/6/22)

Garth Ltd 190 000 80 000 110 000 5 000

Brooks Ltd 110 000 76 000 34 000 4 000

115 000 40 000 75 000 80 000

38 000 6 000 32 000 88 000

155 000 34 000 0

120 000 0 15 000

34 000 121 000

15 000 105 000

Adjustments Dr Cr 7 500 600 2 500

3 000

1 080

1 2 1 2

1 680 56 600 7 000 4 200

4 200 7 000

1 2

15 000

Group 1 1

307 500 154 100 153 400 6 000 159 400 47 920 111 480 109 720 0 221 200 34 000 0 34 000 187 200

27.82

Asset revaluation surplus (1/7/21) Gains on revaluation Asset revaluation surplus (30/6/22) Provisions Payables Deferred tax liability Shares in Brooks Ltd Cash Accounts receivable Inventories Plant Accumulated depreciation - plant Goodwill Brands

280 000 20 000

200 000 48 000

2 2 2 2 2

421 000 12 000

353 000 0

487 200 12 000

12 000 24 000

0 0

12 000 24 000

445 000 15 000 40 000 0 500 000

353 000 12 000 8 000 0 373 000

511 200 27 000 48 000 3 600 589 800

320 000 12 000 28 000 30 000 230 000 (120 000)

0 30 000 12 000 51 000 320 000 (40 000)

0 0 500 000

0 0 373 000

1 1

200 000 33 000 15 000 30 400 7 000

24 800 12 000 398 280

280 000 20 000 8 400 24 800 4 200

1 1 2

3 600

320 000

0 42 000 40 000 81 000 550 000 (160 000) 24 800 12 000 589 800

398 280

GARTH LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Revenues Expenses

$307 500 154 100 153 400 6 000 $159 400 47 920 $111 480

Gains on sale of non-current assets Profit before income tax Income tax expense Profit for the period Other comprehensive income: Gains on revaluation of assets Total comprehensive income for the period

12 000 $123 480

GARTH LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022 Comprehensive income for the period

$123 480

Retained earnings balance at 1 July 2021 Profit for the period Dividend paid Retained earnings balance at 30 June 2022

$109 720 111 480 (34 000) $187 200

27.83

Chapter 27: Consolidation: wholly owned entities

Share capital balance at 1 July 2021 Share capital balance at 30 June 2022

$280 000 $280 000

General reserve balance at 1 July 2021 General reserve balance at 30 June 2022

$20 000 $20 000

Asset revaluation surplus at 1 July 2021 Gains on revaluation Asset revaluation surplus at 30 June 2022

$12 000 12 000 $24 000

GARTH LTD Consolidated statement of financial position as at 30 June 2022 Current assets Cash Accounts receivable Inventories Total current assets Non-current assets Property, plant, and equipment Accumulated depreciation Goodwill Brands Total non-current assets Total assets Current liabilities Payables Provisions Total current liabilities Non-current liabilities Deferred tax liability Total liabilities Equity Share capital General reserve Asset revaluation surplus Retained earnings Total equity Total equity and liabilities

$42 000 40 000 81 000 $163 000 $550 000 (160 000)

390 000 24 800 12 000 $426 800 $589 800 48 000 27 000 $75 000 __3 600 $78 600 $280 000 20 000 24 000 187 200 $511 200 $589 800

27.84

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 27.17 Undervalued and unrecorded assets, pre-acquisition reserves transfers Imagine Ltd acquired all the issued shares (cum div.) of Dragons Ltd on 1 July 2021. At this date the statement of financial position of Dragons Ltd included the following information: Carrying amount Plant

Accumulated depreciation — plant

1 000 000

Fair value $

882 000

(128 000)

Goodwill

24 000

Receivables

76 000

Cash

25 000

Inventories

75 000

95 000

1 072 000 Share capital (120 000 shares)

600 000

General reserve

116 000

Retained earnings

220 000

Provisions

96 000

Dividend payable

40 000

1 072 000

The plant was considered to have a further 10-year life and is depreciated on a straightline basis. The goodwill on hand at 1 July 2021 was written off as the result of an impairment test conducted in June 2023. All the inventories were sold by 30 June 2022. The dividend on hand at 1 July 2021 was paid in August 2021. The assets recognised by Dragons Ltd did not include an internally generated patent of Dragons Ltd that was valued by Imaging Ltd at $50 000. Its useful life was considered to be 5 years, with benefits being received equally over that period. In exchange for the shares in Dragons Ltd, Imagine Ltd gave the following as consideration: • 250 000 shares in Imagine Ltd, each share having a fair value of $2.00 per share. • Cash of $200 000. • Artworks having a fair value of $300 000. Imagine Ltd incurred legal and accounting costs of $25 000 and share issue costs of $20 000. In January 2025, Dragons Ltd paid a bonus dividend of $40 000, being one share for every three shares held, the dividend being paid from retained earnings on hand at 1 July 2021. The tax rate is 30%. Required Prepare the consolidation worksheet entries for Imagine Ltd’s group at 30 June 2026. (LO5) Acquisition analysis at 1 July 2021: Net fair value of identifiable assets © John Wiley and Sons Australia Ltd, 2020

27.85

Chapter 27: Consolidation: wholly owned entities

and liabilities of Dragons Ltd = – + + + = Net consideration transferred = + = Gain on bargain purchase = = Goodwill written off =

($600 000 + $116 000 + $220 000) (equity) $24 000 (goodwill) ($882 000 – ($1 000 000 – $128 000)) (1 – 30%) (BCVR – plant) $20 000 (1 – 30%) (BCVR – inventories) $50 000 (1 – 30%) (BCVR – patent) $968 000 250 000 x $2 (shares) + $200 000 (cash) $300 000 (artworks) – $40 000 (dividend) $960 000 $968 000 – $960 000 $8 000 $24 000

The legal and accounting costs incurred by Mendes Ltd for the acquisition are not considered as part of the acquisition analysis or in any other part of the consolidation process. Those costs are treated as expenses by Mendes Ltd and recognised as such in its own individual statements. On consolidation, there is no adjustment needed for them. Business combination valuation entries at 30 June 2026: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2026: • the depreciation of the plant during the previous periods and the current period • the amortisation of the patents during the previous periods and the current period • the de-recognition of the patents during the current period as they are fully amortised. The inventories were sold and the goodwill was written off prior to the beginning of the current period and therefore no BCVR entries for inventories or goodwill are needed at 30 June 2026. Accumulated depreciation - plant Dr 128 000 Plant Cr 118 000 Deferred tax liability Cr 3 000 Business combination valuation reserve Cr 7 000 Depreciation expense - plant Retained earnings (1/7/25) Accumulated depreciation – plant (1/10 x $10 000 p.a.)

Dr Dr Cr

1 000 4 000

Deferred tax liability Income tax expense Retained earnings (1/7/25)

Dr Cr Cr

1 500

Amortisation expense - patents Income tax expense Retained earnings (1/7/25) Transfer from BCVR (1/5 x $50 000 p.a.)

Dr Cr Dr Cr

10 000

220 000

5 000

300 1 200 3 000 28 000 35 000

Pre-acquisition entries: At 1 July 2021: Retained earnings (1/7/21)

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Share capital General reserve Business combination valuation reserve Gain on bargain purchase Shares in Dragons Ltd Dividend payable Dividend receivable

Dr Dr Dr Cr Cr Dr Cr

600 000 116 000 32 000 8 000 960 000 40 000 40 000

As the dividend was declared out of pre-acquisition equity, the dividend payable and the dividend receivable related to it are eliminated in the second pre-acquisition entry at acquisition date. At 30 June 2026: These pre-acquisition entries are affected by the following events: •

Payment of dividend on hand at acquisition – prior period

Dividend payable/receivable doesn’t need to be eliminated anymore

• • •

Bonus dividend from pre-acquisition equity – prior period Sale of the inventories – prior period. The write-off of goodwill – prior period.

Their effects will adjust the first pre-acquisition entry

Its effects will need to be reversed in the further preacquisition entries The gain on bargain purchase will be recognised now as an adjustment to the debit to “Retained earnings (1/7/25)”. •

The derecognition of the patents – current period.

Retained earnings (1/7/25)* Share capital General reserve Business combination valuation reserve ** Shares in Dragons Ltd

Dr Dr Dr Dr Cr

2 000 800 000 116 000 42 000 960 000

* $220 000 – $8 000 (gain on bargain purchase) – $200 000 (bonus dividend) + $14 000 (transfer of BCVR – inventories) – $24 000 (transfer of BCVR – goodwill) ** $6 000 (plant) + $35 000 (patents) Transfer from BCVR Business combination valuation reserve

Dr Cr

35 000 35 000

27.87

Chapter 27: Consolidation: wholly owned entities

Exercise 27.18 Undervalued and unrecorded assets, unrecorded liabilities, pre-acquisition reserves transfers James Ltd operates a number of supermarkets with an emphasis on supplying highquality produce. The operations of Blunt Ltd are primarily in the fine fruit market. Believing that the acquisition of Blunt Ltd would enable James Ltd to expand its supply to its customers, James Ltd commenced actions to acquire the shares of Blunt Ltd. On 1 July 2019, James Ltd acquired all the issued shares (cum div.) of Blunt Ltd for $123 500. At this date the equity of Blunt Ltd consisted of the following.

On 1 July 2019, Blunt Ltd had recorded a dividend payable of $6000 and goodwill of $5000 (net of accumulated impairment losses of $7000). The dividend was paid in August 2019. In the previous year’s annual report Blunt Ltd had reported the existence of a contingent liability for damages based upon a lawsuit by a customer who had slipped on some fallen fruit in one of the stores operated by Blunt Ltd. James Ltd calculated that this liability had a fair value of $10 000. Blunt Ltd also had some customer databases that were not recorded as assets but James Ltd placed a fair value of $6000 on these items. Blunt Ltd believed that the databases had a future life of 4 years. All of the identifiable assets and liabilities of Blunt Ltd were recorded at amounts equal to their fair values except for the following.

The plant had an expected remaining useful life of 10 years. The land was sold by Blunt Ltd in February 2021. The inventories were all sold by 30 June 2020. In February 2022, Blunt Ltd transferred $3000 of the reserves on hand at 1 July 2019 to retained earnings. The remaining $2000 was transferred to retained earnings in February 2023. The court case involving the damages sought by the customer was settled in May 2023. Blunt Ltd was required to pay $7500 to the customer. Required Prepare the consolidation worksheet entries for James Ltd’s group at 30 June 2023. (LO5) Acquisition analysis at 1 July 2019: Net fair value of identifiable assets and liabilities of Blunt Ltd = ($100 000 + $5 000 + 10 000) (equity) – $5 000 (goodwill) – $10 000 (1 – 30%) (BCVR – damages payable) + $6 000 (1 – 30%) (BCVR – databases) © John Wiley and Sons Australia Ltd, 2020

27.88

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+ + + = Net consideration transferred = = Goodwill acquired = = Recorded goodwill = Goodwill written off = =

($96 000 – $94 000) (1 – 30%) (BCVR – plant) ($85 000 – $80 000) (1 – 30%) (BCVR – land) ($24 000 – $20 000) (1 – 30%) (BCVR – inventories) $114 900 $123 500 – $6 000 (dividend) $117 500 $117 500 – $114 900 $2 600 $5 000 $5 000 – $2 600 $2 400

Consolidation worksheet entries for James Ltd’s group at 30 June 2023: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2023: • the settlement of the lawsuit with the customer during the current period • the amortisation of the customer databases during the previous periods and the current period • the de-recognition of the customer databases during the current periods as they were fully amortised • the depreciation of the plant during the previous periods and the current period. The land and inventories were sold prior to the beginning of the current period, so there won’t be any BCVR entries for those assets at 30 June 2023. The goodwill was not affected by any events up to the end of the current period, so the BCVR entry for it will be exactly the same as that prepared at acquisition date. Transfer from BCVR Income tax expense Damages expense Gain on settlement of lawsuit Amortisation expense – databases Income tax expense Retained earnings (1/7/22) Transfer from BCVR

Dr Dr Cr Cr Dr Cr Dr Cr

7 000 3 000

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

26 000

Depreciation expense Retained earnings (1/7/22) Accumulated depreciation - plant (1/10 x $2 000 p.a. for 4 years)

Dr Dr Cr

200 600

Deferred tax liability

240

7 500 2 500 1 500 450 3 150 4 200

24 000 600 1 400

800

27.89

Chapter 27: Consolidation: wholly owned entities

Income tax expense Retained earnings (1/7/22)

Cr Cr

60 180

Accumulated impairment losses - goodwill Goodwill

Dr Cr

7 000

Business combination valuation reserve Goodwill

Dr Cr

2 400

Retained earnings (1/7/22) Share capital Reserves Business combination valuation reserve Shares in Blunt Ltd

Dr Dr Dr Dr Cr

10 000 100 000 5 000 2 500

Dividend payable Dividend receivable

Dr Cr

6 000

7 000 2 400

(2) Pre-acquisition entries: At 1 July 2019:

117 500

6 000

At 30 June 2023: The pre-acquisition entries are affected by: Dividend payable/receivable doesn’t need to be eliminated anymore

•

Payment of dividend: $6 000 – prior period.

• • •

Sale of land – prior period. Sale of inventories – prior period. Transfer from pre-acquisition reserves – prior period.

Their effects will adjust the first pre-acquisition entry

• • •

Settlement of court case – current period. De-recognition of databases – current period . Transfer from pre-acquisition reserves – current period.

Their effects will need to be reversed in the further preacquisition entries

Retained earnings (1/7/22)* Dr 19 300 Share capital Dr 100 000 Reserves Dr 2 000 Business combination valuation reserve Cr 3 800 Shares in Blunt Ltd Cr 117 500 * $10 000 + $3 500 (BCVR – land) + $2 800 (BCVR – inventories) + $3 000 (reserve transfer) Business combination valuation reserve Transfer from BCVR (Court case settled)

Dr Cr

7 000

Transfer from BCVR

4 200

7 000

27.90

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Business combination valuation reserve Cr (Databases de-recognised) Transfer from reserves Reserves

Dr Cr

4 200

2 000

27.91

Chapter 27: Consolidation: wholly owned entities

Exercise 27.19 Undervalued assets, unrecorded liabilities, pre-acquisitions transfers On 1 July 2021, Jessica Ltd acquired all the issued shares (ex div.) of Mauboy Ltd for $227 500. At this date the equity of Mauboy Ltd consisted of the following.

At acquisition date, Mauboy Ltd reported a dividend payable of $8000. All the identifiable assets and liabilities of Mauboy Ltd were recorded at amounts equal to their fair values except for the following.

The plant was considered to have a further 3-year useful life. The land was sold in January 2022 for $170 000. Of the above inventories, 90% was sold by 30 June 2022 and the remainder was sold by 30 June 2023. Mauboy Ltd had recorded goodwill of $2000 (net of accumulated impairment losses of $12 000). Mauboy Ltd was involved in a court case that could potentially result in the company paying damages to customers. Jessica Ltd calculated the fair value of this liability to be $8000, but Mauboy Ltd had not recorded any liability. The following events occurred in the year ending 30 June 2022: • On 12 August 2021, Mauboy Ltd paid the dividend that existed at 1 July 2021. • On 1 December 2021, Mauboy Ltd transferred $17 000 from the general reserve existing at 1 July 2021 to retained earnings. • On 1 January 2022, Mauboy Ltd made a call of 10c per share on its issued shares. All call money was received by 31 January 2022. • On 29 June 2022, Jessica Ltd reassessed the liability of Mauboy Ltd in relation to the court case as the chances of winning the case had improved. The fair value was now considered to be $2000. Required Prepare the consolidation worksheet entries for Jessica Ltd’s group at 30 June 2022. (LO5) Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Mauboy Ltd = – + + +

($150 000 + $34 000 + $20 000) (equity) $2 000 (goodwill) ($190 000 – $175 000) (1 – 30%) (BCVR – plant) ($155 000 – $150 000) (1 – 30%) (BCVR – land) ($40 000 – $32 000) (1 – 30%) (BCVR – inventories)

27.92

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– = = = = = = =

Consideration transferred Goodwill acquired Goodwill recorded Unrecorded goodwill

$8 000 (1 – 30%) (BCVR – provision for damages) $216 000 $227 500 $227 500 – $216 000 $11 500 $2 000 $11 500 – $2 000 $9 500

Worksheet entries at 30 June 2022: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2022: • the depreciation of the plant during the current period • the sale of the land during the current period • the sale of 90% of the inventories during the current period • the re-measurement of the contingent liability during the current period. 10% of the inventories are still on hand and therefore the BCVR entry for those inventories will be the same as the one posted at acquisition date, but only for the 10% of the value of inventories. The goodwill was not affected by any events, so the BCVR entry for goodwill will be the same as the one posted at acquisition date. Accumulated depreciation – plant Plant Deferred tax liability Business combination valuation reserve Depreciation expense Accumulated depreciation - plant (1/3 x $15 000)

Dr Cr Cr Cr Dr Cr

25 000

Deferred tax liability Income tax expense

Dr Cr

1 500

Gain on sale of land Income tax expense Transfer from BCVR

Dr Cr Cr

5 000

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

7 200

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

800

*Transfer from BCVR Income tax expense

Dr Dr

4 200 1 800

10 000 4 500 10 500 5 000 5 000

1 500

1 500 3 500

2 160 5 040

240 560

27.93

Chapter 27: Consolidation: wholly owned entities

Gain on settlement of claim Business combination valuation reserve Deferred tax asset Provision for damages

6 000

Dr Dr Cr

1 400 600 2 000

*If the value of the claim decreased by $6 000, that is equivalent to the settlement of a part of the contingent liability that had a fair value of $8 000 at acquisition date that is recognised by: • recording a gain on re-measurement of the liability of $6 000 and a negative transfer from business combination valuation reserve to retained earnings • recording the provision of only $2 000 remaining. Accumulated impairment losses - goodwill Goodwill

Dr Cr

12 000

Goodwill Business combination valuation reserve

Cr Cr

9 500

Dr Dr Dr Dr Cr

20 000 150 000 34 000 23 500

12 000

9 500

(2) Pre-acquisition entries: At 1 July 2021: Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Mauboy Ltd

227 500

At 30 June 2022: The pre-acquisition entries at 30 June 2022 are affected by the following events that took place during the current period: • the sale of land • the sale of 90% of inventories • the transfer from pre-acquisition general reserve • the call of 10c per share on 100 000 shares • re-measurement of liability. The first pre-acquisition entry will be the same as the one prepared at acquisition date. Further pre-acquisition entries will be prepared to reverse the effects of the above events in the current period. The pre-acquisition dividend declared prior to the acquisition was paid to external parties and therefore it does not have any impact on the consolidation worksheet entries. Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Shares in Mauboy Ltd

Dr Dr Dr Dr Cr

20 000 150 000 34 000 23 500

227 500 27.94

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Transfer from BCVR Business combination valuation reserve (Sale of land)

Dr Cr

3 500

Transfer from BCVR Business combination valuation reserve (Sale of inventories)

Dr Cr

5 040

Transfer from general reserve General reserve

Dr Cr

17 000

Share capital Shares in Mauboy Ltd

Dr Cr

10 000

Business combination valuation reserve Transfer from BCVR (Re-measurement of liability)

Dr Cr

4 200

3 500

5 040

17 000

10 000

4 200

27.95

Chapter 27: Consolidation: wholly owned entities

Exercise 27.20 Undervalued and unrecorded assets, unrecorded liabilities, pre-acquisition reserves transfers Jersey Ltd acquired all the issued shares (ex div.) of Boys Ltd on 1 July 2023 for $246 000. At this date the equity of Boys Ltd consisted of the following. Share capital

$ 260 000

General reserve

100 000

Retained earnings

81 000

At the acquisition date all the identifiable assets and liabilities of Boys Ltd were recorded at amounts equal to the fair value except for the following. Carrying amount Plant (cost $460 000)

Fair value

400 000

$ 420 000

Land

200 000

240 000

Inventories

60 000

76 000

The plant was considered to have a further 5-year life. The plant was sold for $310 000 on 1 January 2022. The land was sold on 1 February 2021 for $300 000. The inventories were all sold by 30 June 2021. Also at acquisition date Boys Ltd had recorded a dividend payable of $7000 and goodwill (net of accumulated impairment losses of $26 000) of $10 000. Boys Ltd had not recorded some internally generated brands that Jersey Ltd considered to have a fair value of $24 000. The brand was considered to have an indefinite life. Also not recorded by Boys Ltd was a contingent liability relating to a current court case in which Boys Ltd was involved and a supplier was seeking compensation. Jersey Ltd placed a fair value of $30 000 on this liability. This court case was settled in May 2022 at which time Boys Ltd was required to pay damages of $32 000. In February 2021, Boys Ltd transferred $40 000 from the general reserve on hand at 1 July 2023 to retained earnings. A further $30 000 was transferred in February 2022. Both companies have an equity account entitled ‘Other components of equity’ that recognise certain gains and losses from financial assets. At 1 July 2021, the balances of these accounts were $60 000 for Jersey Ltd and $30 000 for Boys Ltd. The financial statements of the two companies at 30 June 2022 contained the following information. Jersey Ltd Boys Ltd $ 260 000 $ 128 000

Revenues

(140 000)

(84 000)

$ 120 000 $

44 000

60 000

16 000

Profit before tax

$ 180 000 $

60 000

Income tax expense

(40 000)

(10 000)

Expenses Trading profit Gains (losses) on sale of non‐current assets

27.96

50 000

Retained earnings (1/7/21)

666 000

110 000

Transfer from general reserve

60 000

30 000

Profit for the period

$ 866 000 $ 190 000 Dividend paid Retained earnings (30/6/22)

(40 000)

$ 826 000 $ 190 000

Share capital

300 000

260 000

General reserve

20 000

40 000

Other components of equity

50 000

36 000

Total equity

$1 196 000 $ 526 000

Accounts payable

80 000

20 000

Deferred tax liability

36 000

20 000

Other non‐current liabilities

496 000

460 000

Total liabilities

$ 612 000 $ 500 000

Total equity and liabilities

$1 808 000 $1 026 000

Plant

860 000

Accumulated depreciation — plant

(364 000) (440 000)

Land

300 000

400 000

Brands

160 000

Shares in Boys Ltd

492 000

Financial assets

220 000

210 000

Cash

20 000

10 000

Inventories

80 000

60 000

Goodwill

40 000

36 000

(26 000)

Accumulated impairment losses Total assets

776 000

$1 808 000 $1 026 000

Required 1. Prepare the acquisition analysis at 1 July 2023. 2. Prepare the consolidation worksheet entries for Jersey Ltd’s group at 30 June 2022. 3. Prepare the consolidated financial statements for Jersey Ltd’s group at 30 June 2022. (LO3, LO5 and LO7) 1. Acquisition analysis at 1 July 2023: Net fair value of identifiable assets and liabilities of Boys Ltd = ($260 000 + $100 000 + $81 000) (equity) – $10 000 (goodwill) + ($420 000 – $400 000) (1 – 30%) (BCVR – plant) + ($240 000 – $200 000) (1 – 30%) (BCVR – land) + ($76 000 – $60 000) (1 – 30%) (BCVR – inventories) + $24 000 (1 – 30%) (BCVR – brands)

27.97

Chapter 27: Consolidation: wholly owned entities

– $30 000 (1 – 30%) (BCVR – liability) = $480 000 Consideration transferred = $492 000 Goodwill acquired = $492 000 – $480 000 = $12 000 Goodwill recorded = $10 000 Unrecorded goodwill = $12 000 – $10 000 = $2 000 2. Worksheet entries at 30 June 2022: (1) Business combination valuation entries: The BCVR entries are affected by the following events that took place during the period from acquisition to 30 June 2022: • the depreciation of the plant during the previous period and current period • the sale of the plant during the current period • the settlement of the court case during the current period. As the land and inventories were sold prior to the beginning of the current period, there won’t be any BCVR entries for those assets. As the brand and goodwill were not affected by any events during the periods ended 30 June 2022, the BCVR entries at 30 June 2022 for those assets will be the same as those entries posted at acquisition date. Depreciation expense Gain/(loss) on sale of plant Income tax expense Retained earnings (1/7/21) Transfer from BCVR (1/5 x $20 000 p.a. for 1½ years.)

Dr Dr Cr Dr Cr

2 000 14 000

Brands Deferred tax liability Business combination valuation reserve

Dr Cr Cr

24 000

*Transfer from BCVR Income tax expense Damages expense

Dr Dr Cr

21 000 9 000

4 800 2 800 14 000

7 200 16 800

30 000

* As the court case was settled for more than the fair value of the claim at acquisition date, on consolidation only the damages expense of an amount equal to the fair value at acquisition date of $30 000 is eliminated. Accumulated impairment losses – goodwill Goodwill

Dr Cr

26 000

Goodwill Business combination valuation reserve

Dr Cr

2 000

26 000

2 000

(2) Pre-acquisition entries:

27.98

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At 1 July 2023: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve Shares in Boys Ltd

Dr Dr Dr Dr Cr

81 000 260 000 100 000 51 000 492 000

At 30 June 2022: The pre-acquisition entries at 30 June 2022 are affected by: • Sale of land – prior period. • Sale of inventories – prior period. • Transfer from pre-acquisition general reserve – prior Period.

Their effects will adjust the first pre-acquisition entry

• Sale of plant – current period. • Settlement of court case – current period. • Transfer from pre-acquisition general reserve – current period.

Their effects will need to be reversed in the further preacquisition entries

The pre-acquisition dividend declared prior to the acquisition was paid to external parties and therefore it does not have any impact on the consolidation worksheet entries. Retained earnings (1/7/21) Dr 160 200* Share capital Dr 260 000 General reserve Dr 60 000 Business combination valuation reserve Dr 11 800 Shares in Boys Ltd Cr 492 000 * $81 000 + $28 000 (BCVR – land) + $11 200 (BCVR – inventories) + $40 000 (general reserve transfer) Transfer from BCVR Business combination valuation reserve (Sale of plant)

Dr Cr

14 000

Business combination valuation reserve Transfer from BCVR (Settlement of court case)

Dr Cr

21 000

Transfer from general reserve General reserve

Dr Cr

30 000

14 000

21 000

30 000

3. Consolidated financial statements at 30 June 2022: In order to prepare the consolidated financial statements, the consolidation worksheet at 30 June 2022 is first prepared based on the entries above. The consolidation worksheet at 30 June 2022 is then: © John Wiley and Sons Australia Ltd, 2020

27.99

Chapter 27: Consolidation: wholly owned entities

Jersey Ltd 260 000 140 000 120 000 60 000

Boys Ltd 128 000 84 000 44 000 16 000

180 000 40 000 140 000 666 000

60 000 10 000 50 000 110 000

Transfer from BCVR

Transfer from general reserve

60 000

30 000

866 000 40 000 826 000

190 000 0 190 000

300 000 20 000 0

260 000 40 000 0

1 146 000 60 000

490 000 30 000

1 162 800 90 000

(10 000) 50 000

6 000 26 000

(4 000) 86 000

1 196 000 80 000 36 000 496 000 1 808 000

526 000 20 000 20 000 460 000 1 026 000

1 248 800 100 000 63 200 956 000 2 368 000

40 000 0

36 000 (26 000)

80 000 20 000 220 000 492 000 300 000 160 000 860 000 (364 000)

60 000 10 000 210 000 0 400 000 0 776 000 (440 000)

1 808 000

1 026 000

Revenues Expenses Trading profit Gains (losses) on sale of non-current assets Profit before tax Income tax expense Profit Retained earnings (1/7/21)

Dividend paid Retained earnings (30/6/22) Share capital General reserve BCVR

Other components of equity (1/7/21) Increases/Decreases Other components of equity (30/6/22) Total equity Accounts payable Deferred tax liability Other liabilities Goodwill Accumulated impairment losses - goodwill Inventories Cash Financial assets Shares in Boys Ltd Land Brands Plant Accumulated depreciation - plant

Adjustments Dr Cr 2 000 30 000

14 000

9 000

1 2 1 2

2 800 160 200 21 000 14 000 30 000

Group 386 000 194 000 192 000 62 000

4 800

14 000 21 000

1 2

254 000 54 200 199 800 613 000 0 60 000 872 800 40 000 832 800

2 2 2 2

260 000 60 000 11 800 21 000

30 000 16 800 2 000 14 000

7 200

24 000

52 000 0

26 000

492 000 1

300 000 30 000 0

2 1 1 2

24 000

655 800

140 000 30 000 430 000 0 700 000 184 000 1 636 000 (804 000) 2 368 000

JERSEY LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Revenues Expenses Trading profit Gains (losses) on sale of non-current assets

$386 000 194 000 192 000 62 000

27.100

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Profit before income tax Income tax expense

254 000 54 200

Profit for the period

$199 800

Other comprehensive income Other components of equity: Losses (4 000) Comprehensive income for the period $195 800 JERSEY LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022 Comprehensive income for the period

$195 800

Retained earnings balance at 1 July 2021 Profit for the period Transfer from general reserve Dividend paid Retained earnings balance at 30 June 2022

$613 000 199 800 60 000 (40 000) $832 800

Share capital balance at 1 July 2021 Share capital balance at 30 June 2022

$300 000 $300 000

General reserve balance at 1 July 2021 Transfer from general reserve General reserve balance at 30 June 2022

$90 000 (60 000) $30 000

Other components of equity at 1 July 2021 Losses Other components of equity at 30 June 2022

$90 000 (4 000) $86 000

JERSEY LTD Consolidated statement of financial position as at 30 June 2022 Current assets Inventories Financial assets Cash Total current assets Non-current assets Property, plant and equipment: Land Plant Accumulated depreciation – plant Brands Goodwill Total non-current assets Total assets

$140 000 430 000 30 000 $600 000

$700 000 1 636 000 (804 000) 184 000 52 000 $1 768 000 $2 368 000

27.101

Chapter 27: Consolidation: wholly owned entities

Liabilities Current liabilities Accounts payable Non-current liabilities Deferred tax liabilities Other Total non-current liabilities Total liabilities Equity Share capital Reserves: General reserve Other components of equity Retained earnings Total equity Total equity and liabilities

$100 000 63 200 956 000 $1 019 200 $1 119 200 $300 000 30 000 86 000 832 800 $1 248 800 $2 368 000

27.102

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 27: Consolidation: wholly owned entities Multiple choice questions 1. The preparation of consolidated financial statements involves: a. adjusting entries in the accounting records of the parent. b. adjusting entries in the accounting records of the subsidiary. c. together the financial statements of the investor and the associate. *d. adding together the financial statements of the parent and the subsidiaries. Answer: d Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet. 2. If a subsidiary’s reporting date does not coincide with the parent entity’s reporting date, adjustments must be made for the effects of significant transactions that occur between the two reporting dates provided the reporting dates differ by no more than: a. *b. c. d.

1 months. 3 months. 6 month. 9 months.

Answer: b Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet. 3. Before undertaking the consolidation process, it may be necessary to make the following adjustments in relation to the individual statements if the end of the subsidiary’s financial period does not coincide with the: *a. the subsidiary will prepare its own financial statements as at the end of the parent’s financial period. b. the parent will prepare its own financial statements as at the end of the subsidiary’s financial period. c. the parent will prepare its own financial statements as at 30 June if the end of the parent’s reporting period is not 30 June. d. the subsidiary will prepare its own financial statements as at 30 June if the end of the parent’s reporting period is not 30 June. Answer: a Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet.

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. Before undertaking the consolidation process, it may be necessary to make the following adjustments in relation to the individual statements if the parent and the subsidiary do not use the same accounting policies for like transactions in similar circumstances: a.

the parent will prepare its own financial statements using the same accounting policies as the subsidiary. b. the subsidiary will prepare its own financial statements using accounting policies that are negotiated with the parent. *c. the subsidiary will prepare its own financial statements using the same accounting policies as the parent. d. all of the options are incorrect. Answer: c Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet.

5. During the consolidation process, it may be necessary to make which of the following adjustments to the individual statements? a. pre-acquisition entries only. *b. business combination valuation entries and pre-acquisition entries in the consolidation worksheet. c. business combination valuation entries only. d. business combination valuation entries and pre-acquisition entries in the individual journals of the parent and the subsidiaries. Answer: b Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet. 6. The business combination valuation entries are used to recognise: the fair value of the assets not recorded in the subsidiary’s accounts at acquisition date. the fair value of the liabilities not recorded in the subsidiary’s accounts at acquisition date. c. the fair value adjustments for assets and liabilities that were recorded in the subsidiary’s accounts at acquisition date based on carrying amounts different from fair value. *d. all of the options are correct. a. b.

Answer: d Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

7. The pre-acquisition entries are used to: *a. eliminate the investment in the subsidiary and the pre-acquisition equity of the subsidiary. b. eliminate the investment in the subsidiary and the post-acquisition equity of the subsidiary. c. eliminate the pre-acquisition equity of the subsidiary. d. eliminate the post-acquisition equity of the subsidiary. Answer: a Learning objective 27.1: discuss the consolidation process in the case of wholly owned entities and the initial adjustments required in the consolidation worksheet.

8. Kansas Limited has two subsidiary entities, Emma Limited and Goldie Limited. Kansas Limited owns 100% of the shares in both entities. Details of the issued share capital are: Kansas Limited Emma Limited Goldie Limited

$300 000 $90 000 $75 000

The consolidated share capital amount of the Kansas - Emma - Goldie group is: a. b. c. *d.

$135 000 $465 000 $165 000 $300 000

Answer: d Learning objective 27.2: explain how a consolidation worksheet is used. 9. Papa Limited has two subsidiary entities, Mumma Limited and Junior Limited. Papa Limited owns 100% of the shares in both entities. Details of the cash accounts of each company are: Papa Limited $160 000, Mumma Limited $85 000, Junior Limited $12 500. The balance of the consolidated cash account of the Papa Limited group is: a. $97 500 b. $160 000 *c. $257 500 d. $62 500 Answer: c Learning objective 27.2: explain how a consolidation worksheet is used.

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Testbank to accompany Financial reporting 3e by Loftus et al.

10. The consolidation worksheet entries have an impact on: *a. the consolidated financial statements. b. the individual statement of the parent. c. the individual statement of the subsidiaries. d. the individual statements of the parent and its subsidiaries. Answer: a Learning objective 27.2: explain how a consolidation worksheet is used.

11. Which of the following statements is incorrect? a.

Where consolidated financial statements are prepared over a number of years, consolidation entries need to be made every time a consolidation worksheet is prepared. b. A consolidation worksheet is used to help the process of adding together the financial statements of the parent and its subsidiaries. *c. Consolidation adjusting entries affect the ledger accounts of the parent and subsidiaries. d. There are no consolidated ledger accounts. Answer: c Learning objective 27.2: explain how a consolidation worksheet is used.

12. In the case of a wholly owned subsidiary, if the fair value of the consideration transferred plus the fair value of the previously held interest is greater than the net fair value of the identifiable assets, liabilities and contingent liabilities of the subsidiary: *a. goodwill has been purchased and must be recognised on consolidation. b. the difference is treated as a special equity reserve in the acquirer’s accounting records. c. the difference is immediately charged to profit or loss in the period in which the business combination occurred. d. a gain on bargain purchase results. Answer: a Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Which of the following statements regarding the acquisition analysis is incorrect? a. b. c.

It determines whether there is goodwill on acquisition or a gain on bargain purchase. It is considered the first step in the consolidation process. It calculates and compares the fair value of the consideration transferred with the fair value of the net identifiable assets and liabilities acquired. *d. It calculates the fair value of the net identifiable assets and liabilities acquired based on the value of the post-acquisition equity in the subsidiary. Answer: d Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

14. Which of the following statements is incorrect? *a. The business combination valuation reserve is an account recorded in the subsidiary’s records. b. The acquisition analysis may include the recognition of assets and liabilities not recognised in the subsidiary’s records. c. The acquisition analysis will determine whether any goodwill or gain on bargain purchase has arisen as a part of the business combination. d. An acquisition analysis is prepared at acquisition date to identify the identifiable assets and liabilities of the subsidiary at fair value. Answer: a Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

15. The acquisition analysis calculates the fair value of the net identifiable assets and liabilities acquired based on the book value of the pre-acquisition equity of the subsidiary, adjusted for the following: a. b.

previously recorded goodwill in the subsidiary at acquisition date fair value adjustments for the assets and liabilities that were recorded in the subsidiary’s accounts at acquisition date based on carrying amounts different from fair value c. the fair value of the assets and liabilities not recorded in the subsidiary’s accounts at acquisition date *d. all of the options are correct Answer: d Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

27.5

Testbank to accompany Financial reporting 3e by Loftus et al.

16. Oceania Limited acquired 100% of the share capital of Broadwater Limited. Broadwater had total shareholder’s equity of $250 000. The book values of Broadwater Limited’s assets were: buildings $150 000, machinery $90 000. The fair values of these assets were: buildings $180 000, machinery $100 000. The tax rate is 30%. The fair value of the identifiable net assets is: a. $280 000 *b. $278 000 c. $210 000 d. $222 222 Answer: b Feedback: Equity + BCVR buildings + BCVR machinery = $250 000 + ((180 000 – 150 000) x 0.7) + ((100 000 – 90 000) x 0.7) = $278 000 Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

17. Stairwell Limited acquired 100% of the share capital of Bannister Limited for $237 500. Bannister had total shareholder’s equity of $200 000. The book values of Bannister Limited’s assets were: buildings $100 000, machinery $120 000. The fair values of these assets were: buildings $120 000, machinery $125 000. The tax rate is 30%. The acquisition analysis will determine: a. a goodwill of $37 500. *b. a goodwill of $20 000. c. a gain on bargain purchase of $12 500. d. a gain on bargain purchase of $37 500. Answer: b Feedback: Consideration transferred – (Equity + BCVR Buildings + BCVR Machinery) = $237 500 – (200 000 + ((120 000 – 100 000) x 0.7) + ((125 000 – 120 000) x 0.7)) = $237 500 - $217 500 = Goodwill $20 000 Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

18. Leather Limited acquired 100% of the share capital of Vinyl Limited for $235 000. Vinyl had total shareholder’s equity of $200 000. The book values of Vinyl Limited’s assets were: buildings $150 000, machinery $80 000. The fair values of these assets were: buildings $180 000, machinery $90 000. Also, Vinyl Limited has not previously recorded an internally generated trademark with a fair value of $40 000 and a contingent liability related to a warranty with a fair value of $10 000. The tax rate is 30%. The acquisition analysis will determine: a. a goodwill of $35 000. b. a goodwill of $14 000. c. a gain on bargain purchase of $21 000. *d. a gain on bargain purchase of $14 000. Answer: d Feedback: Consideration transferred – (Equity + BCVR Buildings + BCVR Machinery) = $235 000 – (200 000 + ((180 000 – 150 000) x 0.7) + ((90 000 – 80 000) x 0.7) + (40 000 x 0.7) – (10 000 x .7)) = $235 000 - $249 000 = Gain on bargain purchase $14 000 Learning objective 27.3: prepare an acquisition analysis for the parent’s acquisition of a subsidiary.

19. Forrest Ltd acquired 100% of the share capital of Desert Ltd when the carrying value of Desert Ltd’s equipment was $75 000. The fair value of the equipment on acquisition date was $90 000. The company tax rate was 30%. What is the amount of the business combination valuation reserve that must be recognised on consolidation? a. $15 000 *b. $10 500 c. $3 500 d. $90 000 Answer: b Feedback: (90 000 – 75 000) x 0.7 Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

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Testbank to accompany Financial reporting 3e by Loftus et al.

20. Breeze Limited acquired Zephyr Limited for a purchase consideration of $140 000. At acquisition date the fair value of Zephyr Limited’s furniture asset was $40 000 and the carrying amount was $35 000. If the company tax rate is 30%, which of the following is the appropriate adjustment to recognise the tax effect of the business combination revaluation of furniture at acquisition date? a. b. c. *d.

DR Deferred tax asset $3 500 CR Deferred tax asset $3 500 DR Deferred tax liability $3 500 CR Deferred tax liability $3 500

Answer: d Difficulty: Easy Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 21. On 1 July Walter Ltd acquired 100% of the share capital of Kristoff Ltd. At that date, the carrying amount of Kristoff Ltd’s machinery was $300 000. The fair value of the machinery on acquisition date was $330 000. The company tax rate was 30%. What is the amount of the business combination valuation reserve that will be recognised on consolidation? *a. $21 000 b. $30 000 c. $33 000 d. $9 000 Answer: a Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

22. At the date of acquisition there is no recognition of a deferred tax item in respect to goodwill because it is a residual amount and the recognition of a deferred tax item would: a. decrease the profit on consolidation. b. increase the profit on consolidation. *c. increase the carrying amount of goodwill. d. decrease the carrying amount of goodwill. Answer: c Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

23. On 1 July 2019 Debbie Ltd acquired a 100% interest in Stefan Ltd. At that date Stefan Ltd had goodwill of $6 000 recorded in its statement of financial position as a result of a previous business combination. The total goodwill arising on Debbie’s acquisition of Stefan was $16 000. The goodwill to be recognised on consolidation as a result of Debbie’s acquisition of Stefan is: a. b. c. *d.

nil. $6 000. $7 000. $10 000.

Answer: d Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 24. Prince Limited acquired 100% of the share capital of Charming Limited for a purchase consideration of $190 000. At acquisition date, the net fair value of Charming Limited’s assets, liabilities and contingent liabilities was $175 000 including goodwill with a carrying amount of $5 000. The company tax rate is 30%. The unrecorded amount of goodwill that must be recognised on the consolidation worksheet is: a. $5 000. b. $10 000. *c. $15 000. d. $20 000. Answer: c Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

25. The pre-acquisition entry is necessary to: *a. avoid overstating the equity and net assets of the group. b. avoid understating the equity and net assets of the group. c. avoid overstating the equity and net assets of the parent. d. record the ‘shares in subsidiary’ account in the parent’s records. Answer: a Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

27.9

Testbank to accompany Financial reporting 3e by Loftus et al.

26. On 1 July 2021, Pineapple Limited acquired all the issued shares of Melon Limited for $250 000 when the equity of Melon Limited consisted of: Share capital Retained earnings

$130 000 120 000

The pre-acquisition entry at 1 July 2021 is: a.

*b.

Shares in Melon Limited Retained earnings Share capital

Dr Cr Cr

250 000

Retained earnings Share capital Shares in Melon Limited

Dr Dr Cr

120 000 130 000

Retained earnings Share capital Shares in Melon Limited

Dr Dr Cr

130 000 120 000

Goodwill Share capital Shares in Melon Limited

Dr Dr Cr

120 000 130 000

250 000

Answer: b Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

27. Rose Ltd acquired on a cum div. basis all of shares in Petal Ltd for $140 000. At the date of acquisition, Trout Ltd had recorded a dividend payable of $40 000 and a total shareholders’ equity of $110 000. Assuming all the identifiable assets in Petal Ltd were recorded at fair value at acquisition date, the consolidation worksheet entries will have to recognise: a. a goodwill of $140 000. b. a goodwill of $40 000. c. a goodwill of $10 000. *d. a gain on bargain purchase of $10 000. Answer: d Feedback:(Consideration $140 000 – Dividend $40 000) – Equity $110 000 = Gain on bargain purchase $10 000 Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 28. At the date of acquisition, a subsidiary had recorded a dividend payable of $10 000. Assuming that the shares were acquired on a cum div. basis, the consolidation adjustment needed at the date of acquisition to eliminate the dividend is: I.

Dr Dividend payable

$10 000

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

II. III. IV.

Cr Dividend receivable Dr Dividend revenue $10 000 Cr Dividend declared Dr Shares in subsidiary $10 000 Cr Dividend receivable Dr Dividend receivable $10 000 Cr Dividend payable

$10 000 $10 000 $10 000 $10 000

*a. I. b. II. c. III. d. IV. Answer: a Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 29. The effect of the pre-acquisition entry is to eliminate the ‘Shares in subsidiary’ asset and the: a. net assets of the subsidiary at the acquisition date. b. equity of the parent at the acquisition date. *c. equity of the subsidiary at the acquisition date. d. net assets of the parent at the acquisition date. Answer: c Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries.

30. Flagstone Limited acquired 100% of the shares in Pebbles Limited on a cum div. basis for $700 000. At acquisition date, the Pebbles Limited had a declared dividend of $80 000. The pre-acquisition entry must include the following line: a. Dr Shares in subsidiary $620 000 *b. Cr Shares in subsidiary $620 000 c. Cr Shares in subsidiary $80 000 d. Cr Shares in subsidiary $780 000

Answer: b Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 31. Where the consideration transferred is less than the fair value of the identifiable net assets and contingent liabilities acquired, the difference must be recognised in the consolidation worksheet as: a.

a transfer to the business combination valuation reserve. © John Wiley and Sons Australia, Ltd 2020

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Testbank to accompany Financial reporting 3e by Loftus et al.

b. an increase in the ‘Shares in subsidiary’ asset. *c. a gain on bargain purchase. d. goodwill. Answer: c Learning objective 27.4: prepare the consolidation worksheet entries at the acquisition date, being the business combination valuation entries and the pre-acquisition entries. 32. At the end of any period after acquisition, the business combination entries prepared for the assets and liabilities that were not recorded at fair value at acquisition date and that are sold, fully depreciated or settled during the current period include: a. b. c.

no adjustments are required. adjustments to the asset or liability account, recognising also the tax effects. adjustments to the asset and liability account and to the gains on sale or to expenses generated by depreciation, amortisation or impairment losses or settlement of liabilities, recognising also the tax effects. *d. adjustments to the gains on sale or to expenses generated by depreciation, amortisation or impairment losses or settlement of liabilities, recognising also the tax effects. Answer: d Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

33. On 1 January 2022, Cowboys Ltd acquired all the issued shares in Magpies Ltd. At that date, the inventory of Magpies Ltd had a fair value of $20 000 more than its carrying amount. By 30 June 2022, 75% of the inventory was sold to an entity outside of the group. The business combination valuation consolidation adjustment against the inventory account as at 30 June 2022 will be: a. DR $15 000 b. CR $10 500 c. CR $5 000 *d. DR $5 000 Answer: d Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

34. On 1 January 2022, Cowboys Ltd acquired all the issued shares in Magpies Ltd. At that date, the inventory of Magpies Ltd had a fair value of $20 000 more than its carrying amount. By 30 June 2022, 75% of the inventory was sold to an entity outside of the group. The business combination valuation consolidation adjustment for inventories as at 30 June 2023 will include: a. *b. c. d.

a debit to inventories of $15 000. a debit to cost of sales of $5 000. a debit to inventories of $15 000 and a debit to cost of sales of $5 000. a credit to inventories of $15 000 and a debit to cost of sales $5 000.

Answer: b Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date. 35. On 1 January 2022, Cowboys Ltd acquired all the issued shares in Dragon Ltd. At that date, the plant of Dragon Ltd had a fair value of $10 000 more than its carrying amount and an estimated useful life of 5 years. Dragon Ltd depreciates the plant on a straight-line basis. The plant was sold during the year ended on 30 June 2023. The business combination valuation consolidation adjustment against plant in relation to the transaction as at 30 June 2023 will be: a. b. c. *d.

a debit of $10 000. a credit of $10 000. a debit of $2 000. there is no adjustment entry recorded against the plant account.

Answer: d Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Testbank to accompany Financial reporting 3e by Loftus et al.

36. On 1 January 2021, Brisbane Ltd acquired all the issued shares in Sydney Ltd. At that date, the plant of Sydney Ltd had a fair value of $20 000 more than its carrying amount and an estimated useful life of 5 years. Sydney Ltd depreciates the plant on a straight-line basis. The plant was still in the business at 30 June 2022. The business combination valuation entries in relation to the plant as at 30 June 2022 will include: I. II. III. IV.

a. b. *c. d.

Adjustments to the current depreciation expense Adjustments to retained earnings (opening balance) Transfers from business combination valuation reserve to retained earnings Adjustments to the plant account to recognise the fair value adjustment at acquisition date I and IV only. II and III only. I, II and IV only. I, II, III and IV.

Answer: c Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date. 37. On 1 January 2021, Brisbane Ltd acquired all the issued shares in Sydney Ltd. At that date, the plant of Sydney Ltd had a fair value of $20 000 more than its carrying amount and an estimated useful life of 5 years. Sydney Ltd depreciates the plant on a straight-line basis. The plant was sold to external parties on 31 December 2022. The business combination valuation entries in relation to the plant for the year ended 30 June 2023 will include: I. Adjustments to the current depreciation expense II. Adjustments to retained earnings (opening balance) III. Transfers from business combination valuation reserve to retained earnings IV. Adjustments to the plant account to recognise the fair value adjustment at acquisition date a. b. c. *d.

III only. I, and III only. I, II, III and IV. I, II and III only.

Answer: d Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

38. On 1 January 2022, Lemon Ltd acquired all the issued shares in Meringue Ltd. At that date, Meringue Ltd recognised in the notes to its financial statements a contingent liability with regards to a loan guarantee that had a fair value of $30 000. The contingent liability was settled at 31 December 2022 by Meringue Ltd making a payment of $20 000. Ignoring the tax effect, the business combination valuation entries in relation to the contingent liability for the year ended 30 June 2023 will include: I. II. III.

a. *b. c. d.

Adjustments to expenses recognised on settlement Transfers from business combination valuation reserve to retained earnings Adjustments to the liability account to recognise the fair value adjustment at acquisition date I only. I, II and III only. II, III and IV only. I, II, III and IV.

Answer: b Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date. 39. One year after acquisition date, acquired goodwill was regarded as having become impaired by $10 000. The appropriate consolidation adjustment in relation to the impairment will include the following line: a. b. *c. d.

DR Goodwill $10 000 CR Impairment loss $10 000 CR Accumulated impairment losses $10 000 CR Business combination valuation reserve $10 000

Answer: c Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Testbank to accompany Financial reporting 3e by Loftus et al.

40. Which of the following statements regarding pre-acquisition entries prepared after acquisition date is incorrect? *a. b.

c. d.

They are adjusted for transfers between post-acquisition equity accounts. They include the pre-acquisition entry prepared at acquisition date adjusted for the effects of all the transfers between pre-acquisition equity accounts and changes in the investment account up to the beginning of the current period. They reverse the transfers between pre-acquisition equity accounts and changes in the investment account that happen in the current period. They are adjusted for the changes in the investment account recognised by the parent in the subsidiary.

Answer: a Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

41. In the periods after acquisition, the gain on bargain purchase will be recognised in the preacquisition entries as: a. b. c. *d.

no adjustment is necessary. a credit to gain for the current period. a debit to retained earnings (closing balance). a decrease in the amount debited to retained earnings (opening balance).

Answer: d Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date. 42. Which of the following events can cause a change in the pre-acquisition entry subsequent to acquisition date? I. II. III. IV.

Depreciation on non-current assets. Transfers to post-acquisition retained earnings. Transfers from pre-acquisition retained earnings. Bonus dividends paid from pre-acquisition equity.

*a. b. c. d.

III and IV only. I, II, III and IV. I, III and IV only. II and III only.

Answer: a Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

43. Turtles Ltd acquired 100% of Dove Ltd on 1 July 2021. At acquisition date, Dove Ltd had the following equity items: Retained earnings Share capital

$120 000 $200 000

In the year following the acquisition, Dove Ltd paid a bonus share dividend of $30 000 out of pre-acquisition retained earnings. Which of the following consolidation adjustments is needed in the consolidation worksheet for 30 June 2022? I.

Dr Shares in subsidiary Cr Share capital Dr Bonus dividend paid Cr Share capital Dr Share capital Cr Bonus dividend paid Dr Retained earnings Cr Share capital

II. III. IV.

a. b. *c. d.

$30 000 $30 000 $30 000 $30 000 $30 000 $30 000 $30 000 $30 000

I. II. III. IV.

Answer: c Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

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Testbank to accompany Financial reporting 3e by Loftus et al.

44. At acquisition date, a wholly owned subsidiary had the following equity items. Retained earnings Share capital

$27 500 $40 000

In the year following the acquisition, the subsidiary transferred $5 000 from pre-acquisition retained earnings to a general reserve account. At the reporting date following the reserve transfer, which of the following consolidation adjustments is needed? I.

Dr Retained earnings Cr General reserve Dr General reserve Cr Transfer to general reserve Dr General reserve Cr Shares in subsidiary Dr Shares in subsidiary Cr Retained earnings

II. III. IV.

a. *b. c. d.

$5 000 $5 000 $5 000 $5 000 $5 000 $5 000 $5 000 $5 000

I. II. III. IV.

Answer: b Learning objective 27.5: prepare the consolidation worksheet entries in periods subsequent to the acquisition date.

45. Which of the following statements is correct? *a. Revaluations of assets such as goodwill and inventory are not permitted in the accounting records of the subsidiary. b. Inventories can be revalued to an amount greater than its cost in the records of the subsidiary. c. AASB 3 Business Combinations requires that any revaluations of a subsidiary’s assets at acquisition date must be done in the consolidation worksheet. d. The revaluation of non-current assets in the subsidiary’s records means that the subsidiary has adopted the cost model of accounting for those assets. Answer: a Learning objective 27.6: prepare the consolidation worksheet entries where the subsidiary revalues its assets at acquisition date.

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Chapter 27: Consolidation: wholly owned entities Not for distribution in full. Instructors may assign selected questions in their LMS.

46. If a revaluation of the subsidiary’s assets is performed on consolidation, the subsidiary’s assets are carried into the consolidated statement of financial position at: a. b. *c. d.

current replacement cost. net present value. fair value. historical cost.

Answer: c Learning objective 27.6: prepare the consolidation worksheet entries where the subsidiary revalues its assets at acquisition date.

47. Which of the following assets cannot be revalued above their cost in the accounting records of the subsidiary? I. II. III. IV.

a. b. c. *d.

Goodwill Inventories Land and buildings Plant and equipment

I, III and IV. II, III and IV. I and III. I and II.

Answer: d Learning objective 27.6: prepare the consolidation worksheet entries where the subsidiary revalues its assets at acquisition date.

48. Which of the following statements is incorrect? *a. All assets can be revalued in the subsidiary’s accounts. b. The fair value adjustments may be made via the consolidation worksheet or in the actual records of the subsidiary. c. If the assets can be revalued in the subsidiary accounts, the increase in value will be recognised as part of the pre-acquisition equity in asset revaluation surplus. d. If the assets are revalued in the consolidation worksheet, the increase in value will be recognised as part of the pre-acquisition equity in the business combination valuation reserve. Answer: a Learning objective 27.6: prepare the consolidation worksheet entries where the subsidiary revalues its assets at acquisition date.

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Testbank to accompany Financial reporting 3e by Loftus et al.

49. According to AASB 3 Business Combinations, the key principle relating to the disclosure of information about business combinations is to disclose information that: a. does not give an advantage to the competitors of a consolidated group. b. provides financial statement users with information about the parent entity only. *c. enables financial statement users to evaluate the nature and financial effect of business combinations that occurred during the reporting period. d. enables the preparation of the consolidated financial statements in the most cost-effective manner. Answer: c Learning objective 27. 7: prepare the disclosures required by AASB 3/IFRS 3 and AASB 12/IFRS 12.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 28: Consolidation: intragroup transactions

Chapter 28: Consolidation: intragroup transactions Comprehension questions 1. Why is it necessary to make adjustments for intragroup transactions? The consolidated financial statements are the statements of the group, i.e. an economic entity consisting of a parent and its subsidiaries. These consolidated financial statements then can only contain revenues, expenses, profits, assets and liabilities that relate to parties external to the group. Adjustments must be made for intragroup transactions as these are internal to the economic entity, and do not reflect the effects of transactions with external parties. This is consistent with the entity concept of consolidation, which defines the group as the net assets of the parent, together with the net assets of the subsidiaries. Transactions between these parties internal to the group must be adjusted in full.

2. Why is it important to identify intragroup transactions as current or previous period transactions? Current period intragroup transactions affect different accounts than prior period transactions. For example, current period intragroup sales of inventories affect sales and cost of sales accounts, whereas prior period sales of inventories affect retained earnings (opening balance) and, to the extent that inventories are sold externally during the current period, the cost of sales account. If the transactions are not correctly placed into a time context, then the adjustments posted in the consolidation worksheet to eliminate the effects of the intragroup transactions may be inappropriate.

3. In making consolidation worksheet adjustments, sometimes tax-effect entries are made. Why? Obviously, not all adjustments have tax consequences. The only adjustment entries that have tax consequences are those where profits or losses are eliminated and carrying amounts of assets or liabilities are adjusted. Accounting for tax is governed by AASB 112/IAS 12 Income Taxes. Deferred tax accounts are raised when a temporary difference arises because the tax base of an asset or liability differs from the carrying amount. Some consolidation adjustments result in changing the carrying amounts of assets and liabilities. Where this occurs, a temporary difference arises as there is no change to the tax base. In these situations, tax-effect entries requiring the recognition of deferred tax assets and liabilities are necessary. Consider an example of an item of inventories carried at cost of $10 000 being sold by a parent to a subsidiary for $12 000, with the item still being on hand at the end of the period. The tax rate is 30%. In the consolidation worksheet, the adjustment entry necessary to eliminate the unrealised profit of the intragroup transaction includes a credit adjustment to inventories of $2000 as the

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. cost to the economic entity for that item differs from that to the subsidiary. In the subsidiary’s accounts, the inventories are carried at $12 000 and has a tax base of $12 000, giving rise to no temporary differences. However, from the group’s point of view, the asset has a carrying amount of $10 000, and, combined with a tax base of $12 000, gives a deductible temporary difference of $2000 (the expected future deduction is greater than the future assessable amount). As a result, a deferred tax asset exists for the group and should be recognised in a taxeffect entry. This has no effect on the amount of tax payable in the current period, but will decrease the Income Tax Expense from the perspective of the group. Another explanation for the tax effect of the consolidation worksheet entry to eliminate the unrealised profit of the intragroup transaction can be provided as follows: as profit of $2000 is eliminated (by crediting Cost of Sales by $10 000 and debiting Sales Revenue by $12 000), the group’s profit is decreased and therefore, the Income Tax Expense (which is normally calculated as 30% of the profit) should decrease as well by 30% of $2000. Also, the entity that made the intragroup sale and recorded the profit would have paid tax on that profit; from the perspective of the group, that tax should not have been paid yet and represents a prepayment of tax in advance of the actual profit being realised by the group; this prepayment is going to be recognised by the group as a future tax benefit, a Deferred tax asset.

4. What are the key questions to consider when preparing consolidation worksheet adjustments for intragroup transactions? The five key questions to consider when preparing consolidation worksheet adjustments for intragroup transactions are as follows. 1. Is this a prior period or a current period transaction? 2. What has been recorded by the legal entities? 3. What should be reported by the group? 4. What adjustments are necessary to get from the legal entities’ amounts to the group amounts? 5. What is the tax effect of the adjustments made? 1. Is this a prior period or a current period transaction? If it is a current period transaction, its effects will be eliminated against the respective accounts. If it is a prior period transaction, the effects on prior period income and expenses accounts will be eliminated against the retained earnings account (opening balance), while its effects on current period accounts will be eliminated against the respective accounts. 2. What has been recorded by the legal entities? That is, what accounts on the left-hand side of the worksheet contain amounts arising from, or affected by, the intragroup transaction and what are the amounts recorded in those accounts? 3. What should be reported by the group? That is, what amounts should the group report on the right-hand side of the worksheet for the individual accounts affected by the intragroup transaction? 4. What adjustments are necessary to get from the legal entities’ amounts to the group amounts? That is, the adjustments are determined by comparing what has been recorded by the legal entities to what the group needs to report.

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Chapter 28: Consolidation: intragroup transactions

5. What is the tax effect of the adjustments made? Having determined the consolidation adjustment for the intragroup transaction, the tax-effect consequences need to be considered. Obviously, not all adjustments have tax consequences. The only adjustment entries that have tax consequences are those where profits or losses are eliminated (current tax effect) and carrying amounts of assets or liabilities are adjusted (deferred tax effect). 5. What is meant by ‘realisation of intragroup profits or losses’? Profits/losses are realised when an economic entity transacts with another external entity. For a group, this is consistent with the concept that the consolidated financial statements show only the results of transactions with external entities. The consolidated statement of profit or loss and other comprehensive income will thus show only realised profits and realised losses. Profits/losses recognised by group members on sale of assets within the group are unrealised profits/losses to the extent that the assets are still within the group. Realisation of profits/losses on intragroup transactions involving assets normally occurs when an external party gets involved. With intragroup sales of inventories, involvement of an external party, or realisation, occurs when the inventories are on-sold to an external entity. With intragroup sales of depreciable assets, realisation occurs as the asset is used up, as the benefits are received by the group as a result of use of the asset. The proportion of profits/losses realised in any one period is measured by reference to the depreciation charged on the transferred depreciable asset.

6. With regards to intragroup transfers of inventories, are adjustments for current period transfers different from adjustments for such transfers happening in a previous period? Explain. In preparing the adjustment entries for inventories sold intragroup for a profit within the current period, note the following. • •

•

In all cases, regardless of the amount of inventories on-sold, the adjustment to sales is always a decrease by the amount of the sales within the group as those should not be recognised by the group. The adjustment to inventories is always equal to the percentage (%) of inventories still on hand within the group multiplied by the profit on the sale within the group (i.e. the unrealised profit = % of inventories still on hand × (transfer price − original cost)). Without this adjustment, the inventories on hand would be overstated from the perspective of the group – this adjustment manes sure that the inventory on hand are recognised in the consolidated financial statements based on the original cost to the group. The adjustment to cost of sales can be determined as a balancing item once the adjustments to sales and inventories have been determined (as the difference between the adjustment to sales and the adjustment to inventories). However, the reason for this adjustment is the need to eliminate the cost of sale recognised on the intragroup transaction and adjust the cost of sales on the external transaction to the original cost to the group of the inventory sold externally.

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•

. The tax effect adjustment is always equal to the tax rate multiplied by the unrealised profit and is posted as a debit to deferred tax asset and a credit to income tax expense. That is needed to reflect that the tax paid on the unrealised profit from the intragroup transaction is a pre-payment of tax, i.e. a tax benefit.

In preparing the consolidation adjustment entry for inventories transferred intragroup in a previous period for the profit remaining in inventories on hand at the beginning of the current period, to the extent that the inventories are on-sold to external entities by the end of the current period, note the following. •

•

The adjustment to retained earnings (opening balance) is the after-tax profit on transferred inventories remaining on hand at the beginning of the period (also known as after-tax unrealised profit in beginning inventories). That is done in order to eliminate the unrealised profit from the previous period from retained earnings. The adjustment to cost of sales is the before-tax profit on inventories on hand at the beginning of the period (also known as before-tax unrealised profit in beginning inventories). This adjustment is needed to adjust the cost of sales recorded on the external sale based on the price paid intragroup to the original cost of the inventory sold externally in the current period. The adjustment to income tax expense is the tax rate times the adjustment to cost of sales. That is needed to reflect the current tax effect given by the realisation of the profit.

7. When are profits realised in relation to inventories transfers within the group? Realisation occurs on involvement of an external entity, namely when the inventories are onsold to an entity that is not a member of the group. If only a part of the inventories initially transferred intragroup is on-sold to external parties by the end of a period, only the part of the intragroup profit related to the inventories on-sold is realised. It should be noted that, as inventories are current assets which should be eventually sold to external parties, it is normally assumed, unless otherwise specified, that inventories transferred intragroup that are not sold to external parties by the end of a period are sold to external parties by the end of the next period and therefore any unrealised profit in opening inventories in one period is considered realised by the end of that period.

8. Where a current period intragroup transaction involves a depreciable asset, why is depreciation expense adjusted? The cost of the depreciable asset to the group is different from that recorded by the acquirer of the depreciable asset within an intragroup transaction if the intragroup transaction generated a profit or loss. The acquirer of the asset (i.e. the new owner) records depreciation in each period after the intragroup transaction based on the price paid for the asset intragroup while in the consolidated financial statements, the group wants to show depreciation calculated based on cost to the group (i.e. the carrying amount of the asset prior to the intragroup transaction). Hence an adjustment is necessary for the depreciation recorded in each period after the intragroup transaction. If a profit is made on a current period intragroup sale of a depreciable asset, then the cost of the asset to the group is less than the cost recorded by the acquirer of the asset (i.e. the new

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Chapter 28: Consolidation: intragroup transactions

owner) and therefore the current depreciation expense that should be recognised by the group is less than the current depreciation expense recorded by the new owner of the asset. Hence an adjustment is necessary to reduce the depreciation expense and accumulated depreciation recorded by the new owner of the asset in relation to the asset. If a loss is made on a current period intragroup sale of a depreciable asset, then the cost of the asset to the group is more than the cost recorded by the acquirer of the asset (i.e. the new owner) and therefore the current depreciation expense that should be recognised by the group is more than the current depreciation expense recorded by the new owner of the asset. Hence an adjustment is necessary to increase the depreciation expense and accumulated depreciation by the new owner of the asset in relation to the asset. Please note that if the intragroup transaction took place sometime after the start of the current period, the adjustment to depreciation expense is calculated based on the time passed since the intragroup transaction until the end of the current period. For example, if the intragroup transaction took place on 1 January 2022, on 30 June 2022 we will need to adjust depreciation expense for 0.5 years’ worth of annual depreciation expense adjustments (for the period from 1 January 2022 to 30 June 2022).

9. Where a previous period intragroup transaction involves a depreciable asset, why is retained earnings adjusted? The cost of the depreciable asset to the group is different from that recorded by the acquirer of the depreciable asset within an intragroup transaction if the intragroup transaction generated a profit or loss. The acquirer of the asset (i.e. the new owner) records depreciation in each period after the intragroup transaction based on the price paid for the asset intragroup while in the consolidated financial statements, the group wants to show depreciation calculated based on cost to the group (i.e. the carrying amount of the asset prior to the intragroup transaction). Hence an adjustment is necessary for the depreciation recorded in each period after the intragroup transaction. If a profit is made on a previous period intragroup sale of a depreciable asset, then the cost of the asset to the group is less than the cost recorded by the acquirer of the asset (i.e. the new owner) and therefore the depreciation expenses that should be recognised by the group each period are less than the depreciation expenses recorded by the new owner of the asset. Hence an adjustment is necessary to reduce the depreciation expenses (from the current period, but also from the previous periods) and accumulated depreciation recorded by the new owner of the asset in relation to the asset. However, the depreciation expenses from the previous periods are in the retained earnings (together with all the other income and expenses from previous periods, including income tax expense) and therefore in order to reduce those, we need to increase retained earnings. The current depreciation expense will be adjusted against the depreciation expense account. If a loss is made on a previous period intragroup sale of a depreciable asset, then the cost of the asset to the group is more than the cost recorded by the acquirer of the asset (i.e. the new owner) and therefore the depreciation expenses that should be recognised by the group are more than the depreciation expenses recorded by the new owner of the asset. Hence an adjustment is necessary to increase the depreciation expenses (from the current period, but also from the previous periods) and accumulated depreciation recorded by the new owner of the asset in

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. relation to the asset. However, as mentioned above, the depreciation expenses from the previous periods are in the retained earnings (together with all the other income and expenses from previous periods, including income tax expense) and therefore in order to increase those, we need to decrease retained earnings. The current depreciation expense will be adjusted against the depreciation expense account. Please note that if the intragroup transaction took place in a previous period, the adjustment to retained earnings is calculated based on the time passed since the intragroup transaction until the beginning of the current period as that will capture all the previous periods’ depreciation expenses. For example, if the intragroup transaction took place on 1 July 2010, on 30 June 2019 we will need to adjust retained earnings for 5 years’ worth of annual depreciation expense adjustments (for the period from 1 July 2010 to 1 July 2015), together with an adjustment to the current depreciation expense for 1 year worth of annual depreciation expense adjustments.

10. When are profits realised on transfers of depreciable assets within the group? As a depreciable asset may never be on-sold by a member of the group to external parties, remaining instead within the group and being consumed by use, the point of realisation may not be directly and exclusively determined by reference to involvement of an external entity. Realisation is then indirectly determined by usage of the asset within the group, that is, in proportion to the consumption of the benefits from the asset within the group. Realisation of the profit/loss on sale within the group is then measured in the same proportion to the depreciation of the asset recorded by the entity that uses it. For example, if the transferred asset is being depreciated on a straight line basis over a 10-year period, that is, at 10% per annum, then the profit on sale is realised at 10% per annum. As such, if the asset is used in the group up to the end of its useful life, the profit will be realised in full only at the end of the useful life. However, the depreciable asset may be on-sold to external parties before the end of the useful life, in which case, the profit is realised in full at the moment of external sale, with a part of it being realised through depreciation (based on the period of time since the intragroup transfer up to the moment of external sale) and the rest through the external sale.

11. Are tax effect-entries required when adjusting for intragroup services or intragroup borrowings? Explain. The consolidation worksheet adjustment entry to eliminate the effects of intragroup services or intragroup borrowings does not affect the carrying amount of any asset or liability that are taxable or the overall profit. Therefore, there is no deferred or current tax-effect adjustment.

12. Are adjustments for post-acquisition intragroup dividends different from those for pre-acquisition intragroup dividends? Explain. All dividends are accounted for as post-acquisition dividends. This treatment is hard to justify conceptually and this decision was made by the standard-setters on pragmatic grounds. Refer to AASB 127/IAS27 and AASB 9/IFRS 9 (paragraph 5.7.6). As a consequence, there is no difference between the form of the main adjustments posted on consolidation for pre- and postacquisition dividends:

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Chapter 28: Consolidation: intragroup transactions

• •

For interim dividends paid: the consolidation adjustment entry will eliminate dividend revenue recorded by the parent and dividends paid recorded by the subsidiary. For final dividends declared: the consolidation adjustment entry will eliminate dividend revenue recorded by the parent and dividends declared recorded by the subsidiary and also the dividend receivable recorded by the parent and dividends payable recorded by the subsidiary.

However, there are two subtle differences in the adjustments posted for pre-acquisition or post-acquisition dividends: • Adjustments for pre-acquisition dividends are normally posted under the pre-acquisition entries, while adjustments for post-acquisition dividends are posted in the elimination entries for intragroup transactions. • If the pre-acquisition dividends cause an impairment of the investment account recognised by the parent, then the pre-acquisition entries will include an additional entry to reverse the effect of that impairment.

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Chapter 28: Consolidation: intragroup transactions

Case studies Case study 28.1 Consolidation adjustments Janelle Ltd sold inventories during the current period to its wholly owned subsidiary, Adam Ltd, for $15 000. These items previously cost Janelle Ltd $12 000. Adam Ltd subsequently sold half the items to Nambour Ltd, an external entity, for $8000. The income tax rate is 30%. The group accountant for Janelle Ltd, Bob Jones, maintains that the appropriate consolidation adjustment entries are as follows.

Required 1. Discuss whether the entries suggested by Bob Jones are correct, explaining on a lineby-line basis the correct adjustment entries. 2. Determine the consolidation worksheet entries in the following period, assuming the inventories are on-sold to external parties, and explain the adjustments on a line-byline basis. 1. The correct entries are: Sales Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr

15 000

Dr Cr

450

13 500 1 500

450

Sales: Recorded sales = $15 000 (Janelle Ltd) + $8 000 (Adam Ltd) = $23 000 Group sales = $8 000 [external entity sales only] Adjustment = $15 000 (decrease) From the point of view of the group, only the external sales should be reported and therefore an adjustment is needed on consolidation to decrease the aggregate figure of Sales by $15 000. Cost of sales: Recorded = $12 000 (Janelle Ltd) + ½ x $15 000 (Adam Ltd) = $19 500 Group = ½ x $12 000 = $6 000 [the original cost of the inventories sold externally only] Adjustment = $13 500

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Chapter 28: Consolidation: intragroup transactions

From the point of view of the group, only the cost of inventories sold to external parties should be reported and that should be based on the original cost of those inventories to the group. Therefore, an adjustment is needed on consolidation to decrease the aggregate figure of Cost of sales by $13 500. Inventories: Recorded = $0 (Janelle Ltd) + ½ x $15 000 (Adam Ltd) = $7 500 Group = ½ x $12 000 = $6 000 [the original cost of the inventories not sold externally] Adjustment = $1 500 From the point of view of the group, only the cost of inventories not sold to external parties should be reported and that should be based on the original cost of those inventories to the group. Therefore, an adjustment is needed on consolidation to decrease the aggregate figure of Inventories by $1 500. That is actually equal to the amount of unrealised profit, i.e. the profit on the intragroup sale of the inventories not yet sold to external parties, as the inventories are overstated from the group’s perspective by this amount in Adam Ltd’s accounts. Deferred tax asset: The first adjustment entry reduces the carrying amount of the inventories by $1500. This reduction in the carrying amount, not compensated by a change in the tax base, creates a deductible temporary difference between it and the tax base giving rise to a deferred tax benefit which will be recognised as a deferred tax asset based on the tax rate of 30%. Another explanation for the tax-effect entry arises from the fact that the profit of $1500 was taxed in Janelle Ltd’s accounts and, as a result, Janelle Ltd would have paid tax which from the group’s perspective is a payment of tax in advance of the profit being realised by the group. As such, the group should recognise that in the future when the profit will be realised, it won’t be required to pay tax of that profit – this is equivalent to having a tax benefit with will be recognised as a deferred tax asset. Income tax expense: The income tax expense, which normally is calculated as the tax rate multiplied by the profit, is reduced as a result of the unrealised profit being eliminated. 2. Assuming inventories are on-sold to an external party in the following year, the entry in the following year will be: Retained earnings (opening balance) Income tax expense Cost of sales

Dr Dr Cr

1 050 450 1 500

Retained earnings (opening balance): In the prior period, Janelle Ltd recorded an after tax profit of $2 100 on sale of inventories to Adam Ltd. Half of this inventories was on-sold to an external entity, leaving half the profit, $1 050, unrealised. In the current period, this profit unrealised at the end of the prior period is in the opening balance of Retained Earnings and, on consolidation, it should be eliminated from there. Income tax expense: In the prior period, the group raised a deferred tax asset of $450. When inventories are on-sold

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. this year the tax benefit for which the deferred tax asset was raised is realised and therefore it doesn’t need to be recognised anymore. Instead, given that the profit is realised, the group’s current profit will increase and therefore an income tax expense calculated as the tax rate multiplied by this realised profit should be recognised. Cost of sales: Recorded = $0 (Janelle Ltd) + ½ x $15 000 (Adam Ltd) = $7 500 Group = ½ x $12 000 = $6 000 [the original cost of the inventories sold externally] Adjustment = $1 500 From the point of view of the group, the original cost to the group of inventories sold to external parties should be reported. Therefore, an adjustment is needed on consolidation to decrease the aggregate figure of Cost of Sales by $1 500. This adjustment decreases an expense for the current period which increases the current period’s profit, recognising the fact that the profit was realised.

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Chapter 28: Consolidation: intragroup transactions

Case study 28.2 Depreciation expense At the beginning of the current period, Janelle Ltd sold a depreciable asset to its wholly owned subsidiary, Adam Ltd, for $80 000. Janelle Ltd had originally paid $200 000 for this asset, and at time of sale to Adam Ltd had charged accumulated depreciation of $150 000. This asset is used differently in Adam Ltd from how it was used in Janelle Ltd; thus, whereas Janelle Ltd used a 10% p.a. straight-line depreciation method, Adam Ltd uses a 20% straight-line depreciation method. In calculating the depreciation expense for the consolidated group (as opposed to that recorded by Adam Ltd), the group accountant, Roger Moore, is unsure of which amount the depreciation rate should be applied to ($200 000, $50 000 or $80 000) and which depreciation rate to use (10% or 20%). Required Provide a detailed response, explaining which depreciation rate should be used and to what amount it should be applied. For the group, depreciation of an asset transferred intragroup is based on the depreciation rate applied by the entity using the asset and on the carrying amount of the asset at the moment of the intragroup transfer. Note that when an asset is transferred within the group, consolidation adjustments are not based on just reversing the intragroup transaction. The purpose of the adjustments is to remove all the effects of the intragroup transaction so that only the group’s position in relation to external entities is reported. As the usage of the asset in the group has changed as a result of transfer within the group, then the depreciation rate used by the group must reflect the actual consumption of benefits within the group. This depreciation rate will then be applied to the carrying amount of the asset at the moment of the intragroup transfer to get the depreciation expense for the asset from the group’s perspective. In this example, the carrying amount at the time of the intragroup transfer is $50 000 ($200 000 (original cost) - $150 000 (accumulated depreciation)). The asset is now being used by Adam Ltd which applies a 20% depreciation rate. Therefore, the depreciation expense from the group’s perspective for the current period will be calculated as 20% multiplied by $50 000 (i.e. $10 000) assuming that the asset was transferred intragroup on the first day of the current period. Given that Adam Ltd would have recognised a depreciation expense of 20% x $80 000 = $16 000, on consolidation an adjustment is posted against the depreciation expense decreasing it by $6000 or 20% of the profit on the intragroup transfer of $30 000 (i.e. $80 000 (price paid intragroup) - $50 000 (carrying amount at the moment of the intragroup sale)).

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. Application and analysis exercises Exercise 28.1 Current and prior periods intragroup transfers of inventories Joey Ltd owns all of the share capital of Chandler Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2022 or 30 June 2023. (a) In January 2023, Joey Ltd sells inventories to Chandler Ltd for $45 000 in cash. These inventories had previously cost Joey Ltd $30 000, and remain unsold by Chandler Ltd at the end of the period. (b) In February 2023, Joey Ltd sells inventories to Chandler Ltd for $51 000 in cash. These inventories had previously cost Joey Ltd $36 000, and are on-sold externally on 2 April 2023. (c) In February 2023, Chandler Ltd sells inventories to Joey Ltd for $66 000 in cash (original cost to Chandler Ltd was $48 000) and half are on-sold externally by 30 June 2023. (d) In March 2023, Joey Ltd sold inventories for $30 000 to Zara Ltd, an external entity. These inventories were transferred from Chandler Ltd on 1 June 2022. The inventories had originally cost Chandler Ltd $18 000, and were sold to Joey Ltd for $36 000. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO3) 1. JOEY LTD – CHANDLER LTD 30 June 2023 (a)

(b)

(c)

Sales revenue Cost of sales Inventories

Dr Cr Cr

45 000

Deferred tax asset Income tax expense

Dr Cr

4 500

Sales revenue Cost of sales

Dr Cr

51 000

Sales revenue Cost of sales Inventories

Dr Cr Cr

66 000

Deferred tax asset Income tax expense

Dr Cr

2 700

30 000 15 000

4 500

51 000

57 000 9 000

2 700

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Chapter 28: Consolidation: intragroup transactions

(d)

Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

12 600 5 400 18 000

2. Detailed explanations on the adjusting journal entries 30 June 2023: (a) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2023. As the inventories remain unsold at the end of the period, at 30 June 2023 the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation by: - Debiting Sales Revenue with an amount equal to the intragroup price - Crediting Cost of Sales with an amount equal to the original cost of inventories - Crediting Inventories with an amount equal to the unrealised profit (i.e. the entire profit on the intragroup sale). The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised by Joey Ltd in advance on the unrealised intragroup profit. (b) The only adjusting entry eliminates the intragroup sales revenue recognised by Joey Ltd (on the intragroup sale) and the cost of sales recognised by Chandler Ltd (on the external sale) as the profit on the intragroup sale is entirely realised during the current period. As the inventories are sold by the end of the period to an external entity, at 30 June 2023 the entire profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales are overstated from the group’s perspective as they include the intragroup sales revenue and the cost of sales recognised based on the price paid intragroup by Chandler Ltd. On consolidation, this overstatement needs to be corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of inventories. (c) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2023. As half of the inventories remain unsold at the end of the period, at 30 June 2023 half of the profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price – this eliminates the amount recognised by Chandler Ltd on the intragroup sale, so that the consolidated figure reflects only the sales revenues generated from transactions with external parties • Crediting Inventories with an amount equal to the unrealised profit (i.e. half of the profit on the intragroup sale) – this corrects the overstatement of inventories still on hand (half of the original amount transferred intragroup) that are recorded by Joey Ltd based on the intragroup price, making sure that those inventories are recorded at the original cost to the group • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by Chandler Ltd (which was based on the original cost) and adjusts the Cost of Sales recognised by Joey Ltd (which was based on the intragroup price), so that the consolidated figure reflects only the cost of sales of the inventories sold to the external party based on their original cost to the group.

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. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised by Chandler Ltd in advance on the unrealised intragroup profit. (d) In this case, the unrealised profit in closing inventories from the period ended 30 June 2022 and recognised as unrealised profit in opening inventories in this period becomes realised by the end of the current period. As such, this profit needs to be transferred from the previous period to the current period by: • Debiting Retained Earnings (1/7/22) with an amount equal to the after-tax unrealised profit in opening inventories – this eliminates the unrealised profit from the prior period’s profit • Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profit to the current period, the current period profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in opening inventories.

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Chapter 28: Consolidation: intragroup transactions

Exercise 28.2 Current and prior periods intragroup transfers of inventories Monica Ltd owns all the share capital of Phoebe Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2022 or 30 June 2023. (a) On 1 May 2022, Monica Ltd sold inventories to Phoebe Ltd for $5 000 on credit, recording a profit of $1000. Half of the inventories were unsold by Phoebe Ltd at 30 June 2022 and none at 30 June 2023. Phoebe Ltd paid half the amount owed on 15 June 2022 and the rest on 1 July 2022. (b) On 10 June 2022, Phoebe Ltd sold inventories to Monica Ltd for $18 000 in cash. The inventories had previously cost Phoebe Ltd $14 000. Half of these inventories were unsold by Monica Ltd at 30 June 2022 and 30% at 30 June 2023. (c) On 1 January 2023, Phoebe Ltd sold inventories costing $5000 to Monica Ltd at a transfer price of $8000, paid in cash. The entire inventories were sold by Monica Ltd to external entities by 30 June 2023. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO3) 1. At 30 June 2022, there will only be adjusting entries for transactions (a) and (b) as these are the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023, there will be adjusting entries for all transactions.

30 June 2022 (a)

(b)

Sales revenue Cost of sales Inventories

Dr Cr Cr

5 000

Deferred tax asset Income tax expense

Dr Cr

150

Accounts payable Accounts receivable

Dr Cr

2 500

Sales revenue Cost of sales Inventories

Dr Cr Cr

18 000

Deferred tax asset Income tax expense

Dr Cr

600

4 500 500

150

2 500

16 000 2 000

600

30 June 2023

28.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. (a)

(b)

(c)

Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

350 150

Retained earnings (1/7/22) Cost of sales Inventories

Dr Cr Cr

2 000

Deferred tax asset Income tax expense Retained earnings (1/7/22)

Dr Dr Cr

360 240

Sales revenue Cost of sales

Dr Cr

8 000

500

800 1 200

600

8 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2022. As half of the inventories remain unsold at the end of the period, at 30 June 2022 half of the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price – to eliminate the intragroup revenues • Crediting Inventories with an amount equal to the unrealised profit – to decrease the value of the inventories left on hand with the group to their original cost to the group • Crediting Cost of Sales with an amount equal to the intragroup price minus the amount of credit to Inventories – to adjust the aggregate figure for Cost of Sales to the amount that should be recognised by the group, i.e. the original cost of the inventories sold to external parties. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised by Monica Ltd on the unrealised profit. The third adjusting entry eliminates the intragroup Accounts Payable and Accounts Receivable for the amount still unpaid on the intragroup sale. (b) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2022. As half of the inventories remain unsold at the end of the period, at 30 June 2022 half of the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price • Crediting Inventories with an amount equal to the unrealised profit – to decrease the value of the inventories left on hand with the group to their original cost to the group • Crediting Cost of Sales with an amount equal to the intragroup price minus the amount of credit to Inventories.

28.17

Chapter 28: Consolidation: intragroup transactions

The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised by Phoebe Ltd in advance on the unrealised intragroup profit. 30 June 2023: (a) In this case, the unrealised profit in closing inventories from the period ended 30 June 2022 and recognised as unrealised profit in opening inventories in this period becomes realised by the end of the current period. As such, this profit needs to be transferred from the previous period to the current period by: • Debiting Retained Earnings (1/7/22) with an amount equal to the after-tax unrealised profit in opening inventories – this eliminates the unrealised profit from the prior period’s earnings • Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profit to the current period, the current period profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in opening inventories. (b) In this case, a part (20%) of the inventories originally transferred intragroup in the previous period is sold during the current period to external parties, while another part (30%) is still unsold. That means that the unrealised profit in closing inventories from the period ended 30 June 2022 and recognised as unrealised profit in opening inventories in this period is only partly realised by the end of the current period. This is recognised in the first adjusting entry by: • Debiting Retained Earnings (1/7/22) with an amount equal to the before-tax unrealised profit in opening inventories – this eliminates the unrealised profit from the prior period’s profit • Crediting Cost of Sales with an amount equal to the unrealised profit in opening inventories that becomes realised during the current period – this increases the current profit as the previously unrealised profit is now realised • Crediting Inventories with an amount equal to the unrealised profit in opening inventories that is still unrealised at the end of the current period – this decreases the value of the inventories still on hand to their original cost to the group. As a result of the recognition of the part of profit that is realised in the current period, the current period profit increases and a current tax effect should also be recognised by: • Debiting Income Tax Expense with an amount equal to the tax on the part of the unrealised profit in opening inventories that is realised by the end of the period. As a result of the elimination of the part of the profit that is unrealised by the end of the current period, a deferred tax effect should also be recognised by: • Debiting Deferred Tax Asset with an amount equal to the tax on the part of the unrealised profit in opening inventories that is still unrealised at the end of the period.

28.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Given that Retained Earnings only recognises profits after tax, debiting Retained Earnings (1/7/22) in the first adjusting entry with the before-tax unrealised profit eliminated from that account more than what it should and therefore the balance of Retained Earnings (1/7/22) should be adjusted by: • Crediting Retained Earnings (1/7/22) with an amount equal to the tax on the unrealised profit in opening inventories – this ensures that the net adjustment to Retained Earnings (1/7/22) is only for the after-tax unrealised profit. (c) The only adjusting entry eliminates the intragroup sales revenue recognised by Phoebe Ltd (on the intragroup sale) and the cost of sales recognised by Monica Ltd (on the external sale) as the profit on the intragroup sale is entirely realised during the current period. As the inventories are sold by the end of the period to an external entity, at 30 June 2023 the entire profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales are overstated from the group’s perspective as they include the intragroup sales revenue and the cost of sales recognised based on the price paid intragroup by Monica Ltd. On consolidation, this overstatement is corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of inventories.

28.19

Chapter 28: Consolidation: intragroup transactions

Exercise 28.3 Current and prior periods intragroup transfers of non-current assets Sophie Ltd owns all the share capital of Ruby Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2022 or 30 June 2023. (a) On 1 July 2021, Sophie Ltd sold a motor vehicle to Ruby Ltd for $15 000. This had a carrying amount to Sophie Ltd of $12 000. Both entities depreciate motor vehicles at a rate of 10% p.a. on cost. (b) Ruby Ltd manufactures items of machinery which are used as property, plant and equipment by other companies, including Sophie Ltd. On 1 January 2022, Ruby Ltd sold such an item to Sophie Ltd for $62 000, its cost to Ruby Ltd being only $55 000 to manufacture. Sophie Ltd charges depreciation on these machines at 20% p.a. on the diminishing value. (c) Sophie Ltd manufactures certain items which it then markets through Ruby Ltd. During the period ended 30 June 2023, Sophie Ltd sold for $12 000 items to Ruby Ltd at cost plus 20%. By 30 June 2023, Ruby Ltd has sold to external entities 75% of these transferred items. (d) Ruby Ltd also sells second-hand machinery. Sophie Ltd sold one of its depreciable assets (original cost $40 000, accumulated depreciation $32 000) to Ruby Ltd for $5000 on 1 January 2023. Ruby Ltd had not resold the item by 30 June 2023. (e) Ruby Ltd sold a depreciable asset (carrying amount of $22 000) to Sophie Ltd on 1 January 2022 for $25 000. Both entities charge depreciation in relation to these items at a rate of 10% p.a. on cost. On 31 December 2022, Sophie Ltd sold this asset to Dubbo Ltd, an external entity, for $20 000. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO4) 1. At 30 June 2022, there will only be adjusting entries for transactions (a), (b) and (e) as these are the only transactions related to the financial period ended 30 June 2022. At 30 June 2023, there will be adjusting entries for all transactions. 30 June 2022 (a)

Proceeds on sale of motor vehicle Dr Carrying amount of motor vehicle sold Cr Motor vehicles Cr

15 000

Gain on sale of vehicles Motor vehicles

Dr Cr

3 000

Deferred tax asset Income tax expense

Dr Cr

900

12 000 3 000

OR 3 000

900

28.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Accumulated depreciation – motor vehicle Depreciation expense

Dr Cr

300

Income tax expense Deferred tax asset

Dr Cr

(b) Sales revenue Cost of sales Machinery Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

62 000

Accumulated depreciation - machinery Depreciation expense

Dr Cr

700

Income tax expense Deferred tax asset

Dr Cr

210

Dr Cr Cr

25 000

Gain on sale of depreciable asset Depreciable asset

Dr Cr

3 000

Deferred tax asset Income tax expense

Dr Cr

900

Accumulated depreciation – depreciable asset Dr Depreciation expense Cr

150

Income tax expense Deferred tax asset

Dr Cr

Retained earnings (1/7/22) Motor vehicles

Dr Cr

3 000

Deferred tax asset Retained earnings (1/7/22)

Dr Cr

900

Accumulated depreciation – motor vehicle Depreciation expense Retained earnings (1/7/22)

Dr Cr Cr

600

Retained earnings (1/7/22) Income tax expense Deferred tax asset

Dr Dr Cr

90 90

(e) Proceeds on sale of depreciable asset Carrying amount of asset sold Depreciable asset

300

55 000 7 000 2 100 2 100

700

210

22 000 3 000

OR 3 000

900

150

30 June 2023 (a)

3 000

900

300 300

180

28.21

Chapter 28: Consolidation: intragroup transactions

(b)

(c)

(d)

Retained earnings (1/7/22) Machinery

Dr Cr

7 000

Deferred tax asset Retained earnings (1/7/22)

Dr Cr

2 100

Accumulated depreciation - machinery Depreciation expense Retained earnings (1/7/22) Retained earnings (1/7/22) Income tax expense Deferred tax asset

Dr Cr Cr Dr Dr Cr

1 960

Sales revenue Cost of sales Inventories

Dr Cr Cr

12 000

Deferred tax asset Income tax expense

Dr Cr

150

Inventories Proceeds on sale of machinery Carrying amount of machinery sold

Dr Dr Cr

3 000 5 000

Inventories Loss on sale of machinery

Dr Cr

3 000

Income tax expense Deferred tax liability

Dr Cr

900

Retained earnings (1/7/22) Income tax expense Depreciation expense Carrying amount of asset sold

Dr Dr Cr Cr

1 995 855

7 000

2 100

1 260 700 210 378 588

11 500 500

150

8 000

(e)

3 000

900

150 2 700

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The first journal entry eliminates the proceeds on sale and the carrying amount of the motor vehicle sold recorded on the intragroup sale. If Sophie Ltd recorded the net amount as gain on sale, then in the alternative adjusting entry that gain will need to be eliminated instead of the proceeds and the carrying amount. In both cases, the adjusting entry will also bring down the balance of the asset account to reflect the original carrying amount of the asset before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the gain on sale (which decreases the current profit) and decreases the carrying

28.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. amount of the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to decrease and a deferred tax asset needs to be recognised for the deductible temporary difference created or, using another explanation, for the tax prepayment made by Sophie Ltd on the unrealised profit from on the intragroup sale. The third adjusting entry is necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is overstated and should be decreased by an amount equal to the depreciation rate multiplied by the gain on the intragroup sale. It should be noted that this adjustment to depreciation expense increases the current profit and therefore it is said to be an indication that a part of the profit on the intragroup sale is now realised. As a part of the intragroup profit is now realised through the depreciation adjustments, the fourth adjusting entry adjusts the tax effect of the previous entry that eliminated the entire profit on the intragroup sale, basically reversing that previous tax effect entry for the part of the profit that is now realised. That is because the depreciation adjustment entry increases the carrying amount of the asset, with no effect on the tax base and therefore decreases the deductible temporary difference that was recorded in the deferred tax asset when eliminating the gain on intragroup sale. (b) The explanation for the adjusting journal entries posted now is exactly the same as for the adjusting entries at 30 June 2022 for transaction (a). In summary: • the first adjusting entry decreases the machine’s value down from the price paid intragroup to the original carrying amount of the machine at the moment of intragroup sale and eliminates the sales revenue and the cost of sales recognised on the intragroup sale, considering that the machine was recognised by the initial owner as inventories. • the second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective. • the third adjusting entry decreases the depreciation expense recognised for the machine down from the depreciation recorded by the user of the machine (based on the intragroup price paid) to the depreciation that should be recorded by the group (based on the carrying amount of the machine at the moment of the intragroup sale). • the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax asset recognised in the second entry by the tax on the profit realised through the depreciation adjustment. It should be noted here that although the original classification of the asset before the intragroup sale was inventories, there won’t be any reclassification needed on consolidation as, from the group’s perspective, the asset is going to be used as a machine from the moment of the intragroup sale. (e) The explanation for the adjusting journal entries posted now is exactly the same as for the adjusting entries at 30 June 2022 for transaction (a). In summary: • the first adjusting entry decreases the depreciable asset’s value down from the price paid intragroup to the original carrying amount of the asset at the moment of intragroup sale and eliminates either the proceeds on sale and the carrying amount of asset sold or, in the alternative form, the net gain on the intragroup sale of asset.

28.23

Chapter 28: Consolidation: intragroup transactions

•

the second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective. • the third adjusting entry decreases the depreciation expense recognised for the asset down from the depreciation recorded by the user of the depreciable asset (based on the intragroup price paid) to the depreciation that should be recorded by the group (based on the carrying amount of the depreciable asset at the moment of the intragroup sale). • the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax asset recognised in the second entry by the tax on the profit realised through the depreciation adjustment. 30 June 2023: (a) The explanation for the adjusting journal entries posted now is as follows: • the first adjusting entry decreases the vehicle’s value down from the price paid intragroup to the original carrying amount of the vehicle at the moment of intragroup sale and eliminates the net gain on the intragroup sale of vehicle recorded in the previous period that is now in the Retained Earnings (1/7/22). • the second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective and adjusting the Retained Earnings (1/7/22) for the previous period’s tax effect. • the third adjusting entry decreases the depreciation expenses from the previous and current periods down from the depreciation recorded by the user of the vehicle (based on the intragroup price paid) to the depreciation expenses that should be recorded by the group (based on the carrying amount of the vehicle at the moment of the intragroup sale); the previous period’s depreciation expense is now in the Retained Earnings (1/7/22) and should be adjusted in there. • the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax asset recognised in the second entry by the tax on the profit realised during the current and previous periods through the depreciations adjustments. (b) The explanation for the adjusting journal entries posted now is similar to that for the adjusting entries at 30 June 2023 for transaction (a). In summary: • the first adjusting entry decreases the machine’s value down from the price paid intragroup to the original carrying amount of the machine at the moment of intragroup sale and eliminates the profit on sale recorded in the previous period that in now in the Retained Earnings (1/7/22). • the second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective and adjusting the Retained Earnings (1/7/22) for the previous period’s tax effect. • the third adjusting entry decreases the depreciation expenses from the previous and current periods down from the depreciation recorded by the user of the vehicle (based on the intragroup price paid) to the depreciation expenses that should be recorded by the group (based on the carrying amount of the vehicle at the moment of the intragroup sale); the previous period’s depreciation expense is now in the Retained Earnings (1/7/22) and should be adjusted in there. Note that the current depreciation expense is adjusted for $1260 calculated as the difference between the current depreciation expense recorded by Sophie Ltd (i.e. ($62 000 - $6200) * 20%) and the current depreciation expense that should be recognised by the group ((i.e. ($55 000 - $5500) * 20%). © John Wiley and Sons Australia Ltd, 2020

28.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

. the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax asset recognised in the second entry by the tax on the profit realised during the current and previous periods through the depreciations adjustments.

(c) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2023. As 25% of the inventories remain unsold at the end of the period, at 30 June 2023 a quarter of the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • • •

Debiting Sales Revenue with an amount equal to the intragroup price Crediting Inventories with an amount equal to the unrealised profit (i.e. 25% of ($12 000 - $12 000/1.2) – to decrease the value of the inventories left on hand with the group to their original cost to the group Crediting Cost of Sales with an amount equal to the intragroup price minus the amount of credit to Inventories.

The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised by Sophie Ltd in advance on the unrealised intragroup profit. (d) The first journal entry eliminates the proceeds on sale and the carrying amount of the machine sold recorded on the intragroup sale. If Ruby Ltd recorded only the net amount as loss on sale (since the proceeds were lower than the carrying amount), then in the alternative adjusting entry that loss will need to be eliminated instead of the proceeds and the carrying amount. In both cases, the adjusting entry will also bring up the balance of the asset account (now treated as inventories) to reflect the original carrying amount of the asset before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the loss on sale (which increases the current profit) and increases the carrying amount of the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to increase and a deferred tax liability needs to be recognised for the taxable temporary difference created or, using another explanation, for the tax that should have been paid by Ruby Ltd if it wouldn’t have claimed the unrealised loss on the intragroup sale as a tax deduction. It should be noted here that although the original classification of the asset before the intragroup sale was machinery, there won’t be any reclassification needed on consolidation as, from the group’s perspective, the asset is going to be used as inventories from the moment of the intragroup sale. As a consequence of this, there won’t be any depreciation adjustments or the related tax effect. (e) To come up with the adjusting entries, a proper understanding of the effects of this set of transactions needs to be achieved. The effects recorded by the entities within the group are summarised below, together with what effects that should be presented by the economic entity, aka the group.

28.25

Chapter 28: Consolidation: intragroup transactions

Ruby Ltd: Carrying amount at sale (prior period) Sales proceeds (prior period) Gain on sale (prior period)

$22 000 25 000 3 000

Cost of asset Depreciation (prior period)

$25 000 1 250 23 750 1 250 22 500 20 000 2 500

Sophie Ltd:

Depreciation (current period) Carrying amount at sale (current period) Sales proceeds (current period) Loss on sale (current period) Economic entity (i.e. the group): Cost of asset Depreciation (prior period) Depreciation (current period) Carrying amount at sale (current period) Sales proceeds (current period) Gain on sale (current period)

$22 000 1 100 20 900 1 100 19 800 20 000 200

From this summary it can be observed that Ruby Ltd recorded in the previous period a profit of $3000, while Sophie Ltd recorded a depreciation expense of $1250. These amounts, after tax, are recorded in the Retained earnings at the beginning of the current period, meaning that the aggregate Retained earnings (1/7/22) includes a net amount of ($3000 – $1250) x (1 – 30%) = $1225. However, from the group’s perspective, Retained Earnings (1/7/19) should only include the depreciation expense for the group after tax, i.e. – $1100 x (1 – 30%) = – $770. Therefore, the adjusting entry should include an adjustment to decrease Retained Earnings (1/7/19) by $1225 + $770 = $1995. It should be noted that this amount of adjustment is actually the unrealised profit at the beginning of the current period, i.e. the profit on the intragroup sale minus for the depreciation adjustment for the previous period. In terms of the current period, it can be observed that Sophie Ltd recorded a depreciation expense of $1250, while from the group’s perspective, the depreciation expense should only be $1100. As such, on consolidation there is another adjustment to be posted and that is to decrease the depreciation expense by $150. Also, Sophie Ltd recorded during the current period a carrying amount at sale of $22 500, while from the group’s perspective, the carrying amount at sale should be only $19 800. Therefore, another adjustment is necessary for the current period and that is to decrease the carrying amount at sale by $2700. It should be noted that this latter amount is actually the gain on intergroup sale that was not realised through the depreciation adjustments ($150 during the prior period and $150 during the current period), but it is realised through the sale to the external entity during the current period.

28.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. In the end, considering that the adjustments for the current period (to the depreciation expense and carrying amount at sale) increase the current profit (by the realised profit), a tax effect should be recognised as increasing the income tax expense for the current period.

28.27

Chapter 28: Consolidation: intragroup transactions

Exercise 28.4 Current and prior periods intragroup transfers of non-current assets Fred Ltd owns all of the share capital of Wilma Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2022 or 30 June 2023. (a) Wilma Ltd sold some land to Fred Ltd in December 2021. The land had originally cost Wilma Ltd $25 000, but was sold to Fred Ltd for only $20 000. To help Fred Ltd pay for the land, Wilma Ltd gave Fred Ltd an interest-free loan of $12 000, and the balance was paid in cash. The land was sold to external entities in June 2022 for $30 000 and immediately after that, Fred Ltd paid the amount owed to Wilma Ltd. (b) On 1 July 2021, Fred Ltd sold equipment costing $10 000 to Wilma Ltd for $12 000. Fred Ltd had not charged any depreciation on the asset before the sale as it just purchased it from an external entity. Both entities depreciate items of equipment at 10% p.a. on cost. The equipment is still held by Wilma Ltd at 30 June 2023. (c) On 1 July 2021, Wilma Ltd sold a building to Fred Ltd for $200 000 in cash. This item had an original cost of $500 000 and accumulated depreciation at time of sale to Wilma Ltd of $250 000. The remaining useful life of that building is estimated to be 10 years and the future economic benefits are assumed to be derived consistently throughout the life. The building was sold to external entities on 1 April 2023 for $210 000. (d) On 1 July 2022, Fred Ltd sold an item regarded as equipment, to Wilma Ltd which regarded it as inventories. At the time of the sale, the carrying amount of the item to Fred Ltd was $5000 and it was sold to Wilma Ltd for $4000. The item is sold to an external entity by Wilma Ltd by 30 June 2023. (e) On 1 October 2022, Fred Ltd sold an item of machinery to Wilma Ltd for $6000. This item had cost Fred Ltd $4000. Fred Ltd regarded this item as inventories whereas Wilma Ltd intended to use it as a non-current asset. Wilma Ltd charges depreciation at the rate of 10% p.a. on cost. The machine was sold to external entities on 1 April 2023 for $5000. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO4) 1. At 30 June 2022, there will only be adjusting entries for transactions (a), (b) and (c) as these are the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023, there will be adjusting entries for all transactions except transaction (a) for which the whole profit was realised in 2022. 30 June 2022 (a)

Gain on sale of land Loss on sale of land

Dr Cr

5 000

28.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b)

. Proceeds on sale of equipment Carrying amount of equipment sold Equipment

Dr Cr Cr

12 000

Gain on sale of equipment Equipment

Dr Cr

2 000

Deferred tax asset Income tax expense

Dr Cr

600

Accumulated depreciation - equipment Depreciation expense

Dr Cr

200

Income tax expense Deferred tax asset

Dr Cr

Proceeds on sale of buildings Buildings Carrying amount of buildings sold

Dr Dr Cr

200 000 50 000

Buildings Loss on sale of buildings

Dr Cr

50 000

Income tax expense Deferred tax liability

Dr Dr

15 000

Depreciation expense Accumulated depreciation - buildings

Dr Cr

5 000

Deferred tax liability Income tax expense

Dr Cr

1 500

Retained earnings (1/7/22) Equipment

Dr Cr

2 000

Deferred tax asset Retained earnings (1/7/22)

Dr Cr

600

Accumulated depreciation - equipment Depreciation expense Retained earnings (1/7/22)

Dr Cr Cr

400

Retained earnings (1/7/22) Income tax expense Deferred tax asset

Dr Dr Cr

60 60

10 000 2 000

(c)

2 000

600

200

250 000

OR 50 000

15 000

5 000

1 500

30 June 2023 (b)

2 000

600

200 200

120

28.29

Chapter 28: Consolidation: intragroup transactions

(c)

(d)

Depreciation expense Carrying amount of machinery sold Retained earnings (1/7/22) Income tax expense

Dr Dr Cr Cr

3 750 41 250

Proceeds on sale of buildings Cost of sales Carrying amount of buildings sold

Dr Dr Cr

4 000 1 000

Cost of sales Loss on sale of equipment

Dr Cr

1 000

Sales revenues Cost of sales Depreciation expense Carrying amount of machinery sold

Dr Cr Cr Cr

6 000

31 500 13 500

5 000

(e)

1 000

4 000 100 1 900

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The only adjusting entry eliminates the intragroup loss on sale recognised by Wilma Ltd and the gain on sale recognised by Fred Ltd as the land is sold externally in the current period. At 30 June 2022, the entire loss on the intragroup sale is realised; however, the aggregate loss on sale and gain on sale are overstated as from the group’s perspective there is no loss nor gain on the sale of the land. On consolidation, this overstatement needs to be corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of the land. (b) The first journal entry eliminates the proceeds on sale and the carrying amount of the equipment sold recorded on the intragroup sale. If Fred Ltd recorded the net amount as gain on sale, then in the alternative adjusting entry that gain will need to be eliminated instead of the proceeds and the carrying amount. In both cases, the adjusting entry will also bring down the balance of the equipment account to reflect the original carrying amount of the equipment before the intragroup sale. All of these adjustments are necessary as the equipment is still on hand with the group and there was no sale involving an external entity. The second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective. The third adjusting entry decreases the depreciation expense recognised for the equipment down from the depreciation recorded by the user of the equipment (based on the intragroup price paid) to the depreciation that should be recorded by the group (based on the carrying amount of the equipment at the moment of the intragroup sale); the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax asset recognised in the second entry by the tax on the profit realised through the depreciation adjustment. (c) The first journal entry eliminates the proceeds on sale and the carrying amount of the buildings sold recorded on the intragroup sale. If Wilma Ltd recorded only the net amount as loss on sale (since the proceeds were lower than the carrying amount), then in the alternative adjusting entry that loss will need to be eliminated instead of the proceeds and the carrying

28.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. amount. In both cases, the adjusting entry will also bring up the balance of the buildings account to reflect the original carrying amount of the asset before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second entry recognises the tax effect of the first entry by raising a deferred tax liability for the tax that should have been paid by the intragroup seller – however, as they claimed a loss on the intragroup transaction, they were able to obtain a tax deduction, but from the group’s perspective they should have paid tax on their entire profit before considering that loss. As the group cannot pay tax by itself, a deferred tax liability is recognised and will be paid by the intragroup seller in the period when the loss is realised from the group’s perspective. The third adjusting entry increases the depreciation expense recognised for the buildings up from the depreciation recorded by the user of the buildings (based on the intragroup price paid) to the depreciation that should be recorded by the group (based on the carrying amount of the buildings at the moment of the intragroup sale); the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax liability recognised in the second entry by the tax on the loss realised through the depreciation adjustment. 30 June 2023: (b) Fred Ltd recorded in the previous period a profit on the intragroup sale of $2000 which is now in retained earnings. The first adjusting entry is necessary to eliminate that profit and decrease the balance of the equipment account from the amount recognised by Wilma Ltd (based on the price paid intragroup) to the original cost recognised by Fred Ltd prior to the intragroup sale. The second adjusting entry is recognising the tax effect of the first entry – as the retained earnings include only the previous periods profits after tax, the adjustment to retained earnings from the first entry should be corrected for the tax related to the intragroup profit and a deferred tax asset should be raised for the tax that Fred Ltd paid on the intragroup profit. Also, during the previous and current periods, Wilma Ltd recorded a depreciation expense of $1200 each period. However, from the group’s perspective, the previous period’s and the current period’s depreciation expense should be $200 each. Therefore, the third adjusting entry includes an adjustment to decrease the current depreciation expense by $200 and to decrease the previous period’s depreciation expense that is now in the retained earnings (1/7/22) by $200 as well, but also to decrease the accumulated depreciation by 2 x $200. The last adjusting entry is needed to recognise the tax effect of the third adjusting entry: a current tax effect due to the current depreciation adjustment; a past tax effect for the previous period’s depreciation adjustment and a future tax effect due to the adjustment to accumulated depreciation that decreases the carrying amount of the asset and therefore decreases the deductible temporary difference recognised as a result on the first adjustment entry. (c) Wilma Ltd recorded in the previous period a loss of $50 000 on the sale of the buildings to Fred Ltd, which should be eliminated as it is a result of an intragroup transaction. Also, Fred Ltd recorded in the previous period a depreciation expense of $200 000 / 10 = $20 000, while from the group’s perspective, the depreciation expense should have been $250 000 / 10 = $25 000. Therefore, an adjustment to retained earnings is needed to increase it by $5000. Those 2 adjustments to retained earnings have a net effect of decreasing the retained earnings by $45 000. However, given that retained earnings only recognise income and expenses from previous periods after tax, the net adjustment to retained earnings should be $45 000 x (1-30%) = $31 500. Also, Fred Ltd recorded in the current period a depreciation expense of $200 000 / 10 x

28.31

Chapter 28: Consolidation: intragroup transactions

9/12 = $15 000 (as the asset was used in the business in the current period only for 9 months prior to the sale on 1 April 2023), while from the group’s perspective, the current depreciation expense should have been $250 000 / 10 x 9/12 = $18 750. Therefore, an adjustment to depreciation expense is needed to increase it by $3750. As a result of the external sale during the current period, Fred Ltd recorded during the current period a carrying amount at sale of $200 000 - $20 000 - $15 000 = $165 000, while from the group’s perspective, the carrying amount of buildings sold should be only $250 000 - $25 000 - $18 750 = $206 250. Therefore, an adjustment is necessary for the current period and that is to increase the carrying amount at sale by $41 250. It should be noted that the adjustment to the carrying amount of buildings sold is actually the loss on intragroup sale that was not realised through the depreciation adjustments ($3750 during the current period and $5000 during the previous period), but it is realised through the sale to the external entity during the current period. (d) The only adjusting entry eliminates the proceeds on sale and the carrying amount of the equipment sold recorded on the intragroup sale and adjusts the cost of sales recognised by Wilma Ltd to the original cost of the equipment to the group as the equipment, now regarded as inventories, is sold externally in the current period. If Wilma Ltd recorded only the net amount as loss on sale (since the proceeds were lower than the carrying amount), then in the alternative adjusting entry that loss will need to be eliminated instead of the proceeds and the carrying amount. At 30 June 2023, the entire loss on the intragroup sale is realised; however, the aggregate loss on sale is overstated and cost of sales is understated. On consolidation, these need to be corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of the equipment. (e) Fred Ltd recorded in the current period sales revenues of $6000 and cost of sales of $4000, which should be eliminated as they are a result of an intragroup transaction. Also, Wilma Ltd recorded a depreciation expense of $600 x 6/12 = $300 while from the group’s perspective, the depreciation expense should be $400 x 6/12 = $200. Therefore, an adjustment to depreciation expense is needed to decrease it by $100. Also, as a result of the external sale, Wilma Ltd recorded during the current period a carrying amount at sale of $6000 - $300 = $5700, while from the group’s perspective, the carrying amount at sale should be only $4000 - $200 = $3800. Therefore, another adjustment is necessary for the current period and that is to decrease the carrying amount at sale by $1900. It should be noted that this latter amount is actually the profit on intragroup sale that was not realised through the depreciation adjustment ($100 during the current period), but it is realised through the sale to the external entity during the current period. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit.

28.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Exercise 28.5 Current period intragroup transfers of inventories and non-current assets Rachel Ltd owns all the share capital of Green Ltd. The income tax rate is 30%. During the period ended 30 June 2023, the following transactions took place: (a) Green Ltd sold inventories costing $75 000 to Rachel Ltd. Green Ltd recorded a $15 000 profit before tax on these transactions. At 30 June 2023, Rachel Ltd has none of these goods still on hand. (b) Rachel Ltd sold inventories costing $12 000 to Green Ltd for $27 000. By 30 June 2023, one-third of these were sold to Willow Ltd for $14 250 and one-third to Layla Ltd for $13 500; the rest are still on hand with Green Ltd. Willow Ltd and Layla Ltd are external entities. (c) On 1 January 2023, Rachel Ltd sold land for cash to Green Ltd at $30 000 above cost. The land is still on hand with Green Ltd. (d) Green Ltd sold a warehouse to Rachel Ltd for $150 000 on 1 July 2022. The carrying amount of this warehouse recognised by Green Ltd at the time of sale was $123 000. Rachel Ltd charges depreciation at a rate of 5% p.a. on cost. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2, LO3 and LO4) 1. 30 June 2023 (a)

(b)

(c)

(d)

Sales revenue Cost of sales

Dr Cr

75 000

Sales revenue Cost of sales Inventories

Dr Cr Cr

27 000

Deferred tax asset Income tax expense

Dr Cr

1 500

Gain on sale of land Land

Dr Cr

30 000

Deferred tax asset Income tax expense

Dr Cr

9 000

Proceeds on sale of warehouse Carrying amount of warehouse sold Warehouse

Dr Cr Cr

150 000

75 000

22 000 5 000

1 500

30 000

9 000

123 000 27 000

28.33

Chapter 28: Consolidation: intragroup transactions

OR Gain on sale of warehouse Warehouse

Dr Cr

27 000

Deferred tax asset Income tax expense

Dr Cr

8 100

Accumulated depreciation - warehouse Depreciation expense

Dr Cr

1 350

Income tax expense Deferred tax asset

Dr Cr

405

27 000

8 100

1 350

405

2. Detailed explanations on the adjusting journal entries 30 June 2023: (a) The only adjusting entry eliminates the intragroup sales revenue recorded by Green Ltd and the cost of sales recognised by Rachel Ltd as the profit on the intragroup sale is entirely realised during the current period. As the inventories are sold by the end of the period to an external entity, at 30 June 2023 the entire profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales are overstated from the group’s perspective as they include the intragroup sales revenue and the cost of sales recognised based on the price paid intragroup by Rachel Ltd. On consolidation, this overstatement needs to be corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of inventories. (b) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2023. As one third of the inventories remain unsold at the end of the period, at 30 June 2023 one third of the profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price – this eliminates the amount recognised by Rachel Ltd on the intragroup sale so that the consolidated figure reflects only the sales revenues generated from transactions with external parties. • Crediting Inventories with an amount equal to the unrealised profit (i.e. one third of the profit on the intragroup sale) – this corrects the overstatement of inventories still on hand (one third of the original amount transferred intragroup) that are recorded by Green Ltd based on the intragroup price, making sure that those inventories are recorded at the original cost to the group. • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by Rachel Ltd (based on the original cost) and adjusts the Cost of Sales recognised by Green Ltd (based on the intragroup price) so that the consolidated figure reflects only the cost of sales of the inventories sold to the external party based on their original cost to the group. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised by Rachel Ltd in advance on the unrealised intragroup profit.

28.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. (c) The first adjusting entry decreases the land’s value down from the price paid intragroup to the original value of the land at the moment of intragroup sale and eliminates the proceeds on sale and the carrying amount of the land sold recognised as a result of the intragroup sale (or alternatively it eliminates the gain on the intragroup sale of land that is unrealised at 30 June 2023); the second entry recognises the tax effect of the first entry by raising a deferred tax asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective. (d) The first journal entry eliminates the proceeds on sale and the carrying amount of the warehouse sold recognised as a result of the intragroup sale (or alternatively it eliminates the intragroup gain on sale of the warehouse). The adjusting entry will also bring down the balance of the warehouse account to reflect the original carrying amount of the warehouse before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the gain on sale (which decreases the current profit) and decreases the amount recognised for the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to decrease and a deferred tax asset needs to be recognised for the deductible temporary difference created or, using another explanation, for the tax prepayment made by Green Ltd on the unrealised profit from the intragroup sale. The third adjusting entry is necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is overstated and should be decreased by an amount equal to the depreciation rate multiplied by the gain on the intragroup sale. It should be noted that this adjustment to depreciation expense increases the current profit and therefore it is said to be an indication that a part of the profit on the intragroup sale is now realised. As a part of the intragroup profit is now realised through the depreciation adjustments, the fourth adjusting entry adjusts the tax effect of the previous entry that eliminated the entire profit on the intragroup sale, basically reversing that previous tax effect entry for the part of the profit that is now realised. That is because the depreciation adjustment entry increases the carrying amount of the asset, with no effect on the tax base and therefore decreases the deductible temporary difference that was recorded in the deferred tax asset when eliminating the gain on intragroup sale.

28.35

Chapter 28: Consolidation: intragroup transactions

Exercise 28.6 Current and prior period intragroup services Darcy Ltd owns all the share capital of Isabella Ltd. The following intragroup transactions took place during the periods ended 30 June 2022 and 30 June 2023: (a) Isabella Ltd paid $20 000 during the period ended 30 June 2022 and $40 000 during the period ended 30 June 2023 as management fees for services provided by Darcy Ltd. (b) Isabella Ltd rented a spare warehouse to Darcy Ltd starting from 1 July 2021 for 1 year. The total charge for the rental was $30 000, and Darcy Ltd paid this amount to Isabella Ltd on 1 January 2022. (c) Isabella Ltd rented a spare warehouse from Darcy Ltd for $50 000 p.a. The rental contract started at 1 January 2022, and the payments are made annually in advance on 1 January. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO5) 1. At 30 June 2022, there will be adjusting entries for all transactions as they are all related to the financial period ended on 30 June 2022. At 30 June 2023 there will only be adjusting entries for transactions (a) and (c); transaction (b) does not have any effects on the period ended 30 June 2023 and therefore no adjustments are necessary as the rental agreement finished before the beginning of the period. 30 June 2022 (a)

(b)

(c)

Management fees revenues Management fee expenses

Dr Cr

20 000

Rent revenues Rent expenses

Dr Cr

30 000

Rent revenues Rent expenses

Dr Cr

25 000

Rent received in advance Prepaid rent

Dr Cr

25 000

Dr Cr

40 000

20 000

30 000

25 000

30 June 2023 (a)

(c)

Management fees revenues Management fee expenses

40 000

If the rental agreement is for 2 or more years, the adjusting entries would be:

28.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Rent revenues Rent expenses

Dr Cr

50 000

Rent received in advance Prepaid rent

Dr Cr

25 000

50 000

25 000

If the rental agreement is only for 1 year and ends on 31 December 2022, the adjusting entries would be: Rent revenues Rent expenses

Dr Cr

25 000 25 000

If the rental agreement is only for 1.5 years and ends on 30 June 2023, the adjusting entries would be: Rent revenues Rent expenses

Dr Cr

50 000 50 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The adjusting entry eliminates the management fee revenue recognised by Darcy Ltd and the management fee expense recognised by Isabella Ltd during the current period. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the management fees incurred this current period. As the management fees were paid during the current period, there won’t be a need to eliminate any another accounts during the current period as there is no Management Fees Payable or Management Fees Receivable. Also, there were no management fees paid in advance for the next period and therefore there are no Prepaid Management Fees and Management Fees Received in Advance to eliminate. (b) The adjusting entry eliminates the rent revenue recognised by Isabella Ltd and the rent expense recognised by Darcy Ltd during the current period. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the rent incurred this current period. As the rent was paid during the current period, there won’t be a need to eliminate any other accounts during the current period as there is no Rent Payable or Rent Receivable. Also, there is no rent paid in advance for the next period and therefore there is no Prepaid Rent and Rent Received in Advance to eliminate. (c) The current period’s rent expense and revenue is half a year worth of rent of $25 000 (from 1 January 2022 to 30 June 2022). The first adjusting entry will eliminate this amount. As this adjusting entry does not have any net impact on the profit:

28.37

Chapter 28: Consolidation: intragroup transactions

• •

there won’t be any tax-effect adjusting entry there won’t be any further adjusting entries in the next period for the rent incurred this current period.

As the rent was paid during the current period in advance on 1 January 2022 for one year, at 30 June 2022 there will be rent paid in advance for the next period up to 31 December 2022 (6 months’ worth) and therefore the second adjustment entry will need to eliminate Prepaid Rent and Rent Received in Advance for half the yearly rent. 30 June 2023: (a) Similar to the adjusting entry at 30 June 2022, the adjusting entry now eliminates the management fee revenue recognised by Darcy Ltd and the management fee expense recognised by Isabella Ltd during the current period (the previous management fees do not need to be eliminated as they are now in the retained earnings – while the previous period’s revenue increases the retained earnings of Darcy Ltd, the previous period’s expense decreases the retained earnings of Isabella Ltd and when aggregating the amounts recognised in the retained earnings, their effects offset each other). As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the management fees incurred this current period. As the management fees were paid during the current period, there won’t be a need to eliminate any another accounts during the current period as there is no Management Fees Payable or Management Fees Receivable. Also, there were no management fees paid in advance for the next period and therefore there are no Prepaid Management Fees and Management Fees Received in Advance to eliminate. (c) If the rent agreement is for 2 years or more starting on 1 January 2022, the current period’s rent expense and revenue is one full year of rent of $50 000 (from 1 July 2022 to 30 June 2023). The first adjusting entry will eliminate this amount. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the rent incurred this current period. As the rent was paid during the current period in advance on 1 January 2023 for one year, at 30 June 2023 there will be rent paid in advance for the next period up to 31 December 2023 (6 months’ worth) and therefore the second adjustment entry will need to eliminate Prepaid Rent and Rent Received in Advance for half the yearly rent. If the rent agreement is for 1 year starting on 1 January 2022, it means it will end on 31 December 2022. Therefore, the current period’s rent expense and revenue is only 6 months’ worth of rent, i.e. $25 000. The first adjusting entry will eliminate this amount. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the rent incurred this current period.

28.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. As the rent agreement ends on 31 December 2022 and the payment has been received previously, there won’t be a need to eliminate any Rent Payable or Rent Receivable. Also, there is no rent paid in advance for the next period and therefore there is no Prepaid Rent and Rent Received in Advance to eliminate. If the rent agreement is for 1.5 years starting on 1 January 2022, it means it will end on 30 June 2023. Therefore, the current period’s rent expense and revenue is a full year worth of rent, i.e. $50 000. The first adjusting entry will eliminate this amount. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the rent incurred this current period. As the rent agreement ends on 30 June 2023 and the payment has been received previously, there won’t be a need to eliminate any Rent Payable or Rent Receivable. Also, there is no rent paid in advance for the next period and therefore there is no Prepaid Rent and Rent Received in Advance to eliminate.

28.39

Chapter 28: Consolidation: intragroup transactions

Exercise 28.7 Current and prior period intragroup dividends Maggie Ltd owns all the share capital of Taylor Ltd. The following intragroup transactions took place during the periods ended 30 June 2022 and 30 June 2023: (a) During the period ended 30 June 2022, Taylor Ltd paid an interim dividend of $40 000 out of pre-acquisition profits. As a result, the investment in Taylor Ltd is considered to be impaired by $40 000. (b) On 30 June 2022, Taylor Ltd declared a final dividend of $25 000 out of postacquisition profits. (c) During the period ended 30 June 2023, Taylor Ltd paid an interim dividend of $30 000 out of post-acquisition profits. (d) On 30 June 2023, Taylor Ltd declared a final dividend of $50 000 out of postacquisition profits. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO6) 1. At 30 June 2022, there will only be adjusting entries for transactions (a) and (b) as these are the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023, there will only be adjusting entries for transactions (a), (c) and (d) as those are the only transactions that affect the financial statements for the financial period ended on 30 June 2023. The dividend transaction (b) from the period ended 30 June 2022 does not have any impact on the period ended 30 June 2023 that needs to be adjusted, but transaction (a) has due to the impairment loss recognised for the investment account. 30 June 2022 (a)

(b)

Dividend revenue Interim dividend paid

Dr Cr

40 000

Accum. impair. losses – Shares in Taylor Ltd Dr Impairment losses Cr

40 000

Dividend revenue Dividend declared

Dr Cr

25 000

Dividend payable Dividend receivable

Dr Cr

25 000

Accum. impair. losses – Shares in Taylor Ltd Dr Retained earnings (1/7/22) Cr

40 000

25 000

30 June 2023 (a)

40 000

28.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. (c)

(d)

Dividend revenue Interim dividend paid

Dr Cr

30 000

Dividend revenue Dividend declared

Dr Cr

50 000

Dividend payable Dividend receivable

Dr Cr

50 000

30 000

50 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The adjusting entry eliminates the dividend revenue recognised by Maggie Ltd and the dividend paid recognised by Taylor Ltd during the current period. As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were paid during the current period, there won’t be a need to eliminate any Dividends Payable or Dividends Receivable. However, given that the dividend paid during the current period was from pre-acquisition equity and caused an impairment of the investment account that was recognised in Maggie Ltd’s accounts, this impairment will need to be eliminated on consolidation in the second adjusting entry (by reversing the entry recognising the impairment) as it is a direct effect of the intragroup transaction involving dividends. The impairment will impact retained earnings at the end of the period and therefore there will be further adjustments in the next periods to eliminate that impairment from the accumulated impairment losses on the investment account. (b) The adjusting entry eliminates the dividend revenue recognised by Maggie Ltd and the dividend declared recognised by Taylor Ltd during the current period. As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were not paid during the current period, there will be a need to eliminate Dividends Payable and Dividends Receivable in the second adjusting entry. 30 June 2023: (a) As previously mentioned, because the impairment loss recognised as a result of the dividend paid from pre-acquisition profits impacts retained earnings at 1 July 2022, there will be further adjustment in this current period to eliminate that impairment from the accumulated impairment losses on the investment account and from the retained earnings opening balance. (c) A similar explanation is used here as for the first adjusting entry at 30 June 2022 for the elimination of the intragroup dividend in (a). However, given that in this case the dividend is from post-acquisition equity, there is no need to post the second adjusting entry that reversed the impairment of the investment account caused by the dividends in (a).

28.41

Chapter 28: Consolidation: intragroup transactions

(d) The same explanation is used here as for the adjusting entry at 30 June 2022 for the elimination of the intragroup dividend in (b).

28.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Exercise 28.8 Current and prior period intragroup debentures Ross Ltd owns all the share capital of Geller Ltd. The following transactions are independent. (a) On 1 January 2022, Geller Ltd issues 20 000 debentures at the nominal value of $20 with an interest rate of 8% p.a., payable half-yearly on 30 June and 31 December each year. Debentures are to be redeemed after 3 years. Ross Ltd takes 100% of the debentures issued. (b) On 1 January 2022, Geller Ltd issues 20 000 debentures at the nominal value of $20 with an interest rate of 8% p.a., payable half-yearly on 30 June and 31 December each year. Debentures are to be redeemed after 3 years. Ross Ltd takes 50% of the debentures issued. (c) On 1 January 2022, Geller Ltd issues 20 000 debentures at the nominal value of $20 with an interest rate of 8% p.a., payable half-yearly on 30 June and 31 December each year. Debentures are to be redeemed after 3 years. Ross Ltd takes 25% of the debentures issued. On 31 March 2022, Ross Ltd acquired another 25% of these debentures cum div. on the open market for $9 each. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO7) 1. All transactions will need to be considered both at 30 June 2022 and 30 June 2023 as they all have effects in both periods. It should be noted here that even though adjusting entries for these transactions are posted at 30 June 2022, entries to eliminate the effects of the intragroup transactions that still exist at 30 June 2023 will still need to be made then; this will sometimes result in repeating some adjusting journal entries posted at 30 June 2022 as they are posted in the consolidation journal and do not carry over to the next period. 30 June 2022 (a)

Debentures Debentures in Geller Ltd

Dr Cr

400 000

Interest revenue Interest expense

Dr Cr

16 000

(b) Debentures Debentures in Geller Ltd

Dr Cr

200 000

Interest revenue Interest expense

Dr Cr

8 000

Debentures

200 000

(c)

400 000

16 000

200 000

8 000

28.43

Chapter 28: Consolidation: intragroup transactions

Debentures in Geller Ltd Gain on redemption

Cr Cr

143 000 57 000

Income tax expense Deferred tax liability

Dr Cr

17 100

Interest revenue Interest expense

Dr Cr

6 000

Debentures Debentures in Geller Ltd

Dr Cr

400 000

Interest revenue Interest expense

Dr Cr

16 000

Debentures Debentures in Geller Ltd

Dr Cr

200 000

Interest revenue Interest expense

Dr Cr

16 000

Debentures Debentures in Geller Ltd Retained earnings (1/7/22)

Dr Cr Cr

200 000

Retained earnings (1/7/22) Deferred tax liability

Dr Cr

17 100

Interest revenue Interest expense

Dr Cr

16 000

17 100

6 000

30 June 2023 (a)

(b)

(c)

400 000

16 000

200 000

16 000

188 000 57 000

17 100

16 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The first adjusting entry is needed to eliminate the liability recognised by Geller Ltd for the debentures that are taken up by Ross Ltd (as it is an intragroup liability) and the investment in those debentures recognised by Ross Ltd (as it is an intragroup investment). As all debentures are held intragroup and Ross Ltd paid for them the nominal value, the amount to be eliminated is the nominal value of all debentures issued by Geller Ltd. The second adjusting entry eliminates the current period’s intragroup interest revenue recognised by Ross Ltd and the interest expense recognised by Geller Ltd on the debentures issued intragroup. None of those adjusting entries have a tax effect as they do not have any net impact on the consolidated profit. (b) The first adjusting entry is needed to eliminate the liability recognised by Geller Ltd for the debentures that are taken up by Ross Ltd (as it is an intragroup liability) and the investment in those debentures recognised by Ross Ltd (as it is an intragroup investment). As only 50% of

28.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. the debentures issued are held intragroup and Ross Ltd paid for them the nominal value, the amount to be eliminated is the nominal value of half of the debentures issued by Geller Ltd. The second adjusting entry eliminates the current period’s intragroup interest revenue recognised by Ross Ltd and the interest expense recognised by Geller Ltd on the debentures issued intragroup, i.e. half on the debentures issued. None of those adjusting entries have a tax effect as they do not have any net impact on the consolidated profit. (c) The first adjusting entry is needed to eliminate the liability recognised by Geller Ltd for the debentures that are taken up by Ross Ltd (as it is an intragroup liability) and the investment in those debentures recognised by Ross Ltd (as it is an intragroup investment). However, as Ross Ltd did not pay the nominal value for all the debentures taken, the balance of the investment account to be eliminated needs to be calculated as follows: • for the debentures taken on issue (25% of all debentures issued), Ross Ltd paid the nominal value of $20 which was recognised in the investment account as 25% x 20 000 x $20 = $100 000. • for the debentures acquired on open market (another 25% of all debentures issued), Ross Ltd paid $9 each, but it acquired them on a cum div. basis. That means that Ross Ltd will receive the interest that was not paid on those debentures prior to their acquisition up to the moment of acquisition. That interest is considered as a refund on the consideration transferred for those debentures; Ross Ltd will also receive the interest on those debentures for the period starting from acquisition which is recognised as part of the interest revenue. Therefore, the interest for the period from 1 January 2022 to 31 March 2022 (3 months’ worth, i.e. 25% x 20 000 x $20 x 8% x 3/12 = $2 000) on those debentures acquired on open market is considered as reducing the consideration transferred for those debentures and so the investment account recognises for those debentures acquired on open market an amount of 25% x 20 000 x $9 - $2 000 = $43 000. Given that there is a difference between the amount to be eliminated from the Debentures liability (i.e. 50% x 20 000 x $20 = $200 000 as half of the debentures issued are now held intragroup) and the amount in the investment account to be eliminated (i.e. $100 000 for the debentures taken on issue + $43 000 for the debentures acquired after = $143 000), the adjusting journal entry will need to recognise this difference as a gain on early redemption of debentures. The treatment of this difference as a gain on redemption is due to the fact that holding those debentures intragroup is equivalent to their redemption from the group’s perspective: the group, through Geller Ltd initially issued those debentures and then the group, though Ross Ltd, took them back, i.e. “redeemed” them. If this gain is considered to be taxable from the group’s perspective, a deferred tax effect needs to be recognised in the second adjusting entry to recognise that the tax on this gain has not been paid and it is deferred for the future. The third adjusting entry should eliminate the interest revenue recognised by Ross Ltd and the equivalent interest expense recognised by Geller Ltd on the debentures held intragroup. The amount of the intragroup interest that is eliminated is $6 000 calculated as follows: • for the debentures taken on issue (25% of all debentures issued), Ross Ltd recognises a current period interest of 6 months’ worth from the issue until 30 June 2022 equal to 25% x 20 000 x $20 x 8% x 6/12= $4000.

28.45

Chapter 28: Consolidation: intragroup transactions

•

for the debentures acquired on open market (another 25% of all debentures issued), Ross Ltd recognises as revenue the interest for the period from 1 April 2022 to 30 June 2022 (3 months’ worth) equal to $2 000.

This last adjusting entry has no tax effect as it do not have any net impact on the consolidated profit. 30 June 2023: (a) The adjusting entries now are similar to the adjusting entries posted for this intragroup transaction at 30 June 2022. The only difference is the amount eliminated in the adjusting entry for interest. As debentures were held intragroup for the entire period ended 30 June 2023, not just for 6 months as in the prior period, the amount is double than before, i.e. 20 000 x $20 x 8% = $32 000. (b) The adjusting entries now are similar to the adjusting entries posted for this intragroup transaction at 30 June 2022. The only difference is the amount eliminated in the adjusting entry for interest. As debentures were held intragroup for the entire period ended 30 June 2023, not just for 6 months as in the prior period, the amount is double than before, i.e. 50% x 20 000 x $20 x 8% = $16 000. (c) The adjusting entries now are similar to the adjusting entries posted for this intragroup transaction at 30 June 2022. The differences are: • the amount of gain on early redemption is recognised against the Retained earnings (1/7/22) as it was generated when the debentures are taken by Ross Ltd, i.e. in the previous period; the related tax effect on this gain is also recognised against the Retained earnings (1/7/22), but as a debit. • the amount of intragroup interest to be eliminated is the interest for the period from 1 July 2022 to 30 June 2023 on the debentures held intragroup; as 50% of all the debentures issued are held intragroup for the whole period, the interest to be eliminated is 50% x 20 000 x $20 x 8% = $16 000.

28.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Exercise 28.9 Current and prior period intragroup borrowings Tony Ltd owns all the share capital of Sean Ltd. The following transactions are independent. (a) Sean Ltd gives $50 000 as an interest-free loan to Tony Ltd on 1 July 2021. Tony Ltd made a $20 000 repayment by 30 June 2022. (b) Sean Ltd borrows $50 000 from Tony Ltd on 1 July 2021 with an interest rate of 6% p.a. The interest is to be paid annually in arrears, starting on 30 June 2022. (c) Sean Ltd borrows $50 000 from Tony Ltd on 31 December 2021 with an interest rate of 6% p.a. The interest is to be paid annually in advance, starting on 31 December 2021. (d) Sean Ltd borrows $50 000 from Tony Ltd on 31 December 2021 with an interest rate of 6% p.a. The interest is to be paid biannually in arrears, starting on 30 June 2022. (e) Sean Ltd borrows $50 000 from Tony Ltd on 1 July 2021 with an interest rate of 6% p.a. The interest is to be paid biannually in advance, starting on 1 July 2021. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2 and LO7) 1. All transactions will need to be considered both at 30 June 2022 and 30 June 2023 as they all have effects in both periods. It should be noted here that even though adjusting entries for these transactions are posted at 30 June 2022, entries to eliminate the effects of the intragroup transactions that still exist at 30 June 2023 will still need to be made then; this will sometimes result in repeating some adjusting journal entries posted at 30 June 2022 as they are posted in the consolidation journal and do not carry over to the next period. 30 June 2022 (a)

(b)

(c)

Loan from Sean Ltd Loan to Tony Ltd

Dr Cr

30 000

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense

Dr Cr

3 000

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense

Dr Cr

1 500

30 000

50 000

3 000

50 000

1 500

28.47

Chapter 28: Consolidation: intragroup transactions

Interest received in advance Prepaid interest

Dr Cr

1 500

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense

Dr Cr

1 500

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense 30 June 2023

Dr Cr

3 000

(d)

(e)

1 500

50 000

1 500

50 000

3 000

The entries for (a), (b) and (e) are the same as at 30 June 2022 to the extent that the loans are not fully or partly paid back during the period ended 30 June 2023. (c)

(d)

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense

Dr Cr

3 000

Interest received in advance Prepaid interest

Dr Cr

1 500

Loan from Tony Ltd Loan to Sean Ltd

Dr Cr

50 000

Interest revenue Interest expense

Dr Cr

3 000

50 000

3 000

1 500

50 000

3 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The only adjusting entry is needed to eliminate the liability recognised by Tony Ltd for the loan taken from Sean Ltd (as it is an intragroup liability) and the receivable recognised by Sean Ltd for the amount it lends to Tony Ltd and that should be paid back to them (as it is an intragroup receivable). As $20 000 out of the initial loan of $50 000 was paid back by 30 June 2022, only the remaining amount needs to be eliminated. There are no other adjusting entries as there is no interest on the loan. (b) The first adjusting entry is needed to eliminate the liability recognised by Sean Ltd for the loan taken from Tony Ltd (as it is an intragroup liability) and the receivable recognised by Tony Ltd for the amount it lends to Sean Ltd and that should be paid back to them (as it is an intragroup receivable). As the loan is not an interest free loan, a second adjusting entry is needed to eliminate the intragroup interest recognised as revenue by Tony Ltd and expense by

28.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Sean Ltd during the current period. As the interest was paid on 30 June 2022 only for the current period up to that date, there is no interest payable, receivable, prepaid interest or interest received in advance that needs to be eliminated. There is also no tax effect entry as none of the adjusting entries posted have any net impact on the consolidated profit. (c) The first adjusting entry is needed to eliminate the liability recognised by Sean Ltd for the loan taken from Tony Ltd (as it is an intragroup liability) and the receivable recognised by Tony Ltd for the amount it lends to Sean Ltd and that should be paid back to them (as it is an intragroup receivable). As the loan is not an interest free loan, a second adjusting entry is needed to eliminate the intragroup interest recognised as revenue by Tony Ltd and expense by Sean Ltd during the current period. As the interest was paid on 31 December 2021 in advance for the period starting on that date up to 31 December 2022, the payment covers not only the current period ended 30 June 2022, but also the next period. Therefore, a third journal entry is required to eliminate the prepaid interest and interest received in advance for the period from 1 July 2022 to 31 December 2022. There is no tax effect entry as none of the adjusting entries posted have any net impact on the consolidated profit. (d) As for transaction (b), the first adjusting entry for this transaction is needed to eliminate the liability recognised by Sean Ltd for the loan taken from Tony Ltd (as it is an intragroup liability) and the receivable recognised by Tony Ltd for the amount it lends to Sean Ltd and that should be paid back to them (as it is an intragroup receivable). As the loan is not an interest free loan, a second adjusting entry is needed to eliminate the intragroup interest recognised as revenue by Tony Ltd and expense by Sean Ltd during the current period. As the interest was paid on 30 June 2022 only for the current period up to that date, there is no interest payable, receivable, prepaid interest or interest received in advance that needs to be eliminated. There is also no tax effect entry as none of the adjusting entries posted have any net impact on the consolidated profit. (e) The first adjusting entry for this transaction is needed to eliminate the liability recognised by Sean Ltd for the loan taken from Tony Ltd (as it is an intragroup liability) and the receivable recognised by Tony Ltd for the amount it lends to Sean Ltd and that should be paid back to them (as it is an intragroup receivable). As the loan is not an interest free loan, a second adjusting entry is needed to eliminate the intragroup interest recognised as revenue by Tony Ltd and expense by Sean Ltd during the current period. As the interest was paid on 1 July 2021 and 1 January 2022 only for the current period up to 30 June 2022, there is no interest payable, receivable, prepaid interest or interest received in advance that needs to be eliminated. There is also no tax effect entry as none of the adjusting entries posted have any net impact on the consolidated profit. 30 June 2023: The explanations for the adjusting entries for transactions (a), (b) and (e) are the same as those explanations for the adjustments for the period ended 30 June 2022. That is because the journal entries are exactly the same as it is assumed there are no repayments on the loans during the period and the interest, if any, is the same across the two periods. For (c) and (d), the only difference between the adjustment entries posted at 30 June 2023 and the ones posted at 30 June 2022 for these intragroup transactions is in terms of the amount eliminated as the intragroup interest for the period. In the period ended 30 June 2022, the intragroup interest was only for 6 months as the loan started on 31 December 2021. However,

28.49

Chapter 28: Consolidation: intragroup transactions

for the period ended 30 June 2023, the intragroup interest is for the whole year and that is the amount to be eliminated now from the interest revenue recognised by Tony Ltd and the interest expense recognised by Sean Ltd.

28.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Exercise 28.10 Intragroup transfers of inventories, non-current assets, services and dividends Karen Ltd owns all the share capital of Anne Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2021 to 30 June 2023. (a) In February 2021, Karen Ltd sold inventories to Anne Ltd for $6000, at a mark-up of 20% on cost. One-quarter of this inventories were unsold by Anne Ltd at 30 June 2021 to external parties and none at 30 June 2022. (b) On 1 January 2021, Anne Ltd sold a new tractor to Karen Ltd for $20 000. This had cost Anne Ltd $16 000 on that day. Both entities charged depreciation at the rate of 10% p.a. on the diminishing balance. The tractor was still on hand with Karen Ltd at 30 June 2023. (c) A non-current asset with a carrying amount of $1000 was sold by Karen Ltd to Anne Ltd for $800 on 1 January 2023. Anne Ltd intended to use this item as inventories, being a seller of second-hand goods. The item was still on hand at 30 June 2023. (d) Anne Ltd rented a spare warehouse to Karen Ltd starting from 1 July 2022 for 1 year. The total charge for the rental was $300, and Karen Ltd paid half of this amount to Anne Ltd on 1 January 2020 and the rest is to be paid on 1 July 2023. (e) In December 2022, Anne Ltd paid a $1500 interim dividend. (f) During March 2023, Anne Ltd declared a $3000 dividend. The dividend was paid in August 2023. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2, LO3, LO4, LO5 and LO6) 1. At 30 June 2022, there will only be adjusting entries for transactions (a) and (b) as these are the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023, there will be adjusting entries for all transactions excluding (a) for which the intragroup profit was fully realised by the beginning of that period. 30 June 2022 (a)

(b)

Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

175 75

Retained earnings (1/7/21) Deferred tax asset Tractor

Dr Dr Cr

2 800 1 200

Accumulated depreciation - tractor Retained earnings (1/7/21) Depreciation expense

Dr Cr Cr

580

Retained earnings (1/7/21)

250

4 000

200 380

28.51

Chapter 28: Consolidation: intragroup transactions

Income tax expense Deferred tax asset

Dr Cr

114

Retained earnings (1/7/22) Deferred tax asset Tractor

Dr Dr Cr

2 800 1 200

Accumulated depreciation - tractor Retained earnings (1/7/22) Depreciation expense

Dr Cr Cr

922

Retained earnings (1/7/22) Income tax expense Deferred tax asset

Dr Dr Cr

174 103

Proceeds on sale of non-current asset (NCA) Dr Inventories Dr Carrying amount of NCA sold Cr

800 200

Inventories Loss on sale of non-current asset

Dr Cr

200

Income tax expense Deferred tax liability

Dr Cr

(d) Rent revenues Rent expenses

Dr Cr

300

Rent payable Rent receivable

Dr Cr

150

Dividend revenue Dividend paid

Dr Cr

1 500

Dividend revenue Dividend declared

Dr Cr

3 000

Dividend payable Dividend receivable

Dr Cr

3 000

174

30 June 2023 (b)

(c)

4 000

580 342

277

1 000

(e)

(f)

200

300

150

1 500

3 000

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) In this case, the unrealised profit in closing inventories from the period ended 30 June 2021 and recognised as unrealised profit in opening inventories in this period becomes realised by the end of the current period (the assumption is that the remaining inventories still on hand

28.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. with the group at 30 June 2021 are sold to external entities by the end of the current period). As such, this profit needs to be transferred from the previous period to the current period by: • Debiting Retained Earnings (1/7/21) with an amount equal to the after-tax unrealised profit in opening inventories – this eliminates the unrealised profit from the prior period’s profit • Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profit to the current period, the current period profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in opening inventories. (b) The first journal entry eliminates the after-tax profit on sale of the tractor intragroup from the previous period’s profits as the intragroup sale took place in the previous period and generated unrealised profits from the group’s perspective. The adjusting entry will also bring down the balance of the tractor account to reflect the original carrying amount of the tractor before the intragroup sale. As this entry decreases the carrying amount of the tractor, without any effect on its tax base, a deferred tax asset needs to be recognised for the deductible temporary difference created or, using another explanation, for the tax that was paid by Anne Ltd on the unrealised profit on the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is necessary to adjust the depreciation expenses recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the previous and current period’s depreciation expenses are overstated and should be decreased by amounts calculated and recorded as follows. • For the previous period’s depreciation: Karen Ltd records a previous period’s depreciation of $20 000 x 10% x 6/12 = $1000, while the group should record a previous period’s depreciation of $16 000 x 10% x 6/12 = $800. Therefore, the adjustment would be a decrease of $200 in previous period’s expenses which will be recorded as a credit to Retained Earnings (1/7/21) as previous period’s expenses are now in the retained earnings. • For the current period’s depreciation: Karen Ltd records a current depreciation of ($20 000 - $1000) x 10% = $1900, while the group should record a depreciation of ($16 000 - $800) x 10% = $1520. Therefore, the adjustment would be a decrease of $380 in current expenses which will be recorded as a credit to Depreciation expense. Overall, the accumulated depreciation is adjusted by the total adjustment to depreciation, i.e. $580. It should be noted that these adjustments to depreciation expenses increase the previous and the current profit and therefore it is said to be an indication that a part of the profit on the intragroup sale is now realised. The third adjusting entry is recognising the tax effect of the second entry. As a part of the intragroup gain is now realised through the depreciation adjustments, this entry adjusts the tax effect recognised in the first entry that eliminated the gain on the intragroup sale. This taxeffect entry is needed because the depreciation adjustment entry increases the carrying amount of the asset, with no effect on the tax base and therefore decreases the deductible temporary

28.53

Chapter 28: Consolidation: intragroup transactions

difference that was recorded in the deferred tax asset when eliminating the gain on the intragroup sale. 30 June 2023: (b) The first journal entry is the same as the first entry for this intragroup transaction at 30 June 2022 because the tractor is still on hand with the group and the intragroup profit is still unrealised. The second adjusting entry is similar to the depreciation adjustment entry at 30 June 2022 with the following differences: • the amount credited to Retained earnings (1/7/22) represents the depreciation adjustments for the periods ended 30 June 2021 and 30 June 2022 (i.e. $580 in total). • the amount credited to Depreciation expense for the current period’s depreciation is the difference between what Karen Ltd records as current depreciation, i.e. ($20 000 - $1000 - $1900) x 10% = $1710, and what the group should record as depreciation, i.e. ($16 000 - $800 - $1520) x 10% = $1368. Therefore, the adjustment to current depreciation would be $342. • overall, the accumulated depreciation is adjusted by the total adjustment to depreciation, i.e. $580 + $342 = $922. The third adjusting entry is recognising the tax effect of the second entry. (c) The first journal entry eliminates the proceeds on sale of the non-current asset intragroup and the carrying amount of the asset sold recognised at the movement of the intragroup sale or alternatively the loss on the intragroup sale of the non-current asset which is unrealised from the point of view of the group. This adjusting entry will also bring up the balance of the asset account (now treated as inventories) to reflect the original carrying amount of the asset before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the loss on sale (which increases the current profit) and increases the carrying amount of the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to increase and a deferred tax liability needs to be recognised for the taxable temporary difference created or, using another explanation, for the tax that should have been paid by Karen Ltd if it wouldn’t have claimed the unrealised loss on the intragroup sale as a tax deduction. It should be noted here that although the original classification of the asset before the intragroup sale was a non-current asset, there won’t be any reclassification needed on consolidation as, from the group’s perspective, the asset is going to be used as inventories from the moment of the intragroup sale. As a consequence of this, there won’t be any depreciation adjustments or the related tax effect. (d) The current period’s rent expense recognised by Karen Ltd and rent revenue recognised by Anne Ltd is one full year of rent of $300. As the consolidated financial statements should not recognise this intragroup rent, the first adjusting entry will eliminate this amount. As this adjusting entry does not have any net impact of the profit there won’t be any tax-effect adjusting entry.

28.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. As the rent was only paid during the next period on 1 July 2023, at 30 June 2023 there will be rent payable for the current period recognised by Karen Ltd and the equivalent rent receivable recognised by Anne Ltd; therefore the second adjustment entry will need to eliminate these further effects of the intragroup transaction. (e) The adjusting entry eliminates the dividend revenue recognised by Karen Ltd and the dividend paid recognised by Anne Ltd during the current period. As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were paid during the current period, there won’t be a need to eliminate any Dividends Payable or Dividends Receivable. (f) The adjusting entry eliminates the dividend revenue recognised by Karen Ltd and the dividend declared recognised by Anne Ltd during the current period. As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were not paid during the current period, there will be a need to eliminate Dividends Payable and Dividends Receivable in the second adjusting entry.

28.55

Chapter 28: Consolidation: intragroup transactions

Exercise 28.11 Intragroup transfers of inventories, non-current assets, services and borrowings Kaitlyn Ltd owns all the share capital of Eve Ltd. The income tax rate is 30%. The following transactions took place during the periods ended 30 June 2022 or 30 June 2023. (a) On 1 May 2022, Eve Ltd sold inventories costing $600 to Kaitlyn Ltd for $1200 on credit. On 30 June 2022, only half of these goods had been sold by Kaitlyn Ltd, and Kaitlyn Ltd had paid $600 to Eve Ltd. All remaining inventories were sold to external entities by 30 June 2023 and Kaitlyn Ltd paid the outstanding amount to Eve Ltd on 5 May 2023. (b) On 1 January 2022, Kaitlyn Ltd sold an item of plant to Eve Ltd for $10 000. Immediately before the sale, Kaitlyn Ltd had the item of plant on its accounts for $12 000. Kaitlyn Ltd depreciated items at 5% p.a. on the diminishing balance and Eve Ltd used the straight-line method over 10 years. (c) An inventories item with a cost of $4000 was sold by Kaitlyn Ltd to Eve Ltd for $3600 on 1 January 2023. Eve Ltd intended to use this item as equipment. Both entities charge depreciation at the rate of 10% p.a. on the diminishing balance on noncurrent assets. The item was still on hand at 30 June 2023. (d) Kaitlyn Ltd provided management services to Eve Ltd during the period ended 30 June 2023. The total charge for those services was $5000 that was unpaid at 30 June 2023. (e) Kaitlyn Ltd borrows $60 000 from Eve Ltd on 1 July 2021 with an interest rate of 6% p.a. The loan is for 5 years. The interest is to be paid biannually in arrears, starting on 31 December 2021. Required In relation to the above intragroup transactions: 1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023. 2. Explain in detail why you made each adjusting journal entry. (LO2, LO3, LO4, LO5 and LO7) 1. At 30 June 2022, there will only be adjusting entries for transactions (a), (b) and (e) as these are the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023, there will be adjusting entries for all transactions. 30 June 2022 (a)

(b)

Sales revenue Cost of sales Inventories

Dr Cr Cr

1 200

Deferred tax asset Income tax expense

Dr Cr

Accounts payable Accounts receivable

Dr Cr

600

Proceeds on sale of plant Plant

Dr Dr

10 000 2 000

900 300

600

28.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Carrying amount of plant sold

12 000

Dr Cr

2 000

Loss on sale of plant Income tax expense Deferred tax liability

Dr Cr

600

Depreciation expense Accumulated depreciation - plant

Dr Cr

100

Deferred tax liability Income tax expense

Dr Cr

Loan from Eve Ltd Loan to Kaitlyn Ltd

Dr Cr

60 000

Interest revenue Interest expense

Dr Cr

3 600

Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

210 90

Plant

Dr Cr

32 000

Retained earnings (1/7/22) Deferred tax liability

Dr Cr

600

Depreciation expense Retained earnings (1/7/22) Accumulated depreciation - plant Deferred tax liability Income tax expense Retained earnings (1/7/19)

Dr Dr Cr Dr Cr Cr

200 100

Equipment Sales revenue Cost of sales

Dr Dr Cr

400 3 600

Income tax expense Deferred tax liability

Dr Cr

120

Depreciation expense Dr Accumulated depreciation - equipment Cr

OR Plant

(e)

2 000

600

100

60 000

3 600

30 June 2023 (a)

(b)

Retained earnings (1/7/22)

(c)

300

2 000

600

300 90 60 30

4 000

120

28.57

Chapter 28: Consolidation: intragroup transactions

(d)

(e)

Deferred tax liability Income tax expense

Dr Cr

Management fees revenue Management fees expense

Dr Cr

5 000

Management fees payable Management fees receivable

Dr Cr

5 000

Loan from Eve Ltd Loan to Kaitlyn Ltd

Dr Cr

56 000

Interest revenue Interest expense

Dr Cr

3 600

5 000

60 000

3 600

2. Detailed explanations on the adjusting journal entries 30 June 2022: (a) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2022. As only half of the inventories transferred intragroup were sold in the current period to external parties, at 30 June 2022 half of the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price – this eliminates the amount recognised by Eve Ltd on the intragroup sale so that the consolidated figure reflects that no revenues have been generated from transactions with external parties. • Crediting Inventories with an amount equal to the unrealised profit on the intragroup sale – this corrects the overstatement of inventories still held by Kaitlyn Ltd which are recorded based at the intragroup price (i.e. 50% x $1200), making sure that those inventories are recorded at the original cost to the group (i.e. 50% x $600). • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by Eve Ltd (based on the original cost) and adjusts the Cost of Sales recognised by Kaitlyn Ltd (based on the intragroup price) so that the consolidated figure reflects only the cost of sales of the inventories sold to external entities based on their original cost to the group. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised by Eve Ltd on the intragroup unrealised profit. This tax adjustment is needed because the first adjustment entry adjusted downwards the carrying amount of inventories still on hand with no effect on the tax base and therefore created a deductible temporary difference that gives rise to a Deferred Tax Asset. The third adjusting entry is needed to eliminate the amount still unpaid intragroup by Kaitlyn Ltd. This amount is recognised by Kaitlyn Ltd in Accounts Payable and in Accounts Receivable by Eve Ltd and those accounts need to be eliminated as they represent intragroup liabilities and assets. (b) The first journal entry eliminates the proceeds on sale of plant intragroup and the carrying amount of plant sold recognised at the movement of the intragroup sale (or alternatively the

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. loss on sale of plant which is unrealised from the group’s perspective). The adjusting entry will also bring up the balance of the plant account to reflect the original carrying amount of the plant before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the loss on sale (which increases the current profit) and increases the carrying amount of the plant, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to increase and a deferred tax liability needs to be recognised for the taxable temporary difference created or, using another explanation, for the tax that should have been paid if Kaitlyn Ltd wouldn’t have claimed a deduction based on the unrealised loss on the intragroup sale. The third adjusting entry is necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is understated and should be increased by an amount equal to the depreciation rate multiplied by the loss on the intragroup sale, but only for half a year since the intragroup sale took place on 1 January 2022. Note that the depreciation method that is used by the new owner of the asset is the one used by the group as well as that reflect how the asset is being used in the group, i.e. the asset is being depreciated on a straight-line method over 10 years, so the depreciation rate is 10% p.a. It should also be noted that this adjustment to depreciation expense decreases the current profit and therefore it is said to be an indication that a part of the loss on the intragroup sale is now realised. As a part of the intragroup loss is now realised through the depreciation adjustments, the fourth adjusting entry adjusts the tax effect of the previous entry that eliminated the entire loss on the intragroup sale, basically reversing that previous tax effect entry for the part of the loss that is now realised. That is because the depreciation adjustment entry decreases the carrying amount of the asset, with no effect on the tax base and therefore decreases the taxable temporary difference that was recorded in the deferred tax liability when eliminating the loss on intragroup sale. (e) The first adjusting entry for this transaction is needed to eliminate the liability recognised by Kaitlyn Ltd for the loan taken from Eve Ltd (as it is an intragroup liability) and the receivable recognised by Eve Ltd for the amount it lends to Kaitlyn Ltd and that should be paid back to them (as it is an intragroup receivable). As the loan is not an interest free loan, a second adjusting entry is needed to eliminate the intragroup interest recognised as revenue by Eve Ltd and expense by Kaitlyn Ltd during the current period. As the interest was paid on 31 December 2021 and 30 June 2022 only for the current period up to 30 June 2022, there is no interest payable, receivable, prepaid interest or interest received in advance that needs to be eliminated. There is also no tax effect entry as none of the adjusting entries posted have any net impact on the consolidated profit. 30 June 2023: (a) In this case, the unrealised profit in closing inventories from the period ended 30 June 2022 and recognised as unrealised profit in opening inventories in this period becomes realised by the end of the current period. As such, this profit needs to be transferred from the previous period to the current period by: © John Wiley and Sons Australia Ltd, 2020

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Chapter 28: Consolidation: intragroup transactions

•

Debiting Retained Earnings (1/7/22) with an amount equal to the after-tax unrealised profit in opening inventories – this eliminates the unrealised profit from the prior period’s profit • Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profit to the current period, the current period profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in opening inventories. (b) The explanation for the adjusting journal entries posted now for the intragroup sale of the plant for a loss on 1 January 2022 is as follows: • the first adjusting entry increases the plant’s value up from the price paid intragroup to the original carrying amount of the plant at the moment of intragroup sale and eliminates the net loss on the intragroup sale of plant recorded in the previous period that is now in the Retained Earnings (1/7/22). • the second entry recognises the tax effect of the first entry by raising a deferred tax liability for the tax unpaid by the intragroup seller due to the loss that is unrealised from the group’s perspective and adjusting the Retained Earnings (1/7/22) for the previous period’s tax effect. • the third adjusting entry increases the depreciation expenses from the previous and current periods up from the depreciation recorded by the user of the plant (based on the intragroup price paid) to the depreciation expenses that should be recorded by the group (based on the carrying amount of the plant at the moment of the intragroup sale); the previous period’s depreciation expense is now in the Retained Earnings (1/7/22) and should be adjusted in there. • the fourth entry recognises the tax effect of the third entry by decreasing the deferred tax liability recognised in the second entry by the tax on the loss realised during the current and previous periods through the depreciations adjustments. (c) The first journal entry eliminates the intragroup sales revenue and cost of sales recognised by Kaitlyn Ltd as those should not be recorded from the group’s perspective. The adjusting entry will also bring up the balance of the equipment account to reflect the original carrying amount of the asset (initially recorded as inventories, but now reclassified as equipment) before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the loss on sale (which increases the current profit) and increases the carrying amount of the equipment, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to increase and a deferred tax liability needs to be recognised for the taxable temporary difference created or, using another explanation, for the tax that should have been paid if Kaitlyn Ltd wouldn’t have claimed a deduction based on the unrealised loss on the intragroup sale. The third adjusting entry is necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is understated and should be increased by an amount equal to the depreciation rate multiplied by the loss on the intragroup sale, but only for half a year since the

28.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. intragroup sale took place on 1 January 2023. It should be noted that this adjustment to depreciation expense decreases the current profit and therefore it is said to be an indication that a part of the loss on the intragroup sale is now realised. As a part of the intragroup loss is now realised through the depreciation adjustments, the fourth adjusting entry adjusts the tax effect of the previous entry that eliminated the entire loss on the intragroup sale, basically reversing that previous tax effect entry for the part of the loss that is now realised. That is because the depreciation adjustment entry decreases the carrying amount of the asset, with no effect on the tax base and therefore decreases the taxable temporary difference that was recorded in the deferred tax liability when eliminating the loss on intragroup sale. (d) The first adjusting entry eliminates the management fee revenue recognised by Kaitlyn Ltd and the management fee expense recognised by Eve Ltd during the current period. As this adjusting entry does not have any net impact of the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the management fees incurred this current period. As the management fees were not paid during the current period, there is a need to eliminate further accounts, i.e. Management Fees Payable and Management Fees Receivable. These accounts are eliminated in the second adjusting entry. (e) The explanation for the adjusting entries for this transaction at 30 June 2023 is exactly the same as that for the adjusting entries for this transaction at 30 June 2022.This is because the entries are exactly the same as those posted at 30 June 2022 as it is assumed there are no repayments on the loans during the period and the interest is the same across the two periods.

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Chapter 28: Consolidation: intragroup transactions

Exercise 28.12 Consolidation worksheet with pre-acquisition equity transfers and intragroup transactions On 1 January 2020, Olivia Ltd acquired all the share capital of Chloe Ltd for $300 000. The equity of Chloe Ltd at 1 January 2020 was as follows.

At this date, all identifiable assets and liabilities of Chloe Ltd were recorded at fair value. On 1 May 2023, Chloe Ltd transferred $15 000 from the general reserve (pre-acquisition) to retained earnings. The income tax rate is 30%. The following information has been provided about transactions between the two entities: (a) The beginning and ending inventories of Olivia Ltd and Chloe Ltd in relation to the current period ended on 31 December 2023 included the following inventories transferred intragroup:

Olivia Ltd sold inventories to Chloe Ltd during the current period for $3000. This was $500 above the cost of the inventories to Olivia Ltd. Chloe Ltd sold inventories to Olivia Ltd in the current period for $2500, recording a pre-tax profit of $800. (b) Olivia Ltd sold an inventories item to Chloe Ltd on 1 July 2023 for use as machinery. The item cost Olivia Ltd $4000 and was sold to Chloe Ltd for $6000. Chloe Ltd depreciated the item at a rate of 10% p.a. on cost. (c) On 31 December 2023, Chloe Ltd owes Olivia Ltd $1000 for items sold on credit. (d) Chloe Ltd undertook an advertising campaign for Olivia Ltd during the period ended 31 December 2023. Olivia Ltd was charged and paid $8000 to Chloe Ltd for this service. (e) Olivia Ltd received dividends totalling $63 000 during the current period ended 31 December 2023 from Chloe Ltd. These dividends were declared in the current period out of post-acquisition profits. Required 1. 2. 3.

Prepare the acquisition analysis at 1 January 2020. Prepare the business combination valuation entries and pre-acquisition entries at 1 January 2020. Prepare the business combination valuation entries and pre-acquisition entries at 31 December 2023. © John Wiley and Sons Australia Ltd, 2020

28.62

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Prepare the consolidation worksheet journal entries to eliminate the effects of intragroup transactions at 31 December 2023. (LO3, LO4, LO5, LO6 and LO7) 4.

1. At 1 January 2020: Net fair value of identifiable assets and liabilities of Chloe Ltd = = Consideration transferred = Goodwill =

$200 000 + $50 000 + $20 000 (equity) $270 000 $300 000 $30 000

2. Business combination valuation entry 1 January 2020 Goodwill Business combination valuation reserve

Dr Cr

30 000 30 000

Pre-acquisition entry at 1 January 2020 Retained earnings (1/1/20) Share capital General reserve Business combination valuation reserve Shares in Chloe Ltd

Dr Dr Dr Dr Cr

50 000 200 000 20 000 30 000 300 000

3. Business combination valuation entry 31 December 2023 Goodwill Business combination valuation reserve

Dr Cr

30 000 30 000

Pre-acquisition entry at 31 December 2023 Retained earnings (1/1/23) Share capital General reserve Business combination valuation reserve Shares in Chloe Ltd

Dr Dr Dr Dr Cr

50 000 200 000 20 000 30 000

Transfer from general reserve General reserve

Dr Cr

15 000

300 000

15 000

4. Adjustments for intragroup transactions at 31 December 2023 (a)

Retained earnings (1/1/23) Income tax expense Cost of sales

Dr Dr Cr

700 300

1 000

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Chapter 28: Consolidation: intragroup transactions

Sales revenue Cost of sales Inventories

Dr Cr Cr

5 500

Deferred tax asset Income tax expense

Dr Cr

120

5 100 400

120

The first adjusting entry deals with the unrealised profits in opening (beginning) inventories. It is assumed that the unrealised profits in closing inventories from the period ended 31 December 2022 and recognised as unrealised profits in opening inventories in this period (i.e. $2000 $1400 for Olivia Ltd and $1200 - $800 for Chloe Ltd) become realised by the end of the current period. As such, these profits need to be transferred from the previous period to the current period by: • Debiting Retained Earnings (1/1/20) with an amount equal to the after-tax unrealised profits in opening inventories (i.e. $1000 x (1 – 30%)) – this eliminates the unrealised profits from the prior period’s profit. • Crediting Cost of Sales with an amount equal to the before-tax unrealised profits in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profits to the current period, the current period’s profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profits in opening inventories. The second adjusting entry eliminates the unrealised profits in closing (ending) inventories of Olivia Ltd and Chloe Ltd at 31 December 2023. As inventories that were originally transferred intragroup are still on hand with both entities at 31 December 2023, the profits related to those inventories items are unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price for current period sales from both Olivia Ltd to Chloe Ltd (i.e. $3000) and from Chloe Ltd to Olivia (i.e. $2500) – this eliminates the amount of revenue recognised by the entities on the intragroup sales so that the consolidated figure reflects only the sales revenues generated from transactions with external parties. • Crediting Inventories with an amount equal to the unrealised profits in ending inventories ($500 - $300 for Olivia Ltd and $900 - $700 for Chloe Ltd) – this corrects the overstatement of inventories still on hand that are recorded by the entities based on the intragroup price, making sure that those inventories are recorded at the original cost to the group. • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by the entities on the intragroup sales (based on the original cost) and adjusts the Cost of Sales recognised by the entities on external sales (based on the intragroup price) so that the consolidated figure reflects only the cost of sales of the inventories sold to the external parties based on their original cost to the group. The second adjusting entry recognises the tax effect of the elimination of the unrealised profits in closing inventories at 31 December 2023 by raising a Deferred Tax Asset for the tax recognised by Olivia Ltd and Chloe Ltd, in advance on the unrealised intragroup profits.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. It is worth noting that the entire profits on the current period’s intragroup sales do not matter for the adjusting entries; it is only the unrealised profits in closing inventories that are considered as they are the ones that need to be eliminated. (b)

Sales revenue Cost of sales Plant & machinery

Dr Cr Cr

6 000

Deferred tax asset Income tax expense

Dr Cr

600

Accumulated depreciation – plant & machinery Depreciation expense (10% x 1/2 x $2000)

Dr Cr

100

Income tax expense Deferred tax asset

Dr Cr

4 000 2 000

600

100

The first adjusting entry decreases the machine’s value down from the price paid intragroup to the original carrying amount of the machine at the moment of intragroup sale and eliminates the sales revenue and the cost of sales recognised on the intragroup sale, considering that the machine was recognised by the initial owner as inventories; the second entry recognises the tax effect of the first entry by raising a Deferred Tax Asset for the tax paid by the intragroup seller on the profit that is unrealised from the group’s perspective (i.e. the entire profit on the intragroup sale). The third adjusting entry decreases the depreciation expense recognised for the machine down from the depreciation recorded by the user of the vehicle (based on the intragroup price paid) to the depreciation that should be recorded by the group (based on the carrying amount of the machine at the moment of the intragroup sale). The annual depreciation adjustment is equal to the intragroup profit multiplied by the depreciation rate per year. As the asset was transferred intragroup on 1 July 2023, six months before the end of the current period, the depreciation adjustment is only half of the annual depreciation adjustment, i.e. ($6000 - $4000) x 10% x ½. This depreciation adjustment decreases the expenses for the current period and therefore increases the current profit by a part of the profit on the intragroup sale. As such, it is said that a part of the intragroup profit has been realised. The fourth entry recognises the tax effect of the third entry by decreasing the Deferred Tax Asset recognised in the second entry by the tax on the profit realised through the depreciation adjustment. It should be noted here that although the original classification of the asset before the intragroup sale was inventories, there won’t be any reclassification needed on consolidation as, from the group’s perspective, the asset is going to be used as a machine from the moment of the intragroup sale. (c)

Accounts payable Accounts receivable

Dr Cr

1 000 1 000

As Chloe Ltd owes Olivia Ltd for items purchased during the period, in the individual accounts a liability Accounts Payable is recognised by Chloe Ltd and an asset Accounts Receivable is

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Chapter 28: Consolidation: intragroup transactions

recognised by Olivia Ltd. As those accounts reflect obligations and resources receivable from within the group, they are eliminated on consolidation in this adjusting entry. (d)

Revenue - services fees Advertising expenses

Dr Cr

8 000 8 000

This adjusting entry eliminates the services fee revenue recognised by Chloe Ltd and the advertising expense recognised by Olivia Ltd as a result of the advertising campaigned that ran intragroup during the current period. As this adjusting entry does not have any net impact on the profit: • there won’t be any tax-effect adjusting entry • there won’t be any further adjusting entries in the next period for the fees incurred this current period. As the services fees were paid during the current period, there won’t be a need to eliminate any another accounts during the current period as there is no Services Fees Payable or Services Fees Receivable. Also, there were no services fees paid in advance for the next period and therefore there are no Prepaid Services Fees and Services Fees Received in Advance to eliminate. (e)

Dividend revenue Dividend paid

Dr Cr

63 000 63 000

This adjusting entry eliminates the dividend revenue recognised by Olivia Ltd and the dividend paid recognised by Chloe Ltd during the current period. As this adjusting entry does not have any net impact of the consolidated retained earnings, there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were paid during the current period, there won’t be a need to eliminate any Dividends Payable or Dividends Receivable.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Exercise 28.13 Consolidation with differences between carrying amount and fair value at acquisition date, impairment of goodwill and intragroup transactions Financial information for Skye Ltd and its 100% owned subsidiary, Blue Ltd, for the period ended 31 December 2023 is provided below. Skye Ltd Sales revenue

Blue Ltd

$ 50 000

$ 47 200

Dividend revenue

2 000

Gain on sale of property, plant and equipment

2 000

4 000

Other income

2 000

4 000

Total income

56 000

55 200

Cost of sales

42 000

36 000

Other expenses

6 000

2 000

Total expenses

48 000

38 000

Profit before income tax

8 000

17 200

Income tax expense

2 700

3 900

Profit for the period

5 300

13 300

Retained earnings (1/1/23)

12 000

6 000

17 300

19 300

Interim dividend paid

5 000

2 000

Retained earnings (31/12/23)

12 300

17 300

Skye Ltd acquired its shares in Blue Ltd at 1 January 2023 for $40 000 on a cum div. basis. At that date, Blue Ltd recorded share capital of $20 000. Blue Ltd had declared prior to the acquisition a dividend of $6000 that was paid in March 2023. At 1 January 2023, all identifiable assets and liabilities of Blue Ltd were recorded at fair value except for inventories, for which the carrying amount was $800 less than fair value. Some of the inventories has been a little slow to sell, and 10% of it is still on hand at 31 December 2023. Inventories on hand in Blue Ltd at 31 December 2023 also includes some items acquired from Skye Ltd during the period ended 31 December 2023. These were sold by Skye Ltd for $10 000, at a profit before tax of $2000. Half of the goodwill on acquisition of Blue Ltd by Skye Ltd was written off as the result of an impairment test on 31 December 2023. During March 2023, Skye Ltd provided some management services to Blue Ltd at a fee of $1000 paid by 31 December 2023.

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Chapter 28: Consolidation: intragroup transactions

On 1 July 2023, Blue Ltd sold machinery to Skye Ltd at a gain of $4000. This machinery had a carrying amount to Blue Ltd of $40 000, and was considered by Skye Ltd to have a 5-year life. By 31 December 2023, the financial assets acquired by Skye Ltd and Blue Ltd from external entities increased in value by $2000 and $1300 respectively with gains and losses being recognised in other comprehensive income. The income tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 January 2023. 2. Prepare the business combination valuation entries and pre-acquisition entries at 1 January 2023. 3. Prepare the business combination valuation entries and pre-acquisition entries at 31 December 2023. 4. Prepare the consolidation worksheet journal entries to eliminate the effects of intragroup transactions at 31 December 2023. 5. Discuss the concept of ‘realisation’ using the intragroup transactions in this question to illustrate the concept. 6. Prepare the consolidation worksheet for the preparation of the consolidated financial statements for the period ended 31 December 2023. 7. Prepare the consolidated statement of profit or loss and other comprehensive income for Skye Ltd and its subsidiary, Blue Ltd, at 31 December 2023. (LO1, LO2, LO3, LO4, LO5, LO6 and LO7) 1. At 1 January 2023: Net fair value of identifiable assets and liabilities of Blue Ltd =

Net consideration transferred Goodwill

= = = = =

($20 000 + $6 000) (equity) + $800 (1 – 30%) (BCVR - inventories) $26 560 $40 000 - $6 000 (dividend) $34 000 $34 000 - $26 560 $7 440

2. Business combination valuation entries at 1 January 2023 Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

800

Goodwill Business combination valuation reserve

Dr Cr

7 440

Dr Dr Dr Cr

6 000 20 000 8 000

240 560

7 440

Pre-acquisition entries at 1 January 2023 Retained earnings (1/1/23) Share capital Business combination valuation reserve Shares in Blue Ltd

34 000

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. Dividend payable Dividend receivable

Dr Cr

6 000 6 000

Note that the adjusting entry for these dividends is posted here as they relate to pre-acquisition equity being declared prior to the acquisition. This adjusting entry related to intragroup preacquisition dividends eliminates from the individual financial statements the dividend payable recognised by Blue Ltd and the dividend receivable recognised by Skye Ltd during the current period. As these dividends would be paid by 31 December 2023, this entry does not need to be repeated then. There is no adjustment to Dividend Revenue as Skye Ltd did not recognise these dividends as revenue, but as a refund on the consideration transferred as they were declared prior to the acquisition. Moreover, since these dividends were declared prior to the acquisition, there is no need to adjust Dividend Declared recognised by Blue Ltd. 3. (1) Business combination valuation entries at 31 December 2023 Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

720

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

Goodwill Business combination valuation reserve

Dr Cr

7 440

Retained earnings (1/1/23) Share capital Business combination valuation reserve Shares in Blue Ltd

Dr Dr Dr Cr

6 000 20 000 8 000

Transfer from business combination valuation reserve Business combination valuation reserve

Dr Cr

504

Impairment loss - goodwill Accumulated impairment losses

Dr Cr

3 720

216 504

24 56

7 440

(2) Pre-acquisition entries at 31 December 2023

34 000

504

3 720

4. Elimination of the effects of intragroup transactions at 31 December 2023 (3) Dividend paid Dividend revenue Interim dividend paid

Dr Cr

2 000 2 000

This adjusting entry eliminates from the individual financial statements the dividend revenue recognised by Skye Ltd and the dividend paid recognised by Blue Ltd during the current period

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Chapter 28: Consolidation: intragroup transactions

for the post-acquisition dividends. As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were paid during the current period, there won’t be a need to eliminate any Dividends Payable or Dividends Receivable. (4) Sales of inventories Sales revenue Cost of sales Inventories

Dr Cr Cr

10 000

Deferred tax asset Income tax expense

Dr Cr

600

8 000 2 000

600

The first adjusting entry eliminates the unrealised profit in closing inventories at 31 December 2023. As inventories originally transferred intragroup are still on hand with the group at 31 December 2023, the profit of $2000 related to those items is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price of the inventories transferred intragroup (it is assumed that the inventories still on hand are all the inventories that were transferred intragroup) – this eliminates the amount recognised by Skye Ltd on the intragroup sale so that the consolidated figure reflects only the sales revenues generated from transactions with external parties. • Crediting Inventories with an amount equal to the unrealised profit – this corrects the overstatement of inventories still on hand that are recorded by Blue Ltd based on the intragroup price, making sure that those inventories are recorded at the original cost to the group. • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by Skye Ltd (based on the original cost) so that the consolidated figure reflects only the cost of sales of the inventories sold to external entities based on their original cost to the group. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 31 December 2023 by raising a Deferred Tax Asset for the tax recognised by Skye Ltd in advance on the unrealised intragroup profit. (5) Management services Other income Other expenses

Dr Cr

1 000 1 000

The adjusting entry eliminates the management fee revenue recognised in Other Income by Skye Ltd and the management fee expense recognised in Other Expenses by Blue Ltd during the current period. As this adjusting entry does not have any net impact of the profit: • there won’t be any tax-effect adjusting entry

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

. there won’t be any further adjusting entries in the next period for the management fees incurred this current period.

As the management fees were paid during the current period, there won’t be a need to eliminate any another accounts during the current period as there is no Management Fees Payable or Management Fees Receivable. Also, there were no management fee paid in advance for the next period and therefore there are no Prepaid Management Fees and Management Fees Received in Advance to eliminate. (6) Sale of machinery Gain on sale of machinery Machinery

Dr Cr

4 000

Deferred tax asset Income tax expense

Dr Cr

1 200

4 000

1 200

The first journal entry eliminates the intragroup gain on sale of the machinery. The adjusting entry will also bring down the balance of the machinery account to reflect the original carrying amount of the machinery before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the gain on sale (which decreases the current profit) and decreases the carrying amount of the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to decrease and a deferred tax asset needs to be recognised for the deductible temporary difference created or, using another explanation, for the tax prepayment made by Blue Ltd on the unrealised profit from the intragroup sale. (7) Depreciation of machinery Accumulated depreciation - machinery Depreciation expense (20% x $4 000 x 1/2)

Dr Cr

400

Income tax expense Deferred tax asset

Dr Cr

120

400

120

These adjusting entries are necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is overstated and should be decreased by an amount equal to the depreciation rate multiplied by the gain on the intragroup sale, but only for the 6 months starting with the intragroup sale. It should be noted that this adjustment to depreciation expense increases the current profit and therefore it is said to be an indication that a part of the profit on the intragroup sale is now realised. As a part of the intragroup profit is now realised through the depreciation adjustments, the other adjusting entry here adjusts the tax effect of the previous entry that eliminated the entire profit

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Chapter 28: Consolidation: intragroup transactions

on the intragroup sale (see worksheet adjustment (6)), basically reversing that previous tax effect entry for the part of the profit that is now realised. That is because the depreciation adjustment entry increases the carrying amount of the asset, with no effect on the tax base and therefore decreases the deductible temporary difference that was recorded in the deferred tax asset when eliminating the gain on intragroup sale. 5. Concept of realisation Profits recognised by group members on sale of assets within the group are unrealised profits to the extent that the assets are still within the group. Realisation of profits on intragroup transactions involving assets normally occurs when an external entity gets involved. For intragroup sales of inventories or non-depreciable assets, realisation occurs when these assets are on-sold to external entities – see worksheet adjustment (4) where adjustment is made for unrealised profits from sales of inventories. If only a part of the inventories initially transferred intragroup is on-sold to external parties by the end of a period, only the part of the intragroup profit related to the inventories on-sold is realised. It should be noted that, as inventories are current assets which should be eventually sold to external parties, it is normally assumed, unless otherwise specified, that inventories transferred intragroup that are not sold to external parties by the end of a period are sold to external parties by the end of the next period and therefore any unrealised profit in opening inventories in one period is considered realised by the end of that period. For intragroup sale of depreciable assets, as a depreciable asset may never be on-sold by a member of the group to external parties, remaining within the group and being consumed by use instead, the point of realisation may not be directly and exclusively determined by reference to involvement of an external entity. Realisation is then indirectly determined by usage of the asset within the group, that is, in proportion to the consumption of the benefits from the asset within the group. Realisation of the profit/loss on sale within the group is then measured in the same proportion to the depreciation of the asset recorded by the entity that uses it. As such, if the asset is used in the group up to the end of its useful life, the profit will be realised in full only at the end of the useful life. However, the depreciable asset may be on-sold to external parties before the end of the useful life, in which case, the profit is realised in full at the moment of external sale, with a part of it being realised through depreciation (based on the period of time since the intragroup transfer up to the moment of external sale) and the rest through the external sale. In this exercise, for the intragroup sale of plant, realisation of the profit occurs as plant is used up and benefits received – see worksheet adjustments (6) and (7). Note that the gain on sale is considered to be fully unrealised at the moment of the intragroup sale but as the asset is depreciated, profit is realised; the credit to depreciation expense in adjustment (7) means an increase in group profit. 6. Consolidation worksheet at 31 December 2023

Sales revenue Dividend revenue Gain on sale of machinery Other income

Skye Ltd 50 000 2 000 2 000

Blue Ltd 47 200 4 0 3 4 000 6

2 000

4 000 5

Adjustments Dr Cr 10 000 2 000 4 000 1 000

Group 87 200 0 2 000 5 000

28.72

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Cost of sales Other expenses

56 000 42 000 6 000

55 200 36 000 1 2 000 2

Profit before tax Tax expense

48 000 8 000 2 700

38 000 17 200 3 900 7

120

5 300 12 000

13 300 6 000 2

6 000

-- 2

504

Profit Retained earnings (1/1/23) Transfer from BCVR Dividend paid Retained earnings (31/12/23)

17 300 5 000 12 300

720 3 720

19 300 2 000 17 300

8 000 4 1 000 5 400 7

216 1 600 4 1 200 6

94 200 70 720 10 320 81 040 13 160 4 704

8 456 12 000 504 1

2 000 3

20 456 5 000 15 456

7. BLUE LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 31 December 2023 Revenue: sales Other income

$87 200 5 000 $92 200

Expenses: Cost of sales Other

70 720 10 320

Gain on sale of non-current assets Profit before income tax Income tax expense Profit for the period Other comprehensive income: Gains on financial assets Comprehensive income for the period

81 040 11 160 2 000 13 160 4 704 $8 456 3 300 $11 756

28.73

Chapter 28: Consolidation: intragroup transactions

Exercise 28.14 Consolidation with differences between carrying amount and fair value at acquisition date and intragroup transactions Waltzing Ltd purchased 100% of the shares of Matilda Ltd on 1 July 2020 for $50 000. At that date the equity of the two entities was as follows.

Asset revaluation surplus

Waltzing Ltd

Matilda Ltd

25 000

4 000

Retained earnings

14 500

2 800

Share capital

50 000

40 000

At 1 July 2020, all the identifiable assets and liabilities of Matilda Ltd were recorded at fair value except for the following.

All of the inventories were sold by December 2020. The plant and equipment had a further 5-year useful life. Any valuation adjustments are made on consolidation. Financial information for Waltzing Ltd and Matilda Ltd for the period ended 30 June 2022 is shown below. Waltzing Ltd Sales revenue

39 000

Matilda Ltd $

20 000

Dividend revenue

2 200

800

Total income

41 200

20 800

Cost of sales

30 000

15 000

Other expenses

5 400

2 500

Total expenses

35 400

17 500

Gross profit

5 800

3 300

Gain on sale of furniture

250

Profit before income tax

5 800

3 550

Income tax expense

1 500

1 100

Profit for the period

4 300

2 450

Retained earnings (1/7/21)

7 250

1 400

11 550

3 850

28.74

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. Interim dividend paid

2 000

1 000

Final dividend declared

4 000

1 200

6 000

2 200

5 500

1 650

Retained earnings (30/6/22)

Additional information (a) Waltzing Ltd records dividend receivable as revenue when dividends are declared. (b) The beginning inventories of Matilda Ltd at 1 July 2021 included goods which cost Matilda Ltd $1000. Matilda Ltd purchased these inventories from Waltzing Ltd at cost plus 33% mark-up. (c) Intragroup sales totalled $5 000 for the period ended 30 June 2022. Sales from Waltzing Ltd to Matilda Ltd, at cost plus 10% mark-up, amounted to $2800. The ending inventories of Waltzing Ltd included goods which cost Waltzing Ltd $2200. Waltzing Ltd purchased these inventories from Matilda Ltd at cost plus 10% markup. (d) On 31 December 2021, Matilda Ltd sold Waltzing Ltd office furniture for $1500. This furniture originally cost Matilda Ltd $1500 and was written down to $1250 just before the intragroup sale. Waltzing Ltd depreciates furniture at the rate of 10% p.a. on cost. (e) The asset revaluation surplus relates to land. The following movements occurred in this account. Waltzing Ltd 1 July 2020 to 30 June 2021

1 July 2021 to 30 June 2022

Matilda Ltd 1500 1000

(250) 250

(f) The income tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 July 2020. 2. Prepare the business combination valuation entries and pre-acquisition entries at 1 July 2020. 3. Prepare the business combination valuation entries and pre-acquisition entries at 30 June 2022. 4. Prepare the consolidation worksheet journal entries to eliminate the effects of intragroup transactions at 30 June 2022. 5. Prepare the consolidation worksheet for the preparation of the consolidated financial statements for the period ended 30 June 2022. 6. Prepare the consolidated statement of profit or loss and other comprehensive income for the period ended 30 June 2022. (LO3, LO4, LO5, LO6 and LO7) 1. At 1 July 2020: Net fair value of identifiable assets and liabilities of Matilda Ltd = ($40 000 + $4 000 + $2 800) (equity) + ($3 500 – $3 000) (1 – 30%) (BCVR - inventories) + ($61 000 – $60 000) (1 – 30%) (BCVR - plant)

28.75

Chapter 28: Consolidation: intragroup transactions

Consideration transferred Goodwill

= = = =

$47 850 $50 000 $50 000 - $47 850 $2 150

2. Business combination valuation entries at 1 July 2020 Accumulated depreciation – plant and equip. Plant and equipment Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

20 000

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

500

Goodwill Business combination valuation reserve

Dr Cr

2 150

19 000 300 700

150 350

2 150

Pre-acquisition entries at 1 July 2020 Retained earnings (1/7/20) Share capital Asset revaluation surplus Business combination valuation reserve Shares in Matilda Ltd

Dr Dr Dr Dr Cr

2 800 40 000 4 000 3 200

50 000

28.76

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. 3. (1) Business combination valuation entries at 30 June 2022 Accumulated depreciation – plant & equip. Plant & equipment Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

20 000

Depreciation expense Dr Retained earnings (1/7/21) Dr Accumulated depreciation - plant & equip. Cr

200 200

Deferred tax liability Income tax expense Retained earnings (1/7/21)

120

19 000 300 700

400

Dr Cr Cr

Goodwill Business combination valuation reserve

Dr Cr

60 60 2 150 2 150

(2) Pre-acquisition entries at 30 June 2022 Retained earnings (1/7/21)* Dr Share capital Dr Asset revaluation surplus Dr Business combination valuation reserve Dr Shares in Matilda Ltd Cr * $2 800 + $500 (1 – 30%) (BCVR - inventories)

3 150 40 000 4 000 2 850 50 000

4. Elimination of the effects of intragroup transactions at 30 June 2022 (3) Dividend paid Dividend revenue Dividend paid

Dr Cr

1 000 1 000

This adjusting entry eliminates the dividend revenue recognised by Waltzing Ltd and the dividend paid recognised by Matilda Ltd during the current period (this dividend is identified by inspecting the financial statements of Matilda Ltd). As this adjusting entry does not have any net impact of the consolidated retained earnings, there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were paid during the current period, there won’t be a need to eliminate any Dividends Payable or Dividends Receivable. (4) Dividend declared Dividend revenue Dividend declared

Dr Cr

1 200

Dividend payable Dividend receivable

Dr Cr

1 200

28.77

Chapter 28: Consolidation: intragroup transactions

The first adjusting entry eliminates the dividend revenue recognised by Waltzing Ltd and the dividend declared recognised by Matilda Ltd during the current period (this dividend is also identified by inspecting the financial statements of Matilda Ltd). As this adjusting entry does not have any net impact of the consolidated retained earnings there won’t be any further adjusting entries in the next period for the dividends paid this current period. Also, for dividends there are no tax effects that should be recognised or adjusted on consolidation. As the dividends were not paid during the current period, there will be a need to eliminate Dividends Payable and Dividends Receivable in the second adjusting entry. (5) Profit in beginning inventories: sales from Zoe Ltd to Matilda in the previous period Retained earnings (1/7/21) Income tax expense Cost of sales

Dr Dr Cr

175 75 250

In this case, the unrealised profit in closing inventories from the period ended 30 June 2021 and recognised as unrealised profit in opening inventories in this period (i.e. $1 000 – $1 000 / 1.33 = $250) is assumed to become realised by the end of the current period. As such, this profit needs to be transferred from the previous period to the current period by: • Debiting Retained Earnings (1/7/21) with an amount equal to the after-tax unrealised profit in opening inventories ($250 x (1 – 30%)) – this eliminates the unrealised profit from the prior period’s profit • Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening inventories – this increases the current profit as the previously unrealised profit is now realised. As a result of this transfer of profit to the current period, the current period profit increases and a tax effect should also be recognised in the adjusting entry by: • Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in opening inventories. (6) Sales of inventories from Waltzing Ltd to Matilda Ltd in the current period Sales revenue Cost of sales

Dr Cr

2 800 2 800

The only adjusting entry eliminates the intragroup sales revenue and the cost of sales recognised by Waltzing Ltd as the profit on the intragroup sale to Matilda Ltd is entirely realised during the current period. As the inventories are sold by the end of the period to an external entity, at 30 June 2022 the entire profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales are overstated from the group’s perspective as they include the intragroup sales revenue and the cost of sales recognised based on the price paid intragroup by Matilda Ltd. On consolidation, this overstatement needs to be corrected. There won’t be any tax-effect adjustment entry as the only adjusting entry posted now does not have any net effect on the profit or on the carrying amount of inventories. (7) Profit in ending inventories: sales from Matilda Ltd to Waltzing Ltd Sales revenue Cost of sales Inventories

Dr Cr Cr

2 200

2 000 200

28.78

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Deferred tax asset Income tax expense

. Dr Cr

60 60

The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June 2022. As inventories originally transferred intragroup by Matilda Ltd remain unsold at the end of the period, at 30 June 2019 the profit on the intragroup sale related to inventories still on hand (i.e. $2 200 - $2 200 / 1.1 = $200) is unrealised and should be eliminated on consolidation by: • Debiting Sales Revenue with an amount equal to the intragroup price – this eliminates the amount recognised by Matilda Ltd on the intragroup sale so that the consolidated figure reflects only the sales revenues generated from transactions with external parties. • Crediting Inventories with an amount equal to the unrealised profit (i.e. $200) – this corrects the overstatement of inventories still on hand that are recorded by Waltzing Ltd based on the intragroup price, making sure that those inventories are recorded at the original cost to the group. • Crediting Cost of Sales with an amount equal to the difference between the debit amount to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales recognised by Matilda Ltd (based on the original cost) so that the consolidated figure reflects only the cost of sales of the inventories sold to the external party based on their original cost to the group. The second adjusting entry recognises the tax effect of the elimination of the unrealised profit in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised by Matilda Ltd in advance on the unrealised intragroup profit. (8) Sale of furniture Gain on sale of office furniture Office furniture

Dr Cr

250

Deferred tax asset Income tax expense

Dr Cr

250

The first journal entry eliminates the intragroup gain on sale of office furniture (i.e. $1 500 $1 250). The adjusting entry will also bring down the balance of the office furniture account to reflect the original carrying amount of the asset before the intragroup sale. All of these adjustments are necessary as the asset is still on hand with the group and there was no sale involving an external entity. The second adjusting entry is recognising the tax effect of the first entry. As the first entry eliminates the gain on sale (which decreases the current profit) and decreases the carrying amount of the asset, without any effect on its tax base, the income tax expense, normally calculated based on the current profit, needs to decrease and a deferred tax asset needs to be recognised for the deductible temporary difference created or, using another explanation, for the tax prepayment made by Matilda Ltd on the unrealised profit from the intragroup sale. (9) Depreciation of furniture Accum. depreciation – office furniture Depreciation expense (10% x 1/2 x $250)

Dr Cr

12.5

28.79

Chapter 28: Consolidation: intragroup transactions

Income tax expense Deferred tax asset (30% x $12.5 – rounded upwards)

Dr Cr

4 4

The first adjusting entry is necessary to adjust the depreciation expense recorded after the intragroup sale by the entity that now uses the asset within the group. As this entity records the depreciation based on the price paid intragroup, while the group should recognise the depreciation based on the carrying amount of the asset at the moment of the intragroup sale, the depreciation expense is overstated and should be decreased by an amount equal to the depreciation rate multiplied by the gain on the intragroup sale but only for the 6 months since the intragroup sale. It should be noted that this adjustment to depreciation expense increases the current profit and therefore it is said to be an indication that a part of the profit on the intragroup sale is now realised. As a part of the intragroup profit is now realised through the depreciation adjustments, the second adjusting entry adjusts the tax effect of the previous entry that eliminated the entire profit on the intragroup sale (see worksheet entry (8)), basically reversing that previous tax effect entry for the part of the profit that is now realised. That is because the depreciation adjustment entry increases the carrying amount of the asset, with no effect on the tax base and therefore decreases the deductible temporary difference that was recorded in the deferred tax asset when eliminating the gain on intragroup sale in worksheet entry (8). 5. Consolidation worksheet at 30 June 2022 Waltzing Matilda Ltd Ltd Sales revenue 39 000 20 000 Dividend revenue

2 200

800

Cost of sales

41 200 30 000

20 800 15 000

5 400 35 400 5 800 0

2 500 17 500 3 300 250

5 800 1 500

3 550 1 100

4 300 7 250

2 450 1 400

11 550 2 000 4 000 6 000 5 550

3 850 1 000 1 200 2 200 1 650

Other expenses Profit from trading Gain on sale of office furniture Profit before tax Tax expense

Profit Retained earnings (1/7/21)

Dividend paid Dividend declared Retained earnings (30/6/22)

6 7 3 4

Adjustments Dr Cr 2 800 2 200 1 000 1 200

100

250

5 9

1 2 5

75 4

100 1 575 175

250 2 800 2 000 12.5

Group 54 000 800

5 6 7 9

54 800 39 950

7 987.5 47 937.5 0

30 1 60 7 75 8 30 1

1 000 2 1 200 3

6 862.5 2 514

4 348.5 6 830

11 178.5 2 000 4 000 6 000 5 268.5 28.80

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

. 6. WALTZING LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Revenues: Sales revenue Dividend revenue

$54 000 800 $54 800

Expenses: Cost of sales Other expenses Profit before income tax Income tax expense Profit for the period Other comprehensive income: Asset revaluations: Increments Comprehensive income for the period

39 950 7 987.5 47 937.5 6 862.5 2 514 $4 348.5 1 250 $ 5 598.5

28.81

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS. © John Wiley & Sons Australia, Ltd 2020

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 28: Consolidation: intragroup transactions Multiple choice questions 1. Which of the following statements is incorrect? a. b. *c. d.

consolidated profit arises only in relation to transactions with entities external to the group. consolidated revenues are earned only from transactions with entities external to the group. consolidated assets are recorded at the cost to the legal entity that owns them. consolidated liabilities are obligations to entities external to the group.

Answer: c Learning objective 28.1: explain the need for making adjustments for intragroup transactions.

2. The adjustments included in the consolidation worksheet are: I. II. III. *a. b. c. d.

pre-acquisition entries business combination valuation entries elimination of the effects of intragroup transactions

I, II and III I and II only I only II only

Answer: a Learning objective 28.1: explain the need for making adjustments for intragroup transactions.

3. AASB 10 Consolidated Financial Statements, requires that the effect of intragroup transactions be: *a. b. c. d.

eliminated in full on consolidation. adjusted for in full in the books of both the parent and subsidiary. eliminated on consolidation to the extent of the parent’s interest in the subsidiary. adjusted for in the books of the parent and subsidiary to the extent of the parent’s interest in the subsidiary.

Answer: a Learning objective 28.2: outline the adjustment process and the key questions to consider.

28.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Which of the following statements is incorrect? a. *b. c. d.

the effects of intragroup transactions need to be eliminated in full. the effects of intragroup transactions that need to be eliminated are those related to the current profit. the adjustments for the elimination of the effects of intragroup transactions may need to be repeated in subsequent periods. the effects of intragroup transactions are recognised in the individual statements of financial position and/or the individual statements of comprehensive income.

Answer: b Learning objective 28.2: outline the adjustment process and the key questions to consider.

5. Key questions to consider when determining the appropriate consolidation adjustment entries include the following except for: a. b. c. *d.

What is the tax effect of the adjustments made? What has been recorded by the legal entities? Is this a prior period or a current period transaction? Does the transaction involve the parent entity selling assets to the subsidiary, or the subsidiary selling assets to the parent entity?

Answer: d Learning objective 28.2: outline the adjustment process and the key questions to consider. 6. The profit on an intragroup business transaction is ‘realised’ when: a. b. *c. d.

the parent sells to the subsidiary. the subsidiary sells to the parent. there is involvement with an external party. only entities within the group are parties to the transaction.

Answer: c Learning objective 28.2: outline the adjustment process and the key questions to consider.

28.2

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following statements is incorrect? a.

*b.

c. d.

Adjustments are required for both prior period and current period intragroup transactions to the extent that the effects of those transactions are still present in the individual accounts of the entities involved. The profits or losses generated from intragroup transfers of assets are considered realised from the group’s perspective until such movement when those assets are transferred to external entities. Adjustments are determined by comparing the amounts recognised in the individual accounts affected with the amounts that the group should recognise. When adjustments for intragroup transactions affect the carrying amount of assets or liabilities, further adjustments are made for the tax effect of those adjustments.

Answer: b Learning objective 28.2: outline the adjustment process and the key questions to consider.

8. During the current period, a subsidiary entity sold inventories to its parent entity at a profit of $6 000. The goods had originally cost the subsidiary $30 000. All the inventories were still on hand at the end of the year. The consolidation adjustment entry would include the following line item: a. b. c. *d.

CR Inventories $30 000. CR Inventories $24 000. CR Inventories $18 000. CR Inventories $6 000.

Answer: d Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

9. During the current period, a subsidiary entity sold inventories to its parent entity at a profit of $6 000. The goods had originally cost the subsidiary $14 000. At the end of the year all the inventories were still on hand. The adjustment entry to deal with this transaction on consolidation would include the following line item: *a. b. c. d.

CR Cost of sales $14 000. CR Cost of sales $20 000. CR Cost of sales $6 000. CR Cost of sales $8 000.

Answer: a Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

28.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. The tax effect of eliminating the unrealised profit from an intragroup sale of inventories and adjusting the value of the inventories on hand is recognised as: a. b. c. *d.

an increase in income tax expense. an increase in deferred tax liability. a decrease in deferred tax liability. an increase in deferred tax asset.

Answer: d Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

11. On 5 June 2022, a parent entity sold inventories to a subsidiary entity for $80 000. The inventories had previously cost the parent entity $72 000. All the inventories are still held by the subsidiary at reporting date, 30 June 2022. Ignoring tax effects, the adjustment entry in the consolidation worksheet at reporting date is: a. Cash Sales revenue Cost of sales Inventories

Dr Cr Dr Cr

72 000

Sales revenue Cash Inventories Cost of sales

Dr Cr Dr Cr

72 000

Sales revenue Cost of sales Inventories

Dr Cr Cr

80 000

Sales revenue Cost of sales Inventories

Dr Cr Cr

80 000

72 000 72 000 72 000

b. 72 000 72 000 72 000

c. 8 000 72 000

*d. 72 000 8 000

Answer: d Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

28.4

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

12. During the current period, a subsidiary entity sold inventories to a parent entity for $40 000. The inventories had previously cost the subsidiary entity $36 000. By reporting date the parent entity had sold 75% of inventories to a party outside the group. The company tax rate is 30%. The adjustment entry in the consolidation worksheet at reporting date is: a. Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

40 000

Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

40 000

Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

30 000

Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

10 000

36 000 4 000 1 200 1 200

*b. 39 000 1 000 300 300

c. 27 000 3 000 900 900

d. 9 000 1 000 300 300

Answer: b Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

28.5

Testbank to accompany Financial reporting 3e by Loftus et al.

13. During the current period, Ambrose Limited sold inventories to its parent entity at a profit of $12 000. The inventories cost Ambrose Limited $36 000. At balance sheet date the parent had sold 50% of the inventories to an external party. The consolidation adjustment entry (excluding tax effects) will eliminate unrealised profit amounting to: a. b. *c. d.

$1 000. $18 000. $6 000. $36 000.

Answer: c Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

14. During the year ended 30 June 2022, a subsidiary entity sold inventories to a parent entity for $50 000. The inventories had previously cost the subsidiary entity $45 000. By 30 June 2022 the parent entity had sold 75% of the inventories to a party outside the group. The company tax rate is 30%. The adjustment entry in the consolidation worksheet at 30 June 2023 is: a. Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

50 000

Retained earnings Income tax expense Cost of sales

Dr Dr Cr

3 500 1 500

Retained earnings Income tax expense Cost of sales

Dr Dr Cr

875 375

Retained earnings Inventories Deferred tax asset Retained earnings

Dr Cr Dr Cr

1 250

48 750 1 250 375 375

5 000

*c.

1250

d. 1 250 375 375

Answer: c Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

28.6

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

15. During the year ended 30 June 2022, a subsidiary entity sold inventories to a parent entity for $50 000. The inventories had previously cost the subsidiary entity $45 000. By 30 June 2022 the parent entity had sold all the inventories to a party outside the group. The company tax rate is 30%. The adjustment entry in the consolidation worksheet at 30 June 2023 is: a. Sales revenue Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr Cr Dr Cr

50 000

Retained earnings Income tax expense Cost of sales

Dr Dr Cr

3 500 1 500

Retained earnings Inventories Deferred tax asset Retained earnings

Dr Cr Dr Cr

5 000

45 000 5 000 1 500 1 500

5 000

*d.

5 000 1 500 1 500

No entry is required

Answer: d Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

16. Sherrin Ltd purchased goods from its subsidiary for $24 000. The goods cost the subsidiary $18 000. The company rate of tax is 30%. Which of the following consolidation adjustment entries is correct? a.

*c.

DR Income tax expense CR Deferred tax liability

$1 800

DR Income tax expense CR Deferred tax asset

$1 800

DR Deferred tax asset CR Income tax expense

$1 800

DR Deferred tax liability CR Income tax expense

$1 800

$1 800.

Answer: c Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

28.7

Testbank to accompany Financial reporting 3e by Loftus et al.

17. A subsidiary sold inventories to its parent entity in the year ended 30 June 2022 at a profit of $8 000. At 30 June 2022 the parent had not sold the inventories. The company tax rate is 30%. The consolidation worksheet prepared at 30 June 2022 will contain the following adjustment entry for inventories: a. b. c. *d.

CR Inventories $2 400. DR Inventories $2 400. DR Inventories $8 000. CR Inventories $8 000.

Answer: d Learning objective 28.3: prepare worksheet entries for intragroup transactions involving profits or losses in beginning and ending inventories.

18. When an entity sells a non-depreciable non-current asset during the current period at a profit to another entity within the same group the following adjustment is necessary on consolidation at the end of the period: a.

DR Asset CR Cash

*b.

DR Gain on sale CR Asset

DR Cash CR Asset

DR Asset CR Gain on sale.

Answer: b Learning objective 28.4: prepare worksheet entries for intragroup transactions involving profits or losses on the transfer of property, plant and equipment in both the current and previous periods.

28.8

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

19. A parent entity group sold a depreciable non-current asset to a subsidiary entity for $5 300. The asset originally cost $7 000 when acquired from an external party and at the date of the intragroup sale the accumulated depreciation was $2 200. The amount of the unrealised gain on the intragroup sale to be eliminated is: *a. b. c. d.

$500. $2 200. $4 800. $5 300.

Answer: a Feedback: $5300 – ($7000 – 2200) Learning objective 28.4: prepare worksheet entries for intragroup transactions involving profits or losses on the transfer of property, plant and equipment in both the current and previous periods.

20. Purple Ltd sold an item of plant to its subsidiary, Rain Ltd, on 1 January 2022 for $50 000. The asset had cost Purple Ltd $60 000 and had an useful life of 6 years when acquired on 1 January 2020 from an external party. The adjustment necessary on consolidation in relation to the transfer of plant as at 30 June 2022 will result in: a. b. c. *d.

an increase in current year profit. a decrease in current year profit. an increase in current year profit and non-current assets. a decrease in current year profit and non-current assets.

Answer: d Learning objective 28.4: prepare worksheet entries for intragroup transactions involving profits or losses on the transfer of property, plant and equipment in both the current and previous periods.

21. Matthew Limited, a subsidiary entity, sold a non-current asset at a profit to its parent entity during the current period. The adjustment necessary on consolidation to reflect the tax effect of this transaction will result in an: a. b. *c. d.

increase in retained earnings. decrease in retained earnings. increase in deferred tax assets. decrease in deferred tax liabilities.

Answer: c Learning objective 28.4: prepare worksheet entries for intragroup transactions involving profits or losses on the transfer of property, plant and equipment in both the current and previous periods.

28.9

Testbank to accompany Financial reporting 3e by Loftus et al.

22. The realisation of the profit or loss on a depreciable asset transferred within the group: a. b. c. *d.

occurs only when the asset is sold to an external party. results in an inconsistent pattern with the allocation of depreciation of the asset. is assumed to occur only when an external entity becomes directly involved with the asset. is assumed to occur when the future benefits embodied in the asset are consumed by the group.

23. Kateri Ltd sold an item of plant to its subsidiary, Patrick Ltd, on 1 January 2022 for $50 000. The asset had cost A Ltd $60 000 and had a useful life of 6 years when acquired on 1 January 2020 from an external party. The adjustment necessary on consolidation to reflect the tax effect of the depreciation adjustment for the year ended 30 June 2022 will result in an increase in: a. *b. c. d.

deferred tax assets. income tax expense. current tax liability. deferred tax liabilities.

24. Kateri Ltd sold an item of plant to its subsidiary, Patrick Ltd, on 1 January 2022 for $50 000. The asset had cost A Ltd $60 000 and had a useful life of 6 years when acquired on 1 January 2020 from an external party. The adjustment necessary on consolidation in relation to the transfer of plant as at 30 June 2023 will result in: a. b. *c. d.

a decrease in retained earnings and a decrease in current year profit. an increase in retained earnings and a decrease in current year profit. a decrease in retained earnings and an increase in current year profit. an increase in retained earnings and an increase in current year profit.

28.10

Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

25. Which of the following statements is incorrect? a.

*b. c.

Where the transferred assets are depreciable, adjustments are made to depreciation accounts (for the current period depreciation) and/or to the retained earnings account (for the previous periods’ depreciation). Adjustments for the gain/loss on intragroup sale of property, plant and equipment are made in all periods after the sale. As depreciation reflects the use of the asset by the group, the depreciation adjustments are realising a part of the gain/loss on the intragroup sale of property, plant and equipment. As the intragroup sale of property, plant and equipment impacts on the profit and the carrying amount of assets, adjustments for the tax effects are also required.

26. On 1 July 2021, Zoe Ltd sold equipment to its subsidiary, Nate Ltd, for $80 000. The equipment had a carrying amount at the time of sale of $70 000. The equipment was depreciated by Zoe Ltd at 10% p.a. on cost, while Nate Ltd applies a rate of 8%. The consolidation worksheet entry for the year ended 30 June 2022 would include the following adjustment in relation to depreciation: a.

DR Depreciation expense CR Accumulated depreciation

$1 000

DR Accumulated depreciation CR Depreciation expense

$1 000

DR Depreciation expense CR Accumulated depreciation

$800

*d. DR Accumulated depreciation CR Depreciation expense

$1 000

$800 $800 $800

Answer: d Feedback: Depreciation recorded by Nate Ltd = $80 000 x 8% = $6400. Depreciation for the group = $70 000 x 8% = $5600. Depreciation is to be reduced by $800. Learning objective 28.4: prepare worksheet entries for intragroup transactions involving profits or losses on the transfer of property, plant and equipment in both the current and previous periods.

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Testbank to accompany Financial reporting 3e by Loftus et al.

27. On 1 January 2021, Gemma Ltd sells inventories to its subsidiary, Tess Ltd, for $24 000. The inventories cost Gemma Ltd $20 000 earlier in the current year. Tess Ltd intends to use the item as plant with a useful life of 10 years. The estimated salvage value of the plant is zero and the straight-line method of depreciation will be applied. The tax rate is 30%. The worksheet entry for the year ended 30 June 2021 would include the following adjustment: a. *b. c. d.

DR CR DR CR

Plant $4 000. Plant $4 000. Inventories $4 000. Inventories $4 000.

28. During the year ended 30 June 2022, Jasmine Ltd rents a warehouse from its subsidiary, Rose Ltd, for $20 000. The company tax rate is 30%. The consolidation adjustment entry needed at 30 June 2022 is: a. Rent revenue Rent expense Income tax expense Deferred tax liability

Dr Cr Dr Cr

20 000

Rent revenue Rent expense Deferred tax asset Income tax expense

Dr Cr Dr Cr

20 000

Rent revenue Rent expense

Dr Cr

20 000

Rent expense Rent revenue

Dr Cr

20 000

20 000 6 000 6 000

b. 20 000 6 000 6 000

*c. 20 000

d. 20 000

Answer: c Learning objective 28.5: prepare worksheet entries for intragroup services.

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Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

29. On 1 July 2021, Xavier Ltd rents a warehouse for one year from its subsidiary, Gabrielle Ltd, for $60 000. The company tax rate is 30%. The consolidation adjustment entry needed at 30 June 2023 is: a. Profit and loss summary Retained earnings Income tax expense Deferred tax liability

DR CR DR CR

60 000

Profit and loss summary Retained earnings Deferred tax asset Income tax expense

DR CR DR CR

60 000

Profit and loss summary Retained earnings

DR CR

60 000

60 000 18 000 18 000

b. 60 000 18 000 18 000

*d.

60 000

No entry is required at 30 June 2023.

Answer: d Learning objective 28.5: prepare worksheet entries for intragroup services.

30. With regards to services provided within the group: a. b. *c. d.

there will be an increase in deferred tax assets. there will be an increase in income tax expense. the consolidation adjustments do not affect the group’s profit. the group’s profit equals service revenue less service expense.

Answer: c Learning objective 28.5: prepare worksheet entries for intragroup services.

31. Which of the following statements is incorrect? a. *b. c. d.

Profits/losses on intragroup services are immediately realised to the group. It is necessary to have a tax-effect adjustment when adjusting for intragroup services. Adjustments for previous periods’ intragroup services affect only statement of financial position accounts, but only if the fees have not been paid. Adjustments for current period intragroup services affect statement of profit or loss and other comprehensive income accounts and statement of financial position accounts if the fees have not been paid and only statement of profit or loss and other comprehensive income accounts otherwise.

Answer: b Learning objective 28.5: prepare worksheet entries for intragroup services.

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Testbank to accompany Financial reporting 3e by Loftus et al.

32. When eliminating an intragroup service, which of the following entries would appear in the consolidation worksheet entry? a. b. c. *d.

CR CR DR DR

Income tax expense. Deferred tax liability. Services expense. Services revenue.

Answer: d Learning objective 28.5: prepare worksheet entries for intragroup services.

33. Changes in accounting standards since 2008 require all dividends: *a. b. c. d.

from a subsidiary to be accounted for by the parent as revenue. from post-acquisition equity to be accounted for by the parent as revenue. from pre-acquisition equity to be accounted for by the parent as a return on investment in the subsidiary. from a subsidiary to be accounted for by the parent as a return on investment in the subsidiary.

Answer: a Learning objective 28.6: prepare worksheet entries for intragroup dividends.

34. When a subsidiary declares a final dividend payable to a parent who has a 100% interest in the subsidiary, the parent recognises a dividend receivable and the subsidiary recognises a dividend payable. In addition to the elimination of these two items on consolidation, the following items must also be eliminated: a. b. *c. d.

Dividend revenue and Cash. Dividend declared and Cash. Dividend declared and Dividend revenue. Dividend declared and Retained earnings.

Answer: c Learning objective 28.6: prepare worksheet entries for intragroup dividends.

35. A dividend paid out of profits earned after the acquisition date is known as a: a. b. *c. d.

final dividend. pre-acquisition dividend. post-acquisition dividend. temporary dividend.

Answer: c Learning objective 28.6: prepare worksheet entries for intragroup dividends.

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Chapter 28: Consolidation: intragroup transactions Not for distribution in full. Instructors may assign selected questions in their LMS.

36. During the current period, Rosina Limited paid an interim dividend of $60 000 to its parent entity, Anastasia Limited. If the tax rate is 30%, what would be the adjustment made in the consolidation entry to record the tax effect of this transaction at the end of the period? a. b. c. *d.

DR Deferred Tax Asset $18 000. DR Income Tax Expense $18 000. CR Deferred Tax Liability $18 000. There is no tax effect entry required.

Answer: d Learning objective 28.6: prepare worksheet entries for intragroup dividends.

37. Paul Limited provided an advance of $150 000 to its subsidiary Caitlin Limited. On consolidation, the following adjustment is needed in relation to this intragroup advance: a.

no adjustment is needed.

DR Advances to Caitlin Ltd CR Advances from Paul Ltd

$150 000

DR Advances from Paul Ltd CR Advances to Caitlin Ltd

$150 000

DR Advances from Paul Ltd CR Cash

$150 000

*c.

$150 000

Answer: c Learning objective 28.7: prepare worksheet entries for intragroup borrowings.

38. Rachel Ltd provided an advance of $100 000 to its subsidiary Marion Ltd. Interest of $10 000 was charged during the year ended 30 June 2021. On consolidation, the following adjustment is needed at 30 June 2021 in relation to the interest charged: a.

no adjustment needed.

DR Interest expense CR Interest revenue

$10 000

DR Retained earnings CR Cash

$10 000

DR Interest revenue CR Interest expense

$10 000

*d.

$10 000

Answer: d Learning objective 28.7: prepare worksheet entries for intragroup borrowings.

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Testbank to accompany Financial reporting 3e by Loftus et al.

39. Margaret Company made an advance of $45 000 to its subsidiary, Jack Limited. Margaret Company charges interest of $15 000 on this advance. The consolidation adjustment to eliminate the advance is: a.

*b.

DR Interest revenue CR Interest expense

$60 000

DR Advance from Margaret Co. CR Advance to Jack Ltd

$45 000

DR Interest expense CR Interest revenue

$60 000

$45 000

DR Advance to Jack Ltd $45 000 CR Advance from Margaret Co.

$60 000

$45 000

Answer: b Learning objective 28.7: prepare worksheet entries for intragroup borrowings.

40. The consolidation adjustments in relation to intragroup borrowings: *a. b. c. d.

do not require tax-effect entry. increase the group’s net assets. increase the group’s interest revenue. decrease the group’s income tax expense.

Answer: a Learning objective 28.7: prepare worksheet entries for intragroup borrowings.

28.16

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Sorin Daniliuc

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 29: Consolidation: non-controlling interest

Chapter 29: Consolidation: non-controlling interest Comprehension questions 1. What is meant by the term ‘non-controlling interest’ (NCI)? NCI is the term used for the ownership interest in a subsidiary other than the parent. It is defined in AASB 10/IFRS 10 Consolidated Financial Statements as: • The equity in a subsidiary not attributable, directly or indirectly, to a parent. The non-controlling interest is still regarded as equity of the group. Hence there are effectively two equity parties in the group: the owners of the parent and the NCI. Classification of the NCI as equity affects both the calculation of the NCI as well as how it is disclosed in the consolidated financial statements. Measurement and disclosure of the NCI are mainly determined by AASB 10/IFRS 10 and AASB 101/IAS 1 Presentation of Financial Statements.

2. Explain whether the NCI is better classified as debt or equity. The non-controlling interest is regarded as equity of the group. Hence there are effectively two equity parties in the group: the owners of the parent and the NCI. Classification of the NCI as equity affects both the calculation of the NCI as well as how it is disclosed in the consolidated financial statements. Measurement and disclosure of the NCI are mainly determined by AASB 10/IFRS 10 and AASB 101/IAS 1 Presentation of Financial Statements. The main argument for the NCI being classified as equity is that it better fits the definition of equity. The subsidiary has no present obligation in relation to the NCI so the NCI does not meet the definition of a debt/liability. Some writers argue that NCI should be disclosed separately from equity and liabilities – the “mezzanine” treatment. This argument relates to the utility of financial statements in relation to the parent’s shareholders. It is argued that this form of presentation will provide more relevant information to the parent shareholders.

3. Explain whether the NCI is entitled to a share of subsidiary equity or some other amount. The NCI, being a part of the equity in the subsidiary, contributes to the equity of the consolidated group and so is entitled to a share of consolidated equity. Nevertheless, the measurement of the NCI share of equity involves firstly allocating to the NCI a part of the subsidiary’s equity proportionate to the ownership interest that it holds in the subsidiary. However, because the subsidiary’s equity is affected by profits or losses made in relation to transactions within the group, the calculation of the NCI is affected by the existence of intragroup transactions. The NCI is only entitled to the share of the subsidiary’s equity that is reflected in the consolidated equity. In other words, the NCI is entitled to a share of the equity of the subsidiary adjusted for the effects of profits or losses made on intragroup transactions.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. For what line items in the financial statements is it necessary to provide a break-down into parent entity share and NCI share? Statement of profit or loss and other comprehensive income: • AASB 101/IAS 1 paragraph 81B: Disclose both NCI and parent share of profit/loss for the period and share of total comprehensive income for the period Statement of financial position: • AASB 10/IFRS 10 paragraph 22: A parent shall present non-controlling interests in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. • AASB 101/IAS 1 paragraph 54 (q) and (r): NCI share of equity, and share capital and reserves attributable to parent. Statement of changes in equity: • AASB 101/IAS 1 paragraph 106 (a): total comprehensive income for the period, showing that attributable to the parent and that attributable to the NCI. • In summary, the information that needs to be disclosed for NCI is: - the NCI share of profit after tax - the NCI share of comprehensive income - the NCI share of consolidated equity.

5. Describe the format of the consolidation worksheet prepared in the presence of the NCI. The consolidation worksheet used for a wholly owned subsidiary is changed to enable the disclosures required where NCI exists in a subsidiary. Figure 29.4 contains a pro‐forma example of such a worksheet. (The assets and liabilities section is not included, as it is not affected by the presence of NCI.) In relation to this worksheet, note the following. •

•

As in the case of wholly owned subsidiaries, the column on the right of the ‘Adjustments’ column is named ‘Group’. The ‘Adjustments’ column contains the business combination valuation reserve (BCVR) and pre‐acquisition entries and the adjustments for intragroup transactions. Combining these adjustments with the financial statement numbers of both the parent and subsidiary provides the group (consolidated) amounts. Note that the consolidated amounts related to equity include the equity attributable to the owners of the parent and to NCI. Two columns (one for debit and one for credit entries) collectively named ‘NCI’ are added to the normal worksheet that was used for wholly owned subsidiaries. These columns record the NCI journal entries prepared in order to transfer the NCI share of each individual consolidated equity account from the consolidated amounts to an account that recognises the NCI share of total consolidated equity. For example, the NCI share of consolidated share capital is transferred from the consolidated share capital amount (by being included on the ‘NCI’ debit column in the ‘Share capital’ line) to the NCI share of total equity (by being on the ‘NCI’ credit column in the new ‘Total equity: NCI’ line described below). One more column, named ‘Parent’, is added which contains the parent share of consolidated equity. This share is calculated by adjusting the consolidated amounts related to equity from the ‘Group’ column for the NCI journal entries posted in the ‘NCI’ columns. The adjustments are made according to the general rules of debits and credits. For example, the © John Wiley and Sons Australia Ltd, 2020

29.3

Chapter 29: Consolidation: non-controlling interest

•

parent share of consolidated share capital is calculated as the consolidated amount (from the ‘Group’ column) minus the NCI share (from the ‘NCI’ debit column). This is because share capital is a credit account, and the NCI share is going to be subtracted from the consolidated share capital to get to the parent share. In contrast, dividend paid has a debit balance, so the NCI share is extracted from the consolidated amount via the ‘NCI’ credit column to get the parent share. Two new lines are added in the worksheet, namely ‘Total equity: parent’ and ‘Total equity: NCI’. These lines contain amounts that show the parent share and the NCI share of total consolidated equity respectively. - ‘Total equity: parent’ is determined by adding together the amounts in the ‘Parent’ column for all individual equity accounts. - ‘Total equity: NCI’ is determined by subtracting the sum of the amounts for this line in the ‘NCI’ debit column from the sum of the amounts in the ‘NCI’ credit column. The resulting amount is written in the ‘Parent’ column. - The sum of the amounts included in these two lines in the ‘Parent’ column equal the total consolidated equity shown in the ‘Group’ column.

The disclosures detailed in section 29.2.2 should be able to be read from this worksheet.

6. Why is it necessary to change the format of the worksheet where a NCI exists in the group? The AASB’s accounting standards, as well as the IFRS, require the disclosure of the equity of the group, as well as the relative proportions of the equity that belongs to the parent’s shareholders and the NCI. The reason the accounting standards ask for separate disclosure of the parent and NCI share of equity is that the owners of the parent want to determine the profitability and the equity of the group that will accrue to them, separate from that belonging to the NCI. As such, disclosure of the NCI is required in the consolidated statement of profit and loss and other comprehensive income, the consolidated statement of changes in equity and the consolidated statement of financial position. The consolidation worksheet used for a wholly owned subsidiary is changed to enable the disclosures required where NCI exists in a subsidiary. For a wholly owned subsidiary situation, the final column in the worksheet represents the group position which is also the parent’s position, as there is no NCI. Where an NCI exists, having determined the group position, the equity must be divided into parent’s shareholders share and the NCI share. Hence, the worksheet must have additional columns to divide the group’s consolidated equity into the relative shares belonging to the parent’s shareholders and the NCI. This is done by calculating the NCI share and subtracting it from the group equity so that the final column is then the parent entity’s share.

7. What is the impact on goodwill of the two methods prescribed by AASB 3/IFRS 3 to measure NCI? Paragraph 32 of AASB 3/IFRS 3 Business Combinations states: The acquirer shall recognise goodwill as of the acquisition date measured as the excess of (a) over (b) below:

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) the aggregate of: (i) the consideration transferred measured in accordance with this Standard, which generally requires acquisition‐date fair value (see paragraph 37); (ii) the amount of any non‐controlling interest in the acquiree measured in accordance with this Standard; and (iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition date fair value of the acquirer’s previously held equity interests in the acquiree. (b) the net of the acquisition‐date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with this Standard. Therefore, in order to determine the amount of goodwill as part of the acquisition analysis, we need to be aware of the methods prescribed by the standard to measure non‐controlling interest. Paragraph 19 of AASB 3/IFRS 3 states: For each business combination, the acquirer shall measure at the acquisition date components of non‐controlling interests in the acquiree that are present ownership interests and entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation at either: (a) fair value; or (b) the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets. The choice of each alternative measurement prescribed in paragraph 19 of AASB3/IFRS 3 affects the determination of goodwill and the subsequent consolidation adjustments. Where the first alternative is used, goodwill attributable to both the NCI and the parent is measured. Under the second alternative, only the goodwill attributable to the parent is measured, with no goodwill recognised for NCI. The methods are sometimes referred to as the ‘full goodwill’ and the ‘partial goodwill’ methods (see paragraph BC205 in the Basis for Conclusions on AASB 3/IFRS 3). These terms are used in this chapter. These methods are demonstrated in sections 29.4.1 and 29.4.2. Under the full goodwill method, the NCI in the subsidiary is measured at fair value. The fair value is determined on the basis of the market prices for shares not acquired by the parent, or, if these are not available, a valuation technique is used. The total goodwill calculated in the acquisition analysis consists of both the goodwill of the subsidiary and a control premium paid by the parent over the fair value of the shares acquired to obtain control over the subsidiary. The goodwill of the subsidiary will be allocated proportionally to the parent and NCI, but the control premium is only attributable to the parent. Under the partial goodwill method, at acquisition date the NCI is measured at the NCI’s proportionate share of the acquiree’s identifiable assets and liabilities. The NCI therefore does not get a share of any goodwill as goodwill is not an identifiable asset. The only goodwill recognised is that attributable to the parent; hence the term ‘partial’ goodwill. This goodwill (that belongs to the parent) will be calculated as follows. Goodwill =

consideration transferred plus previously acquired investment by parent less parent share of the net fair value of identifiable assets and liabilities of subsidiary.

29.5

Chapter 29: Consolidation: non-controlling interest

8. Describe the disadvantages of the two methods prescribed by AASB 3/IFRS 3 to measure NCI for users and preparers of financial information. It is unusual for the standard setters to allow a choice of methods as this leads to non‐ comparability of financial statements between entities. As some entities may use the full goodwill method, while others partial goodwill method when measuring NCI, users of financial information may find it difficult to compare the financial statements of those entities. Choosing one method over the other results in different outcomes as follows. 1. The reported amounts at acquisition date will be different. The amounts recognised for goodwill and the NCI share of equity would be higher under the full goodwill method. 2. If the goodwill is tested for impairment subsequent to acquisition date, the test is less complex under the full goodwill method. Further, any impairment of goodwill will be recognised for the entire subsidiary under the full goodwill method, but only for the parent’s share of the goodwill under the partial goodwill method. 3. Where a parent acquires some or all of the NCI subsequent to obtaining control, there is a lower negative impact on equity attributable to the parent shareholders under the full goodwill method due to the NCI being recognised at a higher carrying amount. Ernst & Young (2010) provides a detailed discussion of these outcomes. When preparing IFRS 3, on which AASB 3 is based, the IASB members could not agree on the use of the fair value measurement for NCI (i.e. the full goodwill method) and so both methods were allowed (see AASB 3/IFRS 3 BC210 and BC213). Some reasons for the disagreement are related to the perceived disadvantages of using the full goodwill method (see AASB 3/IFRS 3 BC213‐214): • it is more costly to measure the NCI at fair value • there is not sufficient evidence to assess the marginal benefits of reporting the acquisition‐ date fair value of the NCI.

9. If a step approach is used in the calculation of the NCI share of equity, what are the steps involved? The NCI is entitled to a share of the recorded equity of the subsidiary as measured at the end of the period for which the consolidated financial statements are being prepared. This share is calculated in three steps as follows. 1. Determine the NCI share of equity of the subsidiary at acquisition date. 2. Determine the NCI share of the changes in subsidiary equity between the acquisition date

and the beginning of the current period for which the consolidated financial statements are being prepared. 3. Determine the NCI share of the changes in subsidiary equity in the current period.

10. How does the existence of the NCI affect the business combination valuation entries? The existence of NCI has no effect on the business combination valuation entries other than the one recognising goodwill. If the full goodwill method is used (NCI is measured based on

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

the fair value), the recognition of the subsidiary’s goodwill (i.e. total goodwill excluding the control premium) is made via a BCVR entry. In contrast, where the partial goodwill method is used, goodwill is recognised only in the pre-acquisition entry. The other BCVR entries, apart from that for goodwill, are not affected because they are prepared in response to the requirement of AASB 3/IFRS 3 Business Combinations to show the identifiable assets and liabilities of the acquiree at fair value at acquisition date. The determination of fair value of those identifiable assets and liabilities is not affected by the parent’s ownership in the subsidiary. 11. How does the existence of the NCI affect the pre-acquisition entries? Normally, the first pre-acquisition entry eliminates the investment account recorded by the parent and the pre-acquisition equity of the subsidiary (including any BCVR for differences between the fair values and the carrying amounts of the subsidiary’s identifiable assets and liabilities at acquisition date plus the goodwill, if any), as well as recognising any gain on bargain purchase. The other pre-acquisition entries in each period after acquisition normally reverse the period’s transfers from pre-acquisition equity. The existence of the NCI has a few effects on the pre-acquisition entries as follows: • The subsidiary’s equity eliminated is only the parent’s share; in each period after acquisition the transfers from pre-acquisition equity are only reversed for the parent’s share. • If the acquisition analysis determines a gain on bargain purchase, the gain on bargain purchase recognised is only that relating to the parent’s share of the equity of the subsidiary. • If the acquisition analysis determines a goodwill: - In the full goodwill method, the subsidiary’s goodwill (i.e. total goodwill excluding control premium) is recognised as part of BCVR and eliminated in the pre-acquisition entry, while the control premium part of goodwill is recognised in the pre-acquisition entry. - In the partial goodwill method, the goodwill determined is recognised in the preacquisition entry.

12. Explain how business combination valuation entries may affect the calculation of NCI in step 2 and step 3. The NCI is entitled to a share of the recorded equity of the subsidiary in the consolidated financial statements as measured at the end of the period for which the consolidated financial statements are being prepared. The recorded equity in the consolidated financial statements is the equity as appearing in the financial statements of the subsidiary, adjusted for the impact of business combination valuation entries, pre-acquisition entries and the elimination entries for the intragroup transactions prepared at the end of the period. The business combination valuation entries prepared at the end of a period may include: • Adjustments to income and expenses for the current period as the assets or liabilities undervalued or overvalued at acquisition date are depreciated, sold or settled – those adjustments impact of the reported equity of the subsidiary and affect the current profit that is to be allocated to NCI in the NCI Step 3

29.7

Chapter 29: Consolidation: non-controlling interest

•

Adjustments to retained earnings for the previous periods as the assets or liabilities undervalued or overvalued at acquisition date were depreciated – those adjustments impact of the reported equity of the subsidiary and affect the retained earnings that is to be allocated to NCI in the NCI Step 2.

As such, before allocating the current profit and the change of retained earnings of the subsidiary to NCI, the impact of the business combination valuation entries on those need to be taken into consideration.

13. What are two events that could occur between the acquisition date and the beginning of the current period that could affect the calculation of the NCI share of retained earnings? The NCI share of retained earnings is calculated as the NCI share of pre-acquisition retained earnings of the subsidiary (in step 1 of NCI allocation) and the NCI share of changes in retained earnings between the acquisition date and the beginning of the current period (in Step 2 of NCI allocation). The changes in retained earnings between the acquisition date and the beginning of the current period may be caused by: • Changes in the assets & liabilities recognised via the BCVR entries (e.g. sale of the inventories or prior period’s depreciations of non-current assets on hand in the subsidiary undervalued at the acquisition date): these changes can cause transfers from BCVR to retained earnings or decreases in retained earnings. • Other transfers involving retained earnings e.g. transfers to/from general reserve or other reserves, prior period profits and dividends. Other than those events above, prior period’s intragroup transactions originating from the subsidiary that still had unrealised profits/losses at the beginning of the current period will also affect the retained earnings of the subsidiary and therefore the calculation of the NCI share of retained earnings.

14. Explain whether an NCI adjustment needs to be made for all intragroup transactions. An NCI adjustment does NOT need to be made for all intragroup transactions. An NCI adjustment only needs to be made for intragroup transactions where there is unrealised profit/loss recorded by the subsidiary. Hence, in order for an NCI adjustment to be made, the intragroup transactions must be upstream transactions, i.e. from subsidiary to parent and must have generated profits/losses that are unrealised from the group’s perspective. Examples of such upstream intragroup transactions include: • Sales of inventories by the subsidiary to the parent for a profit/loss, with some inventories still on hand with the parent at the beginning or at the end of the period. • Sales of non-current assets by the subsidiary to the parent for a profit/loss, with the assets still on hand with the parent at the beginning or at the end of the period. • Transfers of inventories to non-current assets or vice-versa by the subsidiary to the parent for a profit/loss, with some of those assets still on hand with the parent at the beginning or at the end of the period. • Dividends declared or dividends declared and paid by the subsidiary during the period. In terms of intragroup borrowings and intragroup services, as there are no unrealised profits, there won’t be any NCI adjustment needed.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

15. Explain how the adjustment for intragroup transactions affects the calculation of the NCI share of equity. The NCI does not affect the adjustments for intragroup transactions, as the full effects of each intragroup transaction are eliminated on consolidation, no matter how much is the parent’s ownership interest in the subsidiary. However, where the subsidiary records profits/losses which are unrealised from the group’s perspective, this affects the calculation of the NCI. The NCI is entitled to a share of the equity from the group’s perspective, rather than just a simple share of the subsidiary’s equity. Hence: • where the subsidiary has recorded unrealised profits/losses in the current profit, the NCI share of the current recorded profit of the group must be adjusted for any of that profit/loss which is unrealised. • where the subsidiary has recorded unrealised profits/losses in the previous period’s profit, the NCI share of the recorded retained earnings of the group must be adjusted for any of that profit/loss which was unrealised. If these profits/losses are realised in the current period, the NCI share of the recorded current profit of the group must be adjusted for any of that profit/loss which was realised. Therefore, the adjustments for intragroup transactions affect the calculation of the NCI share of equity in the Step 2 & Step 3 calculations where those intragroup transactions generate unrealised or realised subsidiary’s profits/losses. The net result after those adjustments is then that the NCI gets only a share of realised subsidiary’s equity.

16. Explain how the gain on bargain purchase affects the measurement of the NCI. In the rare case that a gain on bargain purchase arises as a result of a business combination, such a gain has no effect on the calculation of the NCI share of equity. The gain is made by the parent paying less than the net fair value of the identifiable assets acquired and liabilities assumed of the subsidiary. The NCI receives a share of the net assets of the subsidiary, and has no involvement with the gain on bargain purchase.

17. Identify the disclosures required in relation to the NCI. The specific disclosure requirements with regards to NCI within the statement of profit or loss and other comprehensive income, statement of changes in equity and statement of financial position are discussed in section 29.2.2 as stipulated in AASB 10/IFRS 10 and AASB 101/IAS 1. Statement of profit or loss and other comprehensive income: • AASB 101/IAS 1 paragraph 81B: Disclose both NCI and parent share of profit/loss for the period and share of total comprehensive income for the period Statement of financial position: • AASB 10/IFRS 10 paragraph 22: A parent shall present non-controlling interests in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. • AASB 101/IAS 1 paragraph 54 (q) and (r): NCI share of equity, and share capital and reserves attributable to parent.

29.9

Chapter 29: Consolidation: non-controlling interest

Statement of changes in equity: • AASB 101/IAS 1 paragraph 106 (a): total comprehensive income for the period, showing that attributable to the parent and that attributable to the NCI. • In summary, the information that needs to be disclosed for NCI is: - the NCI share of profit after tax - the NCI share of comprehensive income - the NCI share of consolidated equity. AASB 12/IFRS 12 Disclosure of Interests in Other Entities also contains disclosures requirements for subsidiaries in which there are NCI. Paragraph 12 of AASB 12/IFRS 12 states: An entity shall disclose for each of its subsidiaries that have non‐controlling interests that are material to the reporting entity: (a) the name of the subsidiary. (b) the principal place of business (and country of incorporation if different from the principal place of business) of the subsidiary. (c) the proportion of ownership interests held by non‐controlling interests. (d) the proportion of voting rights held by non‐controlling interests, if different from the proportion of ownership interests held. (e) the profit or loss allocated to non‐controlling interests of the subsidiary during the reporting period. (f) accumulated non‐controlling interests of the subsidiary at the end of the reporting period. (g) summarised financial information about the subsidiary (see paragraph B10).

29.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 29.1 Classification of the NCI Bruce Williams is the accountant for Vintage Cars Ltd. This entity has an 80% holding in the entity Antique Parts Ltd. Bruce is concerned that the consolidated financial statements prepared under AASB 10/IFRS 10 may be misleading. He believes that the NCI in Antique Parts Ltd does not belong to the group and it should be treated as a liability, rather than as a part of consolidated equity. He therefore wants to prepare the consolidated financial statements showing the NCI in Antique Parts Ltd under liabilities in the statement of financial position, and for the statement of profit and loss and other comprehensive income and the statement of changes in equity to show the profit numbers relating to the parent shareholders only. Required Discuss the differences that would arise in the consolidated financial statements if the NCI were classified as debt rather than equity, and the reasons the standard setters have chosen the equity classification of NCI in AASB 10/IFRS 10. 1. Differences that will arise in the consolidated financial statements if NCI would be classified as debt: The current disclosure requirements regarding NCI are summarised below: 1. Statement of profit or loss and other comprehensive income: - AASB 101/IAS 1 paragraph 81B: Disclose both NCI and parent share of profit/loss for the period and share of total comprehensive income for the period 2. Statement of financial position: - AASB 10/IFRS 10 paragraph 22: A parent shall present non-controlling interests in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. - AASB 101/IAS 1 paragraph 54 (q) and (r): NCI share of equity, and share capital and reserves attributable to parent. 3. Statement of changes in equity: - AASB 101/IAS 1 paragraph 106 (a): total comprehensive income for the period, showing that attributable to the parent and that attributable to the NCI. If the NCI were classified as debt, any dividends would be disclosed as an expense, while the NCI would not receive a share of profit or total comprehensive income. Therefore, in the statement of financial position the NCI would be shown under liabilities, the NCI share of dividends would be shown in the statement of profit and loss and other comprehensive income while in the statement of changes in equity there would be no NCI information.

29.11

Chapter 29: Consolidation: non-controlling interest

2. Reasons for NCI to be classified as equity: The main argument for the NCI being classified as equity is that it better fits the definition of equity. The subsidiary has no present obligation in relation to the NCI so the NCI does not meet the definition of a liability. Some people argue that the NCI should be disclosed separately from equity and liabilities – the “mezzanine” treatment. This argument relates to the utility of financial statements in relation to the user group, the parent shareholders. It is argued that this form of presentation provides more relevant information to the parent shareholders.

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Case study 29.2 Choice of full or partial goodwill methods The following statement appears in Note 1 of the annual report of Margaret Ltd: On an acquisition-by-acquisition basis, the Group recognises any non-controlling interest in the acquiree either at fair value or at the non-controlling interest’s proportionate share of the acquiree’s net identifiable assets. Required Discuss under what circumstances Margaret Ltd would choose one method over the other in recognising any non-controlling interest in an acquiree. It is unusual for the standard-setters to allow a choice of methods as this leads to noncomparability of financial statements between entities. However, when preparing IFRS 3 Business Combinations, the IASB was unable to get sufficient members to agree on one method, and so both methods were allowed. It should be noted that many users of financial reports see no value in the reported NCI, regardless of how it is measured. Nevertheless, it is expected that choosing between the two methods is a matter of the costs involved. As such, if measuring NCI at fair value (i.e. the full goodwill method) is more costly that measuring NCI based on its proportionate share of the acquiree’s net identifiable assets (i.e. the partial goodwill method), the company will choose the latter method and vice-versa. Moreover, given that the amounts recognised for goodwill and the NCI share of equity would be higher under the full goodwill method, it is expected that the full goodwill method may be used by the company when it needs to show a better debt-to-assets ratio. If an impairment test is undertaken subsequent to acquisition date, the test is considered to be less complex under the full goodwill method. Further, any impairment of goodwill will be recognised for the entire subsidiary under the full goodwill method, but only for the parent’s share of the goodwill under the partial goodwill method. Therefore, if the company expects the goodwill to be impaired after acquisition, to make things easier it will choose the full goodwill method. Where a parent acquires some or all of the NCI subsequent to obtaining control, there is a lower impact on equity attributable to the parent shareholders under the full goodwill method. In those circumstances, the full goodwill method might be preferable.

29.13

Chapter 29: Consolidation: non-controlling interest

Case study 29.3 Realisation of profits The consolidated financial statements of Submarine Ltd are being prepared by the group accountant, Raz Putin. He is currently in dispute with the auditors over the need to adjust the NCI share of equity for intragroup transactions. He believes that it would be unnecessary. He argues that, as the NCI group of shareholders has an equity interest in the subsidiary, it is entitled to a share of what the subsidiary records as equity, including the profit obtained from all transactions. He also disputes with the auditors the notion of ‘realisation’ of profit in relation to the NCI. If realisation requires the involvement of an external entity in a transaction, then in relation to transactions such as intragroup transfers of vehicles and services or interest payments, the profit will never be realised as those transactions never involve external entities. As a result, the most appropriate accounting is to give the NCI a share of subsidiary equity and not be concerned with the fictitious involvement of external entities. Required Write a report to Raz convincing him that his arguments are fallacious. Raz has two criticisms about the treatment of NCI in the consolidated financial statements: 1. He argues that, as the NCI group of shareholders has an equity interest in the subsidiary, it is entitled to a share of what the subsidiary records as equity, including the profit obtained from all transactions. 2. He also disputes with the auditors the notion of ‘realisation’ of profit in relation to the NCI. If realisation requires the involvement of an external entity in a transaction, then in relation to transactions such as intragroup transfers of vehicles and services or interest payments, the profit will never be realised as those transactions never involve external entities. 1. The need to adjust for the NCI share of equity in relation to intragroup transactions: It is true that the holders of NCI are entitled to the share of what subsidiary records as equity based on their ownership interest in the subsidiary. However, the consolidated financial statements should disclose the NCI share of the consolidated equity from the group’s perspective. Note that consolidated equity includes the subsidiary’s equity post-acquisition adjusted for the effects of intragroup transactions that originate from the subsidiary and generate unrealised profits/losses – that is, realised subsidiary equity. 2. The notion of ‘realisation’ of profit: It is also true that profit is normally realised when the group transacts with an entity external to the group. The point of realisation depends then on identifying when the external entity is involved. With intragroup sales of inventories, the point of profit/loss ‘realisation’ is easily identified as being the moment when the inventories are on-sold to external entities. It is at this point that the group recognises profit/loss on sale, being the excess of the sale proceeds over the cost to the group of the item being sold and that includes the intragroup profit, making it realised. This

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is also true for other assets initially transferred intragroup that are then on-sold to external entities. With assets used by the group such as depreciable assets, the group does not interact directly with an external entity. It is then impossible to determine a point of ‘realisation’ based on direct involvement of the group with an external entity. The point of realisation is then based on the indirect involvement as the asset is used by the group to produce items/services that will be sold, at some point, to external entities. The depreciable asset is used by the group to assist in its interaction with external entities e.g. by making inventories for sale to external entities. The depreciation charge measures the extent of that involvement in any one year as the depreciation charge is based on paragraph 60 of AASB 116/IAS 16 which notes that the depreciation charge reflects the pattern of benefits consumed by the entity. Realisation of profit then occurs as the asset is used up or consumed by the entity. Realisation is then achieved in proportion to the depreciation charge made on the asset. With intragroup transactions such as providing a service to the parent or receiving interest payments on an intragroup borrowing to the parent, the subsidiary records revenue, which increases subsidiary’s profit. However, as the parent records expenses, which decreases its profit, there is no net effect on the consolidated profit and therefore on the consolidated equity. As such, no adjustment is needed to the NCI share of consolidated equity for this type of transactions; there is no unrealised profits in these transactions.

29.15

Chapter 29: Consolidation: non-controlling interest

Case study 29.4 Calculation of NCI In December 2022, William Ltd acquired 60% of the issued shares of Thomas Ltd. The accountant for William Ltd, Nikki Romanov, is concerned about the approach she should take in preparing the consolidated financial statements for the newly established group. In particular, she is concerned about the calculation of the NCI share of equity, particularly in the years after acquisition date. She has heard accountants in other companies talking about a ‘step’ approach, and in particular how this makes accounting in periods after the acquisition date very easy. Required Prepare a report for Nikki, explaining the step approach for the calculation of NCI and the effects of this approach in the years after acquisition date. The 3 steps in the calculation of NCI are: 1. Determine the NCI share of equity of the subsidiary at acquisition date. 2. Determine the NCI share of the changes in subsidiary’s equity between the acquisition date

and the beginning of the current period for which the consolidated financial statements are being prepared. 3. Determine the NCI share of the changes in subsidiary’s equity in the current period. This approach assumes that the period between the acquisition date and the end of the current period is longer than one financial period. If it is not, in preparing the consolidated financial statements at, say, 30 June 2023, the consolidation worksheet will only contain Steps 1 and 2: • Step 1 journal entry never changes. • Step 2 is recognising the NCI share of the changes in equity between December 2022 and 30 June 2023. If the assumption is satisfied, in preparing the consolidated financial statements at, say, 30 June 2024, the consolidation worksheet will contain all Steps 1, 2 and 3. • • •

Step 1 journal entry never changes. Step 2 is recognising the NCI share of the changes in equity between December 2022 and 30 June 2023. Step 3 is recognising the NCI share of the changes in equity between 1 July 2023 and 30 June 2024.

Every period after that: • Step 1 journal entry never changes • Step 2 is the combination of Step 2 and Step 3 from the previous period. • The only new calculations relate to Step 3, namely the share of changes in equity for the current period.

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Case study 29.5 Intragroup transactions Because the Joshua Cement Works Ltd has a number of subsidiaries, the accountant, Evelyn Chen, is required to prepare a set of consolidated financial statements for the group. She is concerned about the calculation of the NCI share of equity particularly where there are intragroup transactions. The auditors require that when adjustments are made for intragroup transactions, the effects of these transactions on the NCI should also be adjusted for. Evelyn has two concerns: • Why is it necessary to adjust the NCI share of equity for the effects of intragroup transactions? • Is it necessary to make NCI adjustments in relation to all intragroup transactions? Required Prepare a report for Evelyn, explaining these two areas of concern. Why is it necessary? Under Australian and international accounting standards, the NCI is classified as equity, mainly because the NCI does not fit the definition of a liability. If the NCI is classified as equity, it is entitled to a share of consolidated equity as it appears in the consolidated financial statements. Consolidated equity is determined after adjusting for the effects of intragroup transactions. The share of the consolidated equity that should be recognised in the consolidated financial statements as belonging to NCI is then the subsidiary’s equity adjusted for the effects of those intragroup transactions affecting subsidiary’s equity – that is, realised subsidiary equity. Is it necessary to make NCI adjustments in relation to all intragroup transactions? The NCI is entitled to a share of the equity from the group’s perspective, rather than just a simple share of the subsidiary’s equity. Hence, the calculation of the NCI is affected by intragroup transactions only when the subsidiary records profits/losses which are unrealised from the group’s perspective: • where the subsidiary has recorded unrealised profits/losses in the current profit, the NCI share of the current recorded profit of the group must be adjusted for any of that profit/loss which is unrealised. • where the subsidiary has recorded unrealised profits/losses in the previous period’s profit, the NCI share of the recorded retained earnings of the group must be adjusted for any of that profit/loss which was unrealised. If these profits/losses are realised in the current period, the NCI share of the recorded current profit of the group must be adjusted for any of that profit/loss which was realised. Therefore, the adjustments for intragroup transactions affect the calculation of the NCI share of equity in the Step 2 and Step 3 calculations where those intragroup transactions generate unrealised or realised subsidiary’s profits/losses. The net result after those adjustments is then that the NCI gets only a share of realised subsidiary’s equity.

29.17

Chapter 29: Consolidation: non-controlling interest

Application and analysis exercises Exercise 29.1 Full and partial goodwill method On 1 July 2022, Rainbow Ltd acquired 80% of the issued shares of Lorikeet Ltd for $330 000. At this date, the equity of Lorikeet Ltd was as follows. Share capital

$200 000

General reserve

80 000

Retained earnings

100 000

At acquisition date, all the identifiable assets and liabilities of Lorikeet Ltd were recorded at amounts equal to fair value. At 30 June 2024, the equity of Lorikeet Ltd consisted of: Share capital

$200 000

General reserve

100 000

Retained earnings

160 000

A transfer from pre-acquisition retained earnings to general reserve of $20 000 was made during the year ended 30 June 2023. During the year ended 30 June 2024, Lorikeet Ltd recorded a profit of $30 000. Required Prepare the consolidated worksheet entries at 30 June 2024 for Rainbow Ltd assuming: 1. At 1 July 2022, the fair value of the non-controlling interest was $80 000 and Rainbow Ltd adopts the full goodwill method. 2. Rainbow Ltd adopts the partial goodwill method. (LO4) 1. Consolidation worksheet entries at 30 June 2024 (Rainbow Ltd uses full goodwill method): Acquisition analysis at 1 July 2022: Fair value of identifiable assets and liabilities of Lorikeet Ltd (a) Consideration transferred (b) NCI in Lorikeet Ltd Aggregate of (a) and (b) Goodwill acquired Goodwill of Lorikeet Ltd Fair value of Lorikeet Ltd Fair value of identifiable assets and liabilities of Lorikeet Ltd Goodwill of Lorikeet Ltd

= = = = = = =

($200 000 + $80 000 + $100 000) (equity) $380 000 $330 000 $80 000 $410 000 $410 000 - $380 000 $30 000

= =

$80 000 / 20% $400 000

= = =

$380 000 $400 000 - $380 000 $20 000

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Goodwill of Rainbow Ltd Goodwill acquired Goodwill of Lorikeet Ltd Control premium – parent

= = = =

$30 000 $20 000 $30 000 - $20 000 $10 000

The control premium can also be calculated as follows: Fair value of the shares Lorikeet Ltd acquired by Rainbow Ltd = = Consideration transferred = Control premium – parent = =

$80 000 / 20% x 80% $320 000 $330 000 $330 000 - $320 000 $10 000

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Lorikeet Ltd, i.e. $10 000 + 80% x $20 000 = $26 000. NCI will only be entitled to its share of the goodwill of Lorikeet Ltd, i.e. 20% x $20 000 = $4 000. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Lorikeet Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Goodwill Dr 20 000 Business combination valuation reserve Cr (Goodwill of Lorikeet Ltd – it does not include the control premium)

20 000

(b) Pre-acquisition entries: Retained earnings (1/7/23)* Share capital General reserve** Business combination valuation reserve Goodwill Shares in Lorikeet Ltd * 80% x ($100 000 - $20 000) ** 80% x ($80 000 + $20 000)

Dr Dr Dr Dr Dr Cr

64 000 160 000 80 000 16 000 10 000 330 000

Only the parent share of the pre-acquisition equity in Lorikeet Ltd is eliminated in the preacquisition entry against the investment account recognised by Rainbow Ltd. It is assumed that there were no transfers from pre-acquisition equity since 1 July 2023 until 30 June 2024. The amounts to be eliminated will be based on the amounts recognised in equity accounts at acquisition date, adjusted for the transfer from pre-acquisition retained earnings to general reserve up to 1 July 2023. There won’t be any need to reverse any current period’s transfers. Also, the control premium is recognised here.

29.19

Chapter 29: Consolidation: non-controlling interest

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve NCI (20% of equity of Lorikeet Ltd at acquisition date)

Dr Dr Dr Dr Cr

20 000 40 000 16 000 4 000 80 000

This entry transfers the NCI share of the pre-acquisition equity in Lorikeet Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (prior period): Retained earnings (1/7/23)* Dr 6 000 General reserve** Dr 4 000 NCI Cr 10 000 *20% of the change in Retained Earnings between acquisition date and 30 June 2023 of $30 000 (i.e. $160 000 - $30 000 (profit for the year ended 30 June 2024) - $100 000) **20% of the change in General Reserve of $20 000 (i.e. $100 000 - $80 000) This entry transfers the NCI share of changes in equity of Lorikeet Ltd for the period from acquisition date to the beginning of the current period to the NCI equity account. As the business combination entries do not have any impact on Retained earnings (1/7/23) and there are no current period transfers between the equity accounts of Lorikeet Ltd, there is no need to adjust the changes in retained earnings or general reserve reflected in the financial statements of Lorikeet Ltd. (e) NCI Step 3: NCI share of changes in equity from 1/7/23 to 30/6/24 (current period): NCI share of profit NCI (20% x $30 000)

Dr Cr

6 000 6 000

This entry transfers the NCI share of changes in equity of Lorikeet Ltd for the current period to the NCI equity account. It is assumed that the only change in equity for the current period is the recognition of the profit. Also, it is assumed that the profit reported is after tax. As the business combination entries do not have any impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. 2. Consolidation worksheet entries at 30 June 2024 (Rainbow Ltd uses partial goodwill method): Acquisition analysis at 1 July 2022: Fair value of identifiable assets and liabilities of Lorikeet Ltd (a) Consideration transferred (b) NCI in Lorikeet Ltd

= = = = =

($200 000 + $80 000 + $100 000) (equity) $380 000 $330 000 20% x $380 000 $76 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Aggregate of (a) and (b) Goodwill acquired – parent only

= = =

$406 000 $406 000 - $380 000 $26 000

As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Lorikeet Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. (a) Business combination valuation entries: There is no BCVR entry as only parent goodwill should be recognised and that is done in the pre-acquisition entry. (b) Pre-acquisition entries: Retained earnings (1/7/23) Dr 80 000 Share capital Dr 160 000 General reserve Dr 64 000 Goodwill Dr 26 000 Shares in Lorikeet Ltd Cr 330 000 There is no BCVR to eliminate in the pre-acquisition entry, but there is goodwill to recognise as determined in the acquisition analysis. This goodwill only belongs to the parent. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/23) Share capital General reserve NCI (20% of equity of Lorikeet Ltd at acquisition date)

Dr Dr Dr Cr

20 000 40 000 16 000 76 000

This entry transfers the NCI share of the pre-acquisition equity in Lorikeet Ltd at acquisition date to the NCI equity account. Note that under this method, the NCI is valued and therefore recognised based on the proportionate share of the fair value of identifiable assets and liabilities of Lorikeet Ltd at acquisition date. The entries for NCI Step 2 and NCI Step 3 are the same as those posted previously for the full goodwill method (see part 1).

29.21

Chapter 29: Consolidation: non-controlling interest

Exercise 29.2 Full and partial goodwill method Hare Ltd acquired 90% of the issued shares (cum div.) of Tortoise Ltd on 1 July 2021 for $711 000. At this date, the equity of Tortoise Ltd consisted of: Share capital

$375 000

Asset revaluation surplus

90 000

Retained earnings

240 000

At acquisition date, all the identifiable assets and liabilities of Tortoise Ltd were recorded at amounts equal to fair value. Tortoise Ltd had recorded a dividend payable of $10 000, which was paid in August 2021, and goodwill of $5000. At 30 June 2023, the equity of Tortoise Ltd consisted of: Share capital

$375 000

Asset revaluation surplus

120 000

Retained earnings

330 000

During the year ended 30 June 2023, Tortoise Ltd recorded a profit of $60 000. Required Prepare the consolidated worksheet entries at 30 June 2023 for Hare Ltd assuming: 1. At 1 July 2021, the fair value of the non-controlling interest was $75 000 and Hare Ltd adopts the full goodwill method. 2. Hare Ltd adopts the partial goodwill method. (LO4) 1. Consolidation worksheet entries at 30 June 2023 (Hare Ltd uses full goodwill method): Acquisition analysis at 1 July 2021: Fair value of identifiable assets and liabilities of Tortoise Ltd

(a) Net consideration transferred (b) NCI in Tortoise Ltd Aggregate of (a) and (b) Goodwill acquired Goodwill of Tortoise Ltd Fair value of Tortoise Ltd Fair value of identifiable assets and liabilities of Tortoise Ltd

= – = = = = = = =

($375 000 + $90 000 + $240 000) (equity) $5 000 (goodwill) $700 000 $711 000 – (90% x $10 000) (dividend) $702 000 $75 000 $777 000 $777 000 – $700 000 $77 000

= =

$75 000 / 10% $750 000

$700 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Goodwill of Tortoise Ltd Goodwill recorded Unrecorded goodwill Goodwill of Hare Ltd Goodwill acquired Goodwill of Tortoise Ltd Control premium – parent

= = = = =

$750 000 – $700 000 $50 000 $5 000 $50 000 – $5 000 $45 000

= = = =

$77 000 $50 000 $77 000 – $50 000 $27 000

The control premium can also be calculated as follows: Fair value of the shares in Tortoise Ltd acquired by Hare Ltd = = Net consideration transferred = Control premium – parent = =

$75 000 / 10% x 90% $675 000 $702 000 $702 000 - $675 000 $37 000

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Tortoise Ltd, i.e. $37 000 + 90% x $50 000 = $82 000. NCI will only be entitled to its share of the goodwill of Tortoise Ltd, i.e. 10% x $50 000 = $5 000. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Tortoise Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries to the extent not previously recognised, i.e. only $45 000. (a) Business combination valuation entries: Goodwill Dr 45 000 Business combination valuation reserve Cr 45 000 (Unrecorded goodwill of Tortoise Ltd – it does not include the control premium) (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Tortoise Ltd

Dr Dr Dr Dr Dr Cr

216 000 337 500 81 000 40 500 27 000 702 000

Only the parent share of the pre-acquisition equity in Tortoise Ltd is eliminated in the preacquisition entry against the investment account recognised by Hare Ltd. It is assumed that there were no transfers from pre-acquisition equity since acquisition until 30 June 2023 and therefore the amounts to be eliminated will be based on the amounts recognised in equity accounts at acquisition date and there won’t be any need to reverse any current period’s transfers. Also, the control premium is recognised here.

29.23

Chapter 29: Consolidation: non-controlling interest

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital Asset revaluation surplus Business combination valuation reserve NCI (10% of equity of Tortoise Ltd at acquisition date)

Dr Dr Dr Dr Cr

24 000 37 500 9 000 4 500 75 000

This entry transfers the NCI share of the pre-acquisition equity in Tortoise Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/21 to 30/6/22 (prior period): Retained earnings (1/7/22)* Dr 9 000 Asset revaluation surplus** Dr 3 000 NCI Cr 12 000 *10% of the change in Retained Earnings of $90 000 (i.e. $330 000 - $240 000) **10% of the change in Asset Revaluation Surplus of $30 000 (i.e. $120 000 - $90 000) This entry transfers the NCI share of changes in equity of Tortoise Ltd for the period from acquisition date to the beginning of the current period to the NCI equity account. It is assumed that the opening balance of the equity accounts at the beginning of the current period is the same as the closing balance – the Retained Earnings does not include the profit for the current period yet. As the business combination entries do not have any impact on Retained earnings (1/7/22) and there are no transfers between the equity accounts of Tortoise Ltd, there is no need to adjust the changes in retained earnings or asset revaluation surplus reflected in the financial statements of Tortoise Ltd. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (10% x $50 000)

Dr Cr

5 000 5 000

This entry transfers the NCI share of changes in equity of Tortoise Ltd for the current period to the NCI equity account. It is assumed that the only change in equity for the current period is the recognition of the profit. Also, it is assumed that the profit reported is after tax. As the business combination entries do not have any impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. 2. Consolidation worksheet entries at 30 June 2023 (Hare Ltd uses partial goodwill method): Acquisition analysis at 1 July 2021: Fair value of identifiable assets and liabilities of Tortoise Ltd

(a) Net consideration transferred

= = = =

($375 000 + $90 000 + $240 000) (equity) $5 000 (goodwill) $700 000 $711 000 – (90% x $10 000) (dividend) $702 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b) NCI in Tortoise Ltd Aggregate of (a) and (b) Goodwill of Hare Ltd Goodwill recorded – write off Unrecorded goodwill – parent only

= = = = = = =

10% x $700 000 $70 000 $772 000 $772 000 - $700 000 $72 000 $5 000 $67 000

As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Tortoise Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here of $67 0000 will belong to the parent and will be recognised in the pre-acquisition entry. However, as the goodwill previously recorded would be allocated proportionally to the parent and NCI unless eliminated, we need to first eliminate that goodwill before we recognise the goodwill for this acquisition. This elimination will be done in the business combination valuation entries. (a) Business combination valuation entries: Business combination valuation reserve Goodwill

Dr Cr

5 000

Dr Dr Dr Dr Cr Cr

216 000 337 500 81 000 72 000

Dr Dr Dr Cr Cr

24 000 37 500 9 000

5 000

(b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Asset revaluation surplus Goodwill Business combination valuation reserve Shares in Tortoise Ltd

4 500 702 000

500 70 000

This entry transfers the NCI share of the pre-acquisition equity in Tortoise Ltd at acquisition date to the NCI equity account. Note that under this method, the NCI is valued and therefore recognised based on the proportionate share of the fair value of identifiable assets and liabilities of Tortoise Ltd at acquisition date. The entries for NCI Step 2 and NCI Step 3 are the same as those posted previously for the full goodwill method.

29.25

Chapter 29: Consolidation: non-controlling interest

Exercise 29.3 Partial goodwill method, gain on bargain purchase Black Ltd acquired 90% of the issued shares of Swan Ltd for $107 600 on 1 July 2022. At this date, the equity of Swan Ltd consisted of:

At acquisition date, all the identifiable assets and liabilities of Swan Ltd were recorded at amounts equal to fair value. At 30 June 2023, the equity of Swan Ltd consisted of:

During the year ended 30 June 2023, Swan Ltd recorded a profit of $15 000. The general reserve was created from a transfer from retained earnings existing at 1 July 2022. Required Prepare the consolidated worksheet entries at 30 June 2023 for Black Ltd assuming Black Ltd adopts the partial goodwill method. (LO4 and LO7) Consolidation worksheet entries at 30 June 2023 (Black Ltd uses partial goodwill method): Acquisition analysis at 1 July 2022: Fair value of identifiable assets and liabilities of Swan Ltd (a) Consideration transferred (b) NCI in Swan Ltd Aggregate of (a) and (b) Gain on bargain purchase

= = = = = = = =

($80 000 + $40 000) (equity) $120 000 $107 600 10% x $120 000 $12 000 $119 600 $120 000 - $119 600 $400

This method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Swan Ltd at acquisition date. The entire gain on bargain purchase calculated here will belong to the parent and will be recognised in the pre-acquisition entry. (a) Business combination valuation entries: There is no BCVR entry as there is no goodwill to be recognised (a gain on bargain purchase occurred) and all the identifiable assets and liabilities of Swan Ltd were recorded at fair values at acquisition date.

29.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Gain on bargain purchase Shares in Swan Ltd

Dr Dr Cr Cr

36 000 72 000

General reserve Transfer to general reserve (90% x $10 000)

Dr Cr

9 000

400 107 600

9 000

Only the parent share of the pre-acquisition equity in Swan Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Black Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. Therefore, the gain on bargain purchase is recognised here in the gain account, not as an adjustment to Retained Earnings as it may be the case if the pre-acquisition entry needs to be prepared in later periods. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from retained earnings to general reserve, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr NCI Cr (10% of the equity of Swan Ltd at acquisition date)

4 000 8 000 12 000

This entry transfers the NCI share of the pre-acquisition equity in Swan Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (10% x $15 000)

Dr Cr

1 500 1 500

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries do not have any impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. It is also assumed that the Retained Earnings at 30 June 2023 does not include the profit for the current period yet. Therefore, the change in the balance of Retained Earnings from acquisition date (i.e. $40 000) to 30 June 2023 (i.e. $30 000) is only caused by the transfer to general reserve of $10 000. As this change increases the general reserve, while decreasing the retained

29.27

Chapter 29: Consolidation: non-controlling interest

earnings (the latter being recognised as a debit to the Transfer to general reserve account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in general reserve. • A decrease in NCI due to the decrease in retained earnings. Those effects can be recorded as: General reserve NCI (10% x $10 000) NCI Transfer to general reserve (10% x $10 000)

Dr Cr

1 000

Dr Cr

1 000

Dr Cr

1 000

These last two entries can be combined into a single entry: General reserve Transfer to general reserve

1 000

29.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.4 Undervalued assets, full and partial goodwill method On 1 July 2022, Jane Ltd acquired 75% of the issued shares of Austen Ltd for $360 000. At this date, the equity of Austen Ltd consisted of share capital of $200 000 and retained earnings of $130 000. All the identifiable assets and liabilities of Austen Ltd were recorded at amounts equal to fair value except for the following.

Austen Ltd also had an internally generated patent not recognised at 1 July 2022. Jane Ltd assessed the fair value of that patent at $50 000. The tax rate is 30%. Required 1. Prepare the acquisition analysis at 1 July 2022 assuming that Jane Ltd used the partial goodwill method. 2. Prepare the acquisition analysis at 1 July 2022 assuming that Jane Ltd used the full goodwill method and the fair value of the non‐controlling interest at 1 July 2022 was $110 000. (LO4 and LO7) 1. Acquisition analysis at 1 July 2022 (Jane Ltd uses partial goodwill method): Net fair value of identifiable assets and liabilities of Austen Ltd = ($200 000 + $130 000) (equity) + ($12 000 – $10 000) (1 – 30%) (BCVR - machine) + ($140 000 – $100 000) (1 – 30%) (BCVR - plant) + ($33 000 – $25 000) (1 – 30%) (BCVR inventories) + $50 000 (1 – 30%) (BCVR - patent) = $400 000 (a) Consideration transferred = $360 000 (b) NCI in Austen Ltd = 25% x $400 000 = $100 000 Aggregate of (a) and (b) = $460 000 Goodwill acquired – parent only = $460 000 - $400 000 = $60 000 As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Austen Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. 2. Acquisition analysis at 1 July 2022 (Jane Ltd uses full goodwill method): Net fair value of identifiable assets and liabilities of Austen Ltd = ($200 000 + $130 000) (equity) + ($12 000 – $10 000) (1 – 30%) (BCVR - machine)

29.29

Chapter 29: Consolidation: non-controlling interest

(a) Consideration transferred (b) NCI in Austen Ltd Aggregate of (a) and (b) Goodwill acquired Goodwill of Austen Ltd Fair value of Austen Ltd

+ ($140 000 – $100 000) (1 – 30%) (BCVR - plant) + ($33 000 – $25 000) (1 – 30%) (BCVR inventories) + $50 000 (1 – 30%) (BCVR - patent) = $400 000 = $360 000 = $110 000 = $470 000 = $470 000 – $400 000 = $70 000

= = Net fair value of identifiable assets and liabilities of Austen Ltd = Goodwill of Austen Ltd = = Goodwill of Jane Ltd Goodwill acquired = Goodwill of Austen Ltd = Control premium - parent = =

$110 000 / 25% $440 000 $400 000 $440 000 – $400 000 $40 000 $70 000 $40 000 $70 000 – $40 000 $30 000

The control premium can also be calculated as follows: Fair value of the shares in Austen Ltd acquired by Jane Ltd = $110 000 / 25% x 75% = $330 000 Consideration transferred = $360 000 Control premium – parent = $360 000 - $330 000 = $30 000 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Austen Ltd, i.e. $30 000 + 75% x $40 000 = $60 000. NCI will only be entitled to its share of the goodwill of Austen Ltd, i.e. 25% x $40 000 = $10 000. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Austen Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries.

29.30

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Exercise 29.5 Undervalued assets, full and partial goodwill method On 1 July 2022, Sugar Ltd acquired 90% of the shares of Glider Ltd for $435 240. At this date, the equity of Glider Ltd consisted of share capital of $300 000 and retained earnings of $120 000. All the identifiable assets and liabilities of Glider Ltd were recorded at amounts equal to fair value except for the following.

The land is still on hand with Glider Ltd at 30 June 2023. The plant was considered to have a further 10-year life. All the inventories were sold by 30 June 2023. The tax rate is 30%. Sugar Ltd uses the partial goodwill method. During the year ended 30 June 2023, Glider Ltd recorded a profit of $30 000. Required 1. Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Sugar Ltd at 30 June 2023. 2. Prepare the consolidation worksheet entries if Sugar Ltd used the full goodwill method, assuming the fair value of the non-controlling interest at 1 July 2022 was $47 700. (LO3, LO4 and LO7)

1. Consolidation worksheet entries at 30 June 2023 (Sugar Ltd uses partial goodwill method): Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Glider Ltd = ($300 000 + $120 000) (equity) + ($95 000 – $80 000) (1 – 30%) (BCVR - land) + ($330 000 – $300 000) (1 – 30%) (BCVR - plant) + ($18 000 – $15 000) (1 – 30%) (BCVR inventories) = $453 600 (b) Consideration transferred = $435 240 (c) NCI in Glider Ltd = 10% x $453 600 = $45 360 Aggregate of (a) and (b) = $480 600 Goodwill acquired – parent only = $480 600 - $453 600 = $27 000

29.31

Chapter 29: Consolidation: non-controlling interest

As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Glider Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. (a) Business combination valuation entries: Land

Dr Cr Cr

15 000

Deferred tax liability Business combination valuation reserve Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

80 000

Depreciation expense - plant Accumulated depreciation - plant (1/10 x $30 000)

Dr Cr

3 000

Deferred tax liability Income tax expense

Dr Cr

900

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

3 000

4 500 10 500

50 000 9 000 21 000

3 000

900

900 2 100

As the land is still in the business at the end of the period and it is not depreciable, the BCVR entry for it is exactly the same as that posted at acquisition date to recognise the fair value adjustment. As the plant is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. As inventories are sold during the current period, the BCVR entry posted now should adjust cost of sales (instead of inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Glider Ltd

Dr Dr Dr Dr Cr

108 000 270 000 30 240 27 000

Transfer from BCVR Business combination valuation reserve (90% x $2 100 (BCVR – inventories))

Dr Cr

1 890

435 240

1 890

29.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Only the parent share of the pre-acquisition equity in Glider Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Sugar Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity due to the sale of inventories undervalued at acquisition date, i.e. a transfer from business combination valuation reserve to retained earnings, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Glider Ltd at acquisition date)

12 000 30 000 3 360 45 360

This entry transfers the NCI share of the pre-acquisition equity in Glider Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (current period): NCI share of profit Dr 2 580 NCI Cr 2 580 (10% x [$30 000 – ($3 000 – $900) depreciation adjustment after tax – ($3 000 – $900) cost of sales adjustment after tax]) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and cost of sales posted in the BCVR entries, taking into consideration their respective tax effects. Even though there are no other changes in the equity accounts reported in the individual statement of Glider Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which causes a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as:

29.33

Chapter 29: Consolidation: non-controlling interest

Transfer from BCVR NCI (10% x $2 100 (BCVR - inventories))

Dr Cr

NCI

Dr Cr

Business combination valuation reserve (10% x $2 100 (BCVR - inventories))

210 210

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (10% x $2 100 (BCVR - inventories))

Dr Cr

210 210

It should be noted that this entry does not have any impact on NCI because the actual transfer does not have any net impact on equity and therefore no impact on NCI share of equity. This entry is actually reversing the transfer for the NCI share as those changes in equity accounts should not be recognised in the consolidated accounts; the NCI share of the amount of $2 100 transfer was already recognised in NCI Step 1 when it was in BCVR. 2. Consolidation worksheet entries at 30 June 2023 (Sugar Ltd uses full goodwill method): Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Glider Ltd = ($300 000 + $120 000) (equity) + ($95 000 – $80 000) (1 – 30%) (BCVR - land) + ($330 000 – $300 000) (1 – 30%) (BCVR - plant) + ($18 000 – $15 000) (1 – 30%) (BCVR inventories) = $453 600 (a) Consideration transferred = $435 240 (b) NCI in Glider Ltd = $47 700 Aggregate of (a) and (b) = $482 940 Goodwill acquired = $482 940 – $453 600 = $29 340 Goodwill of Glider Ltd Fair value of Glider Ltd

= = Net fair value of identifiable assets and liabilities of Glider Ltd = Goodwill of Glider Ltd = Goodwill of Sugar Ltd Goodwill acquired = Goodwill of Glider Ltd = Control premium - parent = =

$47 700 / 10% $477 000 $453 600 $477 000 – $453 600 = $23 400 $29 340 $23 400 $29 340 – $23 400 $5 940

The control premium can also be calculated as follows. Fair value of the shares in Glider Ltd

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

acquired by Sugar Ltd Consideration transferred Control premium – parent

= = = = =

$47 700 / 10% x 90% $429 300 $435 240 $435 240 - $429 300 $5 940

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Glider Ltd, i.e. $5 940 + 90% x $23 400 = $27 000. NCI will only be entitled to its share of the goodwill of Glider Ltd, i.e. 10% x $23 400 = $2 340. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Glider Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: There will need to be an additional BCVR entry, together with the BCVR entries recorded under the partial goodwill method: Goodwill Business combination valuation reserve

Dr Cr

23 400 23 400

This entry recognises the goodwill of Glider Ltd that excludes the control premium. (b) Pre-acquisition entries: Retained earnings (1/7/22) Dr 108 000 Share capital Dr 270 000 Business combination valuation reserve* Dr 51 300 Goodwill Dr 5 940 Shares in Glider Ltd Cr 435 240 *90% x [$10 500 (BCVR – land) + $21 000 (BCVR – plant) + $2 100 (BCVR – inventories) + $23 400 (BCVR – goodwill)] Transfer from BCVR Dr 1 890 Business combination valuation reserve Cr 1 890 (90% x $2 100 (BCVR – inventories)) Only the parent share of the pre-acquisition equity in Glider Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Sugar Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one which would be prepared at acquisition date under the full goodwill method. Note that the difference between this entry under the full goodwill method and the entry prepared under the partial goodwill method is due to the treatment of goodwill. As there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries.

29.35

Chapter 29: Consolidation: non-controlling interest

The NCI entries are the same as those prepared under the partial goodwill method with the only exception being again due to the way the goodwill is recognised under those 2 methods. Only the NCI Step 1 entry will be affected and it will change to: (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr 12 000 Share capital Dr 30 000 Business combination valuation reserve* Dr 5 700 NCI Cr 47 700 *10% x [$10 500 (BCVR – land) + $21 000 (BCVR – plant) + $2 100 (BCVR – inventories) + $23 400 (BCVR – goodwill)] All the other entries prepared under the partial goodwill method are the same for the full goodwill method.

29.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.6 Undervalued assets, full and partial goodwill method On 1 July 2022, James Ltd acquired 90% of the issued shares of Cameron Ltd for $145 080. The equity of Cameron Ltd at this date consisted of: Share capital

$100 000

Retained earnings

40 000

The carrying amounts and fair values of the assets and liabilities recorded by Cameron Ltd at 1 July 2022 were as follows.

Carrying amount Inventories

5 000

Fair value

6 000

Fittings (net)

10 000

Land

45 000

50 000

Machinery (net)

100 000

110 000

Liabilities

20 000

All inventories on hand at 1 July 2022 are sold by 30 June 2023. The fittings and machinery have a further 10-year life beyond 1 July 2022, with benefits to be received evenly over this period. Differences between carrying amounts and fair values are recognised in the consolidation worksheet. James Ltd uses the partial goodwill method. The tax rate is 30%. Required 1. Prepare the acquisition analysis at acquisition date. 2. Prepare the business combination valuation entries and the pre-acquisition entry at acquisition date. 3. Prepare the journal entry to recognise NCI at acquisition date. 4. Prepare the consolidation worksheet entries at 30 June 2023. Assume a profit for Cameron Ltd for the year ended 30 June 2023 of $20 000 and no other changes in Cameron Ltd’s equity since the acquisition date. 5. Identify and prepare the journal entries in requirements 2 to 4 that will change if the full goodwill method is used. Assume a fair value for NCI on 1 July 2022 of $15 900. (LO3, LO4 and LO5) 1. Acquisition analysis at 1 July 2022 (James Ltd uses the partial goodwill method): Net fair value of identifiable assets and liabilities of Cameron Ltd = ($100 000 + $40 000) (equity) + ($6 000 – $5 000) (1 – 30%) (BCVR inventories) + ($50 000 – $45 000) (1 – 30%) (BCVR - land)

29.37

Chapter 29: Consolidation: non-controlling interest

+ ($110 000 – $100 000) (1 – 30%) (BCVR machinery) = $151 200 (a) Consideration transferred = $145 080 (b) NCI in Cameron Ltd = 10% x $151 200 = $15 120 Aggregate of (a) and (b) = $160 200 Goodwill acquired – parent only = $160 200 – $151 200 = $9 000 As the partial goodwill method that James Ltd uses recognises NCI based on the proportionate share of the identifiable assets and liabilities of Cameron Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the pre-acquisition entry. 2. Business combination valuation entries and pre-acquisition entries at acquisition date (James Ltd uses the partial goodwill method): (a) Business combination valuation entries: Inventories Deferred Tax Liability Business combination valuation reserve

Dr Cr Cr

1 000

Land

5 000

Deferred tax liability Business combination valuation reserve

Dr Cr Cr

Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Dr Dr Dr Dr Cr

36 000 90 000 10 080 9 000

300 700

1 500 3 500

3 000 7 000

(b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Cameron Ltd

145 080

Only the parent share of the pre-acquisition equity in Cameron Ltd is eliminated in the preacquisition entry against the investment account recognised by James Ltd. Also, there is goodwill to recognise as determined in the acquisition analysis. This goodwill only belongs to the parent.

29.38

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3. NCI Step 1: NCI share of equity at acquisition date (James Ltd uses the partial goodwill method): Retained earnings (1/7/22) Share capital Business combination valuation reserve NCI

Dr Dr Dr Cr

4 000 10 000 1 120 15 120

This entry transfers the NCI share of the pre-acquisition equity in Cameron Ltd at acquisition date to the NCI equity account. 4. Consolidation worksheet entries at 30 June 2023 (James Ltd uses the partial goodwill method): (a) Business combination valuation entries: Land

Dr Cr Cr

5 000

Deferred tax liability Business combination valuation reserve Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Depreciation expense - machinery Accumulated depreciation - machinery (1/10 x $10 000)

Dr Cr

1 000

Deferred tax liability Income tax expense

Dr Cr

300

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

1 000

1 500 3 500

3 000 7 000 1 000

300

300 700

As the land is still in the business at the end of the period and it is not depreciable, the BCVR entry for it is exactly the same as that posted at acquisition date to recognise the fair value adjustment. As the machinery is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the machinery is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. As inventories are sold during the current period, the BCVR entry posted now should adjust cost of sales (instead of the inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill

Dr Dr Dr Dr

36 000 90 000 10 080 9 000

29.39

Chapter 29: Consolidation: non-controlling interest

Shares in Cameron Ltd Transfer from BCVR Business combination valuation reserve

Cr Dr Cr

145 080 630 630

Only the parent share of the pre-acquisition equity in Cameron Ltd is eliminated in the first pre-acquisition entry that also eliminates the investment account recognised by James Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Cameron Ltd at acquisition date)

4 000 10 000 1 120 15 120

This entry transfers the NCI share of the pre-acquisition equity in Cameron Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr 1 860 NCI Cr 1 860 (10% x [$20 000 – ($1 000 - $300) depreciation adjustment after tax – ($1 000 – $300) cost of sales adjustment after tax]) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and cost of sales posted in the BCVR entries, taking into consideration their respective tax effects. Even though there are no other changes in the equity accounts reported in the individual statement of Cameron Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which causes a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as:

29.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• •

An increase in NCI due to the increase in retained earnings. A decrease in NCI due to the decrease in BCVR.

Those effects can be recorded as: Transfer from BCVR NCI (10% x $700)

Dr Cr

NCI

Dr Cr

Business combination valuation reserve (10% x $700)

70 70

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (10% x $700)

Dr Cr

70 70

It should be noted that this entry does not have any impact on NCI because the actual transfer does not have any net impact on equity and therefore no impact on NCI share of equity. This entry is actually reversing the transfer for the NCI share as those changes in equity accounts should not be recognised in the consolidated accounts; the NCI share of the amount of $700 transfer was already recognised in NCI Step 1 when it was in BCVR before the transfer. 5. Differences if James Ltd uses the full goodwill method: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Cameron Ltd = ($100 000 + $40 000) (equity) + ($6 000 – $5 000) (1 – 30%) (BCVR inventories) + ($50 000 – $45 000) (1 – 30%) (BCVR - land) + ($110 000 – $100 000) (1 – 30%) (BCVR machinery) = $151 200 (a) Consideration transferred = $145 080 (b) NCI in Cameron Ltd = $15 900 Aggregate of (a) and (b) = $160 980 Goodwill acquired = $160 980 - $151 200 = $9 780 Goodwill of Cameron Ltd Fair value of Cameron Ltd = $15 900 / 10% = $159 000 Net fair value of identifiable assets and liabilities = $151 200 Goodwill of Cameron Ltd = $159 000 - $151 200 = $7 800 Goodwill of James Ltd

29.41

Chapter 29: Consolidation: non-controlling interest

Goodwill acquired Goodwill of Cameron Ltd Control premium – parent

= = = =

$9 780 $7 800 $9 780 - $7 800 $1 980

The control premium can also be calculated as follows: Fair value of the shares in Cameron Ltd acquired by James Ltd = $15 900 / 10% x 90% = $143 100 Consideration transferred = $145 080 Control premium – parent = $145 080 - $143 100 = $1 980 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Cameron Ltd, i.e. $1 980 + 90% x $7 800 = $9 000. NCI will only be entitled to its share of the goodwill of Cameron Ltd, i.e. 10% x $7 800 = $780. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Cameron Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Both at acquisition date (requirement 2) and at 30 June 2023 (requirement 4), there will need to be an additional BCVR entry, together with the BCVR entries recorded under the partial goodwill method: Goodwill Business combination valuation reserve

Dr Cr

7 800 7 800

This entry recognises the goodwill of Cameron Ltd that excludes the control premium. (b) Pre-acquisition entries: At acquisition date (requirement 2): Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Cameron Ltd

Dr Dr Dr Dr Cr

36 000 90 000 17 100 1 980 145 080

29.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings (1/7/22) Dr 36 000 Share capital Dr 90 000 Business combination valuation reserve* Dr 17 100 Goodwill Dr 1 980 Shares in Cameron Ltd Cr 145 080 *90% x [$700 (BCVR – inventories) + $3 500 (BCVR – land) + $7 000 (BCVR – machinery) + $7 800 (BCVR – goodwill)] Transfer from BCVR Business combination valuation reserve

Dr Cr

630 630

Only the parent share of the pre-acquisition equity in Cameron Ltd is eliminated in the first pre-acquisition entry that also eliminates the investment account recognised by James Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one which would be prepared at acquisition date under the full goodwill method. Note that the difference between this entry under the full goodwill method and the entry prepared under the partial goodwill method is due to the treatment of goodwill. As there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries. The NCI entries are the same as those prepared under the partial goodwill method with the only exception being again due to the way the goodwill is recognised under those 2 methods. Only the NCI Step 1 entry will be affected (requirement 3 and requirement 4) and it will change to: (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr 4 000 Share capital Dr 10 000 Business combination valuation reserve* Dr 1 900 NCI Cr 15 900 *10% x [$700 (BCVR – inventories) + $3 500 (BCVR – land) + $7 000 (BCVR – machinery) + $7 800 (BCVR – goodwill)] All the other entries prepared under the partial goodwill method are the same for the full goodwill method.

29.43

Chapter 29: Consolidation: non-controlling interest

Exercise 29.7 Undervalued assets, partial goodwill method, dividends On 1 July 2019, Leo Ltd acquired 80% of the issued shares of Sayer Ltd for $240 000 when the equity of Sayer Ltd consisted of:

At this date, all identifiable assets and liabilities of Sayer Ltd were recorded at fair value except for the following.

Half of the inventories were sold by 30 June 2020 and the remainder by 30 June 2021. The plant has a further 3-year life beyond 1 July 2019, with benefits to be received evenly over this period. The land was sold on 1 March 2023 to an external party. Adjustments for the differences between carrying amounts and fair values are to be made in the consolidation worksheet. Leo Ltd uses the partial goodwill method. The tax rate is 30%. During the 4 years since acquisition, Sayer Ltd has recorded the following annual results and declared the following dividends. Year ended

Profit (loss)

Dividends

30 June 2020

15 000

5 000

30 June 2021

20 000

10 000

30 June 2022

(5 000)

1 000

30 June 2023

20 000

14 000

Dividends were paid within 6 weeks of the end of each period. There have been no transfers to or from the general reserve since the acquisition date. Required 1. Prepare the consolidation worksheet entries as at 1 July 2019. 2. Prepare the consolidation worksheet entries for the year ended 30 June 2020. 3. Prepare the consolidation worksheet entries for the year ended 30 June 2021. 4. Prepare the consolidation worksheet entries for the year ended 30 June 2022. 5. Prepare the consolidation worksheet entries for the year ended 30 June 2023. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 1 July 2019:

29.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Acquisition analysis at 1 July 2019: Net fair value of identifiable assets and liabilities of Sayer Ltd = ($160 000 + $10 000 + $59 000) (equity) + ($14 000 – $10 000) (1 – 30%) (BCVR inventories) + ($99 000 – $90 000) (1 – 30%) (BCVR - plant) + ($87 000 – $70 000) (1 – 30%) (BCVR - land) = $250 000 (a) Consideration transferred = $240 000 (b) NCI in Sayer Ltd = 20% x $250 000 = $50 000 Aggregate of (a) and (b) = $290 000 Goodwill acquired – parent only = $290 000 - $250 000 = $40 000 As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Sayer Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. (a) Business combination valuation entries: Inventories Deferred tax liability Business combination valuation reserve Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Dr Cr Cr Cr

Land

Dr Cr Cr

Deferred tax liability Business combination valuation reserve

4 000 1 200 2 800 130 000 121 000 2 700 6 300 17 000 5 100 11 900

These entries recognise the fair value adjustments for the assets that were undervalued at acquisition date in Sayer Ltd’s accounts: i.e. inventories, plant and land. (b) Pre-acquisition entries: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve Goodwill Shares in Sayer Ltd

Dr Dr Dr Dr Dr Cr

47 200 128 000 8 000 16 800 40 000 240 000

Only the parent share of the pre-acquisition equity in Sayer Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Leo Ltd.

29.45

Chapter 29: Consolidation: non-controlling interest

As the entries are prepared at acquisition date, the NCI needs to be recognised in only 1 step. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

11 800 32 000 2 000 4 200 50 000

This entry transfers the NCI share of the pre-acquisition equity in Sayer Ltd at acquisition date to the NCI equity account. 2. Consolidation worksheet entries at 30 June 2020: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

2 000

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

2 000

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

130 000

Depreciation expense - plant Accumulated depreciation - plant (1/3 x $9 000)

Dr Cr

3 000

Deferred tax liability Income tax expense

Dr Cr

900

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

17 000

600 1 400

121 000 2 700 6 300

3 000

900

5 100 11 900

As half of the inventories are sold during the current period, the BCVR entry posted now should adjust cost of sales for half of the inventories value increment (instead of inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As the plant is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect.

29.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

As the land is still in the business and it is not depreciable, the BCVR entry for it is the same as that prepared at acquisition date. (b) Pre-acquisition entries: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve Goodwill Shares in Sayer Ltd

Dr Dr Dr Dr Dr Cr

47 200 128 000 8 000 16 800 40 000

Transfer from BCVR Business combination valuation reserve (80% x (1 - 30%) x ½ x $4 000)

Dr Cr

1 120

240 000

1 120

Only the parent share of the pre-acquisition equity in Sayer Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Leo Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • •

NCI share of equity at acquisition date (Step 1). NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period).

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

11 800 32 000 2 000 4 200 50 000

This entry transfers the NCI share of the pre-acquisition equity in Sayer Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (current period): NCI share of profit Dr 2 300 NCI Cr 2 300 (20% x [$15 000 – ($2 000 - $600) cost of sales adjustment after tax – ($3 000 - $900) depreciation adjustment after tax])

29.47

Chapter 29: Consolidation: non-controlling interest

Dr Cr

1 000 1 000

An increase in NCI due to the increase in retained earnings. A decrease in NCI due to the decrease in BCVR.

Those effects can be recorded as: Transfer from BCVR Dr NCI Cr (20% x ½ x $4 000 x (1 – 30%) BCVR - inventories)

280

NCI Dr Business combination valuation reserve Cr (20% x ½ x $4 000 x (1 – 30%) BCVR - inventories)

280

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (25% x $4 000 x (1 – 30%))

Dr Cr

280

Dr Cr

2 000

280

3. Consolidation worksheet entries at 30 June 2021: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from business combination valuation reserve

600 1 400

29.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

15 000

Depreciation expense - plant Retained earnings (1/7/20) Accumulated depreciation - plant

Dr Dr Cr

3 000 3 000

Deferred tax liability Income tax expense Retained earnings (1/7/20)

Dr Cr Cr

1 800

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

17 000

9 000 1 800 4 200

6 000

900 900

5 100 11 900

As half of inventories are sold during the previous period, no BCVR entry needs to be posted now for that first half of inventories. As the other half of inventories are sold during the current period, a BCVR entry is required to adjust the cost of sales, the income tax expense and to recognise a transfer from business combination valuation reserve for that inventories. As the plant is still in the business (it has one more year of useful life), the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the previous and current period and the related tax effect. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/20), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/20). As the land is still in the business and it is not depreciable, the BCVR entry for it is the same as that prepared at acquisition date. (b) Pre-acquisition entries: Retained earnings (1/7/20) Share capital General reserve Business combination valuation reserve Goodwill Shares in Sayer Ltd

Dr Dr Dr Dr Dr Cr

48 320 128 000 8 000 15 680 40 000

Transfer from BCVR Business combination valuation reserve (80% x (1 - 30%) x ½ x $4 000)

Dr Cr

1 120

240 000

1 120

As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should differ based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at

29.49

Chapter 29: Consolidation: non-controlling interest

acquisition date, adjusted for the prior period pre-acquisition equity transfers. The only such transfer in the prior period is the transfer from BCVR to retained earnings caused by the sale of half of the inventories undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 80% (parent share) of the amount reported in Retained earnings at acquisition date ($59 000) plus the amount transferred from BCVR (1/2 x $4 000 x (1 – 30%) = $1 400), while the amount of BCVR to be eliminated will be the parent share of the amount that would have been recognised at acquisition date ($2 800 BCVR inventories + $6 300 BCVR plant + $11 900 BCVR land) minus the amount transferred for it ($1 400 BCVR inventories). There is also an additional pre-acquisition entry for this period because there is another current period transfer from pre-acquisition equity. As there is a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of the other half of inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/20) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

11 800 32 000 2 000 4 200 50 000

This entry transfers the NCI share of the pre-acquisition equity in Sayer Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $10 000 as a result of the profit recognised during the period adjusted for the dividends and decreased by $2 100 ($3 000 - $900) as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2021, giving a net effect of an increase of $7 900. • BCVR decreased by $1 400 as a result of the sale of half of the inventories undervalued at acquisition date during the period. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/20) NCI (20% x ($10 000 – [$3 000 - $900])

Dr Cr

1 480

NCI

280

1 480

29.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Business combination valuation reserve (20% x ½ x $4 000 x (1 - 30%))

280

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the credit to BCVR means that a part of the decrease in BCVR is allocated to NCI. They can be combined into one single entry: Retained earnings (1/7/20) Business combination valuation reserve NCI

Dr Cr Cr

1 580 280 1 300

(e) NCI Step 3: NCI share of changes in equity from 1/7/20 to 30/6/21 (current period): NCI share of profit Dr 3 300 NCI Cr 3 300 (20% x ($20 000 – [$2 000 - $600] (cost of sales adjustment after tax – [$3 000 $900] (depreciation adjustment after tax ))) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustments posted in the BCVR entries to cost of sales and depreciation expense, taking into consideration the respective tax effects. Beside the current profit, Sayer Ltd reports a dividend for the current period. As such, it should be noted that Sayer Ltd would have recorded for those dividends a corresponding decrease in equity. This decrease in equity is a change in equity for the current period and the NCI share of that decrease should be recognised as decreasing NCI: NCI Dividend declared (20% x $10 000 dividend)

Dr Cr

2 000 2 000

There are no other changes in equity in the current period reported in Sayer Ltd’s statements or recognised on consolidation. Therefore, there are no other NCI entries to be prepared. 4. Consolidation worksheet entries at 30 June 2022: (a) Business combination valuation entries: Depreciation expense - plant Income tax expense Retained earnings (1/7/21) Transfer from business combination valuation reserve

Dr Cr Dr

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

3 000 900 4 200

6 300 17 000 5 100 11 900

29.51

Chapter 29: Consolidation: non-controlling interest

As inventories are sold during the previous periods, no BCVR entry needs to be posted now for inventories. As the plant is not in the business at the end of the period (it reached the end of the useful life and it would have been derecognised), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings. There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/21), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/21). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. As the land is still in the business and it is not depreciable, the BCVR entry for it is the same as that prepared at acquisition date. (b) Pre-acquisition entries: Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve Goodwill Shares in Sayer Ltd

Dr Dr Dr Dr Dr Cr

49 440 128 000 8 000 14 560 40 000

Transfer from BCVR Business combination valuation reserve (80% x $9 000 x (1 – 30%))

Dr Cr

5 040

240 000

5 040

29.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/21) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

11 800 32 000 2 000 4 200 50 000

This entry transfers the NCI share of the pre-acquisition equity in Sayer Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/21 (prior period): We identify the following changes in equity for this period from the individual statement of Sayer Ltd and the consolidation entries: • Retained earnings increased by $10 000 + $10 000 as a result of the profits recognised during the period not distributed via dividends and decreased by $4 200 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2022, giving a net effect of an increase of $15 800. • BCVR decreased by $2 800 as a result of the sale of inventories undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/21) NCI

Dr Cr

3 160

NCI Business combination valuation reserve

Dr Cr

560

3 160

560

Dr Cr Cr

3 160 560 2 600

(e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI NCI share of profit/loss (20% x [(5 000) – ($3 000 - $900)])

Dr Cr

1 420 1 420

29.53

Chapter 29: Consolidation: non-controlling interest

adjusted by the increase caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current loss, Sayer Ltd reports a dividend for the current period. As such, it should be noted that Sayer Ltd would have recorded for those dividends a corresponding decrease in equity. This decrease in equity is a change in equity for the current period and the NCI share of that decrease should be recognised as decreasing NCI: NCI Dividend declared (20% x $1 000 dividend)

Dr Cr

200 200

Even though there are no other changes in the equity accounts reported in the individual statement of Sayer Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as: Transfer from BCVR NCI (20% x $9 000 x (1 – 30%)) NCI Business combination valuation reserve (20% x $9 000 x (1 – 30%))

Dr Cr

1 260

Dr Cr

1 260

These last 2 entries can be combined into one single entry: Transfer from BCVR Business combination valuation reserve (20% x $9 000 x (1 – 30%))

Dr Cr

1 260

Dr Cr Cr

17 000

1 260

5. Consolidation worksheet entries at 30 June 2023: (a) Business combination valuation entries: Gain on sale of land Income tax expense Transfer from BCVR

5 100 11 900

As inventories and plant are sold and derecognised respectively during the previous periods, no BCVR entries need to be posted now for those assets. However, land is sold during the current period, so a BCVR entry is required to adjust the gain on sale of land, the income tax expense and recognise a transfer from business combination valuation reserve. (b) Pre-acquisition entries: Retained earnings (1/7/22)

54 480 29.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Share capital General reserve Business combination valuation reserve Goodwill Shares in Sayer Ltd

Dr Dr Dr Dr Cr

128 000 8 000 9 520 40 000

Transfer from BCVR Business combination valuation reserve (80% x $17 000 x (1 – 30%))

Dr Cr

9 520

240 000

9 520

Dr Dr Dr Dr Cr

11 800 32 000 2 000 4 200 50 000

29.55

Chapter 29: Consolidation: non-controlling interest

Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/22) NCI

Dr Cr

2 800

NCI Business combination valuation reserve

Dr Cr

1 810

2 800

1 810

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. These 2 entries can be combined into one single entry: Retained earnings (1/7/22) Business combination valuation reserve NCI

Dr Cr Cr

2 800 1 810 990

(e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (20% x ($20 000- $11 900))

Dr Cr

1 620 1 620

Dr Cr

2 800 2 800

An increase in NCI due to the increase in retained earnings. A decrease in NCI due to the decrease in BCVR.

29.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Those effects can be recorded as: Transfer from BCVR NCI (20% x $17 000 x (1 – 30%))

Dr Cr

2 380

NCI Business combination valuation reserve (20% x $17 000 x (1 – 30%))

Dr Cr

2 380

These last 2 entries can be combined into one single entry: Transfer from BCVR Business combination valuation reserve (20% x $17 000 x (1 – 30%))

Dr Cr

2 380 2 380

29.57

Chapter 29: Consolidation: non-controlling interest

Exercise 29.8 Undervalued assets, partial goodwill method On 1 July 2019, Errol Ltd acquired 75% of the issued shares of Flynn Ltd for $503 000 when the equity of Flynn Ltd consisted of:

Share capital

$320 000

General reserve

80 000

Retained earnings

160 000

At this date, all identifiable assets and liabilities of Flynn Ltd were recorded at fair value except for the following. Carrying amount Inventories

80 000

Fair value $

96 000

Machinery (cost $200 000)

140 000

164 000

Land

200 000

280 000

All the inventories were sold by 30 June 2020. The machinery has a further 3-year life beyond 1 July 2019, with benefits to be received evenly over this period. The land was sold on 1 March 2022 for $75 000. Adjustments for the differences between carrying amounts and fair values are to be made in the consolidation worksheet except for land which is to be measured in Flynn Ltd’s accounts at fair value. Errol Ltd uses the partial goodwill method. The tax rate is 30%. During the 4 years since acquisition, Flynn Ltd has recorded the following annual results. Year ended 30 June 2020

Profit (loss) $

40 000

Total comprehensive income $

48 000

30 June 2021

92 000

112 000

30 June 2022

(24 000)

4 000

30 June 2023

88 000

The other comprehensive income item relates to gains/losses on revaluation of land. There have been no transfers to or from the general reserve or any dividends paid or declared by Flynn Ltd since the acquisition date. Required 1. Prepare the consolidation worksheet entries as at 1 July 2019. 2. Prepare the consolidation worksheet entries for the year ended 30 June 2020. 3. Prepare the consolidation worksheet entries for the year ended 30 June 2021. 4. Prepare the consolidation worksheet entries for the year ended 30 June 2022. 5. Prepare the consolidation worksheet entries for the year ended 30 June 2023. (LO3, LO4, LO5 and LO6)

29.58

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. Consolidation worksheet entries at 1 July 2019: Acquisition analysis at 1 July 2019: Net fair value of identifiable assets and liabilities of Flynn Ltd = ($320 000 + $80 000 + $160 000) (equity) + ($96 000 – $80 000) (1 – 30%) (BCVR inventories) + ($164 000 – $140 000) (1 – 30%) (BCVR – machinery) + ($280 000 – $200 000) (1 – 30%) (ARS - land) = $644 000 (a) Consideration transferred = $503 000 (b) NCI in Flynn Ltd = 25% x $644 000 = $161 000 Aggregate of (a) and (b) = $664 000 Goodwill acquired – parent only = $664 000 - $644 000 = $20 000 As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Flynn Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. (a) Business combination valuation entries: Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

16 000

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

60 000

4 800 11 200

36 000 7 200 16 800

These entries recognise the fair value adjustments for the assets that were undervalued at acquisition date in Flynn Ltd’s accounts: i.e. inventories and machinery. If the land was revalued by Flynn Ltd, there is no need to recognise a fair value adjustment for it in the BCVR entries. Nevertheless, it should be noted that an Asset Revaluation Surplus (recognising the value increment on land at acquisition date) would have been raised in Flynn Ltd’s accounts as a result of the revaluation recorded – this surplus is also part of the pre-acquisition equity of the subsidiary that will have to be eliminated in the pre-acquisition entry (for the parent share) and transferred to NCI in the NCI Step 1 entry (for the NCI share). (b) Pre-acquisition entries: Retained earnings (1/7/19) Share capital General reserve Asset revaluation surplus

Dr Dr Dr Dr

120 000 240 000 60 000 42 000

29.59

Chapter 29: Consolidation: non-controlling interest

Business combination valuation reserve Goodwill Shares in Flynn Ltd

Dr Dr Cr

21 000 20 000 503 000

Only the parent share of the pre-acquisition equity in Flynn Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Errol Ltd. As the entries are prepared at acquisition date, the NCI needs to be recognised in only 1 step. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Dr Cr

40 000 80 000 20 000 14 000 7 000 161 000

This entry transfers the NCI share of the pre-acquisition equity in Flynn Ltd at acquisition date to the NCI equity account. 2. Consolidation worksheet entries at 30 June 2020: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

16 000

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

60 000

Depreciation expense - machinery Accumulated depreciation - machinery (1/3 x $24 000)

Dr Cr

8 000

Deferred tax liability Income tax expense

Dr Cr

2 400

4 800 11 200

36 000 7 200 16 800

8 000

2 400

As inventories are sold during the current period, the BCVR entry posted now should adjust cost of sales (instead of inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As the machinery is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the machinery is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. (b) Pre-acquisition entries: Retained earnings (1/7/19)

120 000

29.60

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Share capital General reserve Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Flynn Ltd Transfer from BCVR Business combination valuation reserve (75% x (1 - 30%) x $16 000)

Dr Dr Dr Dr Dr Cr Dr Cr

240 000 60 000 42 000 21 000 20 000 503 000 8 400 8 400

Only the parent share of the pre-acquisition equity in Flynn Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Errol Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Dr Cr

40 000 80 000 20 000 14 000 7 000 161 000

This entry transfers the NCI share of the pre-acquisition equity in Flynn Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (current period): NCI share of profit Dr 5 800 NCI Cr 5 800 (25% x [$40 000 – ($16 000 - $4 800) cost of sales adjustment after tax – ($8 000 - $2 400) depreciation adjustment after tax]) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to cost of sales and depreciation expense posted in the BCVR entries, taking into consideration their respective tax effects.

29.61

Chapter 29: Consolidation: non-controlling interest

Beside the current profit, Flynn Ltd reports a total comprehensive income for the current period. That includes the profit, but also, according to the text of the question, gains or losses on revaluation of land. As such, it should be noted that Flynn Ltd would have recorded for those gains or losses on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the difference between the total comprehensive income and the profit for the current period, i.e. $48 000 - $40 000 = $8 000. This increase in Asset Revaluation Surplus is a change in equity and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus Dr 2 000 NCI Cr (25% x [$48 000 total comprehensive income - $40 000 profit])

2 000

Even though there are no other changes in the equity accounts reported in the individual statement of Flynn Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as: Transfer from BCVR Dr NCI Cr (25% x $16 000 x (1 – 30%) BCVR - inventories)

2 800

NCI Dr Business combination valuation reserve Cr (25% x $16 000 x (1 – 30%) BCVR - inventories)

2 800

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (25% x $16 000 x (1 – 30%))

Dr Cr

1 400

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

60 000

Depreciation expense - machinery Retained earnings (1/7/20)

Dr Dr

8 000 8 000

1 400

3. Consolidation worksheet entries at 30 June 2021: (a) Business combination valuation entries:

36 000 7 200 16 800

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Accumulated depreciation - machinery Deferred tax liability Income tax expense Retained earnings (1/7/20)

16 000

Dr Cr Cr

4 800 2 400 2 400

As inventories are sold during the previous period, no BCVR entry needs to be posted now for inventories. As the machinery is still in the business (it has one more year of useful life), the first BCVR entry for it is the same as that prepared at acquisition date; however, as the machinery is depreciable, two other entries are posted to recognise depreciation adjustments for the previous and current period and the related tax effect. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/20), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/20). (b) Pre-acquisition entries: Retained earnings (1/7/20) Share capital General reserve Asset revaluation surplus (1/7/20) Business combination valuation reserve Goodwill Shares in Flynn Ltd

Dr Dr Dr Dr Dr Dr Cr

128 400 240 000 60 000 42 000 12 600 20 000 503 000

Dr Dr Dr Dr

40 000 80 000 20 000 14 000

29.63

Chapter 29: Consolidation: non-controlling interest

Business combination valuation reserve NCI

Dr Cr

7 000 161 000

This entry transfers the NCI share of the pre-acquisition equity in Flynn Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $40 000 as a result of the profit recognised during the period and decreased by $5 600 ($8 000 - $2 400) as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2021, giving a net effect of an increase of $34 400 • Asset Revaluation Surplus increased by $8 000 as a result of the gain on revaluation of the land recognised during the period in the total comprehensive income • BCVR decreased by $11 200 as a result of the sale of inventories undervalued at acquisition date during the period. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/20) NCI (25% x ($40 000 – [$8 000 - $2 400])

Dr Cr

8 600

Asset revaluation surplus NCI (25% x 82 000)

Dr Cr

2 000

NCI Business combination valuation reserve (25% x $16 000 x (1 - 30%))

Dr Cr

2 800

8 600

2 000

2 800

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in BCVR is allocated to NCI. They can be combined into one single entry: Retained earnings (1/7/20) Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Cr Cr

8 600 2 000 2 800 7 800

(e) NCI Step 3: NCI share of changes in equity from 1/7/20 to 30/6/21 (current period): NCI share of profit NCI

Dr Cr

21 600 21 600

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(25% x ($92 000 – [$8 000 - $2 400] (depreciation adjustment after tax))) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current profit, Flynn Ltd reports a total comprehensive income for the current period. That includes the profit, but also, according to the text of the question, gains or losses on revaluation of land. As such, it should be noted that Flynn Ltd would have recorded for those gains or losses on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the difference between the total comprehensive income and the profit for the current period, i.e. $112 000 - $92 000 = $20 000. This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus Dr 5 000 NCI Cr (25% x ($112 000 total comprehensive income - $92 000 profit))

5 000

There are no other changes in equity in the current period reported in Flynn Ltd’s statements or recognised on consolidation. Therefore, there are no other NCI entries to be prepared. 4. Consolidation worksheet entries at 30 June 2022: (a) Business combination valuation entries: Depreciation expense - machinery Income tax expense Retained earnings (1/7/21) Transfer from BCVR

Dr Cr Dr Cr

8 000 2 400 11 200 16 800

As inventories are sold during the previous period, no BCVR entry needs to be posted now for inventories. As the machinery is not in the business at the end of the period (it reached the end of the useful life and it would have been derecognised), but was on hand at the beginning of the period, a BCVR entry needs to be posted for machinery to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings. There are no adjustments needed for the machinery account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/21), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/21). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. (b) Pre-acquisition entries: Retained earnings (1/7/21) Share capital

Dr Dr

128 400 240 000

29.65

Chapter 29: Consolidation: non-controlling interest

General reserve Asset revaluation surplus (1/7/21) Business combination valuation reserve Goodwill Shares in Flynn Ltd Transfer from BCVR Business combination valuation reserve (75% x $24 000 x (1 – 30%))

Dr Dr Dr Dr Cr Dr Cr

60 000 42 000 12 600 20 000

Transfer from asset revaluation surplus Asset revaluation surplus (75% x $80 000 x (1 – 30%))

Dr Cr

42 000

503 000 12 600 12 600

42 000

As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods' pre-acquisition equity transfers. The only such transfer in the prior periods is the transfer from BCVR to retained earnings caused by the sale of inventories undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($160 000) plus the amount transferred from BCVR ($16 000 x (1 – 30%) = $11 200), while the amount of BCVR to be eliminated will be the parent share of the amount that would have been recognised at acquisition date ($11 200 BCVR inventories + $4 200 BCVR machinery) minus the amount transferred from it ($11 200 BCVR inventories). It should be noted that this pre-acquisition entry is the same as the first preacquisition entry at 30 June 2021 because no transfers from pre-acquisition equity took place during the period ended 30 June 2021. However, there were two transfers during the current period from pre-acquisition equity: • a transfer from business combination valuation reserve to retained earnings (caused by the derecognition of machinery that reached the end of the useful life) • a transfer from asset revaluation surplus to retained earnings (caused by the sale of land for which Flynn Ltd recognised the revaluation at acquisition date). Therefore, two other pre-acquisition entries need to be posted to reverse these transfers for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/21) Share capital General reserve Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Dr Cr

40 000 80 000 20 000 14 000 7 000 161 000

This entry transfers the NCI share of the pre-acquisition equity in Flynn Ltd at acquisition date to the NCI equity account.

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(d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/21 (prior period): We identify the following changes in equity for this period from the individual statement of Flynn Ltd and the consolidation entries: • Retained earnings increased by $40 000 + $92 000 as a result of the profits recognised during the period and decreased by $11 200 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2019, giving a net effect of an increase of $120 800. • Asset Revaluation Surplus increased by $8 000 + $20 000 as a result of the gains on revaluation of the land recognised during the period in the total comprehensive income. • BCVR decreased by $11 200 as a result of the sale of inventories undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/21) NCI

Dr Cr

30 200

Asset revaluation surplus NCI

Dr Cr

7 000

NCI Business combination valuation reserve

Dr Cr

2 800

30 200

7 000

2 800

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in BCVR is allocated to NCI. They can be combined into one single entry: Retained earnings (1/7/21) Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Cr Cr

30 200 7 000 2 800 34 400

(e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI NCI share of profit/loss (25% x [(24 000) – ($8 000 - $2 400)])

Dr Cr

7 400 7 400

This entry recognises the NCI share of the current loss. It is assumed that the loss reported is after tax. As the business combination entries have an impact on the current loss, there is a need to adjust the current loss before allocating it to NCI. Specifically, the current loss needs to be adjusted by the increase caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current loss, Flynn Ltd reports a total comprehensive income for the current period. That includes the profit, but also, according to the text of the question, gains or losses on

29.67

Chapter 29: Consolidation: non-controlling interest

revaluation of land. As such, it should be noted that Flynn Ltd would have recorded for those gains or losses on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the difference between the total comprehensive income and the loss for the current period, i.e. $4 000 - $(24 000) = $28 000. This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus Dr 7 000 NCI Cr (25% x ($4 000 total comprehensive income - $(24 000) loss))

7 000

Also, as a result of the sale during the current period of land for which Flynn Ltd recognised Asset Revaluation Surplus of $56 000 at acquisition date, in the financial statements of Flynn Ltd it will be recorded a decrease in Asset Revaluation Surplus and an increase in a Transfer from Asset Revaluation Surplus account. As this change increases the retained earnings, while decreasing the recognised Asset Revaluation Surplus (the former being recognised as a credit to the Transfer from Asset Revaluation Surplus account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in Asset Revaluation Surplus. Those effects can be recorded as: Transfer from asset revaluation surplus NCI (25% x $80 000 x (1 – 30%))

Dr Cr

14 000

NCI Asset revaluation surplus (25% x $80 000 x (1 – 30%))

Dr Cr

14 000

These last 2 entries can be combined into one single entry: Transfer from asset revaluation surplus Asset revaluation surplus (25% x $80 000 x (1 – 30%))

Dr Cr

14 000 14 000

Even though there are no other changes in the equity accounts reported in the individual statement of Flynn Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of machinery which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as: Transfer from BCVR NCI

Dr Cr

4 200 4 200

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(25% x $24 000 x (1 – 30%)) NCI Dr Business combination valuation reserve Cr (25% x $24 000 x (1 – 30%)) These last 2 entries can be combined into one single entry: Transfer from BCVR Business combination valuation reserve (25% x $24 000 x (1 – 30%))

4 200 4 200

Dr Cr

4 200 4 200

5. Consolidation worksheet entries at 30 June 2023: (a) Business combination valuation entries: As inventories and machinery are sold and derecognised respectively during the previous periods, no BCVR entry needs to be posted now. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Goodwill Shares in Flynn Ltd

Dr Dr Dr Dr Cr

183 000 240 000 60 000 20 000 503 000

Dr Dr Dr Dr Dr Cr

40 000 80 000 20 000 14 000 7 000 161 000

This entry transfers the NCI share of the pre-acquisition equity in Flynn Ltd at acquisition date to the NCI equity account.

29.69

Chapter 29: Consolidation: non-controlling interest

(d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/22 (prior period): We identify the following changes in equity for this period from the individual statement of Flynn Ltd and the consolidation entries: • Retained earnings increased by $40 000 + $92 000 + $(24 000) as a result of the profits/losses recognised during the period, giving a net effect of an increase of $108 000. • Asset Revaluation Surplus increased by $8 000 + $20 000 + $28 000 as a result of the gains on revaluation of the land recognised during the period in the total comprehensive income and decrease by $56 000 as a result of the sale of land for which ARS was recognised, given a net effect of $0. • BCVR decreased by $11 200 + $16 800 as a result of the sale of inventories and derecognition of machinery undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/22) NCI

Dr Cr

27 000

NCI Business combination valuation reserve

Dr Cr

7 000

27 000

7 000

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. These 2 entries can be combined into one single entry: Retained earnings (1/7/22) Business combination valuation reserve NCI

Dr Cr Cr

27 000 7 000 20 000

(e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (25% x $88 000)

Dr Cr

22 000 22 000

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As there are no business combination valuation entries, there is no need to adjust the current profit before allocating it to NCI. As the total comprehensive income for this period is equal to the profit, there is no gain on revaluation that needs to be recognised in ARS.

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Exercise 29.9 Undervalued assets, full goodwill method On 1 July 2019, Charlie Ltd acquired 60% of the issued shares of Chapman Ltd for $111 700 when the equity of Chapman Ltd consisted of:

At this date, the identifiable assets and liabilities of Chapman Ltd were recorded at fair value except for the following assets.

Half of the inventories on hand at acquisition date were sold by 30 June 2020, with the remainder being sold during the year ended 30 June 2021. The equipment has a further 5-year life beyond 1 July 2019, with benefits to be received evenly over this period. The equipment was sold on 1 January 2021 for $70 000. Adjustments for the differences between carrying amounts and fair values are to be made in the consolidation worksheet. At 30 June 2022, the goodwill recorded on acquisition was written down by $3000 as the result of an impairment test. The tax rate is 30%. Charlie Ltd uses the full goodwill method. The fair value of the non-controlling interest at 1 July 2019 was $74 100. During the 3 years since acquisition, Chapman Ltd has recorded the following annual results. Year ended

Profit

30 June 2020

$15 000

30 June 2021

27 000

30 June 2022

12 000

There have been no transfers to or from the general reserve or any dividend paid or declared by Chapman Ltd since the acquisition date. Required 1. Prepare the consolidation worksheet entries as at 1 July 2019. 2. Prepare the consolidation worksheet entries for the year ended 30 June 2020. 3. Prepare the consolidation worksheet entries for the year ended 30 June 2021. 4. Prepare the consolidation worksheet entries for the year ended 30 June 2022. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 1 July 2019: Acquisition analysis at 1 July 2019:

29.71

Chapter 29: Consolidation: non-controlling interest

Net fair value of identifiable assets and liabilities of Chapman Ltd = ($120 000 + $10 000 + $30 000) (equity) + ($50 000 - $45 000) (1 – 30%) (BCVR inventories) + ($75 000 - $65 000) (1 – 30%) (BCVR equipment) + ($90 000 - $80 000) (1 – 30%) (BCVR - land) = $177 500 (a) Consideration transferred = $111 700 (b) NCI in Chapman Ltd = $74 100 Aggregate of (a) and (b) = $185 800 Goodwill acquired = $185 800 - $177 500 = $8 300 Goodwill of Chapman Ltd: Fair value of Chapman Ltd = $74 100 / 40% = $185 250 Net fair value of identifiable assets and liabilities of Chapman Ltd = $177 500 Goodwill of Chapman Ltd = $185 250 - $177 500 = $7 750 Goodwill of Charlie Ltd: Goodwill acquired = $8 300 Goodwill of Chapman Ltd = $7 750 Control premium - parent = $8 300 - $7 750 = $550 The control premium can also be calculated as follows: Fair value of the shares in Chapman Ltd acquired by Charlie Ltd = $74 100 / 40% x 60% = $111 150 Consideration transferred = $111 700 Control premium – parent = $111 700 - $111 150 = $550 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Chapman Ltd, i.e. $550 + 60% x $7 750 = $5 200. NCI will only be entitled to its share of the goodwill of Chapman Ltd, i.e. 40% x $7 750 = $3 100. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Chapman Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Inventories

5 000

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Deferred tax liability Business combination valuation reserve

Cr Cr

1 500 3 500

Accumulated depreciation – equipment Equipment Deferred tax liability Business combination valuation reserve Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr Dr Cr Cr

15 000

Goodwill Business combination valuation reserve

Dr Cr

7 750

5 000 3 000 7 000 10 000 3 000 7 000

7 750

These entries firstly recognise the fair value adjustments for the assets that were undervalued at acquisition date in Chapman Ltd’s accounts: i.e. inventories, equipment and land. Also, the business combination valuation entries at acquisition date recognise the goodwill of Chapman Ltd that can be distributed to the parent and NCI (that excludes the control premium, recognised in the pre-acquisition entry). (b) Pre-acquisition entries: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve Goodwill Shares in Chapman Ltd

Dr Dr Dr Dr Dr Cr

18 000 72 000 6 000 15 150 550 111 700

Only the parent share of the pre-acquisition equity in Chapman Ltd is eliminated in the first pre-acquisition entry that also eliminates the investment account recognised by Charlie Ltd and recognises the control premium as a part of goodwill. As the entries are prepared at acquisition date, the NCI needs to be recognised in only 1 step. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

12 000 48 000 4 000 10 100 74 100

This entry transfers the NCI share of the pre-acquisition equity in Chapman Ltd at acquisition date to the NCI equity account and it will be repeated in the same form in the consolidation entries in the next periods as NCI Step 1 entry. 2. Consolidation worksheet entries at 30 June 2020: (a) Business combination valuation entries:

29.73

Chapter 29: Consolidation: non-controlling interest

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

2 500

Inventories Deferred tax liability Business combination valuation reserve Accumulated depreciation - equipment Equipment Deferred tax liability Business combination valuation reserve

Dr Cr Cr Dr Cr Cr Cr

2 500

Depreciation expense - equipment Accumulation depreciation - equipment (20% x $10 000)

Dr Cr

2 000

Deferred tax liability Income tax expense

Dr Cr

600

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Goodwill Business combination valuation reserve

Dr Cr

7 750

750 1 750

750 1 750 15 000 5 000 3 000 7 000

2 000

600

3 000 7 000

7 750

As a part of inventories are sold during the current period (50%), the BCVR entry posted now for that part of inventories sold should adjust cost of sales (instead of inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. The BCVR entry for the other inventories will be similar to the one posted at acquisition date as those inventories are still on hand, but only for half of the amounts originally recognised as adjustments. As the equipment is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the equipment is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. The entries for land and goodwill are exactly the same as those posted at acquisition date with regards to these assets as there are no changes in these assets during the period since acquisition. (b) Pre-acquisition entries: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve Goodwill

Dr Dr Dr Dr Dr

18 000 72 000 6 000 15 150 550

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Shares in Chapman Ltd

111 700

Transfer from BCVR Dr 1 050 Business combination valuation reserve Cr 1 050 (60% x ½ x ($50 000 - $45 000) x (1 – 30%) - BCVR for inventories sold during the period) Only the parent share of the pre-acquisition equity in Chapman Ltd is eliminated in the first pre-acquisition entry that also eliminates the investment account recognised by Charlie Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of half of the inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/19) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

12 000 48 000 4 000 10 100 74 100

This entry transfers the NCI share of the pre-acquisition equity in Chapman Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (current period): NCI share of profit Dr 4 740 NCI Cr 4 740 (40% x ($15 000 – [$2 500 - $750] cost of sales adjustment after tax – [$2 000 - $600] depreciation adjustment after tax)) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to cost of sales and depreciation expense posted in the BCVR entries, taking into consideration their respective tax effects. Even though there are no other changes in the equity accounts reported in the individual statement of Chapman Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which

29.75

Chapter 29: Consolidation: non-controlling interest

cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • •

An increase in NCI due to the increase in retained earnings. A decrease in NCI due to the decrease in BCVR.

Those effects can be recorded as: Transfer from BCVR Dr 700 NCI Cr 700 (40% x ½ x ($50 000 - $45 000) x (1 – 30%) BCVR for inventories sold during the period) NCI Dr 700 Business combination valuation reserve Cr 700 (40% x ½ x ($50 000 - $45 000) x (1 – 30%) BCVR for inventories sold during the period) These last two entries can be combined into a single entry: Transfer from BCVR Dr 700 Business combination valuation reserve Cr 700 (40% x ½ x ($50 000 - $45 000) x (1 – 30%) BCVR for inventories sold during the period) 3. Consolidation worksheet entries at 30 June 2021: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

2 500

Depreciation expense - equipment Carrying amount of equipment sold Income tax expense Retained earnings (1/7/20) Transfer from BCVR

Dr Dr Cr Dr Cr

1 000 7 000

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Goodwill Business combination valuation reserve

Dr Cr

7 750

750 1 750

2 400 1 400 7 000

3 000 7 000

7 750

As half of inventories are sold during the previous period, no BCVR entry needs to be posted now for that half of inventories. The other half is assumed to be sold during the current period. As the equipment is not in the business at the end of the period (it was sold during the current

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period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for equipment to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings, while also adjusting the carrying amount of the equipment sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the equipment was sold on 1 January 2021 (1.5 years after the acquisition date), the carrying amount recognised by Chapman Ltd at the moment of sale is $65 000 - $65 000 / 5 x 1.5 years = $45 500, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $75 000 - $75 000 / 5 x 1.5 years = $52 500; therefore, a $7 000 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the equipment was sold: i.e. ($75 000 - $65 000) / 5 years x (5 years – 1.5 years). There are no adjustments needed for the equipment account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/20), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/20). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. The entries for land and goodwill are exactly the same as those posted at acquisition date with regards to these assets as there are no changes in these assets during the period since acquisition. (b) Pre-acquisition entries: Retained earnings (1/7/20)* Share capital General reserve Business combination valuation reserve** Goodwill Shares in Chapman Ltd *$18 000 + (60% x ½ x $5 000 x (1 – 30%)) **$15 150 – (60% x ½ x $5 000 x (1 – 30%))

Dr Dr Dr Dr Dr Cr

19 050 72 000 6 000 14 100 550

Transfer from BCVR Dr Business combination valuation reserve Cr (Sale of inventories: 60% x ½ x $5 000 x (1 – 30%))

1 050

Transfer from BCVR Dr Business combination valuation reserve Cr (Sale of equipment: 60% x $10 000 x (1 – 30%))

4 200

111 700

1 050

4 200

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Chapter 29: Consolidation: non-controlling interest

BCVR (1/2 x $5 000 x (1 – 30%) = $1 750), while the amount of BCVR to be eliminated will be the parent share of the amount that would have been recognised at acquisition date ($3 500 BCVR inventories + $7 000 BCVR equipment + $7 000 BCVR land + $7 750 BCVR goodwill) minus the amount transferred from it ($1 750 BCVR inventories). However, there were two transfers during the current period from pre-acquisition equity: • a transfer from business combination valuation reserve to retained earnings (caused by the sale of the remaining inventories) • a transfer from business combination valuation reserve to retained earnings (caused by the sale of equipment). Therefore, two other pre-acquisition entries need to be posted to reverse these transfers for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/20) Dr 12 000 Share capital Dr 48 000 General reserve Dr 4 000 Business combination valuation reserve Dr 10 100 NCI Cr 74 100 This entry transfers the NCI share of the pre-acquisition equity in Chapman Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/20 (prior period): We identify the following changes in equity for this period from the individual statement of Chapman Ltd and the consolidation entries: • Retained earnings increased by $15 000 as a result of the profits recognised during the period and decreased by $1 400 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2021, giving a net effect of an increase of $13 600. • BCVR decreased by $1 750 as a result of the sale of inventories undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/20) NCI (40% x ($15 000 – $1 400))

Dr Cr

5 440

NCI Business combination valuation reserve (40% x $1 750)

Dr Cr

700

5 440

700

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is

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transferred to NCI, while the credit to BCVR means that a part of the decrease in BCVR is allocated to NCI. They can be combined into one single entry: Retained earnings (1/7/20) Business combination valuation reserve NCI

Dr Cr Cr

5 440 700 4 740

(e) NCI Step 3: NCI share of changes in equity from 1/7/20 to 30/6/21 (current period): NCI share of profit Dr 7 860 NCI Cr 7 860 (40% x ($27 000 – [$2 500 - $750] cost of sales adjustment after tax – [$1 000 + $7 000 - $2 400] carrying amount and depreciation expense adjustment after tax)) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustments posted in the BCVR entries to cost of sales for inventories sold during the current period and to depreciation expense and carrying amount of equipment sold, taking into consideration the respective tax effect. Even though there are no other changes in the equity accounts reported in the individual statement of Chapman Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of equipment and inventories which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • •

An increase in NCI due to the increase in retained earnings. A decrease in NCI due to the decrease in BCVR.

Those effects can be recorded as: Transfer from BCVR Dr 3 500 NCI Cr (40% x ($1 750 BCVR inventories + $7 000 BCVR equipment)) NCI Business combination valuation reserve

Dr Cr

3 500

3 500 3 500

These last 2 entries can be combined into one single entry: Transfer from BCVR Business combination valuation reserve

Dr Cr

3 500 3 500

4. Consolidation worksheet entries at 30 June 2022: (a) Business combination valuation entries:

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Chapter 29: Consolidation: non-controlling interest

Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Goodwill Business combination valuation reserve

Dr Cr

7 750

Impairment loss – goodwill Dr Accumulated impairment losses – goodwill Cr

3 000

3 000 7 000

7 750

3 000

As inventories and equipment are sold during the previous periods, no BCVR entries are need for those assets now. However, as the land and goodwill is still in the business, BCVR entries will be posted for these latter assets. It should be noted that the only changes in these accounts is the impairment of the goodwill that is recognised here separate from the fair value adjustments. (b) Pre-acquisition entries: Retained earnings (1/7/21)* Share capital General reserve Business combination valuation reserve Goodwill Shares in Chapman Ltd *60% x ($30 000 + $3 500 + $7 000)

Dr Dr Dr Dr Dr Cr

24 300 72 000 6 000 8 850 550 111 700

Dr Dr Dr Dr Cr

12 000 48 000 4 000 10 100 74 100

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We identify the following changes in equity for this period from the individual statement of Chapman Ltd and the consolidation entries: • Retained earnings increased by $15 000 + $27 000 as a result of the profits/losses recognised during the period, giving a net effect of an increase of $42 000. • BCVR decreased by $7 000 + $3 500 as a result of the sale of inventories and equipment undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/21) NCI (40% x ($15 000 + $27 000))

Dr Cr

16 800

NCI Business combination valuation reserve (40% x ($7 000 + $3 500))

Dr Cr

4 200

16 800

4 200

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. These 2 entries can be combined into one single entry: Retained earnings (1/7/21) Business combination valuation reserve NCI

Dr Cr Cr

16 800 4 200 12 600

(e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI share of profit NCI (40% x ($12 000 - $3 000))

Dr Cr

3 600 3 600

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As there is a business combination valuation entry that impacts on the current profit (the recognition of the impairment loss on goodwill), we need to adjust the current profit before allocating it to NCI.

29.81

Chapter 29: Consolidation: non-controlling interest

Exercise 29.10 Undervalued assets, full goodwill method On 1 July 2022, Huntsman Ltd acquired 90% the issued shares of Spider Ltd for $140 300. At this date the equity of Spider Ltd consisted of share capital of $100 000 and retained earnings of $50 000. All the identifiable assets and liabilities of Spider Ltd were recorded at amounts equal to fair value at 1 July 2022, except for plant for which the carrying amount of $80 000 (net of accumulated depreciation of $40 000) was $3000 less than the fair value. The plant was estimated to have a further 3-year life beyond 1 July 2022, with the benefits expected to flow evenly over the period. Huntsman Ltd uses the full goodwill method. The fair value of the non-controlling interest at 1 July 2022 was $15 500. The following annual results were recorded by Spider Ltd following the business combination.

Year ended

Profit/(loss)

30 June 2023

8 000

Other items of comprehensive income $

2 000

30 June 2024

9 000

3 000

30 June 2025

10 000

4 000

30 June 2026

11 000

5 000

The other items of comprehensive income relate to the gains on revaluation of land of Spider Ltd. The tax rate is 30%. Required 1. Prepare the consolidation worksheet entries as at 1 July 2022. 2. Prepare the consolidation worksheet entries for the year ended 30 June 2023. 3. Prepare the consolidation worksheet entries for the year ended 30 June 2024. 4. Prepare the consolidation worksheet entries for the year ended 30 June 2025. 5. Prepare the consolidation worksheet entries for the year ended 30 June 2026. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 1 July 2022: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Spider Ltd = + = (a) Consideration transferred = (b) NCI in Spider Ltd = Aggregate of (a) and (b) = Goodwill acquired = =

($100 000 + $50 000) (equity) $3 000 (1 – 30%) (BCVR - plant) $152 100 $140 300 $15 500 $155 800 $155 800 – $152 100 $3 700

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Goodwill of Spider Ltd Fair value of Spider Ltd

= $15 500 / 10% = $155 000

Fair value of identifiable assets and liabilities of Spider Ltd = $152 100 Goodwill of Spider Ltd = $155 000 – $152 100 = $2 900 Goodwill of Huntsman Ltd Goodwill acquired = $3 700 Goodwill of Spider Ltd = $2 900 Control premium - parent = $3 700 – $2 900 = $800 The control premium can also be calculated as follows. Fair value of the shares in Spider Ltd acquired by Huntsman Ltd = $15 500 / 10% x 90% = $139 500 Consideration transferred = $140 300 Control premium - parent = $140 300 – $139 500 = $800 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Spider Ltd, i.e. $800 + 90% x $2 900 = $3 410. NCI will only be entitled to its share of the goodwill of Spider Ltd, i.e. 10% x $2 900 = $290. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Spider Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

40 000

Goodwill Business combination valuation reserve

Dr Cr

2 900

37 000 900 2 100

2 900

The first entry recognises the fair value adjustments for the asset that was undervalued at acquisition date in Spider Ltd’s accounts: i.e. plant. The second entry recognises the goodwill of Spider Ltd that can be allocated to the parent and NCI. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill

Dr Dr Dr Dr

45 000 90 000 4 500 800

29.83

Chapter 29: Consolidation: non-controlling interest

Shares in Spider Ltd

140 300

Only the parent share of the pre-acquisition equity in Spider Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Huntsman Ltd. As the entries are prepared at acquisition date, the NCI needs to be recognised in only 1 step. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Spider Ltd at 1 July 2022)

5 000 10 000 500 15 500

This entry transfers the NCI share of the pre-acquisition equity in Spider Ltd at acquisition date to the NCI equity account. 2. Consolidation worksheet entries at 30 June 2023: (a) Business combination valuation entries: Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

40 000

Depreciation expense - plant Accumulated depreciation - plant (1/3 x $3 000)

Dr Cr

1 000

Deferred tax liability Income tax expense

Dr Cr

300

Goodwill Business combination valuation reserve

Dr Cr

2 900

37 000 900 2 100

1 000

300

2 900

As the plant is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. The entry for goodwill is the same as that posted on acquisition date as there are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Spider Ltd

Dr Dr Dr Dr Cr

45 000 90 000 4 500 800 140 300

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Only the parent share of the pre-acquisition equity in Spider Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Huntsman Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. There are no transfers during the current period from pre-acquisition equity, so there is no need for any other entries. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr 5 000 Share capital Dr 10 000 Business combination valuation reserve Dr 500 NCI Cr 15 500 (10% of the equity of Spider Ltd at 1 July 2022) This entry transfers the NCI share of the pre-acquisition equity in Spider Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr 730 NCI Cr (10% x ($8 000 – [$1 000 - $300] depreciation adjustment after tax))

730

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration their respective tax effects. Beside the current profit, Spider Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Spider Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income, i.e. $2 000. This increase in Asset Revaluation Surplus is a change in equity and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (10% x $2 000)

Dr Cr

200

40 000

200

3. Consolidation worksheet entries at 30 June 2024: (a) Business combination valuation entries: Accumulated depreciation - plant

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Chapter 29: Consolidation: non-controlling interest

Plant Deferred tax liability Business combination valuation reserve

Cr Cr Cr

37 000 900 2 100

Depreciation expense - plant Retained earnings (1/7/23) Accumulated depreciation - plant (1/3 x $3 000 p.a. for 2 years)

Dr Dr Cr

1 000 1 000

Deferred tax liability Income tax expense Retained earnings (1/7/23)

Dr Cr Cr

600

Dr Cr

2 900

Goodwill Business combination valuation reserve

2 000

300 300

2 900

As the plant is still in the business (it has one more year of useful life), the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the previous and current period and the related tax effect. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/23), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/23). The entry for goodwill is the same as that posted on acquisition date as there are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/23) Share capital Business combination valuation reserve Goodwill Shares in Spider Ltd

Dr Dr Dr Dr Cr

45 000 90 000 4 500 800 140 300

As there were no transfers from pre-acquisition equity during the period since acquisition, the pre-acquisition entry is the same as the one posted at acquisition date. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/23) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Spider Ltd at acquisition date)

5 000 10 000 500 15 500

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We identify the following changes in equity for this period: • Retained earnings increased by $8 000 as a result of the profit recognised during the period and decreased by $700 ($1 000 - $300) as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2024, giving a net effect of an increase of $7 300. • Asset Revaluation Surplus increased by $2 000 as a result of the gain on revaluation of the land recognised during the period in the other comprehensive income. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/23) NCI (10% x ($8 000 – [$1 000 - $300]))

Dr Cr

730

Asset revaluation surplus NCI (10% x $2 000)

Dr Cr

200

730

200

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to ARS means that a part of the increase in ARS is transferred to NCI. They can be combined into one single entry: Retained earnings (1/7/23) Asset revaluation surplus NCI

Dr Dr Cr

730 200 930

(e) NCI Step 3: NCI share of changes in equity from 1/7/23 to 30/6/24 (current period): NCI share of profit NCI (10% x ($9 000 – [$1 000 - $300]))

Dr Cr

830 830

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Chapter 29: Consolidation: non-controlling interest

Revaluation Surplus is a change in equity for the current period and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (10% x $3 000)

Dr Cr

300 300

There are no other changes in equity in the current period reported in Spider Ltd’s statements or recognised on consolidation. Therefore, there are no other NCI entries to be prepared. 4. Consolidation worksheet entries at 30 June 2025: (a) Business combination valuation entries: Depreciation expense - plant Income tax expense Retained earnings (1/7/24) Transfer from BCVR

Dr Cr Dr Cr

1 000

Goodwill Business combination valuation reserve

Dr Cr

2 900

300 1 400 2 100

2 900

As the plant is not in the business at the end of the period (it reached the end of the useful life and it would have been derecognised), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings. There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/24), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/24). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. The entry for goodwill is the same as that posted on acquisition date as there are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/24) Share capital Business combination valuation reserve Goodwill Shares in Spider Ltd

Dr Dr Dr Dr Cr

45 000 90 000 4 500 800

Transfer from BCVR Business combination valuation reserve

Dr Cr

1 890

140 300

1 890

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combination valuation reserve to retained earnings, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/24) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Spider Ltd at acquisition date)

5 000 10 000 500 15 500

This entry transfers the NCI share of the pre-acquisition equity in Spider Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/24 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $8 000 + $9 000 as a result of the profit recognised during the period and decreased by $1 400 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2025, giving a net effect of an increase of $15 600 • Asset Revaluation Surplus increased by $2 000 + $3 000 as a result of the gain on revaluation of the land recognised during the period in the other comprehensive income It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/24) NCI (10% x ($8 000 + $9 000 – [$2 000 - $600])

Dr Cr

1 560

Asset revaluation surplus NCI (10% x ($2 000 + $3 000))

Dr Cr

500

1 560

500

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to ARS means that a part of the increase in ARS is transferred to NCI. They can be combined into one single entry: Retained earnings (1/7/24) Asset revaluation surplus NCI

Dr Dr Cr

1 560 500 2 060

(e) NCI Step 3: NCI share of changes in equity from 1/7/24 to 30/6/25 (current period):

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Chapter 29: Consolidation: non-controlling interest

NCI share of profit NCI (10% x ($10 000 – [$1 000 - $300])

Dr Cr

930 930

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current profit, Spider Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Spider Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income and for the current period, i.e. $4 000 (it is assumed that this amount is after tax). This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share of that increase should be recognised as increasing NCI:

Gains/(losses): asset revaluation surplus NCI (10% x $4 000)

Dr Cr

400 400

Even though there are no other changes in the equity accounts reported in the individual statement of Spider Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as: Transfer from BCVR NCI (10% x $3 000 x (1 – 30%) BCVR - plant)

Dr Cr

210

NCI Business combination valuation reserve (10% x $3 000 x (1 – 30%) BCVR - plant)

Dr Cr

210

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (10% x $3 000 x (1 – 30%) BCVR - plant)

Dr Cr

210 210

5. Consolidation worksheet entries at 30 June 2026:

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(a) Business combination valuation entries: Goodwill Business combination valuation reserve

Dr Cr

2 900 2 900

As plant is derecognised during the previous period, no BCVR entry needs to be posted now other than the entry to recognise the goodwill of Spider Ltd. (b) Pre-acquisition entries: Retained earnings (1/7/25) Share capital Business combination valuation reserve Goodwill Shares in Spider Ltd

Dr Dr Dr Dr Cr

46 890 90 000 2 610 800 140 300

The pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the derecognition of plant undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 90% (parent share) of the amount reported in Retained earnings at acquisition date ($50 000) plus the amount transferred from BCVR ($2 100 BCVR plant), while the amount of BCVR to be eliminated will be the parent share of goodwill of Spider Ltd. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/25) Dr Share capital Dr Business combination valuation reserve Dr NCI Cr (10% of the equity of Spider Ltd at acquisition date)

5 000 10 000 500 15 500

This entry transfers the NCI share of the pre-acquisition equity in Spider Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/25 (prior period): We identify the following changes in equity for this period from the individual statement of Spider and the consolidation entries: • Retained earnings increased by $8 000 + $9 000 + $10 000 as a result of the profit recognised during the period, giving a net effect of an increase of $27 000. • Asset Revaluation Surplus increased by $2 000 + $3 000 + $4 000 as a result of the gain on revaluation of the land recognised during the period in the other comprehensive income. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be:

29.91

Chapter 29: Consolidation: non-controlling interest

Retained earnings (1/7/25) NCI (10% x ($8 000 + $9 000 + $10 000))

Dr Cr

2 700

Asset revaluation surplus NCI (10% x ($2 000 + $3 000 + $4 000))

Dr Cr

900

2 700

900

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to ARS means that a part of the increase in ARS is transferred to NCI. They can be combined into one single entry: Retained earnings (1/7/25) Asset revaluation surplus NCI

Dr Dr Cr

2 700 900 3 600

(e) NCI Step 3: NCI share of changes in equity from 1/7/25 to 30/6/26 (current period): NCI share of profit NCI (10% x $11 000)

Dr Cr

1 100 1 100

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have no impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. Beside the current profit, Spider Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Spider Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income and for the current period, i.e. $5 000 (it is assumed that this amount is after tax). This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share of that increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (10% x $5 000)

Dr Cr

500 500

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.11 Undervalued assets, full goodwill method On 1 July 2022, Fur Ltd acquired 75% of the issued shares of Seal Ltd for $191 000 when the equity of Seal Ltd consisted of share capital of $120 000 and retained earnings of $90 000. At this date, all the identifiable assets and liabilities of Seal Ltd were recorded at amounts equal to their fair values except for the following.

In relation to these assets, the following information is available.  



All the inventories were sold by 30 June 2023. The land was revalued in the records of Seal Ltd immediately after the business combination. It was subsequently sold by Seal Ltd on 1 June 2024 for $113 000. At this date, the recorded gains on revaluation of this land taken to other comprehensive income were $3000, the land being revalued to fair value by Seal Ltd immediately prior to sale. The machinery was considered to have a further useful life of 3 years.

The fair value of the non-controlling interest in Seal Ltd at 1 July 2022 was $63 000. Fur Ltd uses the full goodwill method. The following annual results were recorded by Seal Ltd following the business combination. Other items of comprehensive income

Year ended

Profit/(loss)

30 June 2023

$ 15 000

30 June 2024

34 500

7 500

30 June 2025

(9 000)

10 500

30 June 2026

33 000

4 000

3 000

The other items of comprehensive income relate to gains/(losses) on the revaluation of land which is measured at fair value in the records of Seal Ltd. The tax rate is 30%. Required 1. Prepare the consolidation worksheet entries as at 1 July 2022. 2. Prepare the consolidation worksheet entries for the year ended 30 June 2023. 3. Prepare the consolidation worksheet entries for the year ended 30 June 2024. 4. Prepare the consolidation worksheet entries for the year ended 30 June 2025. 5. Prepare the consolidation worksheet entries for the year ended 30 June 2026. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 1 July 2022: © John Wiley and Sons Australia Ltd, 2020

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Chapter 29: Consolidation: non-controlling interest

Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Seal Ltd = ($120 000 + $90 000) (equity) + ($26 000 - $20 000) (1 – 30%) (BCVR-inventories) + ($110 000 - $80 000) (1 – 30%) (ARS - land) + ($57 000 - $48 000) (1 – 30%) (BCVR - machinery) = $241 500 (a) Consideration transferred = $191 000 (b) NCI in Seal Ltd = $63 000 Aggregate of (a) and (b) = $254 000 Goodwill acquired = $254 000 – $241 500 = $12 500 Goodwill of Seal Ltd Fair value of Seal Ltd = $63 000 / 25% = $252 000 Fair value of identifiable assets and liabilities of Seal Ltd = $241 500 Goodwill of Seal Ltd = $252 000 - $241 500 = $10 500 Goodwill of Fur Ltd Goodwill acquired = $12 500 Goodwill of Seal Ltd = $10 500 Control premium – parent = $12 500 - $10 500 = $2 000 The control premium can also be calculated as follows: Fair value of the shares in Seal Ltd acquired by Fur Ltd = = Consideration transferred = Control premium – parent = =

$63 000 / 25% x 75% $189 000 $191 000 $191 000 - $189 000 $2 000

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Seal Ltd, i.e. $2 000 + 75% x $10 500 = $9 875. NCI will only be entitled to its share of the goodwill of Seal Ltd, i.e. 25% x $10 500 = $2 625. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the preacquisition entry. As the goodwill of Seal Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

6 000

Accumulated depreciation - machinery Machinery

Dr Cr

20 000

1 800 4 200

11 000

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Deferred tax liability Business combination valuation reserve

Cr Cr

Goodwill Business combination valuation reserve

Dr Cr

2 700 6 300 10 500 10 500

The first two entries recognise the fair value adjustments for the assets that were undervalued at acquisition date in Seal Ltd’s accounts: i.e. inventories and machinery. The third entry recognises the goodwill of Seal Ltd that can be allocated to the parent and NCI. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Seal Ltd

Dr Dr Dr Dr Dr Cr

67 500 90 000 15 750 15 750 2 000 191 000

Only the parent share of the pre-acquisition equity in Seal Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Fur Ltd. As the entries are prepared at acquisition date, the NCI needs to be recognised in only 1 step.

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr Asset revaluation surplus Dr Business combination valuation reserve Dr NCI Cr (25% of the equity of Seal Ltd at acquisition date)

22 500 30 000 5 250 5 250 63 000

This entry transfers the NCI share of the pre-acquisition equity in Seal Ltd at acquisition date to the NCI equity account. 2. Consolidation worksheet entries at 30 June 2023: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

6 000

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

20 000

1 800 4 200

11 000 2 700 6 300

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Chapter 29: Consolidation: non-controlling interest

Depreciation expense - machinery Accumulated depreciation - machinery (1/3 x $9 000)

Dr Cr

3 000

Deferred tax liability Income tax expense

Dr Cr

900

Goodwill Business combination valuation reserve

Dr Cr

10 500

3 000

900

10 500

As inventories are sold during the current period, the BCVR entry posted now for inventories should adjust cost of sales (instead of the inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As the machinery is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the machinery is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. The entry for goodwill is the same as that posted on acquisition date as there are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Seal Ltd

Dr Dr Dr Dr Dr Cr

67 500 90 000 15 750 15 750 2 000 191 000

Transfer from BCVR Dr 3 150 Business combination valuation reserve Cr 3 150 (75% x ((1 - 30%) x $6 000 – BCVR for inventories sold during the period)) Only the parent share of the pre-acquisition equity in Seal Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Fur Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date:

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Retained earnings (1/7/22) Share capital Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

22 500 30 000 5 250 5 250 63 000

This entry transfers the NCI share of the pre-acquisition equity in Seal Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr 2 175 NCI Cr 2 175 (25% x ($15 000 – [$6 000 - $1 800] cost of sales adjustment after tax [$3 000 - $900] depreciation adjustment after tax)) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to cost of sales and depreciation expense posted in the BCVR entries, taking into consideration their respective tax effects. Beside the current profit, Seal Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Seal Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income, i.e. $3 000. This increase in Asset Revaluation Surplus is a change in equity and the NCI share of that increase should be recognised as increasing the equity account NCI: Gains/(losses): asset revaluation surplus NCI (25% x $3 000)

Dr Cr

750 750

Even though there are no other changes in the equity accounts reported in the individual statement of Seal Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded as: Transfer from BCVR NCI (25% x (1 - 30%) x $6 000)

Dr Cr

1 050

NCI

1 050

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Chapter 29: Consolidation: non-controlling interest

Business combination valuation reserve (25% x (1 - 30%) x $6 000)

1 050

These last two entries can be combined into a single entry: Transfer from BCVR Business combination valuation reserve (25% x (1 - 30%) x $6 000)

Dr Cr

1 050

Accumulated depreciation - machinery Machinery Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

20 000

Depreciation expense - machinery Retained earnings (1/7/23) Accumulated depreciation - machinery

Dr Dr Cr

3 000 3 000

Deferred tax liability Income tax expense Retained earnings (1/7/23) Goodwill Business combination valuation reserve

Dr Cr Cr Dr Cr

1 800

1 050

3. Consolidation worksheet entries at 30 June 2024: (a) Business combination valuation entries:

11 000 2 700 6 300

6 000

900 900 10 500 10 500

As the machinery is still in the business (it has one more year of useful life), the first BCVR entry for it is the same as that prepared at acquisition date; however, as the machinery is depreciable, two other entries are posted to recognise depreciation adjustments for the previous and current period and the related tax effect. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/23), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/23). The entry for goodwill is the same as that posted on acquisition date as they are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/23)* Share capital Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Seal Ltd ($67 500 + $3 150 BCVR – inventories)

Dr Dr Dr Dr Dr Cr

70 650 90 000 15 750 12 600 2 000 191 000

The pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the sale of inventories undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($90 000) plus the amount transferred from BCVR ($4 200 BCVR inventories). There is also a transfer during the current period from pre-acquisition equity, i.e. a transfer from asset revaluation surplus to retained earnings. Therefore, an additional pre-acquisition entry is needed to reverse this transfer for the parent share. The amount of transfer that needs to be reversed is only $30 000 (i.e. the fair value adjustment at acquisition date) x (1 - 30%), even though the land further increases in value after the acquisition date and before the external sale (this further increase belongs to post-acquisition equity). Note that this further increase was recognised after tax in other comprehensive income for the period ended 30 June 2024 as $3 000. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. Transfer from asset revaluation surplus Asset revaluation surplus (75% x (1 - 30%) x $30 000)

Dr Cr

15 750

Dr Dr Dr Dr Cr

22 500 30 000 5 250 5 250

15 750

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/23) Share capital Asset revaluation surplus Business combination valuation reserve NCI

63 000

29.99

Chapter 29: Consolidation: non-controlling interest

Given that those changes in equity induce changes in the NCI share of equity in the same direction, the combined entry to recognise the effect on NCI will be: Retained earnings (1/7/23)* Dr Asset revaluation surplus** Dr Business combination valuation reserve*** Cr NCI Cr *25% x ($15 000 – [$3 000 - $900]) **25% x $3 000 ***25% x (1 - 30%) x $6 000 BCVR - inventories

3 225 750 1 050 2 925

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/23 to 30/6/24 (current period): NCI share of profit NCI (25% x ($34 500 – [$3 000 - $900])

Dr Cr

8 100 8 100

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current profit, Seal Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Seal Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income and for the current period, i.e. $7 500 (it is assumed that this amount is after tax). This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share of this increase should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (25% x $7 500)

Dr Cr

1 875 1 875

There is also a transfer during the current period from asset revaluation surplus to retained earnings due to the sale of land undervalued at acquisition date. As this transfer increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in asset revaluation surplus.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The amount of transfer that needs to be considered here for NCI is not only $30 000 (i.e. the fair value adjustment at acquisition date) x (1 – 30%). As the land further increases in value after the acquisition date and before the external sale (this further increase belongs to postacquisition equity and it was recognised after tax in other comprehensive income as $3 000), the entire transfer is $21 000 + $3 000. While in the pre-acquisition entries we only considered the pre-acquisition transfer, for NCI we are interested in both pre- and post-acquisition equity transfers. Transfer from asset revaluation surplus Asset revaluation surplus (25% x ((1 - 30%) x $30 000 + $3 000))

Dr Cr

6 000

Depreciation expense - machinery Income tax expense Retained earnings (1/7/24) Transfer from BCVR

Dr Cr Dr Cr

3 000

Goodwill Business combination valuation reserve

Dr Cr

10 500

6 000

4. Consolidation worksheet entries at 30 June 2025: (a) Business combination valuation entries:

900 4 200 6 300

10 500

As the machinery is not in the business at the end of the period (it reached the end of the useful life and it would have been derecognised), but was on hand at the beginning of the period, a BCVR entry needs to be posted for machinery to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings. There are no adjustments needed for the machinery account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/24), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/24). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. The entry for goodwill is the same as that posted on acquisition date as they are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/24)* Dr 86 400 Share capital Dr 90 000 Business combination valuation reserve Dr 12 600 Goodwill Dr 2 000 Shares in Seal Ltd Cr *75% x ($90 000 + $4 200 BCVR inventories + $21 000 ARS land)

191 000

29.101

Chapter 29: Consolidation: non-controlling interest

amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the sale of inventories and from ARS to retained earnings caused by the sale of land undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($90 000) plus the amount transferred from BCVR ($4 200 BCVR inventories) and the amount transferred from pre-acquisition ARS ($21 000 ARS land). The amount of BCVR to be eliminated will be the parent share of goodwill of Seal Ltd and the fair value adjustment for machinery. There is no amount of ARS to eliminate as the entire ARS at acquisition date was transferred to retained earnings in the prior periods. There is also a transfer during the current period from pre-acquisition equity, i.e. a transfer from BCVR to retained earnings due to the derecognition of the machinery at the end of the current period. Therefore, an additional pre-acquisition entry is needed to reverse this transfer for the parent share. The amount of transfer that needs to be reversed is $9 000 (i.e. the fair value adjustment at acquisition date) x (1 – 30%). The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. Transfer from BCVR Business combination valuation reserve (75% x $6 300 BCVR machinery)

Dr Cr

4 725

Dr Dr Dr Dr Cr

22 500 30 000 5 250 5 250

4 725

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/24) Share capital Asset revaluation surplus Business combination valuation reserve NCI

63 000

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It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the combined entry to recognise the effect on NCI will be: Retained earnings (1/7/24)* Dr 17 325 Asset revaluation surplus** Cr 3 375 Business combination valuation reserve*** Cr 1 050 NCI Cr 12 900 *25% x ($15 000 + $34 500 – $4 200 depreciation adjustments after tax for machinery + $24 000 transfer from ARS) **25% x ($3 000 + $7 500 – [$3 000 + ((1 - 30%) x $30 000)] transfer from ARS) ***25% x ((1 - 30%) x $6 000) BCVR inventories These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI.

(e) NCI Step 3: NCI share of changes in equity from 1/7/24 to 30/6/25 (current period): NCI NCI share of profit/loss (25% x [(9 000) – ($3 000 - $900)])

Dr Cr

2 775 2 775

This entry recognises the NCI share of the current loss. It is assumed that the loss reported is after tax. As the business combination entries have an impact on the current loss due to depreciation adjustment after tax for machinery, there is a need to adjust the current loss before allocating it to NCI. Beside the current profit, Seal Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Seal Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income and for the current period, i.e. $10 500 (it is assumed that this amount is after tax). This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (25% x $10 500)

Dr Cr

2 625 2 625

29.103

Chapter 29: Consolidation: non-controlling interest

Even though there are no other changes in the equity accounts reported in the individual statement of Seal Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of machinery which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Those effects can be recorded in a combined entry as: Transfer from business combination valuation reserve Business combination valuation reserve (25% x $6 300 BCVR machinery)

Dr Cr

1 575 1 575

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). 5. Consolidation worksheet entries at 30 June 2026: (a) Business combination valuation entries: Goodwill Business combination valuation reserve

Dr Cr

10 500 10 500

As machinery is derecognised during the previous period, no BCVR entry needs to be posted now other than the entry to recognise the goodwill of Seal Ltd. (b) Pre-acquisition entries: Retained earnings (1/7/25)* Dr 91 125 Share capital Dr 90 000 Business combination valuation reserve** Dr 7 875 Goodwill Dr 2 000 Shares in Seal Ltd Cr 191 000 *75% x ($90 000 + $4 200 BCVR inventories + $6 300 BCVR machinery + $21 000 ARS land) **75% x $10 500 The pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the sale of inventories and derecognition of machinery undervalued at acquisition date and the transfer from ARS to retained earnings on sale of land undervalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($90 000) plus the amount transferred from BCVR ($4 200 BCVR inventories + $6 300 BCVR

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

machinery). The amount of BCVR to be eliminated will be the parent share of goodwill of Seal Ltd and there won’t be any ARS to eliminate. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/25) Share capital Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

22 500 30 000 5 250 5 250 63 000

This entry transfers the NCI share of the pre-acquisition equity in Seal Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/25 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $15 000 + $34 500 + ($9 000) as a result of the profits/losses recognised during the period and further increased by $24 000 as a result of the transfer of ARS on sale of land ($30 000 x (1 – 30%) + $3 000), giving a net effect of an increase of $64 500. • Asset Revaluation Surplus increased by $3 000 + $7 500 + $10 500 as a result of the gain on revaluation of the land recognised during the period in the other comprehensive income and decreased by $24 000 on sale of land, given a net effect of a decrease of $3 000. • BCVR decreased by $4 200 + $6 300 as a result of the sale of inventories and derecognition of machinery undervalued at acquisition date during the period. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the combined entry to recognise the effect on NCI will be: Retained earnings (1/7/25)* Dr 16 125 Asset revaluation surplus** Cr Business combination valuation reserve*** Cr NCI Cr *25% x ($15 000 + $34 500 - $9 000 + [$21 000 + $3 000]) **25% x ($3 000 + $7 500 + $10 500 – [$21 000 +$3 000]) ***25% x (1 - 30%) x ($6 000 + $9 000)

750 2 625 12 750

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/25 to 30/6/26 (current period): NCI share of profit NCI

Dr Cr

8 250 8 250

29.105

Chapter 29: Consolidation: non-controlling interest

(25% x $33 000) This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have no impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. Beside the current profit, Seal Ltd reports other comprehensive income for the current period. That includes the gains on revaluation of land. As such, it should be noted that Seal Ltd would have recorded for those gains on revaluation of land a corresponding increase in Asset Revaluation Surplus – that would be equal to the other comprehensive income and for the current period, i.e. $4 000 (it is assumed that this amount is after tax). This increase in Asset Revaluation Surplus is a change in equity for the current period and the NCI share should be recognised as increasing NCI: Gains/(losses): asset revaluation surplus NCI (25% x $4 000)

Dr Cr

1 000 1 000

29.106

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.12 Undervalued assets, partial goodwill method Bradley Ltd purchased 75% of the issued shares of Cooper Ltd for $500 000 on 1 July 2016 when the equity of Cooper Ltd was as follows. Share capital

$200 000

General reserve

120 000

Retained earnings

80 000

At this date, Cooper Ltd had not recorded any goodwill, and all identifiable assets and liabilities were recorded at fair value except for the following assets. Carrying amount Inventories

Fair value

140 000

$ 200 000

Equipment (cost $340 000)

300 000

380 000

Land

100 000

200 000

All the inventories on hand at 1 July 2016 were sold by 30 June 2017. The equipment has a remaining useful life of 10 years, with benefits to be received evenly over this period. Differences between carrying amounts and fair values are recognised in the consolidation worksheet. The NCI at acquisition date is measured based on the proportionate share of the identifiable assets and liabilities in Cooper Ltd. The tax rate is 30%. At 30 June 2022, the trial balances of Bradley Ltd and Cooper Ltd are as follows.

Current assets

Bradley Ltd

Cooper Ltd

324 000

168 000

Shares in Cooper Ltd

500 000

—

Equipment

851 000

380 000

Land

220 000

100 000

Cost of sales

450 000

70 000

Other expenses

130 000

14 000

Income tax expense

100 000

10 000

Share capital

2 575 000

742 000

800 000

200 000

General reserve

120 000

160 000

Retained earnings (1/7/21)

240 000

150 000

1 021 200

160 000

Payables

145 800

24 000

Accumulated depreciation — equipment

248 000

48 000

Sales revenue

29.107

Chapter 29: Consolidation: non-controlling interest

Bradley Ltd

Cooper Ltd

2 575 000

742 000

Required 1. Prepare the acquisition analysis at acquisition date. 2. Prepare the business combination valuation entries and the pre-acquisition entry at acquisition date. 3. Prepare the journal entry to recognise NCI at acquisition date. 4. Prepare the consolidation worksheet entries at 30 June 2017. Assume a profit for Cooper Ltd for the year ended 30 June 2017 of $80 000 and no other changes in Cooper Ltd’s equity since the acquisition date. 5. Prepare the consolidation worksheet entries at 30 June 2022. 6. Prepare the consolidated financial statements as at 30 June 2022. (LO3, LO4 and LO5) 1. Acquisition analysis at 1 July 2016: Net fair value of identifiable assets and liabilities of Cooper Ltd = + +

(a) Consideration transferred (b) NCI in Cooper Ltd Aggregate of (a) and (b) Goodwill acquired - parent only

+ = = = = = = =

($200 000 + $120 000 + $80 000) (equity) ($200 000 - $140 000) (1 – 30%) (BCVR inventories) ($380 000 - $300 000) (1 – 30%) (BCVR – equipment) ($200 000 - $10 000) (1 – 30%) (BCVR - land) $568 000 $500 000 25% x $568 000 $142 000 $642 000 $642 000 - $568 000 $74 000

As the NCI at acquisition date is measured based on the proportionate share of the identifiable assets and liabilities in Cooper Ltd, we use the partial goodwill method and therefore the goodwill determined in the acquisition analysis belongs only to the parent and, as such, it is recognised in the pre-acquisition entries. 2. Business combination valuation entries and pre-acquisition entries at 1 July 2016: (a) Business combination valuation entries: Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

60 000

Equipment Accumulated depreciation - equipment Deferred tax liability

Dr Dr Cr

40 000 40 000

28 000 42 000

24 000

29.108

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Business combination valuation reserve

56 000

Land Dr 100 000 Deferred tax liability Cr 30 000 Business combination valuation reserve Cr 70 000 The entries recognise the fair value adjustments for the assets undervalued at acquisition date in Cooper Ltd’s accounts: i.e. inventories, equipment and land. There is no entry for goodwill under the partial goodwill method (b) Pre-acquisition entries: Retained earnings (1/7/16) Share capital General reserve Business combination valuation reserve Goodwill Shares in Cooper Ltd

Dr Dr Dr Dr Dr Cr

60 000 150 000 90 000 126 000 74 000 500 000

Only the parent share of the pre-acquisition equity in Cooper Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Bradley Ltd. 3. NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/16) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

20 000 50 000 30 000 42 000 142 000

This entry transfers the NCI share of the pre-acquisition equity in Cooper Ltd at acquisition date to the NCI equity account. 4. Consolidation worksheet entries at 30 June 2017: (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

60 000

Equipment Accumulated depreciation - equipment Deferred tax liability Business combination valuation reserve

Dr Dr Cr Cr

40 000 40 000

Depreciation expense - equipment Accumulated depreciation - equipment (10% x $80 000)

Dr Cr

8 000

Deferred tax liability

2 400

18 000 42 000

24 000 56 000

8 000

29.109

Chapter 29: Consolidation: non-controlling interest

Income tax expense

2 400

Land Dr 100 000 Deferred tax liability Cr 30 000 Business combination valuation reserve Cr 70 000 As inventories were sold during the current period, the BCVR entry posted now for inventories should adjust cost of sales (instead of the inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As the equipment is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the equipment is depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. The entry for land is the same as that posted on acquisition date as they are no events impacting on that land. (b) Pre-acquisition entries: Retained earnings (1/7/16) Share capital General reserve Business combination valuation reserve Goodwill Shares in Cooper Ltd

Dr 60 000 Dr 150 000 Dr 90 000 Dr 126 000 Dr 74 000 Cr

500 000

Transfer from BCVR Business combination valuation reserve (75% x $421 000)

Dr Cr

31 500

Only the parent share of the pre-acquisition equity in Cooper Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Bradley Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one prepared at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of inventories undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/16) Share capital General reserve Business combination valuation reserve

Dr Dr Dr Dr

20 000 50 000 30 000 42 000

29.110

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NCI

142 000

This entry transfers the NCI share of the pre-acquisition equity in Cooper Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/16 to 30/6/17 (current period): NCI share of profit Dr 8 100 NCI Cr (25% x ($80 000 – [$60 000 - $18 000] – [$8 000 - $2 400]))

8 100

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to cost of sales and depreciation expense posted in the BCVR entries, taking into consideration their respective tax effects. Even though there are no other changes in the equity accounts reported in the individual statement of Cooper Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from BCVR Business combination valuation reserve (25% x $42 000)

Dr Cr

10 500

Equipment Accumulated depreciation - equipment Deferred tax liability Business combination valuation reserve

Dr Dr Cr Cr

40 000 40 000

Depreciation expense - equipment Retained earnings (1/7/21) Accumulated depreciation - equipment

Dr Dr Cr

8 000 40 000

Deferred tax liability Income tax expense

Dr Cr

14 400

10 500

5. Consolidation worksheet entries at 30 June 2022: (a) Business combination valuation entries:

24 000 56 000

48 000

2 400

29.111

Chapter 29: Consolidation: non-controlling interest

Retained earnings (1/7/21)

12 000

Land Dr 100 000 Deferred tax liability Cr 30 000 Business combination valuation reserve Cr 70 000 As inventories were sold during the prior period, there won’t be any BCVR entry posted now for inventories. As the equipment is still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the equipment is depreciable, two other entries are posted to recognise depreciation adjustments for both the prior and current period and the related tax effects. Note that the adjustments to depreciation expenses for prior periods and the related tax effects will be posted against Retained Earnings (1/7/21). The entry for land is the same as that posted on acquisition date as they are no events impacting on that land. (b) Pre-acquisition entries: Retained earnings (1/7/21)* Dr 91 500 Share capital Dr 150 000 General reserve Dr 90 000 Business combination valuation reserve Dr 94 500 Goodwill Dr 74 000 Shares in Cooper Ltd Cr *75% x ($80 000 +$42 000 (BCVR – inventories))

500 000

Dr Dr Dr Dr Cr

20 000 50 000 30 000 42 000 142 000

This entry transfers the NCI share of the pre-acquisition equity in Cooper Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/16 to 30/6/21 (prior period): We identify the following changes in equity for this period:

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•

• •

Retained earnings increased by $70 000 (from $80 000 to $150 000) as reflected in the individual statement of Cooper Ltd and decreased by $28 000 ($40 000 - $12 000) as a result of depreciation adjustments posted against this account in the BCVR entries at 30 June 2019, giving a net effect of an increase of $42 000. General reserve increased by $40 000 (from $120 000 to $160 000) as reflected in the individual statement of Cooper Ltd. BCVR decreased by $42 000 as a result of the sale of inventories undervalued at acquisition date during the period.

10 500 10 000 10 500 10 000

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in this equity account is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI share of profit NCI (25% x ($66 000 – [$8 000 - $2 400]))

Dr Cr

15 100 15 100

The only change in equity for the current period is the increase generated by the current profit. The adjustment entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense posted in the BCVR entries, taking into consideration the respective tax effect.

29.113

Chapter 29: Consolidation: non-controlling interest

Consolidation worksheet for Bradley Ltd at 30 June 2022 Financial Statements Sales revenue Cost of sales Other expenses Profit before tax Tax expense Profit for the period Retained earnings (1/7/21) Retained earnings (30/6/22) Capital General reserve BCVR

Bradley Ltd 1 021 200 450 000 571 200 130 000 441 200 100 000 341 200 240 000

Cooper Ltd 160 000 70 000 90 000 14 000 76 000 10 000 66 000 150 000

Adjustments Cr

581 200

216 000

800 000 120 000

200 000 160 000

b b

150 000 90 000

94 500

a b

Group Cr

8 000

40 000 165 500

2 400

12 000

56 000 70 000

NCI Cr

1 181 200 520 000 661 200 152 000 509 200 107 600 401 600 e 196 500 c d 598 100 850 000 c 190 000 c d 31 500 c

15 100 20 000 10 500

50 000 30 000 10 000 42 000

576 000

1 669 600

Payables Deferred tax liabilities

145 800 -

24 000 -

Total liabilities

145 800

24 000

Shares in Cooper Ltd Equipment Accum. depreciation Land Current assets Goodwill Total assets

500 000 851 000 (248 000) 220 000 324 000

380 000 a (48 000) a 100 000 a 168 000

500 000

40 000 40 000 100 000

48 000

1 647 000

600 000

742 400

14 400

24 000 30 000

169 800 39 600

a a

209 400

800 000 150 000 10 500

c d e

177 600

142 000 10 000 15 100 177 600

1 501 200

386 500 166 000 552 500

Total equity: parent Total equity: NCI

Total equity

Parent Cr

-635 500 (152 000) 210 000 246 000 939 500

29.114

150 500 167 100

1 669 600

Chapter 29: Consolidation: non-controlling interest

6. Consolidated financial statements for Bradley Ltd prepared at 30 June 2022: BRADLEY LTD Consolidated statement of profit or loss and other comprehensive income for the year ended 30 June 2022 Sales revenue

$1 181 200

Cost of sales Other expenses

520 000 152 000 672 000 509 200 107 600

Profit before income tax Income tax expense Profit for the period Attributable to: Parent shareholders Non-controlling interest

401 600 386 500 15 100 $401 600

BRADLEY LTD Consolidated statement of changes in equity for the year ended 30 June 2022 Comprehensive income for the period Non-controlling interest Parent shareholders

$401 600 $15 100 $386 500 Group

Parent

Retained earnings: Balance at 1 July 2021 Profit for the period Balance at 30 June 2022

$196 500 401 600 $598 100

$166 000 386 500 $552 500

Business combination valuation reserve: Balance at 1 July 2021 Balance at 30 June 2022

$31 500 $31 500

Share capital: Balance at 1 July 2021 Balance at 30 June 2022

$850 000 $850 000

$800 000 $800 000

General reserve: Balance at 1 July 2021 Balance at 30 June 2022

$190 000 $190 000

$150 000 $150 000

29.115

Chapter 29: Consolidation: non-controlling interest

BRADLEY LTD Consolidated statement of financial position as at 30 June 2022 Assets Current assets Non-current assets: Property, plant and equipment Equipment Accumulated depreciation - equipment Land Total non-current assets Total assets

$492 000

$1 271 000 (304 000) 420 000

Equity and liabilities Equity attributable to owners of the parent: Share capital Other reserves: General reserve Retained earnings Parent interest Non-controlling interest Total equity Current liabilities Payables Non-current liabilities Tax liabilities: Deferred tax liability Total liabilities Total equity and liabilities

1 387 000 1 387 000 $1 879 000

$800 000 150 000 552 500 1 502 500 167 100 1 669 600 169 800 39 600 209 400 $1 879 000

29.116

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Exercise 29.13 Undervalued and unrecorded assets, partial and full goodwill method On 1 July 2020, Adam Ltd acquired 80% of the issued shares (cum div.) of Mosely Ltd for $202 000 when the equity of Mosely Ltd consisted of:

At this date, the carrying amounts and fair values of the assets of Mosely Ltd were as follows.

At 1 July 2020, Mosely Ltd had not recorded an internally generated trademark that Adam Ltd considered to have a fair value of $50 000. This intangible asset was considered to have an indefinite useful life. Both plant and fittings were expected to have a further 5-year useful life beyond 1 July 2020, with benefits being received evenly over those periods. The plant was sold on 1 January 2023. Any adjustment for the differences between carrying amounts and fair values is recognised in the consolidation worksheet. Adam Ltd uses the partial goodwill method. Additional information • In August 2020, the dividend payable of $5000 on hand at 1 July 2020 was paid by Mosely Ltd. • The following profits were recorded by Mosely Ltd.

• •

For the year ended 30 June 2021

$20 000

For the year ended 30 June 2022

25 000

For the year ended 30 June 2023

30 000

In June 2022, Mosely Ltd transferred $5000 to general reserve, and in June 2023, a further $6000 was transferred. Dividends declared or paid since 1 July 2020 are: - $8000 dividend declared in June 2021, paid in August 2021 - $6000 dividend declared in June 2022, paid in August 2022 - $5000 dividend paid in December 2022 - $8000 dividend declared in June 2023, expected to be paid in August 2023.

Required 1. Prepare the worksheet entries for the preparation of the consolidated financial statements of Adam Ltd and its subsidiary, Mosely Ltd, at 30 June 2023.

29.117

Chapter 29: Consolidation: non-controlling interest

Prepare the worksheet entries that would differ from those in requirement 1 if Adam Ltd uses the full goodwill method. Assume the value of the non-controlling interest at 1 July 2020 was $49 250. (LO3, LO4 and LO5) 1. Consolidation worksheet entries at 30 June 2023 (Adam Ltd uses the partial goodwill method): Acquisition analysis at 1 July 2020: Net fair value of identifiable assets and liabilities of Mosely Ltd = + + + = (a) Net consideration transferred = = (b) NCI in Mosely Ltd = = Aggregate of (a) and (b) = Goodwill acquired – parent only = = Recorded goodwill – write off = =

($100 000 + $40 000 + $50 000) (equity) ($90 000 - $70 000) (1 – 30%) (BCVR - land) ($85 000 - $80 000) (1 – 30%) (BCVR - plant) $50 000 (1 – 30%) (BCVR - trademark) $5 000 (goodwill) $237 500 $202 000 – (80% x $5 000) (dividend) $198 000 $237 500 x 20% $47 500 $245 500 $245 500 - $237 500 $8 000 $5 000 $4 000

As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Mosely Ltd at acquisition date, there won’t be any goodwill recognised for NCI. However, the previously recorded goodwill would be allocated to the parent and NCI unless eliminated – therefore, first we need to eliminate in a business combination valuation entry the goodwill previously recorded. The goodwill acquired calculated in the acquisition analysis should then be recognised in the pre-acquisition entry. (a) Business combination valuation entries: Land Deferred tax liability Business combination valuation reserve

Dr Cr Cr

20 000

Depreciation expense - plant Carrying amount of plant sold Income tax expense Retained earnings (1/7/22) Transfer from BCVR

Dr Dr Cr Dr Cr

500 2 500

Accumulated depreciation - fittings Fittings

Dr Cr

20 000

Trademark Deferred tax liability

Dr Cr

50 000

6 000 14 000

900 1 400 3 500

20 000

15 000

29.118

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Business combination valuation reserve Business combination valuation reserve Goodwill

Cr Dr Cr

35 000 5 000 5 000

As land is not depreciable and trademark is not subject to amortisation and there are no changes in those assets up to the end of the current period, the BCVR entries for those assets are the same as those posted at acquisition date. As the plant is not in the business at the end of the period (it was sold during the current period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings, while also adjusting the carrying amount of the plant sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the plant was sold on 1 January 2023 (2.5 years after the acquisition date), the carrying amount recognised by Mosely Ltd at the moment of sale is $80 000 - $80 000 / 5 x 2.5 years = $40 000, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $85 000 - $85 000 / 5 x 2.5 years = $42 500; therefore, a $2 500 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the plant was sold: i.e. ($85 000 - $85 000) / 5 years x (5 years – 2.5 years). There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/22), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/22). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. Note that even though there were no differences between the carrying amount and fair value of fittings at acquisition date, we may post a BCVR entry to write off the accumulated depreciation of fitting at acquisition date and this entry will be repeated until the fittings are sold or derecognised. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Goodwill Shares in Mosely Ltd

Dr Dr Dr Dr Dr Cr

40 000 80 000 32 000 38 000 8 000

Transfer from business combination valuation reserve Business combination valuation reserve (80% x (1 - 30%) x $5 000)

Dr Cr

2 800

198 000

2 800

Now we are after the period that included the acquisition date, but there were no pre-acquisition equity transfers recorded in prior periods. Therefore, the first pre-acquisition entry is the same as the one posted at acquisition date. However, there was a transfer from pre-acquisition BCVR

29.119

Chapter 29: Consolidation: non-controlling interest

to retained earnings during the current period due to the sale of plant undervalued at acquisition date and that is reversed for the parent share in the second pre-acquisition entry. The NCI share of this transfer will be reversed in the Step 3 NCI allocation entries below. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Cr

10 000 20 000 8 000 9 500 47 500

This entry transfers the NCI share of the pre-acquisition equity in Mosely Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/20 to 30/6/22 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $20 000 + $25 000 as a result of the profits recognised during the period, decreased by $5 000 as a result of a transfer to general reserve in June 2022, decreased by $8 000 + $6 000 due to dividends and further decreased by $1 400 as a result of depreciation adjustments posted against this account in the BCVR entries at 30 June 2023, giving a net effect of an increase of $24 600. • General reserve increased by $5 000 as a result of the transfer from post-acquisition profits during the period. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/22) Dr 4 920 NCI Cr (20% x ($20 000 + $25 000 - $5 000 - [$6 000 + $8 000] - $1 400))

4 920

General reserve NCI (20% x $5 000)

1 000

Dr Cr

1 000

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to General Reserve means that a part of the increase in this reserve is transferred to NCI. They can be combined into one single entry: Retained earnings (1/7/22) General reserve NCI

Dr Dr Cr

4 920 1 000 5 920

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(e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (20% x ($30 000 – [$500 + $2 500 - $900]))

Dr Cr

5 580 5 580

This entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and carrying amount of plant sold posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current profit, Mosely Ltd reports a transfer from retained earnings to general reserve during the current period. The effects on NCI can be recognised as: • An increase in NCI due to the increase in general reserve. • A decrease in NCI due to the decrease in retained earnings. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (retained earnings) to another (general reserve). Those effects can be recorded as: General reserve Dr 1 200 Transfer to general reserve Cr 1 200 (20% x $6 000) Also, during the current period, Mosely Ltd recognises a dividend paid of $5 000 and a dividend declared of $8 000. These dividends reduce the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends. NCI Dividend paid (20% x $5 000)

Dr Cr

1 000

NCI Dividend declared (20% x $8 000)

Dr Cr

1 600

1 000

1 600

Even though there are no other changes in the equity accounts reported in the individual statement of Mosely Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as:

29.121

Chapter 29: Consolidation: non-controlling interest

Transfer from BCVR Business combination valuation reserve (20% x (1 - 30%) x $5 000)

Dr Cr

700 700

(f) Dividend paid: As the parent share of the dividend paid by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and the subsidiary recognised dividend paid, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. Dividend revenue Dividend paid (80% x $5 000)

Dr Cr

4 000 4 000

(g) Dividend declared: As the parent share of the dividend declared by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and dividend receivable, while the subsidiary recognised dividend declared and dividend payable, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. Dividend revenue Dr 6 400 Dividend receivable Cr 6 400 (80% x $8 000) Dividend payable Dividend declared (80% x $8 000)

Dr Cr

6 400 6 400

2. Consolidation worksheet entries at 30 June 2023 (Adam Ltd uses the full goodwill method): Acquisition analysis at 1 July 2020: Net fair value of identifiable assets and liabilities of Mosely Ltd = + + + = (a) Net consideration transferred = = (b) NCI in Mosely Ltd = Aggregate of (a) and (b) = Goodwill acquired = = Recorded goodwill = Unrecorded goodwill = = Goodwill of Mosely Ltd:

($100 000 +$40 000 + $50 000) (equity) ($90 000 - $70 000) (1 – 30%) (BCVR - land) ($85 000 - $80 000) (1 – 30%) (BCVR - plant) $50 000 (1 – 30%) (BCVR - trademark) $5 000 (goodwill) $237 500 $202 000 – (80% x $5 000) (dividends) $198 000 $49 250 $247 250 $247 250 - $237 500 $9 750 $5 000 $9 750 - $5 000 $4 750

29.122

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Fair value of Mosely Ltd

= = Net fair value of identifiable assets and liabilities of Mosely Ltd = Goodwill of Mosely Ltd = = Recorded goodwill = Unrecorded goodwill = = Goodwill of Adam Ltd: Goodwill acquired Goodwill of Mosely Ltd Control premium - parent

= = = =

$49 250 / 20% $246 250 $237 500 $246 250 - $237 500 $8 750 $5 000 $8 750 - $5 000 $3 750

$9 750 $8 750 $9 750 - $8 750 $1 000

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Mosely Ltd, i.e. $1 000 + 80% x $8 700 = $6 960, out of which a part has already been recorded prior to the acquisition, i.e. 80% x $5 000 = $4 000. NCI will only be entitled to its share of the goodwill of Mosely Ltd, i.e. 20% x $8 700 = $1 740, out of which a part has already been recorded prior to the acquisition, i.e. 20% x $5 000 = $1 000. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Mosely Ltd is allocated to both the parent and NCI, the part that is not yet recognised prior to the acquisition (i.e. $8 750 - $5 000) will be recognised in the business combination valuation entries. The control premium can also be calculated as follows: Fair value of the shares in Mosely Ltd acquired by Adam Ltd = $49 250 / 20% x 80% = $197 000 Consideration transferred = $198 000 Control premium - parent = $198 000 – $197 000 = $800 Different entries (a) Business combination valuation entries: There will need to be a different BCVR entry for goodwill, together with all the other BCVR entries recorded under the partial goodwill method: Goodwill Business combination valuation reserve

Dr Cr

3 750 3 750

This entry recognises the unrecorded goodwill of Mosely Ltd that excludes the control premium. (b) Pre-acquisition entries:

29.123

Chapter 29: Consolidation: non-controlling interest

Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Goodwill Shares in Mosely Ltd

Dr Dr Dr Dr Dr Cr

40 000 80 000 32 000 45 000 1 000 198 000

Only the parent share of the pre-acquisition equity in Mosely Ltd is eliminated in the preacquisition entry that also eliminates the investment account recognised by Adam Ltd. Now we are after the period that included the acquisition date, but there were no pre-acquisition equity transfers recorded in prior periods. Therefore, the first pre-acquisition entry is the same as the one that would have been posted at acquisition date. Note that the only difference between this entry under the full goodwill method and the entry prepared under the partial goodwill method is due to the treatment of goodwill. (c) NCI Step 1: NCI share of equity at acquisition date: The NCI entries are the same as those prepared under the partial goodwill method with the only exception being again due to the way the goodwill is recognised under those 2 methods. Only the NCI Step 1 entry will be affected and it will change to: Retained earnings (1/7/22) Dr 10 000 Share capital Dr 20 000 General reserve Dr 8 000 Business combination valuation reserve Dr 11 250 NCI Cr 49 250 All the other entries prepared at 30 June 2023 under the partial goodwill method are the same as those that would be posted under the full goodwill method.

29.124

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.14 Undervalued and unrecorded assets, full goodwill method On 1 July 2019, Riley Ltd acquired 70% of the issued shares (cum div.) of Tyler Ltd for $141 950. At this date, the equity of Tyler Ltd consisted of:

Tyler Ltd’s records showed a dividend payable at 1 July 2019 of $10 000. The dividend was paid on 1 November 2019. A comparison of the carrying amounts and fair values of the assets of Tyler Ltd at 1 July 2019 revealed the following.

Both plant and vehicles were expected to have a further 5-year life beyond the acquisition date, with benefits being received evenly over those periods. The plant was sold on 30 June 2022. Tyler Ltd had not recorded an internally generated brand name for an item that was considered by Riley Ltd to have a fair value of $20 000. The brand name is regarded as having an indefinite useful life. Adjustments for the differences in carrying amounts and fair values are recognised in the consolidation worksheet. At 30 June 2020, goodwill was considered to be impaired by $1000, and a further impairment loss of $2000 was recognised by 30 June 2021. Riley Ltd uses the full goodwill method. The fair value of the NCI at 1 July 2019 was $57 000. The tax rate is 30%. Additional information • The dividends paid and declared since 1 July 2019 are: - $10 000 dividend declared in June 2020, paid in October 2020 - $5000 dividend declared in June 2021, paid in September 2021 - $8000 dividend paid in April 2022. • In June 2021, Tyler Ltd transferred an amount of $20 000 from the general reserve to retained earnings. • The Other Components of Equity account reflects movements in the fair values of financial assets. The balances of this account at 1 July 2021 were $4000 for Riley Ltd and $11 000 for Tyler Ltd. • On 30 June 2022, the financial data of both companies were as follows. Riley Ltd

Tyler Ltd

Revenues

$280 000

$190 000

Expenses

220 000

140 000

Profit before tax

60 000

50 000

29.125

Chapter 29: Consolidation: non-controlling interest

Riley Ltd

Tyler Ltd

Income tax expense

26 000

14 000

Profit for the period

34 000

36 000

Retained earnings (1/7/21)

76 000

65 000

Total available for appropriation

110 000

101 000

Dividend paid

20 000

8 000

Retained earnings (30/6/22)

90 000

93 000

Share capital

100 000

General reserve

44 000

11 000

Other components of equity

6 000

9 000

Payables

20 000

12 000

$260 000

$225 000

$ 22 050

$ 43 000

Financial assets

20 000

30 000

Vehicles

35 000

50 000

Accumulated depreciation — vehicles

(12 000)

(30 000)

Plant and equipment

80 000

120 000

Accumulated depreciation — plant and equipment

(50 000)

(75 000)

Land

30 000

—

Goodwill

—

10 000

Accumulated impairment — goodwill

—

(3 000)

Trademarks

—

80 000

134 950

—

$260 000

$225 000

Cash

Shares in Tyler Ltd

Required Prepare the consolidated financial statements of Riley Ltd as at 30 June 2022. (LO3, LO4, LO5, LO6 and LO7) Consolidated financial statements of Riley Ltd prepared at 30 June 2022: Acquisition analysis at 1 July 2019: Net fair value of identifiable assets and liabilities of Tyler Ltd

= ($100 000 + $31 000 + $25 000 + $9 000) (equity) + ($60 000 – $45 000) (1 – 30%) (BCVR - plant) + $20 000 (1 – 30%) (BCVR – brand name) - $10 000 (goodwill)

29.126

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) Net consideration transferred (b) NCI in Tyler Ltd Aggregate of (a) and (b) Goodwill acquired Recorded goodwill Unrecorded goodwill

Goodwill of Tyler Ltd: Fair value of Tyler Ltd

= = = = = = = = = =

$179 500 $141 950 – (70% x $10 000) (dividends) $134 950 $57 000 $191 950 $191 950 – $179 500 $12 450 $10 000 $12 450 – $10 000 $2 450

= $57 000 / 30% = $190 000

Fair value of identifiable assets and liabilities of Tyler Ltd = $179 500 Goodwill of Tyler Ltd = $190 000 – $179 500 = $10 500 Unrecorded goodwill = $10 500 – $10 000 = $500 Goodwill of Riley Ltd: Goodwill acquired = $12 450 Goodwill of Tyler Ltd = $10 500 Control premium - parent = $12 450 – $10 500 = $1 950 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Tyler Ltd, i.e. $1 950 + 70% x $10 500 = $9 300, out of which a part has already been recorded prior to the acquisition, i.e. 70% x $10 000 = $7 000. NCI will only be entitled to its share of the goodwill of Tyler Ltd, i.e. 30% x $10 500 = $3 150, out of which a part has already been recorded prior to the acquisition, i.e. 30% x $10 000 = $3 000. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Tyler Ltd is allocated to both the parent and NCI, the part that is not yet recognised prior to the acquisition (i.e. $10 500 - $10 000) will be recognised in the business combination valuation entries. The control premium can also be calculated as follows. Fair value of the shares in Tyler Ltd acquired by Riley Ltd = $57 000 / 30% x 70% = $133 000 Consideration transferred = $134 950 Control premium - parent = $134 950 – $133 000 = $1 950 (a) Business combination valuation entries: Depreciation expense - plant Carrying amount of plant sold Income tax expense Retained earnings (1/7/21)

Dr Dr Cr Dr

3 000 6 000 2 700 4 200

29.127

Chapter 29: Consolidation: non-controlling interest

Transfer from BCVR

10 500

Accumulated depreciation - vehicles Vehicles

Dr Cr

17 000

Brand name Deferred tax liability Business combination valuation reserve

Dr Cr Cr

20 000

Goodwill Business combination valuation reserve

Dr Cr

500

17 000

6 000 14 000

500

As the plant is not in the business at the end of the period (it was sold during the current period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expense and to transfer the BCVR to retained earnings, while also adjusting the carrying amount of the plant sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the plant was sold on 30 June 2022 (3 years after the acquisition date), the carrying amount recognised by Tyler Ltd at the moment of sale is $45 000 - $45 000 / 5 x 3 years = $18 000, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $60 000 - $60 000 / 5 x 3 years = $24 000; therefore, a $6 000 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the plant was sold: i.e. ($60 000 - $45 000) / 5 years x (5 years – 3 years). There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/21), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/21). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. Note that even though there were no differences between the carrying amount and fair value of vehicles at acquisition date, we may post a BCVR entry to write off the accumulated depreciation of vehicles at acquisition date and this entry will be repeated until the vehicles are sold or derecognised. As brand name is not subject to amortisation or impairment and there are no other changes in this asset up to the end of the current period, the BCVR entry for it is the same as that posted at acquisition date. If we assume that the goodwill impaired in the prior periods is the one recorded prior to the acquisition date, there is no additional BCVR entry to post for the goodwill other than the one posted at acquisition date. (b) Pre-acquisition entries: Retained earnings (1/7/21)* Share capital General reserve Other components of equity (1/7/21) Business combination valuation reserve** Goodwill

Dr Dr Dr Dr Dr Dr

31 500 70 000 7 700 6 300 17 500 1 950

29.128

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Shares in Tyler Ltd Cr 134 950 *70% x ($25 000 + $20 000 (general reserve)) **70% x ($10 500 [plant] + $14 000 [brand names] + $500 [goodwill]) Transfer from BCVR Business combination valuation reserve (70% x $10 500 BCVR - plant)

Dr Cr

7 350 7 350

As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from pre-acquisition general reserve to retained earnings. Therefore, the amount of retained earnings to be eliminated will be calculated as 70% (parent share) of the amount reported in Retained earnings at acquisition date ($25 000) plus the amount transferred from general reserve ($20 000), while the amount of general reserve to be eliminated will be only the NCI share of the pre-acquisition general reserve that remains after the transfer ($31 000 - $20 000). Also, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of plant undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/21) Dr 7 500 Share capital Dr 30 000 General reserve Dr 9 300 Other components of equity Dr 2 700 Business combination valuation reserve* Dr 7 500 NCI Cr 57 000 *30% x ($10 500 [BCVR - plant] + $14 000 [BCVR - brand names] + $500 [BCVR – goodwill]) This entry transfers the NCI share of the pre-acquisition equity in Tyler Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/19 to 30/6/21 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $40 000 (from $25 000 to $65 000) as reflected in the individual statement of Tyler Ltd and decreased by $4 200 ($20 000 - $6 000) as a result of depreciation adjustments posted against this account in the BCVR entries at 30 June 2022, giving a net effect of an increase of $35 800. • Other components of equity increased by $2 000 (from $9 000 to $11 000) as reflected in the additional information (c). • General reserve decreased by $20 000 due to the transfer to retained earnings as reflected in the additional information (b).

29.129

Chapter 29: Consolidation: non-controlling interest

It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Also, the effects of the dividends paid and declared during the period under consideration here are already taken out from the retained earnings; therefore, there is no need to further recognise a decrease in equity due to them. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: Retained earnings (1/7/21)* Other components of equity (1/7/21)** General reserve*** NCI *30% x ([$65 000 - $25 000] - $4 200) **30% x ($11 000 - $9 000) ***30% x ($31 000 - $11 000)

Dr Dr Cr Cr

10 740 600 6 000 5 340

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to General Reserve means that a part of the decrease in this equity account is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI share of profit Dr NCI Cr (30% x ($36 000 – [$6 000 + $3 000 - $2 700]))

8 910 8 910

The first change in equity for the current period considered is the increase generated by the current profit. The adjustment entry recognises the NCI share of the current profit. It is assumed that the profit reported is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and carrying amount of plant sold posted in the BCVR entries, taking into consideration the respective tax effect. The balance of other components of equity decreases during the current period from $11 000 to $9 000 according to the financial statements of Tyler Ltd. As such, the equity decreases by $2 000 and we need to recognise a decrease in the NCI share of the equity, essentially allocating a part of the losses on other components of equity to NCI. NCI Losses on other components of equity (30% x ($9 000 - $11 000))

Dr Cr

600 600

Also, during the current period, Tyler Ltd recognises a dividend paid of $8 000. This dividend reduces the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of this dividend.

29.130

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

NCI Dividend paid (30% x $8 000)

Dr Cr

2 400 2 400

Even though there are no other changes in the equity accounts reported in the individual statement of Tyler Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from BCVR Business combination valuation reserve (30% x $10 500)

Dr Cr

3 150 3 150

Dr Cr

5 600 5 600

29.131

Chapter 29: Consolidation: non-controlling interest Financial Statements Revenues Expenses

Riley Ltd 280 000 220 000

Tyler Ltd 190 000 140 000

Profit before tax Tax expense Profit for period Retained earnings (1/7/21)

60 000 26 000 34 000 76 000

50 000 14 000 36 000 65 000

Transfer from BCVR

-110 000 20 000 90 000 100 000 190 000 4 000

-101 000 8 000 93 000 100 000 193 000 11 000

2 000 6 000 196 000 44 000 --

(2 000) 9 000 202 000 11 000 --

Dividend paid Retained earnings (30/6/22) Share capital Other comps of equity (1/7/21) Gains/(losses) Other comps of equity (30/6/22) General reserve BCVR

f a a

Adjustments Dr 5 600 6 000 3 000

Group

4 200 31 500 7 350

10 500

5 600

95 400 37 300 58 100 105 300

70 000

6 300

3 150 166 550 22 400 144 150 130 000 274 150 8 700

7 700 17 500

0 8 700 282 850 47 300 4 350

b b

14 000 500 7 350

a a b

Total equity: parent Total equity: NCI

Total equity Deferred tax liabilities Payables Total equity & liabilities Financial assets Cash Vehicles Accum. deprec. - vehicles Plant & equipment Accum. deprec. – plant & equip Land Trademarks Brand name Shares in Tyler Ltd Goodwill Accum. impairment - goodwill

240 000 -20 000 20 000 260 000 20 000 22 050 35 000 (12 000) 80 000 (50 000) 30 000 --134 950 --

213 000 -12 000 12 000 225 000 30 000 43 000 50 000 (30 000) 120 000 (75 000) -80 000 --10 000

-260 000

(3 000) 225 000

17 000

20 000

a b

500 1 950 198 600

Parent Cr

464 400 369 000

2 700 a b b

NCI

6 000

17 000

a a

134 950

198 600

334 500 6 000 32 000 38 000 372 500 50 000 65 050 68 000 (25 000) 200 000 (125 000) 30 000 80 000 20 000 -12 450 (3 000) 372 500

29.132

e c d e

8 910 7 500 10 740 3 150

30 000

c d

2 700 600

49 190 87 060

2 400

600

c c

9 300 7 500

6 000 3 150

d e

e e

2 400 600

57 000 5 340 8 910 83 400

c d e

83 400

-136 250 20 000 116 250 100 000 216 250 5 400 600 6 000 222 250 44 000 --

266 250 68 250

334 500

Chapter 29: Consolidation: non-controlling interest

RILEY LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Revenues Expenses Profit before income tax Income tax expense Profit for the period Comprehensive income for the period Profit for the period attributable to: Parent interest Non-controlling interest

$464 400 369 000 95 400 37 300 $58 100 $ 58 100 $49 190 8 910 $58 100

Comprehensive income for the period attributable to: Parent interest Non-controlling interest

$49 790 $8 310 $58 100

RILEY LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022

Comprehensive income for the period

Group $58 100

Parent $49 790

Retained earnings: Balance at 1 July 2021 Profit for the period Transfer from BCVR Dividend paid Balance at 30 June 2022

105 300 58 100 3 150 (22 400) $144 150

87 060 49 190 -(20 000) $116 250

Business combination valuation reserve: Balance at 1 July 2021 Transfer to retained earnings Balance at 30 June 2022

7 500 (3 150) $4 350

-___-____-

General reserve: Balance at 1 July 2021 Balance at 30 June 2022

$47 300 $47 300

$44 000 $44 000

Other components of equity: Balance at 1 July 2021 Gains/(losses) Balance at 30 June 2022

$8 700 ___0 $8 700

$5 400 _600 $6 000

Share capital: Balance at 1 July 2021 Balance at 30 June 2022

$130 000 $130 000

$100 000 $100 000

29.133

Chapter 29: Consolidation: non-controlling interest

RILEY LTD Consolidated statement of financial position as at 30 June 2022 Assets Current assets Cash Financial assets Total current assets Non-current assets Property, plant and equipment: Vehicles less Accumulated depreciation Plant and equipment less Accumulated depreciation Land Intangible assets: Trademarks Brand name Goodwill less Accumulated impairment Total non-current assets Total assets

65 050 50 000 $115 050

$68 000 (25 000) 200 000 (125 000) 30 000

Equity and liabilities Equity attributable to equity holders of the parent Share capital Reserves: General reserve Other components of equity Retained earnings Parent interest Non-controlling interest Total equity Current liabilities Payables Non-current liabilities Tax liabilities: Deferred tax liability Total liabilities Total equity and liabilities

$43 000 75 000 148 000 80 000 20 000 12 450 (3 000)

100 000 9 450 257 450 $372 500

$100 000 44 000 6 000 116 250 266 250 68 250 334 500 32 000 6 000 38 000 $372 500

29.134

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.15 Undervalued assets, partial goodwill method, intragroup transactions On 1 July 2022, Isabel Ltd acquired 80% of the issued shares of Darcy Ltd for $264 800. On that date, the statement of financial position of Darcy Ltd consisted of:

Share capital

750 000

General reserve

30 000

Asset revaluation surplus

45 000

Retained earnings

30 000

Liabilities

540 000 $ 1 395 000

Cash

105 000

Inventories

210 000

Land

195 000

Plant and equipment

900 000

Accumulated depreciation — plant and equipment

(390 000)

Trademark

300 000

Goodwill

75 000 $ 1 395 000

At 1 July 2022, all identifiable assets and liabilities of Darcy Ltd were recorded at fair value except for the following. Carrying amount

Fair value

Inventories

$210 000

$240 000

Land

195 000

255 000

Plant and equipment (cost $300 000)

510 000

570 000

Trademark

300 000

330 000

During the year ended 30 June 2023, all inventories on hand at the beginning of the year were sold, and the land was sold on 28 February 2023 to Outback Ltd for $70 000. The plant and equipment had a further 5-year life beyond 1 July 2022 and was expected to be used evenly over that time. The trademark was considered to have an indefinite life. Any adjustments for differences at acquisition date between carrying amounts and fair values are made in the consolidation worksheet. Isabel Ltd uses the partial goodwill method. The tax rate is assumed to be 30%.

29.135

Chapter 29: Consolidation: non-controlling interest

Financial information for Isabel Ltd and Darcy Ltd for the year ended 30 June 2023 is shown below.

Isabel Ltd

Darcy Ltd

Sales revenue

$600 000

$ 516 000

Other income

225 000

90 000

825 000

606 000

Cost of sales

486 000

384 000

Other expenses

159 000

93 000

645 000

477 000

Profit from trading

180 000

129 000

Gains/(losses) on sale of non‐current assets

30 000

15 000

Profit before tax

210 000

144 000

Income tax expense

60 000

54 000

Profit for the period

150 000

90 000

Retained earnings (1/7/22)

90 000

30 000

—

24 000

240 000

144 000

Interim dividend paid

36 000

30 000

Final dividend declared

18 000

12 000

54 000

42 000

$186 000

$ 102 000

Transfer from general reserve

Retained earnings (30/6/23) Asset revaluation surplus (1/7/22)

15 000

Gain on revaluation of specialised plant Asset revaluation surplus (30/6/23)

45 000

60 000

The transfer from general reserve for Jeff Ltd is from pre-acquisition equity. During the year ended 30 June 2023, Darcy Ltd sold inventories to Isabel Ltd for $24 000. The original cost of these items to Darcy Ltd was $15 000. One-third of these inventories were still on hand at the end of the year. On 31 March 2023, Darcy Ltd transferred an item of plant with a carrying amount of $30 000 to Isabel Ltd for $45 000. Isabel Ltd treated this item as inventories. The item was still on hand at the end of the year. Darcy Ltd applied a 20% p.a. depreciation rate to this type of plant.

29.136

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required 1. Prepare the consolidation worksheet entries necessary for preparation of the consolidated financial statements for Darcy Ltd and its subsidiary for the year ended 30 June 2023. 2. Prepare the consolidated statement of profit or loss and other comprehensive income and statement of changes in equity for Isabel Ltd and its subsidiary at 30 June 2023. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 30 June 2023: Acquisition analysis at 1 July 2022: Net fair value of identifiable assets and liabilities of Darcy Ltd = ($750 000 + $30 000 + $30 000 + $45 000) (equity) + ($240 000 – $210 000) (1 – 30%) (BCVR – inventories) + ($255 000 – $195 000) (1 – 30%) (BCVR – land) + ($270 000 – $210 000) (1 – 30%) (BCVR – plant & equipment) + $30 000 (1 – 30%) (BCVR – trademark) – $75 000 (goodwill) = $906 000 (a) Consideration transferred = $794 400 (b) NCI in Darcy Ltd = 20% x $906 000 = $181 200 Aggregate of (a) and (b) = $975 600 Goodwill acquired = $975 600 – $906 000 = $69 600 Recorded goodwill – write off = $75 000 As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Darcy Ltd at acquisition date, there won’t be any goodwill recognised for NCI. However, the previously recorded goodwill would be allocated to the parent and NCI. The goodwill calculated in the acquisition analysis should be recognised in the pre-acquisition entry, while the previously recorded goodwill will be written-off in the business combination valuation entries. (a) Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

30 000

Carrying amount of land sold Income tax expense Transfer from BCVR

Dr Cr Cr

60 000

9 000 21 000

18 000 42 000

29.137

Chapter 29: Consolidation: non-controlling interest

Accumulated depreciation - P&E Plant and equipment Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

390 000

Depreciation expense - P&E Accumulated depreciation - P&E ($60 000 / 5)

Dr Cr

12 000

Deferred tax liability Income tax expense

Dr Cr

3 600

Trademark Deferred tax liability Business combination valuation reserve

Dr Cr Cr

30 000

Business combination valuation reserve Goodwill

Dr Cr

75 000

330 000 18 000 42 000

12 000

3 600

9 000 21 000

75 000

As inventories were sold during the current period, the BCVR entry posted now for inventories should adjust cost of sales (instead of the inventories account), recognise the current tax effect as the profit decreases due to the adjustment to cost of sales (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As land was sold during the current period, the BCVR entry posted now for land should adjust carrying amount of land sold – an expense (instead of the land account), recognise the current tax effect as the profit decreases due to the adjustment to the carrying amount of land sold (instead of a deferred tax) and recognise a transfer from business combination valuation reserve to retained earnings. As the plant and equipment are still in the business, the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant and equipment are depreciable, two other entries are posted to recognise depreciation adjustments for the current period and the related tax effect. The entry for trademark is the same as that posted on acquisition date as they are no events impacting on that trademark. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital General reserve Asset revaluation surplus Business combination valuation reserve Goodwill Shares in Darcy Ltd

Dr Dr Dr Dr Dr Dr Cr

24 000 600 000 24 000 36 000 40 800 69 600

Transfer from general reserve General reserve (80% x $24 000)

Dr Cr

19 200

Transfer from BCVR Business combination valuation reserve

Dr Cr

16 800

794 400

19 200

16 800

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(Sale of inventories: 80% x $21 000) Transfer from BCVR Business combination valuation reserve (Sale of land: 80% x $42 000)

Dr Cr

33 600 33 600

Only the parent share of the pre-acquisition equity in Darcy Ltd is eliminated in the first preacquisition entry that also eliminates the investment account recognised by Isabel Ltd. As the beginning of the current period is the acquisition date, the first pre-acquisition entry prepared now is exactly the same as the one that would have been prepared at acquisition date. However, there were some transfers during the current period from pre-acquisition equity, i.e. a transfer from general reserve recorded in the statements of Darcy Ltd and transfers from business combination valuation reserve to retained earnings due to the sale of inventories and land undervalued at acquisition date. Therefore, additional pre-acquisition entries need to be posted to reverse those transfers for the parent share. The NCI share of those transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. As the beginning of the current period is the acquisition date, the NCI needs to only be recognised in 2 steps: • NCI share of equity at acquisition date (Step 1). • NCI share of changes in equity from acquisition date to the end of the current period (i.e. the current period). (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital General reserve Asset revaluation surplus Business combination valuation reserve NCI

Dr Dr Dr Dr Dr Cr

26000 150 000 6 000 9 000 10 200 181 200

This entry transfers the NCI share of the pre-acquisition equity in Darcy Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr 3 720 NCI Cr 3 720 (20% x ($90 000 – [$30 000 - $9 000]) – [$60 000 - $18 000] – [$12 000 - $3 600])) This entry recognises the NCI share of the current after tax profit. As the business combination entries have impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to cost of sales, sale of land and depreciation expense of plant and equipment posted in the BCVR entries, taking into consideration their respective tax effects. Beside the current profit, Darcy Ltd reports a transfer from general reserve to retained earnings during the current period. The effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings.

29.139

Chapter 29: Consolidation: non-controlling interest

• A decrease in NCI due to the decrease in general reserve. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (general reserve) to another (retained earnings). Those effects can be recorded as: Transfer from general reserve General reserve (20% x $24 000)

Dr Cr

4 800 4 800

Also, during the current period, Darcy Ltd recognises a dividend paid of $30 000 and a dividend declared of $12 000. These dividends reduce the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends. NCI Interim dividend paid (20% x $30 000)

Dr Cr

6 000

NCI Final dividend declared (20% x $12 000)

Dr Cr

2 400

6 000

2 400

The last change in equity during the current period that can be observed by looking at the financial statements prepared by Darcy Ltd is the increase in asset revaluation surplus due to gain on revaluation of specialised plant ($15 000 – the amount after tax). This change increases the NCI and a part of it should be allocated to NCI. Gains/(losses): asset revaluation surplus NCI (20% x $15 000)

Dr Cr

3 000 3 000

Even though there are no other changes in the equity accounts reported in the individual statement of Darcy Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the sale of inventories and land undervalued at acquisition date which cause a transfer of BCVR to Retained earnings. As these changes increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings • A decrease in NCI due to the decrease in BCVR Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Transfer from BCVR Business combination valuation reserve (20% x ($21 000 + $42 000))

Dr Cr

12 600 12 600

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(e) Interim dividend paid: As the parent share of the dividend paid by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and the subsidiary recognised dividend paid, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. The impact on NCI of this dividend was already recognised under NCI Step 3 entries. Dividend revenue Interim dividend paid (80% x $30 000)

Dr Cr

24 000 24 000

(f) Final dividend declared: As the parent share of the dividend declared by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and dividend receivable, while the subsidiary recognised dividend declared and dividend payable, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. The impact on NCI of this dividend was already recognised under NCI Step 3 entries. Dividend revenue Dividend receivable

Dr Cr

9 600

Dividend payable Final dividend declared (80% x $12 000)

Dr Cr

9 600

(g) Unrealised profit in closing inventories: Darcy Ltd – Isabel Ltd: During the current year, there was an intragroup sale of inventories that generated $9 000 profit for Darcy Ltd ($24 000 - $15 000). As one third of these inventories are still on hand, one third of the profit is unrealised profit in ending inventories and we should eliminate it on consolidation, together with the intragroup sales revenues of $24 000. Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. That is because the cost of sales is overstated as it includes the cost of sales recorded by Darcy Ltd on the intragroup sale ($15 000) and the cost of sales recorded by Isabel Ltd on the 2 thirds of the inventories that they sold to external parties (from Isabel Ltd’s perspective, that will be equal to 2/3 x $24 000 = $16 000), while the cost of sales to the group should be reported as 2/3 x $15 000 = $10 000). Therefore, an adjustment of $21 000 to cost of sales is needed. Eliminating the sales revenue, together with the adjustment to cost of sales reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup, i.e. 1/3 x $24 000 = $8 000, while they should be reported based on the original cost to the group, i.e. 1/3 x $15 000 = $3 000. The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Darcy Ltd would have in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales Cost of sales

Dr Cr

24 000 21 000

29.141

Chapter 29: Consolidation: non-controlling interest

Inventories Deferred tax asset Income tax expense

Cr Dr Cr

3 000 900 900

(h) NCI adjustment for the unrealised profit in closing inventories: Darcy Ltd – Isabel Ltd: As the above elimination of the after tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (20% x ($3 000 - $900))

Dr Cr

420 420

(i) Unrealised profit on transfer of plant to inventories: Darcy Ltd – Isabel Ltd: During the current year, there was another intragroup transaction involving a transfer of plant to inventories that generated $15 000 profit for Darcy Ltd ($45 000 - $30 000). As the item transferred is still on hand with the group, this profit is unrealised in and we should eliminate it on consolidation. Therefore, an adjustment of $15 000 to gain on sale of plant is needed. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup, i.e. $45 000, while they should be reported based on the original amount recorded by the group prior to the intragroup transfer, i.e. $30 000. The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Darcy Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Gain on sale of plant Inventories

Dr Cr

15 000

Deferred tax asset Income tax expense

Dr Cr

4 500

15 000

4 500

(j) NCI adjustment for the unrealised profit on transfer of plant to inventories: Darcy Ltd – Isabel Ltd: As the above elimination of the after tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (20% x ($15 000 - $4 500))

Dr Cr

2 100 2 100

3. Consolidated statement of profit or loss and other comprehensive income and statement of changes in equity for Isabel Ltd at 30 June 2023:

29.142

Chapter 29: Consolidation: non-controlling interest

Consolidation worksheet for Isabel Ltd at 30 June 2023 Financial Statements Sales revenue Other income

Isabel Ltd 600 000 225 000

Darcy Ltd 516 000 90 000

Cost of sales Other expenses

825 000 486 000 159 000

606 000 384 000 93 000

645 000 180 000 30 000

477 000 129 000 15 000

210 000 60 000

144 000 54 000

Profit

150 000

90 000

Retained earnings (1/7/22) Transfer from BCVR

90 000

30 000

24 000

Transfer from general reserve

24 000

b b b

16 800 33 600 19 200

240 000 36 000 18 000 54 000 186 000

144 000 30 000 12 000 42 000 102 000

0 0

45 000 15 000

0 0

60 000 0

Profit from trading Gains/(losses) on sale of NCA Profit before tax Tax expense

Dividend paid Dividend declared Retained earnings (30/6/23) ARS (1/7/22) Gains/(losses) on revaluation ARS (30/6/23) BCVR

g e f

Adjustments Dr 24 000 24 000 9 600

a a a

30 000 60 000 12 000

Group Dr

21 000

21 000 42 000

24 000 9 600

100 800

1 373 400 879 000 324 000 1 203 000 170 400 30 000

9 000 18 000 3 600 900 4 500

36 000

Parent Cr

1 092 000 281 400

15 000

NCI

21 000 42 000 16 800 33 600

a a a g i

a a

e f

a a b b

200 400 78 000

122 400 d

3 720

96 000 c

6 000

90 000

12 600

4 800 d

4 800

235 800 42 000 20 400 62 400 173 400

6 000 2 400

9 000 c 51 000 d

9 000 3 000

24 000 12 600 c

25 200

29.143

420 2 100

h j

d d

121 200

211 200 36 000 18 000 54 000 157 200

0 12 000

12 600

12 000 0

Chapter 29: Consolidation: non-controlling interest

ISABEL LTD Consolidated statement of profit or loss and other comprehensive income for financial year ended 30 June 2023 Income: Sales revenue Other income

$1 092 000 281 400 1 373 400

Expenses: Cost of sales Other

879 000 324 000 1 203 000 170 400 30 000 200 400 78 000 $122 400

Profit from trading Gains/(losses) on sale of non-current assets Profit before income tax Income tax expense Profit for the period Other comprehensive income: Asset revaluation surplus: gains on revaluation Comprehensive income for the period

15 000 $137 400

Profit for the period attributable to: Parent interest Non-controlling interest

$121 200 1 200 $122 400

Comprehensive income for the period attributable to: Parent interest Non-controlling interest

$133 200 4 200 $137 400

ISABEL LTD Consolidated statement of changes in equity for the financial year ended 30 June 2023 Group $137 400

Parent $133 200

Retained earnings: Balance at 1 July 2022 $96 000 Profit for the period 122 400 Transfer from general reserve 4 800 Transfer from business combination valuation reserve 12 600 Dividend paid (42 000) Dividend declared (20 400) Balance at 30 June 2023 $173 400

$90 000 121 200 (36 000) (18 000) $157 200

General reserve: [Assumes no balances in parent entity’s accounts] Balance at 1 July 2022 $6 000 Transfer to retained earnings 4 800 Balance at 30 June 2023 $1 200

Comprehensive income for the period

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Business combination valuation reserve: Balance at 1 July 2022 Transfer to retained earnings Balance at 30 June 2023

$25 200 12 600 $12 600

Asset revaluation surplus: Balance at 1 July 2022 Gains/(losses) Balance at 30 June 2023

$9 000 15 000 $24 000

$0 12 000 $12 000

29.145

Chapter 29: Consolidation: non-controlling interest

Exercise 29.16 Full goodwill method, intragroup transactions On 1 July 2017, Nathan Ltd acquired 75% of the issued shares of Jones Ltd at a cost of $27 600. At this date, the equity of Jones Ltd consisted of:

At 1 July 2017, Jones Ltd had not recorded any goodwill, and all the identifiable assets and liabilities of Jones Ltd were recorded at fair value. Nathan Ltd uses the full goodwill method. The fair value of the non-controlling interest in Jones Ltd at 1 July 2017 was $9000. The trial balances of the two companies as at 30 June 2022 are as follows. Trial balances as at 30 June 2022 Nathan Ltd Dr

Jones Ltd Cr

Share capital

40 000

30 000

Retained earnings (1/7/21)

19 000

14 500

Other components of equity

—

5 000

8 500

2 900

Current tax liability Plant

30 000

Accumulated depreciation — plant

60 000

17 000

30 500

Shares in Jones Ltd

27 600

—

10% debentures in Jones Ltd

2 500

—

Inventories

12 000

15 500

Cash

14 050

500

—

11 000

2 000

5 000

Financial assets Deferred tax asset

50 000

Sales revenue

80 000

Cost of sales

34 000

58 500

Selling expenses

4 000

6 000

Other expenses

1 500

Financial expenses

1 500

2 000

Income tax expense

5 000

5 500

Interest received from debentures Dividend revenue Dividend paid

250

—

1 800

—

2 400

29.146

5 000

2 400 $ 136 550

$ 136 550

$ 167 900

Additional information (a) Intragroup sales of inventories for the year ended 30 June 2022 from Jones Ltd to Nathan Ltd: $19 000. (b) Unrealised profits on inventories held at 1 July 2021: inventories held by Nathan Ltd purchased from Jones Ltd at a profit before tax of $800. (c) Unrealised profits on inventories held at 30 June 2022: inventories held by Nathan Ltd purchased from Jones Ltd at a profit before tax of $1200. (d) The Other Components of Equity account relates to financial assets held by Jones Ltd. The balance of this account at 1 July 2021 was $4000. (e) The tax rate is 30%. Required Prepare the consolidated financial statements for Nathan Ltd the year ended 30 June 2022. (LO4 and LO6) Acquisition analysis at 1 July 2017: Net fair value of identifiable assets and liabilities of Jones Ltd (a) Consideration transferred (b) NCI in Jones Ltd Aggregate of (a) and (b) Goodwill acquired Goodwill of Jones Ltd: Fair value of Jones Ltd

= = = = = =

$30 000 + $6 000 (equity) $36 000 $27 600 $9 000 $36 600 $600

= =

$9 000 / 25% $36 000

Net fair value of identifiable assets and liabilities of Jones Ltd = Goodwill of Jones Ltd = = Goodwill of Nathan Ltd: Goodwill acquired = Goodwill of Jones Ltd = Control premium - parent = =

$36 000 $36 000 – $36 000 $0 $600 $0 $600 – $0 $600

The control premium can also be calculated as follows: Fair value of the shares in Jones Ltd acquired by Nathan Ltd Consideration transferred

= = =

$9 000 / 25% x 75% $27 000 $27 600

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Chapter 29: Consolidation: non-controlling interest

Control premium - parent

= =

$27 600 – $27 000 $600

As goodwill of Jones Ltd is $0, the goodwill to be recognised will only be the control premium that belongs to the parent. It will be recognised in the pre-acquisition entry. (a) Business combination valuation entries: No entries necessary (b) Pre-acquisition entries: Retained earnings (1/7/21) Share capital Goodwill Shares in Jones Ltd

Dr Dr Dr Cr

4 500 22 500 600 27 600

If we assume that there are no transfers from pre-acquisition equity since acquisition (there is no information about any transfers), the pre-acquisition entry is the same as the one that would have been prepared at acquisition date. Only the parent share of the pre-acquisition equity in Jones Ltd is eliminated in this pre-acquisition entry that also eliminates the investment account recognised by Nathan Ltd and recognises the control premium as part of goodwill. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/21) Share capital NCI

Dr Dr Cr

1 500 7 500 9 000

This entry transfers the NCI share of the pre-acquisition equity in Jones Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/17 to 30/6/21 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $8 500 (from $6 000 to $14 500) as a result of the profits recognised during the period. • Other components of equity increased by $4 000 (from $0 to $4 000) as reported under additional information (d) as a result of the gain on revaluation of financial assets. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. However, we do not have consolidation entries that recognise changes in equity in this exercise. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the combined entry to recognise the effect on NCI will be: Retained earnings (1/7/21)* Dr Other components of equity (1/7/21)** Dr

2 125 1 000

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NCI *25% x ($14 500 - $6 000) **25% x $4 000

3 125

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to Other Components of Equity means that a part of the increase in this account is transferred to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/21 to 30/6/22 (current period): NCI share of profit NCI (25% x $6 500)

Dr Cr

1 625 1 625

This entry recognises the NCI share of the current profit. This profit is calculated based on the information from the trial balance of Jones Ltd regarding revenues ($80 000) and expenses ($58 500 + $6 000 + $1 500 + $2 000 + $5 500). As the business combination entries have no impact on the current profit, there is no need to adjust the current profit before allocating it to NCI. Based on the information in the trial balance and additional information (d), a change in Other Components of Equity can be observed in the current period, i.e. an increase from $4 000 to $5 000. A part of this increase needs to be allocated to NCI. Gains/(losses): other components of equity NCI (25% x $1 000)

Dr Cr

250 250

Also, during the current period, Jones Ltd recognises a dividend paid of $5 000. This dividend reduces the equity and therefore reduces the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends.

NCI Dividend paid (25% x $2 400)

Dr Cr

600 600

(f) Unrealised profit in beginning inventories: Jones Ltd - Nathan Ltd: During the previous period, a series of intragroup sale of inventories took place and, at the beginning of the current period, there was an $800 unrealised profit before tax for Darcy Ltd (additional information (b)). As the assumption is that this unrealised profit will be realised during the current period, we should transfer the unrealised profit from the previous period (i.e. from Retained earnings (1/7/21)) to the current period. As retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/21) for is $800 x (1 – 30%) = $560. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales. That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $800 to cost of

29.149

Chapter 29: Consolidation: non-controlling interest

sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/21) Income tax expense Cost of sales

Dr Dr Cr

560 240 800

(g) NCI adjustment for unrealised profit in beginning inventories: Jones Ltd - Nathan Ltd: As the above transfer of the after tax unrealised profit in beginning inventories from the previous profit to the current profit decreases Retained Earnings (1/7/21) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings. • An increase in NCI due to the increase in current profit. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Retained earnings (1/7/21) (25% x $560) NCI share of profit NCI (25% x $560)

Dr Cr

140

Dr Cr

140

These entries transfer the NCI share of those changes in the retained earnings and current profit to the NCI account, i.e. the credit to Retained Earnings means that a part of the decrease in Retained Earnings is allocated to NCI, while the debit to NCI share of profit means that a part of the increase in current profit is allocated to NCI. They can be combined into one single entry: NCI share of profit Dr 140 Retained earnings (1/7/21) Cr 140 (25% x $560) Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another. (h) Unrealised profit in ending inventories: Jones Ltd - Nathan Ltd: During the current period, $19 000 worth of intragroup sales of inventories took place (additional information (a)) and, at the end of the current period, there was a $1 200 unrealised profit before tax for Darcy Ltd (additional information (c)). We should eliminate this unrealised profit on consolidation, together with the intragroup sales revenues. Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. Therefore, an adjustment of $17 800 to cost of sales is needed. The elimination of the intragroup sales revenue, together with the adjustment to cost of sales, reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup that is greater than the original cost to the group due to the unrealised profit). The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

benefit for the future for the tax that Darcy Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales

19 000

Cost of sales Inventories

Dr Cr Cr

Deferred tax asset Income tax expense

Dr Cr

360

17 800 1 200

360

(i) NCI adjustment for unrealised profit in ending inventories: Jones Ltd - Nathan Ltd: As the above elimination of the after tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (25% x $840)

Dr Cr

210 210

(j) Intragroup debentures: The trial balances of the parent and the subsidiary include the effects of an intragroup borrowing involving debentures issued by Jones Ltd. The investment account recognised in Nathan Ltd’s accounts recognises the amount of those debentures held intragroup. The effects of this intragroup borrowing need to be eliminated in full on consolidation. As this elimination does not have impact on equity, there is no NCI adjustment entry required for it. 10% Debentures 10% Debentures in Jones Ltd

Dr Cr

2 500 2 500

(k) Interest on intragroup debentures: As the debentures held intragroup offer a 10% rate of interest (equivalent to $250 per year on the debentures held by Nathan Ltd), we can assume that the interest received from debentures recognised in Nathan Ltd’s accounts is the intragroup interest and therefore it needs to be eliminated in full. As this elimination does not have impact on equity, there is no NCI adjustment entry required for it. Interest revenue Financial expenses

Dr Cr

250 250

(l) Dividend paid: As the parent share of the dividend paid by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and the subsidiary recognised dividend paid, in the

29.151

Chapter 29: Consolidation: non-controlling interest

consolidation worksheet an adjustment entry is posted to eliminate those effects. The impact on NCI of this dividend was already recognised under NCI Step 3 entries. Dividend revenue Dividend paid (75% x $2 400)

Dr Cr

1 800

29.152

Chapter 29: Consolidation: non-controlling interest

Consolidation worksheet for Nathan Ltd at 30 June 2022 Financial Statements Sales revenue Interest revenue Dividend revenue Cost of sales Financial expense Selling expense Other expense Profit before tax Tax expense Profit Retained earnings (1/7/21) Dividend paid Retained earnings (30/6/22) Share capital Other comp. of equity (1/7/21) Gains/(losses) Other comp. of equity (30/6/22) Total equity: parent Total equity: NCI

Total equity Current tax liabilities Debentures Total liabilities Total equity and liabilities

Nathan Ltd 50 000 250 1 800 52 050 34 000

Jones Ltd 80 000 --80 000 58 500

1 500 4 000 1 500 41 000 11 050 5 000 6 050

2 000 6 000 1 500 68 000 12 000 5 500 6 500

19 000

14 500

25 050 2 400 22 650 40 000 62 650 0

21 000 2 400 18 600 30 000 48 600 4 000

0 0

1 000 5 000

62 650 8 500 -8 500 71 150

53 600 2 900 5 000 7 900 61 500

h k l

b f

Adjustments Dr Cr 19 000 250 1 800

240

Group

800 17 800 250

f h k

360

4 500 560

22 500

3 250 10 000 3 000 90 150 20 850 10 380 10 470

38 910 3 000 35 910 47 500 83 410 4 000 1 000 5 000

2 500

Parent Cr

111 000 --111 000 73 900

28 440

1 800 b

NCI Dr

88 410 11 400 2 500 13 900 102 310

29.153

e g c d

1 625 140 1 500 2 125

7 500

1 000

250

e i

600 210

14 950

210

8 915

140

24 955

600

33 870 2 400 31 470 40 000 71 470 3 000 750 3 750

9 000 3 125 1 625 250 14 950

c d e e

75 220 13 190

88 410

Chapter 29: Consolidation: non-controlling interest

Financial Statements Plant Accum. depreciation Shares in Jones Ltd Debentures in Jones Ltd Inventories Cash Financial assets Deferred tax asset Goodwill Total assets

Nathan Ltd 30 000 (17 000) 27 600 2 500 12 000 14 050 0 2 000 -71 150

Jones Ltd 60 000 (30 500) 15 500 500 11 000 5 000 -61 500

Adjustments Dr Cr

27 600 2 500 1 200

h b

360 600 52 310

-52 310

Group

NCI Dr

b j h

90 000 (47 500) --26 300 14 550 11 000 7 360 600 102 310

29.154

Parent Cr

Chapter 29: Consolidation: non-controlling interest

NATHAN LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2022 Revenue Sales revenue $111 000 Expenses: Cost of sales 73 900 Financial 3 250 Selling 10 000 Other 3 000 90 150 Profit before income tax 20 850 Income tax expense 10 380 Profit for the period $10 470 Other comprehensive income: Other components of equity: gains 1 000 Comprehensive income for the period $11 470 Profit for the period attributable to: Parent interest Non-controlling interest

$8 915 1 555 $10 470

Comprehensive income for the period attributable to: Parent interest Non-controlling interest

$9 665 1 805 $11 470

NATHAN LTD Consolidated statement of changes in equity for the financial year ended 30 June 2022

Comprehensive income for the period

Group $11 470

Parent $9 665

Retained earnings: Balance at 1 July 2021 Profit for the period Dividend paid Balance at 30 June 2022

$28 440 10 470 (3 000) $35 910

$24 955 8 915 (2 400) $31 470

Other components of equity: Balance at 1 July 2021 Gains/(losses) Balance at 30 June 2022

$4 000 1 000 $5 000

$3 000 750 $3 750

Share capital: Balance at 1 July 2021 Balance at 30 June 2022

$47 500 $47 500

$40 000 $40 000

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Chapter 29: Consolidation: non-controlling interest

NATHAN LTD Consolidated statement of financial position as at 30 June 2022 Assets Current assets Inventories Cash Financial assets Total current assets Non-current assets Property, plant and equipment Plant $90 000 Accumulated depreciation (47 500) Tax assets: Deferred tax asset Intangible assets: Goodwill Total non-current assets Total assets Equity and liabilities Equity attributable to equity holders of the parent Share capital Reserves: Other components of equity Retained earnings Parent entity interest Non-controlling interest Total equity Current liabilities: Tax liabilities Non-current liabilities: Interest-bearing liabilities: Debentures Total liabilities Total liabilities and equity

$26 300 14 550 11 000 51 850

42 500 7 360 __600 50 460 $102 310

$40 000 3 750 31 470 75 220 13 190 $88 410 11 400 2 500 $13 900 $102 310

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Exercise 29.17 Undervalued assets, partial goodwill method, intragroup transactions On 1 July 2021, Matthew Ltd paid $236 400 for 75% of the issued shares of Crawley Ltd. At this date, the equity of Crawley Ltd consisted of:

A comparison of the carrying amounts and fair values of Crawley Ltd’s assets at the acquisition date showed the following.

In relation to these assets, the following information is available.  The plant had a further 5-year life but was sold on 1 January 2023.  All the inventories were sold by 30 June 2022.  All the accounts receivable were collected by 30 June 2022. Any valuation reserves arising on consolidation are transferred on realisation of the asset to retained earnings. Matthew Ltd uses the partial goodwill method. The following transactions occurred between 1 July 2021 and 30 June 2023.

Required Prepare the consolidation worksheet entries for the preparation of consolidated financial statements by Matthew Ltd at 30 June 2023. (LO4 and LO6)

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Chapter 29: Consolidation: non-controlling interest

Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Crawley Ltd = + + + = Consideration transferred = NCI in Crawley Ltd = = Aggregate of (a) and (b) = Gain on bargain purchase = = Recorded goodwill – write off =

($200 000 + $80 000 + $40 000) (equity) ($200 000 - $184 000) (1 – 30%) (BCVR - land) ($120 000 - $100 000) (1 – 30%) (BCVR - plant) ($90 000 - $65 000) (1 – 30%) (BCVR - inventories) ($40 000 - $35 000) (1 – 30%) (BCVR - accounts receivable) $4 000 (goodwill) $355 200 $236 400 25% x $355 200 $88 800 $325 200 $325 200 - $236 400 $30 000 $4 000

This method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Crawley Ltd at acquisition date. The entire gain on bargain purchase calculated here will belong to the parent and will be recognised in the pre-acquisition entry.

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(a) Business combination valuation entries: Land Deferred tax liability Business combination valuation reserve

Depreciation expense - plant Carrying amount of plant sold Retained earnings (1/7/22) Income tax expense Transfer from BCVR (Sale of plant)

Dr Cr Cr

16 000

Dr Dr Dr Cr Cr

2 000 14 000 2 800

4 800 11 200

4 800 14 000

As the land is still in the business at the end of the period and it is not depreciable, the BCVR entry for it is exactly the same as that posted at acquisition date to recognise the fair value adjustment. As the plant is not in the business at the end of the period (it was sold during the current period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings, while also adjusting the carrying amount of the plant sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the plant was sold on 1 January 2023 (1.5 years after the acquisition date), the carrying amount recognised by Crawley Ltd at the moment of sale is $100 000 - $100 000 / 5 x 1.5 years = $70 000, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $120 000 - $120 000 / 5 x 1.5 years = $84 000; therefore, a $14 000 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the plant was sold: i.e. ($120 000 $100 000) / 5 years x (5 years – 1.5 years). There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/22), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/22). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. There are no BCVR entries for inventories and accounts receivable as they were derecognised prior to the beginning of the current period. Business combination valuation reserve Goodwill

Dr Cr

4 000 4 000

The previously recorded goodwill has to be written off because in the acquisition analysis we determine that there is a gain on bargain purchase.

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Chapter 29: Consolidation: non-controlling interest

(b) Pre-acquisition entries: Retained earnings (1/7/22* Dr 25 500 Share capital Dr 150 000 General reserve** Dr 45 000 Business combination valuation reserve Dr 18 900 Shares in Crawley Ltd Cr 236 400 *75% x ($40 000 + $17 500 BCVR inventories - $3 500 BCVR accounts receivable + $20 000 general reserve) - $30 000 gain on bargain purchase **75% x ($80 000 - $20 000) As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the sale of inventories and the collection of accounts receivable existing at acquisition date and a transfer from pre-acquisition general reserve to retained earnings on 1 January 2022. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($40 000) plus the amount transferred from BCVR ($17 500 BCVR inventories - $3 500 BCVR accounts receivable) plus the amount transferred from general reserve ($20 000). However, given that the gain on bargain purchase should now be recognised as part of retained earnings, the amount of retained earnings to be eliminated will be decreased by this gain. The amount of General Reserve to the eliminated will be the parent share of $60 000 ($80 000 - $20 000 transferred), while the amount of BCVR to be eliminated will be only the NCI share of the BCVR for land and plant. There is also a current period transfer from pre-acquisition equity that will need to be reversed in the second pre-acquisition entry, but only for the parent share; the NCI share will be reversed in the NCI allocation entries. Transfer from BCVR Business combination valuation reserve (75% x $14 000 BCVR - plant)

Dr Cr

10 500 10 500

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Dr Share capital Dr Business combination valuation reserve Dr General reserve Dr NCI Cr (25% of equity of Crawley Ltd at acquisition date)

10 000 50 000 8 800 20 000 88 800

This entry transfers the NCI share of the pre-acquisition equity in Crawley Ltd at acquisition date to the NCI equity account.

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(d) NCI Step 2: NCI share of changes in equity from 1/7/21 to 30/6/22 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $20 000 as a result of the general reserve transfer and by $130 000 as a result of the profit in that period, and decreased by $8 000 + $15 000 as a result of dividends paid and declared during that period, and further decreased by $2 800 as a result of depreciation adjustments posted against this account in the BCVR entries at 30 June 2023, giving a net effect of an increase of $124 200. • General reserve decreased by $20 000 as a result of the transfer to retained earnings. • BCVR decreased by $17 500 as a result of the sale of inventories undervalued at acquisition date and increased by $3 500 as a result of the collection of accounting receivable overvalued at acquisition during the period, giving a net effect of a decrease of $14 000. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: Retained earnings (1/7/22)* Dr 31 050 General reserve** Cr 5 000 Business combination valuation reserve Cr 3 500 NCI Cr 22 550 *25% x ($20 000 general reserve - $8 000 dividends - $15 000 dividends + $130 000 profit - $2 800 depreciation adjustment after tax) **25% x $20 000 These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to General Reserve means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr NCI Cr (25% x ($150 000 – [$14 000 + $2 000 - $4 800])

34 700 34 700

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Chapter 29: Consolidation: non-controlling interest

NCI

Dr Cr

Dividend paid (25% x $16 000)

4 000 4 000

Even though there are no other changes in the equity accounts reported in the individual statement of Crawley Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings • A decrease in NCI due to the decrease in BCVR Note that there is no overall net impact on NCI as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from business combination valuation reserve Business combination valuation reserve (25% x $14 000 BCVR plant)

Dr Cr

3 500 3 500

Dr Cr

12 000 12 000

(g) Unrealised profit in beginning inventories: Crawley Ltd – Matthew Ltd: During the previous period, a series of intragroup sale of inventories took place and, at the beginning of the current period, there was a 1/4 x $10 000 = $2 500 unrealised profit before tax for Crawley Ltd. As the assumption is that this unrealised profit will be realised during the current period, we should transfer the unrealised profit from the previous period (i.e. from Retained earnings (1/7/22)) to the current period. As retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/22) for is $2 500 x (1 – 30%) = $1 750. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales. That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $2 500 to cost of sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

1 750 750 2 500

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(h) NCI adjustment for the unrealised profit in beginning inventories: Crawley Ltd – Matthew Ltd: As the above transfer of the after tax unrealised profit in beginning inventories from the previous profit to the current profit decreases Retained Earnings (1/7/22) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings • An increase in NCI due to the increase in current profit Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Retained earnings (1/7/22) (25% x $1 750) NCI share of profit NCI (25% x $1 750)

Dr Cr

438

Dr Cr

438

Dr Cr

438 438

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another.

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Chapter 29: Consolidation: non-controlling interest

Exercise 29.18 Undervalued assets, full and partial goodwill method, intragroup transactions On 1 July 2018, Robert Ltd acquired 75% of the issued shares of Grantham Ltd for $160 000. The following balances appeared in the records of Grantham Ltd at this date. Share capital

$80 000

General reserve

8 000

Retained earnings

40 000

At 1 July 2018, all the identifiable assets and liabilities of Grantham Ltd were recorded at fair value except for the following.

Carrying amount Machinery (cost $144 000)

Fair value

$120 000

160 000

Inventories

64 000

80 000

Receivables

80 000

72 000

The machinery had a remaining useful life of 5 years beyond 1 July 2018, with benefits to be received on a straight-line basis over the period. The machinery was sold by Grantham Ltd on 1 January 2023 for $16 000. By 30 June 2019, receivables had all been collected and inventories sold. Any adjustments for differences at acquisition date between carrying amounts and fair values are made in the consolidation worksheet. For the year ended 30 June 2023, the following information is available. • Intragroup sales were: Grantham Ltd to Robert Ltd — $80 000. The mark-up on cost of all sales was 25%. • At 30 June 2023, inventories of Robert Ltd included $8000 of items acquired from Grantham Ltd. • At 1 July 2022, inventories of Robert Ltd included goods of $4000 resulting from a sale on 1 March 2022 of non-current assets by Grantham Ltd at a before-tax profit of $800. These items were on-sold to external entities by Robert Ltd on 1 September 2022. This class of non-current assets is depreciated using a 10% p.a. depreciation22e on a straight-line basis. • On 1 January 2023, Grantham Ltd sold an item of plant to Robert Ltd for $8000 at a before-tax profit of $2400. For plant assets, Grantham Ltd applies a 10% p.a. straightline depreciation rate, while Robert Ltd uses a 2.5% p.a. straight-line rate. • The tax rate is 30%. • Financial information for the year ended 30 June 2023 includes the following. Robert Ltd Sales revenue

336 000 12 000

Dividend revenue

Grantham Ltd $

204 000 —

29.164

Grantham Ltd

Other revenue

48 000

32 000

Total revenue

396 000

236 000

Cost of sales

232 000

104 000

Other expenses:

16 000

8 000

32 000

24 000

Total expenses

280 000

136 000

Profit from trading

116 000

100 000

Gains/(losses) on sale of non‐current assets

16 000

4 000

Profit before tax

132 000

104 000

Income tax expense

52 800

41 600

Profit for the period

79 200

62 400

Retained earnings (1/7/22)

160 000

80 000

239 200

142 400

Transfer to general reserve

15 200

4 000

Interim dividend paid

16 000

32 000

Final dividend declared

16 000

47 200

52 000

Selling and administrative (including depreciation) Financial

Retained earnings (30/6/23)

192 000

90 400

Asset revaluation surplus (1/7/22)

12 000

8 000

4 000

Gains on property revaluation Asset revaluation surplus (30/6/23)

16 000

2 000 $

10 000

Required 1. Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Robert Ltd at 30 June 2023 using the partial goodwill method. 2. Prepare the entries that would change in requirement 1 above if the full goodwill method were used. The fair value of the NCI at 1 July 2018 was $51 600. (LO3, LO4 and LO6) 1. Consolidation worksheet entries at 30 June 2023 (Robert Ltd uses the partial goodwill method): Acquisition analysis at 1 July 2018:

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Chapter 29: Consolidation: non-controlling interest

Net fair value of identifiable assets and liabilities of Grantham Ltd = ($80 000 + $8 000 + $40 000) (equity) + ($160 000 - $120 000) (1 – 30%) (BCVR – machinery) + ($80 000 - $64 000) (1 – 30%) (BCVR – inventories) - ($80 000 - $72 000) (1 – 30%) (BCVR – receivables) = $161 600 (a) Consideration transferred (b) NCI in Grantham Ltd Aggregate of (a) and (b) Goodwill acquired – parent only

= = = =

$160 000 25% x $161 600 $40 400 $200 400

= =

$200 400 - $161 600 $38 800

As the partial method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Grantham Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the pre-acquisition entry. (a) Business combination valuation entries: Carrying amount of machinery sold Depreciation expense - machinery Retained earnings (1/7/22) Income tax expense Transfer from BCVR (Depreciation is 20% x $40 000 p.a.)

Dr Dr Dr Cr Cr

4 000 4 000 22 400 2 400 28 000

As the machinery is not in the business at the end of the period (it was sold during the current period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings, while also adjusting the carrying amount of the machinery sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the machinery was sold on 1 January 2023 (4.5 years after the acquisition date), the carrying amount recognised by Grantham Ltd at the moment of sale is $120 000 - $120 000 / 5 x 4.5 years = $12 000, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $160 000 - $160 000 / 5 x 4.5 years. = $16 000; therefore, a $4 000 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the plant was sold: i.e. ($160 000 - $120 000) / 5 years x (5 years – 4.5 years). There are no adjustments needed for the machinery account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/22), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the

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previous period’s expenses are now in the Retained earnings (1/7/22). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. (b) Pre-acquisition entries: Retained earnings (1/7/22)* Dr 34 200 Share capital Dr 60 000 Business combination valuation reserve Dr 21 000 General reserve Dr 6 000 Goodwill Dr 38 800 Shares in Grantham Ltd Cr 160 000 *75% x ($40 000 + $11 200 (BCVR - inventories) – $5 600 (BCVR - receivables)) As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior periods pre-acquisition equity transfers. Those transfers in the prior periods are the transfers from BCVR to retained earnings caused by the sale of inventories and the collection of accounts receivable existing at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($10 000) plus the amount transferred from BCVR ($11 200 BCVR inventories - $5 600 BCVR accounts receivable), while the amount of BCVR to be eliminated will be only the NCI share of the BCVR for machinery. There is also a current period transfer from pre-acquisition equity due to the sale of machinery that will need to be reversed in the second pre-acquisition entry, but only for the parent share; the NCI share will be reversed in the NCI allocation entries. Transfer from BCVR Business combination valuation reserve (75% x $28 000 (BCVR – machinery))

Dr Cr

21 000

Dr Dr Dr Dr Cr

10 000 20 000 8 400 2 000

21 000

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital Business combination valuation reserve General reserve NCI

40 400

This entry transfers the NCI share of the pre-acquisition equity in Grantham Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/18 to 30/6/22 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $40 000 (from $40 000 to $80 000) as reflected in the individual statement of Grantham Ltd and decreased by $22 400 as a result of depreciation

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• •

adjustments posted against this account in the BCVR entries at 30 June 2023, giving a net effect of an increase of $17 600. Asset revaluation surplus increased by $8 000 (from $0 to $8 000) as reflected in the individual statement of Grantham Ltd. BCVR decreased by $11 200 as a result of the sale of inventories undervalued at acquisition date and increased by $5 600 as a result of the collection of accounts receivable overvalued at acquisition date.

4 400 2 000 1 400 5 000

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (25% x ($46 800 – [$4 000 + $4 000 - $2 400]))

Dr Cr

10 650 10 650

This entry recognises the NCI share of the current profit after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and carrying amount of machinery sold posted in the BCVR entries, taking into consideration the respective tax effect. Beside the current profit, Grantham Ltd reports a transfer from retained earnings to general reserve during the current period. The effects on NCI can be recognised as: • An increase in NCI due to the increase in general reserve. • A decrease in NCI due to the decrease in retained earnings. Note that there is no overall net impact on NCI as a result of this transfer from one equity account (retained earnings) to another (general reserve). Those effects can be recorded as: General reserve Transfer to general reserve

Dr Cr

1 000

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(25% x $4 000) Also, during the current period, Grantham Ltd recognises a dividend paid of $32 000 and a dividend declared of $16 000. These dividends reduce the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends. NCI Interim dividend paid (25% x $32 000)

NCI Final dividend declared (25% x $16 000)

Dr Cr

8 000

Dr Cr

4 000

8 000

4 000

The last change in equity during the current period that can be observed by looking at the financial statements prepared by Grantham Ltd is the increase in asset revaluation surplus due to gain on revaluation of property ($2 000 – the amount after tax). This change increases the NCI and a part of it should be allocated to NCI. Gains/(losses): asset revaluation surplus NCI (25% x $2 000)

Dr Cr

500 500

Even though there are no other changes in the equity accounts reported in the individual statement of Grantham Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of machinery which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on NCI as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from BCVR Business combination valuation reserve (Sale of machinery: 25% x $28 000)

Dr Cr

7 000 7 000

(f) Interim dividend paid: As the parent share of the dividend paid by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and the subsidiary recognised dividend paid, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. The impact on NCI of this dividend was already recognised under NCI Step 3 entries. Dividend revenue Interim dividend paid

Dr Cr

24 000

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(75% x $32 000) (g) Final dividend declared: As the parent share of the dividend declared by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and dividend receivable, while the subsidiary recognised dividend declared and dividend payable, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. Dividend revenue Dividend receivable (75% x $16 000) Dividend payable Final dividend declared (75% x $16 000)

Dr Cr

12 000

Dr Cr

12 000

(h) Unrealised profit in ending inventories: Grantham Ltd – Robert Ltd: During the current period, $160 000 worth of intragroup sales of inventories took place (additional information (a)) and, at the end of the current period, there was a $8 000 x 25% / (1 + 25%) = $1 600 unrealised profit before tax for Grantham Ltd (additional information (b), considering the mark-up of 25% of cost). We should eliminate this unrealised profit on consolidation, together with the intragroup sales revenues. Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. Therefore, an adjustment of $158 400 to cost of sales is needed. The elimination of the intragroup sales revenue, together with the adjustment to cost of sales, reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup that is greater than the original cost to the group due to the unrealised profit). The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Darcy Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales

Dr 160 000 Cr Cr

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

158 400 1 600

480 480

(i) NCI adjustment for unrealised profit in ending inventories: Grantham Ltd – Robert Ltd: As the above elimination of the unrealised after-tax profit by the subsidiary, Grantham Ltd, on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for the unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised after-tax profit. NCI

280

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NCI share of profit (25% x $1 120)

280

(j) Unrealised profit on intragroup transfer of non-current assets to inventories in prior period: Grantham Ltd – Robert Ltd: During the previous period, a series of intragroup sales of non-current assets took place and, at the beginning of the current period, there was a $800 unrealised profit before tax for Grantham Ltd (additional information (c)). As this unrealised profit will be realised during the current period, we should transfer the unrealised profit from the previous period (i.e. from Retained Earnings (1/7/22)) to the current period. As retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/22) for is $800 x (1 – 30%) = $560. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales (as the items are treated as inventories now). That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $800 to cost of sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

560 240 800

(k) NCI adjustment for unrealised profit on intragroup transfer of non-current asset to inventories in prior period: Grantham Ltd – Robert Ltd: As the above transfer of the after-tax unrealised profit from the previous profit to the current profit decreases Retained Earnings (1/7/22) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings • An increase in NCI due to the increase in current profit Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Retained earnings (1/7/22) (25% x $560) NCI share of profit NCI (25% x $560)

Dr Cr

140

Dr Cr

140

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Retained earnings (1/7/22) (25% x $560)

140

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another. (l) Unrealised profit on intragroup sale plant: Grantham Ltd – Robert Ltd: During the current year, there was another intragroup transaction involving a plant that generated $3 200 profit for Grantham Ltd. As the item transferred is still on hand with the group, this profit is unrealised and we should eliminate it on consolidation. Therefore, an adjustment of $3 200 to gain on sale of plant is needed. The plant still on hand is also adjusted due to overstatement (it is recorded based on the price paid intragroup, i.e. $8 000, while they should be reported based on the original amount recorded by the group prior to the intragroup transfer, i.e. $4 800. The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Grantham Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Gains/(losses) on sale of plant Plant

Dr Cr

3 200

Deferred tax asset Income tax expense

Dr Cr

960

3 200

960

(m) NCI adjustment for unrealised profit on intragroup sale of plant: Grantham Ltd – Robert Ltd: As the above elimination of the after-tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (25% x $2 240)

Dr Cr

560 560

(n) Depreciation on plant sold intragroup: Grantham Ltd – Robert Ltd: As the plant was sold intragroup on 1 January 2023, at 30 June 2023 we need to recognise depreciation adjustments for half a year. That is because the depreciation expense for this period is overstated, being based on the price paid intragroup rather than the carrying amount at the moment of the intragroup sale. The depreciation adjustment, being ½ x $3 200 x 2.5% (we use Jack Ltd’s depreciation rate as Robert Ltd uses the asset now – from the group’s perspective, this method describes how the asset is used now), is recognising that a part of the unrealised profit at the moment of the intragroup sale is realised as the plant is used in the business. As such, the tax effect on the unrealised profit is reversed for the part of the profit that is realised through the depreciation adjustments.

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Accumulated depreciation - plant Depreciation expense - plant (1/2 x 2.5% x $3 200)

Dr Cr

Income tax expense Deferred tax asset

Dr Cr

(o) NCI adjustment for depreciation on plant sold intragroup: Grantham Ltd – Robert Ltd: As the above recognition of the after-tax realised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we eliminated above the NCI share of the entire profit on the intragroup sale, before we adjusted this profit for this realised part. Therefore, we need to reverse the NCI entry that eliminated the profit on the intragroup sale of plant for the realised part of the profit. NCI share of profit NCI (25% x $28)

Dr Cr

8 8

2. Consolidation worksheet entries at 30 June 2023 (Robert Ltd uses the full goodwill method): Acquisition analysis at 1 July 2018: Net fair value of identifiable assets and liabilities of Grantham Ltd = ($80 000 + $8 000 + $40 000) (equity) + ($160 000 - $1120 000) (1 – 30%) (BCVR machinery) + ($80 000 - $64 000) (1 – 30%) (BCVR – inventories) - ($80 000 - $72 000) (1 – 30%) (BCVR – receivables) = $161 600 (a) Consideration transferred = $160 000 (b) NCI in Grantham Ltd = $51 600 Aggregate of (a) and (b) = $211 600 Goodwill acquired = $50 000 Goodwill of Grantham Ltd: Fair value of Grantham Ltd

= = Net fair value of identifiable assets and liabilities of Grantham Ltd = Goodwill of Grantham Ltd = = Goodwill of Robert Ltd: Goodwill acquired = Goodwill of Grantham Ltd = Control premium - parent = =

$51 600 / 25% $206 400 $161 600 $206 400 - $161 600 $44 800 $50 000 $44 800 $50 000 - $44 800 $5 200

29.173

Chapter 29: Consolidation: non-controlling interest

The control premium can also be calculated as follows: Fair value of the shares in Grantham Ltd acquired by Robert Ltd = $51 600 / 25% x 75% = $154 800 Consideration transferred = $160 000 Control premium - parent = $160 000 – $154 800 = $5 200 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Grantham Ltd, i.e. $5 200 + 75% x $44 800 = $38 800. NCI will only be entitled to its share of the goodwill of Spider Ltd, i.e. 25% x $44 800 = $11 200. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Grantham Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. Different entries (a) Business combination valuation entries: There will need to be an additional BCVR entry, together with the BCVR entries recorded under the partial goodwill method: Goodwill Business combination valuation reserve

Dr Cr

44 800 44 800

This entry recognises the unrecorded goodwill of Grantham Ltd that excludes the control premium. (b) Pre-acquisition entries: Retained earnings (1/7/22)* Dr 34 200 Share capital Dr 60 000 Business combination valuation reserve** Dr 54 600 General reserve Dr 6 000 Goodwill Dr 5 200 Shares in Grantham Ltd Cr 160 000 *75% x ($40 000 + $11 200 (BCVR - inventories) – $5 600 (BCVR - receivables)) **75% x ($28 000 + $44 800) Note that the only difference between this entry under the full goodwill method and the entry prepared under the partial goodwill method is due to the treatment of goodwill. The second entry to reverse the current period transfer from pre-acquisition entry is the same as under the partial goodwill method. (c) NCI Step 1: NCI share of equity at acquisition date:

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The NCI entries are the same as those prepared under the partial goodwill method with the only exception being again due to the way the goodwill is recognised under those 2 methods. Only the NCI Step 1 entry will be affected and it will change to: Retained earnings (1/7/22) Share capital Business combination valuation reserve* General reserve NCI * 25% x ($33 600 + $44 800)

Dr 10 0100 Dr 20 000 Dr 19 600 Dr 2 000 Cr

51 600

All the other entries prepared at 30 June 2023 under the partial goodwill method are the same as those that would be posted under the full goodwill method.

29.175

Chapter 29: Consolidation: non-controlling interest

Exercise 29.19 Undervalued assets, partial goodwill method, intragroup transactions On 1 July 2021, Richard Ltd acquired 80% of the issued shares (cum div.) of Carson Ltd for $166 400. At this date, the equity of Carson Ltd consisted of:

At 1 July 2021, one of the liabilities of Carson Ltd was a dividend payable of $10 000. This was paid on 1 September 2021. One of the assets recorded by Carson Ltd was goodwill of $5000. Richard Ltd uses the partial goodwill method. At 1 July 2021, all the identifiable assets and liabilities of Carson Ltd were recorded at amounts equal to their fair values except for the following.

In relation to these assets, the following information is available.  The plant had an expected useful life of 4 years.  Land is revalued in the records of Carson Ltd at acquisition date. The land on hand at 1 July 2021 was sold by Carson Ltd on 8 February 2023. On sale any related asset revaluation surplus is transferred to retained earnings.  The inventory was all sold by 30 June 2022. Additional information • During the period ended 30 June 2022, Carson Ltd transferred $8000 from the general reserve existing at 1 July 2021 to retained earnings. • At 30 June 2022, Carson Ltd recognised gains on revaluation of land of $6000 in other comprehensive income for the period. • In June 2022, Carson Ltd sold inventories to Richard Ltd for $7000. The inventories had originally cost Carson Ltd $5000. 20% of these inventories remained unsold by Richard Ltd at 30 June 2022. • During the period ended 30 June 2023, Carson Ltd sold inventories to Richard Ltd for $120 000. At 30 June 2023, Richard Ltd holds inventories sold to it by Carson Ltd for $20 000 which had cost Carson Ltd $15 000. • On 1 January 2023, Carson Ltd sold an inventories item to Richard Ltd at a beforetax profit of $5000. The original cost of this item to Carson Ltd is $10 000. This asset was classified as plant by Richard Ltd and depreciated over a 5-year period. • The tax rate is 30%. • Financial information provided by the companies at 30 June 2023 was as follows.

29.176

Carson Ltd

Sales revenue

$ 910 000

$ 624 000

Other revenue

60 000

65 600

Total revenue

970 000

689 600

Cost of sales

(625 000)

(464 000)

Other expenses

(225 000)

(129 600)

Total expenses

850 000

593 600

Profit before tax

120 000

96 000

Tax expense

(30 000)

(32 000)

Profit for the period

90 000

64 000

Retained earnings at 1 July 2022

100 000

48 000

Transfer from asset revaluation surplus

—

14 000

Transfer to general reserve

—

(12 000)

Dividend paid

(20 000)

(12 000)

Dividend declared

(30 000)

(6 000)

Retained earnings at 30 June 2023

140 000

96 000

Share capital

400 000

120 000

General reserve

—

28 000

Asset revaluation surplus

—

10 000

540 000

254 000

Total equity Provisions

40 000

30 000

Payables

30 000

40 000

Deferred tax liabilities

12 000

15 000

Non‐current liabilities

83 000

65 000

Total liabilities Total equity and liabilities

165 000

150 000

$ 705 000

$ 404 000

$ 158 400

—

Plant

800 000

$ 320 000

Accumulated depreciation — plant

(544 000)

(120 000)

Land

60 000

90 000

Intangible assets

75 000

60 000

Deferred tax assets

15 000

8 000

Cash

20 000

5 000

Receivables

40 600

6 000

Inventories

80 000

30 000

Shares in Carson Ltd

29.177

Chapter 29: Consolidation: non-controlling interest

Goodwill Total assets

Richard Ltd

Carson Ltd

—

5 000

$ 705 000

$ 404 000

Required Prepare the consolidation worksheet for the preparation of consolidated financial statements by Richard Ltd at 30 June 2023. (LO3, LO4, LO5 and LO6) Acquisition analysis at 1 July 2021: Net fair value of identifiable assets and liabilities of Carson Ltd = ($120 000 + $24 000 + $16 000) (equity) + ($88 000 – $80 000) (1 – 30%) (BCVR – plant) + ($80 000 – $60 000) (1 – 30%) (ARS – land) + ($52 000 – $40 000) (1 – 30%) (BCVR – inventories) – $5 000 (goodwill) = $183 000 (a) Net consideration transferred = $166 400 – (80% x $10 000) (dividends) = $158 400 (b) NCI in Carson Ltd = 20% x $183 000 = $36 600 Aggregate of (a) and (b) = $195 000 Goodwill acquired - parent only = $12 000 Recorded goodwill – write off = $5 000 As the partial goodwill method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Carson Ltd at acquisition date, there won’t be any goodwill recognised for NCI. However, the previously recorded goodwill would be allocated to the parent and NCI unless eliminated. The goodwill calculated in the acquisition analysis should be recognised in the pre-acquisition entry, while the previously recorded goodwill has to be eliminated. (a) Business combination valuation entries: Accumulated depreciation - plant Dr Plant Cr Deferred tax liability Cr Business combination valuation reserve Cr

20 000

Depreciation expense - plant Retained earnings (1/7/22) Accumulated depreciation - plant (1/4 x $8 000 p.a. for 2 years)

Dr Dr Cr

2 000 2 000

Deferred tax liability Income tax expense

Dr Cr

1 200

12 000 2 400 5 600

4 000

600

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Retained earnings (1/7/22)

600

As the plant is still in the business (it has two more years of useful life), the first BCVR entry for it is the same as that prepared at acquisition date; however, as the plant is depreciable, two other entries are posted to recognise depreciation adjustments for the previous and current period and the related tax effect. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/22), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/22). As land is revalued in Carson Ltd’s account at acquisition, no BCVR entry needs to be posted for land. As inventories are sold during the previous period, no BCVR entry needs to be posted now for inventories. Business combination valuation reserve Goodwill

Dr Cr

5 000 5 000

(b) Pre-acquisition entries: Retained earnings (1/7/22)* Dr 25 920 Share capital Dr 96 000 Asset revaluation surplus Dr 11 200 General reserve Dr 12 800 Business combination valuation reserve Dr 480 Goodwill Dr 12 000 Shares in Carson Ltd Cr 158 400 *80% x ($16 000 + $8 000 (transfer from general reserve) + $8 400 (transfer from BCVR - inventories)) As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior period pre-acquisition equity transfers. The transfers in the prior period are the transfers from BCVR to retained earnings caused by the sale of inventories undervalued at acquisition date and the transfer from pre-acquisition general reserve to retained earnings (additional information (a)). Therefore, the amount of retained earnings to be eliminated will be calculated as 80% (parent share) of the amount reported in Retained earnings at acquisition date ($16 000) plus the amount transferred from BCVR ($12 000 x (1 – 30%) = $8 400) and that transferred from general reserve ($8 000). The other amounts to eliminate are also calculated based on those transfers. There is also a transfer during the current period from pre-acquisition equity, i.e. a transfer from asset revaluation surplus to retained earnings due to the sale of land undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. Transfer from asset revaluation surplus Dr 11 200 Asset revaluation surplus Cr (80% of the transfer on sale of land in current period)

11 200

29.179

Chapter 29: Consolidation: non-controlling interest

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital Asset revaluation surplus General reserve Business combination valuation reserve NCI

Dr Dr Dr Dr Dr Cr

3 200 24 000 2 800 4 800 1 800 36 600

This entry transfers the NCI share of the pre-acquisition equity in Carson Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/21 to 30/6/22 (prior period): We identify the following changes in equity for this period from the individual statement of Carson Ltd and the consolidation entries: • Retained earnings increased from $16 000 to $48 000 (1/7/22) as a result of the profits recognised during the period and decreased by $1 400 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2023, giving a net effect of an increase of $30 600 • Asset revaluation surplus increased from $14 000 to $20 000 as a result of the gain on revaluation of land during the period • General Reserve decreased by $8 000 as a result of the transfer to retained earnings. • BCVR decreased by $8 400 as a result of the sale of inventories undervalued at acquisition date during the period. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/22)* Dr 6 120 Asset revaluation surplus** Dr 1 200 General reserve*** Cr 1 600 Business combination valuation reserve Cr 1 680 NCI Cr 4 040 *20% x ($48 000 - $16 000 – ($2 000 - $600) (depreciation adjustment for plant after tax for prior period)) **20% x ($20 000 - $14 000) ***20% x $8 000 These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to General Reserve means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI

Dr Cr

12 520

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(20% x ($64 000 – [$2 000 - $600] (depreciation adjustment for plant after tax for current period)) This entry recognises the NCI share of the current profit. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustments posted in the BCVR entries to depreciation expense, taking into consideration the respective tax effect. A change in asset revaluation surplus during the current period is reported in the individual statement of Carson Ltd. This change is a transfer from ARS to Retained earnings due to the sale of land revalued at acquisition date in Carson Ltd’s accounts. As this change increases the retained earnings, while decreasing the ARS (the former being recognised as a credit to the Transfer from asset revaluation surplus account at the moment of transfer), the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings • A decrease in NCI due to the decrease in asset revaluation surplus. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (ARS) to another (retained earnings). The combined effects can be recorded as: Transfer from asset revaluation surplus Asset revaluation surplus (20% x $14 000)

Dr Cr

2 800 2 800

Another change in equity during the current period that can be observed by looking at the financial statements prepared by Carson Ltd is the transfer to general reserve of $12 000. As this change increases the general reserve, while decreasing the retained earnings (the latter being recognised as a debit to the Transfer to general reserve account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in general reserve • A decrease in NCI due to the decrease in retained earnings Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (retained earnings) to another (general reserve). The combined effects can be recorded as: General reserve Dr 2 400 Transfer to general reserve Cr 2 400 (20% x $12 000) Also, during the current period, Carson Ltd recognises a dividend paid of $12 000 and a dividend declared of $6 000. These dividends reduce the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends. NCI Dividend paid

Dr Cr

2 400

29.181

Chapter 29: Consolidation: non-controlling interest

(20% x $12 000) NCI Dividend declared (20% x $6 000)

Dr Cr

1 200 1 200

The last change in equity during the current period that can be observed by looking at the financial statements prepared by Carson Ltd is the increase in asset revaluation surplus due to gain on revaluation of land. The asset revaluation surplus was $14 000 (recognising the increase in value of land undervalued) at acquisition date and then it increases by $6 000 (additional information (b)) during the prior period. However, during the current period, $14 000 is transferred out from this account, but the balance at the end of the period is $10 000, meaning that during the current period an increase of $4 000 is recognised (i.e. $10 000 – ($14 000 + $6 000) - $14 000). This change increases the NCI and a part of it should be allocated to NCI. Gains/(losses): asset revaluation surplus NCI (20% x $4 000)

Dr Cr

800 800

Dr Cr

9 600 9 600

Dr Cr

4 800

Dividend payable Dr 4 800 Dividend declared Cr (80% x $6 000) (h) Unrealised profit in beginning inventories: Carson Ltd – Richard Ltd:

4 800

During the previous period, a series of intragroup sale of inventories took place and, at the beginning of the current period, there was an unrealised profit before tax for Carson Ltd (additional information (c)), i.e. 20% x ($7 000 - $5 000) = $400. As the assumption is that this unrealised profit will be realised during the current period, we should transfer the unrealised profit from the previous period (i.e. from Retained earnings (1/7/22)) to the current period. As

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retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/22) for is $400 x (1 – 30%) = $280. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales. That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $400 to cost of sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/22) Income tax expense Cost of sales (Unrealised profit is 20% x $2 000)

Dr Dr Cr

280 120 400

(i) NCI adjustment for unrealised profit in beginning inventories: Carson Ltd – Richard Ltd: As the above transfer of the after-tax unrealised profit in beginning inventories from the previous profit to the current profit decreases Retained Earnings (1/7/22) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings • An increase in NCI due to the increase in current profit Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Retained earnings (1/7/22) (20% x $280) NCI share of profit NCI (20% x $280)

Dr Cr

56 56

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another. (j) Unrealised profit in ending inventories: Carson Ltd – Richard Ltd: During the current period, $120 000 worth of intragroup sales of inventories took place (additional information (d)) and, at the end of the current period, there was a $20 000 - $15 000 = $5 000 unrealised profit before tax for Carson Ltd (additional information (d)). We should eliminate this unrealised profit on consolidation, together with the intragroup sales revenues.

29.183

Chapter 29: Consolidation: non-controlling interest

Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. Therefore, an adjustment of $115 000 to cost of sales is needed. The elimination of the intragroup sales revenue, together with the adjustment to cost of sales, reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup that is greater than the original cost to the group due to the unrealised profit). The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Carson Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales revenue Cost of sales Inventories

Dr Cr Cr

120 000

Deferred tax asset Income tax expense

Dr Cr

1 500

115 000 5 000

1 500

(k) NCI adjustment for unrealised profit in ending inventories: Carson Ltd – Richard Ltd: As the above elimination of the after-tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (20% x $3 500)

Dr Cr

700 700

(l) Unrealised profit on intragroup transfer of inventories to non-current asset in prior period: Carson Ltd – Richard Ltd: During the current period, Carson Ltd sold a plant to Richard Ltd (additional information (e)). As the plant is still with Richard Ltd at the end of the period, the intragroup profit of $5 000 is unrealised and should be eliminated in full. As Carson Ltd recognised this transfer as a sale of inventories, to eliminate the unrealised profit we will need to eliminate the sales revenues (based on the price paid intragroup) and cost of sales (based on the original cost to the group). Also, the plant is overstated as it is recorded based on the price paid intragroup, not based on the original carrying amount at the moment of the intragroup sale, so the plant account also needs to be adjusted. The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Carson Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales revenue Dr 15 000 Cost of sales Cr 10 000 Plant Cr 5 000 Deferred tax asset Income tax expense

Dr Cr

1 500

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(m) NCI adjustment for unrealised profit on intragroup transfer of inventories to non-current asset in prior period: Carson Ltd – Richard Ltd: As the above elimination of the after-tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI

Dr Cr

NCI share of profit (20% x $3 500)

700 700

(n) Depreciation on plant transferred intragroup: Carson Ltd – Richard Ltd: As the plant was sold intragroup on 1 January 2023, at 30 June 2023 we need to recognise depreciation adjustments for half a year. That is because the depreciation expense for this period is overstated, being based on the price paid intragroup rather than the carrying amount at the moment of the intragroup sale. The depreciation adjustment, being ½ x $5 000 / 5, is recognising that a part of the unrealised profit at the moment of the intragroup sale is realised as the plant is used in the business. As such, the tax effect on the unrealised profit is reversed for the part of the profit that is realised through the depreciation adjustments. Accumulated depreciation - plant Dr Depreciation expense - plant Cr (Depreciation of 20% x $5 000 p.a. for 0.5 years)

500

Income tax expense Deferred tax asset

150

500

Dr Cr

150

(o) NCI adjustment for depreciation on plant transferred intragroup: Carson Ltd – Richard Ltd: As the above recognition of the after-tax realised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we eliminated above the NCI share of the entire profit on the intragroup sale, before we adjusted this profit for this realised part. Therefore, we need to reverse the NCI entry that eliminated the profit on the intragroup sale of plant for the realised part of the profit. NCI share of profit NCI (20% x ($1 000 - $300) x 1/2)

Dr Cr

70 70

Consolidation worksheet for Richard Ltd at 30 June 2023 Financial Statements Sales revenue

Richard Ltd 910 000

Carson Ltd 624 000

Other revenue

60 000

65 600

970 000

689 600

j l f g

Adjustments Dr Cr 120 000 15 000 9 600 4 800

Group

NCI Dr

Parent Cr

1 399 000 111 200 1 510 200

29.185

Chapter 29: Consolidation: non-controlling interest

Cost of sales

625 000

464 000

Other expenses Profit before tax Tax expense

225 000 850 000 120 000 30 000

129 600 593 600 96 000 32 000

Profit

90 000

64 000

Retained earnings (1/7/22)

100 000

48 000

Transfer from ARS

0 190 000

14 000 126 000

Transfer to general reserve Dividend paid Dividend declared

12 000

20 000 30 000 50 000 140 000

12 000 6 000 30 000 96 000

400 000 0

120 000 28 000

b b

96 000 12 800

a b

5 000 480

540 000

244 000

ARS (1/7/22)

20 000

Transfer from ARS Gains/(losses) ARS (30/6/23) Total equity: parent

0 0

(14 000) 4 000 10 000

Retained earnings (30/6/23) Share capital General reserve BCVR

2 000

h n

120 150

400 115 000 10 000 500

h j l n

600 1 500 1 500

a j l

963 600

356 100 1 319 700 190 500 58 670

131 830

a b h b

2 000 25 920 280 11 200

600

120 400

2 800 255 030

9 600 4 800

f g

12 520 56 70 3 200 6 120

2 800

700 700

k m

2 400

22 400 31 200 65 600 189 430

2 400 1 200

e e

120

c c e c

24 000 4 800 2 400 1 800

c d

2 800 1 200

800

e e k m

120 584

111 136

12 000

424 000 15 200 5 600

e i o c d

231 720 9 600 20 000 30 000 59 600

1 600

172 120 400 000 9 600

1 680

628 750 b

11 200

8 800 11 200

(2 800) 4 000 10 000

581 720 4 800 2 800

2 400 1 200 700 700

36 600 4 040 12 520 800 70

c d e e o

67 566

0 3 200 8 000 589 720

Total equity: NCI

Total equity

540 000

254 000

638 750

Provisions Payables Deferred tax liabilities Non-current liabilities Total liabilities Total equity and liabilities

40 000 30 000 12 000 83 000 165 000 705 000

30 000 40 000 15 000 65 000 150 000 404 000

70 000 65 200 28 200 148 000 311 400 950 150

Shares in Carson Ltd Plant

158 400 800 000

0 320 000

Accumulated depreciation - plant Land Intangibles Deferred tax assets

(544 000))

(120 000)

60 000 75 000 15 000

90 000 60 000 8 000

Cash Receivables Inventories Goodwill Total assets

20 000 40 600 76 000 4 000 705 000

5 000 6 000 30 000 5 000 404 000

g a

a n

j l

4 800 1 200

20 000 500

1 500 1 500

12 000 358 050

2 400

158 400 12 000 5 000 4 000

b a l a

150

4 800 5 000 5 000 358 050

g j

0 1 103 000 (647 500)) 150 000 135 000 25 850 25 000 41 800 101 000 16 000 950 150

29.186

49 030

638 750

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.20 Undervalued assets, full goodwill method, intragroup transactions Mary Ltd acquired 75% of the issued shares of Edith Ltd on 1 July 2018. In exchange for these shares, Mary Ltd gave a consideration of $26 000 cash and 10 000 shares in Mary Ltd, these having a fair value of $2 each. At this date the shareholders’ equity of Edith Ltd consisted of:

At this date all the identifiable assets and liabilities of Edith Ltd were recorded at amounts equal to their fair values except for plant for which the fair value was $2000 greater than the carrying amount of $25 000 (original cost was $35 000). The plant was expected to have a further 5-year life. The fair value of the non-controlling interest at 1 July 2018 was $15 000. Mary Ltd uses the full goodwill method. The tax rate is 30%. Assets held by Edith Ltd at 30 June 2023 include financial assets. Gains and losses on these assets are recognised in other comprehensive income. During the year ended 30 June 2023, Edith Ltd recorded gains of $1500 on these assets. Financial information supplied by the two companies at 30 June 2023 was as follows. Mary Ltd Sales revenue

75 000

Edith Ltd $

118 000

Interest revenue

375

1 000

Dividend revenue

2 700

1 000

78 075

120 000

Cost of sales

(51 000)

(87 750)

Financial expenses

(2 250)

(3 000)

Selling expenses

(6 000)

(9 000)

Other expenses

(2 250)

(61 500)

(102 000)

Profit before tax

16 575

18 000

Income tax expense

(7 500)

(8 200)

Profit for the year

9 075

9 800

Retained earnings (1/7/22)

28 900

21 700

37 975

31 500

(4 000)

(3 600)

Mary Ltd

Edith Ltd

33 975

27 900

Dividend paid

Retained earnings (30/6/23)

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Chapter 29: Consolidation: non-controlling interest

60 000

45 000

—

7 500

Total equity

93 975

80 400

Current liabilities

12 750

4 350

—

7 500

12 750

11 850

Share capital Other components of equity

Non‐current liabilities: Loans Total liabilities Total equity and liabilities

106 725

92 250

Plant

45 000

90 000

Accumulated depreciation — plant

(25 500)

(45 750)

Shares in Edith Ltd

46 000

—

Loans to Edith Ltd

3 750

—

Inventories

13 400

23 250

Cash

21 075

750

—

16 500

3 000

7 500

Financial assets Deferred tax assets Total assets

106 725

92 250

Additional information (a) At 1 July 2022, Mary Ltd held inventories that had been sold to it by Edith Ltd in the previous year at a profit of $1200. (b) During the year ended 30 June 2023, Edith Ltd sold inventories to Mary Ltd for $28 500. At 30 June 2023, Mary Ltd still had on hand inventories that had been sold to it by Edith Ltd for a profit of $1800 before tax. (c) Interest of $375 was paid by Mary Ltd to Edith Ltd on both 30 June 2022 and 30 June 2023. Required Prepare the consolidated financial statements of Mary Ltd for the year ended 30 June 2023. (LO3, LO4, LO5 and LO6) Acquisition analysis at 1 July 2018: Net fair value of identifiable assets and liabilities of Edith Ltd

(a) Consideration transferred (b) NCI in Edith Ltd Aggregate of (a) and (b) Goodwill acquired

= + = = = = = =

$45 000 + $9 000 (equity) $2 000 (1 – 30%) (BCVR – plant) $55 400 $46 000 $15 000 $61 000 $61 000 - $55 400 $5 600

Goodwill of Edith Ltd:

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Fair value of Edith Ltd

= =

Net fair value of identifiable assets and liabilities of Edith Ltd = Goodwill of Edith Ltd = =

Goodwill of Mary Ltd: Goodwill acquired Goodwill of Edith Ltd Control premium - parent

= = = =

$15 000 / 25% $60 000 $55 400 $60 000 - $55 400 $4 600

$5 600 $4 600 $5 600 - $4 600 $1 000

The control premium can also be calculated as follows: Fair value of the shares in Edith Ltd acquired by Mary Ltd = $15 000 / 25% x 75% = $45 000 Consideration transferred = $46 000 Control premium - parent = $46 000 – $45 000 = $1 000 The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Edith Ltd, i.e. $1 000 + 75% x $4 600 = $4 450. NCI will only be entitled to its share of the goodwill of Edith Ltd, i.e. 25% x $4 600 = $1 150. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Edith Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. (a) Business combination valuation entries: Depreciation expense - plant Income tax expense Retained earnings (1/7/22) Transfer from BCVR (1/5 x $2 000 p.a. for 5 years)

Dr Cr Dr Cr

Goodwill Dr Business combination valuation reserve Cr

400 120 1 120 1 400

4 600 4 600

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Chapter 29: Consolidation: non-controlling interest

expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/22). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. The entry for goodwill is the same as that posted on acquisition date as there are no changes in that goodwill. (b) Pre-acquisition entries: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Edith Ltd

Dr Dr Dr Dr Cr

Transfer from business combination valuation reserve Dr Business combination valuation reserve Cr (75% x $1 400)

6 750 33 750 4 500 1 000 46 000

1 050 1 050

As there were no transfers from pre-acquisition equity during the previous periods, the first pre-acquisition entry is the same as the one posted at acquisition date. However, as there was a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings (due to the derecognition of plant), the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. (c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital Business combination valuation reserve NCI

Dr Dr Cr Cr

2 250 11 250 1 500 15 000

This entry transfers the NCI share of the pre-acquisition equity in Edith Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/21 to 30/6/22 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $12 700 (from $9 000 to $21 700) as a result of the profits recognised during the period and decreased by $1 120 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2020, giving a net effect of an increase of $11 580. • Other components of equity increased by $6 000 (from $0 to $7 500 - $1 500) as reported in the financial statement of Edith Ltd as a result of the gain on revaluation of financial assets (considering that $1 500 of the balance of that account at 30 June 2020 represents an increase during the current period).

29.190

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2 895 1 500 4 395

These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while the debit to Other Components of Equity means that a part of the increase in this account is transferred to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit Dr 2 380 NCI Cr (25% x ($9 800 – ($400 - $120) depreciation adjustment after tax)

2 380

This entry recognises the NCI share of the current profit. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustments posted in the BCVR entries to depreciation expense, taking into consideration the respective tax effect. Also, during the current period, Edith Ltd recognises a dividend paid of $3 600. This dividend reduces the equity and therefore reduces the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of this dividend. NCI

Dr Cr

Dividend paid (25% x $3 600)

900 900

The last change in equity during the current period that can be observed by looking at the financial statements prepared by Edith Ltd, considering the information about the other components of equity account, is the increase in this account during the period due to gain on revaluation of financial assets, an increase of $1 500 is recognised. This change increases the NCI and a part of it should be allocated to NCI.

Gains/(losses): other components of equity NCI (25% x $1 500)

Dr Cr

375 375

29.191

Chapter 29: Consolidation: non-controlling interest

Even though there are no other changes in the equity accounts reported in the individual statement of Edith Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from BCVR Dr Business combination valuation reserve Cr (25% x $1 400)

350 350

(f) Unrealised profit in beginning inventories: Edith Ltd - Mary Ltd: During the previous period, a series of intragroup sale of inventories took place and, at the beginning of the current period, there was a $1 200 unrealised profit before tax for Edith Ltd (additional information (a)). As the assumption is that this unrealised profit will be realised during the current period, we should transfer the unrealised profit from the previous period (i.e. from Retained Earnings (1/7/22)) to the current period. As retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/22) for is $1 200 x (1 – 30%) = $840. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales. That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $1 200 to cost of sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

840 360 1 200

(g) NCI adjustment for unrealised profit in beginning inventories: Edith Ltd - Mary Ltd: As the above transfer of the after-tax unrealised profit in beginning inventories from the previous profit to the current profit decreases Retained Earnings (1/7/22) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings • An increase in NCI due to the increase in current profit. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Dr 210 Retained earnings (1/7/22) Cr 210 (25% x $840)

29.192

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NCI share of profit NCI (25% x $840)

Dr Cr

210 210

Dr Cr

210 210

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another. (h) Unrealised profit in ending inventories: Edith Ltd - Mary Ltd: During the current period, $28 500 worth of intragroup sales of inventories took place (additional information (b)) and, at the end of the current period, there was a $1 800 unrealised profit before tax for Edith Ltd (additional information (b)). We should eliminate this unrealised profit on consolidation, together with the intragroup sales revenues. Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. Therefore, an adjustment of $26 700 to cost of sales is needed. The elimination of the intragroup sales revenue, together with the adjustment to cost of sales, reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup that is greater than the original cost to the group due to the unrealised profit). The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Edith Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales

Dr Cr Cr

28 500

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

540

26 700 1 800

540

(i) NCI adjustment for unrealised profit in ending inventories: Edith Ltd - Mary Ltd: As the above elimination of the after-tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI Dr 315 NCI share of profit Cr 315 (25% x ($1 800 - $540))

29.193

Chapter 29: Consolidation: non-controlling interest

(j) Dividend paid: As the parent share of the dividend paid by the subsidiary is an intragroup dividend for which the parent recognised a dividend revenue and the subsidiary recognised dividend paid, in the consolidation worksheet an adjustment entry is posted to eliminate those effects. The impact on NCI of this dividend was already recognised under NCI Step 3 entries. Dividend revenue Dividend paid (75% x $3 600)

Dr Cr

2 700 2 700

(k) Intragroup loans: The financial statements of the parent and the subsidiary include the effects of an intragroup borrowing involving loans to Edith Ltd. The receivable account recognised in Mary Ltd’s accounts recognises the amount of those intragroup loans with is recognised under liabilities by Edith Ltd. The effects of this intragroup borrowing need to be eliminated in full on consolidation. As this elimination does not have impact on equity, there is no NCI adjustment entry required for it. Loans Loans to Edith Ltd

Dr Cr

3 750 3 750

(l) Interest on intragroup loans: As the loan held intragroup paid $375 in interest during the current period (the interest paid in the prior period does not matter as it does not have any net impact on the prior period consolidated profit), we need to eliminate it in full. As this elimination does not have impact on equity, there is no NCI adjustment entry required for it. Interest revenue Financial expenses

Dr Cr

375 375

29.194

Chapter 29: Consolidation: non-controlling interest

Consolidation worksheet for Mary Ltd at 30 June 2023 Financial Statements

Mary Ltd 75 000 375 2 700 78 075 51 000

Edith Ltd 118 000 1 000 1 000 120 000 87 750

Profit before tax Tax expense

2 250 6 000 2 250 61 500 16 575 7 500

3 000 9 000 2 250 102 000 18 000 8 200

Profit

9 075

9 800

Retained earnings (1/7/22)

28 900

21 700

37 975 4 000 33 975 60 000 0

31 500 3 600 27 900 45 000 0

93 975 0 0 0

72 900 6 000 1 500 7 500

Sales revenue Interest rev. Dividend rev. Cost of sales Financial exp. Selling exp. Other exp. incl depreciation

Transfer from BCVR Dividend paid Retained earnings (30/6/23) Share capital BCVR

Other comp (1/7/22) Gains/(losses) Other comp (30/6/23) Total equity: parent Total equity: NCI

Total equity

93 975

80 400

Current liabilities Loans Total liabilities Total equity and liabilities

12 750 0 12 750 106 725

4 350 7 500 11 850 92 250

h l j

Adjustments Dr Cr 28 500 375 2 700

400

360

Group

1 200 26 700 375

f h l

120 540

a h

b b

1 120 6 750 840 1 050

4 875 15 000 4 900 135 625 30 875 15 400

33 750 4 500

41 890

1 400

2 700

4 600 1 050

a b

350 57 715 4 900 52 815 71 250 1 150 125 215 6 000 1 500 7 500 132 715

132 715

3 750

Parent Cr

164 500 1 000 1 000 166 500 110 850

15 475 a b f b

NCI Dr

17 100 3 750 20 850 153 565

29.195

e g c d

2 380 210 2 250 2 895

350

c c

11 250 1 500

d e

1 500 375

e i

900 315

315

13 200

210

36 955

900

350

15 000 4 395 2 380 375

c d e e

0 50 155 4 000 46 155 60 000 0 106 155 4 500 1 125 5 625 111 780 20 935

132 715

Chapter 29: Consolidation: non-controlling interest

Plant Accumulated depreciation Shares in Edith Ltd Loans from Edith Ltd Inventories Cash Financial assets Deferred tax assets Goodwill

45 000 (25500) 46 000 3 750 13 400 21 075 0 3 000 0

90 000 (45750) 0 0 23 250 750 16 500 7 500 0

Total assets

106 725

92 250

46 000 3 750 1 800

h a b

540 4 600 1 000 90 235

90 235

b k h

135 000 (71 250) 0 0 34 850 21 825 16 500 11 040 5 600 153 565

29.196

Chapter 29: Consolidation: non-controlling interest

MARY LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2023 Revenue: Sales revenue Interest revenue Dividend revenue Total revenue Expenses: Cost of sales Financial expenses Selling Other Total expenses Profit before income tax Income tax expense Profit for the period Other comprehensive income: Other components of equity: gains Comprehensive income for the period

$164 500 1 000 1 000 166 500 110 850 4 875 15 000 4 900 135 625 30 875 15 400 $15 475 1 500 $16 975

Profit for the period attributable to: Parent interest Non-controlling interest

$13 130 2 345 $15 475

Comprehensive income for the period attributable to: Parent interest Non-controlling interest

$14 255 2 720 $16 975

MARY LTD Consolidated statement of changes in equity for the financial year ended 30 June 2023

Comprehensive income for the period

Group $14 255

Parent $2 720

Retained earnings: Balance at 1 July 2022 Profit for the period Transfer from BCVR Dividend paid Balance at 30 June 2023

$41 890 15 475 350 (4 900) $52 815

$36 955 13 130 0 (4 000) $46 085

Other components of equity: Balance at 1 July 2022 Gains/(losses) Balance at 30 June 2023

$6 000 1 500 $7 500

$4 500 1 125 $5 625

29.197

Chapter 29: Consolidation: non-controlling interest

Business combination valuation reserve: Balance at 1 July 2022 Transfer to retained earnings Balance at 30 June 2023

$1 500 350 $1 150

0 0 0

Share capital: Balance at 1 July 2022 Balance at 30 June 2023

$71 250 $71 250

$60 000 $60 000

MARY LTD Consolidated statement of financial position as at 30 June 2023 Assets Current assets Inventories Cash Financial assets Total current assets Non-current assets Property, plant and equipment Plant Accumulated depreciation Tax assets: Deferred tax assets Goodwill Total non-current assets Total assets

$34 850 21 825 16 500 73 175

$135 000 (71 250)

Equity and liabilities Equity attributable to equity holders of the parent Share capital Reserves: Other components of equity Retained earnings Parent entity interest Non-controlling interest Total equity Current liabilities Non-current liabilities Interest-bearing liabilities: loans Total liabilities Total equity and liabilities

63 750 11 040 5 600 80 390 $153 565

$60 000 5 625 46 085 111 710 21 005 $132 715 17 100 3 750 $20 850 $153 565

29.198

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 29.21 Undervalued assets, full and partial goodwill method, intragroup transactions On 1 July 2018, Downton Ltd acquired 75% of the issued shares (cum div.) of Abbey Ltd for $67 500. At this date the equity of Abbey Ltd consisted of: Share capital

$60 000

General reserve

6 000

Retained earnings

30 000

At the date of the business combination, all the identifiable assets and liabilities of Abbey Ltd had carrying amounts equal to their fair values except for the following. Carrying amount

Fair value

80 000

$ 110 000

Inventories

50 000

62 000

Receivables

66 000

60 000

Plant (cost $120 000)

The plant had a further useful life of 5 years. It was sold by Abbey Ltd to external entities on 1 April 2023 for $6000. By 30 June 2019, all the inventories were sold to entities outside the group. Also, by 30 June 2019, receivables of $66 000 had been collected. One of the liabilities of Abbey Ltd at 1 July 2018 was dividend payable of $20 000. The tax rate is 30%. Downton Ltd uses the partial goodwill method. Additional information • At 30 June 2022, inventories of Downton Ltd included assets sold to it by Abbey Ltd for a before-tax profit of $600. These items were sold to external entities during the year ended 30 June 2023. • During the year ended 30 June 2023, Abbey Ltd had sold inventories to Downton Ltd for $120 000. The mark-up on sales was 25% on cost. At 30 June 2023, Downton Ltd still had some of these inventories on hand, amounting to items acquired from Abbey Ltd for $6000. • On 1 January 2023, Abbey Ltd sold plant to Downton Ltd for a before-tax profit of $2400. This plant was carried at $6000 (original cost $40 000) in the records of Abbey Ltd at time of sale. Depreciation on this type of plant is calculated using a 20% p.a. straight-line method. • Financial information provided by Abbey Ltd concerning events affecting it during the year ended 30 June 2023 was as follows. Profit for the year

$ 46 800 60 000

Retained earnings at 1 July 2022

$ 106 800 Dividend paid

(24 000)

Dividend declared

(12 000)

Transfer to general reserve

(3 000)

29.199

Chapter 29: Consolidation: non-controlling interest

(39 000) Retained earnings at 30 June 2023

$ 67 800

The transfer to general reserve is from post-acquisition retained earnings. Abbey Ltd also reported a comprehensive income for the year ended 30 June 2023 of $48 300, which included gains on revaluation of land of $1500, as the asset revaluation surplus in relation to the land had increased from $6000 to $7500 over the year. Required 1. Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Downton Ltd at 30 June 2023. 2. Prepare the consolidation worksheet entries at 30 June 2023 if Downton Ltd had used the full goodwill method and the fair value of the non-controlling interest at 1 July 2018 was $39 000. (LO3, LO4, LO5 and LO6) 1. Consolidation worksheet entries at 30 June 2023 (Downton Ltd uses the partial goodwill method): Acquisition analysis at 1 July 2018: Net fair value of identifiable assets and liabilities of Abbey Ltd = ($60 000 + $6 000 + $30 000) (equity) + ($110 000 - $80 000) (1 – 30%) (BCVR – plant) + ($62 000 - $50 000) (1 – 30%) (BCVR – inventories) - ($66 000 - $60 000) (1 – 30%) (BCVR – receivables) = $121 200 (a) Net consideration transferred = $135 000 – (75% x $20 000) (dividends) = $120 000 (b) NCI in Abbey Ltd = 25% x $121 200 = $30 300 Aggregate of (a) and (b) = $150 300 Goodwill acquired – parent only = $150 300 - $121 200 = $29 100 As this method recognises NCI based on the proportionate share of the identifiable assets and liabilities of Abbey Ltd at acquisition date, there won’t be any goodwill recognised for NCI. The entire goodwill calculated here will belong to the parent and will be recognised in the preacquisition entry. (a) Business combination valuation entries: Depreciation expense - plant Carrying amount of plant sold Income tax expense Retained earnings (1/7/22)

Dr Dr Cr Dr

4 500 1 500 1 800 16 800

29.200

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Transfer from BCVR (Depreciation is 20% x $30 000 p.a.)

21 000

As the plant is not in the business at the end of the period (it was sold during the current period), but was on hand at the beginning of the period, a BCVR entry needs to be posted for plant to adjust the depreciation expenses and to transfer the BCVR for it to retained earnings, while also adjusting the carrying amount of the plant sold to reflect the carrying amount from the group’s perspective just before the external sale. Given that the plant was sold on 1 April 2023 (4 ¾ years after the acquisition date), the carrying amount recognised by Abbey Ltd at the moment of sale is $80 000 - $80 000 / 5 x 4.75 years = $4 000, while the carrying amount from the group’s perspective (based on the fair value at acquisition date) at the moment of sale is $110 000 - $110 000 / 5 x 4.75 years = $5 500; therefore, a $1500 increase is necessary to be recorded against the carrying amount – that is equivalent to the depreciation adjustments that we did not adjust for because the plant was sold: i.e. ($110 000 - $80 000) / 5 years x (5 years – 4.25 years). There are no adjustments needed for the plant account or the related accumulated depreciation account as they were written off and they should stay written off. The adjustments for previous depreciation expenses and the related tax effect will be posted against Retained earnings (1/7/22), while the adjustments for the current depreciation expenses and the related tax effect will be recognised against the Depreciation expense and Income tax expense account respectively. This is because the previous period’s expenses are now in the Retained earnings (1/7/22). All the tax effects are realised as the asset is derecognised and therefore no deferred tax needs to be recognised. As inventories and receivables existing at acquisition date are derecognised prior to the beginning of the current period, there are no BCVR entries needed now for them. (b) Pre-acquisition entries: Retained earnings (1/7/22)* Dr 25 650 Share capital Dr 45 000 Business combination valuation reserve** Dr 15 750 General reserve Dr 4 500 Goodwill Dr 29 100 Shares in Abbey Ltd Cr 120 000 *75% x ($30 000 + $8 400 (transfer from BCVR - inventories) – $4 200 (transfer from BCVR - receivables)]) **75% x $21 000 (BCVR – plant) As now we are after the period that included the acquisition date, the first pre-acquisition entry is not the same as the one posted at acquisition date, but it should be different based on the transfers from pre-acquisition equity that took place in the previous periods. As such, the amounts to be eliminated now will be equal to the parent share of the amounts in the equity accounts at acquisition date, adjusted for the prior period pre-acquisition equity transfers. The only such transfer in the prior period is the transfer from BCVR to retained earnings caused by the sale of inventories undervalued at acquisition date and the collection of accounts receivable overvalued at acquisition date. Therefore, the amount of retained earnings to be eliminated will be calculated as 75% (parent share) of the amount reported in Retained earnings at acquisition date ($30 000) plus the amount transferred from BCVR ($8 400 BCVR inventories - $4 200 BCVR receivables), while the amount of BCVR to be eliminated will be the parent share of the BCVR for plant only.

29.201

Chapter 29: Consolidation: non-controlling interest

There is also a transfer during the current period from pre-acquisition equity, i.e. a transfer from business combination valuation reserve to retained earnings due to the sale of plant undervalued at acquisition date, the second pre-acquisition entry needs to reverse this transfer for the parent share. The NCI share of this transfer will be reversed in the NCI allocation entries that deal with the NCI share of changes in equity in the current period. Transfer from BCVR Business combination valuation reserve (75% x $21 000 (BCVR – plant))

Dr Cr

15 750

Dr Dr Dr Dr Cr

7 500 15 000 6 300 1 500

15 750

(c) NCI Step 1: NCI share of equity at acquisition date: Retained earnings (1/7/22) Share capital Business combination valuation reserve General reserve NCI (25% of equity of Abbey Ltd at acquisition date)

30 300

This entry transfers the NCI share of the pre-acquisition equity in Abbey Ltd at acquisition date to the NCI equity account. (d) NCI Step 2: NCI share of changes in equity from 1/7/21 to 30/6/22 (prior period): We identify the following changes in equity for this period: • Retained earnings increased by $30 000 (from $30 000 to $60 000) as a result of the profit recognised during the period and decreased by $16 800 as a result of depreciation adjustments after tax posted against this account in the BCVR entries at 30 June 2023, giving a net effect of an increase of $13 200. • Asset Revaluation Surplus increased by $6 000 (from $0 to $6 000 according to additional information) as a result of the gain on revaluation of the land recognised during the period in the total comprehensive income. • BCVR decreased by $8 400 as a result of the sale of inventories undervalued at acquisition date and increased by $4 200 as a result of the collection of receivables overvalued at acquisition date during the period. It should be noted here that the changes in equity that should be considered are not only those visible in the individual statement of the subsidiary, but also those recognised in the consolidation journal entries posted above. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the effect on NCI will be: Retained earnings (1/7/22)* Asset revaluation surplus (1/7/22)** Business combination valuation reserve*** NCI *25% x ($60 000 - $30 000 - $16 800) **25% x $6 000 ***25% x ((1 - 30%) x [$12 000 - $6 000])

Dr Dr Cr Cr

3 300 1 500

1 050 3 750

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These entries transfer the NCI share of those changes in the equity accounts to the NCI account, i.e. the debit to Retained Earnings means that a part of the increase in Retained Earnings is transferred to NCI, while, for example, the credit to BCVR means that a part of the decrease in this reserve is allocated to NCI. (e) NCI Step 3: NCI share of changes in equity from 1/7/22 to 30/6/23 (current period): NCI share of profit NCI (25% x ($46 800 – [$4 500 + $1 500 - $1 800]))

Dr Cr

10 650 10 650

This entry recognises the NCI share of the current profit. It is assumed that the profit reported under additional information (d) is after tax. As the business combination entries have an impact on the current profit, there is a need to adjust the current profit before allocating it to NCI. Specifically, the current profit needs to be adjusted by the decrease caused by the adjustment to depreciation expense and carrying amount of plant sold posted in the BCVR entries, taking into consideration the respective tax effect. During the current period, Abbey Ltd recognises a dividend paid of $24 000 and a dividend declared of $12 000. These dividends reduce the equity and therefore reduce the NCI share of that equity. Therefore, the impact on NCI will be recognised by a decrease in the NCI account for the NCI share of those dividends. NCI Dividend paid (25% x $24 000)

Dr Cr

6 000

NCI Dividend declared (25% x $12 000)

Dr Cr

3 000

6 000

3 000

Abbey Ltd also reports a current period transfer from retained earnings to general reserve during the current period. The effects on NCI can be recognised as: • An increase in NCI due to the increase in general reserve. • A decrease in NCI due to the decrease in retained earnings. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (retained earnings) to another (general reserve). Those effects can be recorded as: General reserve Transfer to general reserve (25% x $3 000)

Dr Cr

750 750

The last change in equity during the current period that can be observed by looking at the financial information prepared by Abbey Ltd is the increase in asset revaluation surplus due to gain on revaluation of land ($750 – the amount after tax). This change increases the NCI and a part of it should be allocated to NCI.

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Gains/(losses): asset revaluation surplus Dr 375 NCI Cr 375 (25% x $1 500) Even though there are no other changes in the equity accounts reported in the individual statement of Abbey Ltd, there are changes recognised in the BCVR entries in the business combination valuation reserve during the current period due to the derecognition of plant which cause a transfer of BCVR to Retained earnings. As this change increases the retained earnings, while decreasing the BCVR (the former being recognised as a credit to the Transfer from BCVR account) at the moment of transfer, the effects on NCI can be recognised as: • An increase in NCI due to the increase in retained earnings. • A decrease in NCI due to the decrease in BCVR. Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account (BCVR) to another (retained earnings). Those effects can be recorded as: Transfer from BCVR Business combination valuation reserve (Sale of plant: 25% x $21 000)

Dr Cr

5 250 5 250

Dr Cr

18 000 18 000

Dr Cr

9 000

Dividend payable Dividend declared (75% x $12 000)

Dr Cr

9 000

(h) Unrealised profit in beginning inventories: Abbey Ltd - Downton Ltd: During the previous period, a series of intragroup sale of inventories took place and, at the beginning of the current period, there was a $600 unrealised profit before tax for Abbey Ltd (additional information (a)). As the items were sold to external entities in the current period,

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

this unrealised profit will be realised during the current period, and therefore we should transfer the unrealised profit from the previous period (i.e. from Retained Earnings (1/7/22)) to the current period. As retained earnings only include prior profits after tax, the amount to adjust Retained Earnings (1/7/22) for is $600 x (1 – 30%) = $420. Recognising the profit as realised during the current period is done by adjusting a current expense, i.e. cost of sales. That is necessary because the cost of sales is overstated as it recognises the cost of sales on the external sale of those inventories based on the price paid intragroup and not based on the cost to the group. Therefore, an adjustment of $600 to cost of sales is needed. The tax effect of recognising the profit as realised is considered also; that is because the current profit increases and therefore the income tax expense should increase. Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

420 180 600

(i) NCI adjustment for unrealised profit in beginning inventories: Abbey Ltd - Downton Ltd: As the above transfer of the after-tax unrealised profit in beginning inventories from the previous profit to the current profit decreases Retained Earnings (1/7/22) and increases the current profit, the NCI will be affected. The effects on NCI can be recognised as: • A decrease in NCI due to the decrease in retained earnings. • An increase in NCI due to the increase in current profit. Given that those changes in equity induce changes in the NCI share of equity in the same direction, the entries to recognise the combined effect on NCI will be: NCI Retained earnings (1/7/22) (25% x $420)

Dr Cr

105

NCI share of profit NCI (25% x $420)

Dr Cr

105

Dr Cr

105 105

Note that there is no overall net impact on the NCI account as a result of this transfer from one equity account to another. (j) Unrealised profit in ending inventories: Abbey Ltd - Downton Ltd: During the current period, $120 000 worth of intragroup sales of inventories took place (additional information (b)) and, at the end of the current period, there was a ($6 000 / (1 +

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25%)) x 25% = $1 200 unrealised profit before tax for Abbey Ltd (this is calculated based considering that the mark-up on cost on the intragroup sale is 25% according to additional information (b)). We should eliminate this unrealised profit on consolidation, together with the intragroup sales revenues. Cost of sales will also need to be adjusted by the difference between the intragroup sales revenues and the unrealised profit in ending inventories. Therefore, an adjustment of $118 800 to cost of sales is needed. The elimination of the intragroup sales revenue, together with the adjustment to cost of sales, reduces the profit by the unrealised profit in ending inventories. Inventories still on hand are also adjusted due to overstatement (they are recorded based on the price paid intragroup that is greater than the original cost to the group due to the unrealised profit). The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Abbey Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Sales Cost of sales Inventories

Dr 120 000 Cr Cr

Deferred tax asset Income tax expense

Dr Cr

118 800 1 200

360 360

(k) NCI adjustment for unrealised profit in ending inventories: Abbey Ltd - Downton Ltd: As the above elimination of the after-tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (25% x $840)

Dr Cr

210 210

(l) Unrealised profit on intragroup sale of plant: Abbey Ltd - Downton Ltd: During the current period, Abbey Ltd sold a plant to Downton Ltd. As the plant is still with Downton Ltd at the end of the period, the intragroup profit of $2 400 is unrealised and should be eliminated in full. Also, the plant is overstated as it is recorded based on the price paid intragroup, not based on the original carrying amount at the moment of the intragroup sale, so the plant account also needs to be adjusted. The tax effect of the elimination of the unrealised profit is considered in the second entry below, recognising a tax benefit for the future for the tax that Abbey Ltd would have paid in advance of the profit being realised by the group; that is because the group would not have to pay tax again on that profit when it will realise it. Gain on sale of plant Plant

Dr Cr

2 000

Deferred tax asset Income tax expense

Dr Cr

720

2 000

720

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(m) NCI adjustment for the unrealised profit on intragroup sale of plant: Abbey Ltd - Downton Ltd: As the above elimination of the after tax unrealised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we recognised the NCI share of the subsidiary’s profit under the NCI Step 2 entry above, before we adjusted this profit for this unrealised part. Therefore, we need to reverse the NCI Step 2 entry for the NCI share of the unrealised profit. NCI NCI share of profit (25% x $1 680)

Dr Cr

420 420

(n) Depreciation of plant sold intragroup: Abbey Ltd - Downton Ltd: As the plant was sold intragroup on 1 January 2023, at 30 June 2023 we need to recognise depreciation adjustments for half a year. That is because the depreciation expense for this period is overstated, being based on the price paid intragroup rather than the carrying amount at the moment of the intragroup sale. The depreciation adjustment, being ½ x $2 400 x 20%, is recognising that a part of the unrealised profit at the moment of the intragroup sale is realised as the plant is used in the business. As such, the tax effect on the unrealised profit is reversed for the part of the profit that is realised through the depreciation adjustments. Accumulated depreciation - plant Depreciation expense - plant (1/2 x 20% x $2 400)

Dr Cr

240

Income tax expense Deferred tax asset

Dr Cr

240

(o) NCI adjustment for depreciation of plant sold intragroup: Abbey Ltd - Downton Ltd: As the above recognition of the after-tax realised profit on the intragroup sale impacts on the profit recognised by the subsidiary, the NCI will be affected. That is because we eliminated above the NCI share of the entire profit on the intragroup sale, before we adjusted this profit for this realised part. Therefore, we need to reverse the NCI entry that eliminated the profit on the intragroup sale of plant for the realised part of the profit. NCI share of profit NCI (25% x $168)

Dr Cr

42 42

2. Consolidation worksheet entries at 30 June 2023 (Downton Ltd uses the full goodwill method): Acquisition analysis at 1 July 2018: Net fair value of identifiable assets and liabilities of Abbey Ltd = ($60 000 + $6 000 + $30 000) (equity) + ($110 000 - $80 000) (1 – 30%) (BCVR - plant) + ($62 000 - $50 000) (1 – 30%) (BCVR – inventories)

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(a) Net consideration transferred (b) NCI in Abbey Ltd Aggregate of (a) and (b) Goodwill acquired

- ($66 000 - $60 000) (1 – 30%) (BCVR – receivables) = $121 200 = $135 000 – (75% x $20 000) (dividend) = $120 000 = $39 000 = $159 000 = $37 800

Goodwill of Abbey Ltd: Fair value of Abbey Ltd

= = Net fair value of identifiable assets and liabilities of Abbey Ltd = Goodwill of Abbey Ltd = Goodwill of Downton Ltd: Goodwill acquired Goodwill of Abbey Ltd Control premium - parent

= = =

$39 000 / 25% $156 000 $121 200 $34 800

$37 800 $34 800 $3 000

The control premium can also be calculated as follows: Fair value of the shares in Abbey Ltd acquired by Downton Ltd = = Net consideration transferred = Control premium – parent = =

$39 000 / 25% x 75% $117 000 $120 000 $120 000 - $117 000 $3 000

The goodwill that belongs to the parent will be the control premium plus the parent’s share of the goodwill of Abbey Ltd, i.e. $3 000 + 75% x $34 800 = $29 100. NCI will only be entitled to its share of the goodwill of Abbey Ltd, i.e. 25% x $34 800 = $8 700. As the control premium can only be recognised as belonging to the parent (as it represents how much the parent paid on top of the fair value of the shares they acquired in the subsidiary), it will be recognised in the pre-acquisition entry. As the goodwill of Abbey Ltd is allocated to both the parent and NCI, it will be recognised in the business combination valuation entries. Different entries (a) Business combination valuation entries: There will need to be an additional BCVR entry, together with the BCVR entries recorded under the partial goodwill method: Goodwill Business combination valuation reserve

Dr Cr

34 800 34 800

This entry recognises the unrecorded goodwill of Abbey Ltd that excludes the control premium.

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(b) Pre-acquisition entries: Only the first pre-acquisition entry is different under the full goodwill method. Retained earnings (1/7/22)* Dr 25 650 Share capital Dr 45 000 Business combination valuation reserve** Dr 41 850 General reserve Dr 4 500 Goodwill Dr 3 000 Shares in Abbey Ltd Cr 120 000 *75% x ($30 000 + $8 400 (transfer from BCVR - inventories) – $4 200 (transfer from BCVR - receivables)) **75% x ($21 000 (BCVR - plant) + $34 800 (BCVR - goodwill)) Note that the only difference between this entry under the full goodwill method and the entry prepared under the partial goodwill method is due to the treatment of goodwill. The second pre-acquisition entry is the same as the one prepared under the partial goodwill method. (c) NCI Step 1: NCI share of equity at acquisition date: The NCI entries are the same as those prepared under the partial goodwill method with the only exception being again due to the way the goodwill is recognised under those 2 methods. Only the NCI Step 1 entry will be affected and it will change to: Retained earnings (1/7/22) Share capital Business combination valuation reserve* General reserve NCI *25% x ($21 000 + $8 400 - $2 400 + $34 800)

Dr Dr Dr Dr Cr

7 500 15 000 15 000 1 500 39 000

All the other entries prepared at 30 June 2023 under the partial goodwill method are the same as those that would be posted under the full goodwill method.

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Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 29: Consolidation: non-controlling interest Multiple choice questions 1. Which of the following is not a reason for an entity to prefer to have less than 100% ownership interest in a subsidiary? a. To comply with regulatory requirements. *b. To receive the whole gain on acquisition. c. To decrease the cash necessary to acquire the control over the subsidiaries. d. To incentivise the subsidiary’s executives by allowing them to hold a non-controlling interest. Answer: b Learning objective 29.1: discuss the nature of the non-controlling interest (NCI).

2. Ownership interests in a subsidiary entity that do not belong to the parent entity are known as: a. b. c. *d.

private interests. unowned interests. proprietary interests. non-controlling interests.

Answer: d Learning objective 29.1: discuss the nature of the non-controlling interest (NCI).

3. A non-controlling interest contributes a. b. *c. d.

to a consolidated group?

assets profit equity liabilities

Answer: c Learning objective 29.1: discuss the nature of the non-controlling interest (NCI).

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Testbank to accompany Financial reporting 3e by Loftus et al.

4. AASB 10 Consolidated Financial Statements classifies non-controlling interest as: a. *b. c. d.

a liability of the group. part of the equity of the group. a liability of the parent entity. a liability.

Answer: b Learning objective 29.1: discuss the nature of the non-controlling interest (NCI). 5. According to AASB 10 Consolidated Financial Statements, the term ‘non-controlling interest’ means: *a. b. c. d.

equity in a subsidiary not attributable, directly or indirectly, to a parent. the total equity of the combined group. the equity in the parent entity other than the portion owned by the subsidiary entity. the equity in the economic entity other than that which can be attributed to the subsidiary entity.

Answer: a Learning objective 29.1: discuss the nature of the non-controlling interest (NCI).

6. Non-controlling interest is entitled to a part of the equity of the: a. b. c. *d.

parent entity. subsidiary entity. parent entity as reflected in the consolidated equity. subsidiary entity as reflected in the consolidated equity.

Answer: d Learning objective 29.1: discuss the nature of the non-controlling interest (NCI). 7. Disclosure of the non-controlling interest’s share of consolidated equity is required in which of the following financial statements? *a. b. c. d.

all of these financial statements. consolidated statement of changes in equity. consolidated statement of financial position. consolidated statement of comprehensive income.

Answer: a Learning objective 29.1: discuss the nature of the non-controlling interest (NCI).

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

8. When presenting a consolidated statement of financial position the non-controlling interest is: a. b. *c. d.

presented as a separate component of total assets and total liabilities. presented separately within the non-current liability section. presented separately within the equity section. shown as a separate portion of net assets.

Answer: c Learning objective 29.2: explain the principles of measurement and disclosure of the NCI.

9. The following information is required to be disclosed for the non-controlling interest (NCI) except for: a. *b. c. d.

the NCI share of consolidated equity. the NCI share of consolidated profit before tax. the NCI share of consolidated profit after tax. the NCI share of consolidated comprehensive income.

Answer: b Learning objective 29.2: explain the principles of measurement and disclosure of the NCI.

10. Which of the following statements is incorrect with regards to a consolidation worksheet in the presence of the non-controlling interest? a. b. c. *d.

there is no NCI share extracted from the assets and liabilities section of the worksheet. one extra column is added that includes the parent share of the individual equity accounts. two extra columns are added to the worksheet to divide the consolidated equity into the NCI and parent share. one extra column is added that includes the NCI share of the individual equity accounts.

Answer: d Learning objective 29.3: explain how the consolidation worksheet is changed by the presence of the NCI in the group.

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Testbank to accompany Financial reporting 3e by Loftus et al.

11. In Bell Group’s consolidation worksheet, the opening balance of retained earnings under ‘Group’ column shows a balance of $70 000. If there is a debit entry of $16 000 in the NCI column, the opening balance of retained earnings under ‘Parent’ column would be: *a. b. c. d.

$54 000. $70 000. $86 000. $16 000.

Answer: a Learning objective 29.3: explain how the consolidation worksheet is changed by the presence of the NCI in the group.

12. On a consolidation worksheet, the non-controlling interest columns are used to: a. b. c. *d.

adjust the amounts that have been recorded for intragroup sales. record the amounts of the non-controlling investment in the parent. adjust the amounts that have been recorded for intragroup services. compile the amounts of non-controlling interest and parent share of particular line items.

Answer: d Learning objective 29.3: explain how the consolidation worksheet is changed by the presence of the NCI in the group.

13. Under the full goodwill method, the NCI is measured based on: a. *b. c. d.

the fair value of the shares that parent owns in the subsidiary. the fair value of the shares that the NCI owns in the subsidiary. the proportionate share of the fair value of the acquiree’s identifiable assets and liabilities. the proportionate share of the carrying amount of the acquiree’s identifiable assets and liabilities.

Answer: b Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Under the full goodwill method: *a. b. c. d.

acquired goodwill consists of both goodwill of the subsidiary and the premium paid by the parent to acquire control over the subsidiary. the NCI is measured at the NCI’s proportionate share of the acquiree’s identifiable assets and liabilities. the NCI does not get a share of any equity relating to goodwill. only goodwill acquired by parent entity will be recognised.

Answer: a Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

15. The following statements are reasons as to why entities do not use the full goodwill method. Which of these statements is incorrect? a. b. c. *d.

It is more costly to measure NCI at fair value. Users of financial statements do not see any value in the reported NCI. There is insufficient evidence to assess the marginal benefits of reporting the acquisition-date fair value of the NCI. The full goodwill method results in less reliable NCI information due to difficulties in measuring NCI at fair value.

Answer: d Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

16. Under the full goodwill method, a control premium is recognised when: a. *b. c. d.

the parent paid less than the fair value for the shares they acquired. the parent paid more than the fair value for the shares they acquired. the consideration transferred by the parent is more than the fair value of the identifiable net assets acquired. the consideration transferred by the parent is less than the fair value of the identifiable net assets acquired.

Answer: b Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

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Testbank to accompany Financial reporting 3e by Loftus et al.

17. Patrick Limited paid $11 000 for 80% of the shares in Rachel Limited. At the date of acquisition Rachel Limited had equity as follows: Share capital Retained earnings Other reserves

$9 000 $2 500 $4 000

All of Rachel Limited’s assets and liabilities were recorded at fair value. The fair value of identifiable net assets acquired by Patrick Limited amounted to: a. *b. c. d.

$8 800 $10 000 $11 000 $12 500

Answer: b Feedback: (9000 + 2500 + 1000) x 80% Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

18. Marion Limited paid $180 000 for 60% of the shares in Lucia Limited. At the date of acquisition Lucia Limited had share capital of $160 000 and retained earnings of $90 000 and all of Lucia Limited’s assets and liabilities were recorded at fair value, except for plant that had a fair value of $40 000 more than its carrying amount. The company tax rate was 30%. The fair value of identifiable net assets acquired by Marion Limited amounted to: *a. b. c. d.

$166 800 $174 000 $178 000 $180 000

Answer: a Feedback: (160 000 + 90 000 + (40 000 x 0.7)) x 60% = $166 800 Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

19. When preparing a set of consolidated financial statements, the pre-acquisition entry relates to: a. b. *c. d.

both the parent and the non-controlling interest in the subsidiary. only the investment by the non-controlling interest in the subsidiary. only the investment by the parent in the subsidiary. the total investment by the parent in the subsidiary plus the after-tax effect of the investment by the non-controlling interest.

Answer: c Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

20. Which of the following statements with regards to control premium is incorrect? a. b. c. *d.

it is recognised under the full goodwill method. it is recognised only in the pre-acquisition entry. it is not recognised under the partial goodwill method. it is recognised in the business combination valuation entries.

Answer: d Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

21. Ryan Limited acquired 80% of the shares in Tully Limited for $165 000. At acquisition date, share capital in Tully was $120 000 and reserves amounted to $40 000. All assets and liabilities of Tully were recorded at fair value at acquisition date except machinery which was recorded at $20 000 below fair value. The fair value of the NCI at the date of Ryan’s acquisition was $40 000 and the full goodwill method is adopted by the group. If the company tax rate was 30%, the total amount of goodwill recorded in relation to this business combination amounts to: a. *b. c. d.

$5 000 $31 000 $26 000 $25 000

Answer: b Feedback: Net FV of Identifiable assets & liabilities = (120 000 + 40 000 + (20 000x0.7)) = 174 000. Consideration transferred + FV of NCI = 165 000 + 40 000 = 205 000. Total goodwill = 205 000 – 174 000 = 31 000. Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

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Testbank to accompany Financial reporting 3e by Loftus et al.

22. Under the partial goodwill method: a. b. c. *d.

only goodwill acquired by NCI will be recognised. the NCI is measured at fair value of the shares they own. the goodwill will be recognised in the business combination valuation entries. the NCI is measured at the NCI’s proportionate share of the fair value of acquiree’s identifiable assets and liabilities.

Answer: d Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

23. Graham Limited acquired 90% of the share capital and reserves of Terry Limited for $340,000. Share capital was $100 000 and reserves amounted to $124 000. All assets and liabilities were recorded at fair value except equipment which was recorded at $60 000 below fair value. The company tax rate was 30%. The partial goodwill method is adopted by the group. The amount of goodwill acquired by Graham Limited in this business combination was: a. b. *c. d.

$5 600 $10 000 $10 600 $26 000

Answer: c Feedback: Net FV of Identifiable assets & liabilities = (240 000 + 124 000 + (60 000x0.7)) = 366 000. Consideration transferred + NCI = 340 000 + (366 000 x 10%) = 376 600. Total goodwill = 376 600 – 366 000 = 10 600. Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

24. Graham Limited acquired 90% of the share capital and reserves of Terry Limited for $340,000. Share capital was $200 000 and reserves amounted to $124 000. All assets and liabilities were recorded at fair value except equipment which was recorded at $60 000 below fair value. The company tax rate was 30%. The partial goodwill method is adopted by the group. The NCI share of equity at the date of acquisition was: *a. b. c. d.

$16 600 $34 000 $32 400 $38 400

Answer: a Feedback: Net FV of Identifiable assets & liabilities = (240 000 + 124 000 + (60 000x0.7)) = 366 000. NCI share of equity = 366 000 x 10% Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill. © John Wiley and Sons Australia, Ltd 2020

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

25. Which of the following is not an effect of choosing the partial goodwill method over the full goodwill method? a. *b. c. d.

There will be differences in the reported amounts at acquisition date in the consolidated statements. It is more costly to measure the NCI under the partial goodwill method. Where the parent acquires some or all of NCI after obtaining control, there will be a higher impact on equity attributable to the parent shareholders. The impairment test on goodwill after acquisition will be more complex under the partial goodwill method.

Answer: b Learning objective 29.4: identify how the existence of an NCI affects the consolidation process, particularly in the measurement of goodwill.

26. A non-controlling interest in a subsidiary entity is entitled to a share of which of the following items? Subsidiary’s equity at acquisition date Changes in the subsidiary’s equity since acquisition date Changes in the subsidiary’s equity of the current period *a. b. c. d.

I Yes

II Yes

III Yes

IV Yes

Yes

I. II. III. IV.

Answer: a Learning objective 29.5: explain how the NCI is calculated in a three-step process.

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Testbank to accompany Financial reporting 3e by Loftus et al.

27. James Limited is a subsidiary of Anastasia Limited. When Anastasia acquired its 75% interest in James, the retained earnings of James were $10 000. At the beginning of the current period James Limited’s retained earnings were $40 000. James earned profit after tax of $20 000 during the current period. The total share of the non-controlling interest in the equity of James Limited at the end of the current period is: a. b. *c. d.

$7 500 $10 000 $15 000 $17 500

Answer: c Feedback: Using the 3-step process: NCI share at acquisition date = $10 000 x 25% = $2500 plus NCI share from acquisition date to beginning of current year = ($40 000 – 10 000) x 25% = $7500 plus NCI share of current period profits = $20 000 x 25% = $5000. Learning objective 29.5: explain how the NCI is calculated in a three-step process.

28. A non-controlling interest in the net assets of a subsidiary consists of the amount of those non-controlling interests at the date of the business combination: a. b. c. *d.

less 100% of any post-acquisition dividends paid. less the parent’s share of any post-acquisition dividends paid or declared. less the non-controlling proportionate share of increases in the subsidiary’s equity since the business combination. plus the non-controlling proportionate share of the changes in the subsidiary’s equity since the business combination.

Answer: d Learning objective 29.5: explain how the NCI is calculated in a three-step process.

29. The step 1 NCI entry to reflect the NCI share of equity at acquisition date: a. changes every period as a result of changes in NCI. *b. never changes, and is the same in all subsequent consolidation worksheets. c. changes every period as a result of changes in the subsidiary’s pre-acquisition equity. d. changes every period as a result of changes in the subsidiary’s post-acquisition equity. Answer: b Learning objective 29.5: explain how the NCI is calculated in a three-step process.

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

30. Changes in equity in the previous periods up to the beginning of the current period that must be identified for the step 2 NCI entry do not include: a. b. *c. d.

transfers to/from reserves. changes in share capital. dividends paid/declared. changes in retained earnings, adjusted for the impact of BCVR entries on the opening balance of retained earnings.

Answer: c Learning objective 29.5: explain how the NCI is calculated in a three-step process.

31. Changes in equity in the current period that must be identified for the step 3 NCI entry include: a. b. c. *d.

dividends paid/declared. transfers to/from reserves. profit/(loss) earned, adjusted for the impact of BCVR entries on the current profit. all of these options.

Answer: d Learning objective 29.5: explain how the NCI is calculated in a three-step process.

32. A non-controlling interest is entitled to a share of which of the following items? I. II. III. IV.

a. b. c. *d.

Equity of the group entity at acquisition date. Equity of the subsidiary at acquisition date. Current period profit or loss of the subsidiary entity. Changes in equity of the subsidiary since acquisition date and the beginning of the current financial period.

III only. I, II and III. I and II only. II, III and IV only.

Answer: d Learning objective 29.5: explain how the NCI is calculated in a three-step process.

29.11

Testbank to accompany Financial reporting 3e by Loftus et al.

33. During the previous year, a partly-owned subsidiary made a transfer from retained earnings to a general reserve. In the current year, which of the following lines would appear in the NCI journal relating to the previous year’s transfer? a. b. *c. d.

DR CR DR CR

NCI. Retained earnings. General reserve. Transfer to general reserve.

Answer: c Learning objective 29.5: explain how the NCI is calculated in a three-step process.

34. During the current year, a partly-owned subsidiary has made a transfer from retained earnings to a general reserve. Which of the following lines would appear in the NCI journal relating to the current year’s transfer? a. b. c. *d.

DR CR DR CR

NCI. General reserve. Retained earnings. Transfer to general reserve.

Answer: d Learning objective 29.5: explain how the NCI is calculated in a three-step process.

35. For an intragroup transaction to require an adjustment to the calculation of the noncontrolling interest share of equity it must have which of the following characteristics? I. II. III.

a. b. *c. d.

The transaction must result in the subsidiary recording a profit or a loss. After the transaction, the other party (not the party holding the non-controlling interest) must have on hand an asset on which unrealised profit is accrued. The initial consolidation adjustment must affect both the statement of financial position and statement of comprehensive income.

I and II only. II and III only. I, II and III. None of the above.

Answer: c Learning objective 29.5: explain how the NCI is calculated in a three-step process.

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

36. Parsley Limited owns 90% of the share capital of Sage Limited. Sage Limited paid a dividend of $60 000 during the financial period. The NCI adjustment entries in the consolidation worksheet for the dividend include: *a. b. c. d.

DR NCI $6 000. DR Dividend revenue $6 000. DR Dividend paid $6 000. DR Dividend payable $6 000.

Answer: a Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

37. Angus Limited owns 80% of the share capital of Boris Limited. Boris Limited paid a dividend of $150 000 during the financial period. The adjustment entries in the consolidation worksheet for the dividend include: a. *b. c. d.

DR Dividend paid DR Dividend revenue DR Dividend payable DR Dividend receivable

$150 000. $120 000. $120 000. $150 000.

Answer: b Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

38. Kenny Ltd holds a 60% interest in Swan Ltd. Kenny Ltd sells inventory to Swan Ltd during the year for $40 000. The inventories originally cost Kenny Ltd $32 000 when purchased from an external party. At the end of the year 50% of the inventories are still on hand. The tax rate is 30%. The NCI adjustment required in relation to this intragroup transaction is a debit to NCI of: *a. b. c. d.

Nil. $1 120 $2 240 $2 800

Answer: a Feedback: There is no NCI adjustment as the sale of inventories was from the parent to the subsidiary. Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

29.13

Testbank to accompany Financial reporting 3e by Loftus et al.

39. Maddie Ltd holds 80% interest in Emily Ltd. Emily Ltd sells inventory to Maddie Ltd during the year for $15 000. The inventories originally cost $13 000 when purchased from an external party. At the end of the year all inventories are still on hand. The tax rate is 30%. The NCI adjustment to this intragroup transaction is a debit to NCI of: a. *b. c. d.

Nil. $280 $400 $600

Answer: b Feedback: Reduction of current period after-tax profit = ($15000 - $13000) x (1-30%) = $1400. NCI share at 20% = $1400 x 20% = $280 Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

40. Maddie Ltd holds 80% interest in Emily Ltd. Emily Ltd sells inventory to Maddie Ltd during the year for $15 000. The inventories originally cost $13 000 when purchased from an external party. At the end of the year 50% of the inventories are still on hand. The tax rate is 30%. The NCI adjustment required in relation to this transaction is a debit to NCI of: *a. b. c. d.

$140 $700 $1000 Nil.

Answer: a Feedback: Reduction of current period’s ‘unrealised’ after-tax profit = ($15000 - $13000) x 50% x (1-30%) = $700. NCI share at 20% = $700 x 20% = $140. Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

41. Maddie Ltd holds 80% interest in Emily Ltd. Emily Ltd sells inventory to Maddie Ltd during the year for $15 000. The inventories originally cost $13 000 when purchased from an external party. At the end of the year all inventories are still on hand, but were sold by the end of the next period. The tax rate is 30%. The NCI adjustment required in relation to this intragroup transaction at the end of the next period is a credit to Retained earnings (opening balance) of: a. b. c. *d.

Nil. $1400 $2000 $280

Answer: d Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI. © John Wiley and Sons Australia, Ltd 2020

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

42. In respect to the intragroup services, any profit or loss is regarded as: a. *b. c. d.

unrealised. immediately realised. insignificant and so not adjusted on consolidation. extraordinary and so ignored for consolidation reporting purposes.

Answer: b Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

43. Which of the following statements is correct? a. *b. c. d.

All intragroup transactions have an impact on the NCI share of equity. Transactions that do not affect profit will not give rise to an adjustment to the NCI. When the parent entity sells inventories to its subsidiary, a consolidation adjustment needs to be recorded to reduce the NCI. The NCI is not entitled to share the group’s profit.

Answer: b Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

44. In respect to the intragroup services provided by a partly-owned subsidiary to the parent, the NCI adjustment required is a debit to NCI of: *a. b. c. d.

Nil. the service fees. the service fees multiplied by the NCI ownership interest. the service fees multiplied by the parent’s ownership interest.

Answer: a Feedback: There is no adjustment to the NCI as the profit is considered to be immediately realised. Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

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Testbank to accompany Financial reporting 3e by Loftus et al.

45. Ryan Ltd holds a 75% interest in Tully Ltd. On 30 June 2021 Tully Ltd transferred a depreciable non-current asset to Ryan Ltd at a profit of $15 000. The remaining useful life of the asset at the date of transfer was 5 years and the tax rate is 30%. The impact of the above transaction on the NCI share of profit at 30 June 2021 is: a. b. *c. d.

an increase of $2 625 an increase of $3 750 a decrease of $2 625 a decrease of $3 750

Answer: c Feedback: Unrealised after-tax profit at 30 June 2021 (the date of sale) = $15 000 x 70% = $10 500. NCI share of unrealised profit = $10 500 x 25% = $2625. Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

46. Ryan Ltd holds a 75% interest in Tully Ltd. On 1 July 2021, Tully Ltd transferred a depreciable non-current asset to Ryan Ltd at a profit of $15 000. The remaining useful life of the asset at the date of transfer was 5 years and the tax rate is 30%. The impact of the above transaction on the NCI share of profit for the year ended 30 June 2022 is: a. b. c. *d.

an increase of $3 000 an increase of $2 100 a decrease of $3 000 a decrease of $2 100

Answer: d Feedback: Unrealised after-tax profit at 30 June 2021 (the date of sale) = $15 000 x 70% = $10 500. NCI share of unrealised profit = $10 500 x 25% = $2625. NCI share of realised profit (depreciation) = $2625/5years = $525. NCI share of the net unrealised profit = $2625 - $525 = $2100. Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

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Chapter 29: Consolidation: non-controlling interest Not for distribution in full. Instructors may assign selected questions in their LMS.

47. Ryan Ltd holds a 75% interest in Tully Ltd. On 1 July 2021, Tully Ltd transferred a depreciable non-current asset to Ryan Ltd at a profit of $15 000. The remaining useful life of the asset at the date of transfer was 5 years and the tax rate is 30%. The impact of the above transaction on the NCI for the year ended 30 June 2023 is: a. *b. c. d.

an increase of $1 050. a decrease of $1 050. an increase of $1 500. a decrease of $1 500.

Answer: b Feedback: NCI share of depreciation adjustment = ($15 000 / 5) x 0.7 x 25% x 2years = $1050 Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

48. The intragroup transactions considered for NCI are normally those involving: a. b. *c. d.

the NCI selling inventories items or non-current assets to the parent for a profit or loss. the parent selling inventories items or non-current assets to the subsidiary for a profit or loss. the subsidiary selling inventories items or non-current assets to the parent for a profit or loss. all of these options are correct.

Answer: c Learning objective 29.6: identify how the existence of intragroup transactions affects the measurement of the NCI.

49. If a gain on bargain purchase arises on a business combination, the non-controlling interest: *a. b. c. d.

receives no share of the gain. is allocated 100% of the gain. is entitled to a proportionate share of the gain based on its level of share ownership. receives a proportionate share of the gain after adjustments for tax effects have been made.

Answer: a Learning objective 29.7: explain how a gain on bargain purchase affects the measurement of the NCI.

29.17

Testbank to accompany Financial reporting 3e by Loftus et al.

50. North Limited acquired 80% of the shares in South Limited for $100 000. At acquisition date, share capital in South was $90 000 and reserves amounted to $50 000. All assets and liabilities of South were recorded at fair value at acquisition date. The partial goodwill method is adopted by the group. If the company tax rate was 30%, the NCI will recognise a gain on bargain purchase of: a. b. c. *d.

$12 000 $8 000 $2 400 Nil.

Answer: d Feedback: The NCI does not receive any share of the gain on bargain purchase. Learning objective 29.7: explain how a gain on bargain purchase affects the measurement of the NCI.

51. In accordance with the AASB 12 Disclosure of Interests in Other Entities, which of the following information relating to the NCI is not required to be disclosed? a. b. *c. d.

The profit or loss allocated to NCI of the subsidiary during the reporting period. The proportion of ownership interests held by NCI. The total number of shares owned by the NCI. The name of the subsidiary.

Answer: c Learning objective 29. 8: identify the disclosures required in relation to the NCI.

29.18

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 30: Consolidation: other issues

Chapter 30: Consolidation: other issues Comprehension questions 1. Discuss the two types of NCI that may exist in a multiple subsidiary group structure. One feature of multiple subsidiary structures where a parent has an interest in a subsidiary that is itself a parent of another subsidiary is the need to classify the NCI ownership in the subsidiaries into direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI). A DNCI exists where the NCI owns shares in a subsidiary. An INCI exists in a subsidiary where that subsidiary is owned by a partially owned subsidiary in the group. The NCI in the partially owned subsidiary is the INCI in the other subsidiary. Example: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

2. Explain the difference in the calculation of the direct and indirect NCI. Direct NCI receives a proportionate share of all equity of the subsidiary over which it has direct ownership interest. Indirect NCI receives a proportionate share of only the post-acquisition equity of the subsidiary over which it has indirect ownership interest. The post-acquisition equity refers to the equity generated after the INCI is considered to be entitled to the indirect ownership; that is, after the multiple subsidiary structure was created. Remember that in calculating the NCI share of equity, it is the consolidated equity rather than recorded equity on which the NCI is calculated. Hence, in calculating both the DNCI and INCI share of equity, adjustments must be made to eliminate any unrealised profits/losses arising from transactions within the group. In adjusting the NCI for the effects of intragroup transactions, generally there is no difference between INCI and DNCI. However, where dividends are paid/payable by a subsidiary containing an INCI, adjustments are necessary to ensure no double counting occurs. The calculation of the DNCI share of equity is therefore the same as the calculation of NCI illustrated in chapter 29. The extra adjustments have to be made for the INCI as it receives a share of post-acquisition equity only.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3. Why does the indirect NCI receive a share of only post-acquisition equity? Assume: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

The DNCI in A Ltd receives a share of the whole of the equity of A Ltd which includes equity relating to the asset “Shares in B Ltd”. This asset reflects the assets of B Ltd that were on hand in B Ltd at the date A Ltd acquired its shares in B Ltd. The pre-acquisition equity of B Ltd also relates to these assets. As the DNCI receives a share of the equity of A Ltd relating to these assets, and as the DNCI in A Ltd is the same party as the INCI in B Ltd, to give the DNCI a share of all the equity of A Ltd as well as the INCI in B Ltd getting a share of the pre-acquisition equity of B Ltd would double-count the share of equity to the NCI. As the investment account “Shares in B Ltd” only relates to the pre-acquisition equity of B Ltd, the INCI is then entitled to a share of the post-acquisition equity of B Ltd.

4. What effect does the existence of a direct and an indirect NCI have on the adjustments for intragroup transactions? Assume: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

The adjustments for the effects of transactions within the group in structures such as in above are the same as those for the two-company structure illustrated in chapter 29. The effects of the transactions must be adjusted in full regardless of the amount of NCI existing in any entity. What must be considered is the effect on the NCI of such adjustments. The key to this is determining which entity recorded the profit on the transaction. Using the structure in the figure above: (4) if A Ltd earned the profit/loss — whether by selling to P Ltd or B Ltd — the NCI adjustment is based on the 20% DNCI in A Ltd. (5) if B Ltd made the profit/loss — whether by selling to P Ltd or A Ltd — the NCI adjustment is based on the total NCI in B Ltd of 52% — that is, the sum of the 40% DNCI and 12% INCI. The effect on the adjustments for intragroup transactions of the existence of indirect NCI is the same as that for DNCI except in the case of dividends – see 5. below.

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Chapter 30: Consolidation: other issues

5. What effect does the existence of a direct and an indirect NCI have on the adjustments for dividends paid within a group? Assume: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

If B Ltd pays/declares a dividend and dividend revenue is recognised by A Ltd, then the share of equity attributed to the DNCI in A Ltd must be adjusted for the dividend revenue recognised by A Ltd using an entry as follows: NCI

Dr Cr

NCI share of profit/loss

x x

The INCI in B Ltd is given a share of the post-acquisition profits of B Ltd prior to the appropriation of any dividend. The INCI in B Ltd is unaffected by any NCI adjustments for dividends paid/declared by B Ltd – only DNCI in B Ltd is affected. The profits of B Ltd are then used to pay dividends to A Ltd and recognised as revenue by A Ltd. Hence the profits of B Ltd are now also being shown in A Ltd as dividend revenue. To give the INCI in B Ltd a share of the profits of B Ltd as well as give the DNCI in A Ltd a share of the profits of A Ltd including the dividend revenue from B Ltd would double count the NCI share of equity. Hence the above adjustment is required, reducing the NCI share in total as well as the NCI share of current period profit/loss. In conclusion, in calculating the NCI share of equity where dividends are paid/payable within the group, adjustments may be necessary to ensure double counting for INCI’s share of dividends does not occur.

6. Explain sequential and non-sequential acquisitions. Assume: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

A sequential acquisition occurs when P Ltd acquires its shares in A Ltd prior to or at the same time as A Ltd acquires its shares in B Ltd. A non-sequential acquisition occurs when A Ltd acquires its shares in B Ltd prior to P Ltd acquiring its shares in A Ltd.

30.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

7. Explain the effects on the consolidation process when the acquisition is non-sequential. Assume: 80% P Ltd

60% A Ltd

B Ltd

P Ltd 80% DNCI 20%

P Ltd 48% DNCI 40% INCI 12%

A non-sequential acquisition occurs when A Ltd acquires its shares in B Ltd prior to P Ltd acquiring its shares in A Ltd. The complicating factor with such an acquisition is that when P Ltd acquires its shares in A Ltd one of the assets of A Ltd is “Shares in B Ltd”, and its carrying amount may be different from its fair value due to an increase in the net assets of B Ltd subsequent to A Ltd’s acquisition of shares in B Ltd. As a result, in preparing the acquisition analysis of P Ltd – A Ltd the post-acquisition equity recognised by B Ltd and any differences between carrying amounts and fair values of B Ltd’s assets and liabilities must be taken into account.

8. Explain how to account for further acquisition of shares by a parent in a subsidiary. Where the parent acquires additional shares in a subsidiary there is no change in the economic entity. Both the parent and the subsidiary are still within the economic entity. These changes in ownership interests cannot then give rise to gains or losses to the economic entity. They are accounted for as equity transactions, as they are transactions between the owners and not with entities outside the group. Where the parent acquires additional shares in the subsidiary this transaction is not a business combination as the parent already had control of the subsidiary. Hence, there is no need to adjust the identifiable assets and liabilities of the subsidiary to fair values or to measure goodwill in relation to the transaction involving acquisition of additional shares. Note paragraphs 23 and B96 of AASB 10/IFRS 10: Paragraph 23: Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as owners). Paragraph B96: When the proportion of the equity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests to reflect the changes in their relative interests in the subsidiary. The entity shall recognise directly in equity any difference between the amount by which the non-controlling interests are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent. Hence, when such transactions occur: • the carrying amounts of the parent’s interest and the NCI are adjusted to reflect the change in the respective ownership interests

30.5

Chapter 30: Consolidation: other issues

•

where the consideration paid by the parent on acquisition of shares in the subsidiary exceeds the carrying value of the relevant interest in the subsidiary sold to the parent, the difference is recognised directly in equity and is attributable to the parents interest.

The parent and the NCI will negotiate the consideration paid on these transactions based on an assessment of the fair value of the subsidiary. In contrast, the relative interests of the parent and the NCI in the subsidiary, as reflected in the consolidated financial statements, are based on the carrying amounts of the net assets of the subsidiary. It is this difference that gives rise to the amount being recognised directly in equity. This method of accounting for the relative interests applies in all circumstances, regardless of whether the measurement of the NCI is based on the full or partial goodwill method.

9. Explain how to account for sales of shares by a parent in a subsidiary that do not result in loss of control. Where the parent sells shares in a subsidiary without losing control there is no change in the economic entity. Both the parent and the subsidiary are still within the economic entity. These changes in ownership interests cannot then give rise to gains or losses to the economic entity. They are accounted for as equity transactions, as they are transactions between the owners and not with entities outside the group. Where the parent sells shares in the subsidiary this transaction is not a business combination as the parent already had control of the subsidiary. Hence, there is no need to adjust the identifiable assets and liabilities of the subsidiary to fair values or to measure goodwill in relation to the transaction involving acquisition of additional shares. Note paragraphs 23 and B96 of AASB 10/IFRS 10: Paragraph 23: Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as owners). Paragraph B96: When the proportion of the equity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests to reflect the changes in their relative interests in the subsidiary. The entity shall recognise directly in equity any difference between the amount by which the non-controlling interests are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent. Hence, when such transactions occur: • the carrying amounts of the parent’s interest and the NCI are adjusted to reflect the change in the respective ownership interests • where the consideration received by the parent on sale of shares in the subsidiary exceeds the carrying value of the relevant interest in the subsidiary sold by the parent, the difference is recognised directly in equity and is attributable to the parent’s interest. The parent and the NCI will negotiate the consideration paid on these transactions based on an assessment of the fair value of the subsidiary. In contrast, the relative interests of the parent and the NCI in the subsidiary, as reflected in the consolidated financial statements, are based

30.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

on the carrying amounts of the net assets of the subsidiary. It is this difference that gives rise to the amount being recognised directly in equity. This method of accounting for the relative interests applies in all circumstances, regardless of whether the measurement of the NCI is based on the full or partial goodwill method.

10. Explain how to account for changes in ownership interests by a parent in a group that result in loss of control. A parent may lose control of a subsidiary for a number of reasons, such as: • it may sell shares in the subsidiary such that another entity has the controlling interest • there may be a change in the dispersion in the holding of shares by entities comprising the NCI such that a parent with less than a 50% holding loses control • a subsidiary may become subject to the control of a government, court, administrator or regulator • there may be a change in a contractual arrangement. Having lost control, but retained an investment in the former subsidiary, in accordance with paragraph 25 of AASB 10/IFRS 10, the investor will record that remaining investment in accordance with AASB 9/IFRS 9 Financial Instruments, namely at fair value. The measurement of the remaining asset at fair value is factored into the calculation of any gain/loss on disposal of the shares in the subsidiary. In accordance with paragraphs 25 and B98 of AASB 10/IFRS 10, when the parent losses control as a result of changes in ownership interests, the parent will: • derecognise the assets and liabilities of the former subsidiary based on the carrying amounts at the date when control was lost • derecognise the carrying amount of any NCI in the former subsidiary at the date when control was lost • recognise the fair value of the consideration received • recognise any investment retained in the former subsidiary at its fair value at the date when control was lost • recognise any gain/loss in profit or loss attributable to the parent. The gain/loss from the group’s perspective is calculated as: • Gain/loss = fair value of the proceeds (if any) from the transaction that resulted in loss of control + fair value of any retained investment in the former subsidiary at the date when control is lost – parent’s share of the carrying amount in the group of the net assets at the date when control is lost. If the group uses the full goodwill method in relation to the NCI then on consolidation the goodwill relating to the control premium is also recognised (via the pre-acquisition entry adjustment in the consolidation worksheet). This goodwill is also included in the parent’s share of the carrying amount in the group of the net assets at the date the control is lost.

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Chapter 30: Consolidation: other issues

11. What are the disclosure requirements relating to changes in ownership interest by a parent in a group? AASB 12/IFRS 12 Disclosure of Interests in Other Entities requires disclosures to be made where there are changes in ownership interests. Paragraph 18 of AASB 12/IFRS 12 sets out the disclosure required where there are changes in a parent’s ownership interest in a subsidiary that do not result in a loss of control: • An entity shall present a schedule that shows the effects on the equity attributable to owners of the parent of any changes in its ownership interest in a subsidiary that do not result in a loss of control. Paragraph 19 of AASB 12/IFRS 12 sets out the disclosure required where a parent loses control of a subsidiary during the reporting period: • An entity shall disclose the gain or loss, if any, calculated in accordance with paragraph 25 of AASB 10, and: (a) the portion of that gain or loss attributable to measuring any investment retained in the former subsidiary at its fair value at the date when control is lost; and (b) the line item(s) in profit or loss in which the gain or loss is recognised (if not presented separately).

30.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 30.1 Non-controlling interest P Ltd owns 20% of B Ltd. In recent months it has been in takeover discussions with A Ltd, and agreement has finally been reached between the different parties on the acquisition by P Ltd of 60% of the issued shares of A Ltd. One of the assets of A Ltd is a 70% holding in B Ltd. The group accountant of P Ltd has been examining the new group under the control of P Ltd and considering the implications for the preparation of consolidated financial statements. One of the members of the accounting team, Mei Fen, has raised the issue of accounting for indirect non-controlling interests. According to Mei Fen, with the new group structure there are both direct and indirect non-controlling interests, and she argues that different measurements are then required. The group accountant has asked you to determine the non-controlling interests in the new group, differentiating between different non-controlling interest groups, and to explain the difference, if any, in the calculation of their interests in group equity. Required Prepare a report for the group accountant. The ownership interests are as follows. P Ltd 20% 60% A Ltd

70%

A Ltd:

DNCI = 40% P Ltd = 60%

B Ltd:

DNCI = 10% INCI = 28% P Ltd = 62%

B Ltd

Direct NCI receives a share of all equity of the subsidiary while indirect NCI receive a share of only post-acquisition equity. In adjusting the NCI for the effects of intragroup transactions, generally there is no difference between INCI and DNCI. However, where dividends are paid/payable by a subsidiary containing an INCI, adjustments are necessary to ensure no double counting occurs. The DNCI in A Ltd receives a share of the whole of the equity of A Ltd which includes equity relating to the asset “Shares in B Ltd”. This asset reflects the assets of B Ltd that were on hand in B Ltd at the date A Ltd acquired its shares in B Ltd. The pre-acquisition equity of B Ltd also relates to these assets. As the DNCI receives a share of the equity of A Ltd relating to these assets, and as the DNCI in A Ltd is the same party as the INCI in B Ltd, to give the DNCI a

30.9

Chapter 30: Consolidation: other issues

share of all the equity of A Ltd as well as the INCI in B Ltd getting a share of the pre-acquisition equity of B Ltd would double-count the share of equity to the NCI. As the investment account “Shares in B Ltd” only relates to the pre-acquisition equity of B Ltd, the INCI is then entitled to a share of the post-acquisition equity of B Ltd.

30.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 30.2 Dividends and non-controlling interests Andrew Brown is the group accountant for P Ltd. P Ltd owns 60% of A Ltd which owns 70% of B Ltd. He has just completed the preparation of the consolidated financial statements of the group, and is discussing issues raised by the auditors. The auditors have raised concerns about the accounting for a dividend paid by B Ltd to A Ltd in the current period. They argue that further consolidation adjustments are necessary to avoid doublecounting the non-controlling interest’s share of equity. Andrew has asked for your advice concerning the effect of the payment of such a dividend on the determination of the noncontrolling interest share of equity. Required Write a report to Andrew explaining the non-controlling interests that exist within the group, and how the calculation of their interests is affected by payment of dividends within the group. 60% 70% P Ltd A Ltd B Ltd P Ltd 60% P Ltd 42% DNCI 40% DNCI 30% INCI 28% If B Ltd pays/declares a dividend and dividend revenue is recognised by A Ltd, then the share of equity attributed to the DNCI in A Ltd must be adjusted for the dividend revenue recognised by A Ltd using an entry of the order: NCI NCI share of profit/loss

Dr Cr

x x

The INCI in B Ltd is given a share of the post-acquisition profits of B Ltd prior to the appropriation of any dividend. The INCI in B Ltd is unaffected by any NCI adjustments for dividends paid/declared by B Ltd – only DNCI in B is affected. The profits of B Ltd are then used to pay dividends to A Ltd and recognised as revenue by A Ltd. Hence the profits of B Ltd are now also being shown in A Ltd as dividend revenue. To give the INCI in B Ltd a share of the profits of B Ltd as well as give the DNCI in A Ltd a share of the profits of A Ltd including the dividend revenue from B Ltd would double count the NCI share of equity. Hence the above adjustment is required, reducing the NCI share in total as well as the NCI share of current period profit/loss.

30.11

Chapter 30: Consolidation: other issues

Case study 30.3 Changes in ownership interests At 1 July 2021, Christina Ltd acquires 60% of the issued shares of Adeline Ltd, enough to give Christina Ltd control. At 30 June 2022, Christina Ltd acquires a further 10%. One year later, on 30 June 2023, Christina Ltd sells 20% of the issued shares of Adeline Ltd, but because of the dispersion of the other shareholders, it still controls Adeline Ltd. On 30 June 2024, Christina Ltd further sells 30% of the issued shares in Adeline Ltd and loses control. Required Write a report explaining the accounting treatment of the changes in the ownership interest by Christina Ltd in Adeline Ltd at different points in time. At 1 July 2021, Christina Ltd becomes the parent for Adeline Ltd and from then on it may need to prepare consolidated financial statements to show the financial position and performance of the combined entity. In those financial statements, Christina Ltd’s share of consolidated equity will be disclosed separately from the non-controlling interest’s share. As discussed in chapter 29, AASB 10/IFRS 10 requires both the parent interest and the NCI to be classified as equity. Where Christina Ltd acquires additional shares in Adeline Ltd (on 30 June 2022) or where it sells shares in Adeline Ltd but still retains control (on 30 June 2023), there is no change in the economic entity. Both Christina Ltd and Adeline Ltd are still within the economic entity. These changes in ownership interests cannot then give rise to gains or losses to the economic entity. They are accounted for as equity transactions, as they are transactions between the owners and not with entities outside the group. Where Christina Ltd acquires additional shares in Adeline Ltd this transaction is not a business combination as Christina Ltd already had control of Adeline Ltd. Hence, there is no need to adjust the identifiable assets and liabilities of the subsidiary to fair values or to measure goodwill in relation to the transaction involving acquisition of additional shares. Note paragraphs 23 and B96 of AASB 10/IFRS 10: Paragraph 23: Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as owners). Paragraph B96: When the proportion of the equity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests to reflect the changes in their relative interests in the subsidiary. The entity shall recognise directly in equity any difference between the amount by which the non-controlling interests are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent. Hence, when such transactions occur: • the carrying amounts of the parent’s interest and the NCI are adjusted to reflect the change in the respective ownership interests • where the consideration paid or received by the parent on acquisition or sale of shares in the subsidiary exceeds the carrying value of the relevant interest in the subsidiary sold to

30.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

the parent or sold by the parent, the difference is recognised directly in equity and is attributable to the parent’s interest. The parent and the NCI will negotiate the consideration paid on these transactions based on an assessment of the fair value of the subsidiary. In contrast, the relative interests of the parent and the NCI in the subsidiary, as reflected in the consolidated financial statements, are based on the carrying amounts of the net assets of the subsidiary. It is this difference that gives rise to the amount being recognised directly in equity. This method of accounting for the relative interests applies in all circumstances, regardless of whether the measurement of the NCI is based on the full or partial goodwill method. On 30 June 2024, having lost control over Adeline Ltd as a result of the sale of a further 30% of the shares, but retained an investment in the former subsidiary, in accordance with paragraph 25 of AASB 10/IFRS 10, Christina Ltd will record that remaining investment in accordance with AASB 9/IFRS 9 Financial Instruments, namely at fair value. The measurement of the remaining asset at fair value is factored into the calculation of any gain/loss on disposal of the shares in the subsidiary. In accordance with paragraphs 25 and B98 of AASB 10/IFRS 10, Christina Ltd will: 1. derecognise the assets and liabilities of the former subsidiary based on the carrying amounts at the date when control was lost 2. derecognise the carrying amount of any NCI in the former subsidiary at the date when control was lost 3. recognise the fair value of the consideration received 4. recognise any investment retained in the former subsidiary at its fair value at the date when control was lost 5. recognise any gain/loss in profit or loss attributable to the parent. The gain/loss from the group’s perspective is calculated as: • Gain/loss = fair value of the proceeds (if any) from the transaction that resulted in loss of control + fair value of any retained investment in the former subsidiary at the date when control is lost – parent’s share of the carrying amount in the group of the net assets at the date when control is lost. If the group uses the full goodwill method in relation to the NCI then on consolidation the goodwill relating to the control premium is also recognised (via the pre-acquisition entry adjustment in the consolidation worksheet). This goodwill is also included in the parents’ share of the carrying amount in the group of the net assets at the date the control is lost.

30.13

Chapter 30: Consolidation: other issues

Application and analysis exercises Exercise 30.1 Calculation of the non-controlling interest, multiple subsidiaries, acquisitions on the same date On 1 July 2020, Fiji Ltd acquired 75% of the issued shares of India Ltd at a cost of $560 000 and India Ltd acquired 80% of the issued shares of Japan Ltd at a cost of $270 000. At acquisition date, the equity of India Ltd and Japan Ltd was as follows. India Ltd Share capital

Japan Ltd

$ 300 000

280 000

General reserve

40 000

—

Retained earnings

100 000

40 000

At 1 July 2020, all identifiable assets and liabilities of India Ltd and Japan Ltd were recorded at fair value. On 30 June 2022, India Ltd transferred the general reserve to retained earnings and declared a dividend of $40 000 which was paid on 1 November 2022. On 30 June 2024, India Ltd and Japan Ltd provided the following information. India Ltd Profit before income tax

Japan Ltd

96 000

64 000

Income tax expense

40 000

30 000

Profit

56 000

34 000

Retained earnings (1/7/23)

150 000

84 000

206 000

118 000

—

40 000

Dividend paid

20 000

—

Dividend declared

30 000

20 000

50 000

60 000

Transfer to general reserve

Retained earnings (30/6/24)

156 000

58 000

Required Calculate the non-controlling interest share of retained earnings at 30 June 2024 for India Ltd and Japan Ltd. (LO3)

30.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

75% Fiji Ltd

80% India Ltd Fiji Ltd 75% DNCI 25%

Japan Ltd Fiji Ltd 60% DNCI 20% INCI 20%

1. NCI share of equity in India Ltd at 1/7/20: Retained earnings (1/7/23) Share capital General reserve NCI

Dr Dr Dr Cr

25 000 75 000 10 000 110 000

2. NCI share of equity in India Ltd: 1/7/20 – 30/6/23: Retained earnings (1/7/23) General reserve NCI (RE: 25% x ($150 000 - $100 000))

Dr Cr Cr

12 500 10 000 2 500

3. NCI share of equity in India Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (25% x $56 000)

Dr Cr

14 000

NCI

Dr Cr

5 000

Dr Cr

7 500

Dr Cr

4 000

Dividend paid (25% x $20 000) NCI Dividend declared (25% x $30 000) NCI NCI share of profit (25% x 80% x $20 000)

14 000

5 000

7 500

4 000

Acquisition analysis: India Ltd – Japan Ltd: At 1 July 2020: Net fair value of identifiable assets and liabilities of Japan Ltd (a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

$320 000 $270 000 20% x $320 000 $64 000 $334 000 $14 000

30.15

Chapter 30: Consolidation: other issues

In the pre-acquisition entry at 30/6/24, the following adjustment would be made: Retained earnings (1/7/23)* *80% x $40 000

32 000

Dr Dr Cr

8 000 56 000

1. DNCI share of equity in Japan Ltd at 1/7/20: Retained earnings (1/7/23) Share capital NCI

64 000

2. NCI share of equity of Japan Ltd: 1/7/20 – 30/6/23: Retained earnings (1/7/23) NCI (DNCI: 20% x ($84 000 - $40 000))

Dr Cr

8 800

Retained earnings (1/7/23) Dr NCI Cr (INCI: 20% x ($84 000 - $32 000/0.8))

8 800

3. NCI share of equity in Japan Ltd from 1/7/23 – 30/6/24: NCI share of profit NCI (DNCI: 20% x $34 000)

Dr Cr

6 800

NCI share of profit NCI (INCI: 20% x $34 000)

Dr Cr

6 800

NCI

Dr Cr

4 000

Dr Cr

16 000

Dividend declared (20% x $20 000) General reserve Transfer to general reserve ((20% + 20%) x $40 000)

6 800

4 000

16 000

The total NCI share of Retained Earnings at 30 June 2024 of India Ltd is $35 000 ($25 000 + $12 500 + $14 000 - $5 000 - $7 500 - $4 000). The total NCI share of Retained Earnings at 30 June 2024 of Japan Ltd is $19 200 ($8 000 + $8 800 + $8 800 + $6 800 + $6 800 - $4 000 - $16 000). The total NCI share of Retained Earnings at 30 June 2024 is $54 200.

30.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.2 Consolidation worksheet entries, multiple subsidiaries, acquisitions on the same date On 1 July 2020, Laos Ltd acquired 70% of the issued shares of Maldives Ltd for $100 000 and Maldives Ltd acquired 60% of the issued shares of Malaysia Ltd for $70 000. The equity of the companies at 1 July 2020 was as follows.

At 1 July 2020, all the identifiable assets and liabilities of both Maldives Ltd and Malaysia Ltd were recorded at fair value. At 30 June 2023, the financial data of the three companies were as follows. Laos Ltd Sales revenue

120 000

Maldives Ltd $

102 000

Malaysia Ltd $

84 000

Other revenue

60 000

44 000

36 000

Total revenues

180 000

146 000

120 000

Cost of sales

90 000

80 000

72 000

Other expenses

60 000

41 000

26 000

Total expenses

150 000

121 000

98 000

Profit before income tax

30 000

25 000

22 000

Income tax expense

8 000

5 000

Profit for the period

22 000

17 000

Retained earnings (1/7/22)

55 000

46 000

25 000

Total available for appropriation

77 000

63 000

42 000

Dividend paid

15 000

10 000

5 000

Retained earnings (30/6/23)

62 000

53 000

37 000

Share capital

148 000

100 000

80 000

Net assets

210 000

153 000

117 000

Since 1 July 2020, the following transactions have occurred between the three companies. • On 1 July 2022, Malaysia Ltd sold a motor vehicle to Maldives Ltd for $25 000. The carrying amount of the vehicle at the date of sale was $23 000. Vehicles are depreciated at 30% p.a. on a straight-line basis. • During the year ended 30 June 2023, Maldives Ltd sold inventories valued at $20 000 to Laos Ltd, this having cost Maldives Ltd $15 000. Half of these inventories are still on hand at 30 June 2023. The tax rate is 30%.

30.17

Chapter 30: Consolidation: other issues

Required Prepare the consolidation worksheet journal entries for the year ended 30 June 2023. (LO3) 70% Laos Ltd

60% Maldives Ltd DNCI 30%

Malaysia Ltd DNCI 40% INCI 18%

Acquisition analysis: Laos Ltd – Maldives Ltd: At 1 July 2020: Net fair value of identifiable assets and liabilities of Maldives Ltd

= = = = = = =

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

$100 000 + $40 000 $140 000 $100 000 30% x $140 000 $42 000 $142 000 $2 000

1. Pre-acquisition entry – 30 June 2023: Retained earnings (1/7/22) Share capital Goodwill Shares in Maldives Ltd

Dr Dr Dr Cr

28 000 70 000 2 000 100 000

2. NCI share of equity in Maldives Ltd at 1/7/20: Retained earnings (1/7/22) Share capital NCI

Dr Dr Cr

12 000 30 000 42 000

3. NCI share of equity in Maldives Ltd: 1/7/20 – 30/6/22: Retained earnings (1/7/22) NCI (30% x ($46 000 - $40 000))

Dr Cr

1 800 1 800

4. NCI share of equity in Maldives Ltd: 1/7/22 – 30/6/23: NCI share of profit NCI (30% x $17 000)

Dr Cr

5 100

NCI

3 000

5 100

30.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dividend paid (30% x $10 000)

NCI

Dr Cr

NCI share of profit (30% x 60% x $5 000)

3 000

900 900

Acquisition analysis: Maldives Ltd – Malaysia Ltd: At 1 July 2020: Net fair value of identifiable assets and liabilities of Malaysia Ltd (a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = = =

$80 000 + $30 000 $110 000 $70 000 40% x $110 000 $44 000 $114 000 $4 000

5. Pre-acquisition entry – 30 June 2023: Retained earnings (1/7/22) Share capital Goodwill Shares in Malaysia Ltd

Dr Dr Dr Cr

18 000 48 000 4 000 70 000

6. NCI share of equity in Malaysia Ltd at 1/7/20: Retained earnings (1/7/22) Share capital NCI

Dr Dr Cr

12 000 32 000 44 000

7. NCI share of equity in Malaysia Ltd: 1/7/20 – 30/6/22: NCI

Dr Cr

2 000

Dr Retained earnings (1/7/22) Cr (INCI: 18% x ($25 000 - $18 000/0.6))

900

Retained earnings (1/7/22) (DNCI: 40% x ($25 000 - $30 000)) NCI

2 000

900

8. NCI share of equity in Malaysia Ltd: 1/7/22 – 30/6/23: NCI share of profit NCI (DNCI: 40% x $17 000)

Dr Cr

6 800

NCI share of profit

3 060

6 800

30.19

Chapter 30: Consolidation: other issues

NCI (INCI: 18% x $17 000)

NCI

Dr Cr

Dividend paid (40% x $5 000)

3 060

2 000 2 000

9. Dividend paid: Maldives Ltd: Malaysia Ltd: Dividend revenue Dividend paid

70% x $10 000 = $7 000 60% x $5 000 = $3 000 Dr Cr

10 000 10 000

10. Sale of inventories: Maldives Ltd – Laos Ltd: Sales

Dr Cr Cr

20 000

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

750

Dr Cr

525

17 500 2 500

750

11. NCI adjustment: NCI NCI share of profit (30% x $1 750)

525

12. Sale of motor vehicle: Malaysia Ltd – Maldives Ltd: Proceeds on sale of motor vehicle Carrying amount of vehicle Motor vehicle

Dr Cr Cr

25 000

Deferred tax asset Income tax expense

Dr Cr

600

Dr Cr

812

Dr Cr

600

180

23 000 2 000

600

13. NCI adjustment: NCI NCI share of profit ((40% + 18%) x ($2 000 – $600)) 14. Depreciation of motor vehicle: Accumulated deprec. – motor vehicle Depreciation expense (30% x $2 000) Income tax expense

812

600

30.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Deferred tax asset

180

15. NCI adjustment: NCI share of profit NCI ((40% + 18%) x ($600-$180))

Dr Cr

244

30.21

Chapter 30: Consolidation: other issues

Exercise 30.3 Consolidation worksheet entries, multiple subsidiaries, acquisitions on the same date On 1 July 2021, Canada Ltd acquired 80% of the issued shares of China Ltd and China Ltd acquired 75% of the issued shares of Chile Ltd. All shares were acquired on a cum div. basis. The equity of China Ltd and Chile Ltd at 1 July 2021 consisted of the following items.

At 1 July 2021, all identifiable assets and liabilities of China Ltd and Chile Ltd were recorded at fair value. No goodwill or gain on bargain purchase arose in any of the acquisitions. The financial statements of the three companies at 30 June 2023 contained the following information. Canada Ltd

China Ltd

Chile Ltd

$130 000

$ 80 000

$60 000

Asset revaluation surplus

—

5 000

—

Retained earnings (1/7/22)

10 000

10 500

13 000

Dividend payable

13 000

8 000

6 000

Profit

4 000

2 000

1 500

Share capital

The dividends payable refer to dividends declared out of profits for the year ended 30 June 2023. Since 1 July 2021, the following intragroup transactions have occurred. (a)China Ltd sold to Chile Ltd an item of machinery for $12 000 on 31 December 2021. The machinery had originally cost China Ltd $14 000 and at the time of sale had been depreciated to $11 200. Chile Ltd charges depreciation at 10% p.a. straight-line on this machinery. (b) During the year ended 30 June 2023, inventories were sold by Chile Ltd to China Ltd at 25% mark-up on cost. Inventories for which China Ltd paid $4000 to Chile Ltd are included in the inventories of China Ltd as at 30 June 2023. The tax rate is 30%. Required Prepare the consolidation worksheet entries for the year ended 30 June 2023. (LO3) 80% 75% Canada Ltd China Ltd Chile Ltd Canada Ltd 80% DNCI 20%

Canada Ltd 60% DNCI 25% INCI 15%

30.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Net fair value of identifiable assets and liabilities of China Ltd = = Net fair value acquired = = Consideration transferred = Goodwill =

($80 000 + $5 000 + $1 000) (equity) $86 000 80% x $86 000 $68 800 $68 800 $0

1. Pre-acquisition entry Canada Ltd – China Ltd: At 30 June 2023: Retained earnings (1/7/22) Share capital Asset revaluation surplus Shares in China Ltd

Dr Dr Dr Cr

800 64 000 4 000

Dr Dr Dr Cr

200 16 000 1 000

68 800

2. NCI share of equity of China Ltd at 1/7/21: Retained earnings (1/7/22) Share capital Asset revaluation surplus NCI

17 200

3. NCI share of equity of China Ltd: 1/7/21 to 30/6/22: Retained earnings (1/7/22) NCI (20% x ($10 500 - $1 000))

Dr Cr

1 900 1 900

4. NCI share of equity of China Ltd: 1/7/22 to 30/6/23: NCI share of profit NCI (20% x $2 000)

Dr Cr

400

NCI

Dr Cr

1 600

Dr Cr

900

Dividend declared (20% x $8 000) NCI NCI share of profit (20% x 75% x $6 000)

400

1 600

900

Acquisition analysis: China Ltd to Chile Ltd: At 1 July 2023: Net fair value of identifiable assets and liabilities of Chile Ltd = =

($60 000 + $4 000) (equity) $64 000

30.23

Chapter 30: Consolidation: other issues

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = =

$48 000 25% x $64 000 $16 000 $64 000 $0

5. Pre-acquisition entry – China Ltd to Chile Ltd: At 30 June 2021: Retained earnings (1/7/22) Share capital Shares in Chile Ltd

Dr Dr Cr

3 000 45 000

Dr Dr Cr

1 000 15 000

48 000

6. DNCI share of equity of Chile Ltd at 1/7/21: Retained earnings (1/7/22) Share capital NCI

16 000

7. NCI share of equity of Chile Ltd: 1/7/21 to 30/6/22: DNCI share Retained earnings (1/7/22) NCI (25% x ($13 000 - $4 000))

Dr Cr

2 250

INCI share Retained earnings (1/7/22) NCI (15% x ($13 000 - $4 000))

Dr Cr

1 350

2 250

1 350

8. NCI share of equity of Chile Ltd: 1/7/22 to 30/6/23: DNCI share NCI share of profit NCI (25% x $1 500)

Dr Cr

375

INCI share NCI share of profit NCI (15% x $1 500)

Dr Cr

225

Dr Cr

1 500

NCI Dividend declared (25% x $6 000)

375

225

1 500

9. Final dividend declared: China Ltd:

30.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dividend payable Final dividend declared (80% x $8 000)

Dr Cr

6 400

Dividend revenue Dividend receivable

Dr Cr

6 400

Dividend payable Final dividend declared (75% x $6 000)

Dr Cr

4 500

Dividend revenue Dividend receivable

Dr Cr

4 500

Retained earnings (1/7/22) Machinery

Dr Cr

800

Deferred tax asset Retained earnings (1/7/22)

Dr Cr

240

Dr Cr

112

Accumulated depreciation - machinery Dr Depreciation expense Cr Retained earnings (1/7/22) Cr

120

6 400

10. Final dividend declared: Chile Ltd:

4 500

11. Sale of machinery: China Ltd – Chile Ltd:

800

240

12. NCI adjustment: NCI Retained earnings (1/7/22) (20% x ($800 - $240))

112

13. Depreciation of machinery:

80 40

Income tax expense Retained earnings (1/7/22) Deferred tax asset 14. NCI adjustment:

Dr Dr Cr

24 12

Retained earnings (1/7/22) NCI share of profit NCI (20% x ($80 - $24) p.a.)

Dr Dr Cr

5.6 11.2

Dr Cr

4 000

16.8

15. Inventories transfer: Chile Ltd – China Ltd: Sales revenue Cost of sales

3 200

30.25

Chapter 30: Consolidation: other issues

Inventories

800

Deferred tax asset Income tax expense

Dr Cr

240

Dr Cr

224

240

16. NCI adjustment: NCI NCI share of profit (25% + 15%) x ($800 - $240)

224

30.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.4 Consolidated financial statements, multiple subsidiaries, acquisitions on the same date Pakistan Ltd acquired 75% of the issued shares of Peru Ltd on 1 July 2019 for $1 900 000. The identifiable assets and liabilities of Peru Ltd were recorded at fair value at acquisition date. The equity of Peru Ltd consisted of the following items.

On the same date, Peru Ltd acquired 60% of the issued shares of Philippines Ltd for $1 100 000. The identifiable assets and liabilities of Philippines Ltd were also recorded at fair value. The equity of Philippines Ltd consisted of the following items.

The financial information provided by the three companies for the year ended 30 June 2024 is as follows. Pakistan Ltd Sales revenue

2 850 000

Peru Ltd $

1 100 000

Philippines Ltd $

880 000

Other revenue

420 000

200 000

60 000

Total revenues

3 270 000

1 300 000

940 000

Cost of sales

1 410 000

520 000

380 000

Other expenses

200 000

80 000

110 000

Total expenses

1 610 000

600 000

490 000

Profit before income tax

1 660 000

700 000

450 000

580 000

160 000

140 000

Profit

1 080 000

540 000

310 000

Retained earnings (1/7/23)

4 070 000

2 300 000

1 120 000

Total available for appropriation

5 150 000

2 840 000

1 430 000

400 000

160 000

80 000

Income tax expense

Dividend paid

30.27

Chapter 30: Consolidation: other issues

Pakistan Ltd

Peru Ltd

Philippines Ltd

Dividend declared

400 000

200 000

90 000

Transfer to general reserve

100 000

50 000

40 000

900 000

410 000

210 000

Retained earnings (30/6/24)

4 250 000

2 430 000

1 220 000

The following additional information was obtained. • •

•

All transfers to general reserve were from post-acquisition profits. Included in the plant and machinery of Philippines Ltd was a machine sold by Peru Ltd on 30 June 2021 for $75 000. The asset had originally cost $130 000 and it had been written down to $60 000 prior to the intragroup sale. Philippines Ltd depreciates the machine on a straight-line basis over 5 years, with no residual value. Philippines Ltd had transferred one of its motor vehicles (carrying amount of $15 000) to Pakistan Ltd on 31 March 2023 for $12 000. Pakistan Ltd regarded this vehicle as part of its inventories. The vehicle was sold by Pakistan Ltd to external entities on 31 July 2023. The tax rate is 30%.

Required Prepare the consolidated statement of profit or loss and other comprehensive income and statement of changes in equity (not including movements in the general reserve and share capital) for the group for the year ended 30 June 2024. (LO3)

30.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

75% Pakistan Ltd

60% Peru Ltd Pakistan Ltd 75% DNCI 25%

Philippines Ltd Pakistan Ltd 45% DNCI 40% INCI 15%

Acquisition analysis: Pakistan Ltd – Peru Ltd: At 1 July 2019: Net fair value of identifiable assets and liabilities of Peru Ltd = = (a) Consideration transferred = (b) Non-controlling interest = = Aggregate of (a) and (b) = Goodwill =

$500 000 + $800 000 + $1 200 000 (equity) $2 500 000 $1 900 000 25% x $2 500 000 $625 000 $2 525 000 $25 000

1. Pre-acquisition entry: Pakistan Ltd – Peru Ltd: At 30 June 2024: Retained earnings (1/7/23)* Share capital General reserve Goodwill Shares in Peru Ltd *(75% x $1 200 000)

Dr Dr Dr Dr Cr

900 000 375 000 600 000 25 000

Dr Dr Dr Cr

300 000 125 000 200 000

1 900 000

2. DNCI share of equity of Peru Ltd at 1/7/19: Retained earnings (1/7/23) Share capital General reserve NCI (25% of balances)

625 000

3. DNCI share of equity of Peru Ltd: 1/7/19 – 30/6/23: Retained earnings (1/7/23) NCI (25% x ($2 300 000 - $1 200 000))

Dr Cr

275 000 275 000

4. DNCI share of equity of Peru Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (25% x $540 000)

Dr Cr

135 000

General reserve Transfer to general reserve (25% x $50 000)

Dr Cr

12 500

135 000

12 500

30.29

Chapter 30: Consolidation: other issues

NCI Dividend paid (25% x $160 000) NCI

Dr Cr

40 000

Dr Cr

50 000

40 000

Dividend declared 50 000 (25% x $200 000) NCI Dr 13 500 NCI share of profit Cr 13 500 (25% x 60% x $90 000 – Dividend declared by Philippines Ltd, in current period) NCI

Dr 12 000 NCI share of profit Cr 12 000 (25% x 60% x $80 000 – Dividend paid by Philippines Ltd, in current period) Acquisition analysis: Peru Ltd – Philippines Ltd: At 1 July 2019: Net fair value of identifiable assets and liabilities of Philippines Ltd (a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

$1 660 000 $1 100 000 40% x $1 660 000 $664 000 $1 764 000 $104 000

5. Pre-acquisition entry: Peru Ltd – Philippines Ltd: Retained earnings (1/7/23) Share capital General reserve Goodwill Shares in Philippines Ltd

Dr Dr Dr Dr Cr

300 000 396 000 300 000 104 000 1 100 000

6. DNCI share of equity of Philippines Ltd at 1/7/19: Retained earnings (1/7/23) Share capital General reserve NCI (40% of balances)

Dr Dr Dr Cr

200 000 264 000 200 000 664 000

7. NCI share of equity of Philippines Ltd: 1/7/19 – 30/6/23: Retained earnings (1/7/23) NCI (40% x ($1 120 000 - $500 000))

Dr Cr

248 000

30.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings (1/7/23) NCI (15% x ($1 120 000 – ($300 000/0.6))

Dr Cr

93 000 93 000

8. NCI share of equity of Philippines Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (40% x $310 000)

Dr Cr

124 000

NCI share of profit NCI (15% x $310 000)

Dr Cr

46 500

General reserve Transfer to general reserve (55% x $40 000)

Dr Cr

22 000

NCI

Dr Cr

32 000

Dr Cr

36 000

Dr Cr

120 000

Dr Cr

48 000

Dividend payable Dividend declared (75% x $200 000)

Dr Cr

150 000

Dividend revenue Dividend receivable

Dr Cr

150 000

Dr Cr

54 000

Dividend paid (40% x $80 000) NCI Dividend declared (40% x $90 000)

124 000

46 500

22 000

32 000

36 000

9. Dividend paid: Peru Ltd: Dividend revenue Dividend paid (75% x $160 000)

120 000

10. Dividend paid: Philippines Ltd: Dividend revenue Dividend paid (60% x $80 000)

48 000

11. Dividend declared: Peru Ltd: 150 000

150 000

12. Dividend declared: Philippines Ltd: Dividend payable Dividend declared (60% x $90 000)

54 000

30.31

Chapter 30: Consolidation: other issues

Dividend revenue Dividend receivable

Dr Cr

54 000 54 000

13. Plant and machinery transfer: Peru Ltd – Philippines Ltd: Retained earnings (1/7/23) Deferred tax asset Plant and machinery

Dr Dr Cr

10 500 4 500

Dr Cr

2 625

Accumulated depreciation - machinery Dr Retained earnings (1/7/23) Cr Depreciation expense Cr

9 000

Income tax expense Retained earnings (1/7/23) Deferred tax asset

Dr Dr Cr

900 1 800

Dr Dr Cr

525 1 050

15 000

14. NCI adjustment: NCI Retained earnings (1/7/23) (25% x $10 500)

2 625

15. Depreciation of machinery:

6 000 3 000

2 700

16. NCI adjustment: NCI share of profit* Retained earnings (1/7/23) NCI (*25% x $2 100 p.a.)

1 575

17. Transfer of non-current assets to inventories in prior period: Philippines Ltd – Pakistan Ltd: Cost of sales Income tax expense Retained earnings (1/7/23)

Dr Cr Cr

3 000

Dr Cr

1 155

900 2 100

18. NCI adjustment: Retained earnings (1/7/23) NCI share of profit (55% x $2 100)

1 155

30.32

Solutions manual to accompany Financial reporting by Loftus et al.

Financial Statements Sales revenue Other revenue

Pakistan Ltd 2 850 000 420 000

Total revenue Cost of sales Other expenses Total expenses Profit before tax Tax expense Profit

3 270 000 1 410 000 200 000 1 610 000 1 660 000 580 000 1 080 000

Peru Philippines Ltd Ltd 1 100 000 880 000 200 000 60 000 9 10 11 12 1 300 000 940 000 520 000 380 000 17 80 000 110 000 600 000 490 000 700 000 450 000 160 000 140 000 15 540 000 310 000

Retained earnings (1/7/23)

4 070 000

2 300 000

1 120 000 1 5 13 15

5 150 000 400 000

2 840 000 160 000

1 430 000 80 000

Dividend declared

400 000

200 000

90 000

Transfer to general reserve

100 000

50 000

40 000

190 000

900 000 4 250 000

310 000 2 430 000

210 000 1 220 000

1 148 000 6 695 800

Dividend paid

Retained earnings (30/6/24)

Adjustments Dr Cr

Group

3 000

900 000 300 000 10 500 1 800

Parent Cr

135 000 124 000 46 500 525 300 000 275 000 200 000 248 000 93 000 1 050 1 155

13 500 12 000 1 155

4 4 18

1 278 630

2 625

5 170 220

40 000 32 000 50 000 36 000 12 500 22 000

4 8 4 8 4 8

4 830 000 308 000

120 000 48 000 150 000 54 000

900

NCI Dr

3 000

900

6 000 2 100

15 17

48 000 120 000 150 000 54 000

10 9 11 12

5 138 000 2 313 000 387 000 2 700 000 2 438 000 880 000 1 558 000

6 285 800

7 843 800 472 000 486 000

4 8 8 16 2 3 6 7 7 16 18

6 448 850 400 000 400 000 155 500 955 500 5 493 350

30.33

Chapter 30: Consolidation: other issues

PAKISTAN LTD Consolidated statement of profit or loss and other comprehensive income for the year ended 30 June 2024 Revenue: Sales revenue Other revenue

$4 830 000 308 000 5 138 000

Expenses: Cost of sales Other expenses

2 313 000 387 000 2 700 000 2 438 000 880 000 $1 558 000 $1 558 000

Profit before income tax Income tax expense Profit for the period Comprehensive Income for the period Attributable to: Parent interest Non-controlling interest

$1 278 630 279 370 $1 558 000

PAKISTAN LTD Consolidated statement of changes in equity (extract) for the year ended 30 June 2024 Consolidated

Parent

Comprehensive income for the period

$1 558 000

$1 278 630

Retained earnings at 1 July 2023 Profit for the period Dividend paid Dividend declared Transfer to general reserve Retained earnings at 30 June 2024

$6 285 800 1 558 000 (472 000) (486 000) (190 000) $6 695 800

$5 170 220 1 278 630 (400 000) (400 000) (155 500) $5 493 350

30.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.5 Calculation of the non-controlling interest, multiple subsidiaries, acquisitions on the same date On 1 July 2022, Nauru Ltd acquired 60% of the issued shares of Nepal Ltd for $450 000, and Nepal Ltd acquired 80% of the issued shares of New Zealand Ltd for $285 000. It was considered that Nauru Ltd exercised control over Nepal Ltd and New Zealand Ltd. At acquisition date, the equity for Nepal Ltd and New Zealand Ltd was as follows. Nepal Ltd

New Zealand Ltd

Share capital

$300 000

$ 210 000

General reserve

195 000

105 000

Retained earnings

120 000

30 000

At 1 July 2022, all the identifiable assets and liabilities of both Nepal Ltd and New Zealand Ltd were recorded at fair value. Three years later, the companies provided the following information. Nepal Ltd $ 36 000

Profit before income tax

New Zealand Ltd $

27 000

Income tax expense

15 000

11 250

Profit

21 000

15 750

Retained earnings (1/7/24)

132 000

41 250

153 000

57 000

15 000

12 000

Dividend declared Retained earnings (30/6/25)

$138 000

45 000

There was a transfer to reserves of $6000 from pre-acquisition profits in the period ended 30 June 2024 by New Zealand Ltd. Required Calculate the non-controlling interest’s share of retained earnings at 30 June 2025 of Nepal Ltd and New Zealand Ltd. (LO3) 60% Nauru Ltd

80% Nepal Ltd DNCI 40%

New Zealand Ltd DNCI 20% 30.35

Chapter 30: Consolidation: other issues

INCI

32%

1. NCI share of equity of Nepal Ltd at 1/7/22: Retained earnings (1/7/22) Share capital General reserve NCI

Dr Dr Dr Cr

48 000 120 000 78 000 246 000

2. NCI share of equity of Nepal Ltd: 1/7/22 – 30/6/24: Retained earnings (1/7/24) Dr 4 800 NCI Cr (40% x ($132 000 - $120 000)) 3. NCI share of equity of Nepal Ltd from 1/7/24 – 30/6/25: NCI share of profit NCI (40% x $21 000)

Dr Cr

8 400

Dr Cr

6 000

Dr Cr

3 840

4 8200

8 400

4. Dividend declared – Nepal Ltd: NCI Dividend declared (40% x $15 000) NCI NCI share of profit (40% x 80% x $12 000)

6 000

3 840

The NCI share of Retained Earnings (30/6/25) of Nepal Ltd is $51 360 (= $48 000 + $4 800 + $84 000 - $6 000 - $3 840). Acquisition analysis: Nepal Ltd – New Zealand Ltd: At 1 July 2025: Net fair value of identifiable assets and liabilities of New Zealand Ltd = = (a) Consideration transferred = (b) Non-controlling interest = = Aggregate of (a) and (b) = Goodwill =

$210 000 + $105 000 + $30 000 (equity) $345 000 $285 000 $20% x $345 000 $69 000 $354 000 $9 000

The pre-acquisition entry at 30 June 2025 is: Retained earnings (1/7/24)* Share capital General reserve Goodwill

Dr Dr Dr Dr

19 200 168 000 88 800 9 000

30.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Shares in New Zealand Ltd *(80% x $30 000) – (80% x $6 000)

285 000

The NCI share of New Zealand Ltd’s equity is then: 5. NCI share of equity of New Zealand Ltd at 1/7/22: Retained earnings (1/7/24) Share capital General reserve NCI

Dr Dr Dr Cr

6 000 42 000 21 000 69 000

6. NCI share of New Zealand Ltd from 1/7/22 – 30/6/24: General reserve Dr 1 200 Retained earnings (1/7/24) Dr 2 250 NCI Cr (GR: 20% x $6 000; RE: 20% x ($41 250 - $30 000)) Retained earnings (1/7/24) Dr NCI Cr (INCI: 32% x ($41 250 - $19 200/0.8))

3 450

5 520 5 520

7. NCI share of equity of New Zealand Ltd: 1/7/24 – 30/6/25: NCI share of profit NCI (20% x $15 750)

Dr Cr

3 150

NCI share of profit NCI (32% x $15 750)

Dr Cr

5 040

Dr Cr

2 400

3 150

5 040

8. Dividend declared: NCI Dividend declared (20% x $12 000)

2 400

The NCI share of Retained Earnings (30/6/25) of New Zealand Ltd is $19 560 (= $6 000 + $2 250 + $5 520 + $ 3 150 + $5 040 - $2 400). The total NCI share of Retained Earnings at 30/6/25 is $70 920.

30.37

Chapter 30: Consolidation: other issues

Exercise 30.6 Consolidated financial statements, multiple subsidiaries, acquisitions on the same date On 1 July 2019, the following balances appeared in the ledgers of the following three companies.

The dividend payable on 1 July 2019 was paid in October 2019. For the year ended 30 June 2024, the following information is available. • Inter-company sales were: - Samoa Ltd to Russia Ltd — $20 000 - Singapore Ltd to Russia Ltd — $15 000 - The mark-up on cost on all sales was 25%. • At 30 June 2024, inventories of Russia Ltd included: - $1000 of goods purchased from Samoa Ltd - $1800 of goods purchased from Singapore Ltd. • The income tax rate is 30%. • Russia Ltd paid $67 200 for 80% of the issued shares of Samoa Ltd at 1 July 2019 when all identifiable assets and liabilities of Samoa Ltd were recorded at fair value. • Samoa Ltd paid $18 750 for 75% of the issued shares of Singapore Ltd at 1 July 2019 when all identifiable assets and liabilities of Singapore Ltd were recorded at fair value as follows.

•

The plant has an expected remaining useful life of 5 years. By 30 June 2020, all receivables had been collected and inventories sold.

The financial information for the year ended 30 June 2024 for all three companies was as follows. Russia Ltd

Samoa Ltd

98 400

$ 48 500

Cost of sales

61 000

29 000

13 000

Gross profit

37 400

19 500

17 000

Sales revenue

Singapore Ltd $

30 000

30.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Russia Ltd

Samoa Ltd

Singapore Ltd

Selling and administrative (including depreciation)

10 000

5 000

3 000

Financial

3 000

1 000

13 000

6 000

4 000

24 400

13 500

13 000

Dividend revenue

3 200

4 500

—

Profit before income tax

27 600

18 000

13 000

Income tax expense

12 000

8 100

5 200

Profit

15 600

9 900

7 800

Retained earnings (1/7/23)

40 000

20 000

10 000

Total available for appropriation

55 600

29 900

17 800

Transfer to general reserve

4 000

1 900

—

Dividend paid

5 000

2 000

4 000

Dividend declared

5 000

2 000

14 000

5 900

6 000

Retained earnings (30/6/24)

41 600

24 000

11 800

General reserve

12 000

3 900

1 000

Share capital

80 000

60 000

20 000

Total equity

$ 133 600

$ 87 900

Receivables

18 000

25 000

11 000

Inventories

25 000

26 400

13 800

Shares in Samoa Ltd

65 600

—

18 750

—

50 000

39 750

20 000

$ 158 600

$ 109 900

Provisions

20 000

10 000

Dividend payable

5 000

2 000

Expenses:

Shares in Singapore Ltd Plant Total assets

32 800

44 800

Total liabilities

25 000

$ 22 000

12 000

Net assets

$ 133 600

$ 87 900

32 800

Required Prepare the consolidated financial statements for Russia Ltd’s group and all its subsidiaries at 30 June 2024. (LO3) © John Wiley and Sons Australia Ltd, 2020

30.39

Chapter 30: Consolidation: other issues

80% Russia Ltd

75% Samoa Ltd DNCI 20%

Singapore Ltd DNCI 25% INCI 15%

Acquisition analysis: Russia Ltd – Samoa Ltd: At 1 July 2019: Net fair value of the identifiable assets and liabilities of Samoa Ltd = = (a) Consideration transferred = = (b) Non-controlling interest = = Aggregate of (a) and (b) = Goodwill = 1. Pre-acquisition entry: Retained earnings (1/7/23)* Share capital General reserve Goodwill Shares in Samoa Ltd

($60 000 + $10 000 + $2 000) (equity) $72 000 $67 200 – (80% x $2 000) $65 600 20% x $72 000 $14 400 $80 000 $8 000

Dr Dr Dr Dr Cr

8 000 48 000 1 600 8 000

Dr Dr Dr Cr

2 000 12 000 400

65 600

2. NCI share of equity in Samoa Ltd at 1/7/19: Retained earnings (1/7/23) Share capital General reserve NCI

14 400

3. NCI share of equity in Samoa Ltd: 1/7/19 – 30/6/23: Retained earnings (1/7/23) NCI (20% x ($20 000 - $10 000))

Dr Cr

2 000 2 000

4. NCI share of equity in Samoa Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (20% x $9 900)

Dr Cr

1 980

General reserve Transfer to general reserve (20% x $1 900)

Dr Cr

380

NCI

400

1 980

380

30.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Dividend paid (20% x $2 000)

NCI

Dr Cr

400

Dr Cr

900

Dividend declared (20% x $2 000) NCI NCI share of profit (20% x 75% x ($2 000 + $4 000))

400

900

Acquisition analysis: Samoa Ltd – Singapore Ltd: At 1/7/19: Net fair value of identifiable assets and liabilities of Singapore Ltd (a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Gain on bargain purchase

= = = = = = =

$20 000 + $1 000 + $5 000 (equity) $26 000 $18 750 25% x $26 000 $6 500 $25 250 $750

5. Pre-acquisition entry: At 1/7/19: Retained earnings (1/7/19) Share capital General reserve Gain on bargain purchase Shares in Singapore Ltd

Dr Dr Dr Cr Cr

3 750 15 000 750 750 18 750

At 30/6/24: Retained earnings (1/7/23)* Dr 3 000 Share capital Dr 15 000 General reserve Dr 750 Shares in Singapore Ltd Cr * $3 000 = (75% x $5 000) - $750 (gain on bargain purchase)

18 750

6. NCI share of equity in Singapore Ltd at 1/7/19: Retained earnings (1/7/23) Share capital General reserve NCI

Dr Dr Dr Cr

1 250 5 000 250 6 500

7. NCI share of equity in Singapore Ltd: 1/7/19 – 30/6/23: Retained earnings (1/7/23) NCI

Dr Cr

1 250

1 250 30.41

Chapter 30: Consolidation: other issues

(25% x ($10 000 - $5 000)) Retained earnings (1/7/23) NCI (15% x ($10 000 - $3 000/0.75))

Dr Cr

900 900

8. NCI share of equity in Singapore Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (25% x $7 800) NCI share of profit NCI (15% x $7 800)

Dr Cr

1 950

Dr Cr

1 170

NCI

Dr Cr

1 000

Dr Cr

500

Dividend paid (25% x $4 000) NCI Dividend declared (25% x $2 000)

1 950

1 170

1 000

500

9. Interim dividend paid: Singapore Ltd: Samoa Ltd: Dividend revenue Interim dividend paid

75% x $4 000 = 80% x $2 000 = Dr Cr

$3 000 $1 600 $4 600

4 600 4 600

10. Dividend declared: Singapore Ltd: Samoa Ltd

75% x $2 000 = 80% x $2 000 =

Dividend payable Dividend declared

Dr Cr

3 100

Dividend revenue Receivables

Dr Cr

3 100

$1 500 $1 600 $3 100 3 100 3 100

11. Sale of inventories: Samoa Ltd – Russia Ltd: Sales

Dr Cr Cr

20 000

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

19 800 200

12. NCI adjustment:

30.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

NCI NCI share of profit (20% x $140)

Dr Cr

28 28

13. Sale of inventories: Singapore Ltd – Russia Ltd: Sales Cost of sales Inventories Deferred tax asset Income tax expense 14. NCI adjustment: NCI NCI share of profit ((25% + 15%) x ($360 - $108))

Dr Cr Cr

15 000

Dr Cr

108

Dr Cr

101

14 640 360 108

101

30.43

Chapter 30: Consolidation: other issues Financial Statements

Russia Ltd

Samoa Ltd

Singapore Ltd

Adjustments Dr 11 13

Group Dr

98 400

48 500

30 000

Cost of sales

61 000

29 000

13 000

20 000 15 000

Gross profit Selling&admin exp Financial expenses Total expenses Dividend revenue

37 400 10 000 3 000 13 000 24 400 3 200

19 500 5 000 1 000 6 000 13 500 4 500

17 000 3 000 1 000 4 000 13 000 -

Profit before tax Tax expense

27 600 12 000

18 000 8 100

13 000 5 200

Profit

15 600

9 900

7 800

Retained earnings (1/7/23)

40 000

20 000

10 000

Transfer to GR Dividend paid

55 600 4 000 5 000

29 900 1 900 2 000

17 800 4 000

4 600

84 208 5 900 6 400

Dividend declared

5 000

2 000

3 100

5 900

Retained earnings (30/6/24) General reserve

14 000 41 600 12 000

5 900 24 000 3 900

6 000 11 800 1 000

Share capital

80 000

60 000

20 000

11 13

68 560 73 340 18 000 5 000 23 000 50 340 -

4 600 3 100 60 108

11 13

50 340 25 132 25 208

1 5

8 000 3 000

1 5

1 600 750

1 5

48 000 15 000

59 000

18 200 66 008 14 550

97 000

Total equity: parent Total equity: NCI

Total equity Provisions Dividend payable Total liabilities Total E & L Deferred tax asset

133 600 20 000 5 000 25 000 158 600 -

87 900 20 000 2 000 22 000 109 900 -

32 800 10 000 2 000 12 000 44 800 -

Receivables Inventories

18 000 25 000

25 000 26 400

11 000 13 800

Shares in Samoa Shares in Singapore Plant Goodwill Total assets

65 600 50 000 158 600

18 750 39 750 109 900

20 000 44 800

3 100

11 13

60 108

177 558 50 000 5 900 55 900 233 458 168 3 100 200 360 65 600 18 750

8 000 130 318

Parent Cr

141 900 19 800 14 640

9 10

NCI

Sales revenue

130 318

10 11 13 1 5

4 8 8 2 3 6 7 7

1 980 1 950 1 170 2 000 2 000 1 250 1 250 900

900 28 101

400 380 250 12 000 5 000

4 4 4 8 8 12 14

400 400 900 1 000 500 28 101 33 859

21 137

51 600

380 400 1 000 400 500

2 4 6 2 6

4 12 14

4 4 8 4 8

72 737 5 520 5 000 5 000 15 520 57 217 13 520

80 000

14 400 2 000 1 980 6 500 1 250 900 1 950 1 170 33 859

2 3 4 6 7 7 8 8

150 737 26 821

177 558

50 900 64 640 109 750 8 000 233 458

30.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

RUSSIA LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2024 Revenue: Sales revenue Expenses: Cost of sales Selling administrative expenses Financial expenses

$141 900 68 560 18 000 5 000 91 560 50 340 25 132 $25 208 $25 208

Profit before income tax Income tax expense Profit for the period Comprehensive income for the period Attributable to: Parent entity Non-controlling interest

$21 137 4 071 $25 208

RUSSIA LTD Consolidated statement of changes in equity (extract) for the year ended 30 June 2024 Consolidated $25 208

Parent $21 137

Retained earnings at 1 July 2023 Profit for the period Dividend paid Dividend declared Transfer to general reserve Retained earnings at 30 June 2024

$59 000 25 208 (6 400) (5 900) (5 900) $66 008

$51 600 21 137 (5 000) (5 000) (5 520) $57 217

General reserve at 1 July 2023 Transfer from retained earnings General reserve at 30 June 2024

$8 650 5 900 $14 550

$8 000 5 520 $13 520

Share capital at 1 July 2023 Share capital at 30 June 2024

$97 000 $97 000

$80 000 $80 000

Comprehensive income for the period

30.45

Chapter 30: Consolidation: other issues

RUSSIA LTD Consolidated statement of financial position as at 30 June 2024 Current assets Receivables Inventories Total current assets Non-current assets Tax assets: Deferred tax asset Property, plant and equipment (net) Goodwill Total non-current assets Total assets Current liabilities: Payables: Accounts payable Provisions: Dividend payable Total liabilities Net assets Equity Share capital Other reserves: General reserve Retained earnings Parent interest Non-controlling interest Total equity

$50 900 64 640 115 540 168 109 750 __8 000 117 918 233 458 50 000 5 900 55 900 $177 558 $80 000 13 520 57 217 150 737 26 821 $177 558

30.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.7 Consolidation worksheet, consolidated financial statements, multiple subsidiaries, acquisitions on the same date On 1 July 2023, Vanuatu Ltd acquired 80% of the shares in Vietnam Ltd (cum div.) for $44 760. At this date, Vietnam Ltd had not recorded any goodwill and all its identifiable net assets were recorded at fair value except for land and inventories for which the differences between the carrying amount and fair value at acquisition date were as follows.

Half of the inventories remained on hand at 30 June 2024. Immediately after the acquisition date, Vietnam Ltd revalued the land to fair value. The land was still on hand at 30 June 2024.

At 1 July 2023, Vietnam Ltd acquired 75% of the issued shares of Brunei Ltd for $15 300. Brunei Ltd had not recorded any goodwill and all its identifiable assets and liabilities were recorded at fair value except for the inventories for which the difference between the carrying amount and fair value at acquisition date was as follows.

All the inventories were sold by 30 June 2024. At the acquisition date, the financial statements of the three companies showed the following.

The following information was provided for the year ended 30 June 2024.

30.47

Chapter 30: Consolidation: other issues

Additional information • Dividends declared for the year ended 30 June 2023 were duly paid. • Intragroup purchases (at cost plus 331/3%) were as follows. - Vanuatu Ltd from Vietnam Ltd — $43 200 - Vietnam Ltd from Brunei Ltd — $37 800 • Intragroup purchases valued at cost to the purchasing company were included in inventories at 30 June 2024, as follows. - Vanuatu Ltd — $5400 - Vietnam Ltd — $4500 • The tax rate is 30%.

Required 1. Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Vanuatu Ltd at 30 June 2024. 2. Prepare the consolidated statement of profit or loss and other comprehensive income and statement of changes in equity (not including movements in share capital and other reserves) at 30 June 2024. (LO3) 80% Vanuatu Ltd

75% Vietnam Ltd Vanuatu Ltd 80% DNCI 20%

Brunei Ltd Vanuatu Ltd 60% DNCI 25% INCI 15%

Acquisition analysis: Vanuatu Ltd – Vietnam Ltd: At 1 July 2023: Net fair value of identifiable assets and liabilities of Vietnam Ltd =

($32 000 + $3 200 + $6 400 + $4 800) (equity) + $2 000 (1 – 30%) (ARS - land) + $3 000 (1 – 30%) (BCVR - inventories) $ 49 900

30.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

$44 760 – (80% x $3 200) (div. receivable) $42 200 20% x $49 900 $9 980 $52 180 $2 280

1. Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Dr Cr

1 500

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

1 500

Dr Dr Dr Dr Dr Dr Cr

3 840 25 600 2 560 6 240 1 680 2 280

Dr Cr

840

Dr Dr Dr Dr Dr Cr

960 6 400 640 1 560 420

450 1 050

2. Pre-acquisition entry: Vanuatu Ltd – Vietnam Ltd: Retained earnings (1/7/23) Share capital General reserve Asset revaluation surplus* Business combination valuation reserve Goodwill Shares in Vietnam Ltd * 80% x ($6 400 + $1 400) Transfer from BCVR Business combination valuation reserve

42 200

840

3. NCI share of equity in Vietnam Ltd at 1/7/23: Retained earnings (1/7/23) Share capital General reserve Asset revaluation surplus Business combination valuation reserve NCI (20% of balances)

9 980

4. NCI share of equity in Vietnam Ltd: 1/7/23 – 30/6/24: NCI share of profit NCI (20% x [$7 680 – ($1 500 - $450)])

Dr Cr

1 326

Transfer from BCVR Business combination valuation reserve (20% x $1 050)

Dr Cr

210

1 326

210

30.49

Chapter 30: Consolidation: other issues

NCI

Dr 300 NCI share of profit Cr (20% x 75% x $2 000, being dividend revenue from Brunei Ltd) NCI Dividend declared (20% x $1 600)

Dr Cr

300

320 320

Acquisition analysis: Vietnam Ltd – Brunei Ltd: At 1 July 2023: Net fair value of identifiable assets and liabilities of Brunei Ltd: = ($20 000 - $3 200) (equity) + $4 000 (1 – 30%)(BCVR - inventories) = $19 600 (a) Consideration transferred = $15 300 (b) Non-controlling interest = 25% x $19 600 = $4 900 Aggregate of (a) and (b) = $20 200 Goodwill = $600 5. Business combination valuation entries: Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

4 000

Business combination valuation reserve Share capital Goodwill Retained earnings (1/7/23) Shares in Brunei Ltd

Dr Dr Dr Cr Cr

2 100 15 000 600

Transfer from BCVR Business combination valuation reserve

Dr Cr

2 100

Dr Dr Cr Cr

5 000 700

1 200 2 800

6. Pre-acquisition entry: Vietnam Ltd – Brunei Ltd: The entry at 30 June 2024 is:

2 400 15 300

2 100

7. 25% DNCI share of equity in Brunei Ltd at 1/7/214 Share capital Business combination valuation reserve Retained earnings (1/7/23) NCI

800 4 900

8. NCI share of equity in Brunei Ltd: 1/7/23 – 30/6/24: NCI share of profit

1 355

30.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

NCI (25% x [$8 220 – ($4 000 - $1 200)])

NCI share of profit NCI (15% x ($8 220 – ($4 000 - $1 200)))

Dr Cr

Transfer from BCVR Business combination valuation reserve (25% x $2 800) NCI Dividend paid (25% x $1 000) NCI Dividend declared (25% x $1 000)

1 355

813 813

Dr Cr

700 700

Dr Cr

250

Dr Cr

250

Dr Cr

750

250

9. Dividend paid: Dividend revenue Dividend paid

750

10. Dividend declared: Vietnam Ltd: 80% x $1 600 Brunei Ltd: 75% x $1 000

= =

$1 280 $ 750 $2 030

Dividend payable Dividend declared

Dr Cr

2 030

Dividend revenue Dividend receivable

Dr Cr

2 030

2030

2 030

11. Intragroup sales: Vietnam Ltd – Vanuatu Ltd: Sales revenue Cost of sales Inventories

Dr Cr Cr

43 200

Deferred tax asset Income tax expense

Dr Cr

405

41 850 1 350

405

12. NCI adjustment: NCI NCI share of profit (20% x ($1 350 - $405)

Dr Cr

189 189

30.51

Chapter 30: Consolidation: other issues

Sales

Dr Cr Cr

37 800

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

338

Dr Cr

315

36 675 1 125

338

14. NCI adjustment: NCI NCI share of profit

315

((25% + 15%) x ($1 125 - $338))

30.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Financial Statements Sales revenue

Vanuatu Ltd 108 000

Vietnam Ltd 72 000

Brunei Ltd 54 000

Cost of sales

72 000

61 200

40 500

Dividend revenue

36 000 9 000 27 000 1 280

10 800 2 700 8 100 1 500

13 500 2 880 10 620 -

Income tax expense

28 280 8 480

9 600 1 920

10 620 2 400

Profit

19 800

7 680

8 220

Retained earnings (1/7/23) Transfer from BCVR

6 400

4 800

(3 200)

3 840

2 400

6 560

2 6

840 2 100

1 050 2 800

1 5

910

26 200 4 000 4 000

12 480 1 600

5 020 1 000 1 000

8 000 18 200

1 600 10 880

2 000 3 020

D&A expenses

Dividend paid Dividend declared

Retained earnings (30/6/24)

11 13 1 5

9 10

Adjustments Dr Cr 43 200 37 800 1 500 41 850 4 000 36 675

Group

Parent Cr

4 8 8 3

1 326 1 335 813 960

300 189 315 800

4 8

210 700

153 000 11 13

100 675 52 325 14 580 37 745 --

750 2 030 450 1 200 405 338

1 5 11 13

37 745 10 407

27 338

NCI Dr

750 2 030

9 10

34 808 4 250 4 570 8 820 25 988

4 12 14 7

24 668

6 400 0

250 320 250

8 4 8

31 068 4 000 4 000 8 000 23 068

30.53

Chapter 30: Consolidation: other issues

VANUATU LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ended 30 June 2024 Sales revenue Expenses: Cost of sales Other

$153 000 100 675 14 580 115 255 37 745 10 407 $27 338 $27 338

Profit before income tax Income tax expense Profit for the period Comprehensive income for the period Attributable to: Parent interest Non-controlling interest

$24 668 $2 670

VANUATU LTD Consolidated statement of changes in equity (extract) for the year ended 30 June 2024 Consolidated

Parent

Comprehensive income for the period

$27 338

$24 668

Retained earnings at 1 July 2023 Profit for the period Transfer from business combination valuation reserve Dividend paid Dividend declared Retained earnings at 30 June 2024

$6 560 27 338 910 (4 250) (4 570) $25 988

$6 400 24 668 0 (4 000) (4 000) $23 068

30.54

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.8 Consolidation worksheet entries, sequential acquisitions On 1 July 2022, Brunei Ltd acquired (ex div.) 80% of the issued shares of Bhutan Ltd for $146 400. At this date, the equity of Bhutan Ltd consisted of:

In the accounts at this date, Bhutan Ltd had recorded a dividend payable of $5000 and goodwill of $13 000. All the identifiable assets and liabilities of Bhutan Ltd were recorded at fair value except for the following.

The plant has a further 5-year life, and is depreciated using the straight-line method. Of the inventories, 90% was sold by 30 June 2023, the remaining 10% being sold by 30 June 2024. During the period ended 30 June 2023, Bhutan Ltd recorded a profit of $40 000 and there were no changes in reserves. During the period ended 30 June 2024, Bhutan Ltd recorded a profit of $36 000, and recorded a transfer to general reserve of $6000. On 1 January 2023, Bhutan Ltd acquired 50% of the issued shares of Burma Ltd for $57 000, giving it a capacity to control that entity. At this date, the equity of Burma Ltd consisted of:

The identifiable assets and liabilities of Burma Ltd consisted of:

All the inventories on hand at 1 January 2023 were sold by 30 June 2023. The plant had a further 10-year useful life, and was depreciated using the straight-line method. The land was sold by Burma Ltd in the period ended 30 June 2024. The profit of Burma Ltd for the period from 1 January 2023 to 30 June 2023 was $8000. © John Wiley and Sons Australia Ltd, 2020

30.55

Chapter 30: Consolidation: other issues

There were no movements in the general reserve during this period. During the period ended 30 June 2024, Burma Ltd earned a $20 000 profit. Burma Ltd also transferred $20 000 from general reserve to retained earnings during the period ended 30 June 2024. Assume a tax rate of 30%. Required Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Brunei Ltd at 30 June 2024. (LO3) 80% Brunei Ltd

50% Bhutan Ltd DNCI 20%

Burma Ltd DNCI 50% INCI 10%

Acquisition analysis: Brunei Ltd – Bhutan Ltd: At 1/7/22: Net fair value of identifiable assets and liabilities of Bhutan Ltd

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill acquired Goodwill recorded Adjustment to goodwill

= ($100 000 + $50 000 + $20 000) (equity) - $13 000 (goodwill) + $10 000 (1 – 30%) (BCVR - plant) + $5 000 (1 – 30%)(BCVR - inventories) = $167 500 = $146 400 = 20% x $167 500 = $33 500 = $179 900 = $12 400 = 80% x $13 000 = $10 400 = $2 000

1. Business combination valuation entries: Accumulated depreciation – plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

30 000

Depreciation expense Retained earnings (1/7/23) Accumulated depreciation – plant (20% x $10 000 per annum)

Dr Dr Cr

2 000 2 000

20 000 3 000 7 000

4 000

30.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Deferred tax liability Income tax expense Retained earnings (1/7/23)

Dr Cr Cr

1 200

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

500

600 600

150 350

30.57

Chapter 30: Consolidation: other issues

2. Pre-acquisition entries: At 30/6/23: Retained earnings (1/7/23)* Share capital General reserve Business combination valuation reserve** Goodwill Shares in Bhutan Ltd *$16 000 + 80% x 90% x $3 500 ** 80% x $7 000 + 80% x 10% x $3 500

Dr Dr Dr Dr Dr Cr

18 520 80 000 40 000 5 880 2 000

Transfer from BCVR BCVR

Dr Cr

280

Dr Dr Dr Dr Cr

4 000 20 000 10 000 2 100

146 400

280

3. NCI share of equity in Bhutan Ltd at 1/7/22: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve NCI (20% of balances at 1/7/22)

36 100

4. NCI share of equity in Bhutan: 1/7/22 – 30/6/23: Retained earnings Dr 7 720 Business combination valuation reserve Cr NCI Cr (RE: 20% x [$40 000 – [$2 000 - $600]; BCVR: 20% x 90% x $3 500)

630 7 090

5. NCI share of equity in Bhutan Ltd: 1/7/23 – 30/6/24: NCI share of profit Dr NCI Cr (20% x [$36 000 – [$2 000 - $600] – [$500 - $150]])

6 850 6 850

Transfer from BCVR Business combination valuation reserve (20% x 10% x $3 500)

Dr Cr

General reserve Transfer to general reserve (20% x $6 000)

Dr Cr

1 200

30.58

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Acquisition analysis: Bhutan Ltd – Burma Ltd: At 1 January 2023: Net fair value of identifiable assets and liabilities of Burma Ltd

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Gain on bargain purchase

= ($80 000 + $40 000 - $10 000) (equity) + $6 000 (1 – 30%) (BCVR - land) + $2 000 (1 – 30%) (BCVR - plant) + $2 000 (1 – 30%)(BCVR - inventories) = $117 000 = $57 000 = 50% x $117 000 = $58 500 = $115 500 = $1 500

6. Business combination valuation entries: Gain on sale of land/Carrying amount of land sold Income tax expense Transfer from BCVR

Dr Cr Cr

6 000

Accumulated depreciation – plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

30 000

Depreciation expense Retained earnings (1/7/23) Accumulated depreciation – plant (10% x $2 000 per annum)

Dr Dr Cr

200 100

Deferred tax liability Income tax expense Retained earnings (1/7/23)

Dr Cr Cr

1 800 4 200 28 000 600 1 400

300

60 30

7. Pre-acquisition entries: At 30/6/24: Transfer from BCVR Dr 2 100 Transfer from general reserve Dr 10 000 Share capital Dr 40 000 General reserve Dr 10 000 Business combination valuation reserve Dr 700 Retained earnings (1/7/23) * Cr 5 800 Shares in Burma Ltd Cr 57 000 *$(5 000) + [50% x $1 400 BCVR-inventories] - $1 500 gain on bargain purchase © John Wiley and Sons Australia Ltd, 2020

30.59

Chapter 30: Consolidation: other issues

8. NCI share of equity in Burma Ltd at 1/1/23: Share capital General reserve Business combination valuation reserve Retained earnings (1/7/23) NCI (50% share of balances – direct NCI only)

Dr Dr Dr Cr Cr

40 000 20 000 3 500 5 000 58 500

9. NCI share of equity in Burma Ltd: 1/1/23 – 30/6/23: Retained earnings (1/7/23) Dr 3 965 Business combination valuation reserve Cr NCI Cr DNCI: (RE: 50% x ($(2 000) – $(10 000) – [$100 - $30])) Retained earnings (1/7/23) Dr NCI Cr INCI: (10% x ($(2 000) – $(5 800)/50% – [$100 - $30]))

700 3 265

953 953

10. NCI share of equity in Burma Ltd: 1/7/23 – 30/6/24: NCI share of profit Dr NCI Cr (50% x ($20 000 – [$200 - $60] – [$6 000 - $1 800]))

7 830

NCI share of profit Dr NCI Cr (10% x ($20 000 – [$200 - $60] – [$6 000 - $1 800]))

1 566

Transfer from general reserve General reserve (50% x $20 000)

10 000

Dr Cr

7 830

1 566

10 000

30.60

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.9 Consolidation worksheet entries, multiple subsidiaries, acquisitions on the same date The statements of financial position of Tonga Ltd, Thailand Ltd and Tuvalu Ltd for the year ended 30 June 2023 are as follows.

Tonga Ltd Share capital

300 000

Thailand Ltd $

100 000

Tuvalu Ltd $

42 000

Retained earnings

120 000

36 000

8 000

Dividend payable

60 000

20 000

12 000

Non‐current assets

480 000

156 000

62 000

240 000

40 000

20 000

111 600

—

42 000

—

Inventories

20 000

50 000

40 000

Receivables

108 400

24 000

2 000

Shares in Thailand Ltd Shares in Tuvalu Ltd

480 000

156 000

62 000

For the year ended 30 June 2023, Thailand Ltd and Tuvalu Ltd recorded a profit of $4000 and $2000 respectively. Thailand Ltd holds 90% of the issued shares of Tuvalu Ltd since their acquisition on 1 July 2020 for a total consideration of $41 460. At the acquisition date, Tuvalu Ltd’s equity comprised of the following items. Share capital (42 000 shares) Retained earning

$ 42 000 2 000

At this date, all identifiable assets and liabilities of Tuvalu Ltd were recorded at fair value except for some plant for which the fair value of $16 000 was $2000 greater than the carrying amount (i.e. original cost of $17 000 less accumulated depreciation of $3000). The plant is expected to last a further 5 years. On 1 July 2020, the directors of Tonga Ltd made a successful offer for 90 000 of Thailand Ltd’s fully paid shares. The consideration was $109 980 and, at the acquisition date, Thailand Ltd’s equity comprised of the following items.

30.61

Chapter 30: Consolidation: other issues

Share capital (100 000 shares)

$100 000 8 000

Retained earnings

At this date, all identifiable assets and liabilities of Tonga Ltd were recorded at fair value except for some machinery whose fair value was $6000 greater than its recorded amount of $12 000, the latter being $20 000 cost less accumulated depreciation of $8000. The machinery is expected to have a further useful life of 3 years. Required Prepare the consolidation worksheet entries for the preparation of the consolidated financial statements of Tonga Ltd at 30 June 2023. (LO3) 90% Tonga Ltd

90% Thailand Ltd DNCI 10%

Tuvalu Ltd DNCI 10% INCI 9%

Acquisition analysis: Thailand Ltd to Tuvalu Ltd: At 1 July 2020: Net fair value of identifiable assets and liabilities of Tuvalu Ltd

(a) (b)

Consideration transferred Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = = =

($42 000 + $2 000) (equity) + $2 000 (1 – 30%) (BCVR - plant) $45 400 $41 460 10% x $45 400 $4 540 $46 000 $600

1. Business combination valuation entries: Tuvalu Ltd: Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

3 000

Depreciation expense Retained earnings (1/7/22) Accumulated depreciation - plant

Dr Dr Cr

400 800

Deferred tax liability Income tax expense Retained earnings (1/7/22)

Dr Cr Cr

360

1 000 600 1 400

1 200

120 240

30.62

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2. Pre-acquisition entry: Thailand Ltd – Tuvalu Ltd: Retained earnings (1/7/22) Share capital Business combination valuation reserve Goodwill Shares in Tuvalu Ltd

Dr Dr Dr Dr Cr

1 800 37 800 1 260 600

Dr Dr Dr Cr

200 4 200 140

Retained earnings (1/7/22) NCI (10% x ($6 000 - 21 000 – ($800 - $240)))

Dr Cr

344

Retained earnings (1/7/22) NCI (9% x ($6 000 - $1800/.9 – ($800 - $240))

Dr Cr

310

41 460

3. DNCI share of equity in Tuvalu Ltd at 1/7/20: Retained earnings (1/7/22) Share capital Business combination valuation reserve NCI (10% of balances at 1/7/23)

4 540

4. NCI share of equity in Tuvalu Ltd: 1/7/20 – 30/6/22:

1 544

1 390

5. NCI share of equity in Tuvalu Ltd: 1/7/22 – 30/6/23: NCI share of profit NCI (10% x ($2 000 – ($400 -- $120)))

Dr Cr

172

NCI share of profit NCI (9% x ($2 000 – ($400 - $120))) NCI Dividend declared (10% x $12 000)

Dr Cr

154

Dr Cr

1 200

172

154

1 200

Acquisition analysis: Tonga Ltd – Thailand Ltd: At 1 July 2017: Net fair value of identifiable assets and liabilities of Thailand Ltd

= $100 000 + $8 000) (equity)

30.63

Chapter 30: Consolidation: other issues

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

+ $6 000 (1 – 30%) (BCVR - machinery) $112 200 $109 980 $10% x $112 200 $11 220 $121 200 $9 000

6. Business combination valuation entries: Thailand Ltd: Depreciation expense Retained earnings (1/7/22) Income tax expense Transfer from BCVR

Dr Dr Cr Cr

2 000 2 800

Dr Dr Dr Dr Cr

7 200 3 780 90 000 9 000

Dr Dr Dr Cr

800 10 000 420

600 4 200

7. Pre-acquisition entry: Tonga Ltd – Thailand Ltd: Retained earnings (1/7/22) Transfer from BCVR Share capital Goodwill Shares in Thailand Ltd

109 980

8. NCI share of equity in Thailand Ltd at 1/7/20: Retained earnings (1/7/22) Share capital Business combination valuation reserve NCI

11 220

9. NCI share of equity in Thailand Ltd: 1/7/20 – 30/6/22: Retained earnings (1/7/22) NCI (10% x ($32 000 - $8 000 – $2 800))

Dr Cr

2 120 2 120

10. NCI share of equity in Thailand Ltd: 1/7/22 - 30/6/23: NCI share of profit NCI (10% x ($4 000 – [$2 000 - $600]))

Dr Cr

260

Transfer from BCVR Business combination valuation reserve (10% x $4 200)

Dr Cr

420

260

420

30.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

NCI Dividend declared (10% x $20 000) NCI NCI share of profit (10% x 90% x $12 000)

Dr Cr

2 000

Dr Cr

1 080

2 000

1 080

11. Dividend declared: Thailand Ltd: Dividend payable Dividend declared (90% x $20 000)

Dr Cr

18 000

Dividend revenue Dividend receivable

Dr Cr

18 000

Dividend payable Dividend declared (90% x $12 000)

Dr Cr

10 800

Dividend revenue Dividend receivable

Dr Cr

10 800

18 000

12. Dividend declared: Tuvalu Ltd:

10 800

30.65

Chapter 30: Consolidation: other issues

Exercise 30.10 Consolidation worksheet entries, non-sequential acquisitions On 1 July 2022, Indonesia Ltd acquired 75% of the issued shares of India Ltd for $320 000. At this date the statement of financial position of India Ltd was as follows.

All the identifiable assets and liabilities of India Ltd were recorded at fair value except for some land for which the fair value was $10 000 greater than the carrying amount and some depreciable assets with a further 5-year life for which the fair value was $12 000 greater than the carrying amount. The tax rate is 30%. On 1 July 2024, Palau Ltd acquired 60% of the issued shares of Indonesia Ltd for $350 000. At this date, the statement of financial position of Indonesia Ltd was as follows.

All the identifiable assets and liabilities of Indonesia Ltd were recorded at fair value except for the investment in India Ltd which had a fair value of $400 000. The statement of financial position of India Ltd at 1 July 2024 was as follows.

30.66

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

All the identifiable assets and liabilities of India Ltd at this date were recorded at fair value except for the land held at 1 July 2022 which, at 1 July 2024, had a fair value of $20 000 greater than carrying amount, and the depreciable assets which have a further 3-year useful life have a fair value of $8000 greater than carrying amount. Financial information about Palau Ltd, Indonesia Ltd and India Ltd at 30 June 2025 is as follows. Palau Ltd Current assets

200 000

Indonesia Ltd $

150 000

India Ltd $

35 000

Non-current assets 350 000

—

320 000

—

Land

100 000

50 000

40 000

Depreciable assets

500 000

400 000

620 000

Accumulated depreciation

(80 000)

(40 000)

Total assets

1 070 000

840 000

655 000

Total liabilities

250 000

260 000

120 000

Investment in Indonesia Ltd Investment in India Ltd

Net assets

820 000

580 000

$ 535 000

Share capital

300 000

200 000

$ 100 000

General reserve

200 000

—

120 000

Retained earnings (1/7/24)

150 000

300 000

280 000

Profit for the period

170 000

80 000

35 000

580 000

$ 535 000

Total equity

820 000

30.67

Chapter 30: Consolidation: other issues

Prepare the worksheet entries for the consolidated financial statements of Palau Ltd’s group at 30 June 2025. (LO3 and LO4) 75% Indonesia Ltd

India Ltd

Acquisition analysis: Indonesia Ltd – India Ltd: At 1 July 2022: Net fair value of identifiable assets and liabilities of India Ltd

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= $100 000 + $100 000 +$200 000 + $10 000 (1 – 30%) (BCVR – land) + $12 000 (1 – 30%) (BCVR – N/C assets) = $415 400 = $320 000 = 25% x $415 400 = $103 850 = $423 850 = $8 450

Business combination valuation entries at 30/6/24: Indonesia Ltd – India Ltd: Land

Dr Cr Cr

10 000

Deferred tax liability Business combination valuation reserve Depreciable assets Deferred tax liability Business combination valuation reserve

Dr Cr Cr

12 000

Retained earnings (1/7/203 Deferred tax liability Accumulated deprec. – depreciable assets ($12 000/5 years = $2 400 p a for 2 years)

Dr Dr Cr

3 360 1 440

3 000 7 000

3 600 8 400

4 800

Pre-acquisition entry at 1/7/22: Indonesia Ltd - India Ltd: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve Goodwill Shares in India Ltd

Dr Dr Dr Dr Dr Cr

150 000 75 000 75 000 11 550 8 450 320 000

60%

30.68

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Palau Ltd ---------------------------- Indonesia Ltd Acquisition analysis: Palau Ltd – Indonesia Ltd: At 1 July 2024: Net fair value of identifiable assets and liabilities of Indonesia Ltd

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= $200 000 + $300 000 + $80 000 (BCVR – Shares in India) = $580 000 = $350 000 = 40% x $580 000 = $232 000 = $582 000 = $2 000

1. Business combination valuation entries - India Ltd at 30 June 2022: Land

10 000

Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Deferred tax liability Business combination valuation reserve

Dr Cr Cr

Retained earnings (1/7/24) Depreciable assets Deferred tax liability Business combination valuation reserve

Dr Dr Cr Cr

4 800 8 000

Depreciation expense Accumulated deprec. – depreciable assets (1/3 x $8 000)

Dr Cr

2 667

Deferred tax liability Income tax expense

Dr Cr

800

Land

3 000 7 000

3 840 8 960 2 667

800

2. Business combination valuation entry - Indonesia Ltd: Shares in India Ltd Business combination valuation reserve

Dr Cr

80 000 80 000

Using the pre-acquisition entry for Indonesia Ltd - India Ltd at 1/7/19: Retained earnings: 75% x ($280 000 - $3 360) - $150 000 General reserve: (75% x $120 000) - $75 000 © John Wiley and Sons Australia Ltd, 2020

= $57 480 = $15 000 30.69

Chapter 30: Consolidation: other issues

Business combination valuation reserve: (75% x $22 960) - $11 550 Goodwill* : $10 300 - $8 450 Total * $10 300 = $400 000 - 75% x ($500 000 + $14 000 + $5 600)

= $5 670 = $1 850 = $80 000

The further entry at 30/6/25 is: Retained earnings (1/7/24) General reserve Business combination valuation reserve Goodwill Shares in India Ltd

Dr Dr Dr Dr Cr

57 480 15 000 5 670 1 850

Dr Dr Dr Dr Cr

180 000 120 000 48 000 2 000

80 000

3. Pre-acquisition entry: Palau Ltd - Indonesia Ltd: Retained earnings (1/7/24) Share capital Business combination valuation reserve Goodwill Shares in Indonesia Ltd

350 000

4. DNCI in Indonesia Ltd at 1/7/24: Retained earnings (1/7/24) Dr 120 000 Share capital Dr 80 000 Business combination valuation reserve Dr 32 000 NCI Cr 232 000 (Retained earnings: 40% x $300 000; Share capital: 40% x $200 000; BCVR: 40% x $80 000) 5. DNCI in Indonesia Ltd from 1/7/24 to 30/6/25: NCI share of profit NCI (40% x $80 000)

Dr Cr

32 000

Dr Dr Dr Dr Dr Cr

150 000 75 000 75 000 11 550 8 450

Dr Dr

50 000 25 000

32 000

6. Pre-acquisition entry: Indonesia Ltd - India Ltd: Retained earnings (1/7/24) Share capital General reserve Business combination valuation reserve Goodwill Shares in India Ltd

320 000

7. DNCI in equity of India Ltd at 1/7/22: Retained earnings (1/7/24) Share capital

30.70

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

General reserve Business combination valuation reserve* NCI (*25% x $15 400)

Dr Dr Cr

25 000 3 850 103 850

8. DNCI in equity of India Ltd from 1/7/22 to 30/6/24: General reserve Dr 5 000 Retained earnings (1/7/24) Dr 18 800 NCI Cr 23 800 (GR: 25% x ($120 000 - $100 000); RE: 25% x ($280 000 - $200 000 - $4 800)) 9. DNCI in India Ltd from 1/7/24 to 30/6/25: Business combination valuation reserve NCI (25% x ($22 960 - $15 400))

Dr Cr

1 890

NCI share of profit NCI (25% x ($35 000 – [$2 667 - $800]))

Dr Cr

8 283

Dr Cr

9 940

1 890

8 283

10. INCI in India Ltd from 1/7/24 to 30/6/25: NCI share of profit NCI (30% x ($35 000 – [$2 667 - $800])

9 940

30.71

Chapter 30: Consolidation: other issues

Exercise 30.11 Consolidated financial statements, multiple subsidiaries, acquisitions on the same date On 1 July 2023, United States Ltd acquired 60% of the issued shares of Peru Ltd for $54 000. On the same day, Peru Ltd acquired 80% of the issued shares (cum div.) of Canada Ltd for $35 800. At the acquisition date, Peru Ltd’s and Canada Ltd’s financial statements showed the following balances. Peru Ltd

Canada Ltd

50 000

$ 30 000

General reserve

15 000

10 000

Retained earnings

7 500

4 000

Dividend payable

—

2 500

Share capital

The dividend of Canada Ltd was paid later in the year ended 30 June 2024. On 1 July 2023, all identifiable assets and liabilities of Peru Ltd and Canada Ltd were recorded at fair values except for the following. Peru Ltd Carrying amount Plant and machinery (cost $40 000) Inventories Vehicles (cost $40 000)

Canada Ltd Fair value

30 000

$ 40 000

20 000

25 000

—

Carrying amount

Fair value

—

15 000

$ 20 000

25 000

27 500

The vehicles have an expected useful life of 4 years and the plant is expected to last a further 10 years. Benefits are expected to be received evenly over these periods. All inventories on hand at 1 July 2023 was sold by 30 June 2024. The financial statements of the three companies at 30 June 2024 are as follows. United States Ltd

Peru Ltd

Canada Ltd

260 000

$ 182 500

80 000

52 500

29 000

340 000

235 000

86 500

Cost of sales

205 000

95 000

43 000

Other expenses

73 000

9 000

21 000

Sales revenue Other revenue

57 500

30.72

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

United States Ltd

Peru Ltd

Canada Ltd

278 000

185 000

64 000

Profit before income tax

62 000

5 000

22 500

Income tax expense

25 500

20 000

10 000

Profit

36 500

30 000

12 500

Retained earnings (1/7/23)

12 000

7 500

4 000

48 500

37 500

16 500

Interim dividend paid

5 000

7 500

1 500

Final dividend declared

8 000

4 000

2 000

Transfer to general reserve

12 500

3 000

2 000

25 500

14 500

5 500

Retained earnings (30/6/24)

23 000

11 000

Share capital

125 000

50 000

30 000

General reserve

72 500

18 000

12 000

Bank overdraft

10 500

3 000

10 000

Provisions

20 500

15 000

10 000

Current tax liability

27 500

21 000

13 000

Deferred tax liability

12 500

6 000

4 000

Dividend payable

8 000

4 000

2 000

299 500

$ 140 000

92 000

24 500

$ 12 500

16 000

Receivables

30 600

8 500

8 000

Inventories

51 500

20 900

34 000

Dividend receivable

2 400

1 600

—

Shares in Peru Ltd

54 000

—

33 800

—

Deferred tax asset

10 500

7 700

4 000

Plant

100 000

90 000

—

Accumulated depreciation — plant

(24 000)

(35 000)

—

Vehicles

65 000

—

50 000

Accumulated depreciation — vehicles

(15 000)

—

(20 000)

$ 299 5000

$ 140 000

Bank

Shares in Canada Ltd

92 000

30.73

Chapter 30: Consolidation: other issues

Additional information (a) Included in the ending inventories of Peru Ltd at 30 June 2024 were inventories purchased from Canada Ltd for $5 000. This had originally cost Canada Ltd $4000. (b) United States Ltd had sold inventories to Canada Ltd during the period ended 30 June 2024 for $12 500. This had cost United States Ltd $10 000. Half of this has been sold to external parties by Canada Ltd during the period for $7 500. (c) The tax rate is 30%. Required Prepare the consolidated financial statements for United States Ltd and its subsidiaries, Peru Ltd and Canada Ltd, for the period ending 30 June 2024. (LO3) 60% United States Ltd

80% Peru Ltd Canada Ltd United States Ltd 60% United States Ltd 48% DNCI 40% DNCI 20% INCI 32%

Acquisition analysis: United States Ltd – Peru Ltd: At 1 July 2023: Net fair value of identifiable assets and liabilities of Peru Ltd =

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

($50 000 + $15 000 + $7 5000) (equity) + $10 000 (1 – 30%) (BCVR - plant) + $5 000(1 – 30%)(BCVR - inventories) $84 000 $54 000 40% x $84 000 $33 200 $87 200 $4 200

1. Business combination valuation entries: Accumulated depreciation – P & M Deferred tax liability Business combination valuation reserve

Dr Cr Cr

10 000

Depreciation expense Accumulated depreciation – P & M (1/10 x $10 000 p.a.)

Dr Cr

1 000

Deferred tax liability Income tax expense

Dr Cr

300

4 000 7 000

1 000

300

30.74

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

5 000 1 500 3 500

2. Pre-acquisition entries: United States Ltd – Peru Ltd: The entry at 30/6/24 is: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve Goodwill Shares in Peru Ltd

Dr Dr Dr Dr Dr Cr

4 500 30 000 9 000 6 300 4 200

Transfer from BCVR Business combination valuation reserve

Dr Cr

2 100

Dr Dr Dr Dr Cr

3 000 20 000 6 000 4 200

54 000

2 100

3. NCI share of equity in Peru Ltd at 1/7/23: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve NCI (40% of balances)

33 400

4. NCI share of equity in Peru Ltd: 1/7/23 – 30/6/24: NCI share of profit Dr 10 320 NCI Cr (40% x ($30 000 – [$1 000 - $300]) – [$5 000 - $1500])

10 320

General reserve Transfer to general reserve (40% x ($18 000 - $15 000))

Dr Cr

1 200 1 200

Transfer from BCVR Business combination valuation reserve (40% x $3 500)

Dr Cr

1 400

NCI

Dr Cr

3 000

Interim dividend paid (40% x $7 500)

1 400

3 000

30.75

Chapter 30: Consolidation: other issues

NCI

Dr 1 120 NCI share of profit Cr 1 120 (40% x 80% x $3 500, being dividend revenue paid & provided from Canada Ltd) NCI

Dr Cr

Final dividend declared (40% x $4 000)

1 600 1 600

Acquisition analysis: Peru Ltd – Canada Ltd: At 1 July 2023: Net fair value of identifiable assets and liabilities of Canada Ltd

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Gain on bargain purchase

= ($30 000 + $10 000 + $4 000) (equity) + $2 500 (1 – 30%) (BCVR - vehicles) + $5 000(1 – 30%)(BCVR - inventories) = $49 250 = $35 800 – (80% x $2 500) (dividend) = $33 800 = 20% x $49 250 = $9 850 = $43 650 = $5 600

5. Business combination valuation entries - Peru Ltd – Canada Ltd: Accumulated depreciation – vehicles Vehicles Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

15 000

Depreciation expense Accumulated depreciation - vehicles (1/4 x $2 500 p.a.)

Dr Cr

625

Deferred tax liability Income tax expense

Dr Cr

188

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

5 000

12 500 750 1 750

625

188

1 500 3 500

30.76

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

6. Pre-acquisition entries: Peru Ltd – Canada Ltd: Retained earnings 1/7/23) Share capital General reserve Business combination valuation reserve Gain – other income Shares in Canada Ltd

Dr Dr Dr Dr Cr Cr

3 200 24 000 8 000 4 200

Transfer from BCVR Business combination valuation reserve (80% x $3 500)

Dr Cr

2 800

Dr Dr Dr Dr Cr

800 6 000 2 000 1 050

5 600 33 800 2 800

7. DNCI share of equity in Canada Ltd at 1/7/23: Retained earnings (1/7/23) Share capital General reserve Business combination valuation reserve NCI (20% of balances)

9 850

8. NCI share of equity in Canada Ltd from 1/7/23 – 30/6/24: NCI share of profit Dr NCI Cr (20% x ($12 500 – [$625 - $188] – [$5 000 - $1 500))

1 713 1 713

NCI share of profit Dr 4 980 NCI Cr (32% x ($12 500 – [$625 - $188] – [$5 000 - $3 500] + $5 600/0.8))

4 980

General reserve Transfer to general reserve ((20% + 32%) x ($12 000 - $10 000))

Dr Cr

1 040 1 040

Transfer from BCVR Business combination valuation reserve (20% x $3 500)

Dr Cr

700

NCI

Dr Cr

300

Dr Cr

400

Interim dividend paid (20% x $1 500) NCI Final dividend declared (20% x $2 000)

700

300

400

30.77

Chapter 30: Consolidation: other issues

9. Interim dividend paid: Peru Ltd: Canada Ltd:

60% x $7 500 80% x $1 500

= =

Dividend revenue Interim dividend paid

$4 500 $1 200 $5 700 Dr Cr

5 700 5 700

10. Dividend declared: Peru Ltd: Canada Ltd:

60% x $4 000 80% x $2 000

= =

$2 400 $1 600 $4 000

Dividend payable Final dividend declared

Dr Cr

4 000

Dividend revenue Dividend receivable

Dr Cr

4 000

Dr Cr Cr

5 000

Cost of sales Inventories Deferred tax asset Income tax expense

Dr Cr

300

Dr Cr

364

4 000

11. Inventories transfer: Peru Ltd – Canada Ltd: Sales

4 000 1 000

300

12. NCI adjustment: NCI NCI share of profit ((20% + 32%) x ($1000 - $300))

364

13. Inventories transfer: United States Ltd to Canada Ltd: Sales

12 500

Cost of sales Inventories

Dr Cr Cr

Deferred tax asset Income tax expense

Dr Cr

375

11 250 1 250

375

30.78

United States Ltd 260 000

Peru Ltd 182 500

Canada Ltd 57 500

Other income

80 000

52 500

29 000

Cost of sales

340 000 205 000

235 000 95 000

86 500 43 000

Other expenses

73 000

90 000

21 000

Profit before tax Tax expense

278 000 62 000 25 500

185 000 50 000 20 000

64 000 22 500 10 000

Profit

36 500

30 000

12 500

12 000

7 500

4 000

48 500

37 500

16 500 -

Interim dividend paid

5 000

7 500

1 500

5 700

8 300

Final dividend declared

8 000

4 000

2 000

4 000

10 000

Transfer to general reserve

12 500

3 000

2 000

17 500 35 800 47 288

Transfer from BCVR Retained earnings (1/7/23)

Retained earnings (30/6/24) Share capital

25 500 23 000

14 500 23 000

5 500 11 000

125 000

50 000

30 000

General reserve

72 500

18 000

12 000

11 13 9 10 1 5 1 5

Adjustments Dr Cr 5 000 12 500 5 700 5 600 4 000 5 000 5 000 1 000 625

4 000 11 250

Group

10 320 1 713 4 980 1 400 700 3 000 800

1 120 364

482 500 6

11 13

157 400 639 900 337 750

1 1 5 5 11 13

523 375 116 525 51 337

65 188

2 100 2 800 4 500 3 200

Parent Cr

185 625

300 1 500 188 1 500 300 375

2 6 2 6

NCI Dr

3 500 3 500

1 5

2 100 15 800

4 8 8 4 8 3 7

4 12

49 659

12 000

83 088

2 6 2 6

30 000 24 000 9 000 8 000

151 000 85 500

61 659

3 000 300 1 600 400 1 200 1 040

4 8 4 8 4 8

5 000 8 000 15 260 28 260 33 399

3 7 3 4 7 8

20 000 6 000 6 000 1 200 2 000 1 040

125 000 75 260

30.79

Chapter 30: Consolidation: other issues

BCVR

2 6

6 300 4 200

7 000 2 100 1 750 2 800

1 2 5 6

3 150

Total equity: Parent Total equity: NCI

220 500

91 000

53 000

286 938

Bank overdraft Provisions Current tax liability Deferred tax liability

10 500 20 500 27 500 12 500

3 000 15 000 21 000 6 000

10 000 10 000 13 000 4 000

23 500 45 500 61 500 25 762

Dividend payable Total liabilities Total equity & liabilities

8 000 79 000 299 500

4 000 49 000 140 000

2 000 39 000 92 000

Bank Receivables Inventories

24 500 30 600 51 500

12 500 8 500 20 900

16 000 8 000 34 000

Dividend receivable Shares in Peru Ltd Shares in Canada Ltd Deferred tax asset

2 400 54 000 10 500

1 600 33 800 7 700

4 000

Plant Accum deprec. - plant Vehicles Accum deprec. - vehicles Goodwill

100 000 (24 000) 65 000 (30 000) -

90 000 (35 000) -

50 000 (20 000) -

299 500

140 000

92 000

1 5 10

300 188 4 000

11 13

300 375

10 000

5 2

15 000 4 200

167 288

3 000 750

1 5

3 7

4 200 1 050

1 400 700

4 8

4 4 4 8 8 12

3 000 1 120 1 600 300 400 364 71 187

33 200 10 320 9 850 1 713 4 980

3 4 7 88

233 659 53 278

71 187

286 937

10 000 166 262 453 200

1 000 1 250 4 000 54 000 33 800

11 13 10 2 6

1 000 12 500 625

1 5 5

167 288

53 000 47 100 104 150 22 875 190 000 (50 000) 102 500 (20 625) 4 200 453 200

30.80

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

UNITED STATES LTD Consolidated statement of profit or loss and other comprehensive income for the year ended 30 June 2024 Sales revenue Other income

$482 500 157 400 639 900 337 750 185 625 523 375 116 525 51 337 $65 188 $65 188

Cost of sales Other expenses Profit before income tax Income tax expense Profit for the period Comprehensive income for the period Attributed to: Parent interest Non-controlling interest

$49 659 $15 529

UNITED STATES LTD Consolidated statement of changes in equity for the year ended 30 June 2024 Consolidated $65 188

Parent $49 659

Retained earnings at 1 July 2023 Profit for the period Transfer from business combination valuation reserve Transfer to general reserve Interim dividend paid Dividend declared Retained earnings at 30 June 2024

$15 800 65 188 2 100 (17 500) (8 300) (10 000) $47 288

$12 000 49 659 0 (15 260) (5 000) (8 000) $33 399

General reserve at 1 July 2023 Transfer from retained earnings General reserve at 30 June 2024

68 000 17 500 $85 500

60 000 15 260 $75 260

Business combination valuation reserve at 1 July 2023 Transfer to retained earnings Business combination valuation reserve at 30 June 2024

$5 250 2 100 $3 150

$151 000 $151 000

$125 000 $125 000

Comprehensive income for the period

Share capital at 1 July 2023 Share capital at 30 June 2024

30.81

Chapter 30: Consolidation: other issues

UNITED STATES LTD Consolidated statement of financial position as at 30 June 2024 Current assets Cash assets: Bank Receivables Inventories Total current assets Non-current assets Property, plant and equipment: Plant $190 000 Accumulated depreciation - plant (50 000) Vehicles 102 500 Accumulated depreciation - vehicles (20 625) Deferred tax asset Goodwill Total non-current assets Total assets Equity Share capital Reserves: General reserve Retained earnings Parent interest Non-controlling Interest Total equity Current liabilities Interest-bearing liabilities: Bank overdraft Provisions Tax liabilities: Current Payables: Dividend payable Total current liabilities Non-current Liabilities Tax liabilities: Deferred tax liability Total liabilities Total equity and liabilities

$53 000 47 100 104 150 204 250

140 000 81 875 55 875 __4 200 248 950 $453 200 $125 000 75 260 33 399 233 659 53 279 $286 938 23 500 45 500 61 500 10 000 140 500 25 762 166 262 $453 200

30.82

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.12 Sale of shares with loss of control X Ltd acquired 80% of the issued shares of Y Ltd for $350 000 on 1 July 2023 when the equity of Y Ltd consisted of $400 000 capital and $150 000 retained earnings. At this date the carrying amounts of Y Ltd’s identifiable assets and liabilities were not different from fair value except for plant for which the fair value was $5 000 greater than the carrying amount. The plant had a further 5-year useful life. On 30 June 2025, X Ltd sold all its interest in Y Ltd for $600 000 when the financial statements of Y Ltd showed the following. Sales revenue

450 000

Expenses

387 500

Profit

62 500

Retained earnings (1/7/24)

250 000

Retained earnings (30/6/25)

312 500

Share capital

200 000

Total equity

512 500

Net assets

512 500

Required Prepare the consolidation worksheet entries for X Ltd at 30 June 2025. (LO5) Acquisition analysis at 1 July 2023: Fair value of identifiable assets and liabilities of Y Ltd

(a) Consideration transferred (b) NCI in Y Ltd Aggregate of (a) and (b) Goodwill – parent share

= $200 000 + $150 000 + $5 000 (1 – 30%) (BCVR - plant) = $353 500 = $350 000 = 20% x $353 500 = $70 700 = $420 700 = $67 200

If there had been no sale of shares, the business combination valuation entries at 30 June 2025 would have been: Plant Deferred tax liability Business combination valuation entry Depreciation expense Retained earnings (1/7/24)

Dr Cr Cr

5 000

Dr Dr

1 000 1 000

1 500 3 500

30.83

Chapter 30: Consolidation: other issues

Accumulated depreciation - plant

Deferred tax liability Income tax expense Retained earnings (1/7/24)

2 000

Dr Cr Cr

600 300 300

X Ltd would pass the following journal entry on sale of its investment in Y Ltd: Cash Shares in Y Ltd Gain on sale of shares

Dr Cr Cr

600 000 350 000 250 000

The real gain to the group is calculated as follows – note there is no remaining investment: Gain = $600 000 (proceeds on sale) - $478 880 (X Ltd’s share of Y Ltd’s net assets) * = $121 120 * = 80% x ($512 500 (recorded net assets) + ($5 000 - $2000) plant – ($1500 - $600) (deferred tax liability)) + $67 200 goodwill to parent The adjustment to the gain on sale on consolidation is then $128 880 (= $250 000 - $121 120). The consolidation worksheet entries at 30 June 2025 are then: 1. Adjustment to gain on sale of shares and reinstatement of equity recognised by the group up to the point of loss of control, i.e. the point of sale: Gain on sale of shares Sales revenue Expenses ($387 500 + ($1 000 - $300)) Retained earnings (1/7/24) ($250 000 - $150 000 – ($1 000 - $300)) Transfer from BCVR ($3 500 – 80% x $3 500) Reduction in equity

Dr 128 880 Cr Dr 388 200

450 000

99 300

Cr Dr

700 32 920

2. NCI reduction: Share of profit (20% x ($62 500 – ($1000 - $300)) Dr Retained earnings (1/7/21) (20% x ($250 000 - $150 000 – ($1000 - $300)) Dr

12 360 19 860

30.84

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Transfer from BCVR (20% x $3500) Reduction in equity

Dr Cr

700 32 920

30.85

Chapter 30: Consolidation: other issues

Exercise 30.13 Sale of shares with no loss of control On 1 July 2023, A Ltd acquired 80% of the issued shares issued by B Ltd for $85 000. At this date, the shareholders’ equity of B Ltd consisted of share capital of $80 000 and retained earnings of $20 000. All identifiable assets were recorded at amounts equal to fair value except for plant for which the fair value was $4000 greater than the carrying amount. The plant had a further 4-year useful life. The partial goodwill method is used on consolidation. On 1 July 2022, A Ltd sold a quarter of its shareholding in B Ltd for $48 000 cash. The financial statements of A Ltd and B Ltd at this date prior to the sale were as follows.

Required Prepare the consolidation worksheet at 1 July 2025 after the sale of shares by A Ltd, assuming that the sale did not result in A Ltd losing control of B Ltd. (LO5) Acquisition analysis at 1 July 2023: Fair value of identifiable net assets of B Ltd

(a) Consideration transferred (a) NCI share of B Ltd Aggregate of (a) and (b) Goodwill

= $80 000 + $20 000 + $4 000 (1 – 30%) (BCVR – plant) = $102 800 = $85 000 = 20% x $102 800 = $20 560 = $105 560 = $2 760

Entry in A Ltd on sale of shares in B Ltd: Cash Shares in B Ltd Gain on sale

Dr Cr Cr

48 000 21 250 26 750

Consolidation worksheet entries at 1 July 2025:

30.86

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1. Business combination valuation entries: Plant Deferred tax liability BCVR Retained earnings (1/7/24) Accumulated depreciation - plant (2 years x ¼ x $4 000) Deferred tax liability Retained earnings (1/7/24)

Dr Cr Cr Dr Cr

4 000

Dr Cr

600

Dr Dr Dr Dr Cr

12 000 48 000 1 680 2 070

Dr Dr Dr Cr

4 000 16 000 560

1 200 2 800 2 000 2 000

600

2. Pre-acquisition entry: Retained earnings (1/7/24) Share capital Business combination valuation reserve Goodwill Shares in B Ltd (60% of balances at acquisition date)

63 750

3. NCI at 1/7/23: Retained earnings (1/7/23) Share capital Business combination valuation reserve NCI (20% of balances)

20 560

4. NCI share of changes in equity from 1/7/23 to 30/6/25: Retained earnings (1/7/24) Dr 9 720 General reserve Dr 2 000 NCI Cr 11 720 (RE: 20% x ($70 000 - $20 000 – ($2 000 - $600); GR: 20% x $10 000) 5. Adjustment to gain on sale of shares: Gain on sale Dr 26 750 Retained earnings (1/7/25) Cr 9 720 Transfer from general reserve Cr 2 000 Other reserves Cr 15 030 (RE: 20% x ($70 000 - $20 000 – ($2 000 - $600)); GR: 20% x $10 000) 6. NCI changes as a result of sale of shares by parent: Retained earnings (1/7/25) Share capital

Dr Dr

13 720 16 000 30.87

Chapter 30: Consolidation: other issues

Business combination valuation reserve Dr 560 General reserve Dr 2 000 NCI Cr 32 280 (RE: 20% x ($70 000 – ($2000 - $600)); SC: 20% x $80 000; BCVR: 20% x $2 800; GR: 20% x $10 000) The consolidation worksheet at 1/7/25 is as follows: A Ltd Gain on sale Retained earnings (1/7/24) Transfer from general reserve Share capital General reserve BCVR

B Ltd

26 750

100 000

70 000

100 000

80 000

20 000

10 000

Other reserves NCI

Adjustments Dr Cr 26 750 2 000 12 000

600 9 720

NCI Dr

Parent Cr 0

4 000 9 720 13 720

138 880

2 000

48 000

1 680

2 800

2 000

16 000 16 000 2 000 2 000 560 560

100 000 26 000 0

15 030

15 030 20 560 11 720 32 280

Liabilities

20 000 266 750

12 000 172 000

600

Shares in B Ltd Other assets Goodwill

63 750

203 000

172 000

4 000

0 266 750

0 172 000

2 070

64 560

1 200

32 600 379 070

63 750

2 000

377 000 2 070 379 070

Note the retained earnings closing balance at 30 June 2025: A Ltd Retained earnings (30/6/25)

100 000

B Ltd 70 000

Adjustments Dr Cr 2 000 600 16 000

NCI Dr 4 000 9 720

Parent Cr 138 880

30.88

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.14 Acquisition of additional shares in subsidiary by parent On 1 July 2023, K Ltd acquired 60% of the issued shares of L Ltd for $66 000 cash when the equity of L Ltd consisted of share capital of $80 000 and retained earnings of $20 000. All the identifiable assets and liabilities of L Ltd were recorded at amounts equal to fair value except for plant for which the fair value was $4000 greater than carrying amount. The plant had a further 4-year useful life. The partial goodwill method is used on consolidation. On 1 July 2025, K Ltd acquired a further 20% of the issued shares of L Ltd for $26 000. At this date, the shareholders’ equity of L Ltd consisted of $80 000 share capital and $40 000 retained earnings. Required Prepare the consolidation worksheet entries for the year ended 30 June 2026. (LO5) Acquisition analysis at 1 July 2023: Fair value of identifiable net assets of L Ltd

(a) Consideration transferred (b) Carrying amount of NCI Aggregate of (a) and (b) Goodwill

= $80 000 + $20 000 + $4 000 (1 – 30%) (BCVR – plant) = $102 800 = $66 000 = 40% x $102 800 = $41 120 = $107 120 = $4 320

On acquisition of the additional shares, K Ltd records the following: Shares in Ltd Cash

Dr Cr

26 000 26 000

Consolidation worksheet entries prior to acquisition of additional shares: 1. Business combination valuation entries: Plant

Dr Cr Cr

4 000

Retained earnings (1/7/25) Accumulated depreciation - plant

Dr Cr

2 000

Deferred tax liability

600

Deferred tax liability Business combination valuation reserve

1 200 2 800

2 000

30.89

Chapter 30: Consolidation: other issues

Retained earnings (1/7/25)

600

2. Pre-acquisition entries: Retained earnings (1/7/25) Share capital Business combination valuation reserve Goodwill Shares in L Ltd

Dr Dr Dr Dr Cr

12 000 48 000 1 680 4 320

Retained earnings (1/7/25) Share capital Business combination valuation reserve NCI (40% of equity balances of L Ltd)

Dr Dr Dr Cr

8 000 32 000 1 120

Retained earnings (1/7/25) NCI (40% x ($40 000 - $20 000 – ($2000 - $600)))

Dr Cr

7 440

Dr Dr Dr

7 720 16 000 560

Dr Cr

1 720

66 000

3. NCI at 1/7/23:

41 120

7 440

4. Acquisition of additional shares by K Ltd: Retained earnings (1/7/25) Share capital Business combination valuation reserve Retained earnings: Decrease due to acquisition of additional shares in L Ltd Shares in L Ltd

26 000

5. Reduction in NCI due to acquisition of shares by K Ltd: NCI Retained earnings (1/7/25) Share capital Business combination valuation reserve (Half of NCI share prior to sale of shares)

Dr Cr Cr Cr

24 280 7 720 16 000 560

30.90

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.15 Acquisition of additional shares in a subsidiary by parent Peter Ltd acquired 80% of the issued shares of Sam Ltd on 1 July 2021 for $32 000 when equity of Sam Ltd consisted of:

All the identifiable assets and liabilities of Sam Ltd were recorded at amounts equal to their fair values at this date except for plant for which the fair value was $2000 greater than the carrying amount. The remaining economic life of the plant was 5 years. The fair value of the non-controlling interest was $8000. The full goodwill method was used on consolidation. On 1 July 2023, Peter Ltd acquired a further 20% of the issued shares of Sam Ltd for $10 000 when the shareholders’ equity of Sam Ltd was as follows.

Required Prepare the consolidation worksheet entries at 1 July 2023 immediately after Peter Ltd’s acquisition of further shares in Sam Ltd. (LO5) At 1 July 2021: Net fair value of identifiable net assets of Sam Ltd = $20 000 + $16 000 + $2 000 x (1 -30%) (BCVR – plant) = $37 400 (a) Consideration transferred = $32 000 (b) NCI in Sam Ltd = $8 000 Aggregate of (a) and (b) = $40 000 Goodwill = $40 000 - $37 400 = $2 600 Goodwill attributed to Peter Ltd: Net fair value acquired = 80% x $37 400 = $29 920 Consideration transferred = $32 000 Goodwill – Peter Ltd = $2 080 Goodwill attributed to NCI = $2 600 – $2 080 = $520 Note: Peter Ltd paid $32 000 for 80%. FV of Sam Ltd was $40 000 (NCI FV $8 000 / 0.2). Therefore, as $32 000 = 80% of $40 000, there is no control premium in this question.

30.91

Chapter 30: Consolidation: other issues

Worksheet entries at 1 July 2023 – prior to acquisition of the further 20% of the issued shares in Sam Ltd: 1. Business combination valuation entries: Plant

Dr Cr Cr

2 000

Deferred tax liability Business comb. valuation reserve Retained earnings (1/7/23) Accumulated depreciation - plant

Dr Cr

800

Deferred tax liability Retained earnings (1/7/23)

Dr Cr

240

Goodwill Business comb. valuation reserve

Dr Cr

2 600

Dr Dr Dr Cr

12 800 16 000 3 200

Dr Dr Dr Cr

3 200 4 000 800

Retained earnings (1/7/23) Dr NCI Cr (20% x [$20 000 – $16 000 – ($800 – $240)])

688

600 1 400

800

240

2 600

2. Pre-acquisition entry: Retained earnings (1/7/23) Share capital Business combination valuation reserve Shares in Sam Ltd

32 000

3. NCI: Retained earnings (1/7/23) Share capital Business combination valuation reserve NCI

8 000

688

Worksheet entries at 1 July 2023 – after the further acquisition of the 20% of the issued shares in Sam Ltd: 1. Business combination valuation entries: Plant Deferred tax liability Business comb. valuation reserve

Dr Cr Cr

2 000

600 1 400

30.92

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Retained earnings (1/7/23) Accumulated depreciation - plant

Dr Cr

800

Deferred tax liability Retained earnings (1/7/23)

Dr Cr

240

Goodwill Business comb. valuation reserve

Dr Cr

2 600

Dr Dr Dr Cr

12 800 16 000 3 200

Dr Dr Dr Cr

3 200 4 000 800

Retained earnings (1/7/23) Dr NCI Cr (20% x [$20 000 – $16 000 – ($800 – $240)])

688

800

240

2 600

2. Pre-acquisition entry: Retained earnings (1/7/23) Share capital Business combination valuation reserve Shares in Sam Ltd

32 000

3. NCI: Retained earnings (1/7/23) Share capital Business combination valuation reserve NCI

8 000

688

4. Reduction in NCI as result of acquisition of further shares: NCI

Dr 8 688 Retained earnings (1/7/23) Cr 3 888 Share capital Cr 4 000 Business comb. valuation reserve Cr 800 (Write-down the whole of the NCI interest as subsidiary is now wholly owned) 5. Elimination of additional interest in Sam Ltd: Share capital Retained earnings (1/7/23) Business combination valuation reserve Retained earnings (1/7/23) Shares in Sam Ltd

Dr Dr Dr Dr Cr

4 000 3 888 800 1 312

10 000

30.93

Chapter 30: Consolidation: other issues

Exercise 30.16 Sale of shares in subsidiary by parent resulting in loss of control Insomnia Ltd acquired 80% of the issued shares of Sleepy Ltd on 1 July 2021 for $101 875 when the shareholders’ equity of Sleepy Ltd consisted of: Share capital

Retained earnings

62 500 50 000

All the identifiable assets and liabilities of Sleepy Ltd were recorded at amounts equal to their fair values except for plant for which the fair value was $6250 greater than carrying amount. The remaining economic life of the plant was 5 years. The fair value of the noncontrolling interest was $25 000. The full goodwill method was used on consolidation. On 1 July 2023, Insomnia Ltd sold 40% of the issued shares of Sleepy Ltd (i.e. 1/2 of its holdings) for $62 500. Shareholders’ equity of Sleepy Ltd at this date consisted of share capital of $62 500 and retained earnings of $62 500. As a result of this sale, Insomnia Ltd lost control of Sleepy Ltd. Required 1. Prepare the journal entries in Insomnia Ltd to record the sale of shares in Sleepy Ltd and any gain/loss on sale. 2. Prepare the consolidation worksheet entries at 1 July 2023 immediately after Insomnia Ltd sold its shares in Sleepy Ltd. (LO5) 1. Journal entries in Insomnia Ltd to record the sale of shares in Sleepy Ltd and any gain/loss on sale. Cash Shares in Sleepy Ltd Shares in Sleepy Ltd Gain [recorded]

Dr Cr Dr Cr

62 500 50 938 11 563 23 125

Note: Insomnia Ltd sold ½ its holding in Sleepy Ltd. Therefore, its investment in Sleepy Ltd is reduced by 1/2. Original investment amount $101 875 x ½ = $50 937.50. If Insomnia Ltd sold ½ its holding for $62 500 then it’s assumed the fair value of its holding was $125 000. Therefore, the recorded gain on sale is $23 125 ($125 000 - $101 875). The real gain to the group is calculated as follows: Real gain to group = $62 500 proceeds of sale + $62 500 fair value of remaining investment - $108 600 Insomnia Ltd’s share of net assets* - $1 875 goodwill recognised by Insomnia Ltd (control premium) = $14 525

30.94

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

* Insomnia Ltd’s share of net assets =80% x [$125 000 recorded by Sleepy Ltd + $8 125 goodwill + ($6 250 - $2 500) unrecorded plant - ($1 875 - $750) unrecorded DTL] = 80% x $135 750 = $108 600 2. Consolidation worksheet entries at 1 July 2023 immediately after Insomnia Ltd sold its shares in Sleepy Ltd. Gain on sale Retained earnings (1/7/23) ($13 125 – $14 525)

Dr Cr

8 600 8 600

Before sale:

Retained earnings (1/7/23)

Insomnia Ltd 0

Sleepy Ltd 62 500

Adjustments Dr Cr 2 500 750 40 000

NCI Dr 10 000 2 150

Insomnia Ltd 0

Sleepy Ltd

NCI

Adjustments Dr Cr 8 600

8 600

Group Cr 8 600

After sale:

Retained earnings (1/7/23) Gain on sale

23 125

Group Cr 8 600

14 525

30.95

Chapter 30: Consolidation: other issues

Exercise 30.17 Sale of shares in subsidiary by parent without loss of control Pretty Ltd acquired 80% of the issued shares of Smart Ltd on 1 July 2021 for $61 125 when the shareholders’ equity of Smart Ltd consisted of: Share capital

$37 500

Retained earnings

30 000

All the identifiable assets and liabilities of Smart Ltd were recorded at amounts equal to their fair values except for plant for which the fair value was $3750 greater than carrying amount. The remaining economic life of the plant was 5 years. The fair value of the non-controlling interest was $15 000. The full goodwill method was used on consolidation. On 1 July 2023, Pretty Ltd sold 16% of the issued shares of Smart Ltd (i.e. 1/5 of its holdings) for $15 000. Shareholders’ equity of Smart Ltd at this date consisted of share capital of $37 500 and retained earnings of $37 500. Required Prepare the consolidation worksheet entries at 1 July 2023 immediately after Pretty Ltd sold its shares in Smart Ltd. (LO5) Acquisition analysis at 1 July 2021: Net fair value of identifiable net assets of Smart Ltd

(a) Consideration transferred (b) NCI in Smart Ltd Aggregate of (a) and (b) Goodwill Goodwill of Smart Ltd: Fair value of Smart Ltd Net fair value of identifiable net assets of Smart Ltd Goodwill of Smart Ltd

= $37 500 + $30 000 + $3 750 (1 – 30%) (BCVR – plant) = $70 125 = $61 125 = $15 000 = $76 125 = $6 000 = $15 000/20% = $75 000 = $70 125 = $75 000 - $70 125 = $4 875

Goodwill of Pretty Ltd: Goodwill acquired = $6 000 Goodwill of Smart Ltd = $4 875 Goodwill of Pretty Ltd: control premium = $1 125 Worksheet entries at 1 July 2023 – prior to the sale of shares by parent:

30.96

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. Business combination valuation entries: Plant

Dr Cr Cr

3 750

Deferred tax liability Business comb. valuation reserve Retained earnings (1/7/23) Accumulated depreciation - plant

Dr Cr

1 500

Deferred tax liability Retained earnings (1/7/23)

Dr Cr

450

Goodwill Business comb. valuation reserve 2. Pre-acquisition entry:

Dr Cr

4 875

Retained earnings (1/7/23) Share capital Business combination valuation reserve Goodwill Shares in Smart Ltd

Dr Dr Dr Dr Cr

24 000 30 000 6 000 1 125

Dr Dr Dr Cr

6 000 7 500 1 500

Retained earnings (1/7/23) Dr NCI Cr (20% x ($37 500 – $30 000 – ($1 500 – $450)))

1 290

1 125 2 625

1 500

450

4 875

61 125

3. NCI: Retained earnings (1/7/23) Share capital Business combination valuation reserve NCI

15 000

1 290

Worksheet entries at 1 July 2023 – after the sale of shares by parent: 1. Business combination valuation entries: Plant

3 750

Deferred tax liability Business comb. valuation reserve

Dr Cr Cr

Retained earnings (1/7/23) Accumulated depreciation - plant

Dr Cr

1 500

Deferred tax liability

450

1 125 2 625

1 500

30.97

Chapter 30: Consolidation: other issues

Retained earnings (1/7/23)

450

Goodwill Business comb. valuation reserve

Dr Cr

4 875

Dr Dr Dr Dr Cr

19 200 24 000 4 800 900

4 875

2. Pre-acquisition entry: Now use only 64% of pre-acquisition equity Retained earnings (1/7/23) Share capital Business combination valuation reserve Goodwill* Shares in Smart Ltd **

48 900

Note: Pretty Ltd sold 1/5 of its holding in Smart Ltd. *Goodwill is reduced by 1/5. ($1 125 – [1/5 x $1 125]) **Shares in Smart Ltd is reduced by 1/5. ($61 125 – [1/5 x $61 125]) 3. NCI: Use entry 3 (shown previously) plus the following entry for the extra 16% interest: Retained earnings (1/7/23) * Share capital Business combination valuation reserve NCI (*RE = 16% x ($37 500 – ($1 500 – $450))

Dr Dr Dr Cr

5 832 6 000 1 200 13 032

4. Elimination of gain recorded by Pretty Ltd: Pretty Ltd records a gain

= $15 000 – 1/5 x $61 125 = $2 775

Gain on sale Dr 2 775 Retained earnings (1/7/23)* Cr Other reserves Cr (*RE: 16% x [($37 500 – $30 000) – ($1 500 – $450)])

1 032 1 743

30.98

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 30.18 Consolidation worksheet entries, analysis of non- controlling interest, sequential acquisitions A client of yours is the chief accountant of Comoros Ltd which, at 30 June 2023, has two subsidiaries, Cook Islands Ltd and Chile Ltd. He is unsure how to prepare the consolidated financial statements and has asked for your help. He has provided you with the information below concerning the group, and has determined a series of questions for which he wants clear, well-written answers. Provide the answers to these questions. Assume a tax rate of 30%. Part A Comoros Ltd acquired 40% of the issued shares of Cook Islands Ltd on 1 July 2020 for a total consideration of $79 400, consisting of $9400 cash and 14 000 Comoros Ltd shares having an estimated fair value of $5 per share. The equity of Cook Islands Ltd at this date is as follows.

All the identifiable assets and liabilities of Cook Islands Ltd were recorded at fair value except for plant (carrying amount $60 000, net of $10 000 depreciation) for which the fair value was $65 000. The plant has a further 5-year useful life. During January 2021, Cook Islands Ltd paid a dividend of $5000. Further, in January 2021, a transfer to retained earnings of $4000 was made from the general reserve established before 1 July 2020. Required 1. Prepare the business combination valuation entries and pre-acquisition entries in relation to Comoros Ltd’s acquisition of Cook Islands Ltd at 30 June 2021, assuming Cook Islands Ltd is a subsidiary of Comoros Ltd at this date. 2. Explain how the calculations used in requirement 1 meet the requirements of AASB 3/IFRS 3 Business Combinations. 3. If Comoros Ltd acquired its shares in Cook Islands Ltd at 1 July 2020, but did not achieve control until 1 July 2021 when the retained earnings of Cook Islands Ltd were $60 000 and the fair value of plant was $30 000 greater than the carrying amount, should the fair values be measured at 1 July 2020, or at 1 July 2021 when Comoros Ltd obtained control of Cook Islands Ltd? Explain your answer, referring to requirements of appropriate accounting standards. 4. If Cook Islands Ltd earned a $10 000 profit between 1 July 2020 and 30 June 2021, determine the non-controlling interest share of Cook Islands Ltd’s equity at 30 June 2021. 5. Explain your calculation of the non-controlling interest share of profit in requirement 4.

30.99

Chapter 30: Consolidation: other issues

Part B Cook Islands Ltd acquired 75% of the issued shares of Chile Ltd at 1 January 2021 for $137 000 when the equity of Chile Ltd consisted of $100 000 capital and $62 000 retained earnings which included profit of $12 000, earned from 1 July 2020. At acquisition date, all the identifiable assets and liabilities of Chile Ltd were recorded at fair value except for the following assets.

Of the inventories, 90% were sold by 30 June 2021 and the remainder by 30 June 2022. The land was sold in January 2023 for $120 000. The plant has a further 5-year life. Required Prepare the business combination valuation entries and pre-acquisition entries in relation to Cook Islands Ltd’s acquisition of Chile Ltd at 30 June 2021 and 30 June 2023. Part C The following transactions affect the preparation of consolidated financial statements of Comoros Ltd’s group at 30 June 2023. (a) Sale of inventories in June 2022 from Chile Ltd to Comoros Ltd — the inventories cost Chile Ltd $2000, and were sold to Comoros Ltd for $3000. At 30 June 2023, Comoros Ltd did not hold any of these inventories. (b) Sale of plant on 1 January 2022 from Chile Ltd to Comoros Ltd — the plant had a carrying amount in Chile Ltd of $12 000 at time of sale, and was sold for $15 000. The plant had a further 5-year useful life. (c) Dividend of $10 000 declared in June 2023 by Chile Ltd to be paid in August 2023. (d) Payment of a $4500 management fee from Chile Ltd to Comoros Ltd in February 2023. Required In relation to the preparation of the consolidated financial statements for Comoros Ltd’s group at 30 June 2023: 1. Provide consolidation worksheet journal entries for the above transactions, including related non-controlling interest adjustments. 2. Explain the adjustment entry for transaction (a). 3. Explain the non-controlling interest adjustment entry in relation to transaction (c). 4. If the retained earnings (1/7/19) of Chile Ltd was $80 000 and the profit for the period ended 30 June 2023 was $10 000, calculate the non-controlling interests share of Chile Ltd’s equity at 30 June 2023, assuming no changes in reserves. 5. The calculation of non-controlling interest is based on the concept of sharing only those profits that are realised to the group. Explain this concept, showing how it is implemented using transactions (a), (b) and (d). (LO2, LO3, LO4 and LO5) Part A

30.100

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. Business combination valuation entries and pre-acquisition entries: Comoros Ltd – Cook Islands Ltd. Acquisition analysis: Comoros Ltd – Cook Islands Ltd: At 1 July 2020: Net fair value of identifiable assets, and liabilities of Cook Islands Ltd =

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

$100 000 + $50 000 + $40 000) (equity) + $5 000 (1 – 30%) (BCVR - plant) $193 500 $79 400 60% x $193 500 $116 100 $195 500 $2 000

The worksheet entries at 30 June 2021 are: Business combination valuation entries: Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

10 000

Depreciation expense Accumulated depreciation - plant

Dr Cr

1 000

Deferred tax liability Income tax expense

Dr Cr

300

Dr Dr Dr Dr Dr Dr Cr

16 000 1 600 40 000 18 400 1 400 2 000

5 000 1 500 3 500

1 000

300

Pre-acquisition entry: Retained earnings (1/7/20) Transfer from general reserve Share capital General reserve Business combination valuation reserve Goodwill Shares in Cook Islands Ltd 2. (i) (ii) (iii)

79 400

Consideration transferred is based on the fair value of what is given up by Comoros Ltd. Identifiable assets and liabilities acquired are measured at fair value. Goodwill is calculated as a residual under the partial goodwill method. © John Wiley and Sons Australia Ltd, 2020

30.101

Chapter 30: Consolidation: other issues

(iv) (v) (vi)

Goodwill is not amortised, but is subject to an impairment test. Fair values are measured at acquisition date. Use of acquisition method.

3. The appropriate date for determination of the fair values of identifiable assets and liabilities acquired is the acquisition date, 1 July 2021, being the date of control. It would be necessary for Comoros Ltd to revalue the investment in Cook Islands Ltd to its fair value at 1 July 2021 according to paragraph 42 of AASB 3 / IFRS 3 Business Combinations. 4. NCI share of equity of Cook Islands Ltd at 30 June 2021: NCI share of equity at 1/7/20: Retained earnings (1/7/20) Share capital General reserve Business combination valuation reserve NCI NCI share of equity: 1/7/20 – 30/6/21:

Dr Dr Dr Dr Cr

24 000 60 000 30 000 2 100 116 100

NCI share of profit NCI (60% x ($10 000 – [$1 000 - $300]))

Dr Cr

5 580

Transfer from general reserve General reserve

Dr Cr

2 400

NCI

Dr Cr

3 000

Dividend paid (60% x $5 000)

5 580

2 400

3 000

5. Need to adjust for the depreciation on revalued plant to avoid double counting. The NCI has a share of the business combination valuation reserve. Cook Islands Ltd’s current period recorded profit includes the benefits in relation to the revalued plant. Not to reduce the recorded profit by the amounts already recognised in the BCVR, would be to double count the NCI share of equity. Part B Business combination valuation entries and pre-acquisition entries at 30 June 2021 and 30 June 2023: Cook Islands Ltd – Chile Ltd Acquisition analysis: Cook Islands Ltd – Chile Ltd: At 1 January 2021: Net fair value of identifiable assets and liabilities of Chile Ltd

($100 000 + $62 000) (equity)

30.102

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) Consideration transferred (b) Non-controlling interest Aggregate of (a) and (b) Goodwill

= = = = = =

+ $10 000 (1 – 30%) (BCVR - land) + $5 000 (1 – 30%) (BCVR - plant) + $5 000(1 – 30%)(BCVR - inventories) $176 000 $137 000 25% x $176 000 $44 000 $181 000 $5 000

Worksheet entries at 30 June 2021: Business combination valuation entries: Land

Dr Cr Cr Dr Cr Cr Cr

10 000

Depreciation expense Accumulated depreciation - plant (1/2 x 1/5 x $5 000)

Dr Cr

500

Deferred tax liability Income tax expense

Dr Cr

150

Cost of sales Income tax expense Transfer from BCVR

Dr Cr Cr

4 500

Inventories Deferred tax liability Business combination valuation reserve

Dr Cr Cr

500

Retained earnings (1/1/21) Share capital Business combination valuation reserve Goodwill Shares in Chile Ltd

Dr Dr Dr Dr Cr

46 500 75 000 10 500 5 000

Transfer from BCVR

2 363

Deferred tax liability Business combination valuation reserve Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

3 000 7 000 15 000 10 000 1 500 3 500

500

150

1 350 3 150

150 350

Pre-acquisition entries:

137 000

30.103

Chapter 30: Consolidation: other issues

Business combination valuation reserve

2 363

Worksheet entries at 30 June 2023: Business combination valuation entries: Gain on sale of land/carrying amount of land sold Income tax expense Transfer from BCVR

Dr Cr Cr

10 000

Accumulated depreciation - plant Plant Deferred tax liability Business combination valuation reserve

Dr Cr Cr Cr

15 000

Depreciation expense Retained earnings (1/7/22) Accumulated depreciation – plant (1/5 x $5 000 per annum)

Dr Dr Cr

1 000 1 500

Deferred tax liability Income tax expense Retained earnings (1/7/22)

Dr Cr Cr

750

Retained earnings (1/1/22)* Dr Share capital Dr Business combination valuation reserve Dr Goodwill Dr Shares in Chile Ltd Cr * (75% x $62 000) + (75% x ($5 000 (1 – 30%))

49 125 75 000 7 875 5 000

Transfer from BCVR Business combination valuation reserve (75% x $7 000)

5 250

3 000 7 000

10 000 1 500 3 500

2 500

300 450

Pre-acquisition entries:

Dr Cr

137 000

5 250

Part C 1. (i) Sale of inventories in prior period from Chile Ltd to Comoros Ltd: Retained earnings (1/7/22) Income tax expense Cost of sales

Dr Dr Cr

700 300 1 000

30.104

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(ii) NCI adjustment: NCI share of profit Retained earnings (1/7/22) ((25% + 45%) x $700))

Dr Cr

490 490

(iii) Sale of plant in prior period from Chile Ltd to Comoros Ltd: Retained earnings (1/7/22) Deferred tax asset Plant

Dr Dr Cr

2 100 900

Dr Cr

1 470

Accumulated depreciation - plant Depreciation expense Retained earnings (1/7/22)

Dr Cr Cr

900

Income tax expense Retained earnings (1/7/22) Deferred tax asset

Dr Dr Cr

180 90

Dr Dr Cr

294 147

Dividend payable Dividend declared

Dr Cr

7 500

Dividend revenue Dividend receivable

Dr Cr

7 500

Dr Cr

4 500

3 000

(iv) NCI adjustment: NCI Retained earnings (1/7/22) ((25% + 45%) x $2 100)) (v) Depreciation of plant:

1 470

600 300

270

(vi) NCI adjustment: NCI share of profit Retained earnings (1/7/22) NCI ((25% + 45%) x ($600 - $180) p.a.))

441

(vii) Dividend declared:

7 500

(viii) Management fee: Management fee revenue Management fee expense

4 500

30.105

Chapter 30: Consolidation: other issues

2. The INCI receives a share of profit of Chile Ltd. The DNCI in Cook Islands Ltd receives a share of profit of Cook Islands Ltd which includes the dividend revenue from Chile Ltd. There is a problem of double counting the NCI share of Chile Ltd’s profits. It will be necessary in calculating the NCI share of Cook Islands Ltd’s equity to reduce the NCI share of equity, and NCI Share of Profit by $4 500 (i.e. 60% x 75% x $10 000). 3. See Chapter 29. Explain effect on profit, effect on cost of sales and tax effect 4. Calculation of NCI: NCI share of equity at 1 January 2021: Retained earnings (1/7/22) Share capital Business combination valuation reserve NCI (25% of balances) NCI share of equity from 1/1/21 – 30/6/22:

Dr Dr Dr Cr

15 500 25 000 3 500

Retained earnings (1/7/22)* Dr Business combination valuation reserve Cr NCI Cr *(25% x ($80 000 - $62 000 – [$1 500 - $450]))

4 238

Retained earnings (1/7/22)* Dr NCI Cr *(45% x ($80 000 - $49 125/0.75 – [$1 500 - $450]))

6 053

44 000

875 3 363

6 053

NCI share of equity from 1/7/22 – 30/6/23: NCI share of profit Dr NCI Cr (25% x ($10 000 – [$1 000 - $300] – [$10 000 - $3 000]))

575 575

NCI share of profit Dr 1 035 NCI Cr (45% x ($10 000 – [$1 000 – $300] – [$10 000 - $3 000]) NCI Dividend declared (25% x $10 000)

Dr Cr

1 035

2 500 2 500

5. Realisation relates to involvement of an external party. • •

In relation to (a): realisation occurs at point of sale to external party. In relation to (b): no direct external party. Assume realisation occurs in proportion to consumption of benefits as asset is used. That is, in proportion to depreciation.

30.106

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

In relation to (d): assume instant realisation.

30.107

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 30: Consolidation: other issues Multiple choice questions 1. Which of the following are other issues to consider in the preparation of the consolidated financial statements? I. II. III.

*a. b. c. d.

when a parent acquires a subsidiary after that subsidiary has acquired its own subsidiary. when the parent changes its ownership interest in a subsidiary after the consolidation group has been formed. where the parent has control over two subsidiaries but only has an ownership interest in one of those subsidiaries.

I, II and III I and II only II and III only I and III only

Answer: a Learning objective 30.1: understand different ways in which a group can be formed and how ownership interests in that group can be changed.

30.1

Testbank to accompany Financial reporting 3e by Loftus et al.

2. Consider the following economic entity structure:

The direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI) are which of the following? DNCI in A Ltd 10% 40% 10% 40%

I. II. III. IV. a. b. *c. d.

INCI in A Ltd 14% Nil Nil Nil

DNCI in B Ltd 40% 10% 40% 10%

INCI in B Ltd 6% 6% 6% 54%

I. II. III. IV.

Answer: c Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI).

3. Katie Limited has a 90% ownership interest in Max Limited. Max Limited has a 60% ownership interest in Josie Limited. As a result of these ownership interests, there is an indirect NCI in Josie Limited of: *a. b. c. d.

6% 10% 40% 54%

Answer: a Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI). © John Wiley and Sons Australia, Ltd 2020

30.2

Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

4. Consider the following economic entity structure.

The direct non-controlling interests (DNCI) and indirect non-controlling interests (INCI) are which of the following?

I. II. III. IV.

DNCI in A Ltd 20% 20% 20% 20%

INCI in A Ltd Nil Nil 18% Nil

DNCI in B Ltd 70% 10% 20% 30%

INCI in B Ltd 6% 6% 12% 12%

a. I. b. II. c. III. *d. IV. Answer: d Feedback: DNCI in B Ltd = 100% - (10% + 60%) = 30%; INCI in B Ltd = 60% x (1-80%) = 12% Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI).

30.3

Testbank to accompany Financial reporting 3e by Loftus et al.

5. Consider the following economic entity structure.

The indirect NCI in B Ltd is the same group of shareholders as the: a. b. c. *d.

shareholders in P Ltd. direct NCI in B Ltd. indirect NCI in A Ltd. direct NCI in A Ltd.

Answer: d Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI).

6. 16Anita Limited has a direct ownership interest of 80% in Mark Limited. Mark Limited has a direct ownership interest of 80% in Bribie Limited. The indirect non-controlling interest in Bribie Limited is: *a. b. c. d.

16%. 20%. 40%. 64%.

Answer: a Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI).

7. Kate Limited has an 80% ownership interest in Harry Limited. Harry Limited has a 60% ownership interest in William Limited. As a result of these ownership interests, there is a direct ownership interest in William Limited amounting to: a. b. *c. d.

12%. 20%. 40%. 80%.

Answer: c Learning objective 30.2: explain the difference between direct non-controlling interest (DNCI) and indirect non-controlling interest (INCI).

30.4

Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

8. An ownership structure in which Opal Limited acquires shares in Pearl Limited before Pearl Limited acquires shares in Quartz Limited is known as: *a. b. c. d.

a sequential acquisition. a consequential acquisition. an aggregate acquisition. a multiple acquisition.

Answer: a Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

9. In a group that has a multiple subsidiary structure, the indirect non-controlling interest is entitled to: a. b. *c. d.

no share of post-acquisition equity. a proportionate share of pre-acquisition equity only. a proportionate share of post-acquisition equity only. no share of either pre-acquisition or post-acquisition equity.

Answer: c Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

10. In a group that has a multiple subsidiary structure, the direct non-controlling interest is entitled to: a. b. c. *d.

no share of post-acquisition equity. a proportionate share of pre-acquisition equity only. a proportionate share of post-acquisition equity only. a proportionate share of both pre-acquisition and post-acquisition equity.

Answer: d Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

30.5

Testbank to accompany Financial reporting 3e by Loftus et al.

11. In a situation where a parent acquires shares in a subsidiary, and the subsidiary later acquires a controlling interest in another entity, the ownership structure is: a. b. *c. d.

ordered. random. sequential. non-sequential.

Answer: c Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

12. The pre-acquisition entry for the Riley group in order to consolidate a 75% interest in a subsidiary contained the following debits: Retained earnings $16 000, share capital $80 000, general reserve $30 000, BCVR $12 000. The direct non-controlling interest’s share of the subsidiary’s equity at the date of acquisition is: a. *b. c. d.

$184 000 $46 000 $138 000 $34 500

Answer: b Feedback: Total subsidiary equity = (16000 + 80000 + 30000 + 12000) / 75% = 184000. DNCI = 184000 x 25% = 46000 Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

13. When calculating the direct non-controlling interest share of equity, consolidation adjustments are needed to: a. b. c. *d.

eliminate intragroup advances. recognise profits made on intragroup services. partially eliminate profits on intragroup services. remove unrealised profits or losses from intragroup transactions.

Answer: d Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

30.6

Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

14. In order to consolidate a 60% interest in a subsidiary, the Morgan Group prepared the following pre-acquisition entry: DR Retained earnings $14 000 DR Share capital $25 000 DR General reserve $6 000 CR Investment in subsidiary

$45 000

The interest in equity attributable to the direct non-controlling interest is: *a. b. c. d.

$30 000. $15 000. $25 000. $20 000.

Answer: a Feedback: $45 000 / 60% x 40% Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

30.7

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Dion Ltd acquired a 60% ownership interest in Sean Ltd on 30 June 2021. On the same day, Sean Ltd acquired a 70% ownership interest in Jayden Ltd. The following interentity transactions have taken place between the entities in the group during the years ended 30 June 2022 and 30 June 2023. i. ii. iii.

iv.

On 1 July 2021 Sean sold an item of plant to Jayden for a profit of $40 000. The remaining useful life of the plant at the date of transfer was 4 years. On 1 September 2021, Jayden paid a dividend of $50 000 from profits earned since 30 June 2021. Dion lent $60 000 to Sean on 1 January 2022. Interest charged on the loan for the year ended 30 June 2022 was $4000 and for the year ended 30 June 2023 was $8000. On 31 May 2022 Dion sold inventories to Jayden for $30 000. Profit earned on the sale was $4000. Jayden sold the inventories to external parties on 1 August 2022.

Details of profits earned by entities within the group for the years ended 30 June 2022 and 30 June 2023 are:

Dion Sean Jayden

30 June 2022 30 June 2023 200 000 250 000 170 000 140 000 40 000 70 000

The tax rate is 30%. For the sale of plant on 1 July 2021, what is the net NCI adjustment for the year ending 30 June 2022? a. *b. c. d.

$7 000 $8 400 $10 000 $11 200

Answer: b Feedback: After-tax profit on sale = $40000 x 70% = $28000. After-tax Depreciation adjustment for the year ending 30 June 2022 = $40000/4 x 70% = $7000. Net after-tax adjustment = $28000-$7000 = $21000. NCI share = $21000 x 40% = $8400 Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

16. Dion Ltd acquired a 60% ownership interest in Sean Ltd on 30 June 2021. On the same day, Sean Ltd acquired a 70% ownership interest in Jayden Ltd. The following interentity transactions have taken place between the entities in the group during the years ended 30 June 2022 and 30 June 2023. i. ii. iii.

iv.

Details of profits earned by entities within the group for the years ended 30 June 2022 and 30 June 2023 are:

Dion Sean Jayden

30 June 2022 30 June 2023 200 000 250 000 170 000 140 000 40 000 70 000

The tax rate is 30%. The NCI share of profit in Jayden for the year ended 30 June 2023 is: a. b. *c. d.

$23 200. $21 000. $40 600. $28 000.

Answer: c Feedback: DNCI = 30%. INCI = 70% x 40% = 28%. DNCI + INCI = 58%. NCI share of profit in Jayden = $70 000 x 58%. Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Testbank to accompany Financial reporting 3e by Loftus et al.

17. Dion Ltd acquired a 60% ownership interest in Sean Ltd on 30 June 2021. On the same day, Sean Ltd acquired a 70% ownership interest in Jayden Ltd. The following interentity transactions have taken place between the entities in the group during the years ended 30 June 2022 and 30 June 2023. i. ii. iii.

iv.

Details of profits earned by entities within the group for the years ended 30 June 2022 and 30 June 2023 are:

Dion Sean Jayden

30 June 2022 30 June 2023 200 000 250 000 170 000 140 000 40 000 70 000

The tax rate is 30%. The effect of the interest paid by Sean to Jayden on the NCI of Sean for the year ended 30 June 2023 is: a. b. c. *d.

an increase in NCI of $2 400 an increase in NCI of $3 200 an increase in NCI of $4 640 nil.

Answer: d Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

18. When calculating the direct non-controlling interest share of equity, consolidation adjustments are needed to: a. b. c. *d.

eliminate any realised profits or losses from inventory transfers. partially eliminate any unrealised profits from inventory transfers. recognise any unrealised profits or losses from intragroup service transfers. fully eliminate any unrealised profits or losses from intragroup transactions.

Answer: d Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

19. An indirect non-controlling interest arises: a. b. *c. d.

when a partly owned subsidiary owns shares in the parent entity. when a wholly owned subsidiary owns shares in the parent entity. only when a partly owned subsidiary holds shares in another subsidiary. only when a wholly owned subsidiary owns shares in another subsidiary.

Answer: c Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Testbank to accompany Financial reporting 3e by Loftus et al.

20. Koala Limited acquired a 75% ownership interest in Kookaburra Limited on 30 June 2021. On the same day, Kookaburra Limited acquired a 60% ownership interest in Kangaroo Limited. The following inter-entity transactions have taken place between the entities in the group during the years ended 30 June 2022 and 30 June 2023: • • • •

On 1 July 2021 Kangaroo sold an item of plant to Koala for a profit of $40 000. The remaining useful life of the plant at the date of transfer was 2 years. On 1 September 2021, Kangaroo paid a dividend of $80 000 from profits earned prior to 30 June 2021. Koala lent $200 000 to Kangaroo on 1 January 2022. Interest charged on the loan for the year ended 30 June 2022 was $10 000 and for the year ended 30 June 2023 was $20 000. On 31 May 2023 Kookaburra sold inventories to Kangaroo for $10 000. Profit earned on the sale was $2 000. Kangaroo sold the inventories to external parties on 1 August 2023.

Details of profits earned by entities within the group for the years ended 30 June 2022 and 30 June 2023 are:

Koala Kookaburra Kangaroo

30 June 2022 30 June 2023 150 000 175 000 95 000 120 000 70 000 85 000

The tax rate is 30%. For the year ended 30 June 2022, the dividend paid by Kangaroo effects the NCI of Kangaroo by: a. b. c. *d.

nil. $12 000 $20 000 $32 000

Answer: d Feedback: DNCI of Kangaroo = 40%. INCI of Kangaroo = 15% and is adjusted for with the DNCI of Kookaburra. Therefore, effect of dividend on NCI of Kangaroo = $80 000 x 40%. Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

21. Koala Limited acquired a 75% ownership interest in Kookaburra Limited on 30 June 2021. On the same day, Kookaburra Limited acquired a 60% ownership interest in Kangaroo Limited. The following inter-entity transactions have taken place between the entities in the group during the years ended 30 June 2022 and 30 June 2023: • • • •

Details of profits earned by entities within the group for the years ended 30 June 2022 and 30 June 2023 are:

Koala Kookaburra Kangaroo

30 June 2022 30 June 2023 150 000 175 000 95 000 120 000 70 000 85 000

The tax rate is 30%. For the year ended 30 June 2023, the effect of the inter-entity sale of inventories on the NCI of Kangaroo Limited is: *a. b. c. d.

Nil. $350 $210 $560

Answer: a Feedback: Profit on sale of inventories was earned by Kookaburra, not Kangaroo. Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

30.13

Testbank to accompany Financial reporting 3e by Loftus et al.

22. Merrivale Limited has an ownership interest of 80% in a subsidiary Bairnsdale Limited. Bairnsdale owns 60% of Clairmont Limited. Since acquisition date the retained earnings of Clairmont Limited have increased from $100 000 to $250 000. The direct noncontrolling interest in the retained earnings of Clairmont is: a. b. c. *d.

$0. $12 000. $60 000. $100 000.

Answer: d Feedback: $250 000 x (1-60%) Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

23. Phillip Limited has an ownership interest of 75% in a subsidiary Jacob Limited. Jacob Limited owns 80% of Baxter Limited. At acquisition date the retained earnings of Baxter Limited were $300 000. At consolidation date, the retained earnings of Baxter Limited were $840 000. The indirect non-controlling interest in the retained earnings of Baxter Limited is: a. *b. c. d.

$0 $108 000 $168 000 $324 000

Answer: b Feedback: Increase in RE = $540 000. INCI = $540 000 x 80% x 25% Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

24. Robinson Group had the following debits in the pre-acquisition entry used to consolidate an 80% direct ownership interest in a subsidiary: Retained earnings $240 000, Share capital $360 000, General Reserve $40 000, BCVR $28 000. The amount attributable to the direct non-controlling interest is: a. b. c. *d.

$72 000 $133 600 $150 000 $167 000

Answer: d Feedback: (240 000 + 360 000 + 40 000 + 28 000) / 80% x 20% Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Chapter 30: Consolidation: other issues Not for distribution in full. Instructors may assign selected questions in their LMS.

25. When preparing consolidation adjustment entries to affect a consolidation of a multiple subsidiary structure, intragroup transactions: a. *b. c. d.

are not eliminated. are eliminated in full. are partially eliminated to the extent of the ownership interest of the parent entity to each transaction. are ignored as it is impractical to attempt to determine the size of the ownership interest relating to each transaction.

Answer: b Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

26. In a multiple subsidiary structure, the direct non-controlling interest is entitled to a proportionate share of: a. b. *c. d.

pre-acquisition equity only. post-acquisition amounts of equity only. pre- and post-acquisition amounts of equity. post-acquisition balance of retained earnings only.

Answer: c Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

27. In a multiple subsidiary structure, the indirect non-controlling interest is entitled to a proportionate share of: a. *b. c. d.

pre-acquisition equity. post-acquisition equity only. both pre- and post-acquisition equity. neither pre- nor post-acquisition equity.

Answer: b Learning objective 30.3: prepare the consolidated financial statements for a multiple subsidiary structure.

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Testbank to accompany Financial reporting 3e by Loftus et al.

28. Erin Limited acquired shares in James Limited. At the time of this acquisition James Limited already held shares in Cameron Limited. This form of acquisition of an indirect ownership interest, by Erin Limited in Cameron Limited, is known as a/an: a. b. *c. d.

unorthodox acquisition. indirect acquisition. non-sequential acquisition. inconsequential acquisition.

Answer: c Learning objective 30.4: explain the effects on the consolidation process where the acquisition is non-sequential.

29. Which of the following can result in a loss of control by a parent over a subsidiary? I. II. III.

The parent sells some of the shares in the subsidiary. There is a change in the dispersion in the holding of shares by entities comprising the NCI. There may be a change in a contractual arrangement.

*a. b. c. d.

I, II and III I and II only I and III only II only

Answer: a Learning objective 30.5: explain how to account for changes in ownership interests by a parent in a group.

30. Where a change in ownership interest results in the loss of control of a subsidiary: a. b. *c. d.

the gain or loss will be recorded in other comprehensive income. the gain or loss in the parent’s records will equal the consolidated gain or loss. the remaining investment will be recorded at fair value in accordance with AASB 9 Financial Instruments. the remaining investment will be accounted for in accordance with AASB 127 Separate Financial Statements.

Answer: c Learning objective 30.5: explain how to account for changes in ownership interests by a parent in a group.

30.16

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 31: Associates and joint ventures

Chapter 31: Associates and joint ventures Comprehension questions 1. What is an associate entity? Paragraph 3 of AASB 128/IAS 28 defines an associate as an entity over which the investor has significant influence. The key criterion is the existence of significant influence, also defined in paragraph 3 defined as the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies. Note that an investor does not have to necessarily hold shares in an associate – yet the application of the equity method depends on such a shareholding. However, refer to the presumptions in paragraph 6 of AASB 128/IAS 28.

2. Why are associates distinguished from other investments held by the investor? The suite of accounting standards provides different levels of disclosure dependent on the relationship between the investor and the investee: • Subsidiaries: a control relationship (AASB 10). • Joint ventures: a joint control relationship (AASB 11). • Associates: a significant influence relationship (AASB 128). • Other investments: no relationship (AASB 9). The investor-associate relationship relates to the ability of the investor to influence the direction of the investee, in comparison to a simple holding of shares as an investment. Where such a relationship exists, it is argued that the investor is both accountable for and benefit from the financial performance and financial position of the investee [why have such an investment if there are no benefits to doing so?]. These effects result in the need for additional disclosure about the nature and the financial effects of that relationship.

3. Discuss the similarities and differences between the criteria used to identify subsidiaries and those used to identify associates. A subsidiary is identified where another entity controls that entity. Control is defined in paragraph 2 of AASB 128/IAS 28. An associate is identified where another entity has significant influence over that entity. Control Power over the investee

Significant influence Power to participate

Exposure or rights to variable returns from involvement in investee

To participate in the financial and operating policy decisions

Ability to affect returns through power

-----------

No ownership interest is necessary

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. What is meant by ‘significant influence’? Paragraph 3 of AASB 128/IAS 28 states: • Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. Key features: • the power to participate • financial and operating policy decision.

5. What factors could be used to indicate the existence of significant influence? Note paragraphs 5 and 6 of AASB 128/IAS 28: Paragraph 5. If an investor holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. Paragraph 6. The existence of significant influence by an investor is usually evidenced in one or more of the following ways: (a) representation on the board of directors or equivalent governing body of the investee; (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; (c) material transactions between the investor and the investee; (d) interchange of managerial personnel; or (e) provision of essential technical information.

6. What is a joint venture? A joint arrangement is an arrangement of which two or more parties have joint control. Where a joint arrangement exists, the arrangement must be classified as either a joint operation or a joint venture. The classification depends on the rights and obligations of the parties to the arrangement. Joint ventures are accounted for under AASB 128/IAS 28 while joint operations are accounted for under AASB 11/IFRS 11. A joint venture is described as an arrangement where the investor has a right to an investment in the investee. The investee will have the following features: • the legal form of the investee and the contractual arrangements are such that the investor does not have rights to the assets and obligations for the liabilities of the investee; and • the investee has been designed to have a trade of its own and as such must directly face the risks arising from the activities it undertakes, such as demand, credit or inventory risks.

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Chapter 31: Associates and joint ventures

7. What is meant by ‘joint control’? Joint control is the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. The key element of joint control is the sharing of control. In other words, there must be at least two investors who have shared control of the investee (AASB 128/IAS 28, paragraph 3)

8. How does joint control differ from control as applied on consolidation? Under AASB 10/IFRS 10, an investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. There are three investor-investee relationships which are based on different levels of control: Relationship Parent - subsidiary Investor - associate Joint arrangement - investee

Level of control Dominant control Significant influence Joint control

With a subsidiary there can be only one parent. With joint control there needs to be at least 2 entities that share control.

9. Discuss the relative merits of accounting for investments by the cost method, the fair value method and the equity method. Cost method: • Advantages: - Simplicity. - Reliable measure. • Disadvantages: - No indication of changes in value since acquisition. - Revenue recognised only on dividend declared or received. Fair value method: • Advantages: - Up-to-date value, present information compared with past information. - Revenue recognised as value changes rather than waiting for dividends. • Disadvantages: - Reliability a function of how active the market is. - Costs associated with regular updating, extra costs for audit and valuation fees. Equity method: • Advantages: - Carrying amount related to change in net assets of the investee. - Share of profit seen as a more informative reflection of the performance of the investor’s investment. © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

•

Disadvantages: - Carrying amount reliant on validity of investee information rather than based on market value. - Recognition of revenue prior to associate declaring dividend; no transaction has occurred.

10. Outline the accounting adjustments required in relation to transactions between the investor and an associate/joint venture. Critically evaluate the rationale for these adjustments. Adjustments required: • Unrealised gains arising from inter-entity transfers of assets such as inventory or property, plant & equipment. Rationale: • Paragraph 11 of AASB 128/IAS 28 justifies the equity method on the basis that it provides more informative reporting of the investor’s net assets and profit or loss. • A key question is whether the equity method is used as a measurement technique to approximate fair value, or as a consolidation technique. • If it is a measurement technique, then why adjust for inter-entity transactions? • If it is a consolidation technique, then adjustments can be justified – however, does the method of adjustment proposed in para 22 conform with consolidation techniques? Debate: • Why should investor’s share of associate’s profits be adjusted if investor sells to associate as associate’s profits are unaffected by this transaction? • Should individual accounts such as “sales”, “cost of sales” and “inventories” be adjusted? • Should downstream transactions affect different accounts than upstream transactions?

11. Compare the accounting for the effects of inter-entity transactions for transactions between parent entities and subsidiaries and between investors and associates/joint ventures. See paragraph 22 of AASB 128/IAS 28. Consolidation • Adjust for upstream & downstream. • Adjust for unrealised profits/losses. • Adjust for inter-entity balances. • Adjust for 100% of effect. • Adjust individual accounts such as sales. •

Transactions identified within group.

Equity method • Adjust for upstream & downstream. • Adjust for unrealised profits/losses. • No adjustment for inter-entity balances. • Proportionate adjustment. • Adjust share of profits/losses & investment account. occurring • No economic entity/group structure.

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Chapter 31: Associates and joint ventures

12. Discuss whether the equity method should be viewed as a form of consolidation or a valuation technique. AASB 128/IAS 28 does not give a clear indication whether the equity method is a consolidation technique or a measurement technique similar to fair value. Note paragraph 20: “Many of the procedures appropriate for the application of the equity method are similar to the consolidation procedures described in AASB 127/IAS 27.” If viewed as a measurement method, the equity method is an extension of the accrual process within the historical cost system. Revenue is recognised in relation to the investee as the investor records profits/losses, instead of merely when the investor pays dividends. The balance sheet is a one-line figure, being an alternative to fair value. If it is a measurement technique, why adjust for the effects of inter-entity transactions? Further, why not just use fair value if available, or if capable of being reliably measured, and only apply equity method as a default? Why use a criterion such as significant influence to determine associates – why not apply the equity method to all material investments? If viewed as a consolidation technique, there is an expansion of the group to include the investor’s share of the associate. The group then is more than just controlled entities. • • •

Why not use proportionate consolidation? Why not adjust fully for inter-entity transactions? Why expand the group beyond controlled entities in the first place?

It appears that equity accounting is a hybrid between a measurement technique and consolidation. It is argued that standard-setters should determine a conceptual basis for accounting for associates and apply an appropriate method. 13. Explain why equity accounting is sometimes referred to as ‘one-line consolidation’. Equity accounting is similar to consolidation in that: • both recognise the investor’s share of post-acquisition equity in the income statement. The consolidation method recognises the NCI share as well, but divides equity into parent and NCI share. • both adjust for the effects of unrealised gains or losses arising from inter-entity transactions • in the income statement, the share of profits/losses of an associate is similar to the parent’s share of the post-acquisition equity of a subsidiary – however, under the equity method this is not taken against individual accounts but there is a one-line disclosure. • in the balance sheet, the investment in the associate is adjusted for the increase in the investor’s share of the net assets of the associate – similar to the parent’s share of the net assets of a subsidiary. However, under equity accounting, there is no recognition of the individual assets and liabilities of the associate, rather, there is a one-line recognition.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

14. Explain the differences in application of the equity method of accounting where the method is applied in the records of the investor compared with the application in the consolidation worksheet of the investor. There are 2 major differences when equity accounting is applied in the consolidation worksheet rather than in the accounts of the investor. First, in relation to past periods: If the adjustments are made in the records of the investor, then in any period, there is only a need to recognise the effects of the current period changes in share of the profit/losses and other comprehensive income of the associate. If the adjustments are made on consolidation, as the worksheet is only a temporary document and has no effect on the actual accounts, in periods subsequent to the date of acquisition, there needs to be a recognition, via retained earnings and reserves, of the investor’s share of prior period profits/losses and other comprehensive income of the associate. Second, in relation to dividend revenue: If the adjustments are made in the accounts of the investor, then on payment of a dividend by the associate, the adjustment is: Cash Investment in associate

Dr Cr

x x

If the adjustments are made on consolidation, the worksheet adjustment is: Dividend revenue Investment in associate

Dr Cr

x x

15. Explain the treatment of dividends from the associate under the equity method of accounting. Under the equity method, dividends are not recognised as revenue. To do so would be double counting as the investor’s share of profit from which such dividends are distributed have already been recognised. Instead, dividends are treated as a return of equity already recognised and so reduce the carrying amount of the investment in the associate. The treatment of dividends differs dependent on whether the equity method is applied in the accounts of the investor or applied on consolidation in the consolidation worksheet. Dividends paid In the accounts of the investor: On payment of the dividend by the associate, in the accounts of the investor, the following entry is made: Cash Investment in associate

Dr Cr

x x

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Chapter 31: Associates and joint ventures

As the investor recognises its share of the profits/losses of the associate as income, and this profit/loss is prior to the appropriation of dividends, then to recognise dividend revenue would double count the income recognised by the investor. The dividend is simply a receipt of equity already recognised via application of the equity method. Consolidation worksheet: In the year of payment of the dividend the consolidation adjustment entry is: Dividend revenue Investment in associate

Dr Cr

x x

When the dividend is paid the investor records the receipt of cash and recognises dividend revenue. The effect of the above entry is to eliminate the dividend revenue previously recognised by the investor. Because the investor recognises a share of the whole of the profit of the associate, the dividend revenue cannot also be recognised as income by the investor. Dividends declared Where revenue is recognised on declaration of the dividend, the effect is the same as for dividends paid. Where the investor does not recognise dividend revenue, then there is no entry in the investor’s accounts, nor is there any adjustment in the consolidation worksheet. In using the consolidation worksheet method, care must be taken in calculating the investor’s share of post-acquisition retained earnings where a dividend was declared at the end of the previous period. This must be added back to the closing balance of retained earnings, as the investor has not yet recognised the appropriation of profits.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 31.1 Significant influences The accountant of Cornett Chocolates Ltd, Ms Fraulein, has been advised by her auditors that the entity’s investment in Concertina’s Milk Ltd should be accounted for using the equity method of accounting. Cornett Chocolates Ltd holds only 20.2% of the voting shares currently issued by Concertina’s Milk Ltd. Since the investment was undertaken purely for cash flow reasons based on the potential dividend stream from the investment, Ms Fraulein does not believe that Cornett Chocolates Ltd exerts significant influence over the investee. Required Discuss the factors that Ms Fraulein should investigate in determining whether an investor–associate relationship exists, and what avenues are available so that the equity method of accounting does not have to be applied. The relevant paragraphs from AASB 128/IAS 28 are: Paragraph 3: • Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. Paragraphs 5 and 6: 5. If an investor holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. 6. The existence of significant influence by an investor is usually evidenced in one or more of the following ways: (a) representation on the board of directors or equivalent governing body of the investee; (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; (c) material transactions between the investor and the investee; (d) interchange of managerial personnel; or (e) provision of essential technical information. Points to discuss: 1. Why the investment is undertaken by Cornett Chocolates is irrelevant. The definition of significant influence is based on the capacity to participate, not the actual or intention to participate. 2. Whether Cornett Chocolates actually exerts influence is irrelevant. 3. The 20% is a guideline only. 4. Factors will include those in paragraph 6. Further an analysis of the 79.8% holding by other parties is very important. If it is closely held, then the ability for Cornett Chocolates to participate may be limited.

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Chapter 31: Associates and joint ventures

Case study 31.2 Nature of a joint venture A shareholder of CSR Limited has come to you confused about something they have seen in note 33 of the company’s 2018 annual report. Under the heading Equity Accounting Information CSR lists Viridian Glass, a New Zealand-based glass products firm, as an investment in which it holds a 58% ownership interest. The shareholder believes that only ownership interests between 20% and 50% qualify for equity accounting and that investments over 50% should be treated as subsidiaries and consolidated in the financial statements. Required Prepare a response to the shareholder outlining why CSR could deem it appropriate to carry their 58% investment in Viridian Glass under the equity method of accounting. Under AASB 128/IAS 28 an associate is an entity over which the investor has significant influence. Significant influence is then defined as the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies. CSR’s 58% ownership interest in Viridian Glass would ordinarily be an indicator of control (under AASB 10/IFRS10). CSR’s treatment of this investment as an associate must be based on a view that they do not have the capacity to control decision making. This may be due to the nature of its contractual arrangements with the other investors. Specifically, CSR’s disclosure note states that Viridian Glass is a limited partnership based in New Zealand. Limited partnerships are a form of partnership involving general partners, (who are liable for all the debts and liabilities of the partnership) and limited partners (who are liable to the extent of their capital contribution to the partnership). Under this type of ownership structure, limited partners are involved in a variety of activities but they do not participate in the management of the entity. So, it may be that despite the relative size of its investment, CSR is a limited partner rather than a general partner.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 31.3 Talvez Ltd, a publicly listed company, has a 19.5% shareholding in another entity. The accountant is considering whether or not this investment satisfies the definition of an associate under AASB 128/IAS 28 and the impacts the decision will have on the company’s financial statements. Required Compare and contrast the impacts on the financial statements of applying the equity method to an investment with those of applying the cost method to the same investment.

Income statement

Other comprehensive income Balance sheet

Cash flow statement

Equity method Includes the investor’s share of the investee’s profit (or loss) as revenue (or an expense) Includes the investor’s share of the investee’s other comprehensive income The investment is carried at its initial cost adjusted for the investor’s share of all the postacquisition changes in the investee’s net assets. Cost of the initial investment reported as an Investing outflow, subsequent dividends reported as cash inflows

Cost method Includes dividends declared or paid by the investee during the period as revenue No effect

The investment is carried at its initial cost

As per the equity method

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Chapter 31: Associates and joint ventures

Case study 31.4 Equity accounting Event Hospitality & Entertainment Limited provided the following information in its 2018 annual report. Notes to the financial statements for the year ended 30 June 2018 Section 5 – group composition 5.3 – interests in other entities Accounting policy Interests in equity accounted investees The Group’s interests in equity accounted investees comprise interests in associates and interests in joint ventures. Associates are those entities in which the Group has significant influence, but not control or joint control, over the financial and operating policies. Significant influence is presumed to exist when the Group holds between 20% and 50% of the voting power of another entity. Interests in associates and joint ventures (see below) are accounted for using the equity method. They are recognised initially at cost, which includes transaction costs. Subsequent to initial recognition, the consolidated financial statements include the Group’s share of the profit or loss and other comprehensive income of equity accounted investees, until the date on which significant influence or joint control ceases. Unrealised gains arising from transactions with equity accounted investees are eliminated to the extent of the Group’s interest in the entity. Unrealised losses are eliminated in the same way as unrealised gains, but only to the extent that there is no evidence of impairment. Joint arrangements A joint arrangement is an arrangement of which two or more parties have joint control, in which the parties are bound by a contractual arrangement, and the contractual arrangement gives two or more of those parties joint control of the arrangement. The Group classifies its interests in joint arrangements as either joint operations or joint ventures depending on the Group’s rights to the assets and obligations for the liabilities of the arrangements. When making this assessment, the Group considers the structure of the arrangements, the legal form of any separate vehicles, the contractual terms of the arrangements and other facts and circumstances. The Group’s interests in joint operations, which are arrangements in which the parties have rights to the assets and obligations for the liabilities, are accounted for on the basis of the Group’s interest in those assets and liabilities. The Group’s interests in joint ventures, which are arrangements in which the parties have rights to the net assets, are equity accounted. Source: Event Hospitality & Entertainment Limited (2018, p. 73). Required Some investors in Event Hospitality & Entertainment Ltd who have limited accounting knowledge, particularly about equity accounting, have asked you to provide a report to them commenting on: 1. the difference between significant influence and control 2. the differences between associates, joint ventures and joint arrangements 3. how the date of significant influence is determined

31.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. what is meant by the term unrealised gains and losses and why they are eliminated. 1. Significant influence vs control: Significant influence is the power to participate in the decision making of the investee but is not control or joint control. It is typically identified by the investor holding, directly or indirectly, 20% or more of the voting power but less than 50%. Control is where the investor has the ability to affect the variability of the returns from the investee because of its power over the investee. It is typically identified by the investor holding, directly or indirectly, more than 50% of the voting power. 2. Associates, joint ventures and joint arrangements: An associate is an entity over which the investor has significant influence. A joint venture is an arrangement whereby the parties have joint control over decision making (meaning) and have rights to the net assets of the arrangement. A joint arrangement is an arrangement over which two or more parties have joint control (meaning decisions require unanimous consent). A joint venture is a particular type of joint arrangement. 3. How the date of significant influence is determined: The date of significant influence is determined by the date at which the investor assumed or attained the power to participate in the decision making of the investee. This would be the date on which the percentage of voting rights held directly or indirectly exceeded 20% or the date on which the investor assumed significant influence in the way described in paragraph 6 of AASB 128/IAS 28. This determination is important because the net assets of the investee must be determined on this date so that the investor’s share of all subsequent movements can be identified. 4. What are unrealised gains and losses and why are they eliminated: Unrealised gains and losses are those arising from transfers between the investor and the investee of assets still carried by either the investor or the investee e.g. inventory or items of property, plant & equipment. They are eliminated applying the same principles as consolidation. The rationale is that transactions between an investor and an associate may not be arm’s length because of the significant influence of the investor. Only gains or losses arising from transactions between either the investor or the investee with entities beyond the investor / associate relationship should be recognised.

31.13

Chapter 31: Associates and joint ventures

Application and analysis exercises Exercise 31.1 Adjustments where investor prepares and does not prepare consolidated financial statements Duckbill Ltd acquired a 30% interest in Platypus Ltd for $75 000 cash on 1 July 2021. The directors of Duckbill Ltd believe this investment represents significant influence over the investee. The equity of Platypus Ltd at the acquisition date was as follows. Share capital Retained earnings

45 000 180 000

All the identifiable assets and liabilities of Platypus Ltd were recorded at fair value. Profits and dividends for the years ended 30 June 2022 to 2024 were as follows. Profit before tax 2022 2023 2024

Income tax expense

$ 120 000 105 000 90 000

Dividends paid

45 000 37 500 30 000

$ 120 000 30 000 15 000

1. Prepare journal entries in the records of Duckbill Ltd for each of the years ended 30 June 2022 to 2024 in relation to its investment in the associate, Platypus Ltd. (Assume Duckbill Ltd does not prepare consolidated financial statements.) 2. Prepare the consolidation worksheet entries to account for Duckbill Ltd’s interest in the associate/joint venture, Platypus Ltd. (Assume Duckbill Ltd does prepare consolidated financial statements.) 3. Calculate the carrying amount of the investment in Platypus Ltd at 30 June 2024. (LO3, LO4 and LO5)

30% Duckbill Ltd

Platypus Ltd

At 1 July 2021: Net fair value of identifiable assets and liabilities of Platypus Ltd Net fair value acquired Cost of investment Goodwill

= = = = = =

$45 000 + $180 000 $225 000 30% x $225 000 $67 500 $75 000 $7 500

31.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. Journal entries in the accounts of Duckbill Ltd: 1 July 2021

2021 – 2022

30 June 2022

2022 – 2023

Investment in Platypus Ltd Cash (Acquisition of shares in Platypus Ltd)

2023 – 2024

75 000 75 000

Cash

Dr 36 000 Investment in Platypus Ltd Cr (Dividend received from Platypus Ltd: 30% x $120 000) Investment in Platypus Ltd Dr 22 500 Share of profit or loss of Cr associates (Recognition of profit in Platypus Ltd: 30% x $75 000) Cash Investment in Platypus Ltd (Dividend received: 30% x $30 000)

30 June 2023

Dr Cr

Investment in Platypus Ltd (Dividend from associate: 30% x $15 000)

Dr Cr

22 500

9 000 9 000

Investment in Platypus Ltd Dr 20 250 Share of profit or loss of Cr associates (Recognition of profit in Platypus Ltd: 30% x $67 500) Cash

36 000

20 250

4 500 4 500

Investment in Platypus Ltd Dr 18 000 Share of profit or loss of Cr associates (Recognition of profit in Platypus Ltd: 30% x $60 000)

18 000

2. Consolidation worksheet entries: 30 June 2022: Investment in Platypus Ltd Share of profit or loss of associates (30% x $75 000)

Dr Cr

22 500

Dividend revenue Investment in Platypus Ltd (30% x $120 000)

Dr Cr

36 000

Dr Cr

13 500

22 500

36 000

30 June 2023: Retained earnings (1/7/22) Investment in Platypus Ltd (30% x $45 000)

13 500

31.15

Chapter 31: Associates and joint ventures

Note. This entry is the combination of the above 2 entries for 30 June 2022 as they are required to be carried over to subsequent years as part of the consolidation process. Investment in Platypus Ltd Share of profit or loss of associates (30% x $67 500)

Dr Cr

20 250

Dividend revenue Investment in Platypus Ltd (30% x $22 500)

Dr Cr

9 000

Dr Cr

2 250

20 250

9 000

30 June 2024: Retained earnings (1/7/23) Investment in Platypus Ltd (30% x [$(45 000) + $37 500])

2 250

Note. Consolidation entries from previous years carried over. Investment in Platypus Ltd Share of profit or loss of associates (30% x $60 000)

Dr Cr

18 000

Dividend revenue Investment in Platypus Ltd (30% x $15 000)

Dr Cr

4 500

18 000

4 500

3. Carrying amount of the investment at 30 June 2024: Cost at acquisition Share of profit of associate 2021/22 Dividend 2021/22 Share of profit of associate 2022/23 Dividend 2022/23 Share of profit of associate 2023/24 Dividend 2023/24 Carrying amount at 30 June 2024

$ 75 000 22 500 (36 000) 61 500 20 250 (9 000) 72 750 18 000 (4 500) 86 250

31.16

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Exercise 31.2 Accounting for an associate/joint venture by an investor On 1 July 2022 Pygmy Ltd issued ordinary shares to acquire a 40% interest in Possum Ltd. On this date, these issued shares had a fair value of $170 000. The directors of Pygmy Ltd believe that they have significant influence over the financial and operating policy decisions of Possum Ltd. The share capital, reserves and retained earnings of Possum Ltd at the acquisition date and at 30 June 2023 were as follows.

At 1 July 2022, all the identifiable assets and liabilities of Possum Ltd were recorded at fair value. The following is applicable to Possum Ltd for the year to 30 June 2023. • •

• • •

Profit (after income tax expense of $11 000): $39 000. Increase in reserves: - General (transferred from retained earnings): $15 000. - Asset revaluation (revaluation of freehold land and buildings at 30 June 2023): $100 000. Dividends paid to shareholders: $15 000. The tax rate is 30%. Pygmy Ltd does not prepare consolidated financial statements.

Required Prepare the journal entries in the records of Pygmy Ltd for the year ended 30 June 2023 in relation to its investment in the associate, Possum Ltd. (LO4) 40% Pygmy Ltd

Possum Ltd

At 1 July 2022: Net fair value of identifiable assets and contingent liabilities of Possum Ltd Net fair value acquired Cost of investment Goodwill

= = = = =

$400 000 40% x $400 000 $160 000 $170 000 $10 000

31.17

Chapter 31: Associates and joint ventures

Recorded profit – Possum Ltd Investor’s share – 40%

$39 000 $15 600

Increment in Asset Revaluation Surplus (40% x $100 000)

$40 000

Note: as the general reserve is created as an appropriation from Retained Earnings, there is no need to adjust for movements in general reserve. The journal entries in the books of Pygmy Ltd for the year ended 30 June 2023 are: 1 July 2022 2022 – 2023

30 June 2023

Investment in Possum Ltd Share capital

Dr Cr

170 000

Dr Investment in Possum Ltd Cr (Dividend from associate: 40% x $15 000)

6 000

Investment in Possum Ltd Share of profit or loss of associates (40% x $39 000)

Dr Cr

15 600

Investment in Possum Ltd Asset revaluation surplus (40% x $100 000)

Dr Cr

40 000

Cash

170 000

6 000

15 600

40 000

31.18

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Exercise 31.3 Investor prepares consolidated financial statements, multiple periods On 1 July 2021, Ground Ltd purchased 30% of the shares of Hog Ltd for $180 000. At this date, the ledger balances of Hog Ltd were as follows. Capital Other reserves Retained earnings

$ 450 000 Assets 90 000 Less: Liabilities 45 000

$675 000 90 000

$ 585 000

$585 000

At 1 July 2021, all the identifiable assets and liabilities of Hog Ltd were recorded at fair value except for plant whose fair value was $15 000 greater than carrying amount. This plant has an expected future life of 5 years, the benefits being received evenly over this period. Dividend revenue is recognised when dividends are declared. The tax rate is 30%. The results of Hog Ltd for the next 3 years were as follows.

Profit/(loss) before income tax Income tax expense Profit/(loss) Dividend declared and paid Dividend declared

30 June 2022

30 June 2023 30 June 2024

$ 150 000 60 000

$ 120 000 60 000

$ (15 000) —

90 000 45 000 30 000

60 000 15 000 15 000

(15 000) 6 000 3 000

Required Prepare, in journal entry format, for the years ending 30 June 2022, 2023 and 2024, the consolidation worksheet adjustments to include the equity-accounted results for the associate, Hog Ltd, in the consolidated financial statements of Ground Ltd. (LO4 and LO5) 30% Ground Ltd At 1 July 2021: Net fair value of identifiable assets and liabilities of Hog Ltd Net fair value acquired Cost of investment Goodwill

Hog Ltd

= = = = = =

$585 000 (equity) + $15 000 (1 – 30%) (plant) $595 500 30% x $595 500 $178 650 $180 000 $1 350

Depreciation adj. of plant p.a.

31.19

Chapter 31: Associates and joint ventures

= 1/5 x $15 000 (1 – 30%) = $2 100

after tax

1. Consolidation worksheet entries: 2021 – 2022: Recorded profit for the period Pre-acquisition adjustment: Depreciation of plant

$90 000 (2 100) 87 900 $26 370

Investor’s share – 30% The consolidation worksheet entries at 30 June 2022 are: Investment in Hog Ltd Share of profit or loss of associates

Dr Cr

26 370

Dividend revenue Investment in Hog Ltd (30% x [$45 000 + $30 000])

Dr Cr

22 500

26 370

22 500

2022 – 2023: Recorded profit for the period Pre-acquisition adjustment: Depreciation of plant

$60 000 (2 100) $57 900 $17 370

Investor’s share – 30% The consolidation worksheet entries at 30 June 2023 are: Investment in Hog Ltd Retained earnings (1/7/22) (30% x [$60 000 - $45 000 - $2 100])

Dr Cr

3 870

Investment in Hog Ltd Share of profit or loss of associates

Dr Cr

17 370

Dividend revenue Investment in Hog Ltd (30% x ($15 000 + $15 000))

Dr Cr

9 000

3 870

17 370

9 000

2023 – 2024: Profit (loss) for the period Pre-acquisition adjustment: Depreciation of plant

$(15 000) (2 100) $(17 100)

31.20

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Investor’s share – 30%

$(5 130)

The consolidation worksheet entries at 30 June 2024 are: Investment in Hog Ltd Retained earnings (1/7/23) (30% x [$90 000 – $45 000 – (2 x $2 100)])

Dr Cr

12 240

Share of profit or loss of associates Investment in Hog Ltd

Dr Cr

5 130

Dividend revenue Investment in Hog Ltd (30% x [$6 000 + $3 000])

Dr Cr

2 700

12 240

5 130

2 700

31.21

Chapter 31: Associates and joint ventures

Exercise 31.4 Adjustments where investor does and does not prepare consolidated financial statements On 1 July 2021, Saltwater Ltd acquired a 30% interest in one of its suppliers, Crocodile Ltd, at a cost of $13 650. The directors of Saltwater Ltd believe they exert ‘significant influence’ over Crocodile Ltd. The equity of Crocodile Ltd at acquisition date was as follows.

All the identifiable assets and liabilities of Crocodile Ltd at 1 July 2021 were recorded at fair values except for some depreciable non-current assets with a fair value of $15 000 greater than carrying amount. These depreciable assets are expected to have a further 5year life. Additional information • At 30 June 2023, Saltwater Ltd had inventories costing $100 000 (2022: $60 000) on hand which had been purchased from Crocodile Ltd. A profit before tax of $30 000 (2022: $10 000) had been made on the sale. • All companies adopt the recommendations of AASB 112 regarding tax-effect accounting. Assume a tax rate of 30% applies. • Information about income and changes in equity of Crocodile Ltd as at 30 June 2023 is as follows. Profit before tax Income tax expense

360 000 180 000 180 000 50 000

Profit Retained earnings at 1/7/22

230 000 Dividend paid Dividend declared

50 000 50 000

Retained earnings at 30/6/23

• •

100 000 $

130 000

All dividends may be assumed to be out of the profit for the current year. Dividend revenue is recognised when declared by investees. The equity of Crocodile Ltd at 30 June 2023 was as follows.

31.22

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The asset revaluation surplus arose from a revaluation of freehold land made at 30 June 2023. The general reserve arose from a transfer from retained earnings in June 2022. Required 1. Assume Saltwater Ltd does not prepare consolidated financial statements. Prepare the journal entries in the records of Saltwater Ltd for the year ended 30 June 2023 in relation to the investment in Crocodile Ltd. 2. Assume Saltwater Ltd does prepare consolidated financial statements. Prepare the consolidated worksheet entries for the year ended 30 June 2023 for inclusion of the equity-accounted results of Crocodile Ltd. (LO4, LO5 and LO6) 30% Saltwater Ltd

Crocodile Ltd

At 1 July 2021: Net fair value of identifiable assets and liabilities of Crocodile Ltd

= = = = = =

Net fair value acquired Cost of investment Goodwill

$20 000 + $10 000 (equity) + $15 000 (1 – 30%) (assets) $40 500 30% x $40 500 $12 150 $13 650 $1 500

Depreciation adjustment: Non-current assets: 20% x $15 000 (1 - 30%) = $2 100 1. Saltwater Ltd does not prepare consolidated financial statements: Profit for 2022-2023 period Pre-acquisition adjustments: Depreciation Post-acquisition profit Adjustments for inter-entity transactions: Unrealised after tax profit in ending inventory $30 000 (1 – 30%) Realised profit on opening inventory $10 000 (1 – 30%)

$180 000 (2 100) $177 900

(21 000)

Investor’s share – 30%

7 000 $163 900 $49 170

Increase in asset revaluation surplus

$30 000

31.23

Chapter 31: Associates and joint ventures

Investor’s share – 30%

$9 000

The required entries in Saltwater Ltd’s accounts for the 2022-2023 year are: Cash

Dr Cr

15 000

Dividend receivable Investment in Crocodile Ltd (30% x $50 000 – dividend provided)

Dr Cr

15 000

Investment in Crocodile Ltd Asset revaluation surplus (30% x $30 000)

Dr Cr

9 000

Investment in Crocodile Ltd Share of profit or loss of associates

Dr Cr

49 170

Investment in Crocodile Ltd (30% x $50 000 – dividend paid)

15 000

9 000

49 170

2. Saltwater Ltd prepares consolidated financial statements: Change in retained earnings balance 2021 – 2022 ($50 000 - $10 000) Pre-acquisition adjustments: Depreciation Post-acquisition equity Adjustments: General reserve transfers Unrealised profit in inventory at 30/6/22 $10 000 (1 - 30%) Change in retained earnings under equity method Investor’s share – 30%

$40 000 (2 100) $37 900 5 000 (7 000) $35 900 $10 770

Note. This calculation is required as previous year’s consolidation adjustments are required to be carried over to the current financial period. The consolidation worksheet entries at 30/6/23 are: Investment in Crocodile Ltd Retained earnings (1/7/22)

Dr Cr

10 770

Investment in Crocodile Ltd Asset revaluation surplus (30% x $30 000)

Dr Cr

9 000

Investment in Crocodile Ltd Share of profit or loss of associates

Dr Cr

49 170

Dividend revenue Investment in Crocodile Ltd

Dr Cr

30 000

10 770

9 000

49 170

30 000

31.24

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(30% x [$50 000 dividend paid + $50 000 dividend declared])

Exercise 31.5 Accounting for an associate within — and where there are no — consolidated financial statements On 1 July 2021, Flying Ltd purchased 40% of the shares of Fox Ltd for $63 200. At that date, equity of Fox Ltd consisted of:

At 1 July 2021, the identifiable assets and liabilities of Fox Ltd were recorded at fair value. Information about income and changes in equity for both companies for the year ended 30 June 2024 was as follows. Flying Ltd

Fox Ltd

Profit before tax Income tax expense

$26 000 10 600

$23 500 5 400

Profit Retained earnings (1/7/23)

15 400 18 000

18 100 16 000

33 400

34 100

Dividend paid Dividend declared

5 000 10 000

4 000 5 000

Retained earnings (30/6/24)

15 000 $18 400

9 000 $25 100

Additional information • Flying Ltd recognises dividends as revenue when they are declared by the investee. • On 31 December 2022, Fox Ltd sold Flying Ltd a motor vehicle for $12 000. The vehicle had originally cost Fox Ltd $18 000 and was written down to $9000 for both tax and accounting purposes at time of sale to Flying Ltd. Both companies depreciated motor vehicles at the rate of 20% p.a. on cost. • The beginning inventories of Fox Ltd included goods at $4000 bought from Flying Ltd; their cost to Flying Ltd was $3200. • The ending inventories of Flying Ltd included goods purchased from Fox Ltd at a profit before tax of $1600. • The tax rate is 30%. Required

31.25

Chapter 31: Associates and joint ventures

1. Prepare the journal entries in the records of Flying Ltd to account for the investment in Fox Ltd under the equity method for the year ended 30 June 2024 assuming Flying Ltd does not prepare consolidated financial statements. (LO3 and LO4) 2. Prepare the consolidated worksheet entries in relation to the investment in Fox Ltd, assuming Flying Ltd does prepare consolidated financial statements at 30 June 2024. (LO3, LO4 and LO5) 40% Flying Ltd

Fox Ltd

At 1 July 2021: Net fair value of identifiable assets and liabilities of Fox Ltd

= $125 000 + $11 000 = $136 000 Net fair value acquired = 40% x $136 000 = $54 400 Cost of investment = $63 200 Goodwill = $8 800 1. Flying Ltd does not prepare consolidated financial statements: Profit for the period 2023 – 2024 Adjustments: Realised profit on motor vehicle 20% x $3 000 (1 – 30%) Realised profit in opening inventory $800 (1 – 30%) Unrealised profit in ending inventory $1 600 (1 – 30%)

$18 100

420 560 (1 120) $ 17 960 $7 184

Investor’s share – 40% The entries in the books of Flying Ltd at 30 June 2024 are: Cash Investment in Fox Ltd (40% x $4 000 – dividend paid)

Dr Cr

1 600

Dividend receivable Investment in Fox Ltd (40% x $5 000 – dividend declared)

Dr Cr

2 000

Investment in Fox Ltd Share of profit or loss of associates

Dr Cr

7 184

1 600

2 000

7 184

2. Flying Ltd prepares consolidated financial statements: Change in retained earnings 2021 – 2023 ($16 000 – $11 000) Adjustments for inter-entity transactions:

$5 000

31.26

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Unrealised profit on motor vehicle Profit on sale $3 000 (1 – 30%) less ½ x 20% x $2 100 Unrealised profit in ending inventory $800 (1 – 30%) Change in retained earnings under equity method Investor’s share – 40%

(1 890) (560) $2 550 $1 020

The consolidation worksheet entries at 30 June 2024 are: Investment in Fox Ltd Retained earnings (1/7/23)

Dr Cr

1 020

Investment in Fox Ltd Share of profit or loss of associates

Dr Cr

7 184

1 020

Dividend revenue Dr 3 600 Investment in Fox Ltd Cr (40% x [$4 000 dividend paid + $5 000 dividend declared])

7 184

3 600

31.27

Chapter 31: Associates and joint ventures

Exercise 31.6 Consolidation worksheet entries including investments in joint ventures You are given the following details for the year ended 30 June 2023. Echidna Ltd

Kangaroo Ltd

Kookaburr a Ltd

$ 400 00 0 124 0 00

$ 120 0 00 40 00 0

$ 100 0 00 24 0 00

276 0 00 80 00 0

80 00 0 48 00 0

76 00 0 44 00 0

$ 356 0 00

$ 128 0 00

$ 120 0 00

$ 56 000

$ 24 0 00

$ 8 00 0

Dividend declared

60 000

Transfer to general reserve (from current period’s profit)

40 000

16 0 00 20 0 00

32 0 00 24 0 00

156 00 0

60 00 0

64 00 0

$ 200 00 0

$ 68 00 0

$ 56 00 0

Profit before tax Income tax expense Profit Retained earnings at 1 July 2022

Dividend paid

Retained earnings at 30 June 2023

Additional information • Echidna Ltd owns 80% of the participating shares in Kangaroo Ltd and 20% of the shares in Kookaburra Ltd. Echidna Ltd has entered into a contractual arrangement with four other venturers in relation to Kookaburra Ltd, and the five investors have a joint control arrangement in relation to Kookaburra Ltd. • On 1 July 2021, all identifiable assets and liabilities of Kangaroo Ltd were recorded at fair value. Echidna Ltd purchased 80% of Kangaroo Ltd’s shares on 1 July 2021, and paid $20 000 for goodwill, none of which had been recorded on Kangaroo Ltd’s records. Echidna Ltd uses the partial goodwill method. • At the date Echidna Ltd acquired its shares in Kookaburra Ltd, Kookaburra Ltd’s recorded equity was as follows. Share capital

400 000

31.28

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60 000 20 000

General reserve Retained earnings • • • • • • • • •

All the identifiable assets and liabilities of Kookaburra Ltd were recorded at fair value. Echidna Ltd paid $100 000 for its shares in Kookaburra Ltd on 1 July 2021. There was $12 000 transferred to general reserve by Kookaburra Ltd in the year ended 30 June 2022, out of equity earned since 1 July 2021. Included in the beginning inventories of Echidna Ltd were profits before tax made by Kangaroo Ltd: $20 000; Kookaburra Ltd: $12 000. Included in the ending inventories of Echidna Ltd were profits before tax made by Kookaburra Ltd: $16 000. Kookaburra Ltd had recorded a profit of $8000 in selling certain non-current assets to Echidna Ltd on 1 January 2023. Echidna Ltd treats the items as non-current assets and charges depreciation at the rate of 25% p.a. straight-line from that date. Echidna Ltd purchased for $40 000 an item of plant from Kangaroo Ltd on 1 September 2021. The carrying amount of the asset at that date was $28 000. The asset was depreciated at the rate of 20% p.a. straight-line from 1 September 2021. During the year ended 30 June 2023, Kookaburra Ltd has revalued upwards one of its non-current assets by $32 000. There had been no previous downward revaluations. Dividend revenue is recognised when dividends are declared. The tax rate is 30%.

Required Prepare the consolidation worksheet entries (in general journal form) needed for the consolidated statements for the year ended 30 June 2023 for Echidna Ltd and its subsidiary Kangaroo Ltd. Include the equity-accounted results of Kookaburra Ltd. (LO3 and LO4) Echidna Ltd 80%

20%

Kangaroo Ltd

Kookaburra Ltd

NCI 20% 1. Consolidated worksheet entries: At 30 June 2021, in relation to Echidna’s acquisition of Kangaroo Ltd: Goodwill acquired (1)

$20 000

Pre-acquisition entry:

31.29

Chapter 31: Associates and joint ventures

Retained earnings (1/7/22) Goodwill Share capital Shares in Kangaroo Ltd

Dr Dr Dr Cr

x 20 000 x x

(2)

NCI in equity: 1/7/21 – 30/6/22: Dr Cr

9 600

(3)

Retained earnings (op. bal.) NCI (20% x $48 000) NCI in equity from 1/7/22 – 30/6/23: NCI share of profit NCI (20% x $80 000)

Dr Cr

16 000

General reserve Transfer to general reserve (20% x $20 000)

Dr Cr

4 000

NCI

Dr Cr

4 800

Dr Cr

3 200

Dr Cr

19 200

Dividend payable Final dividend declared (80% x $16 000)

Dr Cr

12 800

Dividend revenue Dividend receivable

Dr Cr

12 800

Interim dividend paid (20% x $24 000) NCI Final dividend declared (20% x $16 000) (4)

(6)

4 000

4 800

3 200

19 200

Dividend declared:

12 800

Unrealised profit in beginning inventory: Kangaroo Ltd – Echidna Ltd: Retained earnings (1/7/22) Income tax expense Cost of sales

(7)

16 000

Dividend paid: Dividend revenue Interim dividend paid (80% x $24 000)

(5)

9 600

Dr Dr Cr

14 000 6 000 20 000

NCI adjustment:

31.30

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NCI share of profit Retained earnings (1/7/22) (20% x $14 000)

Dr Cr

2 800 2 800

(8)

Sale of plant: Kangaroo Ltd – Echidna Ltd: Dr Dr Cr

8 400 3 600

(9)

Retained earnings (1/7/22) Deferred tax asset Plant NCI adjustment: NCI

Dr Cr

1 680

Retained earnings (1/7/22) (20% x $8 400)

12 000

1 680

(10) Depreciation: Accumulated depreciation Dr 4 400 Retained earnings (1/7/22) Cr 2 000 Depreciation expense Cr 2 400 (20% x 10/12 x $12 000 in previous period and 20% x $12 000 in current period) Income tax expense Retained earnings (1/7/22) Deferred tax asset

Dr Dr Cr

720 600

Dr Dr Cr

336 280

1 320

(11) NCI adjustment: NCI share of profit Retained earnings (1/7/22) NCI

616

(12) Equity accounted results of Kookaburra Ltd: Net fair value of identifiable assets and liabilities of Kookaburra Ltd Net fair value acquired Cost of investment Goodwill

= = = = = =

$400 000 + $60 000 + $20 000 (equity) $480 000 20% x $480 000 $96 000 $100 000 $4 000

Change in Retained Earnings 2021 – 2022 ($44 000 - $20 000) Adjustments: Increase in general reserve Unrealised profit in closing inventory $12 000 (1 – 30%)

$24 000

12 000 (8 400) 27 600

31.31

Chapter 31: Associates and joint ventures

Investor’s share – 20%

$5 520

Recorded profit Adjustments: Realised profit on opening inventory Unrealised profit in closing inventory $16 000 (1 – 30%) Unrealised profit on sale of non-current assets $8 000 (1 – 30%) less depreciation of ½ x 25% x $5 600

$76 000 8 400 (11 200)

Investor’s share – 20%

(4 900) $68 300 $13 660

Increase in asset revaluation surplus [$32 000 (1 – 30%)] Investor’s share – 20%

$22 400 4 480

The worksheet entries are: Investment in Kookaburra Ltd Share of OCI of associates Retained earnings (1/7/22) Share of profit or loss of associates

Dr Cr Cr

23 660

Share of OCI of associates Asset revaluation surplus

Dr Cr

4 480

Dividend revenue Investment in Kookaburra Ltd (20% x [$8 000 + $32 000])

Dr Cr

8 000

4 480 5 520

13 660

4 480

8 000

31.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 31.7 Inter-entity transactions where investor does not prepare consolidated financial statements Dolphin Ltd owns 25% of the shares of its associate, Shark Ltd. At the acquisition date, there were no differences between the fair values and the carrying amounts of the identifiable assets and liabilities of Shark Ltd. For 2022–23, Shark Ltd recorded a profit of $200 000. During this period, Shark Ltd paid a $20 Dur dividend, declared in June 2022, and an interim dividend of $16 000. The tax rate is 30%. The following transactions have occurred between Dolphin Ltd and Shark Ltd. •

On 1 July 2021, Shark Ltd sold a non-current asset costing $20 000 to Dolphin Ltd for $24 000. Dolphin Ltd applies a 10% p.a. on cost straight-line method of depreciation. • On 1 January 2023, Shark Ltd sold an item of plant to Dolphin Ltd for $30 000. The carrying amount of the asset to Shark Ltd at time of sale was $22 The. Dolphin Ltd applies a 15% p.a. straight-line method of depreciation. • A non-current asset with a carrying amount of $40 000 was sold by Shark Ltd to Dolphin Ltd for $56 000 on 1 June 2023. Dolphin Ltd regarded the item as inventories and still had the item on hand at 30 June 2023. • On 1 July 2021, Dolphin Ltd sold an item of machinery to Shark Ltd for $14 000. This item had cost Dolphin Ltd $8000. Dolphin Ltd regarded this item as inventories whereas Shark Ltd intended to use the item as a non-current asset. Shark Ltd applied a 10% p.a. on cost straight-line depreciation method. Dolphin Ltd applies the equity method in accounting for its investment in Shark Ltd. Dolphin Ltd does not prepare consolidated financial statements. Required Prepare the journal entries of Dolphin Ltd for the year ended 30 June 2023 in relation to its investment in Shark Ltd. (LO6) Profit for the period (assume after-tax) $200 000 Adjustments: Realised profit on equipment sold on 1/7/21 (a) 10% x $4 000 (1 - 30%) 280 Unrealised profit on sale of plant on 1/1/23 (b) original profit $8 000 (1 – 30%) less depreciation of 15% x ½ x $5 600 (5 180) Unrealised profit in ending inventory (c) $16 000 (1 – 30%) (11 200) Realised profit on inventory to non-current asset sale (d) 10% x $6 000 (1 – 30%) 420 184 320 Investor’s share – 25% (approx.)

$46 080

31.33

Chapter 31: Associates and joint ventures

Note: amounts rounded to the nearest whole number. Cash

Dr Investment in Shark Ltd Cr (Dividend received from associate: 25% x $20 000)

5 000 5 000

Cash

Dr 4 000 Investment in Shark Ltd Cr (Interim dividend received from associate: 25% x $16 000) Investment in Shark Ltd Share of profit or loss of associates

Dr Cr

4 000

46 080

31.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 31.8 Inter-entity transactions where investor has no subsidiaries Dibbler Ltd acquired 20% of the ordinary shares of Potoroo Ltd on 1 July 2022. At this date, all the identifiable assets and liabilities of Potoroo Ltd were recorded at fair value. An analysis of the acquisition showed that $2000 of goodwill was acquired. Dibbler Ltd has no subsidiaries, and records its investment in the associate, Potoroo Ltd, in accordance with AASB 128. In the 2023–24 period, Potoroo Ltd recorded a profit of $100 eri, paid an interim dividend of $10 000 and, in June 2024, declared a further dividend of $15 000. In June 2023, Potoroo Ltd had declared a $20 000 dividend, which was paid in August 2023. Dibbler Ltd recognises dividends as revenue when they are received. The following transactions have occurred between the two entities (all transactions are independent unless specified). • In January 2024, Potoroo Ltd sold inventories to Dibbler Ltd for $15 000. These inventories had previously cost Potoroo Ltd $10 The, and remains unsold by Dibbler Ltd at the end of the period. • In February 2024, Dibbler Ltd sold inventories to Potoroo Ltd at a before-tax profit of $5000. Half of this was sold by Potoroo Ltd before 30 June 2024. • In June 2023, Potoroo Ltd sold inventories to Dibbler Ltd for $18 000. These inventories had cost Potoroo Ltd $12 000. At 30 June 2023, these inventories remained unsold by Dibbler Ltd. However, it was all sold by Dibbler Ltd before 30 June 2024. • The tax rate is 30%. Required Prepare the journal entries in the records of Dibbler Ltd in relation to its investment in Potoroo Ltd for the year ended 30 June 2024. (LO6) Profit for the period Adjustments: Unrealised after tax profit in ending inventory (a) [$5 000 (1 – 30%)] Unrealised after tax profit in ending inventory (b) [$2 500 (1 – 30%)] Unrealised profit in opening inventory (c) [$6 000 (1 – 30%)

$100 000

(3 500) (1 750) 4 200 98 950 $19 790

Investor’s share – 20% Cash Investment in Potoroo Ltd (20% x ($10 000 + $20 000)) Investment in Potoroo Ltd Share of profit or loss of associate

Dr Cr

6 000

Dr Cr

19 790

6 000

19 790

31.35

Chapter 31: Associates and joint ventures

Exercise 31.9 Consolidated financial statements including investments in associates Box Ltd acquired 90% of the ordinary shares of Jelly Ltd on 1 July 2018 at a cost of $150 750. At that date the equity of Jelly Ltd was as follows.

At 1 July 2018, all the identifiable assets and liabilities of Jelly Ltd were at fair value except for the following assets.

The inventories was all sold by 30 June 2019. Depreciable assets have an expected further 5-year life, with depreciation being calculated on a straight-line basis. Valuation adjustments are made on consolidation. Box Ltd uses the partial goodwill method. On 1 July 2021, Box Ltd acquired 25% of the capital of Fish Ltd for $3500 entering into a joint venture with three other venturers. All the identifiable assets and liabilities of Fish Ltd were recorded at fair value except for the following.

All these inventories were sold in the 12 months after 1 July 2021. The depreciable assets were considered to have a further 5-year life. Information on Fish Ltd’s equity position is as follows. 1 July 2021 Share capital General reserve Retained earnings

10 000 — 2 150

30 June 2022 $10 000 2 000 4 000

For the year ended 30 June 2023, Fish Ltd recorded a profit before tax of $2600 and an income tax expense of $600. Fish Ltd paid a dividend of $200 in January 2023. Box Ltd regards Fish Ltd as a joint venture investee.

31.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

During the year ended 30 June 2023, Fish Ltd sold inventories to Jelly Ltd for $6000. The cost of these inventories to Fish Ltd was $4000. Jelly Ltd has resold only 20% of these items. However, Jelly Ltd made a profit before tax of $500 on the resale of these items. On 1 January 2022, Box Ltd sold Fish Ltd a motor vehicle for $4000, at a profit before tax of $800 to Box Ltd. Both companies treat motor vehicles as non-current assets. Both companies charge depreciation at 20% p.a. on the diminishing balance. Assume a tax rate of 30%. Information about income and changes in equity for Box Ltd and its subsidiary, Jelly Ltd, for the year ended 30 June 2023 is as follows. Box Ltd

Jelly Ltd

$200 000 110 000

$60 000 30 000

Gross profit

90 000

30 000

Less: Depreciation Other expenses

16 000 22 000

4 000 3 000

38 000

7 000

Plus: Other revenue

52 000 30 000

23 000 5 000

Profit before income tax Less: Income tax expense

82 000 20 000

28 000 10 000

Profit Plus: Retained earnings (1/7/22)

62 000 120 000

18 000 80 000

Less: Dividend paid

182 000 20 000

98 000 4 000

Retained earnings (30/6/23)

$162 000

$94 000

Sales revenue Less: Cost of sales

Required 1. Prepare the consolidated statement of profit or loss and other comprehensive income of Box Ltd and its subsidiary Jelly Ltd as at 30 June 2023. 2. In the consolidated statement of financial position, what would be the balance of the investment shares in Fish Ltd? (LO3, LO4, LO5 and LO7) 90% Box Ltd Jelly Ltd NCI 10% 25%

31.37

Chapter 31: Associates and joint ventures

Fish Ltd 1. At 1 July 2018: Net fair value of identifiable assets and liabilities of Jelly Ltd = + + = (a) Consideration transferred = (b) Non-controlling interest = Aggregate of (a) and (b) = Goodwill = Business combination valuation entry:

$100 000 + $8 000 + $12 000 (equity) $5 000 (1 – 30%) (inventory) $10 000 (1 – 30%) (depreciable assets) $130 500 $150 750 10% x $130 500 = $13 050 $163 800 $33 300

Depreciation expense Income tax expense Retained earnings (1/7/22) Transfer from BCVR

Dr Cr Dr Cr

2 000 600 5 600 7 000

Pre-acquisition entries: Retained earnings (1/7/22)* Dr 13 950 Share capital Dr 90 000 General reserve Dr 7 200 Business combination valuation reserve Dr 6 300 Goodwill Dr 33 300 Shares in Jelly Ltd Cr *(90% x $12 000) + 90% x ($5 000 - $1 500) (BCVR - inventory) Transfer from BCVR Business combination valuation reserve

Dr Cr

6 300

Dr Dr Dr Dr Cr

1 200 10 000 800 1 050

150 750

6 300

NCI in equity of Jelly Ltd at 1/7/21: Retained earnings (1/7/22) Share capital General reserve Business combination valuation reserve NCI

13 050

NCI in equity of Jelly Ltd: 1/7/18 – 30/6/22: Retained earnings (1/7/22) Dr 6 240 Business combination valuation reserve Cr 350 NCI Cr 5 890 (RE: 10% x ($80 000 - $12 000 – $5 600); BCVR: 10% x $3 500 [inventory]) NCI in equity of Jelly Ltd: 1/7/22 – 30/6/23:

31.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

NCI share of profit NCI (10% x ($18 000 – [$2 000 - $600]))

Dr Cr

1 660

Transfer from BCVR Business combination valuation reserve

Dr Cr

700

NCI

Dr Cr

400

Dr Cr

3 600

Dividend paid (10% x $4 000)

1 660

700

400

Dividend paid: Other revenue Dividend paid (90% x $4 000)

3 600

Equity accounting entries: Box Ltd – Fish Ltd: At 1 July 2021: Net fair value of identifiable assets and liabilities of Fish Ltd =

Net fair value acquired Cost of investment Goodwill Inventory adjustment Depreciation p.a.

= = = = =

$10 000 + $2 150 (equity) + $500 (1 – 30%) (inventory) + $1 000 (1 – 30%) (depreciable assets) $13 200 25% x $13 200 $3 300 $3 500 $200

= = =

$350 1/5 x $1 000 (1 – 30%) $140

Change in Retained Earnings 2021 – 2022 ($4 000 - $2 150) Pre-acquisition adjustments: Inventory Depreciation Post-acquisition equity Adjustments: Unrealised profit on sale of motor vehicle Profit of $800 (1 – 30%) less depreciation of ½ x 20% x $560 Increase in general reserve Change in retained earnings under the equity method Investor’s share – 25%

$1 850 (350) (140) $1 360

(504) 2 000 $2 856 $714

31.39

Chapter 31: Associates and joint ventures

Profit for the period 2022 - 2023 Pre-acquisition adjustments: Depreciation Post-acquisition profit Adjustments: Realised profit on motor vehicle 20% x ($560 - $56) Unrealised profit on ending inventory (80% x $2 000) (1 – 30%)

$2 000 (140) $1 860

101 (1 120) $841

Investor’s share – 25%

$210

The equity accounting entries are: Equity accounting – Fish Ltd:

Financial Statements Sales revenue Other revenue

Cost of sales Depreciation Other expenses

Share of profit/loss of associates Profit before tax Tax expense Profit Retained earnings (1/7/22)

Dividend revenue Investment in Fish Ltd (25% x $200)

Dr Cr

Investment in Fish Ltd Retained earnings (1/7/22) Share of profit or loss of associates

Dr Cr Cr

924

Box Ltd 200 000 30 000

Group

230 000 110 000 16 000 22 000

Jelly Ltd 60 000 5 000 6 7 65 000 30 000 4 000 1 3 000

148 000 82 000 -

37 000 28 000 -

82 000

28 000

20 000 62 000 120 000

10 000 18 000 80 000 1 2

Adjustments Dr Cr

714 210 NCI Dr Cr

Parent

1 660 1 200 6 240

73 500 173 724

260 000 31 350

3 600 50

291 350 140 000 22 000 25 000

2 000

210

187 000 104 350 210

104 560 600 5 600 13 950

714

1 7

29 400 75 160 181 164

5 3 4

31.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Transfer from BCVR Dividend paid Retained earnings (30/6/23)

182 000 20 000 162 000

- 2 98 000 4 000 94 000

6 300

7 000

700

3 600

257 024 20 400 236 624

700

400

31.41

247 224 20 000 227 224

Chapter 31: Associates and joint ventures

BOX LTD Consolidated statement of profit or loss and other comprehensive income for the financial year ending 30 June 2023

Sales revenue Cost of sales Gross profit Other revenue

$260 000 (140 000) 120 000 31 350

Depreciation expense Other expenses

(22 000) (25 000)

Share of profit/loss of associates Profit before income tax Income tax expense

___210 104 560 (29 400)

Profit for the period

$75 160

Comprehensive income for the period

$75 160

Attributable to: Parent interest Non-controlling interest

$73 500 1 660 $75 160

2. Investment in Fish Ltd ($3 500 + $924 - $50)

$4 374

31.42

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 31: Associates and joint ventures Multiple choice questions 1. Which of the following statements is correct? *a. Joint arrangements classified as joint ventures are accounted for under AASB 128/IAS 28. b. All joint arrangements are accounted for under AASB 128/IAS 28. c. Joint arrangements classified as joint ventures are accounted for under AASB 11. d. Joint arrangements classified as joint operations are accounted for under AASB 128/IAS 28. Answer: a Learning objective 31.1: explain the nature of associates and joint ventures.

2. For the purposes of equity accounting for an investment in an associate, it is presumed that the investor has significant influence over the other entity where the investor holds: *a. 20% or more of the voting power of the investee. b. 50% or more of the voting power of the investee. c. between 1% and 5% of the voting power of the investee. d. between 5% and 10% of the voting power of the investee. Answer: a Learning objective 31.2: discuss the concepts of significant influence and joint control.

3. The following are regarded as factors indicating the existence of significant influence over another entity: interchange of managerial personnel participation in decisions about dividends representation on the board of directors ability to control the investee’s operating policies

I Yes No No No

II Yes Yes Yes No

III No Yes Yes No

IV Yes Yes Yes Yes

a. I. *b. II. c. III. d. IV. Answer: b Learning objective 31.2: discuss the concepts of significant influence and joint control.

31.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. For the purposes of equity accounting, significant influence is regarded as the power of an investor to: a. dominate the financing decisions of an entity. b. control the financial and operating policies of an associate. c. participate in the day-to-day management of a joint venture interest. *d. participate in the financial and operating policy decisions of an investee. Answer: d Learning objective 31.2: discuss the concepts of significant influence and joint control.

5. On 1 July 2021 Barry Ltd acquired 25% of the ordinary issued share capital of Charlie Ltd for $300 000. This investment gave rise to significant influence. The share capital and reserves of Charlie Ltd at 1 July 2021 were: Share capital $500 000 General reserve 200 000 Retained earnings 384 000 $1 084 000 All the identifiable net assets of Charlie Ltd were stated at fair value at the date of acquisition except for equipment whose carrying value was $30 000 less than the fair value. The tax rate is 30%. Goodwill arising on Barry’s acquisition of Charlie was: a. $21 500 b. $29 000 *c. $23 750 d. $25 000 Answer: c Feedback: $1084 000 + (30 000 x [1-30%]) = $1105 000. Share of associate at 25% = $276 250. Goodwill = $300 000 - $276 250 = $23 750. Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

31.2

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

6. David Limited acquired a 20% share in Tennant Limited for $52 000. David Limited has no other investments. At the date on which it became an associate, Tennant Limited had the following equity (which reflected the fair value of net assets on that date): Share capital Retained earnings

$155 000 $110 000

At the end of the financial year following the investment, Tennant Limited generated a profit of $96 000. After applying the equity method of accounting, David Limited will have the following carrying amount for the investment: a. $19 200 b. $32 800 c. $52 000 *d. $71 200 Answer: d Feedback: $52 000 + ($96 000 x 20%) Learning objective 31.4: apply the equity method to an investment in an associate.

7. Robert Limited acquired a 25% interest in Jones Limited for $80 000. Robert holds other equity investments but does not prepare consolidated financial statements. Jones Limited revalued its plant and equipment class of assets during the current financial period which resulted in an increase to the asset revaluation surplus account of $36 000. The balance of the Investment in Associate account at the end of the current financial period is: a. $29 000. b. $80 000. c. $86 300. *d. $89 000. Answer: d Learning objective 31.4: apply the equity method to an investment in an associate.

31.3

Testbank to accompany Financial reporting 3e by Loftus et al.

8. Coral Limited acquired a 40% investment in Reef Limited for $120 000. Reef declared and paid a dividend of $30 000. Coral Limited does not prepare consolidated financial statements. The appropriate entry for the investor to record this dividend is: a. DR Dividends payable $12 000; CR Cash $12 000 b. DR Cash $12 000; CR Dividend revenue $12 000 *c. DR Cash $12 000; CR Investment in associate $12 000 d. DR Investment in associate $12 000; CR Dividend revenue $12 000. Answer: c Learning objective 31.6: account for the effects of inter-entity transactions.

9. The equity method of accounting for an investment in an associate includes the following steps:

Recognise the initial investment at cost Recognise the initial investment at fair value Reduce the carrying amount by any distributions Adjust the carrying amount by the investor’s share of the associate’s profit or loss

I Yes No Yes Yes

II Yes Yes No No

III No Yes No Yes

IV No No Yes No

*a. I. b. II. c. III. d. IV. Answer: a Learning objective 31.4: apply the equity method to an investment in an associate.

10. Adjustments made for the purpose of calculating the incremental adjustment to the share of profit of an associate are: a. recognised in the books of the investee. b. recognised in the books of the investor. *c. notional adjustments and not recorded in the books of the investee. d. relate to realised transactions and so are recognised directly by the investee. Answer: c Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

31.4

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

11. When goodwill is acquired by an investor in an associate, the amortisation of goodwill is: *a. not permitted. b. included in the revaluation of the investment. c. spread evenly across the useful life of the investment. d. included in the determination of the investor’s share of the associate’s profit or loss. Answer: a Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

12. On 1 July 2021 Alpha Ltd acquired a 40% share of Beta Ltd. At that date, the following assets had carrying amounts different to their fair values in Beta’s books: Asset Inventories Plant

Carrying amount $18 000 $30 000

Fair value $20 000 $35 000

All inventories were sold to third parties by 30 June 2022. On 1 July 2021, the plant had a remaining useful life of 2 years. The tax rate is 30%. The adjustment required to the Investment in Associate account at 30 June 2022 in relation to the above assets is: *a. $1 260 b. $1 400 c. $1 750 d. $3 150 Answer: a Feedback: Inventories adjustment: (20000 – 18000) x (1-30%) = 1400. Depreciation adjustment: (35000 – 30000) x (1-30%) / 2 years = 1 750. Total adjustments = 1400 + 1750 = 3150. Associate’s share at 40% = 3150 x 40% = 1260. Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

31.5

Testbank to accompany Financial reporting 3e by Loftus et al.

13. Where an acquisition in an associate results in an excess, how is the excess accounted for in the year of acquisition? a. CR Investment in associate account. *b. CR Share of associate profit account. c. DR Share of associates retained earnings account. d. No adjustment is required due to the single line method of accounting followed under the equity method. Answer: b Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

14. Carnation Ltd purchased a 25% shareholding in Bloom Ltd on 1 January 2021 for $90 000. Bloom Ltd’s assets were recorded at fair values and its owners’ equity, totalling $350 000, was represented as follows: Share capital General reserve Asset revaluation surplus Retained profits

$100 000 $60 000 $50 000 $140 000

During July 2021, Bloom Ltd paid an interim dividend of $15 000. At 31 December 2021, Bloom Ltd reported: Profit after tax for 2021 Final dividend payable A transfer to the general reserve Increase of the asset revaluation surplus to

$64 000 $30 000 $20 000 $80 000

The equity carrying amount of the investment in Bloom Ltd at 31 December 2021 is: a. $106 000 b. $109 750 *c. $102 250 d. $113 500 Answer: c Learning objective 31.5: adjust the application of the equity method for fair value/carrying amount differences of identifiable assets and liabilities at acquisition date and account for goodwill or gain on bargain purchase at acquisition.

31.6

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

15. Carnation Ltd purchased a 25% shareholding in Bloom Ltd on 1 January 2021 for $90 000. Bloom Ltd’s assets were recorded at fair values and its owners’ equity, totalling $350 000, was represented as follows: Share capital General reserve Asset revaluation surplus Retained profits

$100 000 $60 000 $50 000 $140 000

$64 000 $30 000 $20 000 $80 000

Assuming that Carnation Ltd applies the equity method in its own books, the entry to record the dividend receivable from Bloom Ltd during the year ended 31 December 2022 would include a: a. DR Dividend revenue account. b. DR Investment in associate account. c. CR Dividend revenue account. *d. CR Investment in associate account. Answer: d Learning objective 31.6: account for the effects of inter-entity transactions.

16. Where there are transactions between the investor and associate that result in an unrealised profit, the investor’s share of the associate’s profit is: a. affected only if the transaction is an upstream one. b. affected only if the transaction is a downstream one. *c. affected regardless of whether the transaction is an upstream or downstream one. d. not affected at all regardless of whether the transaction is an upstream or downstream one. Answer: c Learning objective 31.6: account for the effects of inter-entity transactions.

31.7

Testbank to accompany Financial reporting 3e by Loftus et al.

17. Where an investor sells inventories to an associate and the inventories are still on hand at the end of the year the investor’s share of the associate’s profits is: *a. decreased by the investor’s share of the unrealised profit. b. increased by the investor’s share of the unrealised profit. c. not affected as the unrealised profit is in the books of the investor, not the associate. d. not affected as unrealised profits are only considered to arise in a parent-subsidiary relationship. Answer: a Learning objective 31.6: account for the effects of inter-entity transactions.

18. Where an investor sells inventories to an associate in a prior year and the inventories are sold by the associate during the current year the investment in associate account is: a. unaffected. b. increased by the full amount of the realised profit. *c. increased by the investor’s share of the realised profit. d. decreased by the investor’s share of the realised profit. Answer: c Learning objective 31.6: account for the effects of inter-entity transactions. 19. Colette Ltd, owns 25% of Ambrose Ltd. Ambrose’s profit after tax for the year ended 30 June 2021 is $50 000. The tax rate is 30%. During the year ended 30 June 2022, Ambrose sold $8000 worth of inventories to Colette. These items had previously cost Ambrose $6500. All the items remain unsold by Colette at 30 June 2022. Colette’s share of Ambrose’s profit for the year ended 30 June 2022 is: a. b. c. *d.

$12 875.00 $11 000.00 $12 500.00 $12 762.50

Answer: d Feedback: Share of after-tax profit from sale on inventories = ($8000 - $6500) x (1-30%) x 25% = $262.50. Total share of profit = $50 000 x 25% + $262.50 = $12 762.50 Learning objective 31.6: account for the effects of inter-entity transactions.

31.8

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

20. Clove Ltd owns 40% of Bark Ltd. Bark Ltd’s profit after tax for the year ended 30 June 2022 is $120 000. The tax rate is 30%. On 1 July 2020, Bark Ltd sold an item of plant to Clove Ltd for $164 000. The carrying amount of the asset on this date in Bark Ltd’s records was $152 000. The plant had a remaining useful life of 4 years. Clove’s share of Bark’s profit for the year ended 30 June 2022 is: a. $41 000 b. $44 000 *c. $48 840 d. $52 800 Answer: c Feedback: Depreciation adjustment for sale of plant in previous year = ($164 000 - $152 000) / 4 x 0.7 x 40% = $840. Total share of profit = ($120 000 x 40%) + $840. Learning objective 31.6: account for the effects of inter-entity transactions.

21. On 1 July 2017 Fred Ltd acquired 30% of the shares of Barney Ltd for $240 000. At that date, the equity of Barney Ltd was $800 000, with all identifiable assets and liabilities being measured at fair value. Profits/(losses) made since the date of acquisition are as follows: Year ended 30 June 2018 2019 2020 2021 2022

Profit/(Loss) $ 40 000 (360 000) (500 000) 15 000 44 000

There have been no dividends paid or movements in reserves since the date of acquisition. At 30 June 2019 the equity accounted balance of the investment in Barney was: a. *b. c. d.

$240 000 $144 000 $252 000 $108 000

Answer: b Learning objective 31.7: account for associates and joint ventures where these entities incur losses.

31.9

Testbank to accompany Financial reporting 3e by Loftus et al.

22. On 1 July 2017 Fred Ltd acquired 30% of the shares of Barney Ltd for $240 000. At that date, the equity of Barney Ltd was $800 000, with all identifiable assets and liabilities being measured at fair value. Profits/(losses) made since the date of acquisition are as follows: Year ended 30 June 2018 2019 2020 2021 2022

Profit/(Loss) $ 40 000 (360 000) (500 000) 15 000 44 000

There have been no dividends paid or movements in reserves since the date of acquisition. At 30 June 2021 the equity accounted balance of the investment in Barney was: *a. b. c. d.

$0 $4 500 ($1 500) $240 000

Answer: a Feedback: At this date, Fred’s share of the accumulated losses is $241 500. Can only recognise share of accumulated losses up to the value of the original investment of $240 000. Learning objective 31.7: account for associates and joint ventures where these entities incur losses.

31.10

Chapter 31: Associates and joint ventures Not for distribution in full. Instructors may assign selected questions in their LMS.

23. On 1 July 2017 Fred Ltd acquired 30% of the shares of Barney Ltd for $240 000. At that date, the equity of Barney Ltd was $800 000, with all identifiable assets and liabilities being measured at fair value. Profits/(losses) made since the date of acquisition are as follows: Year ended 30 June 2018 2019 2020 2021 2022

Profit/(Loss) $ 40 000 (360 000) (500 000) 15 000 44 000

There have been no dividends paid or movements in reserves since the date of acquisition. At 30 June 2022 the equity accounted balance of the investment in Barney was: a. b. c. *d.

nil. $228 300 $13 200 $11 700

Answer: d Learning objective 31.7: account for associates and joint ventures where these entities incur losses.

24. If an associate incurs losses the investor is required to: a. b. *c. d.

reclassify the investment as a current asset. ignore the losses for the purposes of equity accounting adjustments. recognise losses to the point where the carrying amount of the investment is zero. recognise losses only to the point where the carrying amount is equal to the initial investment.

Answer: c Learning objective 31.7: account for associates and joint ventures where these entities incur losses.

31.11

Testbank to accompany Financial reporting 3e by Loftus et al.

25. Where an investor has discontinued the use of the equity method because the associate has incurred losses it must disclose the: a. b. c. *d.

reason why it has discontinued the method. accounting policy it has adopted in place of the equity method. effect on the statement of changes in equity if it had continued to use the method. unrecognised share of current period and cumulative losses of the associate.

Answer: d Learning objective 31.8: discuss the disclosures required in relation to associates and joint ventures.

26. Investments in associates accounted for using the equity method are presented in the statement of financial position as part of: a. b. *c. d.

equity. current assets. non-current assets. non-current liabilities.

Answer: c Learning objective 31.8: discuss the disclosures required in relation to associates and joint ventures.

27. When disclosing information about investments in associates, AASB 12/IFRS 12 Disclosure of Interests in Other Entities requires separate disclosure of which of the following? I. II.

IV.

Unrecognised share of losses in associates, in the Notes to the accounts. Shares of changes recognised directly in the associate’s equity, in the statement of changes in equity. Share of profit or loss of associates, in the statement of profit or loss and other comprehensive income. Carrying amounts of investments in associates, in the statement of financial position.

*a. b. c. d.

I, II, III and IV. I, II and IV only. I, II and III only. II, III and IV only.

III.

Answer: a Learning objective 31.8: discuss the disclosures required in relation to associates and joint ventures.

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Chapter 32: Joint arrangements

Chapter 32: Joint arrangements Comprehension questions 1. What is a joint arrangement? AASB 11/IFRS 11 states: 4. A joint arrangement is an arrangement of which two or more parties have joint control. 5. A joint arrangement has the following characteristics: (a) The parties are bound by a contractual arrangement (see paragraphs B2–B4). (b) The contractual arrangement gives two or more of those parties joint control of the arrangement (see paragraphs 7–13). 6. A joint arrangement is either a joint operation or a joint venture.

2. What is meant by joint control? See AASB 11/IFRS 11 para 3 and Appendix A. Joint control is the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. The key element of joint control is the sharing of control. In other words, there must be at least two investors who have shared control of the investee.

3. How does joint control differ from control as used in classifying subsidiaries? Under AASB 10/IFRS 10: An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. There are three investor-investee relationships which are based on different levels of control: Relationship Level of control Parent - subsidiary Dominant control Investor-associate Significant influence Joint arrangement - investee Joint control With a subsidiary there can be only one parent. With joint control there needs to be at least 2 entities that share control.

4. How does a joint venture differ from a joint operation? The classification of a joint arrangement into either a joint operation or a joint venture depends on the rights and obligations of the parties to the arrangement. A joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. Those parties are called joint operators. A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Those parties are called joint venturers.

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5. What are the key steps in classifying a joint arrangement into joint ventures and joint operations? The key element in the classification of a joint arrangement is the rights and obligations of the parties to the arrangement. For a joint operation the rights pertain to the rights and obligations associated with individual assets and liabilities, whereas with a joint venture, the rights and obligations pertain to the net assets, that is the investment in net assets. See AASB 11/IFRS 11 paragraph 14. The assessment of the classification of a joint arrangement requires judgement. The assessment of the rights and obligations in an arrangement involves analysing four factors: 1. the structure of the arrangement 2. the legal form of the arrangement 3. the terms agreed to by the parties in the contractual arrangement, and 4. any other relevant facts and circumstances.

6. How are joint ventures accounted for? With a joint venture, the joint venturers have an interest in the investment in the joint arrangement. The accounting for this interest is done by application of the equity method in accordance with AASB 128/IAS 28 Investments in Associates and Joint Ventures. 7. How are joint operations accounted for? The key feature of a joint operation is that the joint operator has an interest in the individual assets and liabilities of the joint operation. In the situation where the joint operation produces an output which is distributed to the joint operators, the joint operator will receive a share of the output of the joint operation as well as be responsible for a share of the expenses of the operation that are not capitalised into the cost of the output. Hence each joint operator needs to recognise its own accounts: (a) its share of any jointly held assets (b) its share of any jointly held liabilities (c) its revenue from the sale of any output received from the joint operation (d) its share of any revenue from the sale of any product that is jointly constructed by the joint operators (e) its share of any expenses incurred by the joint operation (f) its expenses incurred in construction of a joint product.

32.3

Chapter 32: Joint arrangements

Case studies Case study 32.1 Classification of a joint arrangement Falls Ltd and Creek Ltd decided to jointly undertake the manufacture of an electric car. They formed Silver Ltd, which will manufacture the car. Falls Ltd and Creek Ltd provide the various parts for the manufacture of the car, which is assembled by Silver Ltd. Falls Ltd and Creek Ltd each hold 50% of the voting rights in Silver Ltd and receive 50% of the cars produced by Silver Ltd. Falls Ltd and Creek Ltd then sell the cars in their own geographic region. The constitution of Silver Ltd requires that the operations of the company must be in accordance with a business plan prepared annually, and to which both Falls Ltd and Creek Ltd both agree. Silver Ltd has six directors, with three being appointed by Falls Ltd and three by Creek Ltd. Required Evaluate whether a joint arrangement exists and how it should be classified. Does a joint arrangement exist? A joint arrangement is an arrangement of which two or more parties have joint control. The two main characteristics are: • the parties are bound by a contractual arrangement, and • the parties have joint control of the arrangement. The contractual arrangement in this case would be the constitution of Silver Ltd which would set out the rights and obligations of the owners, namely Falls Ltd and Creek Ltd. Falls Ltd and Creek Ltd each hold 50% of the voting rights in Silver Ltd. In the absence of any other agreement, this would mean that both parties would have to agree before any decision was made. Note the existence of the business plan which requires joint agreement, and note further the structure of the board – 3 directors from each company. Hence it would seem that joint control exists. Hence a joint arrangement exists. How should the joint arrangement be classified? Note firstly that a separate vehicle, namely Silver Ltd, is established. Hence it could be either a joint operation of a joint venture. However, the other factor to consider is that Silver Ltd produces cars. These cars, as output, are distributed to Falls Ltd and Creek Ltd who sell the cars in their own geographic regions. The profit is then generated by the owners of Silver Ltd subsequent to the receipt of the output from the joint arrangement. Silver Ltd does not make any profit or loss. It just produces output. The parties to the joint arrangement then have a right to substantially all the economic benefits of the assets held by the arrangement.

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Another feature of such an arrangement is that, as a result of the decision to supply the output of the joint arrangement to the parties themselves, there is no cash inflow to the joint arrangement from the sale of the product. The joint arrangement relies solely on the parties to the arrangement for the supply of cash to continue the operations of the arrangement as well as to pay for the liabilities incurred by the arrangement. The parties themselves are then responsible for the liabilities of the arrangement as the latter has no facility to be able to generate cash for the settlement of liabilities. These forms of arrangement are generally classified as joint operations.

32.5

Chapter 32: Joint arrangements

Case study 32.2 Existence and classification of a joint arrangement The Chinese mining company Changchun Mining Ltd and the Australian mining company Seal Rush Ltd have agreed to set up a separate company, Dragon Rush Ltd, to mine for gold in Australia. The Australian Government has issued permits to the Australian company to mine for gold in specified areas of Australia. The companies have set up a joint operating agreement which contains the following provisions:  The assets and liabilities of Dragon Rush Ltd are those of that company and not of the parties owning shares in Dragon Rush Ltd.  Dragon Rush Ltd has a board of directors that will consist of six persons, three provided by each of Changchun Mining Ltd and Seal Rush Ltd. Each of these companies has a 50% ownership in Dragon Rush Ltd. For any resolution to be passed by the board, there has to be unanimous consent of all directors.  Seal Rush Ltd will provide the management team for Dragon Rush Ltd for which a management fee will be paid by Dragon Rush Ltd. However, all budget matters and work programs have to be approved by the board of Dragon Rush Ltd.  The rights and obligations arising from the exploration development and production activities of Dragon Rush Ltd are to be shared by all parties to the joint arrangement. In particular, the parties will share in the production obtained from the mining activities and all costs associated with the work undertaken.  If cash is required for ongoing mining activities, the board of Dragon Rush Ltd may make calls on the parties owning shares in that company. Required Discuss whether a joint arrangement exists and whether it should be classified as a joint venture or a joint operation. Does a joint arrangement exist? A joint arrangement is an arrangement of which two or more parties have joint control. The two main characteristics are: • the parties are bound by a contractual arrangement, and • the parties have joint control of the arrangement. In this example there is an agreement between Changchun Mining Ltd and Seal Rush Ltd. The board of directors has 6 members with 3 from each company. There has to be unanimous consent of all directors. There is then a joint arrangement. How is the joint arrangement classified? The parties carry out the joint arrangement through a separate vehicle whose legal form confers separation between the parties and the separate vehicle. However, the parties have been able to reverse the initial assessment of their rights and obligations arising from the legal form of the separate vehicle in which the arrangement is conducted. They have done this by agreeing terms in the joint arrangement agreement that

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entitle them to rights to the assets (e.g. exploration and development permits, production, and any other assets arising from the activities) and obligations for the liabilities (e.g. all costs and obligations arising from the work programmes) that are held in Dragon Rush Ltd. The joint arrangement is thus classified as a joint operation. Both Changchun Mining Ltd and Seal Rush Ltd would recognise in their financial statements their own share of the assets and of any liabilities resulting from the arrangement on the basis of their agreed participating interest. On that basis, each party also recognises its share of the revenue (from the sale of their share of the production) and its share of the expenses.

32.7

Chapter 32: Joint arrangements

Case study 32.3 Classification of a joint arrangement Two smaller banks that operate in Australia are the Ballarat Bank and the St Martins Bank. These have in the past primarily offered domestic banking services to their customers. However in recent times, these customers have made increasing demands for international currency transactions and access to offshore banking arrangements. As both banks individually are not prepared to undertake the risks associated with international operations on their own, they have decided to join together to provide these services to their customers. To this end, they have formed the Overseas Bank. This bank is regarded as a separate vehicle in its own right, with the assets and liabilities of the Overseas Bank being those of the bank itself. The Ballarat Bank and St Martins bank will each hold a 50% interest in the Overseas Bank. These two banks have signed an agreement such that all major decisions in relation to the Overseas Bank require the unanimous agreement of the two banks. The board of the Overseas Bank will consist of an equal number of representatives of these two banks. The Ballarat Bank and the St Martins bank have agreed to provide initial funding to establish the Overseas Bank and have also agreed on a mechanism for further cash inflows if required. Required Discuss whether a joint arrangement exists and how it should be classified. The joint arrangement is carried out through a separate vehicle – the Overseas Bank - whose legal form confers separation between the parties and the separate vehicle. The terms of the contractual arrangement do not specify that the parties have rights to the assets, or obligations for the liabilities, of the Overseas Bank, but it establishes that the parties have rights to the net assets of the Overseas Bank. The commitment by the parties to provide support if the Overseas Bank is not able to comply with the applicable legislation and banking regulations is not by itself a determinant that the parties have an obligation for the liabilities of the Overseas Bank. There are no other facts and circumstances that indicate that the parties have rights to substantially all the economic benefits of the assets of the Overseas Bank and that the parties have an obligation for the liabilities of the Overseas Bank. The joint arrangement is a joint venture. Both the Ballarat Bank and the St Martins Bank recognise their rights to the net assets of the Overseas Bank as investments and account for them using the equity method.

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Case study 32.4 Accounting for an asset used by a number of companies Raby Ltd and Bay Ltd are companies that have newly discovered oil wells in a MiddleEastern country. There is some distance to the nearest port and, rather than build separate pipelines, they have agreed to jointly build a pipeline to the port and share the use of the pipeline for transporting oil. The management of the pipeline is conducted in accordance with an agreement between Raby Ltd and Bay Ltd which requires unanimous agreement in relation to such issues as maintenance and future expansion or contraction of the pipeline. Kalgoorlie Ltd also has oil wells in the area and has agreed to use any excess capacity of the pipeline. Required Discuss how you would account for the pipeline. In this circumstance there is a jointly controlled asset, namely the pipeline. As there is no separate vehicle established the joint arrangement is classified as a joint operation. Both Raby Ltd and Bay Ltd will recognise a share of the jointly controlled asset in their records. These two companies will also recognise any expenses associated with the operation of the pipeline such as maintenance costs. If the pipeline is expanded then any costs associated with this would be capitalised equally into the pipeline asset in the records of each of the companies. Any revenues received from Kalgoorlie Ltd would be recognised equally in the records of the two joint operators.

32.9

Chapter 32: Joint arrangements

Application and analysis questions Exercise 32.1 Contributions of cash Seal Ltd’s main area of interest is the production of glass products. Manatee Ltd manufactures products that require the employment of artists with skills in fine etchings. After negotiations, on 1 July 2022 the executives of both companies reached an agreement to establish a joint operation that would be involved in the production of fine glass tableware. Under the contractual agreement, both operators agreed to invest $210 000 each in the joint operation. Each party to the joint operation would have a 50% interest in the joint operation and the output of the joint operation would be distributed equally to each operator. After the first year of operation the following information about the joint operation was provided at 30 June 2023. Cash Inventories: Finished goods Work in progress Raw materials Plant Accumulated depreciation

49 000 14 000 28 000 28 000 175 000 (35 000)

Total assets

259 000

Creditors Accrued expenses

35 000 14 000

Total liabilities

49 000

The joint operation reported the following costs incurred during the financial year. Salaries and wages Raw materials Other expenses including depreciation

98 000 63 000 91 000 252 000 224 000

Total costs incurred Cost of inventories Work in progress at 30 June 2023

28 000

The joint operation also reported the following cash receipts and payments for the year ending 30 June 2023.

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Receipts Contributions by operators Payments Acquisition of plant at 1 July 2022 Acquisition of raw material Salaries and wages Other expenses

$ $

175 000 56 000 84 000 56 000

371 000 $

Cash balance at 30 June 2023

420 000

49 000

Required In relation to the joint operation for the year ending 30 June 2023 prepare the journal entries in the records of Manatee Ltd. (LO3 and LO4) 1 July 2022 Cash in JO Cash (Investment in JO with Seal Ltd)

Dr Cr

210 000

Dr Dr Dr Dr Dr Cr Cr Cr Cr

105 000 14 000 7 000 14 000 87 500

210 000

30 June 2023 Inventory Raw materials in JO Inventory in JO Work in progress in JO Plant in JO Accum. deprec. – plant in JO Creditors in JO Accrued expenses in JO Cash in JO

((224 000 – 14 000)/2) (28 000/2) (14 000/2) (28 000/2) (175 000/2) 17 500 (35 000/2) 17 500 (35 000/2) 7 000 (14 000/2) 185 500 (210 000 – ½ x 49 000))

32.11

Chapter 32: Joint arrangements

Exercise 32.2 Contribution of plant On 1 July 2022, Sea Ltd and Lion Ltd signed a contractual agreement to form a joint operation for the manufacture of kitchen products. The agreement provided that Lion Ltd would contribute $240 000 in cash while Sea Ltd would provide $40 000 in cash as well as manufacturing equipment currently held by Sea Ltd that had a fair value of $200 000. The equipment was currently recorded by Sea Ltd at a carrying amount of $180 000, net of accumulated depreciation of $30 000. The agreement provided that each operator would receive half of the output of the joint operation. Depreciation on equipment is charged at 20% p.a. on cost, based on the expected pattern of use in the joint operation. Financial information provided by the joint operation at 30 June 2023 was as follows. Statement of financial position (partial) Cash Raw materials Inventories (undistributed) Work in progress Equipment Accumulated depreciation

56 000 Accounts payable 32 000 Accrued wages 16 000 Loan 32 000 400 000 (80 000)

$ 456 000

40 000 16 000 200 000

256 000

Cash receipts and payments Payments Contributions Loan Purchase of raw materials Wages Purchase of equipment (2 July 2022) Other expenses

Receipts $

280 000 200 000

480 000

112 000 72 000 144 000

$ 64 000 96 000 200 000 64 000 $ 424 000 Costs incurred

Wages Raw materials Overheads including depreciation on equipment

328 000 (296 000)

Cost of inventories

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Statement of financial position (partial) Work in progress at 30 June 2023

32 000

Required Prepare the journal entries in the records of Sea Ltd in relation to the joint operation for the year ending 30 June 2023. (LO3 and LO4) 1 July 2022 Cash in JO Plant in JO Accum. deprec. – plant Cash Gain on sale of equipment Plant (Investment in JO with Lion Ltd)

Dr Cr Dr Cr Cr Cr

140 000 90 000 30 000

Dr Dr Dr Dr Dr Cr Cr Cr Cr Cr

140 000 16 000 8 000 16 000 100 000

Depreciation charged on contributed asset Depreciation on cost to Sea Ltd Adjustment

$40 000 $36 000 $4 000

((240 000 + 40 000)/2) (180 000/2) 40 000 10 000 210 000

(20 000/2)

30 June 2023 Inventory Raw materials in JO Inventory in JO Work in progress in JO Equipment in JO Accum. deprec – equip. JO Accounts payable in JO Accrued wages in JO Loan Cash in JO

(280 000/2) (32 000/2) (16 000/2) (32 000/2) (200 000/2) (80 000/2) (40 000/2) (16 000/2) (200 000/2) (140 000 – ½ x 56 000))

40 000 20 000 8 000 100 000 112 000

Workings:

Proportionate allocation of $2 000: Work in progress in JO Inventory in JO Inventory Accum. deprec. – equipment – JO Work in progress in JO Inventory in JO Inventory

20% x $200 000 20% x $180 000

$16 000 8 000 140 000 $164 000 Dr Cr Cr Cr

$195 98 1 707 $2 000 2 000 195 98 1 707

32.13

Chapter 32: Joint arrangements

Exercise 32.3 Sharing output On 1 July 2022, Darwin Ltd entered into a joint agreement with Broome Ltd to form an unincorporated entity to produce a new type of widget. It was agreed that each party to the agreement would share the output equally. Darwin Ltd’s initial contribution consisted of $2 000 000 cash and Broome Ltd contributed machinery that was recorded in the records of Broome Ltd at $1 900 000. During the first year of operation both parties contributed a further $3 000 000 each. On 30 June 2023, the venture manager provided the following statements (in $’000).

Costs incurred $ 1 840 2 800 2 200

Wages Supplies Overheads

6 840 4 840

Cost of inventories

$ 2 000

Work in progress at 30 June 2023 Receipts and payments Receipts: Original contributions Additional contributions

2 000 6 000 8 000

Payments: Machinery (2/7/22) Wages Supplies Overheads Operating expenses

$ 800 1 800 3 000 2 100 200

Closing cash balance

7 900 $

100

Assets and liabilities Assets

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Costs incurred Cash Machinery Supplies Work in progress

100 2 800 400 2 000

Total assets

5 300

Liabilities Accrued wages Creditors

40 300

Total liabilities

340 $

Net assets

4 960

Each joint operator depreciates machinery at 20% p.a. on cost in its own records.

Required 1. Prepare the journal entries in the records of Darwin Ltd and Broome Ltd in relation to the joint operation. 2. Prepare the journal entries in the records of Broome Ltd assuming that the joint operation, not the operators, had depreciated the machinery and included that expense in the cost of inventories transferred. (LO3 and LO4) 1. Journal entries in records of Darwin Ltd: 1 July 2022 Cash in JO Dr 1 000 Machinery in JO Dr 1 000 Cash Cr Cash in JO Cash 30 June 2023 Machinery in JO Supplies in JO Work in progress in JO Inventory Operating expenses Accrued wages in JO Creditors in JO Cash in JO Inventory Accum. depreciation in JO

Dr Cr

3 000

Dr Dr Dr Dr Dr Cr Cr Cr

400 200 1 000 2 420 100

Dr Cr

280

(2 000/2) (2 000/2) 2 000

3 000

20 150 3 950

(2 800/2 – 1 000) (400/2) (2 000/2) (4 840/2) (200/2) (40/2) (300/2) (100/2 – 4 000) (20% x 1 400)

280

32.15

Chapter 32: Joint arrangements

Journal entries in the records of Broome Ltd: 1 July 2022 Cash in JO Dr 1 000 Machinery in JO Dr 950 Gain on machinery sold Cr Machinery Cr Cash in JO Cash 30 June 2023 Machinery in JO Supplies in JO Work in progress in JO Inventory Operating expenses Accrued wages in JO Creditors in JO Cash in JO Inventory Accum. depreciation in JO

Dr Cr

3 000

Dr Dr Dr Dr Dr Cr Cr Cr

400 200 1 000 2 420 100

Dr Cr

270

50 1 900

(2 000/2) (1 900/2) (100/2)

3 000

20 150 3 950

(2 800/2 – 1 000) (400/2) (2 000/2) (4 840/2) (200/2) (40/2) (300/2) (100/2 – 4 000) (20% x (400 + 950))

270

2. Journal entries in the records of Broome Ltd: 1 July 2022 Cash in JO Machinery in JO Gain on machinery sold Machinery Cash in JO Cash 30 June 2023 Machinery in JO Supplies in JO Work in progress in JO Inventory Other expenses Accum depreciation in JO Accrued wages in JO Creditors in JO Cash in JO

Dr Dr Cr Cr

1 000 950

Dr Cr

3 000

Dr Dr Dr Dr

400 200 1 000 2 700

Dr Cr Cr Cr Cr

100

50 1 900

(2 000/2) (1 900/2) (100/2)

3 000

280 20 150 3 950

(2 800/2 – 1 000) (400/2) (2 000/2) (4 840/2 + 280 depn) (200/2) (20% x 2 800/2) (40/2) (300/2) (100/2 – 4 000)

Accum depreciation in JO Dr 10 Inventory Cr 7 Work in progress in JO Cr 3 (Adjustment for depreciation being based on carrying amount rather than fair value)

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Workings: Total Value $ Inventory 2 700 Work in Progress in JO 1 000 3 700

% 73% 27%

Allocation $ 7 3 10

32.17

Chapter 32: Joint arrangements

Exercise 32.4 Unincorporated joint operation On 1 July 2021, Platypus Ltd entered into a joint agreement with Otter Ltd to establish an unincorporated joint operation to manufacture timber-felling equipment. It was agreed that the output of the operation would be shared in the proportions Platypus Ltd 60% and Otter Ltd 40%. To commence the operations, contributions were as follows. • Platypus Ltd: cash of $550 000 and equipment having a carrying amount of $150 000 and a fair value of $200 000. • Otter Ltd: cash of $300 000 and plant having a carrying amount of $225 000 and a fair value of $200 000. Otter Ltd revalued the plant it contributed to fair value prior to its transfer to the joint operation. Plant and equipment was depreciated (to the nearest month) in the joint operation’s books at 20% p.a. on cost. During December 2021, an additional $1 000 000 cash was contributed by the operators in the same proportion as their initial contributions. The following information, in relation to the joint operations for the year ended 30 June 2022, was provided by the operation manager. (a) Costs incurred for the year ended 30 June 2022 Wages Raw materials Overheads Depreciation

200 000 600 000 325 000 102 500 1 227 500 1 002 500

Less: Cost of inventories Work in progress at 30 June 2022

225 000

(b) Receipts and payments for year ended 30 June 2022 Payments

Receipts $ 1 350 000

Contributions Plant (3 January 2022) Wages Accounts payable Overhead costs Operating expenses

225 000 175 000 490 000 305 000 20 000

$ 1 215 000

$ 1 350 000

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Dr Cash Raw materials Work in progress Inventories Plant and equipment Accumulated depreciation — plant and equipment Accounts payable Accrued expenses — wages and overheads

135 000 50 000 225 000 127 500 625 000 $ 102 500 160 000 45 000

Required Prepare the journal entries in the records of Platypus Ltd in relation to the joint operation for the year ended 30 June 2022. (Round all amounts to the nearest dollar and show all relevant workings.) (LO3 and LO4) 1 July 2021 Cash in JO Plant & equip in JO Gain on equipment sold Equipment Cash

Dr Dr Cr Cr Cr

510 210

Dr Cr

300

Dr Dr Dr Dr Dr Dr

30 135 77 525 135 12

20 150 550

(850 x .6) ((200 + 150) x .6) (50 x .4)

December 2021 Cash in JO Cash

300

30 June 2022 Raw material in JO Work in progress in JO Inventory in JO Inventory Plant & equipment in JO Other expenses in JO Accum depreciation Plant & equip in JO Accounts payable in JO Accrued expenses in JO Cash in JO Accumulated depreciation Plant & equip in JO Inventory in JO Inventory

Cr Cr Cr Cr

Dr Cr Cr

(50 x .6) (225 x .6) (128 x .6) (850 x .6) (225 x .6) (20 x .6) 62 81 27 729

(103 x .6) (160 x .6) (45 x .6) (810 - (135 x .6))

6 1 4

32.19

Chapter 32: Joint arrangements

Work in progress in JO

Depreciation based on 60% x ($200 000 - $150 000) requires a $6 000 adjustments to depreciation expense which must be allocated across all forms of inventory which include the depreciation expense:

Work in progress Inventory in JO Inventory

Total Value $ 135 77 525 737

% 18 10 72

Allocation $ 1 1 4

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Exercise 32.5 Share of output Alice Ltd is a mining company operating in Victoria. Its main areas of mining are openpit gold mines and iron ore mines. In 2022 while exploring for ore the company discovered a major source of spring water suitable for bottling for human consumption. Alice Ltd believed the find was commercially significant. Given its lack of past expertise in the bottled water industry Alice Ltd decided to establish a joint operation with Springs Ltd to operate a factory to produce bottled water. The joint operation agreement was signed on 1 January 2023, with Alice Ltd and Springs Ltd having a 50% share in the unincorporated joint operation. The initial contributions by the two operators were as follows.

The capitalised expenses were recorded in the books of Alice Ltd at $320 000, while the equipment was recorded at a carrying amount of $640 000. In order to supply the cash, Alice Ltd borrowed $800 000 of its required contribution. It is expected that the reserves of water will be depleted within 10 years, and the equipment is expected to have a similar useful life. On 1 June 2023, the joint operation was ready to start producing bottles of water. The joint operation’s accounts at 30 June 2024 contained the following information. Statement of financial position (extract)

Work in progress Capitalised costs Plant and equipment Cash Accounts payable — plant Accrued expenses — wages etc.

2024

2023

$ 800 000 8 160 000 80 000 (240 000) (160 000)

$ 200 000 800 000 7 760 000 240 000 (800 000) (200 000)

Cash receipts and payments (extract) 2024 Payments

Receipts

$480 000

32.21

Chapter 32: Joint arrangements

Cash receipts and payments (extract) 2024 Payments

Receipts

160 000 560 000 960 000

Administration Wages Accounts payable — plant Contributions from joint operators

$2 000 000

The output of the first year’s operations was distributed equally to the joint operators. Production in the first year was estimated to be 15% of the reserves. At 30 June 2024, Alice Ltd held 10% of its share of output in inventories, having sold the rest to its customers for $2 000 000. Expenses of the joint operation incurred up to 30 June 2024 were allocated to the operators. Because of some damage to the environment caused by the establishment of the pumping station to extract the water, there is a potential restoration cost to be incurred at closure of the joint operation. Whether this will be required will depend on the result of current legal inquiries. Required Prepare the journal entries in the records of Alice Ltd for the periods ending 30 June 2023 and 2024. (LO3 and LO4) 1 January 2023 Capitalised expenses in JO Equipment in JO Cash in JO Gain on equipment sold Gain on capitalised expenses sold Cash Equipment Capitalised expenses Cash Bank loan

Dr Dr Dr Cr Cr Cr Cr Cr Dr Cr

160 320 3 200 80 240 2 400 640 320

(320/2) (640/2) ((2 400 + 4 000)/2) (160/2) (480/2)

800 800

30 June 2023 Work-in-progress Plant & equipment in JO Cash in JO Accounts payable in JO Accrued expenses in JO

Dr Dr Cr Cr Cr

100 3 480 3 080 400 100

(200/2) ((7 760 - 800)/2) ((240 - 6 400)/2) (800/2) (200/2)

32.22

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Year ended 30 June 2024 Cash in JO Cash

Dr Cr

1 000

Inventory Plant & equipment in JO Accounts payable in JO Accrued expenses in JO Administration expenses Cash in JO Work-in-progress in JO

Dr Dr Dr Dr Dr Cr Cr

600 200 280 20 80

Inventory Accum amortisation Capitalised expenses in JO Accum depreciation Plant & equipment in JO

624

(2 000/2) 1 000

1 080 100

600

((8 160 - 7 760)/2) ((800 - 240)/2) ((200 - 160)/2) (160/2) (80/2 - 1 120)

Workings: Cost of inventory: Work-in-progress Materials and supplies Wages (560 - 200 + 160)

$ 200 480 520 1 200 x 50% = $600

Amortisation of capitalised expenses: Alice Ltd: 15% x $160 = $24 Depreciation of plant & equipment: Alice Ltd: Balance at 1 January 1923 Acquisitions to 30 June 1923 Acquisitions to 30 June 1924 Total depreciation = $600

$320 x $3 480 x $200 x

Cost of sales Inventory (90% x ($600 + $624))

Dr Cr

1 102

Cash/receivables Sales revenue

Dr Cr

2 000

15% = $48 15% = $522 15% = $30

1 102

2 000

Note: the balance of inventory in Alice Ltd is 10% x ($600 + $624) = $122

32.23

Chapter 32: Joint arrangements

Exercise 32.6 Operations share output On 1 July 2023, Dalby Ltd entered into a joint operation agreement with Chinchilla Ltd to manufacture stevedoring equipment. It was agreed that each party to the agreement would share the output equally. To commence the operation, contributions were as follows. • Dalby Ltd: cash of $2 000 000 and equipment having a $400 0 00 carrying amount and a fair value of $600 000 • Chinchilla Ltd: cash of $1 800 000 and plant having a carrying amount of $900 000 and a fair value of $800 000. Chinchilla Ltd revalued the plant it contributed to the joint operation prior to its transfer to the joint operation. Plant and equipment is depreciated (to the nearest month) in the joint operation’s books at 20% p.a. on cost. During December 2023, both parties contributed an additional $1 500 000 cash. The following information, in relation to the joint operation’s operations for the year ended 30 June 2024, was provided by the operations manager. (a) Costs incurred for the year ended 30 June 2024 $ 1 200 000 2 150 000 1 860 000 470 000

Wages Raw materials Overheads Depreciation

5 680 000 2 580 000

Less: Cost of inventories

$ 3 100 000

Work in progress at 30 June 2024 (b) Receipts and payments for the year ended 30 June 2024 Payments Contributions Plant (10 July 2023) Wages Accounts payable Overhead costs Operating expenses

Receipts $ 6 800 000

950 000 1 150 000 1 980 000 1 810 000 440 000

$ 6 330 000

$ 6 800 000

32.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c) Assets and liabilities as at 30 June 2024 Dr Cash Raw materials Work in progress Inventories Plant and equipment Accumulated depreciation — plant and equipment Accounts payable Accrued expenses

$ 470 000 360 000 3 100 000 580 000 2 350 000 $ 470 000 530 000 100 000

Required Prepare the journal entries in the records of Dalby Ltd and Chinchilla Ltd in relation to the joint operation for the year ended 30 June 2024. (LO3 and LO4) Journal entries in records of Dalby Ltd: 1 July 2023 Cash in JO Plant & equipment in JO Gain on plant & equipment sold Plant & equipment Cash

Dr Dr

1 900 600

Cr Cr Cr

(3 800/2) (800/2 + 400/2) 100 400 2 000

December 2023 Cash in JO Cash

Dr Cr

1 500

30 June 2024 Raw material in JO Work-in-progress in JO Inventory in JO Inventory Plant & equipment in JO Other expenses in JO Accum. depreciation in JO Accounts payable in JO Accrued expenses in JO Cash in JO

Dr Dr Dr Dr Dr Dr Cr Cr Cr Cr

180 1 550 290 1 000 475 220

Accum. depreciation in JO Inventory in JO Work-in-progress in JO Inventory

Dr Cr Cr Cr

(200/2)

1 500

235 265 50 3 165

(360/2) (3 100/2) (580/2) (2 000/2) (950/2) (440/2) (470/2) (530/2) (100/2) (3 400 – 470/2)

2 11 7

32.25

Chapter 32: Joint arrangements

Depreciation based on 50% x ($600 000 - $400 000) requires a $20 000 adjustment to depreciation expense which must be allocated across all forms of inventory which include the depreciation cost. Workings:

Work-in-progress Inventory in JO Inventory

Total Value $ 1 550 290 1 000 2 840

% 54.6 10.2 35.2

Allocation $ 10 920 2 040 7 040 20 000

Journal entries in the accounts of Chinchilla Ltd: 1 July 2023 Loss on revaluation of plant Plant

Dr Cr

100

Cash in JO Plant & equipment in JO Plant & equipment Cash

Dr Dr Cr Cr

1 900 700

December 2023 Cash in JO Cash

Dr Cr

1 500

30 June 2024 Raw material in JO Work-in-progress in JO Inventory in JO Inventory Plant & equipment in JO Other expenses in JO Accum depreciation in JO Accounts payable in JO Accrued expenses in JO Cash in JO

Dr Dr Dr Dr Dr Dr Cr Cr Cr Cr

180 1 550 290 1 000 475 220

100 (3 800/2) (800/2 + 600/2) 800 1 800

1 500

235 265 50 3 165

(360/2) (3 100/2) (580/2) (2 000/2) (950/2) (440/2) (470/2) (530/2) (100/2) (3 400 – 470/2)

32.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 32.7 Operators share output After prospecting unsuccessfully for a number of years for gold, in November 2023 Greens Pool Ltd finally found an economically viable deposit. Realising that it did not have sufficient expertise to operate a gold mine successfully, Greens Pool Ltd formed an unincorporated joint operation with Apollo Bay Ltd, agreeing to share the output of the mine equally. It was agreed that the two operators would initially contribute the following assets. Greens Pool Ltd: Capitalised exploration costs, including permits licences, and mining rights, currently recorded by Greens Pool Ltd at $100 000 Cash Apollo Bay Ltd: Cash

400 000 350 000 750 000

The joint operation commenced on 1 January 2024. By 31 December 2024, the mine had been operating successfully. It was reliably estimated at the commencement of the project that the mine had expected reserves of 50 000 tonnes. In the first year following commencement, 2500 tonnes of gold was extracted, while in 2025, 5 000 tonnes was extracted. This output was distributed to the operators equally. All costs except general administration costs were capitalised into the cost of the output, with depreciation of equipment and capitalised exploration costs being written off in proportion to the depletion of the reserves. General administration expenses were allocated to the operators equally. The financial statements of the joint operation over the first 2 years of operation showed the following information. Cash receipts and payments

Balance at 1 January Contributions from operators

Plant and equipment Wages Materials General administration

Balance at 31 December

2024

2025

— $ 1 100 000

$ 150 000 600 000

1 100 000

750 000

400 000 300 000 100 000 150 000

95 000 330 000 120 000 150 000

950 000

695 000

$ 150 000

$ 55 000

32.27

Chapter 32: Joint arrangements

Statement of financial position 2024 Capitalised exploration costs Plant and equipment Accumulated depreciation Cash Materials

Accrued wages Accounts payable (materials)

Net assets

Operators’ equity: Contributions as at 1 January

2025

380 000 400 000 (20 000) 150 000 25 000

$ 340 000 495 000 (70 000) 55 000 20 000

935 000

840 000

5 000 10 000

10 000 15 000

15 000

25 000

920 000

$ 815 000

1 500 000

920 000 600 000

Additional contributions

Less: Output distributed Allocation: general administration

Balance at 31 December

1 500 000

1 520 000

430 000 150 000

555 000 150 000

580 000

705 000

920 000

$ 815 000

Required Prepare the journal entries in the records of Greens Pool Ltd to record its interest in the joint operation for the years ending 31 December 2024 and 2022. (LO4) 2024 Cash in JO Capitalised expenses in JO Capitalised expenses Gain on capitalised expenses sold Cash

Dr 550 000 Dr 50 000 Cr 100 000

Plant & equipment in JO Materials in JO Inventory General admin expenses Accum depreciation in JO

Dr 200 000 Dr 12 500 Dr 215 000 Dr 75 000 Cr

Cr Cr

150 000 350 000

10 000

((350 000 + 750 000)/2) (100 000/2)

(300 000/2) ((400 000 – 0)/2) ((25 000 – 0)/2) (430 000/2) (150 000/2) ((20 000 – 0)/2)

32.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Capitalised expenses in JO Cash in JO Accrued wages in JO Accounts payable in JO

Cr Cr Cr Cr

10 000 475 000 2 500 5 000

((400 000 – 380 000)/2) ((150 000 – 550 000)/2) ((5 000 – 0)/2) ((10 000 – 0)/2)

As the capitalised expenses are at $50 000 for Greens Pool Ltd, and not $200 000, then the amortisation expense is $2 500, not $10 000. Hence a reduction in the cost of the output is required: Capitalised expenses in JO Inventory

Dr Cr

7 500

Cash in JO Cash

Dr 300 000 Cr 300 000

Plant & equipment in JO Capitalised expenses in JO Accum depreciation in JO Cash in JO

Dr Cr Cr Cr

Materials in JO Accrued wages in JO Accounts payable in JO Inventory General admin expenses

Cr Cr Cr Dr 277 500 Dr 75 000

7 500

2025

47 500 20 000 25 000 347 500 2 500 2 500 2 500

(600 000/2) ((495 000 – 400 000)/2) ((340 000 – 380 000)/2) ((70 000 – 20 000)/2) ((55 000 – 150 000 – 600 000)/2) ((20 000 – 25 000)/2) ((10 000 – 5 000)/2) ((150 000 – 10 000)/2) (555 000/2) (150 000/2)

Capitalised expenses are at $50 000, not $200 000. Therefore, the adjustment should be $5 000 not $20 000. Hence a reduction in the cost of the output is required: Capitalised expenses in JO Inventory

Dr Cr

15 000 15 000

32.29

Chapter 32: Joint arrangements

Exercise 32.8 Management fees supplied by one of the joint operators On 1 July 2022, Broome Ltd and Kalbarri Ltd agreed to a joint operation that would be involved in the production of furniture. The contractual arrangement required both parties to invest $270 000 cash in the joint operation with each party having a 50% interest. Under the contractual arrangement the joint operation would distribute the output equally to each venturer. The joint operation agreed to pay Broome Ltd $30 000 p.a. to supply management services to the joint operation. The cost to Broome Ltd to supply these services is $24 000. At 30 June 2023 the joint operation reported the following information. Statement of financial position (partial) Cash Raw materials Inventories (undistributed) Work in progress Machinery Accumulated depreciation

$ 33 000 36 000 20 000 54 000 225 000 (45 000)

$ 45 000 18 000

Accounts payable Accrued wages

$ 323 000

$ 63 000

Cash receipts and payments Payments Contributions Purchase of raw materials Wages Purchase of equipment (2 July 2022) Management services (supplied by Broome Ltd) Other expenses

Receipts $

540 000

72 000 108 000 225 000 30 000 72 000

507 000 $

540 000

126 000 81 000 30 000 117 000

Costs incurred Wages Raw materials Management services Overheads including depreciation

354 000 (300 000)

Cost of inventories Work in progress at 30 June 2023

54 000

32.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Prepare the journal entries in the records of Broome Ltd in relation to the joint operation for the year ending 30 June 2023. (LO4) 1 July 2022 Cash in JO Dr Cash Cr (Investment in JO with Kalbarri Ltd)

270 000 270 000

30 June 2023 Inventory Raw materials in JO Inventory in JO Work in progress in JO Machinery in JO Accumulated depreciation – equipment – JO Accounts payable in JO Accrued wages in JO Cash in JO

Dr Dr Dr Dr Dr

140 000 18 000 10 000 27 000 112 500

Management services expense Cash (Cost of supplying services to JO)

Dr Cr

24 000

Dr Management services revenue Cr (Receipt from JO for supply of services)

30 000

Cr Cr Cr Cr

Cash

(280 000/2) (36 000/2) (20 000/2) (54 000/2) (225 000/2) 22 500 22 500 9 000 253 500

(45 000/2) (45 000/2) (18 000/2) (270 000 – ½ x 33 000))

24 000

30 000

Management services revenue Dr 12 000 Management services expense Cr 12 000 (Elimination of expense of supply of services to self: ½ x $24 000) The profit element on supplying services to the JO is $6 000 i.e. $30 000 less $24 000. The profit to itself i.e. $3 000 is proportionately adjusted across inventory-related assets:

Work in progress in JO Inventory in JO Inventory

Management services revenue Work in progress in JO Inventory in JO Inventory

Share of $3 000 $458 169 2 373 $3 000

$27 000 10 000 140 000 $177 000 Dr Cr Cr Cr

3 000 458 169 2 373

32.31

Chapter 32: Joint arrangements

Exercise 32.9 Operations share output Walrus Ltd enters into an arrangement with another operator, Whale Ltd, to establish an unincorporated joint operation to produce a drug that assists both hay fever sufferers and those with sinus problems. To produce the drug requires a combination of the technical and pharmaceutical knowledge of both companies. Each company will receive an equal share of the output of the drug, which they will retail through their own preferred outlets, potentially under different names. Walrus Ltd agrees to manage the project for a fee of $100 000 p.a. Walrus Ltd estimates that it will cost $80 000 to provide the service. The management fee is capitalised into the cost of inventories produced. The operation commences on 1 January 2023, with each operator providing $1 000 000 cash. At the end of the first year, the statement of financial position of the joint operation showed:

Required 1. Prepare the journal entries in the records of Walrus Ltd during 2023. 2. What differences would occur if the management fee paid to Walrus Ltd were treated as general administration costs? (LO4) 1. 1 January 2023 Cash in JO Cash

Dr Cr

1 000 000

32.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

During the period in relation to the supply of management services: Cash

100 000

Revenue

Dr Cr Dr Cr

80 000

Cash

Dr Dr Dr Dr Dr Dr Dr Cr Cr Cr Cr Cr

100 000 410 000 40 000 160 000 105 000 200 000 100 000

Dr Cr

40 000

Dr Cr Cr Cr

10 000

Expenses

31 December 2023 Vehicles in JO Equipment in JO Inventory in JO Work-in-progress in JO Materials in JO Inventory Expenses Accum. deprec. – vehicles in JO Accum. deprec. – equipment in JO Provisions in JO Payables in JO Cash in JO (Share of assets and liabilities of JO) Revenue Expenses (1/2 x cost of providing services) Revenue Inventory Inventory in JO Work-in-progress in JO (Elimination of profit element) Workings: Inventory Inventory in JO Work-in-progress in JO

$ 200 000 40 000 160 000 400 000

100 000

80 000

25 000 30 000 40 000 20 000 1 000 000

40 000

5 000 1 000 4 000

1/2 1/10 2/5

$ 5 000 1 000 4 000 10 000

2. If the management fee is regarded as general administration expense by the JO instead of being capitalised into inventory, then instead of the two revenue adjustments shown under Part 1 above, the journal entry in the venturer is: Revenue Expense

Dr Cr

50 000 50 000

This eliminates the revenue in relation to itself as well as the expense brought across from the JO.

32.33

Chapter 32: Joint arrangements

Exercise 32.10 Unincorporated joint operation managed by one of the operators During 2021, discussions took place between Cairns Ltd, a company concerned with the design of specialised tools and machines, and two companies, Townsville Ltd and Mackay Ltd, which could potentially assist in the manufacture of a new tool. The new tool is called SmartTool and is to be used in the making of high grade mining instruments. On 1 June 2022, the three companies agreed to form an unincorporated joint operation to achieve this purpose. It was agreed that the relative interests in the joint operation would be as follows. Cairns Ltd 50% Townsville Ltd 25% Mackay Ltd 25% It was further agreed that Mackay Ltd would undertake a management role in relation to the new operation, being responsible for operating decisions and for record keeping. Mackay Ltd would be paid a management fee by the joint operation of $30 000. In establishing the joint operation, the various parties agreed to provide the following assets as their initial contribution. • Cairns Ltd was to provide the patent to SmartTool, which was being recorded by Cairns Ltd at a capitalised development cost of $2 100 000. The operators agreed that this asset had a fair value of $3 000 000, with an expected useful life of 10 years. • Townsville Ltd was to provide cash of $1 500 000. • Mackay Ltd was to provide the basic plant and equipment to manufacture the new tool. The plant and equipment was recorded in the books of Mackay Ltd at $900 000, but the operators agreed that it had a fair value of $1 500 000. The plant and equipment was estimated to have a further useful life of 5 years. During the first period of its operation, the output of the joint operation was distributed to each of the operators in proportion to their agreed interests. By 30 June 2023, Mackay Ltd had sold 80% of the output received from the joint operation for $450 000. The joint operation had not paid the management fee to Mackay Ltd by 30 June 2023. Information from the financial statements of the joint operation as at 30 June 2023 is as follows. Assets Cash Plant and equipment Accumulated depreciation Patent Accumulated depreciation Office equipment Accumulated depreciation Work in progress

60 000 1 620 000 (312 000) 3 000 000 (300 000) 132 000 (13 200) 60 000

32.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Liabilities Creditors — for materials Accruals — salaries etc., including the management fee Cash payments Salaries Materials Operating expenses

204 000 168 000

330 000 732 000 126 000

Required 1. Prepare the journal entries in the records of Cairns Ltd and Townsville Ltd at the commencement of the joint operation. 2. Prepare the journal entries in the records of Mackay Ltd for the financial year ending 30 June 2023. (LO4) 1. Journal entries – entries in the accounts of Cairns Ltd and Townsville Ltd at 1 July 2022: 1 July 2022 Cairns Ltd (50%): Patent in JO Cash in JO Plant & equipment in JO Gain on patent sold Capitalised R&D costs

Dr Dr Dr Cr Cr

1 050 750 750

Dr Dr Dr Cr

750 125 125

450 2 100

(2100/2) (1 500/2) (1 500/2) (900/2)

Townsville Ltd (25%): Patent in JO Cash in JO Plant & equipment in JO Cash

(3 000/4) (1 500/4) (1 500/4) 500

2. Journal entries in the accounts of Mackay Ltd: 1 July 2022 Patent in JO Cash in JO Plant & equipment in JO Gain on plant & equipment sold Plant & equipment 30 June 2023 Workings of cost of output: Cash expenses Accruals

Dr Dr Dr Cr Cr

750 375 225

(3 000/4) (1 500/4) (900/4) 450 900

(3/4 x 600)

32.35

Chapter 32: Joint arrangements

Creditors

204 1 560 625 2 185 60 2 125

Depreciation Work in progress Cost of inventory

Plant & equipment in JO Dr 30 ((1 620 - 1 500)/4) Accum depn - P&E in JO Cr 78 (312/4) Accum depn - patent in JO Cr 75 (300/4) Office equipment in JO Dr 33 (132/4) Accum depn - OE in JO Cr 3 (13.2/4) Work in progress in JO Dr 15 (60/4) Inventory Dr 531 (2 125.2/4) Cash in JO Cr 360 ((60 - 1 500)/4) Creditors in JO Cr 51 (204/4) Accruals in JO Cr 42 (168/4) Accum depn - P&E in JO Dr 30 Inventory Cr 29 Work in progress in JO Cr 1 (Adjustment in depreciation is $30 = 1/5 x 1/4 x ($1 500 - $900) Allocation to inventory is $29 = 531/546 x $30) Cash/Accounts receivable Sales revenue

Dr Cr

450

Cost of sales Inventory (80% x ($531 – $29 – $8))

Dr Cr

396

Management fee receivable Fee revenue

Dr Cr

Cost of supplying service Cash

Dr Cr

Fee revenue Cost of supplying service (1/4 x $30)

Dr Cr

Accruals in JO Management fee receivable

Dr Cr

450

396

32.36

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 32: Joint arrangements Multiple choice questions 1. Which of the following statements is incorrect? a. *b. c. d.

Joint arrangements may be entered into to manage risks involved in a project. Joint arrangements require investors to have equal interests in the joint arrangement. Joint arrangements may be entered into to provide the parties with access to new technology or new markets. The key feature of a joint arrangement is that the parties involved have joint control over the decision making in relation to the joint arrangement.

Answer: b Learning objective 32.1: discuss the use of joint arrangements by companies to structure their business.

2. AASB 11 Joint Arrangements, provides that joint control exists where: *a. no single party is in a position to control the activity unilaterally. b. no one party may be appointed as the manager of the joint arrangement. c. one party alone has power to control the strategic operating decisions of the joint arrangement. d. the decisions in areas essential to the goals of the joint arrangement do not require the consent of the parties. Answer: a Learning objective 32.2: explain the nature of a joint arrangement and how to classify joint arrangements into joint ventures and joint operations.

3. The particular relationship between parties that signifies the existence of a joint arrangement is: a. b. *c. d.

control over the operating policies of one party by another party. shared influence by two parties over the activities of another party. joint control by the parties over the activities of an operation. significant influence by one party over the other party.

Answer: c Learning objective 32.2: explain the nature of a joint arrangement and how to classify joint arrangements into joint ventures and joint operations.

32.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The matters generally dealt with in a joint arrangement contract include the:

Activity, duration and reporting obligations Capital contribution of the venturers Sharing of the output, expenses or results Voting rights of the venturers *a. b. c. d.

I Yes Yes Yes Yes

II Yes Yes Yes No

III Yes Yes No No

IV Yes No Yes No

I. II. III. IV.

Answer: a Learning objective 32.2: explain the nature of a joint arrangement and how to classify joint arrangements into joint ventures and joint operations.

5. Which of the following statements in relation to joint control is incorrect? *a. b. c. d.

Each party must have an equal interest for joint control to exist. Joint control requires the unanimous consent of the parties sharing control. Joint control exists only where there is contractually agreed sharing of control. Entities over which a party has joint control are accounted for in accordance with AASB 11 Joint Arrangements.

Answer: a Learning objective 32.2: explain the nature of a joint arrangement and how to classify joint arrangements into joint ventures and joint operations.

32.2

Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

6. Which of the following statements is correct? a. b.

c. *d.

All joint arrangements which are not structured through a separate vehicle are classified as joint ventures. For a joint venture, the rights pertain to the rights and obligations associated with individual assets and liabilities, whereas with a joint operation, the rights and obligations pertain to the net assets. Where the joint operators have designed the joint arrangement so that its activities primarily aim to provide the parties with an output it will be classified as a joint venture. In considering the legal form of the separate vehicle if the legal form establishes rights to individual assets and obligations, the arrangement is a joint operation. If the legal form establishes rights to the net assets of the arrangement, then the arrangement is a joint venture.

Answer: d Learning objective 32.2: explain the nature of a joint arrangement and how to classify joint arrangements into joint ventures and joint operations.

7. Harry Limited and Potter Limited agreed to form a joint operation to offer health services. To start the operation the joint operators agreed to contribute cash of $100 000 each. The joint operation will record which of the following entries to recognise this event? a.

*d.

DR Joint operator contributions CR Cash

$200 000

DR Cash CR Joint operator contributions

$200 000

DR Venturer’s equity — Harry DR Venturer’s equity — Potter CR Cash

$100 000 $100 000

DR Cash CR Joint operation contribution — Harry CR Joint operation contribution — Potter

$200 000

$100 000 $100 000

Answer: d Learning objective 32.3: explain the accounting undertaken by the joint operation.

32.3

Testbank to accompany Financial reporting 3e by Loftus et al.

8. Cash contributed to a joint operation was used to purchase machinery ($500 000) and raw materials ($120 000). The following entry would be part of the overall recording of these transactions: *a.

DR Machinery DR Raw materials CR Cash

$500 000 $ 120 000

DR Work in progress CR Joint operation capital

$620 000

DR Cash $620 000 CR Contribution to joint operation $620 000

DR Cash CR Machinery CR Raw materials

$620 000 $500 000 $ 120 000

Answer: a Learning objective 32.3: explain the accounting undertaken by the joint operation.

9. Three joint operators are involved in a joint operation that manufactures fishing boats. At the beginning of the year the joint operation held $45 000 in cash. During the year the joint operation incurred the following expenses: Wages paid $60 000, Overheads accrued $20 000. Additionally, creditors amounting to $45 000 were paid and the joint operators contributed $27 500 cash each to the joint operation. The balance of cash held by the joint operation at the end of the year is: a. b. c. *d.

$2 500 $42 500 $25 000 $22 500

Answer: d Feedback: 45 000 + (27 500 x 3) – 60 000 – 45 000 = $22 500 Learning objective 32.3: explain the accounting undertaken by the joint operation.

32.4

Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

10. Jack Limited and Beanstalk Limited formed a joint operation and share in the output of the joint operation 60:40. The joint operation paid a management fee of $42 000 to Jack Limited during the current period. The cost to Jack Limited of supplying the management service was $35 000. Jack Limited records the management fee revenue as follows: *a.

DR Cash $42 000 CR Fee revenue

$42 000

DR Cash $35 000 CR Fee revenue

$35 000

DR Cash $28 000 CR Fee revenue

$28 000

DR Cash $7 000 CR Fee revenue

$7 000

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

11. A 50:50 joint operation was commenced between two participants. Mary Company contributed cash of $90 000, and Strickland Company contributed a Building with a fair value of $90 000 and a carrying amount of $75 000. Using the line-by-line method of accounting, Strickland Company would record: a.

DR Building in JO CR Building

$75 000

DR Building in JO CR Building CR Gain on sale of building

$945000

DR Investment in joint operation CR Building CR Gain on sale of building

$45 000

*d. DR Cash in JO DR Building in JO CR Building CR Gain on sale of building

$45 000 $45 000

$75 000

$37 500 $7 500

$75 000 $15 000

Answer: d Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

32.5

Testbank to accompany Financial reporting 3e by Loftus et al.

12. A joint operation holds plant and equipment with a carrying amount of $450 000. The two joint operators participating in this arrangement share control equally. They also depreciate plant and equipment using the straight-line method. The plant and equipment has a useful life of 6 years. At reporting date, each joint operator must recognise the following entry, in relation to depreciation, in its records: *a. b. c. d.

DR Depreciation $37 500. DR Depreciation $75 000. DR Assets in joint operation $37 500. DR Investment in joint operation $75 000.

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

13. In relation to the supply of a service to a joint operation by one of the joint operators, which of the following statements is correct? a. *b. c. d.

A joint operator can recognise 100% of the earnings through the supply of services to the joint operation. A joint operator cannot earn a profit on supplying services to itself. A joint operator is entitled to recognise a profit from the supply of services to itself. A joint operator is not able to recognise the service revenue or service cost for the services supplied to the joint operation.

Answer: b Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

32.6

Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

14. Justice Company and League Company equally share the output of their joint operation. The joint operation paid a service fee of $60 000 to Justice Company during the current period. The cost incurred by Justice Company to supply the service was $48 000. Justice Company records the service fee revenue as: *a.

DR Cash $60 000 CR Fee revenue

$60 000

DR Cash $48 000 CR Fee revenue

$48 000

DR Cash $30 000 CR Fee revenue

$30 000

DR Cash $24 000 CR Fee revenue

$24 000

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

15. Rose Limited and Petal Limited formed a joint operation and share in the output of the joint operation 75:25. The joint operation paid a management fee of $250 000 to Rose Limited during the current period. The cost to Rose Limited of supplying the management service was $200 000. The amount of profit that Rose Limited will recognise in relation to the provision of the management fee to the joint operation is: a. b. *c. d.

$50 000 $37 500 $12 500 $0

Answer: c Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

32.7

Testbank to accompany Financial reporting 3e by Loftus et al.

16. Four joint operators agree to an arrangement in which they have an equal share in a joint operation that produces sunflower oil. The work undertaken in setting up the joint operation cost $200 000 and each operator contributed in cash. Each operator will need to recognise the following accounting entry: *a.

DR Cash in JO CR Cash

$50 000

DR Inventories in JO CR Cash

$50 000

DR Cash in JO CR Cash

$200 000

DR Cost of joint operation product CR Cash

$200 000

$50 000

$200 000

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

17. A 60:40 joint operation was commenced between two participants. Andrews Limited contributed cash of $90 000, and Michaels Limited contributed a Building with a fair value of $60 000. Using the line-by-line method of accounting, Andrews Limited would record which of the following entries? a.

*c.

DR Building in JO CR Cash

$90 000

DR Cash in JO CR Cash

$90 000

DR Cash in JO DR Building in JO CR Cash

$54 000 $36 000

DR Investment in joint operation CR Cash

$90 000

Answer: c Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

32.8

Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

18. A 70:30 joint operation was commenced between two participants. Marian Limited contributed cash of $210 000, and Keyes Limited agreed to provide technical services to the joint operation over a period of three years. The fair value of the services was determined to be $90 000 and the cost to provide the services was estimated to be $81 000. Using the lineby-line method of accounting, Keyes Limited would record which of the following entries? a.

*b.

DR Cash in JO CR Obligation to JO

$90 000 $90 000

DR Cash in JO $63 000 CR Obligation to JO CR Profit on provisions of services

$56 700 $ 6 300

DR Cash in JO CR Obligation to JO

$81 000 $81 000

DR Cash in JO DR Receivable in JO CR Obligation to JO

$81 000 $ 9 000 $90 000

Answer: b Feedback: Cash in JO = $210 000 x 0.3. Obligation to JO = $81 000 x 0.7. Profit = $9 000 x 0.7 Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

19. Jensen Ltd and Harris Ltd have established the JH Joint Operation. Jensen Ltd has a 75% interest in the joint operation and Harris Ltd has a 25% interest. Jensen Ltd contributed an asset with a carrying amount of $130 000 and a fair value of $150 000 and Harris Ltd agreed to provide technical services to the joint operation over the first two years of operations. The fair value of the technical services was agreed to be $50 000 and the cost to provide the services was estimated at $45 000 at the inception of the joint operation. As part of its initial contribution entry Jensen Ltd will record a: a. *b. c. d.

DR Services receivable in JO $50 000. DR Plant in JO $97 500. CR Gain on sale of plant $15 000. CR Plant $150 000.

Answer: b Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

20. Jensen Ltd and Harris Ltd have established the JH Joint Operation. Jensen Ltd has a 75% interest in the joint operation and Harris Ltd has a 25% interest. Jensen Ltd contributed an asset with a carrying amount of $130 000 and a fair value of $150 000 and Harris Ltd agreed to provide technical services to the joint operation over the first two years of operations. The fair value of the technical services was agreed to be $50 000 and the cost to provide the services was estimated at $45 000 at the inception of the joint operation. As part of its initial contribution entry Harris Ltd will record a: a. b. c. *d.

DR Plant in JO $12 500. DR Services receivable in JO $45 000. CR Gain on provision of services $5 000. CR Obligation to JO $33 750.

Answer: d Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

21. On 1 July 2023, the North & South Joint Operation was established. The two joint operators participating in this arrangement, North Ltd and South Ltd, share control equally. Both joint operators contributed cash to establish the joint operation. The joint operation holds equipment with a carrying amount of $600 000. Both joint operators depreciate equipment using the straight-line method and the depreciation is regarded as a cost of production. The equipment has a useful life of 5 years. At 30 June 2024 North Ltd had sold all of the inventories distributed to it and South Ltd had sold 50% of the inventories distributed to it. At 30 June 2024 South Ltd must recognise the following entry, in relation to depreciation, in its records: *a. b. c. d.

DR Inventories $30 000. DR Depreciation expense $120 000. DR Cost of goods sold $120 000. DR Accumulated depreciation $60 000.

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

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Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

22. When eliminating any unrealised profit arising when a joint operator provides services to a joint operation the profit is eliminated against: a. b. c. *d.

retained earnings. cost of goods sold. the investment in the joint operation. work in progress, finished goods and other inventories related accounts.

Answer: d Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

23. On 1 July 2023 Perth Ltd entered into a 50:50 joint operation with Hobart Ltd to develop robotic home appliances. Each operator’s initial contribution was $1 million. Perth contributed $500 000 cash and equipment with a fair value of $500 000 and a book value of $400 000. The remaining useful life of the equipment contributed by Perth is 5 years. Tasmania Ltd contributed $1 million cash. Additional information: An extract of the joint operation’s balance sheet at 30 June 2024 shows: Assets $ Cash 290,000 Raw materials 80,000 Work in progress 460,000 Finished goods inventories 100,000 Equipment 500,000 less: Accumulated depreciation -100,000 Total Assets

1,330,000

Liabilities Accrued wages Accounts payable

40,000 140,000

Total Liabilities

$180,000

Net Assets

1,150,000

Production costs for the joint operation for the year ended 30 June 2024 were: Raw materials $420,000 Wages 340,000 Depreciation 100,000 Overhead expenses 550,000 Total production costs 1,410,000 Less Cost of inventories -950,000 Work in Progress at 30 June 2024

$460,000

Cash receipts and payments for the year ended 30 June 2024 were: Payments Receipts Contributions $1,500,000 Wages $300,000 Raw materials 360,000 Overhead expenses 550,000

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Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

$1,210,000

$1,500,000

The following entries will form part of Perth Ltd’s initial contribution entry except for: a. *b. c. d.

DR Cash in JO account $750 000. DR Equipment in JO account $250 000. CR Cash $500 000. CR Gain on equipment $50 000.

Answer: b Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

32.13

Testbank to accompany Financial reporting 3e by Loftus et al.

24. On 1 July 2023, Perth Ltd entered into a 50:50 joint operation with Hobart Ltd to develop robotic home appliances. Each operator’s initial contribution was $1 million. Perth contributed $500 000 cash and equipment with a fair value of $500 000 and a book value of $400 000. The remaining useful life of the equipment contributed by Perth is 5 years. Tasmania Ltd contributed $1 million cash. Additional information: An extract of the joint operation’s balance sheet at 30 June 2024 shows: Assets $ Cash 290,000 Raw materials 80,000 Work in progress 460,000 Finished goods inventories 100,000 Equipment 500,000 less: Accumulated depreciation -100,000 Total Assets

1,330,000

Liabilities Accrued wages Accounts payable

40,000 140,000

Total Liabilities

$180,000

Net Assets

1,150,000

$460,000

Cash receipts and payments for the year ended 30 June 2024 were: Payments Receipts Contributions $1,500,000 Wages $300,000 Raw materials 360,000 Overhead expenses 550,000

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Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

$1,210,000

$1,500,000

Tasmania Ltd’s initial contribution entry will include a debit to the Cash in JO account of: *a. b. c. d.

$750 000. $1 000 000. $1 500 000. $2 000 000.

Answer: a Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

25. On 1 July 2023, Perth Ltd entered into a 50:50 joint operation with Hobart Ltd to develop robotic home appliances. Each operator’s initial contribution was $1 million. Perth contributed $500 000 cash and equipment with a fair value of $500 000 and a book value of $400 000. The remaining useful life of the equipment contributed by Perth is 5 years. Tasmania Ltd contributed $1 million cash. Additional information: An extract of the joint operation’s balance sheet at 30 June 2024 shows: Assets $ Cash 290,000 Raw materials 80,000 Work in progress 460,000 Finished goods inventories 100,000 Equipment 500,000 less: Accumulated depreciation -100,000 Total Assets

1,330,000

Liabilities Accrued wages Accounts payable

40,000 140,000

Total Liabilities

$180,000

Net Assets

1,150,000

$460,000

Cash receipts and payments for the year ended 30 June 2024 were: Payments Receipts Contributions $1,500,000 Wages $300,000 Raw materials 360,000 Overhead expenses 550,000

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Chapter 32: Joint arrangements Not for distribution in full. Instructors may assign selected questions in their LMS.

$1,210,000

$1,500,000

By 30 June 2024, Tasmania Ltd has sold all of the robotic appliances distributed to it by the joint operation and Perth has sold 60% of its distribution of robotic appliances. The value of these inventories sold by Perth Ltd is: *a. b. c. d.

$255 000 $285 000 $425 000 $475 000

Answer: a Feedback: Cost of inventories $950 000 less finished goods inventories $100 000 = $850 000. Each JO receives 50% of $850 000 = $425 000. Perth sold 60% = $425 000 x 0.6 = $255 000. Learning objective 32.4: prepare the journal entries required by a joint operator to recognise its share of the assets, liabilities, revenues and expenses of the joint operation.

26. When a joint operator is accounting for an interest in a joint operation it is required to recognise which of the following in its financial statements?

The assets that it controls The liabilities that it incurs Its share of income from the sale of goods by the joint operation The expenses that it incurs a. b. c. *d.

I Yes No No

II Yes Yes No

III Yes No Yes

IV Yes Yes Yes

Yes

I. II. III. IV.

Answer: d Learning objective 32.5: discuss the disclosures required in relation to joint operations.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 33: Insolvency and liquidation

Chapter 33: Insolvency and liquidation Comprehension questions 1. Describe the meaning of ‘insolvency’ with regards to companies. Section 95A of the Corporations Act 2001 (the Corporations Act) provides a definition of solvent and insolvent with reference to a person, but the definition can be extended to a company, which is considered a legal person: (1) A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable. (2) A person who is not solvent is insolvent. 2. Briefly describe the procedures through which the Corporations Act attempts to avoid liquidation of companies if possible. The main intention of the Corporations Act 2001 is to treat liquidation as a last resort. The Corporations Act 2001 provides extensive guidance on the rights of members and creditors whenever it is decided that the life of the company is in danger of drawing to a close due to financial difficulties. The Corporations Act also attempts to avoid the liquidation or winding up (these terms can be used interchangeably) of companies in certain circumstances by allowing the appointment of receivers and/or administrators to protect the rights of creditors and members, and to help the company through any financial difficulties it may face. In an attempt to avoid liquidation, Part 5.3A of the Act deals with the topic of appointing an administrator to a company whenever the directors believe that the company may be insolvent. According to Australian Securities and Investments Commission (ASIC) (on its website www.asic.gov.au), administration is designed to resolve the company’s future direction quickly. The administrator takes full control of the company to try to work out a way to save either the company or the company’s business. If this is not possible, a liquidator will ultimately be appointed to wind up the company. The website of the ASIC – the body that administers Corporations Act 2001 also provides guidance for directors, shareholders and creditors when a company becomes insolvent. For example, ASIC instructs directors that, if their company is insolvent, they must act not only on behalf of shareholders, but also on behalf of creditors and not allow the company to go further into debt. Unless it is possible to promptly restructure, refinance or obtain equity funding to recapitalise the company, generally the options are to appoint a voluntary administrator or a liquidator. The first signs of potential or existing insolvency may be detected by creditors, who may then initiate the receivership for the satisfaction of their claims before it is too late. 3. Who can appoint a receiver for a company facing financial difficulties? A receiver or a receiver and manager may be appointed by a court or by creditors, e.g., debenture holders, according to the terms of the agreement, in order to protect the security of those creditors. A receiver must always be a registered liquidator. In general, receivers are appointed at the instigation of a secured creditor who is given such power in his or her trust deed. For example, a receiver may be appointed by a debenture holder as a result of failure by the company to abide by the provisions of the trust deed (e.g. failure by the company to pay interest to the debenture holders). © John Wiley and Sons Australia Ltd, 2020

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The power of a court to appoint a receiver is given by statute, and the court will make such an appointment when it perceives that it is just and convenient that such an order be made. The court would generally be required to make the order when a situation arises that is not covered by a trust deed or the strict letter of the security arrangement, or where parties other than secured creditors are seeking the appointment of a receiver. 4. Outline the role and powers of a receiver appointed by a secured creditor. The main effect of appointing a receiver (and manager) would be that relevant property can be sold in order to repay the debt of the secured creditor. The receiver is responsible to the secured creditor, not to the company, but also has the same general duties as a company director. The receiver’s role is to: • collect and sell enough of the charged assets to repay the debt owed to the secured creditor • pay out the money collected in the order required by the Corporations Act • report to ASIC any offences or other irregular matters they discover in performing their duties. In performing those duties, a receiver has great powers stipulated in s. 420 of the Corporations Act: (1) Subject to this section, a receiver of property of a corporation has power to do, in Australia and elsewhere, all things necessary or convenient to be done for or in connection with, or as incidental to, the attainment of the objectives for which the receiver was appointed. In accordance with s. 429(2)(b), when a receiver is appointed, the company is required to submit to him or her a report as to affairs of the company in accordance with Form 507. A receiver is required to open his or her own special bank account (s. 421) and, in accordance with s. 432, to lodge every 6 months an account of the receiver’s receipts and payments. Form 524 is used for the purpose of submitting this information. Once the security is paid off, the receiver may simply resign. Alternatively, a winding up order may be made even though a receiver is in possession of the property of the company. The receivership still continues, and the receiver may be appointed as the liquidator. If a separate liquidator is appointed, the receiver is entitled to remain in control of the property on which the security is based. He or she still has the power to hold and dispose of relevant property, including the power to use the company’s name for that purpose. 5. Who can appoint a voluntary administrator? According to s. 436A of the Corporations Act 2001, directors are expected to appoint a voluntary administrator to the company even before it becomes insolvent. (1) A company may, by writing, appoint an administrator of the company if the board has resolved to the effect that: (a) in the opinion of the directors voting for the resolution, the company is insolvent, or is likely to become insolvent at some future time; and (b) an administrator of the company should be appointed. An administrator may be appointed also by a liquidator or provisional liquidator if he or she believes that the company is or will become insolvent (Corporations Act s. 436B), or by a secured creditor who is entitled to enforce a charge on the whole, or substantially the whole, of a company’s property (s. 436C). © John Wiley and Sons Australia Ltd, 2020

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Chapter 33: Insolvency and liquidation

6. Outline the role of an administrator appointed to a company which is insolvent. According to ASIC, administration is designed to resolve the company’s future direction quickly. An independent and suitably qualified person — the administrator — takes full control of the company in an attempt to save either the company or the company’s business. Section 437A(1) of the Act spells out the role of an administrator. (1) While a company is under administration, the administrator: (a) has control of the company’s business, property and affairs; and (b) may carry on that business and manage that property and those affairs; and (c) may terminate or dispose of all or part of that business, and may dispose of any of that property; and (d) may perform any function, and exercise any power, that the company or any of its officers could perform or exercise if the company were not under administration. According to ASIC’s website and s. 438A of the Act, the administrator, after taking control of the company, must investigate and report to creditors information as to the company’s business, property, affairs and financial circumstances, and on the three options available to creditors. These are: 1. End the administration and return the company to the directors’ control 2. Approve a deed of company arrangement through which the company will pay all or part of its debts and then be free of those debts, or 3. Wind up the company and appoint a liquidator. The administrator must give an opinion on each option and recommend which option is in the best interests of creditors (s. 439A). The creditors then make the decision as to which option should be taken (s. 439C). If option 2 is taken, the administrator will continue his or her duties in order to see the deed of arrangement through to its end, if suitable to the creditors. If option 3 is taken, the administrator can become the company’s liquidator and, according to s. 446A, the liquidation process will proceed under the requirements of a creditors’ voluntary winding up. The administrator takes over all the powers of the company and its directors, and the powers of directors are suspended (s. 437C). The administrator has the power to sell or close down the company’s business or sell individual assets in the lead up to the creditors’ decision on the company’s future. The administrator must also report to ASIC on possible offences by people involved with the company, as strict liabilities apply to officers who continue to trade on the company’s behalf. According to s. 437D, only the administrator can deal with company’s property and any such transaction or dealing is void unless: (a) the administrator entered into it on the company’s behalf; or (b) the administrator consented to it in writing before it was entered into; or (c) it was entered into under an order of the Court. (s. 437D(2)) Additional powers are given to the administrator under s. 442A which states: Without limiting section 437A, the administrator of a company under administration has power to do any of the following: (a) remove from office a director of the company; (b) appoint a person as such a director, whether to fill a vacancy or not;

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c) execute a document, bring or defend proceedings, or do anything else, in the company’s name and on its behalf; (d) whatever else is necessary for the purposes of this Part. Even though the administrator is given wide powers under the Act, he or she is also given wide responsibilities. For example, under s. 443A, the administrator of a company is liable for debts he or she incurs in the performance or exercise of any of his or her functions and powers as administrator. According to s. 438E of the Act, an administrator is required to keep proper accounting records and to submit a statement of receipts and payments each six months. 7. Outline the role of directors before and during voluntary administration. If a company is insolvent, the directors can get themselves into serious trouble with the Law if they allow the company to continue to trade. According to s. 436A of the Corporations Act 2001, directors are expected to appoint a voluntary administrator to the company even before it becomes insolvent: (1) A company may, by writing, appoint an administrator of the company if the board has resolved to the effect that: (a) in the opinion of the directors voting for the resolution, the company is insolvent, or is likely to become insolvent at some future time; and (b) an administrator of the company should be appointed. According to Australian Securities and Investments Commission (ASIC) (on its website www.asic.gov.au), administration is designed to resolve the company’s future direction quickly. An independent and suitably qualified person — the administrator — takes full control of the company in an attempt to save either the company or the company’s business. The company’s directors are required under the Act to help the administrator in performing his or her necessary tasks. According to s. 438B, each director must: (1) (a) deliver to the administrator all books in the director’s possession that relate to the company, other than books that the director is entitled, as against the company and the administrator, to retain; and (b) if the director knows where other books relating to the company are—tell the administrator where those books are. (2) Within 5 business days after the administration of a company begins or such longer period as the administrator allows, the directors must give to the administrator a statement about the company’s business, property, affairs and financial circumstances. (3) A director of a company under administration must: (a) attend on the administrator at such times; and (b) give the administrator such information about the company’s business, property, affairs and financial circumstances; as the administrator reasonably requires.

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Chapter 33: Insolvency and liquidation

8. Briefly discuss the ways in which a company may be wound up, indicating the likely circumstances in which each is applicable. There are two types of "windings-up" of companies: (a) winding up by the court; and (b) voluntary winding up by creditors or members. (a) Winding up by the court - addressed in Parts 5.4 to 5.4B and 5.6 of the Corporations Act 2001. General grounds on which a company may be wound up by the court are listed in s. 461 of the Corporations Act. The court may order the winding up of a company if: (a) the company has by special resolution resolved that it be wound up by the court; or (b) the company does not commence business within one year from its incorporation or suspends its business for a whole year; or (c) the company has no members; or (d) directors have acted in affairs of the company in their own interests rather than in the interests of the members as a whole, or in any other manner whatsoever that appears to be unfair or unjust to other members; or (e) affairs of the company are being conducted in a manner that is oppressive or unfairly prejudicial to, or unfairly discriminatory against, a member or members or in a manner that is contrary to the interests of the members as a whole; or (f) an act or omission, or a proposed act or omission, by or on behalf of the company, or a resolution, or a proposed resolution, of a class of members of the company, was or would be oppressive or unfairly prejudicial to, or unfairly discriminatory against, a member or members or was or would be contrary to the interests of the members as a whole; or (g) ASIC has stated in a report prepared under Division 1 of Part 3 of the ASIC Act, that, in its opinion: (h) the company cannot pay its debts and should be wound up; or (i) (ii) it is in the interests of the public, of the members, or of the creditors, that the company should be wound up; (j) (k) the court is of opinion that it is just and equitable that the company be wound up. However, the most common reason for winding up by the court is insolvency. Under s. 459P, 462 and 464 of the Act, various people and institutions may apply for the winding up of an insolvent company. These include the company itself, a creditor, a director, Australian Securities and Investments Commission (ASIC) and a contributory. A contributory is defined in s. 9 and refers to the holders or immediate past holders of shares in the company. On hearing the application, the court may then issue an order to wind up the company, and the liquidation of the company is said to have commenced on the day of the winding up order, unless the company has been previously operating under an administrator. In this circumstance, the date of commencement is the day on which the administration began (see s. 513A and 513C). A provisional liquidator may be appointed any time after the filing of the application (s. 472(2)) in order to see that the status quo of the company is maintained; that is, that the assets are not quickly drained from the company. On the day that the court issues the winding up order, it appoints a liquidator (s. 472(1)). It is common practice for the provisional liquidator (if any) to be appointed liquidator.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b) Voluntary winding up by members or creditors – addressed in Parts 5.5 and 5.6 of the Corporations Act 2001. (i) Voluntary winding up – Members: • A voluntary winding up by members commences with the passing of a special resolution to wind up the company. The statutory requirement is that the company can pay its debts as and when they fall due. Accordingly the directors will make a written declaration that they believe that the company can pay its debts in full within a period not exceeding twelve months. This is known as a "Declaration of Solvency" (Form 520). (ii) Voluntary winding up – Creditors: • There is no declaration of solvency in this case as the company is unable to pay its debts. The winding up proceeds under the control of both members and creditors in separate meetings. The members still resolve that the company be wound up but their choice of liquidator is subject to ratification by creditors, at a meeting held immediately after the members meeting which places the company in liquidation.

9. What is the purpose of the report as to affairs (Form 507), the summary of affairs (Form 509) and the statement of receipts and payments (Form 524)? A report as to affairs (Form 507) is required under s. 494(2) as an accompanying document to the Declaration of Solvency (Form 520) in a voluntary winding up by members. The report as to affairs is also required under s. 475(1) of Corporations Act 2001 to be submitted by directors of the company to the liquidator not later than 14 days after the making of the winding up order in a court ordered winding up. The purpose of the report as to affairs is to provide information concerning the company's estimated realisable value of assets and any expected surplus or deficiency of assets after deducting creditors' claims. It is really a statement of financial position prepared on a realisation basis excluding the usual reporting assumptions of going concern and historical cost. Form 509 – Presentation of Summary of Affairs of a Company (Summary of Affairs) is similar to Form 507 except that it is less detailed. It is required to be submitted by the company to the creditors along with a list of creditors. It is only used in a creditors’ voluntary winding up. Form 524’s purpose is to provide a statement of receipts and payments and is used by an administrator, a provisional liquidator, a liquidator and a receiver. See Form 524 to see its contents.

10. Outline the powers of a liquidator in winding up a company (a) under a court order and (b) in a voluntary winding up. The powers of a liquidator in a court ordered winding up are wide reaching and are specified in s. 477 of Corporations Act 2001, but are controlled by the court. Primarily they allow the liquidators to carry on the business of the company so far as it is necessary for its beneficial winding up.

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Chapter 33: Insolvency and liquidation

The liquidator is also required to pay any class of creditors in full and make compromises with creditors and agreements regarding calls, liabilities and claims existing between the company and contributories. (Further powers are dealt with in detail in Section 33.5 of the text). The powers of a liquidator under a voluntary winding up are specified in s. 506 of the Act and are similar to those of a liquidator in a court ordered winding up. In addition, the liquidator may exercise the power under s. 478 of a liquidator appointed by the court to settle the list of contributories and under s. 483(3) in respect of making calls on contributories. The liquidator also exercises the powers of the court in fixing a time to have debts and claims proved and convene a general meeting of the company to obtain agreement for matters as the liquidator thinks fit. Finally the liquidator must pay the debts of the company as far as possible and settle the rights of contributories. 11. Describe how a company’s debts are identified and admitted on liquidation. Section 553 of the Corporations Act entitles all creditors’ claims to be admissible to proof against the company in liquidation. (1) Subject to this Division [Division 6] and Division 8, in every winding up, all debts payable by, and all claims against, the company (present or future, certain or contingent, ascertained or sounding only in damages), being debts or claims the circumstances giving rise to which occurred before the relevant date, are admissible to proof against the company. (2) Where, after the relevant date, an order is made under section 91 of the ASIC Act against a company that is being wound up, the amount that, pursuant to the order, the company is liable to pay is admissible to proof against the company. The actual procedures to be followed if proof of debts is required by the liquidator are provided in Corporations Regulations 5.6.39 to 5.6.57. Debts may be admitted by the liquidator without formal proof; however, if a formal proof is requested, the creditor must complete Form 535 ‘Formal proof of debt or claim’ found in Schedule 2 of the Regulations (Corporations Act s. 553D). The size of any debt (including a debt that is for or includes interest) is calculated for the purposes of the winding up as at the relevant date (Corporations Act s. 554), which is defined in s. 9 as the day on which the winding up is taken to have begun, in accordance with ss. 513A– 513C.

12. Discuss the order of priority of payment in the event of winding up a company. The order of recovery in terms of s. 556 of the Corporations Act 2001 is as follows: (a) Secured creditor: - Secured by a non-circulating or circulating interest. (b) Preferential unsecured creditors: - liquidation expenses (the liquidator is a relevant authority - costs of administration prior to liquidation

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

other liquidation expenses salary workers’ compensation long service leave.

(c) Ordinary unsecured creditors (rank equally): - research costs - PAYG income tax - directors' fees - telephone bill payable - audit fees - accounts payable/Trade creditors. (d) Deferred creditors: - Creditors are paid in order of priority, which is usually the following order: creditors secured by a non-circulating security interest (specific charge), creditors secured by a circulating security interest (floating charge), preferential unsecured creditors, ordinary unsecured creditors and then deferred creditors. In cases of insolvency, some preferential unsecured creditors rank for payment ahead of creditors secured by a circulating security interest, namely wages payable, leave payable and retrenchment payments payable.

13. Who are the contributories of a company? Explain. The contributories of a company are past or existing members who are likely to contribute to the property of the company in the event of it being wound up. In general terms the liability for existing shareholders only relates to those who have uncalled capital (partly paid shares). In this case their liability only extends to the amount unpaid on their shares. Former shareholders are not liable to contribute where: (a) they disposed of their shareholding more than twelve months after the commencement of winding up. (b) the debt or liability of the company occurred after they ceased to be members. The liability of such former shareholders will only arise where existing members cannot make the required contribution i.e. the former shareholder will be required to contribute the uncalled part of the share capital that was unable to be recovered from the existing shareholder.

14. Outline the principles to be followed in apportioning a deficiency among contributories. Assuming the creditors are to be paid in full but there is insufficient funds to pay out all shareholders, reference will be made to the company's constitution to determine whether there exists a priority as to repayment of capital. If there are different classes of shareholders with different rights in the event of a winding up (i.e. preference shares or different categories of ordinary capital with different rights enshrined in the constitution), calls will be made on the contributing class of ordinary capital in order to satisfy the priority enjoyed by the other classes of share capital.

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Chapter 33: Insolvency and liquidation

If there is only one class of shareholder, then the deficiency of capital will be borne equally amongst that class. If there are insufficient funds to pay the creditors and partly paid shares exist, the court is empowered, in a winding up by the court, to issue an order to make calls on all or any of the contributories to the extent of their liability, to be paid into a bank account kept by the liquidator (Corporations Act 2001 s. 483(3) and (4)). In a voluntary winding up, power to make calls on contributories is conferred on the liquidator by s. 506(1)(d). To enforce payment of the call, the liquidator may bring a court action against the contributory. Section 527 states that the liability of a contributory is of the nature of a specialty debt, and is payable when calls are made for enforcing the liability. Once all shares have been paid in full, any deficiency of funds must be borne by creditors in the reverse order of priority of payment. Thus, deferred creditors suffer losses first, followed by unsecured creditors, then preferential unsecured creditors, and so on.

15. If there is a surplus on liquidation, discuss how the surplus is to be apportioned among contributories. In the case of a surplus of capital, reference will be made to the constitution to assess the rights of shareholders. If, for example, there exists preference shareholders as a class (and that preferential status is recognised in the constitution) then that class will be paid first with ordinary shareholders receiving the balance equally amongst themselves. Also a surplus might attract the interest of the Australian Taxation Office. Companies in liquidation are subject to taxation laws equally with those not in liquidation, and if necessary the liquidator would lodge a tax return. Procedures for distributing a surplus to contributories are set down in Corporations Regulations 5.6.71 and 5.6.72.

16. What must a liquidator do if he or she is unable to collect unpaid call money from shareholders? If there are insufficient funds to pay creditors requiring a call on contributories and there is no response to that call, the liquidator may take action against that contributory as the requirement to pay the call is a specialty debt permitting the liquidator then to sue the contributory for recovery. The liquidator will in pragmatic terms assess the situation as to whether there is reasonable chance of recovery before proceeding with the action of recovery being conscious of the cost/benefit nature of these actions as liquidator.

17. Arrears of dividends are paid in the winding up process in certain circumstances. Outline those circumstances. Reference to the constitution is required to ascertain the degree of preference existing to the preference capital and any arrears of dividend. If the dividend is a legal debt and not yet paid, those shareholders will have a priority over other classes of shares but after payment of unsecured creditors. If there is no substance to the claim of preference, there will be no claim recognised.

33.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

18. Describe the accounts used in accounting for a liquidation. The realisation of assets is accounted for in the company’s records using a liquidation account and a liquidator’s receipts and payments account. Note that this latter account is actually a cash account that recognises the cash of the company now controlled by the liquidator; however, given that the information included there is exactly the same as that required to be included in the statement of receipts and payments according to ASIC Form 524, in this text is it identified as the liquidator’s receipts and payments account. The cash available at the liquidation date is recognised as the beginning balance of the liquidator’s receipts and payments account. As the liquidation process begins, first the carrying amounts of all assets that will be sold by the liquidator (i.e. except cash and assets subject to a security interest) are transferred to the liquidation account. If the carrying amount of an asset is the result of a balance in the asset account adjusted for a related contra‐account (e.g. the carrying amount of a non‐current asset is the balance in the asset account minus the related accumulated depreciation), the balance in the asset account is written off as a credit to the asset against a debit to the liquidation account, while the balance of the related contra‐account is written off by debiting the contra‐ account against a credit to the liquidation account. Second, on realisation (sale) of the assets by the liquidator, the liquidator’s receipts and payments account is debited and the liquidation account is credited by the proceeds on sale. Assets over which a non‐circulating security interest (i.e. a fixed charge) is held are commonly taken into possession by the secured creditor and sold. Any net proceeds after payment of the security are then handed over to the liquidator. Note that the gain on sale represents the excess of the sale proceeds of the secured asset over the carrying amount of the asset and is recognised as a credit to the liquidation account. If the secured asset was sold for a loss, the credit to the liquidation account would be replaced by a debit for the amount of loss. The liquidator’s receipts and payments account will record the net proceeds after payment of the security. For example, if the secured asset had a carrying amount of $15 000 and was sold by the secured creditor for $18 000, while the security interest was $13 000, the liquidator will recognise a gain on disposal of secured asset of $3 000 (i.e. $18 000 − $15 000) as a credit to the liquidation account, while the secured creditor will hand over to the liquidator $5 000 in cash (i.e. $18 000 − $13 000), which will be recognised as a debit to the liquidator’s receipts and payments account. As the unsecured and secured assets not taken into possession by the secured creditor were already debited to the liquidation account in the first step and the net proceeds of disposal of these assets are credited to the liquidation account, the balance of the liquidation account represents, after the adjustments for the secured assets, the gain/loss on liquidation of all the assets. The liquidator needs to pay off the remaining creditors in strict order of priority from the balance of the liquidator’s receipts and payments account, which includes the proceeds of sale of the assets. However, if that balance is not enough to cover those claims and the shares are only partly paid, the company will issue calls on contributories to pay further amounts due on the shares. The money received on calls will increase the balance of the liquidator’s receipts and payments account, being recognised as a debit to it. In the course of determining a list of creditors, the liquidator is likely to find certain liabilities that were not recorded in the company’s records; for example, liquidation expenses and remuneration, and unrecorded interest payable. Such unrecorded liabilities, in effect, increase the loss or reduce the gain on liquidation, and are best accounted for by debiting the liquidation account and crediting the appropriate liability accounts in order for payment to proceed.

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Chapter 33: Insolvency and liquidation

In some cases, certain creditors may be willing to settle for an amount lower than the carrying amount of the debt. This represents a discount given to the company by those creditors and should be accounted for by debiting the appropriate liability accounts and crediting the liquidation account, thus increasing the gain on liquidation of the net assets. Next, the payment of creditors’ claims will be recognised as a credit to the liquidator’s receipts and payments account. After the payment to creditors, the remaining cash should be distributed to contributories as a return of capital. The accounting procedures to return capital to contributories are as follows. 1. Calculate the appropriate distribution of funds for each class of shareholder in accordance with the rights of contributories as discussed in section 33.8. 2. Make any necessary further calls on the various classes of partly paid shares and recognise the money received on those calls as a debit to the liquidator’s receipts and payments account. 3. Transfer share capital to a shareholders’ distribution account. If there is more than one class of shares, separate shareholders’ distribution accounts may be used for each class, or one account may be used with multiple columns. In this text one account is used for simplicity. If there are shares with calls in arrears, and the liquidator is unable to recover these calls, it is important that the shares be forfeited before share capital is transferred to shareholders’ distribution. Any forfeited shares surplus is treated as part of the gain on liquidation and is not refunded to the previous shareholders. 4. Transfer all reserve accounts (including any forfeited shares surplus from the previous step and retained earnings) to the liquidation account. Note that if the retained earnings account has a debit balance (i.e. accumulated losses), its balance is transferred to the debit side of the liquidation account; otherwise, to the credit side, together with the other reserves. The balance of the liquidation account after these transfers represents the ultimate deficiency (if it is on the credit side) or surplus (if it is on the debit side) to be borne by/distributed to contributories. 5. Pay any appropriate capital distribution to the various classes of shareholders by crediting the liquidator’s receipts and payments account and debiting the shareholders’ distribution account. 6. Transfer the balance of the liquidation account (representing the deficiency or surplus) to the shareholders’ distribution account. At this point, all accounts in the ledger should be closed.

33.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case studies Case study 33.1 Liquidation of a family company Assume that you are the managing director of a small, family-owned proprietary company operating in Australia. The members of the company have decided to wind up its operations for family reasons. The company has been trading profitably and has had no problem in paying its accounts when they fall due. Required Visit the ASIC website and investigate what you must do in order to wind up the company properly in accordance with the law. Report your findings and show details of the forms that must be completed. The winding up procedure will differ depending on whether the company is solvent or insolvent. If insolvent, then a members’ voluntary winding up cannot occur. It will usually be either a creditors’ voluntary wind-up or a wind-up by the court. See Section 33.4 of the chapter for details of forms to be used etc. In a members’ voluntary winding up, directors must provide a declaration of solvency attached to the report as to affairs. A declaration of solvency is not needed in any other winding up. The ASIC website (www.asic.gov.au) provides information as to what must be done to wind up a family company. See the section on “For Business > Closing your company”, where much information is available, including deregistering a company.

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Chapter 33: Insolvency and liquidation

Case study 33.2 Current liquidations of previously listed companies Visit www.delisted.com.au or a similar website and present brief details of three companies that have been listed on the securities exchange, and that are currently going through the process of liquidation. Provide reasons (if possible) for such liquidations occurring. From the Delisted website (www.delisted.com.au), the home page provides the names of companies who have recently been delisted from the ASX. From this list, identify companies who are in the process of liquidation and select three. From there, access can be found to each of those company news sites or websites, which provide some details of liquidation proceedings. Use the company listings on the Delisted website to search for more data, as well as search engines such as Google.

33.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 33.1 Order of priority for paying creditors Flea Ltd, whose capital consisted of $25 000 in fully paid shares, was wound up as a result of a court order. Its liquidator realised $335 825 from the sale of the company’s assets. This amount included $85 000 from the proceeds on sale of the company’s land and buildings. Debts proved and admitted were as follows. Unsecured notes Debentures (secured by circulating security interest) First mortgage on land and buildings Trade accounts payable PAYG tax instalment Fringe benefits tax Directors’ fees GST Employees’ holiday pay Employees’ wages — 5 employees for 1 week at $400 per week Secretary’s salary — 3 weeks at $120 per week Managing director’s salary — 2 weeks at $600 per week Sales commission Liquidation expenses Second mortgage on land and buildings Liquidator’s remuneration

50 000 150 000 50 000 40 000 390 1 000 1 500 995 2 500 2 000 360 1 200 250 1 500 40 000 4 000

Required Show the order of priority of payment of debts for Flea Ltd and calculate the amount payable to the company’s trade accounts payable. (LO7) Proceeds from sale of assets

$335 825

Less payment of debts (in order of priority) 1. Liquidator's expenses 2. Secured debts First mortgage Second mortgage 3. Circulating security interest: Debentures 4. Liquidator’s remuneration

$1 500 $50 000 35 000

85 000 150 000 4 000

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Chapter 33: Insolvency and liquidation

5. Wages: Employees Secretary Managing director Sales commission 6. Employees' holiday pay

2 000 360 1 000 250

3 610 2 500

Amount available for unsecured creditors

246 610 89 215

7. Ordinary unsecured creditors Unsecured notes Trade accounts payable Fringe benefits tax PAYG tax instalment GST Directors' fees Managing director's salary Second mortgage

Owed 50 000 40 000 1 000 390 995 1 500 200 5 000 $99 085

Percent dividends 90.04 90.04 90.04 90.04 90.04 90.04 90.04 90.04

Paid 45 020 36 016 900 351 896 1 350 180 4 502 $89 215

Percentage dividend to trade accounts payable = $89 215/$99 085 = 90.04c in a $.

33.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.2 Distribution to different classes of shareholders On 1 September 2023, Mouse Ltd went into liquidation. At that date, the equity of Mouse Ltd comprised the following.

Required Prepare a statement detailing the distribution of cash to shareholders assuming that after realising the assets and paying all creditors, the liquidator had the following cash available to distribute to shareholders. (a) $0 (b)$50 000 (c) $150 000 (d)$250 000 (LO8) It is assumed that ordinary “A” shareholders and ordinary “B” shareholders have the same rights with regards to return of capital. (a) Distribution of cash if available cash is $0: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

200 000 300 000 500 000

Paid to

$ 300 000 300 000 600 000 . 600 000

Notional Notional Actual Deficiency Call Refund Refund share 20c (Call) $ $ $ $ 100 000 40 000 (60 000) 360 000 . 60 000 60 000 240 000 100 000 100 000 . 600 000 . . 100 000

Total notional cash per share = $100 000 ÷ 500 000 = 20c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $0 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price. Thus, $100 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 20c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $60 000 (i.e. 20c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is greater than the notional refund on these shares ($40 000, i.e. 20c × 200 000 shares), the holders of those shares will be called to pay a total of $60 000 (30c per share). The table above also shows that, as a result of

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Chapter 33: Insolvency and liquidation

the final distribution to shareholders, the total deficiency of funds to contributories of $600 000 (i.e. $600 000 − $0) is shared between ‘A’ ordinary shareholders — who lose $360 000 ($300 000 paid-up capital + $60 000 call) and ‘B’ ordinary shareholders – who lose $240 000 ($300 000 paid-up capital – $60 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $60 000 (i.e. 30c per share held). Ordinary “B” shareholders will receive $60 000, i.e. 20c for each share held prior to the liquidation. (b) Distribution of cash if available cash is $50 000: No of Shares Ordinary “A” Ordinary “B”

200 000 300 000 500 000

Cash available Deficiency Total notional cash

Paid to

$ 300 000 300 000 600 000 (50 000) 550 000

Notional Notional Actual Deficiency Call Refund Refund share 30c (Call) $ $ $ $ 100 000 60 000 (40 000) 340 000 . 90 000 90 000 210 000 100 000 150 000 50 000 550 000 50 000 . 150 000

Total notional cash per share = $150 000 ÷ 500 000 = 30c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $50 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price. Thus, $150 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 30c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $90 000 (i.e. 30c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is greater than the notional refund on these shares ($60 000, i.e. 30c × 200 000 shares), the holders of those shares will be called to pay a total of $40 000 (20c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $550 000 is shared between ‘A’ ordinary shareholders — who lose $340 000 ($300 000 paid-up capital + $40 000 call) and ‘B’ ordinary shareholders – who lose $210 000 ($300 000 paid-up capital – $90 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $40 000 (i.e. 20c per share held). Ordinary “B” shareholders will receive $90 000, i.e. 30c for each share held prior to the liquidation. (c) Distribution of cash if available cash is $150 000: No of Shares Ordinary “A” Ordinary “B”

200 000 300 000

Paid to

$ 300 000 300 000

Notional Notional Actual Deficiency Call Refund Refund share 50c $ $ $ $ 100 000 100 000 - 300 000 . 150 000 150 000 150 000

33.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

500 000 Cash available Deficiency Total notional cash

600 000 (150 000) 450 000

100 000 250 000 150 000 150 000 . 250 000

450 000

Total notional cash per share = $250 000 ÷ 500 000 = 50c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $150 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price. Thus, $250 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 50c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $150 000 (i.e. 50c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is equal to the notional refund on these shares ($60 000, i.e. 50c × 200 000 shares), the holders of those shares will not be called to pay the rest of the share price, but they will not receive a refund either. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $450 000 is shared between ‘A’ ordinary shareholders — who lose the $300 000 paid-up capital) and ‘B’ ordinary shareholders – who lose $150 000 ($300 000 paid-up capital – $150 000 refund). In summary, the ordinary “A” shareholders will not receive any money and will not be asked to pay any calls. Ordinary “B” shareholders will receive $150 000, i.e. 50c for each share held prior to the liquidation. (d) Distribution of cash if available cash is $250 000: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

200 000 300 000 500 000

Paid to

$ 300 000 300 000 600 000 (250 000) 350 000

Notional Notional Actual Deficiency Call Refund Refund share 70c $ $ $ $ 100 000 140 000 40 000 260 000 . 210 000 210 000 90 000 100 000 350 000 250 000 350 000 250 000 . 350 000

Total notional cash per share = $350 000 ÷ 500 000 = 70c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $250 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price. Thus, $350 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 70c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $210 000 (i.e. 70c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($140 000, i.e. 70c × 200 000 shares), the holders of those shares will receive a total refund of $40 000 (20c per share). The table above also shows that, as a result

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Chapter 33: Insolvency and liquidation

of the final distribution to shareholders, the total deficiency of funds to contributories of $350 000 is shared between ‘A’ ordinary shareholders — who lose $260 000 ($300 000 paid-up capital - $40 000 refund) and ‘B’ ordinary shareholders – who lose $90 000 ($300 000 paid-up capital – $210 000 refund). In summary, the ordinary “A” shareholders will receive $40 000 (i.e. 20c per share held). Ordinary “B” shareholders will receive $210 000, i.e. 70c for each share held prior to the liquidation.

33.20

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.3 Distribution to different classes of shareholders On 31 May 2023, White Ant Ltd went into liquidation. At that date, the equity of White Ant Ltd comprised the following. 200 000 preference shares issued for $1 paid to 50c 500 000 ordinary shares issued for $1 paid to 80c

100 000 400 000

500 000

After realising the assets and paying all creditors, the liquidator had $150 000 cash available to distribute to shareholders. Required 1. Prepare a statement detailing the distribution of cash to shareholders assuming the company’s constitution was silent regarding the rights of shareholders upon winding up. 2. Prepare a statement detailing the distribution of cash to shareholders assuming the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital. (LO8) 1. Distribution of cash if preference shareholders are not preferential as to return of capital: No of Shares

Preference Ordinary Cash available Deficiency Total notional cash

Paid to

$ 200 000 100 000 500 000 400 000 700 000 500 000 (150 000) 350 000

Notional Notional Actual Deficiency Call Refund Refund share 50c $ $ $ $ 100 000 100 000 - 100 000 100 000 250 000 150 000 250 000 200 000 350 000 150 000 350 000 150 000 . 350 000

Total notional cash per share = $350 000 ÷ 700 000 = 50c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $150 000 plus a notional call on the partly paid preference shares of $100 000 and also on the partly paid ordinary shares of $100 000 up to their full issue price. Thus, $350 000 is potentially available for distribution across the 700 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 50c per share. As the notional call on the preference shares to make them fully paid ($100 000) is equal to the notional refund on these shares ($100 000, i.e. 50c × 200 000 shares), the holders of those shares will be not need to pay the call, but at the same time, will not receive any refund either.

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Chapter 33: Insolvency and liquidation

As the notional call on the ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($250 000, i.e. 20c × 500 000 shares), the holders of those shares will be not be called to pay the remainder of the nominal value of the share and instead will receive a refund of $150 000 from the total contributed prior to the liquidation of $400 000 (30c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $350 000 is shared between preference shareholders — who lose the $100 000 paid-up capital and ordinary shareholders – who lose $250 000 ($400 000 paid-up capital – $150 000 refund). In summary, if the company’s constitution was silent regarding the rights of shareholders upon winding up, it is considered that preference shareholders and ordinary shareholders participate equally in the final distribution and therefore the preference shareholders will not receive any money, while ordinary shareholders will receive $150 000, i.e. 30c for each share held prior to the liquidation.

2. Distribution of cash if preference shareholders are preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to the paid up capital of $100 000. The remaining cash of distribution to preference shareholders will be refunded to ordinary shareholders, i.e. $50 000 ($150 000 - $100 000)

33.22

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.4 Distribution to different classes of shareholders On 1 December 2023, Elephant Ltd went into liquidation. At that date, the equity of Elephant Ltd comprised the following.

After realising the assets and paying all creditors, the liquidator had $60 000 cash available to distribute to shareholders. Required 1. Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. 2. How will the statement of the cash distribution to shareholders change if the ordinary shares ‘A’ were paid to: (a) $1.25? (b) $1.75? (LO8) It is assumed that ordinary “A” shareholders and ordinary “B” shareholders have the same rights with regards to return of capital. 1. Distribution of cash if available cash is $60 000 and ordinary “A” shares are paid to $1.55: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

200 000 300 000 500 000

Paid to

$ 310 000 300 000 610 000 (60 000) 550 000

Notional Notional Actual Deficiency Call Refund Refund share 30c $ $ $ $ 90 000 60 000 (30 000) 340 000 . 90 000 90 000 210 000 90 000 150 000 60 000 550 000 60 000 . 150 000

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Chapter 33: Insolvency and liquidation

need to pay a total of $30 000 (15c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $550 000 is shared between ‘A’ ordinary shareholders — who lose $340 000 ($310 000 paid-up capital + $30 000 calls) and ‘B’ ordinary shareholders – who lose $210 000 ($300 000 paid-up capital – $90 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $30 000 (i.e. 15c per share held). Ordinary “B” shareholders will receive $90 000, i.e. 30c for each share held prior to the liquidation. 2. (a) Distribution of cash if available cash is $60 000 and ordinary “A” shares are paid to $1.25: No of Shares Ordinary “A” Ordinary “B”

200 000 300 000 500 000

Cash available Deficiency Total notional cash

Paid to

$ 250 000 300 000 550 000 (60 000) 490 000

Notional Notional Actual Deficiency Call Refund Refund share 42c $ $ $ $ 150 000 84 000 (66 000) 316 000 . 126 000 126 000 174 000 150 000 210 000 60 000 490 000 60 000 . 210 000

Total notional cash per share = $210 000 ÷ 500 000 = 42c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $60 000 plus a notional call on the partly paid ‘A’ ordinary shares of $150 000 up to their full issue price. Thus, $210 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 42c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $126 000 (i.e. 42c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($150 000) is higher than the notional refund on these shares ($84 000, i.e. 42c × 200 000 shares), the holders of those shares will need to pay a total of $66 000 (33c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $490 000 is shared between ‘A’ ordinary shareholders — who lose $316 000 ($250 000 paid-up capital + $66 000 calls) and ‘B’ ordinary shareholders – who lose $174 000 ($300 000 paid-up capital – $126 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $66 000 (i.e. 33c per share held). Ordinary “B” shareholders will receive $126 000, i.e. 43c for each share held prior to the liquidation. 2. (b) Distribution of cash if available cash is $60 000 and ordinary “A” shares are paid to $1.75: No of Shares

Paid to

Notional Notional Call Refund 22c

Actual Deficiency Refund share

33.24

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

200 000 300 000 500 000

$ 350 000 300 000 650 000 (60 000) 590 000

$ $ 50 000 44 000 . 66 000 50 000 110 000 60 000 . 110 000

$ (6 000) 66 000 60 000

$ 356 000 234 000 590 000

Total notional cash per share = $110 000 ÷ 500 000 = 22c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $60 000 plus a notional call on the partly paid ‘A’ ordinary shares of $50 000 up to their full issue price. Thus, $110 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 22c per share. The ‘B’ ordinary shares, being fully paid, are therefore entitled to receive $66 000 (i.e. 22c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($50 000) is higher than the notional refund on these shares ($44 000, i.e. 22c × 200 000 shares), the holders of those shares will receive need to pay a total of $6 000 (3c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $590 000 is shared between ‘A’ ordinary shareholders — who lose $356 000 ($350 000 paid-up capital + $6 000 calls) and ‘B’ ordinary shareholders – who lose $234 000 ($300 000 paid-up capital – $66 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $6 000 (i.e. 3c per share held). Ordinary “B” shareholders will receive $66 000, i.e. 22c for each share held prior to the liquidation.

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Chapter 33: Insolvency and liquidation

Exercise 33.5 Distribution to different classes of shareholders On 1 December 2023, Leo Ltd went into liquidation. At that date, the equity of Leo Ltd comprised the following.

After realising the assets and paying all creditors, the liquidator had $100 000 cash available to distribute to shareholders. Required 1. Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. 2. How would the statement of the cash distribution to shareholders change if both ordinary shares ‘A’ and ‘B’ were fully paid at 1 December 2023? 3. How would the statement of the cash distribution to shareholders change if the ordinary shares ‘A’ were fully paid, while ordinary shares ‘B’ were only paid to 75c at 1 December 2023? 4. How would the statement of the cash distribution to shareholders change if the ordinary shares ‘A’ were partly paid to $1, while ordinary shares ‘B’ were only paid to 75c at 1 December 2023? (LO8) 1. Distribution of cash if available cash is $100 000 and ordinary “A” shares are paid to $1 and ordinary “B” shares are fully paid: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

Paid to

$ 200 000 200 000 300 000 300 000 500 000 500 000 (100 000) 400 000

Notional Notional Actual Deficiency Call Refund Refund share 60c $ $ $ $ 200 000 120 000 (80 000) 280 000 . 180 000 180 000 120 000 200 000 300 000 100 000 400 000 100 000 . 300 000

Total notional cash per share = $300 000 ÷ 500 000 = 60c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $100 000 plus a notional call on the partly paid ‘A’ ordinary shares of $200 000 up to their full issue price. Thus, $300 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 60c per share. The ‘B’ ordinary shares, being

33.26

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

fully paid, are therefore entitled to receive $180 000 (i.e. 60c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($200 000) is higher than the notional refund on these shares ($120 000, i.e. 60c × 200 000 shares), the holders of those shares will need to pay a total of $80 000 (40c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $400 000 is shared between ‘A’ ordinary shareholders — who lose $280 000 ($200 000 paid-up capital + $80 000 calls) and ‘B’ ordinary shareholders – who lose $120 000 ($300 000 paid-up capital – $180 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $80 000 (i.e. 40c per share held). Ordinary “B” shareholders will receive $180 000, i.e. 60c for each share held prior to the liquidation. 2. Distribution of cash if available cash is $100 000 and ordinary “A” shares are paid to $1 and ordinary “B” shares are fully paid: No of Shares Ordinary “A” Ordinary “B”

200 000 300 000 500 000

Cash available Deficiency Total notional cash

Paid to

$ 400 000 300 000 700 000 (100 000) 600 000

Notional Notional Actual Deficiency Call Refund Refund share 60c $ $ $ $ - 40 000 40 000 360 000 - 60 000 60 000 240 000 - 100 000 100 000 600 000 100 000 . 100 000

Total notional cash per share = $100 000 ÷ 500 000 = 20c per share. From the table above, note that the cash available of $100 000 is distributed proportionally to both ordinary ‘A’ and ‘B’ shareholders, based on the number of shares held. $100 000 is available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 20c per share. As both types of shares are fully paid, there is no call to consider. As such, the ‘A’ ordinary shareholders are entitled to receive $40 000 (i.e. 20c × 200 000 shares), while the holders of ‘B’ ordinary shares will receive $60 000 (again, 20c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $600 000 is shared between ‘A’ ordinary shareholders — who lose $360 000 ($400 000 paid-up capital – $40 000 refund) and ‘B’ ordinary shareholders – who lose $240 000 ($300 000 paid-up capital – $60 000 refund). 3. Distribution of cash if available cash is $100 000 and ordinary “A” shares are fully paid to $2 and ordinary “B” shares are partly paid to 75c: No of Shares Ordinary “A” Ordinary “B”

200 000 300 000 500 000

Paid to

$ 400 000 225 000 625 000

Notional Notional Actual Deficiency Call Refund Refund share 35c $ $ $ $ - 70 000 70 000 330 000 75 000 105 000 30 000 195 000 75 000 175 000 100 000 525 000

33.27

Chapter 33: Insolvency and liquidation

Cash available Deficiency Total notional cash

(100 000) 525 000

100 000 . 175 000

Total notional cash per share = $175 000 ÷ 500 000 = 35c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $100 000 plus a notional call on the partly paid ‘B’ ordinary shares of $75 000 up to their full issue price. Thus, $175 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 35c per share. The ‘A’ ordinary shares, being fully paid, are therefore entitled to receive $70 000 (i.e. 35c × 200 000 shares). As the notional call on the ‘B’ ordinary shares to make them fully paid ($75 000) is lower than the notional refund on these shares ($105 000, i.e. 35c × 300 000 shares), the holders of those shares will receive a refund of $30 000 (10c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $525 000 is shared between ‘A’ ordinary shareholders — who lose $330 000 ($400 000 paid-up capital $70 000 refund) and ‘B’ ordinary shareholders – who lose $195 000 ($225 000 paid-up capital – $30 000 refund). In summary, the ordinary “A” shareholders will receive $70 000 (i.e. 35c per share held). Ordinary “B” shareholders will receive $30 000, i.e. 10c for each share held prior to the liquidation. 4. Distribution of cash if available cash is $100 000 and ordinary “A” shares are partly paid to $1 and ordinary “B” shares are partly paid to 75c: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

200 000 300 000 500 000

Paid to

$ 200 000 225 000 425 000 (100 000) 325 000

Notional Notional Actual Deficiency Call Refund Refund share 75c $ $ $ $ 200 000 150 000 (50 000) 250 000 75 000 225 000 150 000 75 000 275 000 375 000 100 000 325 000 100 000 . 375 000

Total notional cash per share = $375 000 ÷ 500 000 = 75c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $100 000 plus a notional call on the partly paid ‘A’ ordinary shares of $200 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $75 000 up to their full issue price. Thus, $375 000 is potentially available for distribution across 500 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 75c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($200 000) is higher than the notional refund on these shares ($150 000, i.e. 75c × 200 000 shares), the holders of those shares will need to pay a total of $50 000 (25c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($75 000) is lower than the notional refund on these shares ($225 000, i.e. 75c

33.28

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

× 300 000 shares), the holders of those shares will receive a refund of $150 000 (50c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $325 000 is shared between ‘A’ ordinary shareholders — who lose $250 000 ($200 000 paid-up capital + $50 000 calls) and ‘B’ ordinary shareholders – who lose $75 000 ($225 000 paid-up capital – $150 000 refund). In summary, the ordinary “A” shareholders will not receive any money, but instead will be asked to pay $50 000 (i.e. 25c per share held). Ordinary “B” shareholders will receive $150 000, i.e. 50c for each share held prior to the liquidation.

33.29

Chapter 33: Insolvency and liquidation

Exercise 33.6 Distribution to different classes of shareholders On 1 December 2023, Hippo Ltd went into liquidation. At that date, the equity of Hippo Ltd comprised the following. 900 000 preference shares fully paid to $1, to be redeemed for $1.10 600 000 ‘A’ ordinary shares issued for $1 and fully paid 1 200 000 ‘B’ ordinary shares issued for $2 and fully paid

$ 900 000 600 000 2 400 000 $ 3 900 000

After realising the assets and paying all creditors, the liquidator had $1 350 000 cash available to distribute to shareholders. The order of priority provided in the constitution for repayment of capital is: (1) preference and (2) ordinary. Required 1. Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. 2. How will the statement of the cash distribution to shareholders change if the ordinary shares ‘B’ were partly paid to: (a) 50c (b) $1.40 (c) $1.70? 3. If all the shares were ranked equally according to the constitution in distributing any surplus or deficiency, how would the statement of the cash distribution to shareholders change? (LO8) 1. Distribution of cash if available cash is $1 350 000, ordinary “B” shares are fully paid and preference shares are preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $990 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $360 000 ($1 350 000 - $1.10 x 900 000). No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 20c $ $ $ $ $ Ordinary “A” 600 000 600 000 - 120 000 120 000 480 000 Ordinary “B” 1 200 000 2 400 000 - 240 000 240 000 2 160 000 1 800 000 3 000 000 - 360 000 360 000 2 640 000 Cash available (360 000) 360 000 Deficiency 2 640 000 . Total notional cash 360 000 Total notional cash per share = $360 000 ÷ 1 800 000 = 20c per share.

33.30

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

From the table above, note that the cash available of $360 000 is distributed proportionally to both ordinary ‘A’ and ‘B’ shareholders, based on the number of shares held. $360 000 is available for distribution across 1 800 000 shares. As all ordinary shares participate equally in the final distribution, no matter their issue price, this is equivalent to 20c per share. As both types of shares are fully paid, there is no call to consider. As such, the ‘A’ ordinary shareholders are entitled to receive $120 000 (i.e. 20c × 600 000 shares), while the holders of ‘B’ ordinary shares will receive $240 000 (again, 20c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $2 640 000 is shared between ‘A’ ordinary shareholders — who lose $480 000 ($600 000 paid-up capital – $120 000 refund) and ‘B’ ordinary shareholders – who lose $2 160 000 ($2 400 000 paid-up capital – $240 000 refund). 2. Still, if the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $990 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $360 000 ($1 350 000 - $1.10 x 900 000). (a) Distribution of cash if available cash is $1 350 000, ordinary “B” shares are partly paid to 50c and preference shares are preferential as to return of capital: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

Paid to

$ 600 000 600 000 1 200 000 600 000 1 800 000 1 200 000 (360 000) 840 000

Notional Notional Actual Call Refund Refund $1.20 $ $ $ 0 720 000 600 000 1 800 000 1 440 000 (240 000) 1 800 000 2 160 000 360 000 360 000 . 2 160 000

Deficiency share $ 0 840 000 840 000

Total notional cash per share = $2 160 000 ÷ 1 800 000 = $1.20 per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $360 000 plus a notional call on the partly paid ‘B’ ordinary shares of $1 800 000 up to their full issue price. Thus, $2 160 000 is potentially available for distribution across 1 800 000 shares. As all ordinary shares participate equally in the final distribution, no matter their issue price, this is equivalent to $1.20 per share. As the notional call on the ‘B’ ordinary shares to make them fully paid ($1 800 000) is greater than the notional refund on these shares ($1 440 000, i.e. $1.20 × 1 200 000 shares), the holders of those shares may need to pay $360 000 (30c per share). The ‘A’ ordinary shares, being fully paid, are entitled to receive $720 000 (i.e. $1.20 × 600 000 shares). However, as the maximum amount to be refunded to ordinary ‘A’ shareholders is the paid-up capital, the company will refund only $600 000 although in the calculations it was determined that $720 000 needs to be refunded to those shareholders. As such, instead of asking the ordinary ‘B’ shareholders to pay $360 000, the company is only asking for the $240 000 required to pay in full the ordinary ‘A’ shareholders. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $840 000 is only borne by the ‘B’ ordinary shareholders – who lose $840 000 ($600 000 paid-up capital + $240 000 call).

33.31

Chapter 33: Insolvency and liquidation

In summary, the ordinary “A” shareholders will receive their contributed capital. Ordinary “B” shareholders will have to pay $824 000, i.e. 20c for each share held prior to the liquidation. (b) Distribution of cash if available cash is $1 350 000, ordinary “B” shares are partly paid to $1.40 and preference shares are preferential as to return of capital: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

Paid to

$ 600 000 600 000 1 200 000 1 680 000 1 800 000 2 280 000 (360 000) 1 920 000

Notional Notional Actual Deficiency Call Refund Refund share 60c $ $ $ $ - 360 000 360 000 240 000 720 000 720 000 - 1 680 000 720 000 1 080 000 360 000 1 920 000 360 000 . 1 080 000

Total notional cash per share = $1 080 000 ÷ 1 800 000 = 60c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $360 000 plus a notional call on the partly paid ‘B’ ordinary shares of $720 000 up to their full issue price. Thus, $1 080 000 is potentially available for distribution across 1 500 000 shares. As all ordinary shares participate equally in the final distribution, no matter their issue price, this is equivalent to 60c per share. The ‘A’ ordinary shares, being fully paid, are entitled to receive $360 000 (i.e. 60c × 600 000 shares). As the notional call on the ‘B’ ordinary shares to make them fully paid ($720 000) is equal to the notional refund on these shares ($720 000, i.e. 60c × 1 200 000 shares), the holders of those shares do need to pay any call, but also will not receive any refund. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $1 920 000 is shared between ‘A’ ordinary shareholders — who lose $240 000 ($600 000 paid-up capital - $360 000 refund) and ‘B’ ordinary shareholders – who lose their $1 680 000 paid-up capital. In summary, the ordinary “A” shareholders will receive $360 000 (i.e. 60c per share held). Ordinary “B” shareholders will not receive any money. (c) Distribution of cash if available cash is $1 350 000, ordinary “B” shares are partly paid to $1.70 and preference shares are preferential as to return of capital: No of Shares Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

Paid to

$ 600 000 600 000 1 200 000 2 040 000 1 800 000 2 640 000 (360 000) 2 280 000

Notional Notional Actual Deficiency Call Refund Refund share 40c $ $ $ $ - 240 000 240 000 360 000 360 000 480 000 120 000 1 920 000 360 000 720 000 360 000 2 280 000 360 000 . 720 000

33.32

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $360 000 plus a notional call on the partly paid ‘B’ ordinary shares of $360 000 up to their full issue price. Thus, $720 000 is potentially available for distribution across 1 500 000 shares. As all ordinary shares participate equally in the final distribution, no matter their issue price, this is equivalent to 40c per share. The ‘A’ ordinary shares, being fully paid, are entitled to receive $240 000 (i.e. 40c × 600 000 shares). As the notional call on the ‘B’ ordinary shares to make them fully paid ($360 000) is lower than the notional refund on these shares ($480 000, i.e. 40c × 1 200 000 shares), the holders of those shares do need to pay any call, and receive a refund of $120 000 (10c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $2 280 000 is shared between ‘A’ ordinary shareholders — who lose $360 000 ($600 000 paid-up capital - $240 000 refund) and ‘B’ ordinary shareholders – who lose their $1 920 000 ($2 040 000 paid-up capital - $120 000 refund). In summary, the ordinary “A” shareholders will receive $240 000 (i.e. 40c per share), while ordinary “B” shareholders will receive $120 000 (i.e. 10c for each share held prior to the liquidation). 3. Distribution of cash if available cash is $1 350 000, shares are fully paid and preference shares are not preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are not preferential as to return of capital, all available cash will be allocated equally to all the shares. No of Shares

Preference Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

Paid to

$ 900 000 900 000 600 000 600 000 1 200 000 2 400 000 2 700 000 3 900 000 (1 350 000) 2 550 000

Notional Notional Actual Deficiency Call Refund Refund share 50c $ $ $ $ - 450 000 450 000 450 000 - 300 000 300 000 300 000 - 600 000 600 000 1 800 000 - 1 350 000 1 350 000 2 550 000 1 350 000 . 1 350 000

Total notional cash per share = $1 350 000 ÷ 2 700 000 = 50c per share. From the table above, note that the cash available of $1 350 000 is distributed proportionally to preference and ordinary ‘A’ and ‘B’ shareholders, based on the number of shares held. $1 350 000 is available for distribution across 2 700 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 50c per share. As all types of shares are fully paid, there is no call to consider. As such, the preference shareholders are entitled to received $450 000 (i.e. 50c x 900 000 shares). ‘A’ ordinary shareholders are entitled to receive $300 000 (i.e. 50c × 600 000 shares), while the holders of ‘B’ ordinary shares will receive $600 000 (again, 50c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $2 550 000 is shared between preference shareholders – who lose $450 000 ($900 000 paid-up capital – $450 000 refund), ‘A’ ordinary shareholders — who lose $300 000 ($600 000 paid-up capital – $300 000 refund) and ‘B’ ordinary shareholders – who lose $1 800 000 ($2 400 000 paid-up capital – $600 000 refund). It can be observed that preference shareholders also lose their premium on redemption of $90 000.

33.33

Chapter 33: Insolvency and liquidation

Exercise 33.7 Distribution to different classes of shareholders On 1 December 2023, Rui Ltd went into liquidation. At that date, the equity of Rui Ltd comprised the following.

After realising the assets and paying all creditors, the liquidator had $250 000 cash available to distribute to shareholders. The order of priority provided in the constitution for repayment of capital is: (1) preference and (2) ordinary. Required 1. Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. 2. How would the statement of the cash distribution to shareholders change if the available cash for distribution after realising the assets and paying all creditors was: (a) $400 000? (b) $640 000? 3. If all the shares were ranked equally according to the constitution in distributing any surplus or deficiency, how would the statement of the cash distribution to shareholders in requirements 1 and 2 change? (LO8) 1. Distribution of cash if available cash is $250 000 and preference shares are preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will be entitled to a refund equal to their redemption value of $330 000 before the available cash can be distributed to ordinary shareholders. However as the total available cash after paying all creditors is only $250 000, the preference shareholders will receive $330 000 and there will be cash deficit to distribute to ordinary shareholders. No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 20c $ $ $ $ $ Ordinary “A” 200 000 100 000 100 000 40 000 (60 000) 160 000 Ordinary “B” 400 000 700 000 100 000 80 000 (20 000) 720 000 600 000 800 000 200 000 120 000 (80 000) 880 000 Cash deficit 80 000 (80 000) Deficiency 880 000 . Total notional cash 120 000 Total notional cash per share = $120 000 ÷ 600 000 = 20c per share.

33.34

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

From the table above, note that the company calculates the notional cash available for payment to all ordinary shareholders as the cash deficit to distribute to the ordinary shareholders of $80 000 adjusted for a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $100 000 up to their full issue price. Thus, $120 000 is potentially available for distribution across 600 000 ordinary shares. As all those shares participate equally in the final distribution, no matter their issue price, this is equivalent to 20c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is higher than the notional refund on these shares ($40 000, i.e. 20c × 200 000 shares), the holders of those shares will need to made a payment of $60 000 (30c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($100 000) is higher than the notional refund on these shares ($80 000, i.e. 20c × 400 000 shares), the holders of those shares will need to made a payment of $20 000 (5c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $880 000 is shared between ‘A’ ordinary shareholders — who lose $160 000 ($100 000 paid-up capital + $60 000 call) and ‘B’ ordinary shareholders – who lose $720 000 ($700 000 paid-up capital + $20 000 call). Note that the ordinary shareholders will need to pay the calls to cover the deficiency in cash that was generated by the redemption of preference shares. In summary, the ordinary “A” shareholders will pay $60 000 (i.e. 30c per share held) and lose as well their paid-up capital. Ordinary “B” shareholders will pay $20 000 (i.e. 5c for each share held prior to the liquidation) and will also lose their paid-up capital. The preference shareholders will receive $330 000 from the available cash of $250 000 plus the amount collected from ordinary shareholders ($60 000 + $20 000). 2. Distribution of cash if preference shares are preferential as to return of capital: (a) Available cash is $400 000: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $330 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $70 000 ($400 000 - $1.10 x 300 000). No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 45c $ $ $ $ $ Ordinary “A” 200 000 100 000 100 000 90 000 (10 000) 110 000 Ordinary “B” 400 000 700 000 100 000 180 000 80 000 620 000 600 000 800 000 200 000 270 000 70 000 730 000 Cash available (70 000) 70 000 Deficiency 730 000 . Total notional cash 270 000 Total notional cash per share = $270 000 ÷ 600 000 = 45c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute the ordinary shareholders of $70 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price

33.35

Chapter 33: Insolvency and liquidation

and a notional call on the partly paid ‘B’ ordinary shares of $100 000 up to their full issue price. Thus, $270 000 is potentially available for distribution across 600 000 ordinary shares. As all those shares participate equally in the final distribution, no matter their issue price, this is equivalent to 45c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is higher than the notional refund on these shares ($90 000, i.e. 65c × 200 000 shares), the holders of those shares will have to pay $10 000 (5c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($180 000, i.e. 45c × 400 000 shares), the holders of those shares will receive a refund of $80 000 (20c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $730 000 is shared between ‘A’ ordinary shareholders — who lose $110 000 ($100 000 paid-up capital + $10 000 call) and ‘B’ ordinary shareholders – who lose $620 000 ($700 000 paid-up capital – $80 000 refund). In summary, the ordinary “A” shareholders will pay $10 000 (i.e. 5c per share held). Ordinary “B” shareholders will receive $80 000, i.e. 20c for each share held prior to the liquidation. (b) Available cash is $640 000: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $330 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $310 000 ($640 000 - $1.10 x 300 000). No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 85c $ $ $ $ $ Ordinary “A” 200 000 100 000 100 000 170 000 70 000 30 000 Ordinary “B” 400 000 700 000 100 000 340 000 240 000 460 000 600 000 800 000 200 000 510 000 310 000 490 000 Cash available (310 000) 310 000 Deficiency 490 000 . Total notional cash 510 000 Total notional cash per share = $510 000 ÷ 600 000 = 85c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute the ordinary shareholders of $310 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $100 000 up to their full issue price. Thus, $510 000 is potentially available for distribution across 600 000 ordinary shares. As all those shares participate equally in the final distribution, no matter their issue price, this is equivalent to 85c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($170 000, i.e. 85c × 200 000 shares), the holders of those shares will receive a refund of $70 000 (35c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($340 000, i.e. 85c × 400 000 shares), the holders of those shares will receive a refund of $240 000 (60c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of

33.36

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

$490 000 is shared between ‘A’ ordinary shareholders — who lose $30 000 ($100 000 paid-up capital – $70 000 refund) and ‘B’ ordinary shareholders – who lose $460 000 ($700 000 paidup capital – $240 000 refund). In summary, the ordinary “A” shareholders will receive $70 000 (i.e. 35c per share held). Ordinary “B” shareholders will receive $240 000, i.e. 60c for each share held prior to the liquidation. 3. Distribution of cash when preference shares are not preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are not preferential as to return of capital, all available cash will be allocated equally to all the shares. (a) Available cash is $400 000: No of Shares

Preference Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

300 000 200 000 400 000 900 000

Paid to

$ 300 000 100 000 700 000 1 100 000 (400 000) 700 000

Notional Notional Actual Deficiency Call Refund Refund share 66.67c $ $ $ $ - 200 000 200 000 100 000 100 000 133 333 33 333 66 667 100 000 266 667 166 667 533 333 200 000 720 000 400 000 700 000 400 000 . 600 000

Total notional cash per share = $600 000 ÷ 900 000 = 66.67c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $400 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $100 000 up to their full issue price. Thus, $600 000 is potentially available for distribution across 900 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 66.67c per share. The preference shares, being fully paid, are entitled to receive $200 000 (i.e. 66.67c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($133 333, i.e. 66.67c × 200 000 shares), the holders of those shares will receive a total refund of $33 333 (16.65c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($266 667, i.e. 66.67c × 400 000 shares), the holders of those shares will receive a refund of $166 667 (41.67c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $700 000 is shared between preference shareholders – who lose $100 000 ($300 000 paid-up capital – $300 000 refund), ‘A’ ordinary shareholders — who lose $66 667 ($100 000 paid-up capital – $33 333 refund) and ‘B’ ordinary shareholders – who lose $533 333 ($700 000 paid-up capital – $166 667 refund). It can be observed that preference shareholders also lose their premium on redemption of $30 000.

33.37

Chapter 33: Insolvency and liquidation

(b) Available cash is $640 000: No of Shares

Preference Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

300 000 200 000 400 000 900 000

Paid to

$ 300 000 100 000 700 000 1 100 000 (640 000) 460 000

Notional Notional Actual Deficiency Call Refund Refund share 93.33c $ $ $ $ - 280 000 280 000 20 000 100 000 186 667 86 667 13 333 100 000 373 333 273 333 436 667 200 000 840 000 640 000 460 000 640 000 . 840 000

Total notional cash per share = $840 000 ÷ 900 000 = 93.33c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $640 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $100 000 up to their full issue price. Thus, $600 000 is potentially available for distribution across 900 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 93.33c per share. The preference shares, being fully paid, are entitled to receive $280 000 (i.e. 93.33c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($186 667, i.e. 93.33c × 200 000 shares), the holders of those shares will receive a total refund of $86 667 (43.33c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($200 000) is lower than the notional refund on these shares ($373 333, i.e. 93.33c × 400 000 shares), the holders of those shares will receive a refund of $273 333 (68.33c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $460 000 is shared between preference shareholders – who lose $200 000 ($300 000 paid-up capital – $280 000 refund), ‘A’ ordinary shareholders — who lose $13 333 ($100 000 paid-up capital – $86 667 refund) and ‘B’ ordinary shareholders – who lose $436 667 ($700 000 paid-up capital – $273 333 refund). It can be observed that preference shareholders also lose their premium on redemption of $30 000.

33.38

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.8 Distribution to different classes of shareholders On 30 April 2023, Puppy Ltd went into voluntary liquidation. At that date, equity comprised the following. Share capital: 200 000 preference shares issued for $1 and fully paid 440 000 ordinary shares issued for $1 and fully paid 320 000 ‘A’ ordinary shares issued for $1 and paid to 60c 40 000 ‘B’ ordinary shares issued for $1 and paid to 50c

$ 200 000 440 000 192 000 20 000 852 000 (512 000)

Retained earnings (accumulated losses)

$ 340 000

Total equity

The liquidator proceeded to realise all of the company’s assets. The loss on liquidation amounted to $128 000 and, after paying sundry creditors, there was a cash balance of $212 000 available for distribution to the shareholders. (The constitution gives preference shareholders a prior claim to return of capital, and other shareholders are to rank equally, based on the number of shares held.) Required Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. (LO8) Distribution of cash: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $200 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $12 000 ($212 000 - $200 000). No of Shares

Ordinary ‘A’ ordinary ‘B’ ordinary Cash available Deficiency Total notional cash

440 000 320 000 40 000 800 000

Paid to Notional Call $ $ 440 000 192 000 128 000 20 000 20 000 652 000 148 000 (12 000) 12 000 640 000 . 160 000

Notional Refund 20c $ 88 000 64 000 8 000 160 000

Actual Deficiency Refund share (Call) $ $ 88 000 352 000 (64 000) 256 000 (12 000) 32 000 12 000 640 000

Total notional cash per share = $160 000 ÷ 800 000 = 20c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $12 000 plus a notional call on the partly paid ‘A’ ordinary shares of $128 000 up to their full issue price and a notional call on © John Wiley and Sons Australia Ltd, 2020

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Chapter 33: Insolvency and liquidation

the partly paid ‘B’ ordinary shares of $20 000 up to their full issue price. Thus, $160 000 is potentially available for distribution across 400 000 shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 20c per share. The 440 000 fully paid ordinary shares are entitled to receive $88 000 (i.e. 20c × 440 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($128 000) is higher than the notional refund on these shares ($64 000, i.e. 20c × 320 000 shares), the holders of those shares will need to pay $64 000 (20c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($20 000) is higher than the notional refund on these shares ($8 000, i.e. 20c × 40 000 shares), the holders of those shares will also need to pay a call of $12 000 (30c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $640 000 is shared between ordinary shareholders – who lose $352 000 ($440 000 paid-up capital – $88 000 refund), ‘A’ ordinary shareholders — who lose $256 000 ($192 000 paid-up capital + $64 000 further call) and ‘B’ ordinary shareholders – who lose $32 000 ($20 000 paid-up capital + $12 000 further call).

33.40

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.9 Distribution to different classes of shareholders On 1 December 2023, Submarine Ltd went into liquidation. At that date, the equity of Submarine Ltd comprised the following.

After realising the assets and paying all creditors, the liquidator had $420 000 cash available to distribute to shareholders. The order of priority provided in the constitution for repayment of capital is: (1) preference and (2) ordinary. Required 1. Prepare a statement of the distribution to shareholders supported by a detailed explanation of the apportionment of any cash among the various classes of shareholders. 2. How would the statement of the cash distribution to shareholders change if the available cash for distribution was only $300 000 after realising the assets and paying all creditors? 3. If all the shares were ranked equally according to the constitution in distributing any surplus or deficiency, how would the statement of the cash distribution to shareholders in requirements 1 and 2 change? (LO8) 1. Distribution of cash if available cash is $420 000 and preference shares are preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will receive a refund equal to their redemption value of $330 000 before the available cash can be distributed to ordinary shareholders. The remaining cash will be available to distribute to ordinary shareholders, i.e. $90 000 ($420 000 - $1.10 x 300 000). No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 65c $ $ $ $ $ Ordinary “A” 200 000 100 000 100 000 130 000 30 000 70 000 Ordinary “B” 400 000 600 000 200 000 260 000 60 000 540 000 600 000 700 000 300 000 390 000 90 000 610 000 Cash available (90 000) 90 000 Deficiency 610 000 . Total notional cash 390 000 Total notional cash per share = $390 000 ÷ 600 000 = 65c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute the ordinary shareholders of $90 000 plus

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Chapter 33: Insolvency and liquidation

a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $200 000 up to their full issue price. Thus, $390 000 is potentially available for distribution across 600 000 ordinary shares. As all those shares participate equally in the final distribution, no matter their issue price, this is equivalent to 65c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($130 000, i.e. 65c × 200 000 shares), the holders of those shares will receive a total refund of $30 000 (15c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($200 000) is lower than the notional refund on these shares ($260 000, i.e. 65c × 400 000 shares), the holders of those shares will receive a refund of $60 000 (15c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $610 000 is shared between ‘A’ ordinary shareholders — who lose $70 000 ($100 000 paid-up capital – $30 000 refund) and ‘B’ ordinary shareholders – who lose $540 000 ($600 000 paidup capital – $60 000 refund). In summary, the ordinary “A” shareholders will receive $30 000 (i.e. 15c per share held). Ordinary “B” shareholders will receive $60 000, i.e. 15c for each share held prior to the liquidation. 2. Distribution of cash if available cash is $300 000 and preference shares are preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are preferential as to return of capital, they will be entitled to a refund equal to their redemption value of $330 000 before the available cash can be distributed to ordinary shareholders. However as the total available cash after paying all creditors is only $300 000, the preference shareholders will receive $330 000 and there will be cash deficit to distribute to ordinary shareholders. No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 45c $ $ $ $ $ Ordinary “A” 200 000 100 000 100 000 90 000 (10 000) 110 000 Ordinary “B” 400 000 600 000 200 000 180 000 (20 000) 620 000 600 000 700 000 300 000 390 000 (30 000) 730 000 Cash deficit 30 000 (30 000) Deficiency 730 000 . Total notional cash 270 000 Total notional cash per share = $270 000 ÷ 600 000 = 45c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash deficit to distribute to the ordinary shareholders of $30 000 adjusted for a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $200 000 up to their full issue price. Thus, $270 000 is potentially available for distribution across 600 000 ordinary shares. As all those shares participate equally in the final distribution, no matter their issue price, this is equivalent to 45c per share. As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is higher than the notional refund on these shares ($90 000, i.e. 45c × 200 000 shares), the holders of those shares will need to made a payment of $10 000 (5c per

33.42

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($200 000) is higher than the notional refund on these shares ($180 000, i.e. 45c × 400 000 shares), the holders of those shares will need to made a payment of $20 000 (5c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $730 000 is shared between ‘A’ ordinary shareholders — who lose $110 000 ($100 000 paid-up capital + $10 000 call) and ‘B’ ordinary shareholders – who lose $620 000 ($600 000 paid-up capital + $20 000 call). Note that the ordinary shareholders will need to pay the calls to cover the deficiency in cash that was generated by the premium paid on redemption of preference shares. In summary, the ordinary “A” shareholders will pay $10 000 (i.e. 5c per share held) and lose as well their paid-up capital. Ordinary “B” shareholders will pay $20 000 (i.e. 5c for each share held prior to the liquidation) and will also lose their paid-up capital. The preference shareholders will receive $330 000 from the available cash of $300 000 plus the amount collected from ordinary shareholders ($10 000 + $20 000). 3. Distribution of cash when preference shares are not preferential as to return of capital: If the company’s constitution provides that upon winding up, preference shareholders are not preferential as to return of capital, all available cash will be allocated equally to all the shares. i. Available cash is $420 000: No of Shares

Preference Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

300 000 200 000 400 000 900 000

Paid to

$ 300 000 100 000 600 000 1 000 000 (420 000) 580 000

Notional Notional Actual Deficiency Call Refund Refund share 80c $ $ $ $ - 240 000 240 000 60 000 100 000 160 000 60 000 40 000 200 000 320 000 120 000 480 000 300 000 720 000 420 000 580 000 420 000 . 720 000

Total notional cash per share = $720 000 ÷ 900 000 = 80c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $420 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $200 000 up to their full issue price. Thus, $720 000 is potentially available for distribution across 900 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 80c per share. The preference shares, being fully paid, are entitled to receive $240 000 (i.e. 80c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($160 000, i.e. 80c × 200 000 shares), the holders of those shares will receive a total refund of $60 000 (30c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($200 000) is lower than the notional refund on these shares ($320 000, i.e. 80c × 400 000 shares), the holders of those shares will receive a refund of $120 000 (30c per share). The table

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Chapter 33: Insolvency and liquidation

above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $580 000 is shared between preference shareholders – who lose $60 000 ($300 000 paid-up capital – $240 000 refund), ‘A’ ordinary shareholders — who lose $40 000 ($100 000 paid-up capital – $60 000 refund) and ‘B’ ordinary shareholders – who lose $480 000 ($600 000 paid-up capital – $120 000 refund). It can be observed that preference shareholders also lose their premium on redemption of $30 000. ii. Available cash is $300 000: No of Shares

Preference Ordinary “A” Ordinary “B” Cash available Deficiency Total notional cash

300 000 200 000 400 000 900 000

Paid to

$ 300 000 100 000 600 000 1 000 000 (300 000) 700 000

Notional Notional Actual Deficiency Call Refund Refund share 66.67c $ $ $ $ - 200 000 200 000 100 000 100 000 133 333 33 333 66 667 200 000 266 667 66 667 533 333 300 000 600 000 300 000 700 000 300 000 . 600 000

Total notional cash per share = $600 000 ÷ 900 000 = 66.67c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $300 000 plus a notional call on the partly paid ‘A’ ordinary shares of $100 000 up to their full issue price and a notional call on the partly paid ‘B’ ordinary shares of $200 000 up to their full issue price. Thus, $600 000 is potentially available for distribution across 900 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 66.67c per share. The preference shares, being fully paid, are entitled to receive $200 000 (i.e. 66.67c × 300 000 shares). As the notional call on the ‘A’ ordinary shares to make them fully paid ($100 000) is lower than the notional refund on these shares ($133 333, i.e. 66.67c × 200 000 shares), the holders of those shares will receive a total refund of $33 333 (16.65c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($200 000) is lower than the notional refund on these shares ($266 667, i.e. 66.67c × 400 000 shares), the holders of those shares will receive a refund of $66 667 (16.65c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $700 000 is shared between preference shareholders – who lose $100 000 ($300 000 paid-up capital – $200 000 refund), ‘A’ ordinary shareholders — who lose $66 667 ($100 000 paid-up capital – $33 333 refund) and ‘B’ ordinary shareholders – who lose $533 333 ($600 000 paid-up capital – $66 667 refund). It can be observed that preference shareholders also lose their premium on redemption of $30 000.

33.44

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.10 Three main ledger accounts for liquidation Mammal Ltd went into voluntary liquidation on 30 June 2023. Its summarised statement of financial position at that date was as follows. MAMMAL LTD Statement of financial position as at 30 June 2023 Equity Share capital:

Current assets Receivables

160 000 shares issued at a price of $1, called to 50c

Inventories $ 80 000 Cash

Less: Calls in arrears (40 000 at 25c)

$ 10 00 0 12 00 0 8 000

(10 000) Non‐current assets Land Plant

40 00 0 18 00 0

Total assets Current liabilities Payables Total equity

$ 30 000

$ 70 000

Net assets

58 000 88 000 (18 000) $ 70 000

All assets realised amounted to $60 000. Calls in arrears were fully collected. Payables allowed a $1000 discount. Costs of liquidation were $5000. Required Record the above in the Liquidation account, the Liquidator’s Receipts and Payments account and the Shareholders’ Distribution account. (LO9) Liquidation Carrying amounts: Land

40 000

Plant Receivables

18 000 10 000

Liquidator’s Receipts and Payments (from sale of assets) Discount from Creditors Loss (to Shareholders’ distribution)

60 000

1 000 24 000

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Chapter 33: Insolvency and liquidation

Inventory Liquidation expense payable

12 000 5 000 85 000

Balance Liquidation (sale of assets) Calls in arrears

85 000

Liquidator’s Receipts and Payments 8 000 Liquidation expense payable 60 000 Payables 10 000

Shareholders’ distribution

78 000

Liquidation (loss) Liquidator’s Receipts and Payments

Shareholders’ Distribution 24 000 Share capital

5 000 17 000 56 000 78 000

80 000

56 000 80 000

80 000

33.46

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.11 Receipts and payments with final distribution to shareholders Jellyfish Ltd went into liquidation on 30 June 2024, its equity being as follows. 10 000 10% preference shares each fully paid at $1 5 000 first issue ordinary shares each fully paid at $1 25 000 second issue ordinary shares issued for $1 and paid to 50c Retained earnings (credit balance) of $750 The constitution states that preference shares carry the right to payment of arrears of dividends whether declared or undeclared up to the commencement of the winding up. The last preference dividend was paid to 30 June 2023. To adjust the rights of contributories, the liquidator made a call of 50c per share on the 2nd issue ordinary shares. All call money was received except that in respect of 250 2nd issue ordinary shares. This money proved to be irrecoverable and the shares were subsequently forfeited. Claims admitted for payment amounted to $8 435, assets realised $15 000, and liquidation expenses $75. Liquidator’s remuneration was fixed at 1% of gross proceeds from sale of assets. Required 1. Prepare the Liquidator’s Receipts and Payments account. 2. Provide a statement showing the final distribution to shareholders, based on the statement in the constitution that all shares, by number, rank equally on distribution of final cash. (LO8 and LO9) 1. Liquidator's Receipts and Payments Receipts $'000 Payments $'000 Proceeds on sale of assets Call on 2nd issue ordinary

15 000 12 375

Liquidation expenses Liquidator's remuneration Other claims Arrears of preference dividend Payment to: Preference First issue ordinary Second issue ordinary

27 375

75 150 8 435 1 000

4 457 2 228 11 030 27 375

2. Distribution of cash (after forfeiture of 250 second issue ordinary shares):

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Chapter 33: Insolvency and liquidation

The cash available for distribution to shareholders is determined as: $15 000 (from assets realised) + (25 000 – 250) x 50c (from the call on second issue ordinary shares) - $8435 (claim admitted for payment) - $75 (liquidation expenses) – 1% x $15 000 (liquidator’s remuneration) - 10% x 10 000 x $1 (preference dividends) = $17 715. The shares on issue consist of 10 000 preference shares, 5 000 first issue ordinary shares and 24 750 second issue ordinary shares (as 250 were forfeited for failing to pay the call). No of Shares

Preference 1st issue ordinary 2nd issue ordinary Cash available Deficiency Total notional cash

10 000 5 000 24 750 39 750

Paid to Notional Call $ 10 000 5 000 24 750 39 750 (17 715) 22 035

$ 17 715 . 17 715

Notional Refund 44.566c $ 4 457 2 228 11 030 17 715

Actual Deficiency Refund share (Call) $ $ 4 457 5 543 2 228 2 772 11 030 13 720 17 715 22 035

Total notional cash per share = $17 715 ÷ 39 750 = 44.566c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute is $17 715. As all share are fully paid now, there is no call to consider. Thus, $17 715 is available for distribution equally across 39 750 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 44.566c per share. The preference shares, being fully paid, are entitled to receive $4 457 (i.e. 44.566c × 10 000 shares). The first issue ordinary shares, being fully paid, are entitled to receive $2 228 (i.e. 44.566c × 5 000 shares). The second issue ordinary shares, being fully paid, are entitled to receive $11 030 (i.e. 44.566c × 24 750 shares). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $22 035 is shared between preference shareholders – who lose $5 543 ($10 000 paid-up capital – $4 457 refund), first issue ordinary shareholders — who lose $2 772 ($5 000 paid-up capital – $2 228 refund) and second issue ordinary shareholders – who lose $13 720 ($24 750 paid-up capital – $11 030 refund).

33.48

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.12 Order of payment of debt and shareholders’ distributions Oatmeal Ltd went into liquidation on 31 March 2023, its equity being as follows.

Debts proved and admitted for payment by the liquidator were as follows.

The land and buildings were seized by the secured creditor and sold to repay the mortgage loan. Surplus funds amounting to $5000 were forwarded to the liquidator. All other assets were sold and realised $230 000. Any calls which the liquidator may need to make are expected to be recoverable. Required Prepare the Liquidator’s Receipts and Payments account and the Shareholders’ Distribution account for Oatmeal Ltd. (Show all calculations.) (LO8 and LO9)

Liquidator's Receipts and Payments Receipts $ Payments Proceeds on sale of assets 230 000 Liquidation expenses Net proceeds from land & 5 000 Director’s salary buildings Annual leave Retrenchment payments Debentures Liquidator’s remuneration

$ 1 300 2 000 45 800 56 400 100 000 5 000 210 500

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Chapter 33: Insolvency and liquidation

Director’s salary Directors’ fees PAYG instalments Accounts payable 235 000 Total debts amount to: Secured Unsecured Cash from proceeds of sale of assets Deficiency

1 120 420 1 085 21 875 235 000

$100 000 250 500 350 500 235 000 $115 500

As there is a deficiency to pay creditors, and there is no amount to be called up on ordinary shares, the amount available is insufficient to satisfy all creditors’ claims. The deficiency must be borne in reverse order of priority. Section 556 of the Corporations Act provides that certain creditors, namely wages, annual leave and retrenchment payments, will be paid prior to the floating charge security. Cash available for unsecured creditors = $24 500 ($24 500 = $235 000 [receipts] - $210 500 [payments to debenture holders and preferential unsecured creditors]). Cash per $1 owed = $24 500 /140 000 = 17.5c per $1. Creditors

Total amount $6 400 2 400 6 200 125 000 $140 000

Director’s salary Directors’ fees PAYG instalments Accounts payable

Payment @ 17.5c $1 120 420 1 085 21 875 $24 500

Shareholders’ Distribution Deficiency

175 000 175 000

Ord. share capital

175 000 175 000

33.50

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.13 Journal entries and ledger accounts for liquidation The trial balance of Mantis Ltd on 1 June 2023, the date on which the court ordered that the company be wound up, is presented below. MANTIS LTD Trial balance as at 1 June 2023 Debit Cash Inventories Plant and machinery Land and buildings Retained earnings (accumulated losses) Accounts payable Mortgage (secured over land and buildings) Share capital: 350 000 ordinary shares issued for $1 each, fully paid

Credit

9 000 188 800 211 400 60 000 80 800 $ 160 000 40 000 350 000

$ 550 000 $ 550 000 Additional information (a) The sale proceeds of assets realised the following amounts in cash: Inventories $120 000 Plant and machinery 140 000 (b) The mortgage holder took possession of the land and buildings and sold them for $90 000 and after settlement of the debt paid any excess funds to the liquidator. (c) Liquidation costs amounted to $19 000. (d) The liquidator paid all liabilities. Required 1. Prepare journal entries to wind up the affairs of Mantis Ltd. 2. Prepare the Liquidation account, the Liquidator’s Receipts and Payments account and the Shareholders’ Distribution account. (LO9) 1. Liquidation Dr Inventory Cr Plant & Machinery Cr (Transfer asset carrying amounts to liquidation)

400 200

Liquidator’s Receipts and Payments Liquidation (Sale of assets)

260 000

Dr Cr

188 800 211 400

260 000

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Chapter 33: Insolvency and liquidation

Liquidation Liquidator’s Costs Payable (Recognition of liability to liquidator)

Dr Cr

19 000 19 000

Liquidator’s Receipts and Payments Dr Mortgage on Land & Buildings Dr Land & Buildings Cr Liquidation (gain on sale: $90 000 - $60 000) Cr (Gain on sale of land & buildings by mortgage holder)

50 000 40 000

Liquidator’s Costs Payable Accounts payable Liquidator’s Receipts and Payments (Payment of liabilities)

Dr Dr Cr

19 000 160 000

Liquidation Dr Accumulated Losses Cr (Transfer of accumulated losses to liquidation)

80 800

60 000 30 000

179 000

80 800

Note: Cash in = $9 000 + $260 000 + $50 000 = $319 000 less cash out $179 000 = $140 000 left. Share Capital – Ordinary Shares Dr 350 000 Shareholders’ Distribution Cr (Transfer share capital account to shareholders’ distribution)

350 000

Shareholders’ Distribution Liquidator’s Receipts and Payments (Payment to shareholders)

Dr Cr

140 000 140 000

Shareholders’ Distribution Liquidation (Transfer of deficiency from liquidation)

Dr Cr

210 000 210 000

2. Carrying amounts of assets: Inventories Plant and machinery Liquidation costs payable Accumulated losses

Liquidation Proceeds on sale of assets: $188 800 Inventories 211 400 Plant and machinery 19 000 Gain on sale of L&B 80 800 Shareholders’ distribution $500 000

$120 000 140 000 30 000 210 000

$500 000

33.52

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Liquidator’s Receipts and Payments Opening balance $9 000 Payments: Liquidation costs payable Proceeds on sale of Accounts payable assets: Inventories 120 000 Plant and machinery 140 000 Shareholders’ distribution Land & buildings 50 000 $319 000 Liquidator’s Receipts and Payments Liquidation

Shareholders’ distribution $140 000 Share capital – ordinary shares 210 000 $350 000

$19 000 160 000

140 000

$319 000

$350 000

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Chapter 33: Insolvency and liquidation

Exercise 33.14 Summary of affairs The trial balance below is of Flower Ltd’s accounts as at 30 June 2023. FLOWER LTD Trial balance as at 30 June 2023 Debit Share capital Calls in arrears (on 16 000 shares) Calls in advance Revaluation surplus Retained earnings Land Buildings Accumulated depreciation — buildings Plant Accumulated depreciation — plant Cash at bank Inventories Accounts receivable Bills receivable Goodwill 12% debentures Mortgage payable Secured creditor (for plant) Unsecured creditors

Credit $

630 000

4 000 3 000 5 000 145 000 182 000 300 000 72 000 340 000 40 000 30 000 100 000 95 000 80 000 50 000 200 000 220 000 50 000 106 000

$ 1 326 000 $ 1 326 000

Share capital consisted of 700 000 ordinary shares, issued at a price of $1 and called to 90c. It was decided on 30 June 2023 to wind up Flower Ltd. Additional information • Debentures are secured by circulating security interest; mortgage is secured over buildings. • Assets are estimated to realise the following amounts.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Land Buildings Inventories Plant Bills receivable Accounts receivable Calls in arrears Goodwill

180 000 200 000 70 000 200 000 58 000 87 000 3 000 —

•

There is an impending lawsuit against the company. Expected damages payout is $30 000.

•

Unsecured creditors comprise the following. Accounts payable GST Director’s salary Directors’ fees Local government rates

85 000 4 000 7 000 6 000 4 000

106 000

Required Present a summary of affairs for sending to creditors. (LO9)

Companies Form 509 Summary of affairs Assets and liabilities as at 30 June 2023 Valuation 1. Assets not specifically charged (a) Interests in land (b) Sundry debtors: Debtors Bill receivable Calls in arrears (c) Cash on hand (d) Cash at bank (e) Stock as detailed in inventory (f) Work in progress (g) Plant and equipment (h) Other assets: Goodwill

$182 000 95 000 80 000 1 000 30 000 100 000 50 000 541 000

Estimated Realisable Value $180 000 87 000 58 000 3 000 30 000 70 000 428 000

2. Assets subject to specific charges

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Chapter 33: Insolvency and liquidation

Plant Less Secured creditor Buildings Less Mortgage payable Total assets Total estimated realisable value 3. Less preferential creditors entitled to priority over the holders of debentures under floating charge Director's salary

300 000 50 000 228 000 220 000

250 000

150 000

8 000 799 000

578 000 578 000

4 000 574 000

4. Less amounts owing and secured by debenture or floating charge over company's assets 12% debentures 5. Less Preferential creditors Estimated amount available for unsecured creditors 6. Creditors (unsecured) Trade creditors GST Local government rates Director’s salary Directors’ fees 7. Balances owing to partly secured creditors Mortgages (total claim) Security held (building) 8. Contingent assets 9. Contingent liabilities Estimated surplus (Subject to costs to liquidation) Share capital Issued: 350 000 ordinary shares at $1 Paid-up: 342 000 shares paid to 90c 8 000 shares paid to 65c

200 000 374 000 374 000

85 000 4 000 4 000 3 000 6 000

220 000 200 000

20 000

122 000 252 000 252 000

700 000 615 600 10 400

700 000

626 000

33.56

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.15 Ledger accounts for liquidation A court order for the winding up of Salamander Ltd was made on 31 March 2023. A statement of financial position prepared on that date was as follows. SALAMANDER LTD Statement of financial position as at 31 March 2023 Current assets Cash at bank Cash in hand Accounts receivable Inventories

4 000 300 46 500 49 500 $ 100 30 0

Total current assets Non‐current assets 96 200 30 000 39 500

Plant and equipment (net) Land and buildings (net) Goodwill Total non‐current assets

165 70 0

Total assets

266 00 0

Current liabilities Accounts payable

29 300

PAYG tax instalments

5 700

Accrued expenses

5 000 40 000

Total current liabilities Non‐current liabilities 2000 $20 10% debentures 11% mortgage on land and buildings

40 000 20 000

Total non‐current liabilities

60 000

Total liabilities

100 00 0 $ 166 00 0

Net assets

33.57

Chapter 33: Insolvency and liquidation

Share capital 20 000 7% cumulative preference shares issued for $2, called to $1.50 each 100 000 ordinary shares issued for $2, called to $1.50 each Less: Calls in arrears: 2000 ordinary shares at 50c

30 000 150 000

180 00 0 (1 000) 179 00 0

Reserves Retained earnings

(13 000) $ 166 00 0

Total equity

Note: Arrears of preference dividends amounted to $4200. Additional information • Accrued expenses included the following.

• Assets are expected to realise the following amounts.

• The mortgage holder took possession of the land and buildings and sold them for $60 000, paying any surplus to the liquidator. • The debentures are secured by a circulating security interest over the assets of Salamander Ltd. • On 1 May 2023, the liquidator realised the assets in (b) for the above amounts. The balance of the unpaid calls was treated as irrecoverable and the shares were forfeited. • On 1 June 2023, the liquidator paid all liabilities and adjusted the rights of shareholders. The constitution, regarding rights of shareholders in a winding up, gives preference shareholders a right to receive arrears of dividend. • Uncalled capital (where required to be called up) proved to be recoverable. • The winding up of the company was completed on 1 July 2023, costs of liquidation being $3000. Required 1. Prepare the Liquidation account and the Shareholders’ Distribution account (show clearly any working in relation to final distribution to shareholders). 2. Prepare the Liquidator’s Receipts and Payments account. (LO9)

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1. Liquidation Proceeds from sale of assets: 46 500 Accounts receivable 49 500 Inventories 96 200 Plant and equipment 39 500 Gain on disposal of secured asset (land and building) 3 000 4 200

Carrying amount of assets: Accounts receivable Inventories Plant and equipment Goodwill Liquidation expenses Arrears of preference dividend

Forfeited shares reserve 13 000 Share of deficiency: Preference Ordinary 251 900

Retained earnings

Shareholders’ Distribution* Share capital: 27 563 Preference 136 437 Ordinary

Share of deficiency: Preference Ordinary Return of capital to: Preference Ordinary

2 437 12 063 178 500

16 400 10 500 30 000 30 000

1 000 27 563 136 437 251 900

30 000 148 500

178 500

*After forfeiture of 1 000 ordinary shares. The cash available for distribution to shareholders is determined as: $4 300 (cash) + $16 400 (accounts receivable realised) + $10 500 (inventories realised) + $30 000 (P&E realised) + ($60 000 - $20 000 mortgage - $1 000 interest) (realised gain on disposal of land & building) + $500 (calls) - $40 800 (debentures and interest) - $3 200 (salary) - $29 300 (accounts payable) - $5 700 (PAYG tax) - $3 000 (liquidation expenses) - $4 200 (preference dividends) = $14 500. The shares on issue consist of 20 000 preference shares, 10 000 first issue ordinary shares and 49 500 second issue ordinary shares (as 500 were forfeited for failing to pay the call). Distribution of cash (after forfeiture of 1 000 ordinary shares for not paying calls in arrears):

Preference

No of Shares

Paid to Notional Call

20 000

$ 30 000

$ 10 000

Notional Refund 62.185c $ 12 437

Actual Deficiency Refund share (Call) $ $ 2 437 27 563

33.59

Chapter 33: Insolvency and liquidation

Ordinary Cash available Deficiency Total notional cash

99 000 148 500 119 000 178 500 (14 500) 164 000

49 500 59 500 14 500 . 74 000

61 563 74 000

12 063 136 437 14 500 164 000

Total notional cash per share = $74 000 ÷ 119 000 = 62.185c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $14 500 plus a notional call on the partly paid preference shares of $10 000 up to their full issue price and a notional call on the partly paid ordinary shares of $49 500 up to their full issue price. Thus, $74 000 is potentially available for distribution across 119 000 shares (after 1 000 shares were forfeited). As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 62.185c per share. As the notional call on the preference shares to make them fully paid ($10 000) is lower than the notional refund on these shares ($12 437, i.e. 62.185c × 20 000 shares), the holders of those shares will receive a refund of $2 437 (12.185c per share). As the notional call on the ‘ordinary shares to make them fully paid ($49 500) is lower than the notional refund on these shares ($61 563, i.e. 62.185c × 99 000 shares), the holders of those shares will receive a refund of $12 063 (12.185c per share). The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $164 000 is shared between preference shareholders – who lose $27 563 ($30 000 paid-up capital – $2 437 refund) and ordinary shareholders – who lose $136 437 ($148 500 paid-up capital – $12 063 refund). 2. Liquidator's Receipts and Payments Receipts $ Payments Balance of cash 4 300 Liquidation expenses Proceeds on sale of Debentures and interest assets: Salaries Accounts receivable 16 400 Accounts payable Inventories 10 500 PAYG tax instalment Plant and equipment 30 000 Arrears of preference dividend Net amount received from 39 000 secured creditors Calls in arrears (ordinary) 500 Return of capital: Preference Ordinary 100 700

$ 3 000 40 800 3 200 29 300 5 700 4 200 86 200

2 437 12 063 100 700

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.16 Order of payment of debts, journal entries for liquidation surplus Glowworm Ltd went into voluntary liquidation on 30 June 2024. The statement of financial position prepared on that date is as follows. GLOWWORM LTD Statement of financial position as at 30 June 2024 Current assets Cash Inventories Accounts receivable Less: Allowance for doubtful debts Non‐current assets Plant and equipment Less: Accumulated depreciation — plant and equipment

$ 32 000 126 000 $ 72 200 (8 200)

64 000

336 000 (70 400)

265 600

Land Shares in listed companies

181 200 104 000

Total assets

772 800

Current liabilities Accounts payable Other payables

86 400 32 200

Non‐current liabilities Mortgage on land Debentures

170 000 300 000

Total liabilities

588 600 $ 184 200

Net assets Equity Share capital: Preference: 40 000 shares, issued at $1, fully paid Ordinary ‘A’ 50 000 shares, issued at $1, fully paid Ordinary ‘B’ 40 000 shares, issued at $1, called to 60c

40 000 50 000 24 000

114 000 14 000 56 200

General reserve Retained earnings

$ 184 200

Total equity

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Chapter 33: Insolvency and liquidation

Additional information • Liquidator’s remuneration and expenses amounted to $3600. • Other payables of $32 200 comprised the following. Inventories Accounts receivable Plant and equipment Shares in listed companies

108 000 52 000 268 000 122 000

• The debentures are secured by a circulating security interest over the company’s assets. • The mortgage holder took possession of the land and sold it for $163 400. • Other assets realised the following amounts. Inventories Accounts receivable Plant and equipment Shares in listed companies

108 000 52 000 268 000 122 000

• Uncalled capital (if required to be called up) is recoverable. • Preference shareholders are preferential as to dividends and return of capital. The constitution does not provide any further rights for preference shareholders. • In relation to return of capital, Ordinary ‘A’ shareholders and Ordinary ‘B’ shareholders rank equally after preference shareholders. Required 1. List the debts paid by the liquidator in their order of priority of payment. 2. Prepare journal entries to wind up Glowworm Ltd. (LO7 and LO9) 1. Order of priority of payment of debts: 1. Liquidator’s remuneration & expenses $3 600 2. Mortgage on land (secured by a non-circulating security interest) 163 400 3. Debentures (secured by a circulating security interest)) 300 000 4. Salary & wages payable (12 000 + 4 000) 16 000 5. Annual leave payable 8 800 6. Ordinary unsecured: Mortgage loan – balance $6 600 Director’s salary – balance 1 600 Accounts payable 86 400 Income tax payable 4 000 Telephone bill payable 1 800 100 400 2. Journal entries: Liquidation Dr Inventory Cr Accounts receivable Cr Plant & equipment Cr Shares in listed companies Cr (Transfer asset carrying amounts to liquidation) © John Wiley and Sons Australia Ltd, 2020

638 200 126 000 72 200 336 000 104 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Allowance for doubtful debts Accum. deprec. – plant & equipment Liquidation (Transfer contra-assets to liquidation)

Dr Dr Cr

8 200 70 400

Liquidation Dr Liquidator’s remun. & expenses payable Cr (Recognition of liability to liquidator)

3 600

Liquidation (loss on sale) Mortgage on land Land (Loss on sale of land by mortgage holder)

Dr Dr Cr

78 600

3 600

17 800 163 400 181 200

Liquidator’s receipts and payments Dr 550 000 Liquidation Cr (Sale of assets = $108 000 + $52 000 + $268 000 + $122 000) General reserve Retained earnings Liquidation (Transfer of reserves to liquidation)

Dr Dr Cr

14 000 56 200

Liquidator’s remun & expenses payable Mortgage on land Debentures Accounts payable Other payables Liquidator’s receipts and payments (Payment of liabilities in order of priority)

Dr Dr Dr Dr Dr Cr

3 600 6 600 300 000 86 400 32 200

550 000

70 200

428 800

Note: Cash in = $32 000 + $550 000 = $582 000 less cash out $428 800 = $153 200 left. Share capital – preference Dr Share capital – ordinary ‘A’ Dr Share capital – ordinary ‘B’ Dr Shareholders’ distribution Cr (Transfer capital accounts to shareholders’ distribution)

40 000 50 000 24 000

Shareholders’ distribution Liquidator’s receipts and payments (Payment firstly to preference shareholders)

Dr Cr

40 000

Liquidation Shareholders’ distribution (Transfer of surplus from liquidation)

Dr Cr

39 200

114 000

40 000

Shareholders’ distribution Dr 113 200 Liquidator’s receipts and payments Cr (Payment of surplus on liquidation to ordinary shareholders)

39 200

113 200

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Chapter 33: Insolvency and liquidation

Distribution of cash ($153 200 less payment to preference shareholders $40 000 = $113 200): No of Paid to Notional Notional Actual Surplus Shares Call Refund Refund share $1.43556 $ $ $ $ $ Ordinary ‘A’ 50 000 50 000 - 71 778 71 778 21 778 Ordinary ‘B’ 40 000 24 000 16 000 57 422 57 422 17 422 90 000 74 000 16 000 129 200 113 200 39 200 Cash available (113 200) 113 200 Surplus 39 200 . Total notional cash 129 200 Total notional cash per share = $129 200 ÷ 90 000 = $1.43556c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available to distribute of $113 200 plus a notional call on the partly paid ‘B’ ordinary shares of $16 000 up to their full issue price. Thus, $129 200 is potentially available for distribution across 90 000 ordinary shares. As all shares participate equally in the final distribution, no matter their issue price, this is equivalent to 1.43556c per share. As the ‘A’ ordinary shares are fully paid, the holders of those shares will receive a refund of $71 778 (1.43556c per share). As the notional call on the ‘B’ ordinary shares to make them fully paid ($16 000) is lower than the notional refund on these shares ($57 422, i.e. 1.43556c × 40 000 shares), the holders of those shares will receive a refund of $41 422. The table above also shows that, as a result of the final distribution to shareholders, the total surplus of funds to contributories of $39 200 is shared between ordinary ‘A’ shareholders – who receive $21 778 (on top of the refund of their contribution of $50 000) and ordinary ‘B’ shareholders – who receive $17 422 (on top of the refund of their contribution of $40 000).

33.64

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.17 Sale of assets, final distribution to shareholders As a result of a court order, Spider Ltd went into liquidation on 30 June 2023. A statement of financial position prepared on that date was as follows. SPIDER LTD Statement of financial position as at 30 June 2023 Equity Share capital: 80 000 preference shares, issued at $2 and paid to $1 136 000 ‘A’ ordinary shares, issued for $2, called to $1.50 100 000 ‘B’ ordinary shares, issued for $1, called to 75c

$ 80 000 204 000 75 000 359 000

Less: Calls in arrears: 24 000 ‘A’ ordinary shares 2400 ‘B’ ordinary shares

(6 000) (600)

(6 600)

Calls in advance: 4000 ‘A’ ordinary shares at 50c General reserve Retained earnings (accumulated losses)

352 400 2 000 51 600 (26 000)

Total equity

$ 380 000

Current assets Cash

1 800

Accounts receivable

111 000

Allowance for doubtful debts

(2 000)

109 000

Inventories

39 200

Total current assets

150 000

Non‐current assets 140 000

Land Buildings

432 000

Less: Accumulated depreciation — buildings

(326 000)

Plant and equipment

210 000

Less: Accumulated depreciation — plant and equipment

(160 000)

106 000 50 000

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Chapter 33: Insolvency and liquidation

Goodwill

44 000

Less: Accumulated impairment losses — goodwill

(8 000)

36 000

Total non‐current assets

332 000

Total assets

482 000

Current liabilities Loan (unsecured)

12 000

Creditors and accruals

50 000

Total current liabilities

62 000

Non‐current liabilities Mortgage (secured on land and buildings)

40 000

Total non‐current liabilities

40 000

Total liabilities

102 000

Net assets

$ 380 000

Additional information (a) The company’s constitution was silent as to return of capital in the event of a winding up. (b) The mortgage holder took possession of the land and buildings, sold them for $286 000, paid off the mortgage plus interest owing of $1600 and refunded the difference to the liquidator. (c) The liquidator was able to realise the following amounts for the assets.

(d)

The ledger account Creditors and Accruals comprised the following.

(e) Additional liabilities accepted by the liquidator and not yet recorded were as follows.

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(f) All calls in arrears were received by the liquidator, except from 4000 ‘A’ ordinary shares. These shares were forfeited. (g) Calls in advance were not paid back before the final distribution by the liquidator. Uncalled capital (where required to be called up) on final distribution proved to be recoverable. (h) Liquidation expenses amounted to $7600. Required 1. Prepare the journal entry in Spider Ltd’s records to record the sale by the mortgage holder of the land and buildings, and the receipt of any net cash from the mortgage holder. 2. Prepare the Liquidation account. 3. Show all workings for calculation of the final distribution of deficiency or surplus to shareholders. 4. Prepare the Liquidator’s Receipts and Payments account, showing clearly the order of priority of payment of liabilities. (LO7, LO8 and LO9) 1. Journal entry for secured creditor: Liquidator’s receipts and payments Dr 244 400 Mortgage payable Dr 40 000 Interest payable** Dr 1 600 Accum. depreciation - buildings Dr 326 000 Buildings Cr 432 000 Land Cr 140 000 Liquidation Cr 40 000 ** Assumes interest recognised by liquidator. If not, then gain on liquidation is $38 400. 2. Accounts receivable Inventories Plant and equipment

Goodwill Liquidation expenses Interest on mortgage

Liquidation 111 000 Allowance for doubtful debts 39 200 Accum, depreciation – plant and equipment 210 000 Accum, impairment losses - goodwill Gain - sale land and buildings 44 000 General reserve 7 600 Cash: Sale of assets 1 600 Forfeited shares reserve

2 000 160 000 8 000 40 000 51 600 190 000 5 000

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Chapter 33: Insolvency and liquidation

Directors’ salaries Retrenchment Wages Accumulated losses

62 000 40 000 S/H distrib 270 000 26 000 -

Preference ‘A’ ordinary ‘B’ ordinary

811 400

456 600 116 616 192 415 45 769 811 400

Entry to forfeit 4 000 shares: Share capital ‘A’ ordinary Call Forfeited shares reserve

Dr Cr Cr

6 000 1 000 5 000

3. Distribution of cash after forfeiture of 4 000 ‘A’ ordinary shares. ‘A’ ordinary shares with calls in advance are treated separately. The cash available to be distributed to the shareholders can be calculated based on the amounts recognised in the Liquidator's statement of receipts and payments below and it is $441 800 $441 600 = $200. If the constitution is silent as to return of capital in the event of a winding up, it is considered that all shares will rank equally. However, as there were some ‘A’ ordinary shares with calls received in advance that made them fully paid, they will be presented separately from the other ‘A’ ordinary shares in the distribution table. Also, some ‘A’ ordinary shares were forfeited and therefore the number of the other ‘A’ ordinary shares is 136 000 - 4 000 (forfeited) - 4 000 (calls in advance) = 128 000. No of Shares

Paid to Notional Call

$ $ 80 000 80 000 80 000 128 000 192 000 64 000 4 000 8 000 100 000 75 000 25 000 312 000 355 000 169 000 Cash available (200) 200 Deficiency 354 800 . Total notional cash 169 200 Preference ‘A’ Ord ‘A’ Ord in adv. ‘B’ Ord

Notional Refund 54.231c $ 43 384 69 416 2 169 54 231 169 200

Actual Deficiency Refund share (Call) $ $ (36 616) 116 616 5 416 186 584 2 169 5 831 29 231 45 769 200 354 800

Total notional cash per share = $169 200 ÷ 312 000 = 54.231c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $200 plus a notional call on the partly paid preference shares of $80 000 and also on the partly paid ‘A’ ordinary shares of 128 000 x 50c and on the partly paid ‘B’ ordinary shares of 100 000 x 25c up to their full issue price. Thus, $169 200 is potentially available for distribution across the 312 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 54.231c per share. As the notional call on the preference shares to make them fully paid ($80 000) is greater than the notional

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

refund on these shares ($43 384, i.e. 54.231c × 80 000 shares), the holders of those shares will need to pay $36 616. As the notional call on the partly paid ‘A’ ordinary shares to make them fully paid ($64 000) is lower than the notional refund on these shares ($69 416, i.e. 54.231c × 128 000 shares), the holders of those shares will be not be called to pay the remainder of the nominal value of the share and instead will receive a refund of $5 416 from the total contributed prior to the liquidation of $192 000. The holders of the ‘A’ ordinary shares that paid the calls in advance will receive a refund of $5 831. As the notional call on the partly paid ‘B’ ordinary shares ($25 000) is lower than the notional refund on these shares ($54 231, i.e. 54.231c × 100 000 shares), the holders of those shares will receive a refund of $29 231. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $354 800 is shared between preference and ordinary shareholders.

4. Liquidator’s Receipts and Payments Receipts Payments Balance 1 800 Liquidation expenses Cash from mortgage holder 244 400 Salaries - directors. Sale of assets 190 000 Wages – employees Call on ‘A’ ordinary 5 000 Worker’s compensation Call on ‘B’ ordinary 600 Annual leave 441 800 Retrenchment Call on preference 36 616 Unsecured - loan Trade creditors Company tax Salaries - directors Annual leave Refund: ‘A’ ordinary ‘B’ ordinary 478 416

7 600 4 000 270 000 10 000 1 500 40 000 12 000 16 000 20 000 58 000 2 500 441 600 7 585 29 231 478 416

33.69

Chapter 33: Insolvency and liquidation

Exercise 33.18 Ledger accounts for liquidation Hornet Ltd went into voluntary liquidation on 1 January 2024, at which date the statement of financial position was as shown below. HORNET LTD Statement of financial position as at 1 January 2024 Liabilities and equity Share capital:

Assets Land and buildings (net) Plant (net)

200 000 ordinary shares fully paid Retained earnings Mortgage loan Debentures Bank overdraft Accounts payable Other payables

$ 230 000 50 000 750 000 50 000 40 000 40 000 24 000

Fixed deposit Accounts receivable Investments Inventories

$ 464 000

$ 125 000 200 000 5 000 49 000 25 000 60 000

$ 464 000

Additional information (a) Creditors were called on to prove their debts. The liquidator discovered that: • Debenture interest of $3750 was due on 1 January 2024 • The Hive Bank holds a mortgage over the plant as security against the overdraft; as the bank has waived its right to seize the plant, the liquidator has undertaken to sell the asset and repay the overdraft • The mortgage loan is secured over land and buildings; the mortgagee has decided to sell the assets to recover the amount owing • The debentures are secured by a circulating security interest over inventories • Other payables comprise loans from directors, made on 1 December 2023. (b) Assets realised the following amounts. Land and buildings Less: Rates and selling expenses Less: Mortgage loan

200 000 (8 000) (750 000)

$ 117 000 195 000 6 000 45 000

Plant and equipment Fixed deposit Accounts receivable

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15 000 50 000

Investments Inventories

$ 428 000

(c) The liquidator made the following payments. Debentures Debenture interest Bank overdraft Accounts payable (in full settlement) Other payables Additional amounts not recorded in the records: Liquidator’s remuneration Liquidation expenses Holiday pay — employee Retrenchment payment — employee Income tax penalty

50 000 3 750 40 000 38 000 24 000 12 500 5 500 2 000 5 000 1 500

$ 182 250 Required 1. Prepare the Liquidation account. 2. Prepare the Liquidator’s Receipts and Payments. 3. Prepare the Shareholders’ Distribution account. (LO9) 1. Liquidation Carrying amount of assets: Proceeds from sale of assets: Accounts receivable 49 000 Accounts receivable 45 000 Inventory 60 000 Inventory 50 000 Plant 200 000 Plant 195 000 Fixed deposit 5 000 Fixed deposit 6 000 Investments 25 000 Investments 15 000 Liquidation expenses 5 500 Gain on sale of land and 67 000 buildings* Liquidator’s remuneration 12 500 Discount accounts payable 2 000 Interest – debentures 3 750 Retained earnings 5 000 Retrenchment payment 5 000 Income tax penalty 1 500 Holiday pay 2 000 369 250 Shareholders’ distribution 15 750 (surplus) 385 000 385 000 *Gain on sale of land & building = $200 000 (sale proceeds) - $8 000 (rates & selling expenses) = $192 000 (net sale proceeds) - $125 000 (carrying amount) = $67 000. © John Wiley and Sons Australia Ltd, 2020

33.71

Chapter 33: Insolvency and liquidation

2. Receipts Land and buildings Plant Fixed deposit Accounts receivable Investments Inventory

Liquidator's Receipts and Payments $ Payments 117 000 Liquidation expenses 195 000 Bank overdraft 6 000 Debentures + interest 45 000 Liquidator's remun 15 000 Holiday pay 50 000 Retrench payment Unsecured: Other payables Accounts payable Income tax penalty

$ 5 500 40 000 53 750 12 500 2 000 5 000

428 000

24 000 38 000 1 500 182 250 245 750 428 000

Shareholders’ Distribution Share capital 245 750 Liquidation

230 000 15 750

Shareholders' distribution

Liquidator's receipts and payments

245 750

33.72

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.19 Ledger accounts, given a report as to affairs Mandarinia Ltd went into liquidation on 31 March 2023. The report as to affairs prepared at that date is shown below. MANDARINIA LTD Report as to affairs as at 31 March 2023

(1) Assets not specifically charged: Calls in arrears (1000 ordinary shares at 25c) Cash on hand Sundry debtors

Valuation

Estimated realisable value

Inventories

250 50 24 40 0 51 90 0

200 50 18 100 17 940

76 60 0

36 290

15 50 0

16 400

$ 92 10 0

$ 52 690

(2) Assets subject to specific charge Carryin g amount

Estimated realisable value

Land

$ 40 000

Less: Mortgage and accrued interest

24 500

$ 40 90 0 24 50 0

Total estimated realisable value

$ 52 690

(3) Less: Preferential creditors entitled to priority over the holders of a floating charge

(600)

(4) Less: Amount owing under floating charge - overdraft

52 090 (19 440)

(5) Less: Other preferential claims

32 650 (1 400) 31 250

33.73

Chapter 33: Insolvency and liquidation

(6) Less: Unsecured creditors —ordinary

(13 450)

Estimated surplus subject to liquidation expenses

$ 17 800

Share capital Paid‐up capital: Issued preference shares: 42 000 shares fully paid at $1 Issued ordinary shares: 60 000 shares called to 60c, issued for $1

$ 42 000 36 000

Called capital Calls on ordinary shares paid in advance: 4000 shares at 40c each

78 000 1 600 $ 9 600 ($ 22 39) 0

Balance of retained earnings, 31/3/23

Except for the return of capital to shareholders, liquidation of the company was completed at 30 September 2023. The Liquidator’s Receipts and Payments account for the 6 months ended 30 September 2023 is shown below.

The mortgage holder had taken possession of the land, sold it for $49 000, and paid the residue to the liquidator after fully satisfying the mortgage claim. Preference shares are preferred to return of capital. All uncalled capital proved recoverable. Required Prepare the Liquidation account and the Shareholders’ Distribution account as they will appear after repayment of capital. (LO9)

Carrying amount of assets: Receivables Inventory Liquidator's expenses & remuneration Interest on mortgage

Liquidation Proceeds on sale of assets: 24 400 51 900

Receivables Inventory Creditors (discount) 3 530 Gain on disposal of secured asset (land) 500 Share of deficiency

17 260 34 020 40 9 000

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Retained earnings

22 390

Ordinary Preference

102 720 Liquidation (deficiency): Ordinary Cash payments: Ordinary (calls in advance refund) Preference

42 400 102 720

Shareholders' Distribution Share capital: 42 400 Preference Ordinary (after final call)*

42 000 41 973

1 173 Calls in advance - ordinary

1 600

42 000 85 573

85 573

*$41 973 = $37 600 - $1 600 (calls in advance) + $5 973 (call – see table below). Distribution of cash (showing shares with calls in advance separately) after payment to preference shareholders = $37 200 - $42 000 = ($4 800): After paying the preference shareholders, we already have a cash deficit of $4 800. However, given that we have shares with uncalled instalments, it makes sense to calculate the distribution of this deficiency. Some ordinary shares paid calls in advance (i.e. 4 000 shares), so they are presented separately from the other ordinary shares as they are fully paid. No of Paid to Notional Notional Actual Deficiency Shares Call Refund Refund share 29.333c (Call) $ $ $ $ $ Ordinary 4 000 4 000 1 173 1 173 2 827 Ordinary 56 000 33 600 22 400 16 427 (5 973) 39 573 60 000 37 600 22 400 17 600 (4 800) 42 400 Cash deficit 4 800 (4 800) Deficiency 42 400 . Total notional cash 17 600 Total notional cash per share = $17 600 ÷ 60 000 = 29.3333c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash deficit to distribute to the ordinary shareholders of $4 800 (as a result of the payment to preference shareholders) adjusted for a notional call on the partly paid ordinary shares of $22 400 (40c x (60 000 shares – 4 000 shares)) up to their full issue price. Thus, $17 600 is potentially available for distribution across the 60 000 ordinary shares. As all those shares participate equally in the final distribution, no matter whether they paid calls in advance or not, this is equivalent to 29.3333c per share. AS the shares with calls in advance are fully paid, they are entitled to a refund of $1 173. As the notional call on the ordinary shares that did not pay the call in advance to make them fully paid ($22 400) is higher than the notional refund on these shares ($16 427, i.e. 29.3333c × 56 000 shares), the holders of those shares will need to made a payment of $5 973. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $42 400 is shared

33.75

Chapter 33: Insolvency and liquidation

between ‘shareholders that paid the calls in advance — who lose $2 827 ($4 000 paid-up capital - $1 173 refund) and the other ordinary shareholders – who lose $39 573 ($33 600 paid-up capital + $5 973 call). Note that these ordinary shareholders will need to pay the calls to cover the deficiency in cash that was generated by the redemption of preference shares. In summary, the ordinary shareholders that paid calls in advance will receive a refund of $1 173. The other ordinary shareholders will pay $5 973. The preference shareholders will receive $42 000 from the available cash of $37 200 plus the amount collected from ordinary shareholders ($5 973 - $1 173).

33.76

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.20 Journal entries and ledger accounts for liquidation The trial balance of Mouse Ltd on 1 September 2024, the date on which the court ordered that the company be wound up, is presented below. MOUSE LTD Trial balance as at 1 September 2024 Debit Bank overdraft (secured over land and buildings) Accounts payable Accrued expenses Unsecured notes Debentures (secured by a circulating security interest over the company’s assets) Share capital: 7% preference issued at $1 ‘A’ ordinary issued at $1 ‘B’ ordinary issued at $1 ‘C’ ordinary issued at $1 Allowance for doubtful debts Accumulated depreciation — vehicles Accumulated depreciation — plant and equipment Cash Accounts receivable Inventories Shares in Bee Pty Ltd Vehicles Plant and equipment Land and buildings (net) Goodwill Retained earnings

Credit $ 114 000 91 000 2 000 150 000 200 000 50 000 200 000 40 000 20 000 1 000 17 000 40 000

100 97 000 146 400 17 500 29 000 181 000 250 000 24 000 180 000

$ 925 000 $ 925 000 Additional information (a) Share capital consisted of the following. 50 000 7% preference shares fully paid 200 000 ‘A’ ordinary shares fully paid 100 000 ‘B’ ordinary shares paid to 40c 100 000 ‘C’ ordinary shares paid to 20c © John Wiley and Sons Australia Ltd, 2020

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Chapter 33: Insolvency and liquidation

The constitution provided that preference shareholders were preferential as to return of capital in a winding up, and ‘C’ ordinary shareholders were deferred as to return of capital until all other classes of shares had been paid in full. (b) Proceeds from sale of assets (the bank agreed to allow the liquidator to sell the land and buildings) were as follows.

(c) Calls on shares: The liquidator called up the uncalled balance on ‘B’ ordinary shares and ‘C’ ordinary shares. Holders of 10 000 ‘C’ ordinary shares and 10 000 ‘B’ ordinary shares failed to pay the call and these shares were subsequently forfeited. (d) Payments made by liquidator after negotiation with creditors were as follows.

Required 1. Prepare journal entries to wind up the affairs of Mouse Ltd. 2. Prepare the Liquidation account, the Liquidator’s Receipts and Payments account and the Shareholders’ Distribution account, clearly showing the share of cash for each class of shares. (LO9) 1. Liquidation Accounts receivable Inventory Shares in Bee Pty Ltd Vehicles Plant and equipment Land and buildings Goodwill (Asset accounts transferred to liquidation)

Dr Cr Cr Cr Cr Cr Cr Cr

744 900

Accum. deprec. - vehicles Accum. deprec. - plant and equipment Allowance for doubtful debts Liquidation (Contra-assets transferred)

Dr Dr Dr Cr

17 000 40 000 1 000

97 000 146 400 17 500 29 000 181 000 250 000 24 000

58 000

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Liquidator’s receipts and payments Liquidation (Proceeds on sale of assets)

Dr Cr

547 000 547 000

Liquidation Dr 18 800 Liquidation expenses payable Cr 2 100 Liquidator’s remun. payable Cr 4 000 Bank overdraft Cr 2 000 Accrued expenses Cr 200 Unsecured notes Cr 4 500 Debentures Cr 6 000 (Unrecorded liabilities, debited to liquidation account and representing interest on unsecured notes and debentures, and liquidation expenses) Accounts payable Liquidation (Discount given by payables)

Dr Cr

2 000 2 000

Call - ‘B’ ordinary Dr 60 000 Call - ‘C’ ordinary Dr 80 000 Share capital - ‘B’ ordinary Cr Share capital - ‘C’ ordinary Cr (Call made on ‘B’ ordinary shares (60c) and ‘C’ ordinary shares (80c)

60 000 80 000

Liquidator’s receipts and payments Dr 126 000 Call - ‘B’ ordinary Cr 54 000 Call - ‘C’ ordinary Cr 72 000 (Receipt of cash on 90 000 ‘B’ ordinary @ 60c and 90 000 ‘C’ ordinary @ 80c) Liquidation expenses payable Bank overdraft Debentures (+ interest) Liquidator’s remun. payable Unsecured notes (+ interest) Accounts payable Accrued expenses Liquidator’s receipts & payments (Liabilities paid in order of priority)

Dr Dr Dr Dr Dr Dr Dr Cr

2 100 116 000 206 000 4 000 154 500 89 000 2 200

Share capital - ‘B’ ordinary Call - ‘B’ ordinary Forfeited shares reserve (Forfeiture of 10 000 ‘B’ ordinary shares)

Dr Cr Cr

10 000

Share capital - ‘C’ ordinary Call - ‘C’ ordinary Forfeited shares reserve (Forfeiture of 10 000 ‘C’ ordinary shares)

Dr Cr Cr

10 000

Share capital - preference

50 000

573 800

6 000 4 000

8 000 2 000

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Chapter 33: Insolvency and liquidation

Share capital - ‘A’ ordinary Dr Share capital - ‘B’ ordinary Dr Share capital - ‘C’ ordinary Dr Shareholders' distribution Cr (Transfer of share capital to shareholders' distribution)

200 000 90 000 90 000 430 000

Liquidation Dr 174 000 Forfeited shares reserve Dr 6 000 Retained earnings Cr 180 000 (Transfer of accumulated losses and forfeited shares reserve to liquidation) Shareholders' distribution Liquidation (Deficiency on liquidation transferred)

Dr Cr

330 700

Shareholders' distribution Dr Liquidator’s receipts & payments Cr (Final payment to shareholders as per schedule)

99 300

Asset balances transferred Unrecorded liabilities

Accumulated losses and forfeited shares reserve

330 700

Liquidation 744 900 Contra-assets

58 000

18 800 Cash (sale of assets) Creditors (discount)

547 000 2 000

Shareholder's distrib: 174 000 (deficiency) (‘A’ ord. $166 000) (‘B’ ord. $74 700) (‘C’ ord. $90 000) 937 700

330 700

Liquidator’s Receipts and Payments Balance 100 Payment of liabilities Liquidation (sale of assets) 547 000 Payment to: preference Calls on ‘B’ ordinary ‘A’ ordinary and ‘C’ ordinary shares 126 000 ‘B’ ordinary 673 100

Liquidation (deficiency) Liquidator’s receipts and Payments

99 300

Shareholders' Distribution 330 700 Share capital 99 300

937 700 573 800 50 000 34 000 15 300 673 100

430 000

430 000 430 000 Distribution of cash (after forfeiture of shares and payment to preference shares of $50 000): The cash available for distribution to shareholders is $100 (cash on hand) + $71 000 (accounts receivable realised) + $100 000 (inventories realised) + $10 000 (Investment in shares sold) + $10 000 (vehicles sold) + $116 000 (plant and equipment sold) + $240 000 (land and buildings sold) + ($1 – 40c) x (100 000 – 10 000) (calls received on ‘B’ ordinary shares) + ($1 – 20c) x © John Wiley and Sons Australia Ltd, 2020

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(100 000 – 10 000) (calls received on ‘C’ ordinary shares) - $2 100 (liquidation expenses) - $4 000 (liquidator’s remuneration) - $116 000 (bank overdraft and interest) - $89 000 (accounts payable) - $2 200 (accrued expenses) - $154 500 (unsecured notes and interest) - $206 000 (debentures and interest) = $99 300. As preference shares were preferential as to return of capital according to the constitution, $50 000 is taken from the cash available first and only $49 300 remains to be distributed to ordinary shareholders. As ‘C’ ordinary shareholders are deferred as to return of capital, the cash remaining is first allocated to the other ordinary shareholders. No of Shares ‘A’ Ordinary ‘B’ Ordinary ‘C’ Ordinary Cash available Deficiency Total notional cash

200 000 90 000 290 000 90 000 380 000

Paid to Notional Call $ 200 000 90 000 290 000 90 000 380 000 (49 300) 330 700

$ 49 300 . 49 300

Notional Refund 17c $ 34 000 15 300 49 300 49 300

Actual Deficiency Refund share (Call) $ $ 34 000 166 000 15 300 74 700 49 300 240 700 - 90 000 49 300 330 700

Total notional cash per ‘A’ and ‘B’ ordinary share = $49 300 ÷ 290 000 = 17c per share From the table above, note that the company calculates first the notional cash available for payment to ‘A’ and ‘B’ shareholders as the cash available of $49 300. As these shares participate equally in the final distribution, this is equivalent to 17c per share. As all the shares are fully paid, there is no call to consider. The holders of ‘A’ ordinary shares will receive a refund of $34 000, while the holders of ‘B’ ordinary shares will receive $15 300. As all the cash available was distributed to ‘A’ and ‘B’ ordinary shares, there is no more available for ‘C’ ordinary shares. The table above shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $330 700 is shared between ‘A’ ordinary shareholders – who lose the $166 000 ($200 000 paid-up capital - $34 000 refund), ‘B’ ordinary shareholders – who lose $74 700 ($90 000 paid-up capital – $15 300 refund) and ‘C’ ordinary shareholders – who lose $90 000 paid-up capital.

33.81

Chapter 33: Insolvency and liquidation

Exercise 33.21 Journal entries, given a report as to affairs At 31 July 2023, the liquidator of PPY Ltd, who had been appointed by the court, prepared the report as to affairs shown below. PPY LTD Report as to affairs as at 31 July 2023

(1) Assets not specifically charged: Interest in land Sundry debtors Cash on hand Cash at bank Inventories Work‐in‐progress Plant and equipment at cost/value Other assets — bills receivable

(2) Assets subject to specific charge: Land and buildings Less: Amounts owing (mortgage)

Valuati on

Estimated realisable value

— $ 58 00 0 — 1 000 122 0 00 — 82 00 0 48 00 0

— 36 000

— 1 000 94 000 — 44 000 28 000

311 0 00

203 000

91 00 0 (70 00) 0

80 000 (70 000 )

21 00 0 $ 332 0 00 Total estimated realisable value (3) Less: Preferential creditors entitled to priority over floating charge: claims by employees — salaries and wages

10 000 $

213 000

(1 400 ) 211 600

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(4) Less: Amounts owing and secured by floating charge — debentures (5) Less: Preferential creditors

(30 000 ) — 181 600

(6) Balances owing to unsecured creditors: Trade creditors Income tax payable

(93 00) 0 (4 000)

(97 000 ) $

84 600

Issued: 90 000 ordinary shares fully paid 50 000 6% preference shares, fully paid

125 000 50 000

Total share capital

175 000

Retained earnings

19 000 Cr

Estimated surplus subject to liquidation expenses Share capital

Additional information (a) Accumulated depreciation on plant and equipment was recorded at $14 000. (b) Arrears of cumulative preference dividend totalled $12 000. The constitution gives the preference shareholders priority of payment of arrears of preference dividends. All shares rank equally per share as to return of capital. (c) Of the $93 000 trade creditors recognised by the liquidator, PPY Ltd had not recorded $3000. Further, PPY Ltd had not recorded unpaid salaries and wages amounting to $1400. (d) At the completion of the winding up, the following additional information was available. • Interest accrued on mortgage, $2000, and on debentures, $1200 • Liquidation expenses, $800, and liquidator’s remuneration, $4000 • No bill receivable was dishonoured • All other creditors were paid the amounts reported in the report as to affairs • Land and buildings realised $75 000 • All other assets realised the amounts estimated. (e) In relation to the land and buildings, the mortgagee sold the assets and remitted to the liquidator any amount in excess of the debt due. Required Prepare the journal entries in PPY Ltd to wind up the company. (Show calculations for the distribution of cash to shareholders.) (LO9)

33.83

Chapter 33: Insolvency and liquidation

Liquidation Sundry debtors Inventory Plant and equipment Bills receivable (Transfer of assets)

Dr Cr Cr Cr Cr

310 000

Accumulated depreciation Liquidation (Transfer of contra-assets) Liquidation Preference dividend payable Trade creditors Salaries and wages payable Mortgage payable Debentures Liquidation expenses payable Liquidator’s remuneration payable (Liabilities arising during liquidation)

Dr Cr

14 000

Dr Cr Cr Cr Cr Cr Cr Cr

24 400

Liquidator’s receipts and payments Mortgage payable Liquidation - loss on disposal Land and buildings (Sale of land and buildings by mortgagee)

Dr Dr Dr Cr

3 000 72 000 16 000

Liquidator’s receipts and payments Liquidation (Proceeds from sale of assets)

Dr Cr

202 000

Liquidation expenses payable Debentures Liquidator’s remuneration payable Salaries and wages payable Trade creditors Preference dividends payable Liquidator’s receipts and payments (Payment of liabilities)

Dr Dr Dr Dr Dr Dr Cr

800 31 200 4 000 1 400 97 000 12 000

Retained earnings Liquidation (Transfer of reserve accounts)

Dr Cr

19 000

Share capital - Preference Share capital - Ordinary Shareholders’ distribution (Transfer of capital accounts)

Dr Dr Cr

50 000 125 000

58 000 122 000 82 000 48 000

14 000

12 000 3 000 1 400 2 000 1 200 800 4 000

91 000

202 000

146 400

19 000

Shareholders’ distribution Dr 115 400 Liquidation Cr (Transfer of balance representing deficiency on liquidation)

175 000

115 400

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Shareholders’ distribution Dr 59 600 Liquidator’s receipts and payments Cr 59 600 (Payment of $21 286 to preference shareholders and $38 314 to ordinary shareholders) Distribution of cash: The cash available for distribution to shareholders is $84 600 (estimated surplus subject to liquidation expenses) - $12 000 (preference dividends) - $2 000 (interest on mortgage) - $1 2000 (interest on debentures) - $800 (liquidation expenses) - $4 000 (liquidator’s remuneration) – ($80 000 - $75 000) (loss on land and buildings) = $59 600. No of Shares

Paid to Notional Call $ $ Preference 50 000 50 000 Ordinary 90 000 125 000 140 000 175 000 Cash available* (59 600) 59 600 Deficiency 115 400 . Total notional cash 59 600

Notional Refund $ 21 286 38 314 59 600

Actual Deficiency Refund share $ $ 21 286 28 714 38 314 86 686 59 600 115 400

Total notional cash per share = $59 600 ÷ 140 000 = 42.5714c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $59 600 as the share are fully paid. Thus, $59 600 is available for distribution across the 140 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 42.5714c per share. The holders of the preference shares will receive a refund of $21 286, while the holders of the ordinary shares will receive a refund of $38 314. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $115 400 is shared between preference shareholders — who lose the $28 714 ($50 000 paid-up capital - $21 286 refund) and ordinary shareholders – who lose $86 686 ($125 000 paid-up capital – $38 314 refund). Sundry debtors Inventory Plant and equipment Bills receivable Arrears – pref. dividends Trade creditors Salaries and wages Interest – mortgage Interest – debentures Liquidation expenses Liquidator’s remuneration Loss on disposal - land and buildings

Liquidation 58 000 Accumulated depreciation 122 000 Proceeds of sale 82 000 Retained earnings 48 000 12 000 3 000 1 400 2 000 1 200 800 4 000 16 000 Shareholders’ distribution 350 400

14 000 202 000 19 000

115 400 350 400

33.85

Chapter 33: Insolvency and liquidation

Opening balance: Sundry debtors Inventory Plant and equipment Bills receivable Mortgage

Liquidation (Deficiency) Cash – Preference Cash – Ordinary

Liquidator’s Receipts and Payments 1 000 Liquidation expenses 36 000 Salaries and wages 94 000 Debentures Liquidator’s remuneration 44 000 Trade creditors 28 000 Preference dividends 3 000 Preference shareholders Ordinary shareholders 206 000 Shareholders' Distribution 115 400 Share capital – Preference 21 286 Share capital – Ordinary 38 314 175 000

800 1 400 31 200 4 000 97 000 12 000 146 400 21 286 38 314 206 000

50 000 125 000 175 000

33.86

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 33.22 Report as to affairs and ledger accounts The statement of financial position of Horse Ltd below was prepared at 30 June 2023, before liquidation proceedings were commenced. HORSE LTD Statement of financial position as at 30 June 2023 Equity Share capital: 60 000 10% preference shares issued at $1, fully paid

$ 60 000

40 000 ordinary shares called to 75c, issued at $1

$ 30 00 0

Less: Calls in arrears 25c on 10 000 ordinary shares

(2 500)

27 500 87 500

Retained earnings

(12 620)

Total equity

74 880

Liabilities 39 80 0

Accounts payable GST payable

200

Rent payable

180

Telephone account payable

500

Electricity account payable

600

PAYG tax instalment

840

Wages payable

1 400

Managing director’s salary payable

4 700

Fringe benefits tax payable

900

Bank overdraft (secured by circulating security interest)

18 00 0

Mortgage payable (secured on freehold)

90 00 0

Partly secured creditor (holding $5000 security on plant)

16 00 0

173 120 $ 248 000

Total equity and liabilities

Assets

33.87

Chapter 33: Insolvency and liquidation

Freehold land and buildings (net) Plant (net) Inventories Bills receivable Accounts receivable Cash on hand

114 000 25 000 68 000 3 400 31 000 6 600

Total assets

$ 248 000

Additional information (a) It is estimated that $2000 of the calls in arrears would be received. (b) The estimated sales values of the assets are as follows. Freehold land and buildings Inventories Accounts receivable Bills receivable Plant (including $10 000 on plant over which a security is held)

120 000 58 000 22 000 3 400 20 000

Required 1. Prepare a summary of affairs as at 30 June 2023. 2. Assuming that the liquidator realises all assets (including land and buildings, and plant) and calls in arrears at the amounts estimated, forfeits those shares that do not pay the call, pays the creditors at the amounts as listed in the statement of financial position (except for accounts payable who settle out at $38 000) and distributes the balance after deducting liquidator expenses of $1900 and liquidator remuneration of $5700, prepare the Liquidation account, the Shareholders’ Distribution account, and the Liquidator’s Receipts and Payments account. The constitution provides that all shares rank equally, per share, as to return of capital. (LO9) Report as to affairs Assets and liabilities as at 30 June 2023 Valuation

$ 1. Assets not specifically charged (a) Interest in land (b) Sundry debtors: Accounts receivable Sundry debtors: Bills receivable Sundry debtors: Calls in arrears

Estimated Realisable Value $

31 000 3 400 2 500

22 000 3 400 2 000

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c) Cash on hand (d) Cash at bank (e) Stock as detailed in inventory (f) Work in progress (g) Plant and equipment (Book value $12 500 - $5 000 partly secured) (Estimated realisable value $10 000 - $5 000) (h) Other assets 2. Assets subject to specific charges Freehold land and buildings Less Mortgage Plant Less Secured creditor

114 000 90 000 10 000 10 000

Total estimated realisable value 3. Less Preferential creditors entitled to priority over the holders of debentures under floating charge Wages Managing director's salary

6 600 68 000 15 000

6 600 58 000 10 000

126 50

102 000

24 000

30 000

150 500

132 000 132 000

1 400 4 000

4. Less Amounts owing and secured by debenture or floating charge over company assets Bank overdraft

18 000 108 600 108 600

5. Less Preferential creditors Estimated amount available for unsecured creditors 6. Creditors (unsecured) Accounts payable GST payable Rent payable Telephone bill payable Electricity bill payable Managing director's salary PAYG tax Instalment Fringe benefits tax payable 7. Balances owing to partly secured creditors Total claims Security held

5 400 126 600

39 800 200 180 500 600 700 840 900 16 000 10 000

8. Contingent assets 9. Contingent liabilities Estimated surplus (Subject to costs of liquidation) Share capital: © John Wiley and Sons Australia Ltd, 2020

6 000

49 720 49 720 49 720

33.89

Chapter 33: Insolvency and liquidation

Issued: 60 000 10% preference shares issued at $1 40 000 ordinary shares at $1 Paid: 60 000 preference shares 30 000 ordinary shares paid to 75c 10 000 ordinary shares paid to 50c

Carrying amount of assets: Land and buildings Plant Inventory Bills receivable Accounts receivable Liquidation expenses Liquidator's remuneration Retained earnings

Deficiency: Preference Ordinary Cash payments: Preference Ordinary

60 000 40 000 60 000 22 500 5 000

Liquidation Proceeds from sale: 114 000 Land and buildings 25 000 Plant 68 000 Inventory 3 400 Bills receivable 31 000 Accounts receivable 1 900 Discount from accounts payable 5 700 Forfeited shares 12 620 Deficiency to: Preference Ordinary 261 620 Shareholders' Distribution * Share capital: 21 686 Preference 13 734 Ordinary (38 000 @ 75c) 38 314 14 766 88 500

100 000

87 500

120 000 20 000 58 000 3 400 22 000 1 800

1 000* 21 686 13 734 261 620

60 000 28 500

88 500

* After forfeiture of 2 000 ordinary shares. Liquidator's Receipts and Payments Receipts $ Payments Cash on hand 6 600 Liquidation expenses Sale of assets: Mortgage payable Land and buildings 120 000 Secured creditor Plant 20 000 Bank overdraft Inventory 58 000 Liquidator’s remuneration Bills receivable 3 400 Wages Accounts receivable 22 000 Managing director's salary Call on ordinary shares 2 000 Unsecured creditors: Accounts payable PAYG tax instalment GST Fringe benefits tax Rent

$ 1 900 90 000 10 000 18,000 5 700 1 400 4 000 38 000 840 200 900 180

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Telephone Electricity Managing director's salary Partly secured creditors Payment to: Preference Ordinary

500 600 700 6 000 178 920 38 314 14 766 232 000

232 000 Distribution of cash (after forfeiture of 2 000 ordinary shares):

The cash available to be distributed to the shareholders can be calculated based on the amounts recognised in the Liquidator's Statement of Receipts and Payments above and it is $232 000 - $178 920 = $53 080. No of Shares

Preference Ordinary Cash available* Deficiency Total notional cash

Paid to Notional Call

$ 60 000 60 000 38 000 28 500 98 000 88 500 (53 080) 35 420

$ 9 500 9 500 53 080 . 62 580

Notional Refund 63.857c $ 38 314 24 266 62 580

Actual Deficiency Refund share (Call) $ $ 38 314 21 686 14 766 13 734 53 080 35 420

Total notional cash per share = $62 580 ÷ 98 000 = 63.857c per share. From the table above, note that the company calculates the notional cash available for payment to all shareholders as the cash available of $53 080 plus a notional call on the partly paid ordinary shares of $9 500 up to their full issue price. Thus, $62 580 is potentially available for distribution across the 98 000 shares. As all shares participate equally in the final distribution, no matter their issue price or whether they are preference or ordinary shares, this is equivalent to 63.857c per share. As the notional preference are fully paid, the holders of those shares will receive a refund of $38 314 (i.e. 63.857c × 60 000 shares). As the notional call on the ordinary shares to make them fully paid ($9 500) is lower than the notional refund on these shares ($24 266, i.e. 63.857c × 38 000 shares), the holders of those shares will be not be called to pay the remainder of the nominal value of the share and instead will receive a refund of $14 766 from the total contributed prior to the liquidation of $28 500. The table above also shows that, as a result of the final distribution to shareholders, the total deficiency of funds to contributories of $35 420 is shared between preference shareholders — who lose the $21 686 ($60 000 paid-up capital - $38 314 refund) and ordinary shareholders – who lose $13 734 ($28 500 paid-up capital – $13 734 refund).

33.91

Chapter 33: Insolvency and liquidation

Exercise 33.23 Receivership and liquidation On 31 March 2023, you were appointed receiver, at a remuneration of 5% of the gross proceeds on sale of assets, in respect of Cicada Ltd. Your appointment was made by the ACE Bank, which held an equitable mortgage over the assets of Cicada Ltd, in respect of an advance of $42 000 which was still owing. On 30 April 2023, Cicada Ltd went into voluntary liquidation and you were appointed liquidator for the purposes of the winding up. The trial balance of Cicada Ltd at 31 March 2023 is shown below. CICADA LTD Trial balance as at 31 March 2023 Debits Inventories Plant — subject to hire purchase agreement with Equipment Hire Co. Ltd Other plant Work in progress Accounts receivable Retained earnings

$ 30 000 3 000 24 000 12 240 39 840 23 400 $ 132 48 0

Credits Share capital (80 000 shares issued for $1 and paid to 60c) ACE Bank Accounts payable Long service leave payable to retrenched employee Local council rates payable PAYG tax deductions from employees (to be remitted to the Australian Taxation Office) Wages owing to Y. Young (2 weeks to 31 March 2023, at $720 per week) Amount still owing as retrenchment payment

$ 48 000 42 000 35 940 2 100 1 800 600 1 440 600 $ 132 48 0

33.92

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

All assets were sold by you in your capacity as receiver, the proceeds of which amounted to $72 000. To achieve this, you had to spend $1200 to complete the work in progress. Expenses of advertising and stocktaking amounted to $1200. You made the appropriate payments from the receivership funds. After this was completed, you retired from the receivership. You were then appointed liquidator and proceeded with the distribution of funds in hand under the liquidation. Liquidator’s expenses amounted to $600. Required 1. Prepare the Receiver’s Receipts and Payments account. 2. Prepare the final receipts and payments account of the liquidator, showing in detail the order in which the funds in hand are distributed. (LO9) 1. Receipts Proceeds on sale of assets

Receiver’s Receipts and Payments $ Payments Receiver’s remuneration 72 000 Receiver’s expenses Mortgage: ACE Bank Balance (to liquidator) 72 000

$ 3 600 2 400 42 000 24 000 72 000

2. Receipts Balance from receiver

Liquidator’s Receipts and Payments $ Payments 24 000 Liquidator’s expenses Wages Long service leave Retrenchment payment Accounts payable Rates PAYG tax 24 000

$ 600 1 440 2 100 600 4 740 18 054 904 302 24 000

Balance available for unsecured creditors = $24 000 - $4 740 = $19 260. Total owing to unsecured creditors = $35 940 + $1 800 + $600 = $38 340. Proportion paid to unsecured creditors = $19 260 ÷ $38 340 = 50.2347c per $1.

33.93

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 33: Insolvency and liquidation Multiple choice questions 1.

refers to when a company is unable to pay its debts as they become due and payable.

a. Liquidation. *b. Insolvency. c. Receivership. d. Administration. Answer: b Learning objective 33.1: describe the meaning of insolvency.

2. Which of the following is not a form of external administration prescribed by the Corporation Act? *a. insolvency. b. liquidation. c. receivership. d. administration. Answer: a Learning objective 33.1: describe the meaning of insolvency.

3. Which of the following statements is incorrect? a.

receivers have power to do whatever is necessary to achieve the objectives for which they were appointed. b. receivers are normally appointed by the court or by secured creditors. c. secured creditors have a ‘charge’ over some or all of the company’s assets. *d. receivers are responsible to the company. Answer: d Learning objective 33.2: describe the role of a receiver appointed by a secured creditor.

33.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. The receiver’s role normally includes the following except for: a.

collecting and selling enough of the charged assets to repay the debt owed to the secured creditor. b. paying out the money collected in the order required by the Corporation Act. *c. liquidating the insolvent company. d. reporting to ASIC any offenses or other irregular matters they discover in performing their duties. Answer: c Learning objective 33.2: describe the role of a receiver appointed by a secured creditor.

5. A receiver should be: *a. a registered liquidator. b. a secured party in relation to any property of the corporation c. an auditor or a director, secretary, senior manager or employee of the corporation. d. an auditor or a director, secretary, senior manager or employee of the body corporate related to the corporation. Answer: a Learning objective 33.2: describe the role of a receiver appointed by a secured creditor.

6. Which of the following statements is incorrect? *a. A receiver must obtain permission from the company before selling any assets. b. A receiver is required to open a special bank account and must lodge a statement of receipts and payments every 6 months. c. Within 14 days of the receiver’s appointment, the company is required to submit a report to the receiver detailing the affairs of the company. d. Wages, superannuation contributions, the superannuation guarantee change, long service leave, sick leave and retrenchment payments are to be given priority over circulating security interests when the company is in receivership, but not yet in the process of being wound up. Answer: a Learning objective 33.2: describe the role of a receiver appointed by a secured creditor.

33.2

Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which of the following is not an example of how a receivership can end. a. The receiver can resign. *b. A voluntary administrator can be appointed to take over from the receiver. c. The receivership can progress to liquidation and the receiver can be appointed as liquidator. d. The receivership can progress to liquidation and a separate party can be appointed as liquidator. Answer: b Learning objective 33.2: describe the role of a receiver appointed by a secured creditor.

8. An administrator may be appointed by: a. the liquidator, but only if the company is solvent. b. the company’s shareholders, as a means of dismissing the managers. c. the company’s directors, but only after the company becomes insolvent. *d. a secured creditor who is entitled to enforce a charge on the whole of the company’s property. Answer: d Learning objective 33.3: describe the meaning of administration and identify the requirements imposed on an administrator of an insolvent company. 9. An administrator’s role is to: I. II. III.

control the company’s business, property and affairs. carry on the business and manage the property and the affairs of the company. terminate or dispose of all or part of the business or the property of the company.

*a. I, II and III b. I and II only c. I and III only d. II and III only Answer: a Learning objective 33.3: describe the meaning of administration and identify the requirements imposed on an administrator of an insolvent company.

33.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. When an administrator is appointed to a company they must give an opinion as to the best of three options available to creditors. These three options are: I. II. III. IV.

Wind up the company and appoint a liquidator. End the voluntary administration and appoint a receiver. End the voluntary administration and return the company to the director’s control. Approve a deed of company arrangement through which the company will pay all or part of its debts and then be free of those debts.

a. I, II and III b. I, II and IV *c. I, III and IV d. II, III and IV Answer: c Learning objective 33.3: describe the meaning of administration and identify the requirements imposed on an administrator of an insolvent company.

11. The administrator of a company under administration has power to do which of the following? I. II. III.

appoint a person as director. remove from office a director of the company. execute a document, bring or defend proceedings, or do anything else, in the company’s name and on its behalf.

*a. I, II and III b. II and III only c. I and II only d. I and III only Answer: a Learning objective 33.3: describe the meaning of administration and identify the requirements imposed on an administrator of an insolvent company.

12. Which of the following is entitled to make an application to the court for an insolvent company to be wound up? *a. ASIC. b. A court appointed receiver. c. Employees of the company. d. The company’s external auditor. Answer: a Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

13. Under s. 461 of the Corporations Act, general grounds on which the court can order a winding up include: I. II. III.

The company has no members. The court is of the opinion that it is just and equitable that the company be wound up. The company has not commenced business within twelve months of its incorporation.

a. I, II and IV b. II, III and IV c. II and III only *d. I, II, III and IV Answer: d Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

14. Under the Corporations Act, tasks of a liquidator include which of the following? I. II. III.

Determine the creditors and order of priority of payment. Bring about the dissolution of the company. Take possession of the company’s assets.

*a. I, II and III b. I and II only c. I and III only d. II and III only Answer: a Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

15. After receiving the statement of affairs from the directors, the liquidator must submit a preliminary report to ASIC within: a. 14 days. *b. 2 months. c. 6 months. d. 12 months. Answer: b Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

16. The report as to affairs (Form 507) is required to be prepared by the: a. liquidator. b. members of the company. *c. directors of the company. d. creditors of the company. Answer: c Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

17. A declaration of solvency is required to be signed by the directors of the company in order for: a. the court to make an order for liquidation. b. the company to borrow more money from a bank. c. the company to issue more shares to its shareholders. *d. the liquidation to proceed as a members’ voluntary winding up. Answer: d Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

18. Which of the following provides the basis for a voluntary winding up of a company? a. The company is unable to pay its debts. b. The company directors vote to wind up the company. *c. A special resolution is passed by the company to wind up. d. ASIC submits a request for the company to be wound up. Answer: c Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

19. At the commencement of a members’ voluntary winding up, a written declaration must be provided by directors stating that all debts will be able to be paid in full within a period of no more than: a. 30 days. b. 6 months. *c. 12 months. d. 2 years. Answer: c Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

20. Under a members’ voluntary winding up, the directors of the company are required to prepare which of the following documents? I. II. III. IV.

Summary of affairs Statement of affairs Declaration of solvency Preliminary liquidation report

*a. II and III. b. I, II and III. c. I, II and IV. d. I, III and IV. Answer: a Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

21. Which of the following is not grounds under s. 461 of the Corporations Act on which the court can order a winding up? I. II. III. IV.

The company has no members. The company has resolved that it be wound up by the court. The company has not commenced business within three months of its incorporation. The court is of the opinion that it is just and equitable that the company be wound up.

*a. III only b. IV only c. I and II only d. III and IV only Answer: a Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

22. A voluntary winding up commences when: a. the company is unable to pay its debts. b. ASIC applies to the court for the winding up. *c. the members of the company pass a special resolution to wind up. d. an application is filed with the court by the company’s external auditor. Answer: c Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

33.7

Testbank to accompany Financial reporting 3e by Loftus et al.

23. A voluntary winding up may be put in place by either: *a. the company’s members or creditors. b. the company’s directors or creditors. c. ASIC or the company’s members. d. ASIC or the company’s creditors. Answer: a Learning objective 33.4: describe the meaning of liquidation and compare the two modes of liquidation.

24. Under a court ordered winding up, a liquidator has the power to: I. II. III. IV.

dispose of the property of the company. use any legal methods to obtain money from a debtor. commence legal proceedings on behalf of the company. pay the company’s shareholders before paying the creditors.

a. II, III and IV. b. I, III and IV. c. I, II and IV. *d. I, II and III Answer: d Learning objective 33.5: describe the duties and powers of a liquidator.

25. Under a voluntary winding up, a liquidator cannot: *a. make concessions on any debts except as under s. 477(2A) of the Corporation Act. b. exercise the power of the court of fixing a time when debts and claims must be proved. c. exercise any power the Corporation Act confers on a liquidator in a winding up by the court. d. convene a general meeting of the company to obtain agreement for matters as the liquidator thinks fit. Answer: a Learning objective 33.5: describe the duties and powers of a liquidator.

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

26. Which of the following statements is correct? I. II. III.

Debts may be admitted by the liquidator without formal proof. All creditors’ claims are admissible to proof against the company in liquidation. The size of any debts is calculated for the purpose of the winding up as at the day on which the winding up is taken to have begun.

a. I only b. II only c. III only *d. I, II and III Answer: d Learning objective 33.6: determine how a company’s debts are proven for liquidation.

27. In relation to the order of priority of payment of debts upon liquidation, which of the following statements is correct? a. Deferred creditors are paid before secured creditors. b. Deferred creditors are paid before ordinary unsecured creditors. *c. Preferential unsecured creditors are paid before deferred creditors. d. Ordinary unsecured creditors are paid before preferential unsecured creditors. Answer: c Learning objective 33.7: determine the order of priority of payment of the company’s debts on liquidation.

28. Claims against a company whereby the creditor has a charge against specific property is known as a: a. floating charge. b. specific debt covenant. c. circulating security interest. *d. non-circulating security interest. Answer: d Learning objective 33.7: determine the order of priority of payment of the company’s debts on liquidation.

33.9

Testbank to accompany Financial reporting 3e by Loftus et al.

29. Which of the following is an example of a preferential unsecured creditor? a. Trade creditors. *b. Liquidator’s fee. c. Arrears of preference dividends. d. Audit fees payable for normal year-end audit prior to insolvency. Answer: b Learning objective 33.7: determine the order of priority of payment of the company’s debts on liquidation.

30. Which of the following is an example of an ordinary unsecured creditor? *a. Trade creditors. b. Liquidator’s remuneration. c. Workers’ injury compensation claims. d. Retrenchment payments payable to employees of the company other than a director or a relative of a director. Answer: a Learning objective 33.7: determine the order of priority of payment of the company’s debts on liquidation.

31. Which of the following is an example of a deferred creditor? a. Trade creditors. b. Audit fees payable. c. Liquidator’s remuneration. *d. Arrears of preference dividends. Answer: d Learning objective 33.7: determine the order of priority of payment of the company’s debts on liquidation.

32. Which of the following statements is incorrect? a. Most liquidations in Australia do not have sufficient funds to pay creditors. *b. Past members must contribute money for company debts, which have been incurred after they cease to be members. c. In the absence of any guidance in the company’s constitution, calls in advance with related interest will be repaid before any payments are made to shareholders. d. If the company is limited by shares, members do not have to contribute more than the amount unpaid on the shares for which each is liable as a past or present member. Answer: b Learning objective 33.8: determine the rights and obligations of contributories on liquidation. © John Wiley and Sons Australia, Ltd 2020

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

33. The details below were extracted from the accounting records of Capricorn Ltd (a company in the process of liquidation). 100 000 $1 preference shares fully paid 200 000 $1 ordinary shares paid to 50 cents

$100 000 100 000 $200 000

Cash available (after payment of all creditors)

$20 000

Assume that the constitution of Capricorn Ltd states that in the event of liquidation, all shares are to rank equally, based on the number of shares held, in distributing any surplus or deficiency. For preference shareholders, the amount of the actual refund or call is: a. A call of $20 000. b. A call of $100 000. c. A refund of $20 000. *d. A refund of $40 000. Answer: d Feedback: If the remaining call of 50 cents is made on ordinary shares the amount to be collected from the ordinary shareholders would be $100 000. Add on the cash available of $20 000 and the total amount of cash that would be available for distribution to shareholders would then be $120 000. The total number of shares held is 300 000. The refund back to preference shareholders is 100 000 / 300 000 x $120 000 = $40 000. Learning objective 33.8: determine the rights and obligations of contributories on liquidation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

34. The details below were extracted from the accounting records of Capricorn Ltd (a company in the process of liquidation). 100 000 $1 preference shares fully paid 200 000 $1 ordinary shares paid to 50 cents

$100 000 100 000 $200 000

Cash available (after payment of all creditors)

$20 000

Assume that the constitution of Capricorn Ltd states that in the event of liquidation, all shares are to rank equally, based on the number of shares held, in distributing any surplus or deficiency. What will be the deficiency or surplus apportioned to preference shareholders? a. A surplus of $40 000. b. A surplus of $60 000. *c. A deficiency of $60 000. d. A deficiency of $100 000. Answer: c Feedback: Preference shareholders have previously paid $100 000 and they are to receive a refund of only $40 000. Therefore, the deficiency is $60 000. Learning objective 33.8: determine the rights and obligations of contributories on liquidation.

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

35. The details below were extracted from the accounting records of Capricorn Ltd (a company in the process of liquidation). 100 000 $1 preference shares fully paid 200 000 $1 ordinary shares paid to 50 cents

$100 000 100 000 $200 000

Cash available (after payment of all creditors)

$20 000

Assume that the constitution of Capricorn Ltd states that in the event of liquidation, all shares are to rank equally, based on the number of shares held, in distributing any surplus or deficiency. For ordinary shareholders, the amount of the actual refund or call is: *a. A call of $220 000. b. A call of $100 000. c. A refund of $20 000. d. A refund of $100 000. Answer: a Feedback: The remaining call of 50 cents on ordinary shares would provide a total cash available for distribution to shareholders of $120 000. The total number of shares held is 300 000. The refund back to preference shareholders is 100 000 / 300 000 x $120 000 = $40 000. There is currently only $20 000 cash available so a call of $20 000 is required. Learning objective 33.8: determine the rights and obligations of contributories on liquidation.

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Testbank to accompany Financial reporting 3e by Loftus et al.

36. The details below were extracted from the accounting records of Capricorn Ltd (a company in the process of liquidation). 100 000 $1 preference shares fully paid 200 000 $1 ordinary shares paid to 50 cents

$100 000 100 000 $200 000

Cash available (after payment of all creditors)

$20 000

Assume that the constitution of Capricorn Ltd states that in the event of liquidation, all shares are to rank equally, based on the number of shares held, in distributing any surplus or deficiency. What will be the deficiency or surplus apportioned to ordinary shareholders? a. A surplus of $40 000. b. A deficiency of $100 000. c. A surplus of $100 000. *d. A deficiency of $120 000. Answer: d Feedback: Ordinary shareholders are required to pay an additional $20 000 so that the preference shareholders can receive their refund. Therefore, the total deficiency for ordinary shareholders is $120 000. Learning objective 33.8: determine the rights and obligations of contributories on liquidation.

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Chapter 33: Insolvency and liquidation Not for distribution in full. Instructors may assign selected questions in their LMS.

37. Which of the following journal entries will be recorded upon realisation of the assets by the liquidator? a. DR Liquidation; CR Liquidator’s receipts and payments *b. DR Liquidator’s receipts and payments; CR Liquidation c. DR Shareholders’ distribution; CR Liquidator’s receipts and payments d. DR Liquidator’s receipts and payments; CR Revenue from sale of assets Answer: b Learning objective 33.9: prepare the accounting records necessary for the liquidation of a company.

38. The journal entry to record the distribution of cash to shareholders includes which of the following? a. CR Liquidation. b. CR Shareholders’ distribution. *c. DR Shareholders’ distribution. d. DR Liquidator’s receipts and payments. Answer: c Learning objective 33.9: prepare the accounting records necessary for the liquidation of a company.

39. Which of the following is not one of the main accounts used for liquidation? a. Liquidation. *b. Liquidator’s distribution. c. Shareholders’ distribution. d. Liquidator’s receipts and payments. Answer: b Learning objective 33.9: prepare the accounting records necessary for the liquidation of a company. 40. The main purpose of the liquidation account is to: a. record additional calls made on shareholders. b. show the capital amount due to contributories. *c. calculate the deficiency or surplus on liquidation. d. show the final cash payment to each class of contributory. Answer: c Learning objective 33.9: prepare the accounting records necessary for the liquidation of a company.

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Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 34: Accounting for mineral resources

Chapter 34: Accounting for mineral resources Comprehension questions 1. Discuss the complexities and considerations an entity involved in the extractive industries may face in determining the accounting policies to apply to expenditures it incurs. Many of the financial reporting issues that affect entities in the extractive industries are a result of the environment in which they operate. The financial reports of such entities need to reflect the risks and rewards to which they are exposed. Aside from government and environmental influences, the main features of activities undertaken in the extractive industries are: • High risks with little relationship to possible rewards: costs are often incurred in the hope of finding mineral re-sources in producible quantities. Sometimes those costs can be very high and nonetheless, lead to no significant finds. On the other hand, some highly valuable mineral resource discoveries are made at very little cost. This makes the accounting for costs incurred in finding mineral resources particularly challenging. • Time and cost to produce: once mineral reserves are discovered, there can be considerable additional expenditure involved in developing and producing those reserves coupled with a significant time lag between commencement of the exploration activities and production of the reserves. This raises issues associated with the likelihood and magnitude of economic benefits from such expenditures, which can make impairment assessments more difficult.

2. Discuss the scope of expenditures to which AASB 6 is limited. According to paragraph 1 of AASB 6, the objective of the standard is limited to specifying the financial reporting for the ‘exploration for and evaluation of mineral resources’, which is defined as ‘the search for mineral resources, including minerals, oil, natural gas and similar non-regenerative resources after the entity has obtained legal rights to explore in a specific area, as well as the determination of the technical feasibility.’ The scope of AASB 6 is specifically limited to accounting for E&E expenditures and it does not 'address other aspects of accounting by entities engaged in the exploration for and evaluation of mineral resources'. In other words, AASB 6 does not deal with the prospecting, development and production activities. Therefore, the standard deals only with E&E expenditures and it does not provide guidance on other industry specific issues that may arise during the E&E phase.

3. Explain the measurement options of E&E assets available to companies, subsequent to initial recognition. Subsequent to initial recognition, E&E assets must be measured using the cost model or the revaluation model. The implications of using the revaluation model will differ depending on the extent to which the components of E&E assets are classified as property, plant and equipment under AASB 116 or intangible assets under AASB 138. The revaluation model in AASB 138 requires the existence of an active market, whereas the revaluation model in AASB 116 only requires that fair value be reliably measurable.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Note that regardless of which model is selected, cost or revaluation, it must be applied consistently to all E&E assets. However, it is extremely rare for the revaluation model to be used in the extractive industries.

4. If an entity want to change their accounting policies applicable to E&E expenditures, discuss the issues they should consider. Paragraph 13 of AASB 6 allows an entity to change its accounting policies related to E&E expenditures on the condition that the change ‘makes the financial report more relevant to the economic decision-making needs of users and no less reliable, or more reliable and no less relevant to those needs’. In assessing the relevance and reliability of the change, entities are directed to the criteria in AASB 108, although they are not expected to fully comply with those criteria. In addition, the AASB inserted an Australian-specific paragraph (Aus 13.1) specifying that any such change must still result in a policy that is consistent with the Australian-specific guidance related to use of the are-of-interest method. An example of an acceptable change in accounting policy following this guidance would be a change from capitalising E&E expenditures using the area-of-interest method to expensing of all E&E expenditures until the technical feasibility and commercial viability of extracting reserves is established.

5. Explain how E&E assets should be classified in the financial statements. AASB 6 does not specify whether E&E assets are tangible or intangible assets; however, it does require an assessment of the nature of E&E assets to determine how they should be classified. For example, the standard notes that drilling rights are treated as intangible assets while vehicles and drilling rigs are treated as tangible assets. In practice, the majority of E&E assets are classified as intangible assets. As a result, they are measured using the cost model because of the restrictive requirements associated with use of the AASB 138 revaluation model. Note that even though equipment used in E&E activities is classified as a tangible asset, the consumption of that equipment, which is reflected through depreciation charges, may qualify for capitalisation as part of an intangible E&E asset if that equipment is being consumed in the E&E activities associated with development of that intangible E&E asset.

6. Discuss the two specific modifications a company could make to the impairment testing of E&E assets compared to other assets under AASB 136/IAS 36. Once an entity has concluded that an E&E asset may be impaired, AASB 136 Impairment of Assets must be used to measure, present and disclose that impairment in the financial statements, subject to two important modifications set out in AASB 6: • it defines separate impairment testing ‘triggers’ for E&E assets; and • it allows groups of cash-generating units to be used in impairment testing. Under AASB 6 one or more of the following facts and circumstances are considered indicators of impairment of E&E assets (the list is not exhaustive):

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Chapter 34: Accounting for mineral resources

• • • •

The exploration rights for the specific area have expired or are expected to expire in the near future and there is no expectation of renewal. There is no budget or plan for further substantive E&E expenditure in the specific area. The entity has decided to discontinue E&E activities in the specific area on the basis that such activities have not led to the discovery of commercially viable quantities of mineral resources. The entity has established that the book value of the E&E asset is unlikely to be recovered in full from successful development or sale.

With respect to expiry of exploration rights, the term ‘near future’ is generally accepted to mean 12 months from the end of the reporting period. In addition, the above list does not include finding that an exploratory or development well does not contain oil or gas in commercial quantities, which is commonly referred to as finding a ‘dry hole’. The reason for this is that often dry holes are merely a function of delineating or defining the exploration area or depending on the nature of the mineral resources being explored such as shale gas; a number of dry holes are needed before the entity is in a position to conclude that there are not commercial quantities of resources present. Nevertheless, if a dry hole marks the end of budgeted or planned exploration activity, it would be considered an indicator of impairment. Other impairment indicators not listed in AASB 6 might include changes in market prices of the applicable mineral resources, adverse regulatory or taxation changes, liquidity restrictions affecting access to funding for E&E activities, civil unrest affecting access to the specific area, and natural disasters causing damage or restricting access to the specific area. In determining the level at which to assess E&E assets for impairment, entities are required to determine an accounting policy for allocating those E&E assets to cash-generating units or groups of cash-generating units. Further, AASB 6 requires that each cash-generating unit or group of cash-generating units to which an E&E asset is allocated must not be larger than an operating segment determined in accordance with AASB 8 Operating Segments. Despite this ability to aggregate cash-generating units for E&E asset impairment testing purposes, the AASB inserted Australian-specific guidance into AASB 6 limiting the level at which an E&E asset may be tested for impairment to a level no larger than the area-of-interest to which the E&E asset relates, consistent with the AASB’s area-of-interest approach for measurement and recognition.

7. Explain how E&E assets that are subsequently developed into producing assets are most commonly depreciated. For E&E assets that are subsequently developed and moved into production, the entity must devise an accounting policy to depreciate or amortise those assets over their estimated useful lives. More often than not, the useful lives of mineral resource properties are directly linked to the life of the underlying economically recoverable reserves. As a result, these assets are usually depreciated using the unit-of-production method to a residual value expected at the conclusion of production. ‘The underlying principle of the unit-of-production method is that capitalised costs associated with a cost centre are incurred to find and develop the commercially producible reserves in that cost centre, so that each unit produced from the centre is assigned an equal amount of cost’ (IASC Issues Paper, Extractive Industries Issues Paper, IASC, November 2000, paragraph 7.19).

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

There are some assets, such as drilling rigs and similar equipment that are used in more than one area-of-interest or have a useful life that is shorter or longer than that of the underlying reserves. Such assets would normally be depreciated using the straight-line method, which means they are depreciated evenly over the time during which they are expected to provide economic benefits to the entity. So the straight-line method allocates an equal amount of cost to each year while the unit-of-production method allocates an equal amount of cost to each unit produced. By its very nature, the unit-of-production method would therefore result in no depreciation being recognised during the E&E phase because production would not have commenced.

8. Discuss the contemporary issues related to accounting for extractive activities. Contemporary issues include stripping costs and IASB review of extractive activities …; each of which is detailed below. Treatment of stripping costs has been clarified under AASB Interpretation 20 (issued in 2011), such that they may be considered an asset if incurred during the development phase (and amortised once production begins), or if they improve access to ore (i.e. ‘stripping activity asset’) subject to certain requirements (e.g. reliable measurement) An international review of accounting for extractive activities was initiated by the IASB, resulting in a 2010 discussion paper (DP) Discussion paper on extractive activities. In 2012, the IASB discontinued this project in favour of a broader research project on intangible assets ‘Intangible assets including extractive activities and research and development activities’. The project aims to assess the feasibility of developing one set of reporting requirements for investigative, exploratory, and developmental activities across a wide range of activities. Activated as an IASB-only research project, a DP is expected to follow.

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Chapter 34: Accounting for mineral resources

Case studies Case study 31.1 Area of interest Redwoods Mining Limited has exploration licences for two areas. The first is in northwestern Australia and is at the prospecting stage. The second is several hundred kilometres east and is in the exploration stage. The company’s management wants to treat the projects as one area of interest and does not believe that AASB 6 will apply. Required Discuss whether you agree with management’s view. AASB 6 is limited to accounting for exploration and evaluation (E & E) expenditure and does not address accounting for other related activities such as prospecting. Hence, expenditure related to the first area in north-western Australia would not be covered by the standard. E & E accounting policies typically relate to areas of interest, being individual geological areas considered favourable for the presences of minerals, oil, or gas. In most cases, an area of interest comprises a single mine or separate oil or gas field (i.e. based on individual licences, with a separate licence for each site). While in some cases there may be several licences for one area of interest, the distance between the two sites suggests they are separate areas of interest, and hence should be accounted for separately. As such, for the second licence (in the exploration stage), AASB 6 would apply. Note: While the full cost method generally involves capitalisation of all costs in the prospecting and exploration stage, this approach is not consistent with the Conceptual Framework and is not used in Australia.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Case study 34.2 Capitalising costs The accountant of Local Oil Limited has recommended to management that the company capitalise its E&E costs, as this will increase the company’s assets and have no effect on profit or loss. Required Discuss whether you agree with the accountant’s advice. Capitalisation is an option under AASB 6. However this will eventually impact on the profit and loss through depreciation, amortisation or impairment expense.

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Chapter 34: Accounting for mineral resources

Case study 34.3 Useful life of an asset Pearl Mining Limited has a number of depreciable assets which it uses in a particular area of interest. Required Discuss the factors you would need to consider in determining the depreciable period (useful life) of the asset. Useful lives of assets such as mineral resources are directly linked to the life of the underlying economically recoverable reserves. However, some assets (e.g. drilling rigs and similar equipment) may be used in more than one area of interest, or have a useful life longer (or shorter) than that of the underlying reserves. The useful life of such assets is normally based on the period over which they are expected to provide economic benefits to the entity. Hence, the company should consider how long the assets are expected to such provide benefits.

34.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Application and analysis exercises Exercise 34.1 Obligations for removal and restoration The management of Oil Ltd is concerned that the E&E activities it has commenced in a specific area will cause significant damage to the surrounding environment, and the government of the country where the area of interest is located has attached strict conditions to the exploration licence for that area. Those conditions require that Oil Ltd return the environment to its original condition. Required What are the implications of the above scenario for Oil Ltd’s financial statements? (LO5) Oil Ltd would be required to recognise a provision for the estimated costs of returning the environment to its original condition at the time the related damage is incurred. The provision would be recognised and measured in accordance with the requirements of AASB 137. The cost would be recognised as part of the carrying value of the E&E asset to which it relates.

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Chapter 34: Accounting for mineral resources

Exercise 34.2 Specifying the level at which E&E assets are assessed for impairment E&E activity in one of LNG Ltd’s areas of interest has not reached a stage that permits a reasonable assessment of the existence of economically recoverable reserves. The exploration licence for that area is still current and LNG Ltd intends to continue E&E activities in that area. One of the wells drilled by LNG Ltd in that area during the period did not result in the finding of any mineral reserves. However, other wells drilled in the area have resulted in mineral reserve findings. Required What alternatives does LNG Ltd have for determining the level at which to assess its E&E assets for impairment in that area of interest? (LO6) LNG Ltd could assess impairment at the individual well level, which would result in the writeoff of the one unsuccessful well drilled during the period. Alternatively, LNG Ltd could aggregate its wells up to the area-of-interest level (or into parts thereof), which would not necessarily result in any impairment charge as the one unsuccessful well would not necessarily be considered an impairment indicator and even if it was, the reserves found related to the other wells could shelter the unsuccessful well.

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Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 34.3 Application of the revaluation model Gold Ltd classifies its E&E assets as intangible assets. A new accountant has just been employed and has suggested that Gold Ltd should change its accounting policy for E&E assets from its existing cost model to the fair value model under AASB 138/IAS 38 because it would provide more relevant information. Required What might prevent Gold Ltd from being able to make this change in accounting policy? (LO6) In relation to the intangible E&E assets, Gold Ltd would need to be able to show that there is an active market for those assets as specifically defined in AASB 138. This would require that the asset be considered homogenous in nature with other assets for which there are buyers and sellers available and a publicly available market price for those assets. This would be extremely rare for E&E assets. For any E&E assets classified as property, plant and equipment, Gold Ltd would need to be able to show that fair value is reliably measurable. In addition, consideration would need to be given as to whether such a change in policy makes the financial statements more relevant and reliable than the existing policy. Given that use of the revaluation method for E&E assets is not common, this may be difficult.

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Chapter 34: Accounting for mineral resources

Exercise 34.4 Change in accounting policy Oil Sands Ltd is a company involved in the search for, production of and sale of oil and gas resources. The company has been following an accounting policy of expensing all of its E&E costs as incurred since adoption of AASB 6/IFRS 6. However, it has noted that its most significant competitor follows a policy of capitalising such costs on an area of interest basis. This makes the competitor’s profit look better in some years than Oil Sands Ltd’s profit. Required Discuss whether Oil Sands Ltd can change its accounting policy to capitalise all of its E&E costs to match its competitor’s accounting policy. (LO7) Oil Sand Ltd would need to consider whether such a change in accounting policy ‘makes the financial report more relevant to the economic decision-making needs of users and no less reliable, or more reliable and no less relevant to those needs’. The costs capitalised must also be expected to be recouped through sale or successful development and exploitation and/or at the end of the reporting period, the E&E activities in the area-of-interest are not at a stage that would permit assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in, or in relation to, the area-of-interest are continuing. The extent to which the above relevance and reliability criteria is met will be a matter of judgement and will depend quite heavily on whether such a policy is applied by the majority of Oil Sand Ltd’s peers.

34.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 34.5 Elements of cost of E&E assets Mining Ltd has acquired a licence to explore a new area of interest and its accounting policy is to fully capitalise all of its E&E expenditures on an area of interest basis. During the period, costs have been incurred in relation to: (a) the acquisition of speculative seismic data in relation to the area of interest to be used to determine whether to apply for an exploration licence for that area (b) labour costs of engineers to analyse the seismic data obtained (c) the exploration licence fee (d) legal costs associated with obtaining the exploration licence (e) labour costs for engineers to carry out topographical, geological, geochemical and geophysical studies on the area after obtaining the exploration licence (f) payroll-related costs for that labour (g) contractors’ fees for exploratory drilling (h) hire of drilling equipment. Required Which of the above items would qualify for capitalisation as part of the E&E asset under AASB 6/IFRS 6? (LO7) Items (c) – (h) would qualify for capitalisation. Items (a) and (b) would not qualify because there were incurred prior to obtaining the licence to explore.

34.13

Chapter 34: Accounting for mineral resources

Exercise 34.6 Impairment of E&E assets During the year ended 30 June 2023, the management of LPG Ltd has been analysing its engineering reports for a specific area of interest, which indicate that sample drilling has not resulted in any findings that confirm the existence of oil and gas in that area. As a result, LPG Ltd is reluctant to invest any further funds in exploring the area. An E&E asset with a carrying value of $1.8 million exists in relation to that asset as at 30 June 2023. Required What is the possible impact of this decision on LPG Ltd’s financial statements as at 30 June 2023? (LO7) This decision would be considered an indicator of impairment. As a result, LPG Ltd will need to determine the recoverable amount of the E&E asset if any, and write the asset down to this recoverable amount. Normally this situation would result in the write-off of the full $1.8 million asset to profit or loss.

34.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercise 34.7 Recognition of E&E assets Ore Ltd has incurred the following costs during the period in relation to a specific area of interest. Its accounting policy is to capitalise all E&E costs on an area of interest basis. Cash paid to acquire seismic study from government that is selling exploration rights for the area (GST exempt) $ Cash paid to acquire exploration rights for the area from government (GST exempt) Cash paid to acquire fencing materials to mark out the area of interest, including GST of $240 Contractor fees for labour to set up the fencing, including GST of $150 Contractor fees for exploratory drilling, including GST of $7 500 Hire of drilling equipment for contractor use, including GST of $1 500 Salary of project manager hired specifically to manage E&E activities in the area Stationery and other office supplies used by the project manager, including GST of $90 Ore Ltd non-executive directors’ fees paid during the period

9 000 30 000 2 640 1 650 82 500 16 500 180 00 0 990 480 00 0

Required Determine the amount of the E&E asset to be capitalised by Ore Ltd in relation to the area of interest. (LO7) Cash paid to acquire exploration rights, GST exempt $ 30 000 Cash paid to acquire fencing materials to mark out the area-of-interest, net of GST 2 400 Contractor fees for labour to set up the fencing, net of GST 1 500 Contractor fees for exploratory drilling, net of GST 75 000 Hire of drilling equipment for contractor use, net of GST 15 000 Salary of project manager 180 000 Stationery and other office supplies, net of GST 900 $304 800

34.15

Chapter 34: Accounting for mineral resources

Exercise 34.8 Measurement of E&E assets During the year ended 30 June 2023, Resources Ltd explored four different areas of interest and spent $200 000 in each. The results of E&E activities suggested that Areas A, B and C may contain mineral reserves so the company acquired leases over these three areas. The leases cost $300 000, $440 000 and $360 000 respectively. During the year ended 30 June 2024, Resources Ltd commenced a drilling program to evaluate Areas A, B and C. Eight exploratory wells were drilled, five in Area A, two in Area B and one in Area C at a cost of $240 000 each. The five wells drilled in Area A did not result in any mineral resource findings (i.e. they were dry holes). The two wells drilled in Area B indicated that the company had discovered economically recoverable reserves. Management was uncertain about the likelihood of finding economically recoverable reserves for the well in Area C as some mineral reserves were found but not enough to be considered economically recoverable at this stage. Therefore, Resources Ltd decided to continue E&E activities in Area C as of 30 June 2024. Area A was abandoned, and, after incurring costs of $100 000 to confirm the technical feasibility and commercial viability of extracting the mineral resources, development of Area B commenced. During the year ended 30 June 2025, to evaluate the area of interest further, three more wells were drilled in Area B. Of these, two were dry. Each well cost $280 000. The successful wells in Area B were developed for a total cost of $600 000. Expenditure on additional plant and equipment related to development was $650 000. After further dry wells costing $350 000 were drilled in Area C, management concluded that Area C did not contain any commercially viable quantities of mineral resources, so it was abandoned. These costs are summarised as follows. Costs incurred for each area of interest A

Total

30/06/2023 Exploration Leases

200 000 300 000

200 000 440 000

200 000 200 000 800 000 360 000 — 1 100 000

30/06/2024 Dry wells Other wells Technical feasibility/ commercial viability costs

1 200 000 —

— 480 000

— 240 000

—

100 000

—

100 000

30/06/2025 Dry wells Other wells Development PPE

— — — —

560 000 280 000 600 000 650 000

350 000 — — —

— — — —

910 000 280 000 600 000 650 000

— 1 200 000 — 720 000

34.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

1 700 000

Total

3 310 000 1 150 000 200 000 6 360 000

Required Determine what amounts would be recognised as an expense (in the profit or loss) versus capitalised as an asset, in relation to each area of interest for each financial year assuming Resources Ltd: 1. expenses all of its E&E costs as incurred 2. capitalises all E&E costs on an area of interest basis 3. capitalises successful E&E costs on an area of interest basis (i.e. expenses dry holes). (LO4, LO5 and LO6) 1. 30/06/2023 Expensed Capitalised 30/06/2024 Expensed

Capitalised 30/06/2025 Expensed

200 000 300 000

200 000 440 000

200 000 360 000

200 000 _

1 500 000 [1 200 000 + 300 000 c/fwd]

580 000 [480 000 + 100 000]

240 000

–

Capitalised

840 000 [560 000 + 280 000] 1 250 000 [600 000 + 650 000]

710 000 [350 000 + 360 000 c/fwd] _

2. 30/06/2023 Expensed Capitalised 30/06/2024 Expensed

Capitalised 30/06/2025 Expensed

Capitalised

_ 500 000

_ 640 000

_ 560 000

200 000 _

1 700 000 [1 200 000 + 500 000 c/fwd] _

580 000

240 000

–

2 090 000 [840 000 + 1 250 000]

1 150 000 [350 000 + 240 000 + 560 000 c/fwd)] _

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Chapter 34: Accounting for mineral resources

3. A

200 000 300 000

200 000 440 000

200 000 360 000

200 000 _

Capitalised

1 500 000 [1 200 000 + 300 000 c/fwd] _

580 000 [(2 x 240 000) + 100 000]

240 000

30/06/2025 Expensed

560 000

Capitalised

1 530 000 [280 000 + 600 000 + 650 000]

950 000 [350 000 + (360 000 + 240 000) c/fwd] _

30/06/2023 Expensed Capitalised 30/06/2024 Expensed

34.18

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 34: Accounting for mineral resources Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 34: Accounting for mineral resources Multiple choice questions 1. As per AASB 6 Exploration for and Evaluation of Mineral Resources, mineral resources include:

I. II. III. IV.

Oil Minerals Natural gas Non-regenerative resources

a. I, II and III only b. I, III and IV only c. II, III and IV only *d. I, II, III and IV Answer: d Learning objective 34.2: describe the objective of AASB 6/IFRS 6.

2. AASB 6/IFRS 6 is an example of: a. a not-for-profit standard. *b. an industry specific standard. c. a standard applicable to disclosing entities. d. a differential reporting standard based on size based criteria. Answer: b Learning objective 34.2: describe the objective of AASB 6/IFRS 6.

3. Accounting policies for exploration and evaluation costs should be determined in accordance with which accounting standard? *a. AASB 6. b. AASB 8. c. AASB 106. d. AASB 108. Answer: a Learning objective 34.3: apply the necessary judgement in determining the nature of the activities and related costs considered to be within the limited scope of AASB 6/IFRS 6.

34.1

Testbank to accompany Financial reporting 3e by Loftus et al.

4. Accounting for the acquisition of equipment to be used in the extraction of mineral resources is covered by: a. AASB 6 Exploration for and Evaluation of Mineral Resources. b. AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. *c. AASB 116 Property, Plant and Equipment. d. AASB 138 Intangible Assets. Answer: c Learning objective 34.3: apply the necessary judgement in determining the nature of the activities and related costs considered to be within the limited scope of AASB 6/IFRS 6.

5. The scope of AASB 6 is specifically limited to accounting for: *a. exploration and evaluation expenditures. b. exploration, evaluation and development expenditures. c. pre-exploration, exploration and evaluation expenditures. d. pre-exploration, exploration, evaluation and development expenditures. Answer: a Learning objective 34.3: apply the necessary judgement in determining the nature of the activities and related costs considered to be within the limited scope of AASB 6/IFRS 6.

6. In the context of AASB 6/IFRS 6, E&E stands for: a. evaluation and extraction. b. extraction and exploration. *c. exploration and evaluation. d. exploration and expenditure. Answer: c Learning objective 34.3: apply the necessary judgement in determining the nature of the activities and related costs considered to be within the limited scope of AASB 6/IFRS 6.

34.2

Chapter 34: Accounting for mineral resources Not for distribution in full. Instructors may assign selected questions in their LMS.

7. Which costs are within the scope of AASB 6? a. Development phase expenditure. *b. Exploration and evaluation phase expenditure. c. Pre-exploration and evaluation phase expenditure. d. Both exploration and development phase expenditure. Answer: b Learning objective 34.3: apply the necessary judgement in determining the nature of the activities and related costs considered to be within the limited scope of AASB 6/IFRS 6.

8. Which method of accounting for exploration and evaluation costs is used by most large oil and gas companies? a. The full cost method. b. The appropriation method. *c. The area of interest method. d. The successful efforts method. Answer: c Learning objective 34.4: evaluate the accounting policy options available for exploration and evaluation assets under AASB 6/IFRS 6.

9. Which of the following methods best reflects the traditional concept of an asset? a. The full cost method. b. The appropriation method. c. The area of interest method. *d. The successful efforts method. Answer: d Learning objective 34.4: evaluate the accounting policy options available for exploration and evaluation assets under AASB 6/IFRS 6.

34.3

Testbank to accompany Financial reporting 3e by Loftus et al.

10. Which of the following methods involves capitalising exploration and evaluation costs using a larger cost centre than an area of interest such as a country or region? *a. The full cost method. b. The appropriation method. c. The area of interest method. d. The successful efforts method. Answer: a Learning objective 34.4: evaluate the accounting policy options available for exploration and evaluation assets under AASB 6/IFRS 6.

11. Which of the following methods best reflects the volatility inherent in E&E activities? a. The full cost method. b. The appropriation method. c. The area of interest method. *d. The successful efforts method. Answer: d Learning objective 34.4: evaluate the accounting policy options available for exploration and evaluation assets under AASB 6/IFRS 6.

12. Subsequent to initial recognition, E&E assets are required to be measured: a. under the cost model. b. under the revaluation model. c. at the lower of the cost and fair value. *d. either under the cost model or revaluation model. Answer: d Learning objective 34.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area-of-interest method as set out in AASB 6/IFRS 6.

34.4

Chapter 34: Accounting for mineral resources Not for distribution in full. Instructors may assign selected questions in their LMS.

13. The entry to record an obligation for removal and restoration incurred during the exploration and evaluation (E&E) phase of a mining project is: a. DR E&E asset; CR E&E expense b. DR Removal and restoration expense; CR E&E asset *c. DR E&E asset; CR Provision for removal and restoration d. DR E&E expense; CR Provision for removal and restoration Answer: c Learning objective 32.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area of interest method as set out in AASB 6/IFRS 6.

14. Which of the following is not included as part of the initial cost of exploration and evaluation assets? a. Trenching. b. Geophysical studies. c. Mining acquisition rights. *d. Pre-exploration survey fees. Answer: d Learning objective 34.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area-of-interest method as set out in AASB 6/IFRS 6. 15. The majority of an entity’s obligations for removal and restorations costs are incurred during which phase of a project? a. Evaluation phase. b. Exploration phase. *c. Development phase. d. Technical feasibility phase. Answer: c Learning objective 32.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area of interest method as set out in AASB 6/IFRS 6.

34.5

Testbank to accompany Financial reporting 3e by Loftus et al.

16. The obligation to record a provision for removal and restoration costs arising from mining exploration and evaluation arises through the application of: a. IFRIC 1. b. AASB 6. *c. AASB 137. d. The Framework. Answer: c Learning objective 32.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area of interest method as set out in AASB 6/IFRS 6.

17. Which of the following statements is correct in relation to the use of the revaluation model to subsequently account for E&E assets? a. The revaluation model can only be used to account for tangible E&E assets. *b. The revaluation model can be used for tangible E&E assets where the fair value can be reliably measured. c. The revaluation model can be used for intangible E&E assets where the fair value can be reliably measured. d. The revaluation model can be used for tangible E&E assets only where there is an active market for the assets. Answer: b Learning objective 32.5: analyse costs incurred during the exploration and evaluation phase of extractive activities in order to apply the area of interest method as set out in AASB 6/IFRS 6.

34.6

Chapter 34: Accounting for mineral resources Not for distribution in full. Instructors may assign selected questions in their LMS.

18. Which of the following are included in AASB 6/IFRS 6 as factors indicating the E&E assets may be impaired? I. II. III. IV.

Where there is no budget or plan for the incurrence of further substantial E&E expenditure in the specific area. Whether the exploration rights for the specific area have expired or are expected to expire in the near future and there is no expectation of renewal. Where the entity has established that the cost of the E&E asset is unlikely to be recovered in full from the successful development or sale of the specific area. Where the entity had decided to discontinue E&E activities in the specific area on the basis that such activities have not led to the discovery of commercially viable quantities of mineral resources.

*a. I, II and IV. b. I, II and III. c. I, III and IV. d. II, III and IV. Answer: a Learning objective 32.7: evaluate the appropriateness of continued capitalisation of costs incurred during the exploration and evaluation phase of extractive activities.

19. Which of the following statements in relation to assessing E&E assets for impairment is correct? a. b.

AASB 6/IFRS 6 allows E&E assets to be tested for impairment at the individual asset level. AASB 6/IFRS 6 does not allow the reversal of impairment write-downs made against E&E assets. *c. The level at which and E&E asset is tested for impairment may consist of one or more cashgenerating units. d. AASB 6/IFRS 6 allows the cash-generating unit or group of cash-generating units to which an E&E asset is allocated to be larger than a segment determined in accordance with IFRS 8. Answer: c Learning objective 32.7: evaluate the appropriateness of continued capitalisation of costs incurred during the exploration and evaluation phase of extractive activities.

34.7

Testbank to accompany Financial reporting 3e by Loftus et al.

20. E&E assets are required to be tested for impairment: a. at least annually. *b. when there is an indication that the assets may be impaired. c. prior to reclassification at the end of E&E activities. d. only where commercially feasible reserves are not found through the E&E activities. Answer: b Learning objective 32.7: evaluate the appropriateness of continued capitalisation of costs incurred during the exploration and evaluation phase of extractive activities.

21. Which of the following E&E costs would be classified as intangibles? I. Drilling rights. II. Exploration licenses. III. Equipment inspection costs. IV. Capitalised consumable costs. *a. I, II and IV. b. I, II and III. c. I, III and IV. d. II, III and IV. Answer: a Learning objective 34.8: apply the disclosure requirements of AASB 6/IFRS 6.

22. AASB 6/IFRS 6 requires disclosure of which of the following? *a. Accounting policies relating to E&E assets. b. Impairment write-downs made on E&E assets. c. Financing cash flows relating to E&E activities. d. Accounting policies relating to pre-exploration costs. Answer: a Learning objective 34.8: apply the disclosure requirements of AASB 6/IFRS 6.

34.8

Chapter 34: Accounting for mineral resources Not for distribution in full. Instructors may assign selected questions in their LMS.

23. The IFRS Interpretations Committee issued an interpretation in relation to the accounting for surface mine stripping costs (i.e. removal of rocks, soil and other waste materials to access the relevant mineral deposits) incurred during the production phase. The interpretation proposes: this asset would be referred to as a stripping activity asset (‘the asset’). the asset would initially be recognised at cost plus directly attributable overhead costs. waste removal (stripping) costs would be capitalised during the production phase of a surface mine, if certain criteria are met. *d. all of the options are correct. a. b. c.

Answer: d Learning objective 34.9: discuss the possible future developments related to accounting for the extractive industries.

24. Which of the following is not within the scope of the IASB extractive activities project? a. The definition of reserves and resources. b. Disclosure requirements for reserves and resources. c. Measurement of reserves and resources on initial recognition as an asset. *d. Whether to expense or capitalise costs recognised after recognition of reserves and resources as assets. Answer: d Learning objective 34.9: discuss the possible future developments related to accounting for the extractive industries.

34.9

Solutions manual to accompany

Financial reporting 3rd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 35: Agriculture

Chapter 35: Agriculture Comprehension questions 1. Explain why IAS 41 was a controversial standard when it was issued. IAS 41 was a controversial standard when it was first issued, mainly because of the requirement to measure assets related to biological activity at fair value, with movements in fair value to be recognised in the statement of comprehensive income as gains or losses. The requirement to measure biological assets poses problems in that it can be difficult to determine reliable fair values for some biological assets such as immature trees. There can also be valuation problems in distinguishing between processing after harvest of biological assets, and biological transformation. The key points can be summarised as follows. • • •

Requirement to measure biological assets at fair value through income statement. Difficulty in determining reliable fair values for some biological assets. Difficulty distinguishing between processing after harvest and biological transformation.

2. Explain why the concept of ‘control’ is problematic when applying the recognition criteria of AASB 141/IAS 41. The concept of control can be problematic in the agricultural industry where leases or management agreements are involved. This occurs because the definition of ‘agricultural activity’ in AASB 141/IAS 41 deals with the ‘management’ by an entity of the biological transformation of biological assets, thus it is possible to confuse management with control. The definitions provided in AASB 141/IAS 41 describe ‘management’ as the facilitation of biological transformation by enhancing the conditions necessary for the process to take place. Some key points to note in the understanding of control are as follows. • • •

Control is a key condition in the definition of an asset. Control is not defined consistently in IFRS. Control may or may not be linked to risks and rewards of ownership.

The scope of AASB 141/IAS 41 refers to “agricultural activity” which refers to the management of biological assets, not the control of such assets. Illustrative Example 35.1 assists in the differentiation between management and control of biological assets. 3. What are the arguments for and against the use of fair value as the measurement basis for biological assets and agricultural produce? Explain why the IASB decided to require fair value. The IASB decided that fair value provided more relevant information and that this information was more comparable and understandable. It also decided that fair value could usually be reliably determined but made an exception for cases where this was not possible (AASB 141/IAS 41, paragraph 30). The exception recognised that fair value may not be able to be measured reliably where market prices are not available and alternative estimates of fair value are determined to be clearly unreliable. However, this exception can only be applied on initial recognition of the biological asset. © John Wiley and Sons Australia Ltd, 2020

35.2

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

The arguments for and against the use of fair value for measuring biological assets are summarised in Table 35.2. The arguments for include that: many biological assets are traded in active markets and active markets provide relevant and reliable information; long production cycles mean that the change in asset value is more relevant than a period-end measure of costs incurred; valuation based on costs is arbitrary when there are joint products and joint costs; and, different sources of animals and plants (e.g. home-grown or purchased) should not be measured differently which would occur if the historic cost valuation model were used rather than the fair value model. 4. How is the risk that future cash flows pertaining to biological assets may not eventuate as predicted taken into account when determining the fair value of a biological asset using the present value of net cash flows method? The risk that future cash flows from biological assets may not eventuate as predicted is taken into account when determining the fair value from such assets, by either using reduced cash flows or a higher discount rate, but not both (otherwise the effect of possible variations in anticipated cash flows would be double-counted).

5. How does a gain arise on initial recognition of a biological asset or agricultural produce? In the case of biological assets a loss may arise on initial recognition because costs to sell (which are deducted in arriving at fair value) may exceed the fair value. A profit may arise on initial recognition when, for example, an animal is born. Gains or losses on initial recognition of agricultural produce may arise as a result of harvesting. For example, say the fair value of a tonne of grapes is $20 and the fair value of the related grape vines is $100 at the date of harvest. On initial recognition, a loss of $20 is recognised to record the fair value of the grapes removed from the vines. These gains and losses are sometimes referred to as “day one [initial] gains or losses” and arise due to the application of the fair value model of valuation.

6. Why is agricultural produce not remeasured to fair value during a reporting period? Agricultural produce is not remeasured to fair value during a reporting period because it is recognised and measured only at the point of harvest (see AASB 141, paragraphs 1(b) and 13) and this amount becomes its cost for ongoing measurement. AASB 141 Paragraph 1: • ‘This standard shall be applied to account for the following when they relate to agricultural activity: (b) agricultural produce at the point of harvest.’ AASB 141 Paragraph 13: • ‘Agricultural produce harvested from an entity’s biological assets shall be measured at its fair value less costs to sell at the point of harvest. Such measurement is the cost at that date when applying AASB 102 or another applicable standard’. Thus there is no remeasurement to fair value of agricultural produce, whereas biological assets are remeasured to fair value at each end of reporting period. © John Wiley and Sons Australia Ltd, 2020

35.3

Chapter 35: Agriculture

7. Discuss the three-level hierarchy for determining fair value under AASB 13/IFRS 13 in the context of the ruling in respect of immature salmon. The Committee of European Securities Regulation (CESR) ruled that there was an active market for immature slaughtered salmon, and that an immature slaughtered salmon was “similar” (in accordance with paragraph 18(b) of AASB 141/IAS 41) to an immature live salmon. In the absence of observable prices in the active market for live salmon, the fair value of live salmon should be determined based on observable prices in an active market for the same category of slaughtered salmon. The context of CESR’s decision is presented in Figure 35.1. The implications of CESR’s ruling are that: • The value would need to be adjusted for the fact that one salmon was alive and the other was slaughtered but both had the same weight; and that, • a company could not say that fair value of an immature live salmon could not be reliably measured when there was an active market for similar assets – i.e. immature slaughtered salmon.

35.4

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Case studies Case study 35.1 Accounting for immature crops The manager of Smithton Ltd does not believe that the company’s immature crops belong in the calculation of biological assets, as there is no active market for immature crops, and they are not yet at the point of harvest. Required Advise the manager whether this position meets the requirements of AASB 141/IAS 41. Under AASB 141/IAS 41, immature biological assets should be measured at fair value, based on the values taken from an existing active market for similar assets. Thus, under the fair value measurement rules, fair value should be estimated based on observable values in the similar active markets. The alternative (estimating fair value as present value of future net cash flows) should only be used if market prices for similar assets in an active market are not available. Under AABS 13/IFRS 13, fair value should be determined, considering the present location and condition of the assets (e.g. weight, quality at balance sheet date). In calculating the amount to be recorded, the value should consider fair value less costs to sell (e.g. on growing, harvesting, freight costs to market).

35.5

Chapter 35: Agriculture

Case study 35.2 Interaction between standards The accountant of Fingal Ltd has presented land and a pine tree plantation as a single asset on the basis that the two are interrelated, with one component being worth almost nothing without the other. Required Advise the account-ant whether this position is acceptable. Under the accounting standards this position is not acceptable. AASB 141 does not apply to land related to agricultural activity, and should be considered under AASB 116 (as property, plant and equipment) or AASB 140 (as investment property). AASB 116 allows a choice between the cost and revaluation method, and is perhaps most relevant given there are no details in the question to suggest the land is investment property. If the land is considered investment property, then it should be measured at either cost or fair value (see Table 35.3 for a summary of the options available).

35.6

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Case study 35.3 Control The lessee of West Coast Wines Ltd manages the vineyards under a lease. It has included vineyards as an asset in its accounting records as it is responsible for the management and harvest. Required Discuss whether this approach is acceptable under AASB 141/IAS 41. Grape vines are classified as bearer plants, and as such are excluded from the scope of AASB 141. However, produce growing on the plants is within the scope of AASB 141/IAS 41. To determine the appropriate accounting treatment of the vineyards or grapes, the following issues should be considered: control over the assets, risks rewards, and benefits relating to the asset. While the question provides only limited detail, an operating lease suggests West Coast Wines Ltd does not have legal ownership (and thus control) over the vineyards or grapes. As such, it is unlikely the company is exposed to the associated risks, rewards, and benefits. On that basis, the approach does not seem acceptable. Note: It is important to distinguish between control and management, as ownership and control gives rise to the right to hold or sell an asset, which is different to the rights available under an operating lease.

35.7

Chapter 35: Agriculture

Application and analysis exercises Exercise 35.1 Agricultural activity — definitions State which of the following meets the definition of ‘agricultural activity’ in AASB 141/IAS 41. Give reasons for your answer. 1. Pig farming 2. Ocean fishing 3. Clearing forests to create farmland 4. Salmon farming 5. Managing vineyards (LO2) The definition of “agricultural activity”, contained within AASB 141/IAS 41 paragraph 6, includes three components: (1) capability to change; (2) management of change; and (3) measurement of change. 1. Pig farming: • Yes – this activity meets the three components of AASB 141/IAS 41 paragraph 6 (capability to change, management of change, measurement of change). 2. Ocean fishing: • No – this activity does not meet the AASB 141/IAS 41 paragraph 6 requirement that there be conditions facilitating the management of change. 3. Clearing forests to create farmland: • No – this activity does not meet the AASB 141/IAS 41 paragraph criteria that there is management of change. 4. Salmon farming: • Yes – this activity meets all three components contained within the definition of agricultural activity in AASB 141/IAS 41 paragraph 6. 5. Managing vineyards: • Yes – this activity meets all three components contained within the definition of agricultural activity in AASB 141/IAS 41 paragraph 6.

35.8

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Exercise 35.2 Agricultural activity — definitions State whether the following are (a) biological assets, (b) agricultural produce, (c) products that are as a result of processing after harvest or (d) bearer plants. 1. Living pigs 2. Living sheep 3. Pigs’ carcasses 4. Pork sausages 5. Trees growing in a plantation forest 6. Furniture 7. Olive trees 8. Olives 9. Olive oil 10. Vines growing in a vineyard (LO2) ‘Biological assets’ are defined in AASB 141/IAS 41 paragraph 5 as ‘a living animal or plant’. ‘Agricultural produce’ is defined in AASB 141/IAS 41 paragraph 5 as ‘the harvested product of the entity’s biological assets.’ ‘Harvest’ is defined in AASB 141/IAS 41 paragraph 5 as ‘the detachment of produce from a biological asset or the cessation of a biological asset’s life processes’. See Table 35.1 for examples illustrating the distinction between biological assets, agricultural produce and other products that are a result of processing after harvest. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Living pigs: Living sheep: Pigs’ carcasses: Pork sausages:

(a) Biological asset. (a) Biological asset. (b) Agricultural produce. (c) Other products that are a result of processing after harvest. Trees growing in a plantation forest: (a) Biological asset. Furniture: (c) Other products that are a result of processing after harvest. Olive trees: (a) Biological asset. Olives: (b) Agricultural produce. Olive oil: (c) Other products that are a result of processing after harvest. Vines growing in a vineyard: (a) Biological asset.

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Chapter 35: Agriculture

Exercise 35.3 Application of theory to accounting Acres Ltd is a listed company with a large dairy farm. The fair value of the company’s herd of cows declined as a result of a drop in the price of milk. The managing director is very worried about the impact that recognising the loss might have on the company’s share price, claiming ‘Investors will think the company is performing poorly, even though we have long-term contracts for delivery of milk.’ The managing director suggests disclosing the decline in fair value in the notes instead of recognising it in the financial statements. Required Prepare a response to the managing director addressing: 1. whether her suggestion complies with the requirements of AASB 141/IAS 41 2. the potential implications of the efficient market hypothesis for the impact of the recognition of the loss on the company’s share price, noting any assumptions in your argument 3. the implications of the efficient market hypothesis for the managing director’s strategy of disclosing the change in fair value in the notes instead of recognising it in the financial statements. (LO3) The question asks students to prepare a response to the managing director, specifying matters to be addressed. Accordingly, the suggested answer provides a bit more background and context, consistent with communication to a non-accountant. 1. Acres Ltd is required to apply Australian accounting standards in the preparation of its financial statements. AASB 141 Agriculture requires the company’s herd or cows to be measured at their fair value less cost to sell and any gains or losses arising from the remeasurement of the herd must be recognised in profit or loss. Accordingly, merely disclosing the current fair value in the notes would not comply with Australian accounting standards. 2. However, the accounting treatment of the change in the fair value is unlikely to have any impact on Acres Ltd’s share price because the company’s shares are trading in a market that is best described as efficient in the semi-strong form. According to the efficient market theory, the share price reflects all publicly available information. This implies that any information signalled by reporting the fair value of the herd would be reflected in the share price irrespective of whether it was presented in the statement of financial position or disclosed in the notes as both are publicly available. Further, the information about the price of milk is publicly available information. Thus, in accordance with the efficient market theory, it is reasonable to expect that the share price has already impounded the estimated effect of falling milk prices on the company’s future cash flows. The information reported in the financial statements would thus be confirmatory with respect to the impact on the value of the company’s assets. 3. Even if it were permitted by accounting standards, the strategy of disclosing in the notes instead of recognising the loss in fair value in profit or loss is unlikely to succeed in an efficient market. The strategy assumes that investors are naïve and fixate on reported numbers, ignoring the manner in which those numbers have been calculated. This view of investor behaviour is

35.10

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

referred to as the mechanistic hypothesis, which is inconsistent with market efficiency. In an efficient market, we would expect share prices to capture all publicly available information about the decline in the value of assets, irrespective of whether it is recognised in profit or loss or disclosed in the notes. As you have noted, Acres Ltd’s future cash flows may be less affected by the declining price of milk because the company has long-term contracts with customers for the supply of milk. To the extent that this is private information, it is unlikely to be reflected in the share price. Investors may overestimate the negative impacts on the declining price of milk if they are not aware of the price protection achieved by the long-term contracts. Accordingly, it may be beneficial to disclose this information in the notes to the financial statements, or through other means such as the operating and financial review section of the annual report, so that this competitive advantage can be reflected in the company’s share price.

35.11

Chapter 35: Agriculture

Exercise 35.4 Agricultural activity — measurement For each of the items in exercise 35.2 state whether they would be measured (a) at fair value under AASB 141/IAS 41 (b) at the lower of cost and net realisable value under AASB 102/IAS 2 or (c) at cost or fair value under AASB 116/IAS 16. 1. Living pigs 2. Living sheep 3. Pigs’ carcasses 4. Pork sausages 5. Trees growing in a plantation forest 6. Furniture 7. Olive trees 8. Olives 9. Olive oil 10. Vines growing in a vineyard (LO3, LO4 and LO5) For items that are either biological assets or agricultural produce included in the scope of AASB 141/IAS 41, the measurement model to be applied is fair value. For products that are a result of processing after harvest, generally AASB102/IAS 2 Inventories applies. For biological assets which are excluded from AASB 141/IAS 41 (e.g. bearer plants), the measurement model of cost or fair value under AASB 116/IAS 16 applies. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Living pigs: Living sheep: Pigs’ carcasses: Pork sausages: Trees growing in a plantation forest: Furniture: Olive trees: Olives: Olive oil: Vines growing in a vineyard:

(a) Fair value (biological asset). (a) Fair value (biological asset). (a) Fair value (agricultural produce). (b) LCM (other products). (c) Cost or fair value (bearer plant). (b) LCM (other products). (c) Cost or fair value (bearer plant). (a) Fair value (agricultural produce). (b) LCM (other products). (c) Cost or fair value (bearer plant).

35.12

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Exercise 35.5 Fair value determination Which of the following is included in determining the fair value of a biological asset that does not have an active market and which has a 5-year production cycle? 1. Revenue from sale in 5 years’ time 2. Costs of growing for 5 years 3. Financing costs on borrowings taken out to fund the growing costs 4. Taxation on taxable income generated from sale in 5 years’ time 5. Discount rate that reflects expected variability in cash flows (LO5 and LO6) 1. Revenue from sale in 5 years’ time: • Yes – AASB 141/IAS 41 paragraph 20 includes the present value of net cash flows in the determination of fair value. 2. Costs of growing for 5 years: • Yes – AASB 141/IAS 41 paragraph 20 includes the present value of net cash flows in the determination of fair value. 3. Financing costs on borrowings taken out to fund the growing costs: • No – financing costs are specifically excluded from fair value under AASB 141/IAS 41 paragraph 22. 4. Taxation on taxable income generated from sale in 5 years’ time: • No – taxation is specifically excluded from the determination of fair value AASB 141/IAS 41 paragraph 22 5. Discount rate that reflects expected variability in cash flows: • Yes – AASB 141/IAS 41 paragraph 23 requires the use of a discount rate that reflects the variability in expected cash flows.

35.13

Chapter 35: Agriculture

Exercise 35.6 Fair value determination Wynyard Ltd owns a plantation forest. As at the end of the reporting period the fair value of the plantation forest including the land was $10.5 million. Wynyard Ltd needs to determine the fair value of the trees excluding the land to comply with AASB 141/IAS 41 at the end of its reporting period. How does Wynyard Ltd determine the fair value of the trees? (LO5 and LO6) Wynyard Ltd needs to determine the fair value of the land excluding the trees and then deduct that value from $10.5 million.

35.14

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Exercise 35.7 Accounting for a government grant Severn Oaks Ltd engages in agricultural activities and measures its biological assets at fair value in accordance with AASB 141/IAS 41. In 2022, Severn Oaks Ltd received a grant of $475 000 from the government. The grant was notified to the company on 31 March 2022. The terms and conditions of the grant were as follows. This grant is effective from 1 July 2022. Severn Oaks Ltd must continue to employ staff from Area A in its agricultural activities until at least 30 June 2027. If Severn Oaks Ltd ceases to employ staff from Area A before that date then Severn Oaks Ltd shall immediately repay the grant. The amount to be repaid shall be calculated according to the following formula. A = B − (C × D) where: A = amount to be repaid B = amount of initial grant C = number of years the company has employed staff in Area A D = $85 000. The end of Severn Oaks Ltd’s reporting period is 30 June. The grant was received on 15 April 2022. Required Prepare the journal entries to account for the grant by Severn Oaks Ltd for the years ended 30 June 2022 and 30 June 2023, assuming Severn Oaks Ltd complies with the conditions of the grant. (LO7) 31 March 2022 Grant is notified. Nothing is recorded since the grant is effective from 1 July 2022. 15 April 2022 Cash

Dr 475 000 Performance obligation Cr 475 000 (To record receipt of the grant and defer the full amount as the grant is not yet effective and the conditions of the grant have not yet been met.) 30 June 2023 Performance obligation Dr 85 000 Income Cr 85 000 (To record one year’s performance under the conditions of the grant.)

35.15

Chapter 35: Agriculture

Exercise 35.8 Disclosure of biological assets State whether each of the following is true or false. 1. Companies applying AASB 141/IAS 41 must disclose separately the fair value (less costs to sell) of mature and immature biological assets. 2. A vineyard planted on land classified as an investment property by the owner must be recognised and measured as part of that investment property. 3. An entity availing itself of the exemption in paragraph 30 of AASB 141/IAS 41 for a particular biological asset must apply AASB 120/IAS 20 if it receives a government grant in respect of that asset. 4. If agricultural produce cannot be reliably measured then it may be accounted for at cost under paragraph 30 of AASB 141/IAS 41. (LO9) 1. Companies applying AASB 141/IAS 41 must disclose separately the fair value (less costs to sell) of mature and immature biological assets: • This is false (encouraged but not required – AASB 141/IAS 41 paragraph 43). 2. A vineyard planted on land classified as an investment property by the owner must be recognised and measured as part of that investment property: • False (the land must be recognised and measured under AASB 140/IAS 40 and the vineyard is recognised and measured under AASB 116/IAS 16). 3. An entity availing itself of the exemption in paragraph 30 of AASB 141/IAS 41 for a particular biological asset must apply AASB 120/IAS 20 if it receives a government grant in respect of that asset: • True (AASB 141 paragraph 37). 4. If agricultural produce cannot be reliably measured then it may be accounted for at cost under paragraph 30 of AASB 141/IAS 41. • False (paragraph 30 applies only to biological assets).

35.16

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Exercise 35.9 Preparation of financial statements applying AASB 141/IAS 41 Heavenleigh Ltd owns sheep and the end of its reporting period is 30 June. The sheep are held to produce wool. At 1 July 2022, Heavenleigh Ltd had 8000 sheep and 400 lambs, with a fair value (less costs to sell) of $180 per sheep and $60 per lamb. During the year ended 30 June 2023 the following occurred. • 500 new sheep were purchased at $190 each. • 120 lambs matured into sheep. • 8 lambs died. • 50 lambs were born. • 300 sheep were sold for $260 each. • Salaries and other operating costs were $82 000. Heavenleigh Ltd owns the farmland, which was purchased for $2.5 million. The land is measured at fair value using the revaluation model under AASB 116/IAS 16. As at 30 June 2023, the fair value of the land was assessed at $3.6 million ($3.2 million as at 30 June 2022). Heavenleigh Ltd also has plant and equipment, which was purchased for $1 million and is depreciated over its expected useful life of 10 years. As at 1 July 2022, the plant and equipment was 2 years old. As at 30 June 2023, the fair value (less costs to sell) is determined as $260 per sheep and $65 per lamb. Heavenleigh Ltd has determined that these are the appropriate fair values to use for the purposes of transfers, births and deaths of lambs. The price change between a lamb and a sheep at the time of maturity during the year was estimated to be $205. During the year Heavenleigh Ltd produced wool with a fair value less costs to sell of $564 000. Required Prepare the relevant extracts from the statement of profit or loss and other comprehensive income and statement of financial position required by paragraph 50 of AASB 141/IAS 41 for Heavenleigh Ltd in accordance with AASB 141/IAS 41 for the year ended 30 June 2023. Show all workings. (LO10) 1. Reconciliation of movements in livestock: Sheep Balance as at 1 July 2022 Purchases Sales Transfer to sheep Births Deaths Balance as at 30 June 2023 Increase in fair value - attributable to physical change - attributable to price change

8 000 500 (300) 120

Fair value $ 1 440 000 95 000 (78 000) 7 800

8 320

2 163 200 23 400 675 000

Lambs 400 --(120) 50 (8) 322

Fair value $ 24 000

(7 800) 3 250 (520) 20 930 5 250

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Chapter 35: Agriculture

2. Reconciliation of movements in fair value – sheep: Physical balance (assuming FIFO) Change in fair value Opening balance: 8 000 @ $180 Sold: 300 @ $260 300 @ $80 Balance: 7 700 @ $180 Year end: 7 700 @ $260 7 700 @ $80

$616 000

Purchased: 500 @ $190 Year end: 500 @ $260 Total attributable to fair value changes

$35 000 $675 000

500 @ $70

Lambs: 120 @ $65 Year end: 120 @ $260 120 @ $195 Total attributable to physical changes 3. Reconciliation of movements in fair value – lambs: Physical balance (assuming FIFO) Change in fair value Opening balance: 400 @ $60 Transfer: 120 @ $65 120 @ $5 Balance: 280 @ $60 Year end: 280 @ $65 280 @ $5 Born: 50 @ $65 50 @ $65 Total attributable to fair value changes Died: 8 @ $65 8 @ $65 (all value lost) Transfer 120 @ $65 Total

Total $24 000

$23 400 $23 400 Total $600 $1 400 $3 250 $5 250 $(520) $(7 800) $3 070

4. Property and equipment: Land measured at revalued amount through equity under the revaluation model of AASB 116/IAS 16. Increase in fair value is $3 600 000 – $3 200 000 = $400 000. Plant and equipment Cost Accumulated depreciation as at 1 July 2022 Balance as at 1 July 2022

$ 1 000 000 $ (200 000) $ 800 000

Annual depreciation

Balance as at 30 June 2022 Land Plant and equipment Total

$ 3 200 000 $ 800 000 $ 4 000 000

Balance as at 30 June 2023 Land Plant and equipment Total

$ 3 600 000 $ 700 000 $ 4 300 000

100 000

HEAVENLEIGH LTD

35.18

Solutions manual to accompany Financial reporting 3e by Loftus et al.. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

Extract from statement of profit or loss and other comprehensive income for the year ended 30 June 2023 $ 564 000

Fair value of wool produced Net gains arising from changes in fair value less costs to sell of livestock (Note y)

703 130

Depreciation expense Other operating expenses

(100 000) (82 000)

Profit from operations Income tax expense Profit after income tax

1 085 130 xx xx

HEAVENLEIGH LTD Extract from statement of financial position as at 30 June 2023 Notes Assets Non-current assets Livestock – immature Livestock – mature Subtotal – biological assets Property and equipment

30 June 2023 $

30 June 2022 $

20 930 2 163 200 2 184 130 4 300 000

24 000 1 440 000 1 464 000 4 000 000

Note y – biological assets: Reconciliation of carrying amounts of livestock: Carrying amount at 1 July 2022 Increases due to purchases Increase in fair value less costs to sell - attributable to price changes - attributable to physical changes Total increase in fair value less costs to sell Decreases due to deaths Net increase in fair value Decreases due to sales

$1 464 000 95 000 680 250 23 400 703 650 (520) 703 130 (78 000)

Carrying amount as at 30 June 2023

$2 184 130

35.19

Testbank to accompany

Financial reporting 3rd edition by Loftus et al.

Not for distribution. Instructors may assign selected questions in their LMS.

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

Chapter 35: Agriculture Multiple choice questions 1.

Which of the following are reasons why the IASC felt that agriculture was an industry that needed its own industry specific standard? I. II. III. IV.

Agriculture was considered to be an emerging industry at that time. The specific exclusion of assets related to agricultural activity from other standards. The nature of agricultural activity had created uncertainty or conflicts when applying traditional accounting models. Accounting guidelines for agricultural activity previously developed by national standard setters had been piecemeal.

a. I, II and III b. I, III and IV *c. II, III and IV d. III and IV only Answer: c Learning objective 35.1: explain the background to the development of AASB 141/IAS 41. 2.

Which standard was issued in 2011 that amended AASB 141/IAS 41?

*a. AASB 13 Fair Value Measurement b. AASB 101 Presentation of Financial Statements c. AASB 15 Revenue from Contracts with Customers d. AASB 6 Exploration for and Evaluation of Mineral Resources Answer: a Learning objective 35.1: explain the background to the development of AASB 141/IAS 41.

35.1

Testbank to accompany Financial reporting 3e by Loftus et al.

AASB 141/IAS 41 applies to accounting for which of the following when they relate to agricultural activity? I. II. III. IV.

Biological assets. Government grants. Agricultural produce. Land related to agricultural activity.

a. I, II and IV. *b. I, II and III. c. II, III and IV. d. I, III and IV. Answer: b Learning objective 35.2: distinguish between agricultural activities, agricultural produce and biological assets.

Each of the following are agricultural activities except for:

a. Oyster farming. b. Pearl farming. c. Fish farming. *d. Ocean fishing. Answer: d Learning objective 35.2: distinguish between agricultural activities, agricultural produce and biological assets. 5.

Which of the following meets the definition of agricultural produce?

*a. Milk. b. Cheese. c. Yoghurt. d. Dairy cattle. Answer: a Learning objective 35.2: distinguish between agricultural activities, agricultural produce and biological assets.

35.2

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

AASB 141/IAS 41 considers that there are three common features to agricultural diversity. These three features are: I. II. III. IV.

Capability to change. Change transformation. Management of change. Measurement of change.

a. I, II and III b. I, II and IV *c. I, III and IV d. II, III and IV Answer: c Learning objective 35.2: distinguish between agricultural activities, agricultural produce and biological assets. 7.

AASB 141/IAS 41 defines an agricultural activity as the management by an entity of the biological transformation and harvest of biological assets:

a. for sale; b. into additional biological assets; c. for conversion into agricultural produce. *d. all of the above. Answer: d Learning objective 35.2: distinguish between agricultural activities, agricultural produce and biological assets. 8.

Which of the following is a product resulting from agricultural produce?

a. Milk. b. Wool. *c. Sugar. d. Cotton. Answer: c Learning objective 35.3: explain the different accounting treatment required before and after harvest.

35.3

Testbank to accompany Financial reporting 3e by Loftus et al.

Under AASB 141/IAS 41, which of the following is a biological asset?

*a. Fruit trees. b. Picked fruit. c. Tinned fruit. d. Processed fruit. Answer: a Learning objective 35.3: explain the different accounting treatment required before and after harvest. 10. Which of the following statements is incorrect? a. Biological transformation is facilitated by management. b. Management is a key part of the definition of agricultural activity under AASB 141/IAS 41. c. There is a link between management and control of a biological asset. *d. Management is a key part of the recognition criteria for biological assets and agricultural produce. Answer: d Learning objective 35.4: explain the recognition criteria for biological assets and agricultural produce. 11. The recognition criteria contained within AASB 141/IAS 41 in relation to recognition of a biological asset or agricultural produce as an asset includes all the following except for: *a. The asset has physical form. b. The fair value or cost can be reliably measured. c. The entity controls the asset as a result of past events. d. It is probable that future economic benefits associated with the asset will flow to the entity. Answer: a Learning objective 35.4: explain the recognition criteria for biological assets and agricultural produce.

35.4

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

12. AASB 141/IAS 41 requires that biological assets be measured on initial recognition and at the end of each reporting period: a. at fair value less costs to sell. b. at fair value less costs to sell at the point of harvest. c. at fair value less estimated costs to sell at the point of harvest. *d. at fair value less costs to sell, except where the fair value cannot be measured reliably. Answer: d Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce. 13. Which of the following is not a cost to sell? a. Transfer taxes and duties. b. Levies by regulatory agencies. *c. Transport costs to get assets to a market. d. Commissions to brokers and dealers. Answer: c Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

14. When determining the fair value of biological assets when there is no market price for that asset in its present condition AASB 141/IAS 41 requires that: a. b. c.

the entity uses sector benchmarks. the entity measures the asset at cost. the entity uses the contract prices for recent sales of similar assets adjusted for the effects of biological transformation. *d. the entity uses the present value of expected net cash flows from the asset discounted at a current market-determined rate. Answer: d Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

35.5

Testbank to accompany Financial reporting 3e by Loftus et al.

15. Pure Milk owns dairy cattle. The market value of the cattle is calculated by reference to the litres of milk able to be produced and the lactation rate of the cows. The cattle are regularly sold at auction. Costs incurred to transport the cattle to auction are $3000 per truck. Each truck can transport approximately 100 cattle. Number of mature cows held at 30 June 2021 Average litres of production per cow Lactation rate Price per litre

16 000 10 000 litres 70% 30 cents

The market value for each cow at 30 June 2021 is: a. $2000. *b. $2100 c. $3000. d. $3360. Answer: b Feedback: 10 000L x 70% x $0.30 = $2100 Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

16. The entry required when an animal is born on a pig farm is: a. DR Agricultural produce CR Profit and loss

*b. DR Biological asset CR Profit and loss

c. DR Profit and loss CR Biological asset

d. DR Profit and loss xx CR Agricultural produce

Answer: b Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

35.6

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

17. At 30 June 2021 the fair value of Green Valley’s vineyard is $2.25 million. At 30 June 2022 the following information is available: Fair value of vines prior to harvest at 31 March 2022 Fair value of grapes harvested at 31 March 2022 Estimated costs to sell — grapes Estimated costs to sell — vines

$2 400 000 $800 000 $30 000 $40 000

There have been no changes in fair values between 1 April and 30 June 2022. At 30 June 2022, the vines will be recorded in Green Valley’s financial statements at an amount of: a. $1 450 000. b. $1 560 000. c. $2 400 000. *d. $1 600 000. Answer: d Feedback: $2 400 000 - $800 000 Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

35.7

Testbank to accompany Financial reporting 3e by Loftus et al.

18. At 30 June 2021, the fair value of Green Valley’s vineyard is $2.25 million. At 30 June 2022, the following information is available: Fair value of vines prior to harvest at 31 March 2022 Fair value of grapes harvested at 31 March 2022 Estimated costs to sell — grapes Estimated costs to sell — vines

$2 400 000 $800 000 $30 000 $40 000

There have been no changes in fair values between 1 April and 30 June 2022. The entry to recognise the grapes at the point of harvest is: a. DR Agricultural produce — grapes CR Profit and loss

830 000

*b. DR Agricultural produce — grapes CR Profit and loss

770 000

c. DR Agricultural produce — grapes CR Biological asset — vines

800 000

d. DR Agricultural produce — grapes CR Cash CR Biological asset — vines

830 000

770 000

800 000

30 000 800 000

Answer: b Learning objective 35.5: analyse the meaning of ‘fair value’ when applied to biological assets and agricultural produce.

35.8

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

19. Whiting Limited operates a fish farm. AASB 141/IAS 41 requires live immature fish to be valued at: a. either cost or fair value less estimated costs to sell. b. cost due to the absence of an active market for such fish. *c. the fair value less costs to sell based on prices of slaughtered immature fish. d. fair value determined by applying a discount factor to the fair value of live mature fish. Answer: c Learning objective 35.6: explain the practical implications of measuring these assets at fair value, including interpreting the disclosures made by companies applying the standard. 20. It is common for companies applying AASB 141/IAS 41 to: attempt to ‘bury’ the fair value movements attributable to agricultural assets in ‘other expenses’. b. disclose the fair value movements attributable to agricultural assets as part of ‘abnormal’ items. c. remain silent in the financial statements about the fair value movements attributable to agricultural assets, but highlight such items in ‘financial commentaries’. *d. separately disclose the fair value movements attributable to agricultural assets in the statement of profit or loss and other comprehensive income or the notes. a.

Answer: d Learning objective 35.6: explain the practical implications of measuring these assets at fair value, including interpreting the disclosures made by companies applying the standard. 21. Outback Co received a $360 000 grant from the government on 1 July 2022. One of the conditions attached to the grant was that Outback Co had to continue farming in the same location for the next 3 years; otherwise the grant would have to be returned in full. The entry to record the receipt of the grant on 1 July 2022 is: a. DR Cash $360 000; CR Revenue $360 000 *b. DR Cash $360 000; CR Performance obligation $360 000 c. DR Cash $360 000; CR Revenue $120 000; CR Performance obligation $240 000 d. No entry is required as the grant is conditional and cannot be recognised until the conditions attached to the grant are met. Answer: b Learning objective 35.7: examine the interaction between AASB 141/IAS 41 and AASB 120/IAS 20 Accounting for Government Grants and Disclosure of Government Assistance.

35.9

Testbank to accompany Financial reporting 3e by Loftus et al.

22. Which of the following statements in relation to government grants is correct? a.

Government grants for biological assets measured at cost are accounted for under AASB 41 / IAS 41. b. Government grants for biological assets measured at fair value are accounted for under AASB 120 / IAS 20. *c. Government grants for biological assets measured at fair value are accounted for under AASB 141/IAS 41. d. Government grants for biological assets measured at cost are accounted for under AASB 118 / IAS 18. Answer: c Learning objective 35.7: examine the interaction between AASB 141/IAS 41 and AASB 120/IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. 23. With regards to land used for agricultural purposes, increases in fair value over cost is recognised in equity when the land is: a. an investment property measured at cost and accounted for under AASB 140/IAS 40. b. an investment property measured at fair value and accounted for under AASB 140/IAS 40. c. not an investment property, is measured at cost and accounted for under AASB 116/IAS 16. *d. not an investment property, is measured at fair value and accounted for under AASB 116/IAS 16. Answer: d Learning objective 35.8: examine the interaction between AASB 141/IAS 41 and AASB 116/IAS 16 Property, Plant and Equipment and AASB 140/IAS 40 Investment Property. 24. The accounting treatment for land under AASB 116/IAS 16 and AASB 141/IAS 41 differs depending on whether the land is/isn’t an investment property. These differences relate to: I. II. III.

the recording of changes in fair value. the initial measurement of the value of the land. the subsequent measurement of the value of the land.

a. I only b. II only *c. I, II and III d. II and III only Answer: c Learning objective 35.8: examine the interaction between AASB 141/IAS 41 and AASB 116/IAS 16 Property, Plant and Equipment and AASB 140/IAS 40 Investment Property.

35.10

Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

25. Which of the following are required disclosures under AASB 141/IAS 41? I. II. III. IV.

Fair value changes attributable to price changes. Fair value changes attributable to physical changes. Aggregate gain or loss on initial recognition of biological assets. Fair value of agricultural produce harvested during the period, at point of harvest.

*a. III and IV only. b. I, II and III only. c. II, III and IV only. d. I, II, III and IV. Answer: a Learning objective 35.9: describe the disclosure requirements of AASB 141/IAS 41.

26. Which of the following is a required disclosure under AASB 141/IAS 41 in relation to government grants? a.

Unfulfilled conditions and other contingencies attached to the grant and details of grants applied for but not yet granted. *b. The nature and extent of grants recognised, unfulfilled conditions and other contingencies attached to the grant and significant decreases expected in the level of government grants. c. The nature and extent of grants recognised, unfulfilled conditions attached to the grant and significant increases expected in the level of government grants. d. The nature and extent of grants recognised, unfulfilled conditions and other contingencies attached to the grant and details of grants applied for but not yet granted. Answer: b Learning objective 35.9: describe the disclosure requirements of AASB 141/IAS 41.

35.11

Testbank to accompany Financial reporting 3e by Loftus et al.

27. Jersey Co is a company that farms dairy cattle. Jersey Co owns the farmland on which the cattle are located, having purchased it for $3.5 million in 2019. The land is measured at cost under AASB 116/IAS 16. Details of cattle at 30 June 2021 were as follows:

Number Fair value (less estimated costs to sell) per head

Cows 1400 $590

Heifers 200 $210

During the year ended 30 June 2022 the following occurred: 400 new cows were purchased at $610 each 76 heifers matured into cows 10 heifers died 600 cows were sold for $650 each The price change between a heifer and a cow at the time of maturity during the year was estimated to be $400. The following is relevant at 30 June 2022: The land has been valued at $5 million. Jersey Co has determined that the following are the appropriate values to use for the purposes of transfers and deaths of heifers. Fair value less estimated costs to sell: Cows: Heifers:

$720 / head $300 / head

The fair value of cows as at 30 June 2022 is: *a. $433 840 b. $430 440 c. $413 000 d. $408 000 Answer: a Feedback: (1400+400+76-600) x $720 = $918 720 Learning objective 35.10: apply the recognition and measurement requirements of AASB 141/IAS 41 to a simple statement of profit or loss and other comprehensive income and statement of financial position.

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Chapter 35: Agriculture Not for distribution in full. Instructors may assign selected questions in their LMS.

28. Jersey Co is a company that farms dairy cattle. Jersey Co owns the farmland on which the cattle are located, having purchased it for $3.5 million in 2019. The land is measured at cost under AASB 116/IAS 16. Details of cattle at 30 June 2021 were as follows:

Number Fair value (less estimated costs to sell) per head

Cows 1400 $590

Heifers 200 $210

$720 / head $300 / head

The increase in fair value of all livestock attributable to price change is: a. $18 000 b. $182 000 *c. $200 000 d. $176 140 Answer: c Feedback: Increase in FV of Cows due to price changes $182 000 (1400 x ($720-$590)) + Increase in FV of Heifers due to price changes $18 000 (200 x ($300-$210) = $200 000 Learning objective 35.10: apply the recognition and measurement requirements of AASB 141/IAS 41 to a simple statement of profit or loss and other comprehensive income and statement of financial position.

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Testbank to accompany Financial reporting 3e by Loftus et al.

29. Which of the following would be disclosed in the statement of financial position as a biological asset under AASB 141/IAS 41? *a. Pigs. b. Picked fruit. c. Wine. d. Grapes. Answer: a Learning objective 35.10: apply the recognition and measurement requirements of AASB 141/IAS 41 to a simple statement of profit or loss and other comprehensive income and statement of financial position.

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